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MEASURING FINANCIAL LIBERALIZATION IN LATIN AMERICA : AN INDEX OF BANKING ACTIVITY

inancial liberalization, or the opening of domestic financial markets to competition and foreign capital, is a multifaceted process involving a complex of markets and institutions intermediating funds between lenders and borrowers. Despite this relative simplicity, it is difficult to appreciate what the financial system really is in any measurable sense because the combined interactions of financial and economic factors cannot be easily gauged or estimated through individual markets or variables. Moreover, liberalization often also involves restructuring and strengthening of domestic markets to make them more market-friendly and efficient. This study attempts to establish a baseline for evaluating the complex process of financial liberalization in Latin America by focusing on important changes in the banking sector. Ideally, we could construct a measure capable of evaluating the totality of the liberalization process— encompassing changes across financial intermediaries, including institutions engaged in banking and nonbanking activity, bond and equity markets. Thus far, however, the types of data available have essentially limited our measure to capturing the changes in the banking sector. Despite this limitation, the banking sector is a viable proxy for the financial system as a whole because much of the early adjustment in a liberalization process occurs in the banking sector as interest rates are lowered and private credit is made available more broadly. During liberalization, banks may experience substantial gains, but they are also subject to the possibility of substantial losses or crisis as the financial system transitions from a controlled to an open system. Our findings are presented in the Index of Banking Activity (hereafter referred to as the index) covering five countries (Argentina, Brazil, Chile, Mexico, and Peru) and spanning the period from 1980 through 2000. Before our discussion of the index, this paper includes a section highlighting important elements of the financial liberalization literature as well as a brief description of the development of the modern financial system in each country. This study also presents the findings from