The Venezuelan financial crisis of 1994, and the steps taken to rectify it, continue to be a source of much debate.

In this article, former Central Bank President Ruth de Krivoy tells her side of the story. «…BANCO LATINO’S MANAGEMENT HAD STATED THAT IT WOULD NOT GO TO FOGADE, SO THERE WAS NO WAY TO PROVIDE FINANCIAL ASSISTANCE WITHOUT FIRST INTERVENING IT; SINCE THE BANK TO BE ASSISTED MUST AGREE TO TAKE FINANCIAL ASSISTANCE AND SUBMIT TO THE MEASURES DEMANDED OF IT…»

THE FINANCIAL CRISIS OF 1994: OPTIONS AND DECISIONS

The financial crisis of 1994 was a complex and traumatic event in Venezuela’s contemporary history. It arose from the interaction of political, social, and economic circumstances that had been building up for a long time, and it had a powerful impact on the country as a whole.

The Central Bank of Venezuela ful1y shouldered the responsibilities imposed on it by the laws and the Constitution, and did its utmost to cope with the difficulties and help overcome this grave crisis.

To gain clear understanding of this episode, it is essential to consider all the factors involved and specify the decisions the Central Bank was called upon to make in the circumstances it confronted and in accordance with the applicable legal constraints.

THE CENTRAL BANK OF VENEZUELA’S LEGAL POWERS

The Central Bank is a unique public institution and its freedom of action is circumscribed by the laws that regulate it, by express mandate of the Constitution.

The Central Bank of Venezuela Act defines the institution’s mission as follows: to foster monetary stability and the economy’s orderly development, and to ensure continuity in the country’s imitational payments. The Central Bank must see that the payment systems indispensable to orderly economic activity – operates proper! y, and that the banking system continues to perform its function, since the payment systems and monetary policy operate through the banking system’s intermediation.

The Central Bank of Venezuela has two means to protect this fundamental national interest.

The first tool directly at its disposal is monetary policy and the actions it takes as the bank for banks or lender of last resort.

To regulate decisions in this area, the law requires discipline in monetary management, systematic analysis of its results, and transmission of information to the executive and legislative branches of govemmen1..

The conduct of monetary policy is vested in the Central Bank Board, a body expressly required by law to be composed of highly qualified officials.

It can only rely on the best judgment responsibly developed through analysis and examination of the economy’s changing circumstances – and in particular, those of the financial markets.

The Central Bank’s second major sphere of activity is its advisory role. The law authorizes it to recommend the measures it considers best able to prevent disturbances in the operation of the institution itself or the country’s economic or financial life as a whole to the executive branch.

No provision of law empowers the Central Bank to perform functions of inspection, supervision, vigilance, or control over banking activity. Neither does the Central Bank have the power to apply sanctions or penalties.

The law defines the Central Bank of Venezuela as an autonomous institution and docs not give it the power to supervise or control other public agencies involved with the banking system, such as the Superintendence of Banks and FOGADE (Deposits Guarantee Fund).

MONETARY STABILITY AND THE PAYMENT SYSTEMS

The multiple functions performed by the Central Bank are interrelated. What the agency does in search of monetary stability cannot be mechanically or for accounting purposes divorced from what it does to protect the operation of the payment systems.

The efficiency, regularity, and reliability of the payment system is the core of a modern economy. In their simplest form, payments are made in cash. But when bank money becomes predominant, the banking system’s healthy operation is crucial to the payment systems, since the banks must meet their obligations to their depositors – those who produce, consume, save, and invest, and hence comprise the base of a country’s economy – in full and timely fashion.

In view of its fundamental importance and close linkage to monetary policy, the Central Bank of Venezuela (like all other central banks throughout the world) is the agency responsible for the national check clearing system,

Under normal conditions, the clearing system is transparent and visible to the public; it would appear to be nothing but a mechanical procedure of computerized accounting records that must be carried out within a specified time period. But in a crisis, when a major bank or group of banks cannot meet its clearing obligations, the medium of payment loses credibility, the economy’s operation is disturbed, and confidence in the currency is undermined. The free use of money by its owners (the depositors) is prevented, and they react with a flight to quality, putting their funds in the most reliable banks or in external assets. That is the origin of runs on banks, massive transfers of deposits from some banks to others, and capital flight.

The Central Bank of Venezuela, as the agency responsible for the country s monetary stability, must ensure an adequate provision of liquidity to the banking system, The money supply needs to be large enough to facilitate real transactions, but not so large as to spur inflation.

With a strong banking system, monetary policy can be pursued without major constraints. But if the banking system is weak, the central bank’s room for maneuver is limited, and in extreme cases its function of regulating monetary liquidity in order to foster price stability will be subordinated to the need to keep the payment systems operating smoothly. Experience in all countries that have experienced banking crises shows that under such conditions, the central bank’s first duty is to preserve the payment systems, even if that means temporarily putting monetary stability on the back burner.

WHY IS THE BANKING PROBLEM A FISCAL PROBLEM?

The state is responsible for ensuring the reliability of the payment systems. It must therefore make sure all citizens can make free use oftl1eir money. That is why the state supervises, regulates, and controls the banks, and that is why it guarantees bank money by providing deposit insurance and assisting banks in trouble.

If the state should decide at any time that it is better to guarantee the public’s deposits than to allow banks to collapse, its moral obligation toward the public turns into a financial fact, and it assumes a commitment which has consequences for the public treasury. The reason why banking crises always end lip as fiscal problems is that the state – through the government and specialized public agencies – must answer to depositors and make sure the financial system is sound and stable.

Venezuelan law makes the Finance Ministry responsible for fiscal and banking affairs. Moreover, the Banking Act puts FOGADE and the Superintendency of Banks under the Finance Ministry’s administrative authority and requires the Finance Minister to chair the Banking Superintendency’s Higher Council, which has broad powers over key factors in the banking system’s good health and operation, specified in the Banking Act. This principle was ratified by the government’s decision to create the Financial Emergency Board – chaired by the Finance Minister – in June 1994.

THE CENTRAL BANK’S CREDIT FUNCTION

Like all the world’s central banks, the Central Bank of Venezuela is the country’s only institution empowered to create money.

When acting as lender of last resort, the Central Bank is guided by its monetary policy goals. Provision of credit is a normal part of its activities, and helps to reduce undesirable volatility in the financial market and contribute to its orderly development. This function is carried out mainly in the form of operations with banks and other financial institutions, and the terms and collateral required for these credit facilities are regulated by the Central Bank of Venezuela Act.

Consistent with sound central banking principles, the law requires collateral and stresses the short term applicable to Central Bank credits (up to 30 days). Rollovers (for up to a maximum of I 80 days) are subject to the favorable vote of a specified majority of the Board and can only be approved when justified by a bank’s immediate need for liquidity.

This credit function of the Central Bank of Venezuela can also be performed through FOGADE when that agency needs support to achieve its purposes and the Central Bank considers the provision of such suppol1 advisable.

For the Central Bank, financial assistance to FOGADE represents a way to ensure the continuity of the banking system’s operations and safeguard its stability. Without it, the Central Bank would be hard put to cope with extreme liquidity problems at banks whose assets do not provide acceptable collateral for direct Central Bank credits.

For FOGADE, Central Bank advances represent a source of short-term funding which can serve as a b1idge until it takes in sufficient funds in the other ways prescribed by law.

The Central Bank Board must decide whether to grant such advances or not, on the basis of the institution’s objectives and the legal provisions that regulate its credit function. It can do so if they are deemed likely to strengthen financial stability and the proper operation of the payment systems.

There are two legal provisions which empower the Central Bank to grant advances to FOGADE; An examination of the Banking Act as a whole shows that Articles 225 and 314 are complementary provisions.

Article 225 specifies a permanent regime and authorizes the Central Bank to grant advances to FOGADE, at the latter’s request and for the achievement of its purposes. Such advances can have up to a one-year term and are secured by the Fund’s assets or the contributions it will receive in the future.

This article contains several provisions which merit close attention.

First, Central Bank advances to FOGADE can only be made in order to achieve FOGADE’s institutional purpose to distribute financial assistance to ensure liquidity or solvency for banks and financial institutions. When a group of institutions which hold a large part of the system’s total deposit volume is in a state of illiquidity or insolvency, and serious repercussions on the money and foreign exchange markets are threatened, there is no question that the financial system’s stability is in peril, and it is equally clear that FOGADE’s institutional purpose includes the provision of financial assistance, to safeguard the banking system’s stability.

Moreover, Article 225 puts no limit on the amount of funds the Central Bank can advance to FOGADE. The only Limitations refer to the term, the use of the funds, the collateral, and the need for FOGADE to request assistance. Flexibility is further reinforced by exempting the Central Bank from the limitations stipulated in the Central Bank Act in regard to its operations with FOGADE.

Article 314 is in force for a period of three years commencing January l, 1994, and was intended to give us a tool with which to cope with situations that threaten the banking system’s stability. It is therefore unreasonable to assume that it would invalidate a broader provision intended to be permanently applicable.

It has two separate aspects: First, refers to assistance FOGADE can give banks or financial institutions that have not been officially intervened, when needed to safeguard the banking system’s stability.

Second, it allows the Central] Bank to grant advances to FOGADE, for up to two years and with no collateral. Such advances in the aggregate may not exceed double the contributions paid in to FOGADE by the banks and financial institutions during the two preceding semesters whose accounting closure has taken place.

The subsequent Financial Emergency Act confirmed this interpretation by setting no quantitative limit on advances and a requirement for them to be secured by FOGADE’s assets and future receipts from bank contributions, and introduced more flexible rules than the Banking Act bad provided regarding the term and possibility of concessionary interest rates.

It is equally unreasonable to assume that the law would prescribe a regime that (excessively or rigidly) limits the responsible agencies’ ability to act to the point of making it clearly inadequate, or in any event far less effective than under ordinary conditions, to cope with systemic crises.

The experience of all countries which have undergone banking crises shows that their trajectory, cost, and magnitude can never be precisely forecast before they break out or while they are under way, nor can the liquidity needs of the deposit insurance agencies be accurately predicted. As a result, no law on this subject ever predetermines the amounts or subjects the central bank to strict limitations on its function as lender of last resort.

FOGADE has a number of tools at its disposal to obtain the funds needed to meet its obligations to the Central Bank: bank contributions, which were increased from 0.25% to 1% of deposit volume per half in February 1994 and are pledged to the Central Bank; and a Bs. 400 billion contribution from the government under the Emergency Act and subsequent Public Credit Act. The Executive and Congress can decide to make more contributions to FOGADE if they consider it necessary, by including them in the annual budgets. FOGADE can also issue bonds of its own to raise funds from the market, and it received assets as collateral for its assistance to failing banks, whose realization will depend on the circumstances and form in which they are offered. All these resources are fungible and are not tied to specific uses.

The sufficiency of the collateral given to FOGADE by the financial institutions it assisted is up to FOGADE itself to analyze and determine. The Central Bank has nothing to say about that. But it should be kept in mind that a financial salvage agency charged with rescuing failing banks must provide financial assistance secured by whatever assets it considers most appropriate under the circumstances prevailing at the time.

If banks are insolvent, as they were in 1994, by definition they have lost their equity and their assets are insufficient to answer to their depositors; worse yet, the deposits can be demanded immediately while the assets cannot be immediately liquidated. The law clearly reflects an understanding of this fact and prescribes special criteria to determine the value of properties for FOGADE’s operations, since the criteria for selection, valuation, and analysis of collateral by a deposit insurance and bank salvage agency cannot be the same as those applied by a financial institution in its normal lending activity.

It is certainly desirable – but not always possible – for as large a portion as possible of the financial assistance the state distributes in a banking crisis to be backed up by assets of good quality and high value. But the state must respond to the real condition of the country’s financial system; if a solvency crisis has broken out it is because there is a dearth of assets and a loss of equity which cannot be denied. It is then up to the public agencies to minimize that loss through every kind of initiative permitted by the law.

All bank solvency crises are characterized by losses on the assets to which the failing banks’ funds were applied. And it is a general rule in the experience of all countries which have undergone such crises that in distributing such losses, the state ends up shouldering the largest part since it is the pal1y responsible for licensing, regulating, and supervising the banks.

CHRONOLOGY OF EVENTS

The Venezuelan banking system’s structural weaknesses reflect the nature of the country’s banking legislation, the weakness of bank supervision, the country’s macroeconomic conditions, and the practices commonly adopted in managing the banking business.

Studies conducted by the Central Bank of Venezuela in 1992 and 1993, based on information available at that time, revealed a set of weaknesses in the banking system: low solvency ratios, high concentration of credit risk, substantial immobilization of assets, high operating costs, and profitability heavily dependent on extraordinary income. The country’s banks suffered from these problems to varying degrees, and in certain cases there was deterioration over time. The results of these studies were reported timely and in detail to the national government and the successive officials responsible for financial affairs at the time, both verbally and in writing.

The grave political and social disturbances that broke out in 1992 marked by two military coup attempts, a succession of four presidents, numerous episodes of instability, and two elections – complicated the situation and triggered the financial crisis by provoking strong uncel1ainty and distrust regarding the viability, continuity, and validity of any action by the country’s public authorities.

The banking system’s problems intensified in 1993 as the Venezuelan economy fell into a condition of rising inflation, falling investment and flagging economic activity, the pressures on the domestic financial system posed by a government budget deficit and PDVSA’s need to borrow money when the November 27, 1992 military coup attempt made it impossible to obtain international financing, increasing delays in government payments to contractors and suppliers, and difficulty in achieving an orderly financing for the budget deficit due to the virtual cutoff of external financing for the stale.

But despite this, the policies pursued by the Central Bank throughout those difficult times allowed the Venezuelan economy to continue operating without serious disruption and kept the foreign reserves at high levels; the value of the currency was defended and inflation contained; and what is most important, the confidence and respect of the international financia1 community did not erode. The reform of the Central Bank of Venezuela Act that was enacted in December 1992 provided additional support for these accomplishments.

Interest rates rose as a result of .this complex set of economic and political factors. High rates helped to bring the financial markets back to a relatively normal state following each of the destabilizing incidents we had to face. But they imposed an increasingly heavy burden on bank debtors and led to a deterioration of the financial institutions’ credit portfolios, which came to undermine their solvency. That portfolio deterioration only intensified as a result of the serious problems affecting major state-owned enterprises and government agencies (which were heavily indebted to domestic and foreign banks) and growing delays in government payments to contractors and suppliers, as well as holders of internal public bonds.

The steady decline of prices on the Stock Exchange, a reflection of the country’ s economic condition and increasingly negative future expectations, was yet another blow to the banks since it depressed the value of their investments in securities.

And to all this must be added the damage caused by improper management and undesirable practices at some of the nations banks.

Capital flight intensified on several occasions in 1993, especially during the last two months of the year, as the Venezuelan banking system was weakened by the distrust provoked by political factors. The weaker banks were subjected to repeated deposit runs and found it increasingly difficult to attract funds from the public and financing on the interbank market; overnight rates soared to undesirable levels.

The Central Bank did its utmost to find solutions. It kept the incumbent and elected administrations informed – in writing and verbally – about how serious the situation had become, the urgent problems faced by Banco Latino and other banks, the possible outbreak of a crisis and its grave consequences, and the need for coordinated, effective, and timely action by all responsible agencies to cope with the situation. It was a state problem.

In a climate overwhelmed by uncertainty and volatility in the financial markets, and following the exhaustion of all the efforts made to avoid that traumatic event, Banco Latino was excluded from the Clearing House on January 13, 1994, in strict compliance with the legal provisions regulating that activity.

At that point, the Central Bank had no other choice. Banco Latino could not cover its clearing obligations, and the numerous initiatives taken to solve the liquidity and solvency problems of this institution – the country’s second-largest bank – through coordinated action by its stockholders, the private banks, and the state had come to nothing. Moreover, Banco Latino’s management had stated that it would not go to FOGADE, so there was no way to provide financial assistance without first intervening it; since the bank to be assisted must agree to take financial assistance and submit to the measures demanded of it.

Exclusion of a bank from the Clearing House is a Central Bank decision, and it does not necessarily imply the bank’s intervention. The Central Bank notifies the appropriate national government agencies (Finance Ministry, Superintendency of Banks, and FOGADE), and the bank in question can only be readmitted to the Clearing House if the Superintendency of Banks expressly so recommends, after the appropriate corrective measures have been taken. Its readmission should come as soon as possible, to prevent undue losses to depositors, provided the authorities agree that the bank is able to reassume and maintain normal operating conditions.

The size of the losses found in the inspection performed by the Superintendency of Banks after January 14, led to the bank’s intervention on January 16, by decision of the Superintendency’s Higher Council and the Superintendent’s request, as prescribed by law.

Banco Latino and all its sister institutions were shut down. More than Bs.400 billion in funds belonging to the public were frozen, along with more than Bs.30 billion in interbank funds and substantial deposits by government agencies, pension funds, trusts, etc. Two million depositors were directly affected; they were plunged into total uncertainty a mere two weeks before a new administration and Congress were to take office, and remained so for 77 days.

On January 16, short1y before the decision to intervene Banco Latino was made; the incoming administration communicated its approval of that measure (above the options of recapitalization and financial support which had been under consideration) through its officials for economic liaison with the incumbent government.

A massive capital flight and withdrawal of bank deposits – especially from the banks the public perceived as associated with Banco Latino or marred by their own weaknesses – sprang up within a few days. The public was also concerned about the imminent inauguration of a new administration and uncertain about its economic policy direction; rumors of exchange control, currency devaluation, and nationalization of bank deposits proliferated.

The spillover effect typical of banking crises rapidly spread to a group of banks which held more than 30% of the public’s total deposits at the time. The situation was especially serious in certain regions of the country, such as Zulia state where some of the affected banks held nearly all the state government’s deposits, accounts for federal revenue-sharing transfers, municipal government funds, deposits by the oil industry and many of its contractors and suppliers, and more than 60% of the public’s deposits.

These banks underwent a rapid deterioration of liquidity as a result of massive withdrawals of deposits from the public and government agencies (including the oil industry), all of whom were alerted by the freezing of deposits at Banco Latino. Money desks and offshore branches of Venezuelan banks were also subjected to major runs; trust in the latter was undermined by the failure of Latino Curacao N.V., which revealed a hidden mass of off-balance-sheet deposits with very little support on the asset side.

The interbank market was virtually closed to this group of banks, so they had to resort to the unusual practice of securing overnight loans with ad hoc trusts. This only called more attention to their weakness vis-a-vis the rest of the system. They rapidly exhausted their secondary reserves and began to make use of their reserves with the Central Bank.

In coordination with the national government, the Central Bank took steps to attack the banking system’s liquidity problem by stages. The first was to encourage a recirculation of funds within the system itself, from the more liquid to the less liquid institutions, through arrangements which would not threaten the lending institutions’ solvency; this was expected to minimize the expansion of monetary liquidity. Bank reserve requirements were cut in association with this recycling mechanism, a reserve in foreign currency for deposits held in that form was introduced, and an arrangement was set up to support liquidity in the interbank market. At the same time, a number of initiatives were taken by the banks themselves to generate financing for the troubled institutions, secured by assets they would put up under ad hoc trusts. And it became evident that financial assistance through FOGADE might be needed in the future.

The president announced the appointment of the first Intervention Board for Banco Latino on January 20, 1994. He also created an Advisory Council made up of commercial bank presidents, and a set of measures to respond to the crisis – including the intention of setting up an assistance program through FOGADE. In addition, he publicly stated that the entire program had been discussed with the incoming administration, thereby signaling the latter’s supp0l1 for a continuation of the policy being adopted.

But capital flight and deposit runs on certain banks continued, in an atmosphere of instability and distrust of the Venezuelan banking system on the public’s part. The nation’s financial system and payment systems were clearly in danger, as the most seriously weakened banks’ growing illiquidity coincided with a general illiquidity of the banking system as a whole.

There were two ways to respond to such a situation.

One was to refuse to assist the affected banks. That could lead to the disorderly collapse of a number of banks when they could not meet their daily check clearing obligations and were inevitably excluded from the Clearing House and subsequently intervened.

The state’ s obvious inability to manage the Banco Latino crisis and its suspension of operations in a timely and effective way clearly showed that it could not manage the simultaneous intervention of eight banks and the suspension of their’ operations. That would have led to an anarchic and increasingly disorderly process which would further destabilize the money and foreign exchange markets, intensifying the problems already experienced in connection with Banco Latino’ s intervention and shutdown.

The other option was to provide financial support to this group of banks, helping them meet their depositors’ demands while giving the incoming administration and financial authorities time to draw up effective plans to cope with the crisis.

Both options posed risks, but the second seemed a more rational, appropriate, and desirable decision at the time.

The immobilization of more than 50% of the monetary liquidity belonging to the public, the banks, and the State would have had a terribly unfortunate economic impact, especially in regions such as Zulia state with more than three million depositors (individuals, families, companies, and state-owned enterprises) directly hutt, it would also have undermined the country’s institutional, social, and political stability. The public’s reaction to the closing of Banco Latino furnished proof enough of that.

This was exactly what happened later, when the eight assisted institutions were intervened and closed down in June 1994, without a plan to reassure the depositors about access to their money. The Central Bank authorities then judged that the money market was so seriously disturb d as to largely justify the government’s adoption of the set of extraordinary measures including suspension of constitutional rights and imposition of exchange and price controls, even though the volume of deposits in those institutions had by that time fallen from Bs.333 billion at the end of 1993 to just Bs. 158 billion at the time of their intervention.

The assistance program did not exclude the option of intervening assisted banks if the authorities came to the conclusion that the interests of the depositors and the state would be thereby better protected, but sought to prevent interventions without a plan to protect the depositors. The authorities hoped to avoid the disturbances that would be provoked by a suspension of operations that would only magnify the system’s problems without helping to overcome them.

The arrangement whereby the Central Bank would grant advances – in view of the clear insufficiency of FOGADE’s own resources – so that the latter could provide the banks with the liquidity they needed to meet their depositors’ demands was set up on January 25, 1994. The requirements imposed on the banks under Article 314 were intended to make sure the funds were actually used for that purpose.

Assistance had to be distributed to three banks during the program’s first three days. The main reason was to avoid an anarchic collapse of several banks and give the public agencies time to act on the root causes of the banking crisis. The incoming administration was then expected to adopt an economic policy that would put an end to the uncertainty and help stabilize the markets.

On January 29, 1994, the Central Bank Board informed the president elect in writing of how serious the financial and foreign exchange crisis was and recommended a plan of action to cope with it through an early normalization of Banco Latino’s operation a strengthening of the weakest banks, and a similar strengthening of the banking system and the bank supervision and deposit insurance agencies. This communication stressed the urgent need to take action and the desirability of using the new president’s inaugural address as an occasion to announce and adopt new policy measures.

The plan in question, based on the Banking Act which had come into force on January 1,1994, involved the administration, the Superintendency of Banks, FOGADE, the Banco Latino Intervention Board, and the Central Bank. Its adoption was to be preceded by a political announcement by the new administration. The urgency reflected two facts. One was the Banco Latino case, since the passage of time would erode the bank’s value, make it more difficult to recover its assets, and increase the anxiety and anger among the affected population. On the other hand, a prompt and adequate solution would help restore confidence in the banking system and stop the propagation of tile crisis. The second related to the need to take action to strengthen the banks already directly affected by the crisis, since the financial assistance program applied through FOGADE was under way and if the needed measures were not taken soon, the funds distributed through it might be lost.

Four institutions were receiving assistance from FOGADE by February 2.

Pressure on the foreign exchange market eased in February, as the public reacted favorably to the foreign exchange policy announcements contained in the President’s inaugural address. Bank liquidity began to recover and the Central Bank focused on sterilizing the surplus liquidity held by those banks which were receiving the deposits the public continued to withdraw from the weaker institutions. The financing program through FOGADE continued, and the amounts advanced were always strictly in accordance with each bank’s need for cash in order to prevent its exclusion from the Clearing House.

The financial market was still very volatile. The public continued to react to Banco Latino’s shutdown and uncertainty about its deposits, as well as rumors of illiquidity and insolvency involving a number of banks and their presumably imminent exclusion from the Clearing House, receipt of FOGADE assistance, and even intervention and closing.

Congress debated a Financial Emergency bill and negotiated with the government on the appointment of the new FOGADE President and Superintendent of Banks; these appointments were not made until the end of April. At the same time, the original Banco Latino intervention Board was replaced by a second one and several new FOGADE Board members were appointed.

The economy was burdened with major destabilizing factors in the fiscal area. In the first place, the 1994 budget was clearly deep in the red and there was no plan to finance the deficit in an orderly way. There was no policy for Treasury Bill issues, and in fact, the government was redeeming bills as they came due (thereby expanding the money supply), despite its serious Treasury constraints. There was no policy for government deposits in the banking system which might help overcome the crisis; on the contrary, the government’s random actions only complicated the situation still further.

It also became known during those weeks that the government intended to apply a Bank Debit Tax as part of its fiscal program. It was included in the Special Powers Act and enacted on May 1.

It is the experience of all countries which have adopted such a tax that it tends to provoke a dolarization of the economy and financial disintermediation. Repeating Venezuela’s experience in mid-1993, when the mere announcement that such a measure was under consideration provoked a serious disturbance of the foreign exchange market, the new announcements began to have their predictable effect and the Bank Debit Tax can reasonably be assumed to have intensified capital night, changes in the patterns of payments, and more use of cash at the expense of bank deposits, all of which only added to the tendencies arising from the banking crisis itself. The share of monetary liquidity (M2) represented by cash normally about 7% – began to rise sharply in March and then went on to reach 11.05% by December; the volume of cash in the public’s hands expanded from Bs. 118 billion in January 1994 to Bs. 285 billion at the end of the year, more than doubling and reversing the structural trend toward declining use of cash.

The money and foreign exchange markets were also strongly influenced by the government’s successive economic policy announcements, which spoke of heterodox stabilization programs (involving negotiated price setting and stabilization of the exchange rate and interest rates) but did not specify their scope and application. This information and the way it was disseminated only destabilized the markets even more.

The banking system continued to totter and capital flight rapidly eroded foreign reserves.

The Financial Emergency Act enacted on March 10, 1994, engendering two particularly important effects. One was a clarification of the official policy toward Banco Latino and starting a process that was to culminate in its reopening on April 4, on the strength of Bs. 313 billion in FOGADE funds received from the Central Bank. The other was the program for capitalizing FOGADE under the provisions of that act and the subsequent Public Credit Act, which put the state’s contribution at Bs. 400 billion.

Until Banco Latino reopened in April, its depositors and those of related institutions – as well as the society as a whole – were burdened by uncertainty, pressure from street demonstrations, and successive waves of rumors about banks and possible economic measures.

In February, March, and April 1994, the Central Bank Board repeated its verbal and written calls on the administration to take action to change the course of the financial assistance program and give prompt attention to the managerial, solvency, and profitability shortcomings of the affected banks, adopt an adequate plan for government deposits in the banking system, and find a way to finance the management of the financial Crisis by fiscal means which are less destabilizing than monetary actions. It also called for placement of FOGADE bonds on the market, to recirculate monetary liquidity in the hands of the public and relieve the pressure on the Central Bank.

The banking system was still unstable, attacked by successive waves of withdrawals from banks perceived as the weakest at any given time for a variety of reasons. The liquidity needs of the assisted banks varied over time; a few days of progressive normalization were often followed by another run, provoked by the prevailing uncertainty.

In the absence of other options, the financial assistance program was the only way to prevent a breakdown of the payment systems. The subject was discussed by the Banking Superintendency’s Higher Council several times in April, and that body decided to keep the program going until the steps planned by FOGADE and the Superintendency were put into effect. The public was informed of that decision by spokesmen appointed at the successive meetings.

The prolonged period of disturbance eroded the public’s confidence and turned into yet another source of pressure on interest rates and the exchange rate. The movement of deposits from one bank to another also contributed to distorting interest rates.

The money and foreign exchange markets were plunged into an increasingly precarious state, reflecting the prevailing uncertainty and the erosion of the Venezuelan economy under the combination of the banking crisis, the unresolved fiscal problem, and ambiguous macroeconomic policy.

These circumstances undermined the effectiveness of monetary policy.

The banking problem virtually ruled out the manipulation of bank reserve requirements to regulate liquidity, since a large number of banks were operating without reserves, relying on FOGADE assistance and subject to special measures. Open market operations remained as the only monetary regulation tool available, and since there was no program for placement of Treasury bills, government bonds, or FOGADE bonds, the Central Bank’s bonds were the only collateral on hand. The Central Bank strove at all times to minimize the expansion of the money supply provoked by the bank assistance, avoid erratic interest rate and exchange rate fluctuations which would worsen financial instability, and preserve the Bolivar’s free convel1ibility.

The financial assistance program remained in effect until the end of June, since it was considered appropriate by the new Central Bank authorities. It was suspended only when the assisted banks were intervened. The decision as to what to do with those institutions was made many months later.

ADMINISTRATIVE PROCEDURES

All the Central Bank Board’s decisions were unanimous, and enjoyed the support of the director representing the administration throughout the period.

We relied for our decisions on the information the Central Bank generates, regarding bank liquidity, bank reserves, Clearing House movements, and the behavior of the money and foreign exchange markets. The evaluation of the banking system was based on the available financial statements, prepared in accordance with the Banking Superintendency’s regulations. The inaccuracy of some of these statements became known only a long time thereafter, as a result of initiatives taken by the Superintendency, FOGADE, and the ]intervention Boards.

The Central Bank Board’s decision-making process was based on weekly monetary policy programming meetings, where the coming week’s plan of action was formulated in response to an evaluation of liquidity projections, the expected effect of National Treasury and PDVSA operations, and the likely behavior of the foreign exchange and money markets. These analyses always included the effect of the advances to FOGADE. In addition, a large number of meetings were held specifically to discuss the banking situation and the financial assistance program.

All the legal regulations and procedures were followed in providing those advances to FOGADE, as the documentation clearly demonstrates.

WHAT GOOD DID THE CENTRAL BANK’S ADVANCES TO FOGADE DO?

In response to so violent financial crisis, the state had to take firm action to ensure the integrity of depositors’ Bolivar holdings. Only to the extent that such action was clear and strong could Venezuelans and foreigners alike regain confidence in the national financial system.

The disorderly collapse of banks could only bring chaos and a total loss of confidence in the country and its currency. The terrible experience of the Banco Latino crisis was an example of what could happen, and it was all too obvious that a repetition had to be avoided.

In addition, the crisis arose chiefly from the long-standing shortcomings of the state’s supervision of the banking system; its failure to adapt the legal regulations to the country’s evolving needs, and its failure to give the supervisory and deposit insurance agencies the resources they needed. The state could hardly have turned its back on the crisis, when the laws and common sense made it responsible for ensuring the operation of the payment systems and the integrity of the public’s money.

The country was also going through the difficulties of a political transition and the imminent formulation of the economic policy for the 1994-1999 presidential term. That made for a climate of uncertainty, which was expected to dissipate in a short time.

The crisis had to be managed with measures going to the root of the banking problem by the responsible agencies (Finance Ministry, Superintendency of Banks, and FOGADE), as well as a macroeconomic policy encouraging stable and sustainable development. The Central Bank of Venezuela, within the scope of its legal powers could contribute only by pursuing policies designed to give those who had the solutions in their hands time to act.

The Central Bank responsibly did its utmost to improve understanding of the situation and encourage the responsible agencies to take timely initiatives within their respective spheres of action to attack the root causes of the crisis.

The state’s action in defense of the payment systems could only be implemented through FOGADE, but that agency did not have the means to do so. The state assigned it functions and responsibilities, but never capitalized it appropriately, and contributions by the banks were clearly insufficient to support the deposit insurance system by themselves.

The Central Bank was the only institution able to generate the initial resources needed to cope with the acute phase of the crisis. It was – and is – the Central Bank’s responsibility to ensure financial stability and the orderly development of the economy. Considering the extremely destabilizing circumstances prevailing in January 1 994, it was appropriate to support the banking system and avoid harm to the depositors and the country. The only way to accomplish that purpose at the time was through FOGADE’s action.

For the Central Bank not to have done so, being legally empowered to do it, would have implied turning its back on its fundamental mission and violating its own law. It would then have been responsible for the collapse of the county’s payment systems and the economic, social, and political turmoil at the start of a new presidential term would have been even worse.

Through advances to FOGADE for distribution to banks in difficulty, the Central Bank of Venezuela provided the time that was clearly needed to find an orderly solution to the crisis. As it provided funds, the Central Bank redoubled its efforts to see that other public policies were put at the service of this crucial objective for the country.

The advisability of the policy at the time it was adopted is not voided by the fact that authorities failed to take better advantage of the time. Any policy can be criticized, but it should be understood in the light of the circumstances in which it was formulated, the objectives it pursued, and the legal provisions which constrained action.

The Central Bank’s response to the financial crisis was entirely in accordance with the law and sound central banking practice. We did what a central bank could and should do under the circumstances we faced within the legal limits. An examination of the experience of other central banks’ performance in banking crises confirms that assertion.

We are part of a group of Venezuelans who, on being called, did not hesitate to give their share of effort and sacrifice, under extremely complex conditions of our history.

The Central Bank Board I had the honor to chair included illustrious Venezuelans with unimpeachable records and many services to the country to their credit, took up its difficult functions fully and honorably. Its decisions were always the outcome of responsible and well-considered analysis. They were adopted unanimously and were grounded in the institution’s professional expertise. The Board’s only loyalty was to the institution, and it acted in defense of the country’s best interests.