Structural reforms, financial fragility and the banking crisis (1983-2000)

Ecuador's 1983 foreign debt crisis marked the beginning of a new stage in its economic history. The difficulties in managing the foreign debt crisis and the subsequent structural reforms resulted in the rapid collapse of the model that emerged with the diversification of production with a bias towards industrialization, which defined the previous phase. Analyzing the events of the 1990s in Ecuador, linking the 1999 crisis with the financial liberalization measures adopted earlier, contributes to a clearer picture of the context that led to the adoption of the dollar as the national currency and how the new monetary-exchange regime conditioned the Ecuadorian economy.

It is worth mentioning that the diagnosis of the Ecuadorian financial system corresponded to the operating parameters of what, in orthodox terms, was mistakenly defined as a "repressed system" (^{McKinnon, 1980}; ^{Díaz, 1991}). This implied a "niche of opportunity" to be explored in Latin America -particularly in small countries- with the liberalization of banking regularization and the expansion of credit availability for the region. According to orthodox literature, financial liberalization was understood as the "necessary remedy" to attract international capital flows and promote "adequate" financing for Latin American economic development. This resulted in the integration into the global financial system being defended as the answer to the chronic constriction of domestic savings capacity. Consequently, the Ecuadorian banking system changed its operating rules during the government of Sixto Durán (1992-1996). In summary, the measures taken were: a) resizing or downsizing of public financial institutions;⁴b) elimination of public subsidies to credit in order to adapt financial policies to market conditions; and c) liberalization of interest rates. Much of this reorientation of the economy was embodied in the 1992 Macroeconomic Stabilization Plan (MSP) (^{Viteri D., 1998}).

Like other stabilization plans, the PME (publicly presented by the national government on September 3, 1992) pursued a fundamental objective: to control inflation. In line with the measures applied in neighboring countries, the way in which inflation would be kept under control was through an incisive recessionary adjustment with wage repression, discouragement of consumption, balanced public accounts, a central bank solely committed to watching over the value of the currency and well-calibrated external accounts. The goal of orthodox adjustment was monetary stability and the consolidation of "good and healthy macroeconomic fundamentals".

Following the financial changes of the PME, a strong monetary devaluation was first implemented - the dollar was now quoted at ECS$2,000 when its previous value was ECS$1,475, and then a fixed exchange rate system was made official. In addition, the issuance of new public bonds backed by up to 15% of the value of the country's exports was authorized. The legally required bank reserve was reduced from 34% to 32% of the value of deposits, and the mandatory 15-point band between deposit and lending interest rates practiced by the banking sector was eliminated, allowing the banking spread to be freely determined (^{Viteri D., 1998}).

With the new General Law for Financial Institutions of May 25, 1994, Ecuador experienced a real credit boom, accompanied by the expansion of activities in the banking sector.⁵ The changes introduced by the new legislation include a) the facilitation of the entry of foreign capital to operate in the sector, the multiplication of offshore banking and operations of national banks abroad, b) simplification of the legal framework of the entities; c) the differentiation between banks and finance companies was changed to only allow the former to capture demand deposits, and other technicalities regarding equity requirements; d) it made it easier for bankers to offer loans to their own companies -linked loans- and thus expand and diversify their businesses; and e) the "modernization" of the form of banking supervision, in which the Banking Supervisory Authority adapted to the trend of "self-regulation" of the sector through prudential measures, which in reality meant the loss of regulation and supervision by the State over this vital economic sector (^{Acosta, 2006, p. 210}; ^{Miño, 2008, pp. 250-251}).

As a result of these changes, there was a breakdown in the country's banking trajectory since "these reforms changed the system of restricted (and relatively controlled) banking into a system of liberalized universal banking, which, in practice, increased the risks in its operations. It also allowed the entry of new banking products in line with the international speculative environment. This banking system channeled massive external resources into the national economy without adopting criteria of productive selectivity and taking the necessary precautions; resources that were taken out of the country as soon as the first symptoms of the crisis appeared" (^{Acosta, 2006, p. 211}).

Another result of the changes in the financial environment was the concentration and centralization of banking capital despite the significant foreignization of banking in other Latin American countries. What was observed with the subordinate insertion of Ecuador into financial globalization was a relatively low degree of direct ownership of banks by foreign groups, with national banking capital prevailing as the leading participant in the local financial system, operating in association with global banking (^{Girón and Correa, 2007}; ^{Meireles, 2015}).

The euphoria surrounding the new business opportunities, increased profitability and greater integration with the international financial system would quickly turn into bitter nostalgia. A precedent for this step was the bankruptcy of several institutions with lower contributions in 1994. The yellow signal was only turned on in 1995 when the ECB had to provide loans to the sector, which rose to US$150 million for banks with liquidity problems. The first to go bankrupt was Banco de los Andes and, later, Ecuacorp, which had severe difficulties. In 1996, the ECB was forced to bail out Banco Continental, the country's fifth-largest financial institution.⁶

At the end of that first cycle of bankruptcy with Banco Continental, the red light was activated to indicate something serious in the Ecuadorian banking system. Doubts about the capacity and sustainability of a banking system that insisted on continuing to operate with such a high foreign exchange exposure began to emerge. Some more judicious analysts warned about the systemic risk suffered since the financial opening up and the worrying banking exposure. In that first wave of bankruptcies, the State's action was highly questioned since, by providing aid to these institutions -always leaving very unclear the criteria for determining the amount of support, when and to whom the resources would be channeled- the increasing moral hazard in banking activity was encouraged.⁷

The analysis of the bailout plans for the failing banks led to a double inference: on the one hand, they were characterized as an explicit measure of state intervention, which, at least in official discourse, sought to minimize the "contagion" of the entire banking system in order to maintain the Ecuadorian economy on track -which is clearly in line with the best of Keynesian-oriented economic policy suggestions-. However, the way the bailouts took place was flawed in its overall smoothness, specifically regarding notorious acts of corruption. In short, the mass of resources channeled from the public sector to save the banking system per se is not to be condemned; on the contrary, it is fundamental to minimize the impact of any financial debacle on the real economy. However, given the way in which bank bailouts were executed -beginning with the bailouts of 1996 and culminating with a veritable drain of public resources for this purpose in 1997/1998-, it is impossible not to point out a myriad of mistakes and a veritable stream of cases of "illicit" use of public resources.

Ecuadorian private banking: echoes of yesterday reverberating today

The succession of events behind Ecuador's massive banking difficulties was overwhelming. From the banking crisis, selective bailouts by the public authorities evolved into a fiscal crisis, culminating in the loss of confidence in the value of the sucre and the subsequent "solving" of the monetary crisis by the formal dollarization of the economy. Thus, financial and economic chaos, with almost no remaining institutional order, led to a severe crisis of governability.

When going back to the beginning of the chronology of events of the 1999 crisis, in mid-1998, the Banco de Préstamos -owned by the Peñafiel group, which was also involved in oil commercialization- faced severe liquidity problems and was rescued by the State. Another significant bankruptcy in that year was that of Filanbanco, whose owners -mainly the Isaías family- operated in other sectors of the economy, such as television and radio media; agribusiness linked to sugar, bananas, milk and cattle; mining and oil exploitation; and, at its peak, a professional soccer team, Club Deportivo Filanbanco, with headquarters in Guayaquil.⁸ Apart from the major banking institutions mentioned above, other smaller banks also went bankrupt and had their restructuring supervised by the State, such as a) Solbanco and Tungurahua in 1998 and b) Finagro, Azuay, Occidente, Progreso, Bancomex, Crediticio, Banco Unión, Popular, Previsora and Pacífico, in 1999 (^{Acosta, 2006}).

Meanwhile, one way to measure the informal dollarization of the country's financial sector and its intrinsic exchange rate risk is the relative share of loans granted and deposits received by banks denominated in foreign currency as a percentage of total deposits and loan portfolio. The discrepancy between the inflow of dollars via deposits and the historical volume of issuing credit contracts in that currency was exorbitant in 1999. By the end of that year, the credit portfolio in foreign currency represented 77% of the total credit operations of banks' assets, while customer deposits registered in hard currency in banks were only 54% of the total (^{ECB, 2010}). In addition to the complications arising from this gap -between the growth in the share of deposits and the portfolio maturing in foreign currency- Ecuadorian private banks had problems with payment defaults and high delinquency levels.⁹

Figure 1 shows the evolution of various indicators of Ecuadorian banks' solvency and liquidity capacity. It is clear how due and overdue portfolios rose dramatically following the reforms in the early 1990s, reaching more than US$5.5 billion in 1997 and 1998. However, both values decreased momentarily after 1999 and remained lower in the first years of official dollarization. It is worth mentioning that, in more recent historical terms, these indicators have shot up sharply since the second half of the 2010s and have continued this trend, reaching over US$33.6 billion by 2021. With respect to the delinquency rate -which is one of the ways of measuring the risk of a group of banking assets and is calculated based on the relative size of the overdue loan portfolio as a proportion of the total portfolio-, it reached an alarming 51% in August 2000, which meant that for every 100 sucres given as loans to the public, only 49 were from operations in which the clients had complied with the payment of amortizations and interest according to the terms of their contracts. If, on the one hand, there was a massive increase in overdue portfolios following the pre-dollarization banking crisis until 2021, on the other hand, the delinquency rate has decreased since 2000, stabilizing at much lower levels between 2011 and 2021.

Note: no data for the 2002 annual period.

Source: Compiled by the authors with data from the ^{ECB (2022a)}.

Figure 1 Private banking: evolution of due and overdue portfolios and delinquency rate (1990-2021) 

Faced with the collapse of the banking sector in the second half of the 1990s, an attempt was made to adapt the legal-institutional instruments to respond to the banks in difficulty and the controversial Deposit Guarantee Agency (AGD) was created in December 1998. A huge volume of credit was injected into the system through the bonds issued by the Agency, making it one of the most significant transfers from the State to the private banking sector known up to that time.¹⁰ At the same time, the Law for Economic Reorganization in the Tax and Financial Area was approved, declaring the unlimited and permanent guarantee of deposits and the imposition of a 1% tax on the circulation of capital in order to guarantee the bailout of the owners of the large banks, depositors with the greatest resources and principal debtors of the private banks (^{Miño, 2008, p. 259}). The bailout required a massive transfer of resources from the State for the recapitalization of the private banking sector. It is calculated that, depending on the source of information, the amount of support was between 20 and 30% of the GDP.

In the case of the direct transfer of ECB credits to the banking system through the purchase of securities alone, as shown in Figure 2, the amount of resources exceeded ECS$7 billion in January 1999. The State was monetizing the sector's accumulated losses by financing the bank reorganization through the issuance of liquidity credits -either in the form of direct credits, by purchasing assets or via the issuance of AGD bonds-. The injection of resources was made possible thanks to a substantial increase in the monetary base in sucres, which ended up being decisive in the currency devaluation pressure in 1999.¹¹

Source: Compiled by the authors with data from the ^{ECB (2022b)}.

Figure 2 ECB Loans to the Financial System (1997-2021) 

Such was the "addiction" of the banks to resources originating from the State that, by "the year 1999, a significant part of the Ecuadorian financial system was facing solvency problems, so much so that their survival depended exclusively on their levels of liquidity. For this reason, they resorted in increasing numbers and magnitude to the liquidity facilities of the Issuing Institute (the ECB)" (^{ECB, 2010, p. 39}). Since 2009, after the financial crisis that originated in the United States and following the trend of global central banks to promote countercyclical measures with massive security purchase programs, the number of loans issued by the ECB, with the financial system as the destination, soared, stabilizing at US$1,045 million at the end of 2021.

However, the massive flight of capital, facilitated by the opening of the capital account contemplated in the financial reforms of 1993 and 1994, led, at the end of 1999, to the Ecuadorian economy entering a vicious circle: monetary issuance-devaluation-inflation. The deterioration of the conditions of the internal variables was compounded by the government's new difficulty in servicing the external debt when, in August 1999, a moratorium was declared on Brady bonds and Eurobonds -which were immediately restructured with the issuance of the contentious and controversial global bonds, subject to the approval and supervision of the International Monetary Fund (IMF) and the US Treasury-, forcing a new round of negotiations with creditors in 2000, after dollarization. Once again, a massive flight of capital contributed to economic and political destabilization.¹²

In short, the sequence of events to connect the dynamics of the private banking sector with Ecuador's formal dollarization are a) the liberalizing financial reforms of 1993 and 1994, b) the financial dollarization -informal or spontaneous- of the economy, c) the fragility stemming from the dollar exposure of the banking-financial system; d) specific bank failures; e) the generalized banking crisis; f) a massive bailout by the government through the monetization of bank debt and the compromise of fiscal capacity as a consequence of such a measure; g) the acceleration of inflation and devaluation, which produced a monetary crisis; and h) the abandonment of the national currency and the formal dollarization of the economy as the winning proposal for the adjustment and way out of the crisis.

Dollarization, concentration and profitability of the banking sector in Ecuador

The drastic transition from the sucre to the dollar as the national currency led to significant changes in the banking landscape. Initially, for the formal dollarization process to be "successful", it was essential to have a financial system in which the main banks had solid balance sheets. However, during 1999 and 2000, Ecuador's private banks faced the problem of many overdue portfolios combined with an accumulation of high deposit rates and liquidity shortages of such magnitude that a national banking holiday had to be established to stop the massive flight of capital. The system also faced pressure from account holders who, overwhelmed by uncertainty and distrust due to the banking crisis, began an intense process of withdrawing their deposits, causing one of the most voracious bank runs ever experienced in Latin America. At the same time, a persistent lack of liquid reserves and bank assets weakened the financial system and threatened the country's macroeconomic stability.

According to ^{Flores et al. (2017)}, the large banks with more significant political influence managed to overcome occasional adversities because they always "anticipated" adverse moments and promoted measures to " shield" themselves, such as constantly buying dollars, thus reducing financial costs and profiting from dollarization itself. The ease of access to these channels was unevenly distributed among the banks in the system, which led to a tendency to concentrate banking activities in a small group of leading institutions, namely Banco Pichincha, Banco del Pacífico, Banco Guayaquil, Banco de la Producción (Produbanco) and Banco Bolivariano. However, despite the predominance of large banks with national capital in the ranking of the largest institutions, the presence of foreign banks or financial correspondents was notable.¹³

Figure 3 shows the evolution of the assets of the five largest banks - and the changes in their position at the top of the ranking. It is worth noting that, in a straightforward analysis, the increase in the volume of assets is not only due to the power of endogenous creation of xenodollars by the banks but also how it affects other accounting metrics to compute profitability. However, despite the systematic increase in the volume of assets, there is a trend toward a deceleration in asset growth rate, with specific exceptions for specific years; for example, the 55% increase in Banco del Pacífico's assets in 2016.¹⁴ Reinforcing the trend towards a deceleration in the growth rate includes the case of Banco Pichincha, whose rate of asset expansion went from 12% in 2003 to 10% in 2020. ¹⁵

Source: Compiled by the authors with data from the ^{Banking Supervisory Authority of Ecuador (2022)}.

Figure 3 Ecuador: G-5, assets, millions of current dollars (2002-2020) 

Meanwhile, if the evolution of profitability of the same group of banks is analyzed using Return on Equity (ROE) as an indicator -which is the ratio between net profits generated and equity- as shown in Figure 4, a sharp drop can be observed after the international financial crisis of 2007-2008, when capital requirements were increased in banks throughout the world. However, even in the context of lower ROE levels, this metric for some of the large Ecuadorian banks exceeds the average profitability observed for the country's banking sector as a whole. For example, for a particularly problematic year such as 2020, due to the COVID-19 pandemic, while Banco Bolivariano's profitability was 9%, the average ROE for the banking sector in Ecuador was 4.8% (^{Asobanca, 2020}). In addition, an essential source of revenue for banks in Ecuador was "transactional commissions”, a group of specific fees for services, such as ATM withdrawals, charged to customers.

Source: Compiled by the authors with data from the ^{Banking Supervisory Authority of Ecuador (2022)}.

Figure 4 Ecuador: G-5, ROE (2002-2020) 

Banks operating in Ecuador also obey trends observed in global banking activity today. For example, following a new business model that favors income obtained from commissions in the administration, management and/or sale/purchase of third-party securities as the primary source of profitability, which is becoming even more important than income related to the asset/liability interest rate differential, i.e., between what the bank collects from loans and what it pays out in favor of savers (^{Cömert et al., 2016}). The same applies to the current existence of renewed tension due to the intensification of competition between large financial groups and a downward trend in profitability due to the increase in bank capital requirements implemented in the post-crisis period of 2007-2008 -whether by regulatory obligation or by voluntary adherence of the participants-, encouraging banks to be more willing to venture into riskier market niches, which result in increased profits.

In short, the heterodox evaluation of banking today gains a lot from examining Ecuadorian banking history intertwined with mapping its links with international capital circuits. This lays the foundations for a type of interpretation that reveals how the actions of private banks can be extremely harmful to the economy as a whole when it enters a trajectory of unscrupulous financial innovation, with doses of excessive speculation, increased exposure in operations susceptible to the ups and downs of the external sector and, now considering more than 20 years of formal dollarization, with the expansion of their assets and profitability determinants anchored in the endogenous expansion of xenodollars.