Patricia Brenner and R. Armando Morales15

Patricia Brenner and R. Armando Morales 15

Financial groups are becoming the dominant institutional structure in the financial services industry around the world (Figure 2.1).16 Financial globalization and innovation have also stimulated increasing cross-border operations in Central America,17 particularly by financial groups operating regionally. These operations have benefited from economies of scale and scope as well as from deregulation and international liberalization. The associated consolidation process has favored the emergence of financial groups with complex management and corporate structures offering a range of financial services on a cross-border basis. Meanwhile, products and services offered by banks and other financial institutions have become closer substitutes.

Figure 2.1.
Figure 2.1.

Asset Share of Financial Conglomerates

(In percent)

Sources: De Nicoló and others (2003); and Worldscope.

Regional Financial Integration

Financial liberalization in Central America has contributed to the growth of large regional financial groups that originated locally. Thus, financial integration integration has progressed concurrently with the growth of large regional financial groups under a variety of corporate structures competing successfully with foreign banks for prime customers. Explanations for these developments include

  • increased cross-border economic linkages. Trade within the region has expanded gradually (Figure 2.2)., and represents a significant share of total international trade for El Salvador and Nicaragua (where most regional financial conglomerates have emerged). Regional operations of most of the large local corporate groups expanded quickly after the peace process in the region was firmly established in the 1990s. In this period, the Salvadoran Kriet Group, owner of TACA airlines, acquired several smaller domestic airlines and became the dominant company in the sector. The Nicaraguan Pellas Group absorbed several small domestic competitors in the beer market and established a strategic alliance with other domestic groups. Often, these large corporate groups have ownership participation in financial groups;

  • political uncertainty and a weak rule of law. In some countries, notably El Salvador and Nicaragua, a long period of social unrest and political uncertainty led major corporate groups to diversify their operations across the region (Figure 2.3). Concerns over the enforceability of property rights may also explain this diversification (Costa Rica and Panama being the exceptions). These concerns may also have discouraged foreign banks from aggressive entry to the regional markets, creating a vacuum that has been filled by large regional financial groups.18 Although some of these concerns have been addressed in recent years, the region is still often perceived as less stable than the rest of Latin America;

  • improved reputation of large domestic banks. Depositor confidence in large banks belonging to regional groups improved after these institutions survived crises and, in some cases, absorbed assets and liabilities of failed banks (Figure 2.4). Also, some groups have been able to obtain credit ratings, which opens access to international capital markets;19

  • economies of scale that may arise from dollarization. Official dollarization in El Salvador and Panama and high dollarization in Nicaragua may have helped to lower operating and intermediation costs regionally. The adoption of official dollarization by El Salvador in 2001 may have helped level the playing field between foreign banks and regional groups (Figure 2.5). Banks have also become more aggressive in implementing cost-cutting strategies, charging fees for their services, and slowing provisioning to consolidate gains in profitability following the initial boost from dollarization;20 and

  • existence of Panama as an international financial center. Most regional financial groups have active offices in Panama and use an international license to conduct operations throughout the region. Easy access from their home countries provides an opportunity to put in place significant managerial capacity in Panama (Table 2.1). Tax advantages may also be a factor when the tax difference is substantial.21

Figure 2.2.
Figure 2.2.

Regional Trade, 1999–2003

(In percent)

Source: IMF, International Financial Statistics.
Figure 2.3.
Figure 2.3.

ICRG Political Stability Index, March 2004

Source: International Country Risk Guide (ICRG).

Financial integration in Central America is a positive development because the diversification of operations across activities and markets helps to reduce business risks (those less correlated across markets). However, financial integration may also magnify financial vulnerabilities and requires a consolidated view of regional financial group operations to ensure appropriate supervisory oversight.

Figure 2.4.
Figure 2.4.

Central America: Foreign Currency to Total Deposits

Source: Central American Monetary Council (2003).
Figure 2.5.
Figure 2.5.

Private Bank Profitability

(Gross profits over operating expenses, in percent)

Source: National authorities.
Table 2.1

Country Distribution of Assets of Regional Financial Groups

(In percent)

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Sources: Individual banks; and IMF staff calculations.

Need for Consolidated Supervision

The complexity of regional financial groups and cross-border operations of financial institutions poses challenges for the uniform application of prudential regulation across countries and sectors. Consolidated supervision shows room for improvement in many jurisdictions worldwide. In particular, consolidation of accounts and consolidated monitoring of compliance with prudential standards, and cooperation between home and host country regulators, are generally inadequate.22 In Central America, the supervisory authorities have responded in several ways to the challenge of adapting supervisory methods to consolidated supervision. On the whole, however, supervisory arrangements lag behind the development of cross-border operations by financial groups.

Consolidated supervision should aim at a comprehensive assessment of the safety and soundness of financial groups. Effective consolidated supervision, including on a regional basis, may not be achieved unless supervisory authorities have mechanisms in place to discourage or prevent regulatory arbitrage, encourage collaboration among supervisors within and across borders, respond to emerging problems in individual banks, and anticipate and/or confront systemic crises.23 In the case of Central America, the agenda for putting in place adequate supervisory and legal tools as well as a political commitment to regulate large financial conglomerates, including harmonization of regulation and supervision of institutions offering similar products, remains to be completed. An overarching requirement would be effective coordination and information sharing among all country regulatory agencies in the region.

The absence of adequate preconditions and infrastructure for effective banking supervision has also hindered the development of consolidated supervision of financial institutions in the region. Recent progress in achieving sound and sustainable macroeconomic policies still faces uncertainties, and the region generally lacks an environment that fosters the honoring and enforcement of financial contracts. Effective market discipline based on transparency and corporate governance is a work in progress. Moreover, problems in terms of operational independence of supervisors and adequate resources affect several countries in the region,24 and legal protection for supervisors is weak or nonexistent (Box 2.1). Political difficulties often preclude implementation of laws and regulations, even when the legislation itself is adequate.

Financial Conglomerates Operating in Central America


In Central America, financial groups are generally financial conglomerates dominated by banks. A financial conglomerate is a group of companies under unified control, primarily engaged in financial services in at least two of the following areas: banking, insurance, and securities.25 A group is characterized by a parent-subsidiary relationship, by a relationship based on a participation, or by a horizontal structure.26 Some of the groups in Central America are parts of larger corporate groups (mixed financial conglomerates).

Status of Legal Protection of Supervisors

There are some provisions in Central America for the legal protection of supervisors performing their official duties in good faith. Formal procedures for the coverage of legal expenses to staff of the superintendency deriving from lawsuits initiated in connection with actions undertaken in their capacity as financial system supervisors and regulators have been established in Guatemala, Honduras, and Nicaragua. Other features of legal protection of supervisors in individual countries are listed here.

Costa Rica: Supervisors are subject to the General Law of Public Administration, by which all public servants are fully accountable in performing their duties. Thus, there are no provisions on legal protection for supervisors’ good faith actions. By board resolution, the central bank provides for the coverage of legal expenses of supervisors for acts related to the exercise of their duties.

El Salvador: The Banking Law (Art. 160) establishes that cases against the directors of the Deposit Guarantee Institute (IGD) must be initiated with the approval of the Supreme Court. It also authorizes the IGD to provide legal assistance to IGD directors and ex-directors facing lawsuits associated with the performance of their duties. The Superintendency of Banks holds an insurance policy to cover legal expenses.

Guatemala: The Financial Supervision Law (Art. 15) generally establishes that criminal actions against the Superintendent of Banks and other specified officials may be initiated only with the approval of the Supreme Court. Legal expenses for the defense of legal actions related to the performance of official duties are covered by the Superintendency of Banks.

Honduras: Three mechanisms in the banking law provide for legal protection of supervisors: (1) no judicial judicial action can be initiated against superintendents and other officials for decisions adopted according to the law, without the prior ruling of the administrative court; (2) supervisors may request a pre-trial hearing as provided in the Law of Organization and Court Attributions; and (3) the National Council of Banking Supervision provides legal defense for its staff, when prosecuted.

Nicaragua: The Superintendency of Banks approved procedures for the coverage of legal expenses to its staff deriving from lawsuits initiated in connection with actions undertaken in the performance of their duties. The Law on the Deposit Guarantee Fund (Art. 11) provides that board members and staff of the Deposit Guarantee Fund shall not be sued for actions taken in the performance of their duties unless an action has been previously brought against the Deposit Guarantee Fund and such action has been decided against the Deposit Guarantee Fund. Recently, the constitution was modified to grant immunity to the superintendent and the deputy superintendent, by which no action of any nature can be initiated in court while they are in office.

Panama: The Banking Law does not provide statutory protection for superintendency personnel or an indemnity against expenses of litigation. Decree No. 49 of 1998 (issued by the Ministry of Planning and Economic Policy) establishes that “the actions of the supervisory personnel of the Superintendency of Banks undertaken in the discharge of their duties are authoritative” and a veracity presumption in favor of the supervisory personnel as to their declarations, with the burden of proof falling on whoever challenges the supervisors’ decisions. However, it appears unclear whether this provision would be upheld should it be reviewed by the courts.

Among groups with cross-border operations, regional financial conglomerates (RFCs) have significant cross-border activities. Banks with links to other regional financial institutions (BFIs) have a minor regional presence. For purposes of this book, RFCs are classified by having physical presence in at least two countries in the region, in addition to the home country of shareholders. The RFCs and several BFIs perform some form of accounting consolidation.

A number of banks with common ownership operate in different countries in the region but do not consolidate their operations and thus operate as parallel banks. Each parallel bank reports to a different supervisor in the region. Other banks run booking offices that basically conduct booking operations not reported to the home supervisor. Shell banks constitute an extreme case (Box 2.2). Parallel banks report to two or more home supervisors, but there is no consolidated supervision of the entire group.

The Basel Committee on Banking Supervision strongly discourages allowing operations of parallel banks, shell banks, and booking offices.27 “Parallelowned banking structures present greater risk for supervisors who may be unaware of the nature and extent of any relationships and transactions between the banks that may have an impact on its safety and soundness. This opaqueness may also provide an incentive to the controllers to use the banks to provide undisclosed support mechanisms or to mask the true risks within the group.”28 This makes it difficult for a supervisor to apply prudential norms to the domestic bank operations, while fully understanding the impact on the overall financial position of the group. In the case of shell banks and booking offices, there is uncertainty as to where mind and management are located.29

Institutions Conducting Cross-Border Financial Transactions in Central America

  • Branches of foreign banks have an identifiable head office located abroad but do not have a separate legal status, and are thus an integral part of the foreign parent bank. Reportedly, some foreign banks operate regionally from branches located in one particular Central American country (Panama, Honduras). These banks are normally institutions of sound reputation (for example, Citibank, HSBC).

  • Subsidiaries of foreign banks are legally independent institutions that are incorporated under the law of the host country. Operations are consolidated in the corresponding parent company’s home country. Three Salvadoran banks and one Nicaraguan bank operate through subsidiaries or affiliates (local banks in which they have purchased a majority share) in other Central American countries.

  • Parallel banks are banks licensed in different jurisdictions that, while not being recognized as part of the same financial group for regulatory consolidation purposes, have the same beneficial owners and consequently often share commonly managed and interlinked business.

  • Booking offices normally provide only basic administrative services to a bank or a number of banks in a jurisdiction where the bank has no meaningful mind and management. Usually, no local operations are originated in the branch. These branches are normally domiciled in an offshore financial center.

  • Shell banks are banks that have no physical presence in the country where they are incorporated and licensed, and are not affiliated with any financial services group that is subject to effective consolidated supervision. The mind and management are located in another jurisdiction, often in the offices of an associated entity or sometimes in a private residence.

Foreign banks operate as branches or subsidiaries in host countries. A branch is primarily regulated by the home country supervisor responsible for the legal entity overall but also monitored in its local operations by the host country supervisor, while a subsidiary is primarily regulated by the host country but subject to additional home country oversight at the group level. Some of these institutions operate as banks with an international license based in Panama but intermediating resources within and outside Central America.

Domestic financial institutions operate either as stand-alone firms or as part of domestic financial conglomerates. All countries in the region perform consolidated supervision of domestic financial conglomerates, albeit with different degrees of effectiveness. A particular case is Banco Nacional de Costa Rica, which owns 80 percent of BICSA, a bank operating in Panama with a general license.

Mapping of Financial Groups Operating in the Region

Four regional financial conglomerates from El Salvador, Nicaragua, and Panama operate in Central America (Table 2.2).30 They all hold an international license to operate from Panama, where they consolidate operations. RFCs operate as a group mostly within the region using holding companies. Nicaraguan and Panamanian groups have significant operations in Panama, while Salvadoran banks have a more limited presence in Panama and have established separate conglomerate structures in various countries. RFCs actively pursue benefits from economies of scale and risk diversification. RFCs exploit economic linkages among countries in the region and generally conduct financial intermediation in foreign currency, reflecting the fact that their countries of origin are dollarized or quasidollarized economies.

Table 2.2

Banks Operating in the Region

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Sources: National superintendencies.

Country of origin is the one where the principal shareholders’ mind and management reside.

Three Nicaraguan groups are parallel-bank based.31 One group has been in contact with the International Finance Corporation to pursue a capital injection conditional on consolidation of operations of their different units. Another group perceives that operations by individual banks are sufficiently isolated, and that consolidation is not justified. Apparent concerns about political uncertainty in the home country of shareholders of parallel-bank-based regional groups partly explain their reluctance to consolidate despite a relatively well-established reputation as de facto financial groups in the region. Specifically, these groups argue that ongoing difficulties in the political arena and weaknesses in the institutional and legal framework in Nicaragua entail risks that are difficult to prevent under arrangements involving consolidation.

Seven banks have links with other financial institutions in the region. Some of these institutions are called “offshore banks”—in practice, they are booking offices originally created to circumvent limitations to operate with sight deposits and/or foreign currency (Costa Rica and Guatemala). Other booking offices operate abroad to accommodate specific interests of their customers. Supervisory authorities are in the process of gathering information from these institutions when they are part of regional groups.

Banks that do not consolidate can facilitate regulatory arbitrage. Many booking offices are established outside of the region. Uncertainties about the permanence of financial deregulation policies in their home countries may explain why these structures continue despite such deregulation. In Costa Rica, the continued presence of banks with limited physical operations outside the country appears to be related to the dominance in the domestic financial system of public banks benefiting from preferential treatment by the government relative to private financial institutions.32

Few foreign banks have operations in Central America. Citibank and the Bank of Nova Scotia (United States and Canada, respectively) operate in different countries in the region. There are 30 other foreign banks and several Panamanian banks operating from Panama with an international license granted by Panama. Some of these Panamanian banks have representation offices in the region (Table 2.2).

Regional Financial Indicators

Regional financial groups account for about one-third of assets and deposits of the regional banking system, of which regional financial conglomerates hold about 22 percent of total loans and deposits. Parallel banks and regional financial institutions combined hold about 10–13 percent of the system in terms of assets, loans, deposits, and equity (Table 2.3).33

Table 2.3

Market Share by Bank Category, June 2004

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Sources: Individual banks; and IMF staff calculations.

Foreign banks, excluding banks operating from Panama with an international license, represent only about 3 percent of the system. The share of banks with an international license not belonging to RFCs is between 10 and 15 percent for different financial aggregates. Many of these banks’ operations are with countries outside Central America.34

Domestic banks account for about half of the regional financial system. Private banks hold about one-third of different financial aggregates, similar to the share of regional financial groups. Public banks account for about 18 percent of the assets of the regional financial system, mostly reflecting the predominance of public banks in Costa Rica.

Regional financial conglomerates have higher capitalization than parallel banks and regional financial institutions. Profitability, as measured by the return on assets, also appears higher for RFCs relative to other groups. Higher capital and profitability of RFCs seems to reflect their success in servicing prime customers. Foreign banks show somewhat lower profitability, which may be partly related to more strict accounting required by parent offices (for example, stricter provisioning) (Table 2.4).35

Table 2.4

Selected Financial Ratios, June 2004

(In percent)

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Sources: Individual banks; and IMF staff calculations.

Note: ROE = return on equity. ROA = return on assets.

Foreign banks’ low share of the market is partly offset by offshore operations. Lending by foreign banks, including entities located in financial hubs outside the region (Miami), has increased by 40–100 percent during the period 1998–2003 in each individual country. Loans by foreign banks operating in financial hubs, mostly to prime customers, are equivalent to more than twice the magnitude of loans from foreign bank offices in the region (Figure 2.6).36

Figure 2.6.
Figure 2.6.

Total Loans, June 2004

(In billions of U.S. dollars)

Source: National authorities.

A trend toward consolidation is observed in the regional financial system. Between 1998 and 2003, 24 banks were closed and 31 mergers took place, more than offsetting the number of new banks (8 banks started operations in the region in the same period).37 Total bank assets expressed in U.S. dollars increased by 38 percent between 1998 and 2002 for Central American countries (excluding Panama, which experienced a slight decline). Concentration in the region, as measured by the share of assets of the five largest banks increased to 73 percent in 2002. At the country level, this phenomenon is observed in all countries except Costa Rica, with Nicaragua showing the highest concentration (96 percent). Banks maintain a dominant position in the region with 90 percent of financial sector assets.

Regional financial groups have increased their share in regional financial markets see (Figure 1.3).38 In addition to the expansion of Salvadoran and Nicaraguan groups, Primer Banco del Istmo (Panama) has participation in Honduras and Costa Rica, and Cuscatlán (El Salvador) acquired the regional banks formerly owned by the British bank, Lloyds. Banks belonging to regional groups acquired selected assets of failed banks, including through cross-border acquisitions: Banex (Panama) in Costa Rica absorbed four banks between 1998 and 2001; Lafisse and Promérica (Nicaragua) absorbed assets and liabilities from failed banks in Nicaragua and El Salvador; and Cuscatlán and Agrícola (both El Salvador) from failed banks in Costa Rica and Guatemala. Banks belonging to regional financial groups are dominant among private banks in Costa Rica, El Salvador, and Nicaragua.

Regional Financial Groups: Risks and Regulatory Responses

Main Risks

Inflated Capital

Capital may be inflated for regional financial groups, despite being apparently sufficient on a solo basis. For a financial conglomerate, capital must be adequate both on a group or consolidated level and on a single-entity solo level. Proper monitoring is complicated by differences in the definitions and calculations of both actual and required capital across borders, differences in accounting standards, and lack of proper financial and auditing consolidation. Also, capital adequacy requirements are not comparable because of differences in the measurement of both the numerator (capital) and the denominator (risk-weighted assets) in individual countries. Minimum capital adequacy requirements are set at 10 percent in all countries except El Salvador and Panama (12 percent and 8 percent, respectively), and compliance is generally good. Actual capital-to-asset ratios (i.e., without risk weights) vary, with Guatemala showing a ratio below 8 percent; Costa Rica, Honduras, and Nicaragua between 8 and 10 percent; and El Salvador and Panama above 10 percent (Figure 2.7).

Figure 2.7.
Figure 2.7.

Capital Ratios, December 2004

Source: National authorities.

Inappropriate recording of intragroup transactions may also inflate capital. These transactions could hide the overall risk exposure of individual entities and/or their corresponding groups. Problems associated with intragroup transactions include (1) capital or income may be inappropriately transferred from a regulated entity; (2) the terms of the transfer may be disadvantageous to a regulated entity; (3) there may be a negative impact on solvency, liquidity, and/or profitability of individual entities; or (4) regulatory requirements may be circumvented.39 Transfers of deposits and loans (including asset dumping offshore) among banks belonging to the same group to boost capital artificially have been particularly problematic. Other areas of concern have been the emergence of outsourcing contracts with related institutions whose pricing is difficult to test against the market, and the use of credit by shareholders to inject capital into related financial institutions, which facilitates double gearing. Double (or multiple) gearing occurs when one entity holds regulatory capital issued by another entity within the same group and the issuer is allowed to count the capital in its own balance sheet.

Contagion Risks

The intricate nature of cross-border operations makes the Central American financial system susceptible to contagion (Table 2.5). Cross-border transfer of deposits may magnify liquidity risk. While the availability of intragroup financing may help overcome temporary liquidity problems, eventual solvency problems of a troubled institution may lead to intragroup contagion to liquidity providers. Contagion may take place within the group (if troubled members of a conglomerate “infect” healthy members of a conglomerate in another jurisdiction), both within and across borders; and among unrelated institutions within a country (if perception of systemic problems is augmented by cross-border risks).

Table 2.5

Central America and Dominican Republic: Regional Financial Links, June 2004

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Sources: National superintendencies.

Opportunities for Regulatory Arbitrage

Credit risk concentration, related in part to concentration of wealth, has been a problem in the region. Cross-border financial intermediation further complicates adequate monitoring of credit risk. Corporate groups may become “too large” relative to domestic financial institutions, making it attractive for both financial institutions and corporate groups to use different regional institutions to conduct business between them.40

Regulation of large credit exposures is uneven in Central America. El Salvador imposes the most stringent regulations overall, with Guatemala and Honduras allowing wider room for lending to groups, presumably because their economies also show the least diversification. On lending to related parties, demand for financing by groups operating as mixed conglomerates tends to be attended first by the group, because lack of capital market development encourages reinvestment as a source of financing. Regulations on related party lending also vary widely across the region—El Salvador and Panama having far more strict requirements than neighboring countries. At the other end of the spectrum, Guatemala and Honduras lack an aggregate limit for overall lending to related parties (Table 2.6).

Table 2.6

Regulations on Loan Concentration and Related Lending

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Sources: Central American Monetary Council; and national superintendencies.

Bad loans from a stricter jurisdiction could be sold to a less strict jurisdiction before recovery problems are detected, increasing the underlying gap between reported and actual credit risk for the group. Risks may be compounded as Central American countries have different requirements for the sale of loan portfolio bundles.

Differences in loan classification and provisioning could also lead to regulatory arbitrage (Table 2.7). A financial group may take advantage of differences in the treatment of collateral for loan classification purposes, and it may record loans in a location where more favorable treatment is available. Costa Rica, El Salvador, and Nicaragua link loan classification to the quality of collateral. Also, differences in the minimum arrears period to reclassify a loan may provide incentives for regulatory arbitrage. Provisioning requirements also vary: for example, El Salvador and Nicaragua require more severe provisioning adjustments in the transition between the first and the second loan categories relative to other countries in the region.

Table 2.7

Regulations on Loan Classification and Provisioning

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Sources: National superintendencies.

Unregulated Risks

Regional financial groups are exposed to sovereign risk. In all jurisdictions within the region, government bonds are subject to zero risk-weight, based on the argument that sovereign risk constitutes the benchmark for local securities (Figure 2.8). Clearly, capital adequacy is overestimated because not all countries are exposed to the same degree of government default risk. However, setting differential risk weights across countries would not be easy, because any official validation of a differential risk may result in volatility in the market for government bonds, especially for less-developed and illiquid markets. For groups that are not subject to consolidated supervision, dependency of the government budget on bank financing may create pressure to maintain the status quo not only in regulation of sovereign risk but also in other areas (including consolidated supervision). For financial conglomerates that are subject to consolidated supervision, the question to be addressed is the appropriate valuation of a regional government bond portfolio.

Figure 2.8.
Figure 2.8.

Share of Government Bonds in Bank Assets, 2003

(In percent)

Source: National authorities.

Currency mismatches could be compounded by cross-border operations. Most loans in foreign currency are to the nontradable sector, even in economies that are not fully dollarized (Figure 2.9). In the case of regional financial groups, transfer of loans and deposits across borders may lead to imbalances in the foreign currency position of individual banks. Financial groups may have an even higher incentive than domestic financial institutions to lend to unhedged borrowers to keep a balanced foreign exchange position. Competition to retain prime customers may also drive domestic financial institutions to offer similar alternatives to those offered by regional groups and foreign banks.

Figure 2.9.
Figure 2.9.

Foreign Currency Lending to Nontradable Sector

(In percent)

Sources: Central American Monetary Council (2004); Alvarez (2003); and IMF staff calculations.

Regulatory Responses

Supervisory authorities have put in practice regulatory responses at the individual country and regional levels. They have attempted to combine the supervision of domestic conglomerates and of cross-border financial intermediation, and in several countries financial legislation has been modified recently to that effect. For countries dealing with parallel banks (notably, Nicaragua), ring fences are being used (more strict prudential regulation for entities belonging to a group and not submitting consolidated financial statements to supervisory authorities). At the regional level, memoranda of understanding and regional plans within the Central American Council of Superintendents of Banks, Insurance, and Other Financial Institutions have been the main instruments utilized by country supervisory authorities in the region.

Individual Country Initiatives

Combining supervision of domestic financial conglomerates and of cross-border financial intermediation

Attempts to incorporate institutions operating abroad into the same supervisory platform as domestic financial conglomerates have proven difficult. The first hurdle to overcome has been adapting the legal framework for financial activities to allow for consolidated supervision. Legislation in Costa Rica and Panama includes long-standing provisions for consolidated supervision, but only Panama has been able to effectively implement to some extent supervision of domestic financial conglomerates and of cross-border intermediation (Box 2.3). El Salvador approved amendments to its banking law in 2002, defining “financial conglomerates” and providing for their supervision on a consolidated basis. However, the Salvadoran superintendency has not conducted supervision of cross-border financial activities because the two Salvadoran regional financial conglomerates consolidate their international operations in Panama. Guatemala and Honduras recently approved modifications to the legal framework, and the process of implementation is under way. Changes in the legal framework for financial activities are still pending approval by congress in Nicaragua, where the supervisory authority has relied on miscellaneous legal provisions and ring fences to control cross-border transactions within financial groups (Box 2.4).41

The main problems with the legal framework for effective consolidated supervision include the lack of a clear definition of a financial group in some countries and the lack of enforcement of legal powers to regulate financial groups to the extent necessary to ensure effective monitoring. Heterogeneous and unclear definitions across countries often lack a structure that would allow for clear parameters to conduct consolidated supervision. Weak legal powers of supervisors to regulate financial groups prevent imposing effective limits on intragroup operations or requiring corrective actions when dubious transactions are observed. Implementation of legal requirements is also made difficult by the limited exchange of information, with critical sensitive information not being shared among supervisors in the region. In some cases, secrecy laws pose obstacles to effective exchange of information between supervisors.

El Salvador has attempted to incorporate non-bank financial institutions and cross-border activities into the scope of consolidated supervision. However, as mentioned, Salvadoran conglomerates consolidate in Panama, and it was not possible to test the effectiveness of the legal framework providing for consolidation of cross-border activities. Other difficulties faced by Salvadoran supervisors were the evolving organization structures of current financial conglomerates and the exclusion of companies such as instrumental companies and fiduciary trusts from the scope of supervision.

Ring fences

In light of the importance of cross-border operations by parallel-bank-based groups of Nicaraguan origin, the Nicaraguan superintendency has put in place ring fences to limit opportunities to circumvent regulation. This is consistent with Basel criteria. According to the Basel Committee on Banking Supervision, “where the supervisor of a parallel bank concludes that there is inadequate access to information about material parts of the parallel-owned banking structure, and cooperation with the foreign supervisor will not sufficiently mitigate the risk of the parallel bank structure, it should seek to ring-fence the operations of the domestic bank.” 42 Consistent with this, the Nicaraguan superintendency issued regulations including limits to investment in financial institutions and special accounting rules; adaptation to the regulation on capital adequacy (for example, higher risk weights for some investment categories); regulation on deposits and investments; 100 percent provisioning on sales of loan-portfolio bundles; and restrictions in the use of a common name. However, implementation of ring-fence-type measures has faced difficulties in practice and does not provide an adequate alternative to consolidated supervision, because it does not allow an overall assessment of vulnerabilities. Recent attempts to expand powers of the superintendency based on ring fences have been subject to injunctions in the courts. While the efforts of the superintendency are commendable in the adverse circumstances they face, prospects for further progress using this strategy appear limited. “It is not feasible or practical to require any supervisor acting alone to gather the necessary supervisory information on all related foreign parallel banks in the group, especially if parts of the organization structure in foreign countries are opaque.”43

Consolidated Supervision of Regional Financial Conglomerates in Panama

Several of Central America’s largest regional financial groups have elected to consolidate their banking activities in Panama, and this has presented challenges for implementation of consolidated supervision. The attraction to consolidate operations in Panama largely results from the advantages of operating in an international banking center and from market factors. The prospect of more favorable international recognition and Panama’s fully dollarized economy and open capital account have attracted foreign-owned banks that offer integrated domestic and international financial services, which may be convenient for cross-border transactions of regional financial groups. Moreover, several of the domestic banks are recognized as among the strongest in Central America; three banks have achieved an investment grade rating from global rating agencies.

Legal and regulatory factors also explain consolidation of activities in Panama. New banking legislation in 1998 established the Superintendency of Banks as an autonomous regulator, independent from the government and with sufficient resources to finance its activities. Key features of the legal and regulatory framework that support consolidated supervision are requirements for (1) consolidated supervision in law and regulation and (2) accounting and auditing standards and financial reporting. However, it must be noted that according to Panamanian legislation, banks with an international banking license are not subject to several prudential requirements applicable to banks with a general banking license.

The Superintendent of Banks is able to supervise economic groups and their bank and nonbank affiliates on a consolidated basis, though with some limitations. There is robust authority for the supervision of domestic banks and their subsidiaries (both domestic and foreign), which include the power to carry out direct on-site inspections. However, for holding companies and other nonbank entities, the Superintendent’s powers are limited to requiring audited financial statements and other reporting information from nonbank affiliates of economic groups. The Superintendent has carried out inspections of the domestic nonbanking subsidiaries and some foreign subsidiaries of Panamanian banks.

Other powers of the Superintendent of Banks include the ability to impose restrictions on the transactions between the domestic bank and the holding company and other affiliates. To facilitate the cross-border supervision, the Superintendent of Banks has in place numerous memoranda of understanding (MOUs) for cooperation with foreign supervisors, establishing the working arrangements on the use of shared information.

Accounting requirements apply to both the general and international license banks and their economic groups. For financial reporting purposes, the Superintendency of Banks requires that economic groups file financial information using International Accounting Standards (IAS) as issued by the International Accounting Standards Committee, or Generally Accepted Accounting Principles (GAAP) as issued by the U.S. Financial Accounting Standards Board. Financial statements are to be prepared on a consolidated basis requiring the combination of balance sheet and income statement accounts for subsidiaries and the holding company, with the elimination of intercompany balances and transactions. Consolidated accounting is necessary to provide a true and fair view of risk concentrations, transactions with affiliates, and capital adequacy. Most importantly, the IAS/GAAP accounting requirement serves investors and other market participants, which is an important factor recognized by regional financial groups for consolidating their operations in Panama.

Gradual absorption of booking offices into the scope of consolidated supervision

There has been some progress in the provision of information from booking offices operating abroad that are part of regional financial groups. In Costa Rica, some information is available for the 7 (out of 14) private financial groups that have offices abroad. However, financial groups have been unwilling to allow full access to their subsidiaries’ accounts. The memoranda of understanding signed with supervisory authorities where these subsidiaries operate have not allowed the verification of consolidated information. Reluctance to report continues despite higher capital adequacy requirements (20 percent for nonreporting groups and 10 percent for groups allowing full access). Private financial groups allege that their behavior aims at mitigating the significant dominance of public banks, which results in the lack of a level playing field. While public banks benefit from a blanket guarantee by the state, there is no deposit insurance for private banks. In Guatemala, the process of integrating information from booking offices is still ongoing. Eleven out of 18 financial groups have offices abroad (3 of which are foreign), and the superintendency has completed a first round of on-site inspections of all offshore entities. However, reporting deficiencies result in unreliable financial statements of banks and groups. So far, only nine financial groups have completed the process of registration as financial groups.

Comparison of Legislation on Consolidated Supervision in Central America

In Costa Rica, the National Council for Financial System Supervision (CONASSIF) regulates the transfer, registration, and functioning of financial groups, including limits on lending or borrowing operations between institutions belonging to the same group. The CONASSIF oversees the General Superintendency of Financial Institutions (SUGEF), an arm of the central bank that supervises banks, nonbank financial institutions, savings and loan mutual associations, savings and credit cooperatives, and solidarity associations. Financial groups are defined as entities subject to joint control or joint management. They comprise holding companies and firms engaging in the provision of financial services, such as banks, nonbank financial institutions, bonded warehouses, stockbrokers, investment companies, financial leasing firms, and banks or financial companies domiciled abroad. The Superintendent may determine the existence of a de facto financial group and must be notified of significant changes in “ownership interest.” While there is no explicit instruction for consolidated supervision, provision is made for consolidated reporting by financial groups. For the purposes of large exposure and related-party lending limits, operations of group members are consolidated. The requirement for external audits includes audits on a consolidated basis. For banks or financial firms operating abroad, SUGEF must assess whether there is sufficient supervision exercised by the host country supervisor. There are no provisions for on-site inspections by SUGEF of entities domiciled abroad.

In El Salvador, financial conglomerates are expressly subject to approval and consolidated supervision by the Financial System Superintendency (SSF). Financial conglomerates consist of companies where more than 50 percent of the respective stock is held by a holding company. They must include one bank and may incorporate insurance companies, pension fund management institutions, brokerage firms, companies specialized in the deposit and custody of securities, credit card issuers, foreign exchange houses, financial leasing companies, and bonded warehouses. Financial conglomerates can also include foreign banks, where at least 45 percent of the stock the holding company owns and exercises control of the bank. There is a presumption of a financial conglomerate based on a determination of common control, but this presumption can be contested. The SSF has access to all information of all members of the financial conglomerate needed to conduct consolidated supervision. Financial conglomerates must satisfy total capital requirements on a consolidated basis, but there is no explicit requirement to apply large exposure and related-party lending limits on a consolidated basis. For banks that are not part of a financial conglomerate, consolidated supervision is applied to banking subsidiaries, including requiring consolidated financial statements and adherence to prudential requirements. Banks may conduct financial operations abroad through branches and subsidiaries, provided there is prudent regulation and supervision in the host country and the SSF has given prior authorization. Foreign subsidiaries of a financial conglomerate are subject to the supervision of the SSF and examination by independent auditors of the parent bank, without prejudice to the powers of foreign authorities.

In Guatemala, the Superintendency of Banks (SB) is granted broad powers for the exercise of supervision over banks and other financial service providers, including on a consolidated basis. A financial group is defined broadly as “two or more legal entities engaging in activities of a financial nature, one of which shall be a bank, when there is common control of such entities based on ownership, management, or use of corporate image.” A holding company or a bank may head the financial group. Only specified entities, such as banks, finance companies, exchange brokerages, bonded warehouses, insurance companies, surety companies, credit card companies, financial leasing companies, factoring companies, securities brokerages, local or offshore entities, and other entities determined by the Monetary Board as well as support service providers, such as automated tellers or electronic data processing providers, are eligible to form part of a financial group. The SB may presume common control, but its presumptions may be challenged. The financial statements of the companies comprising the financial group must be prepared on a consolidated basis. The law explicitly states that companies comprising the financial group shall maintain required capital on a solo and consolidated basis, and prudential requirements may be applied to such entities on a solo and consolidated basis. The SB is empowered to request information from entities in a financial group as needed and to carry out on-site examinations while safeguarding the identity of depositors. Banks may establish branches abroad, provided that the host country exercises supervision in a manner that allows for the exercise of consolidated supervision by the home country supervisor in line with international standards.

In Honduras, the Financial System Law of September 2004 introduces consolidated supervision, to be carried out by the National Commission of Banks and Insurance (CNBS), an entity “in service” to the central bank, reporting directly to the President of the Republic. Financial groups consist of two or more companies engaged in activities of a financial nature under common control and may include banks, savings and loan associations, finance companies, subsidiaries, and branches and offices of foreign financial institutions. The CNBS may determine that the relationships or transactions with nonfinancial members of the same financial group may endanger the financial stability of the group, in which case it shall have the right to conduct all inspections necessary to evaluate risks and require the implementation of necessary measures. The CNBS may not authorize the existence of a financial group without being able to exercise consolidated supervision of the financial activities undertaken. Financial groups must provide the CNBS with consolidated financial statements including its subsidiaries and branches abroad. Consolidated capital of the financial group must be at least equal to the sum of the capital requirements of the companies in the group, and intercompany investments among group members are subtracted from the paid-in capital of the investing company. The CNBS authorizes the opening of branches or subsidiaries abroad of a Honduran financial system institution and may supervise them directly or through auditors hired abroad. For a foreign financial institution to operate a branch in Honduras, the CNBS must have executed a memorandum of understanding with the home country supervisor.

In Nicaragua, the Superintendent of Banks is empowered to exercise consolidated supervision over financial groups. A financial group is defined as banks and nonbank financial institutions (including domiciled abroad) and affiliates that are directly or indirectly controlled by a majority of shares. The Superintendent may specify cases where setting up holding companies may be necessary. All banks or nonbank financial institutions must inform the Superintendent of whether they belong to a financial group. The coordinator of a financial group is the member established in Nicaragua with the largest asset value. The coordinator must consolidate the statements of the financial group and submit them together with individual financial statements of its members. The Superintendent may set general prudential standards as deemed necessary to supervise financial groups on a consolidated basis. The Superintendent may apply a range of preventive measures “when the situation so warrants it” to members of a financial group. Prior authorization from the Superintendent is required to open branches abroad. However, there is no explicit authority to limit the range of activities a financial group may conduct in foreign locations, or for the Superintendency of Banks and Other Financial Institutions (SBOIF) to conduct onsite inspections, but the Superintendent has broad authority to cooperate with foreign supervisors as necessary for consolidated supervision. Branches of foreign banks must apply for authorization to operate in Nicaragua.

In Panama, the Superintendency of Banks (SBP) is authorized to supervise Panamanian banks (both with general and international banking licenses) on a consolidated basis, and is responsible for the supervision of economic groups that include Panamanian banks. An economic group is defined as a group of natural or juridical persons whose interests are interrelated in such a way that the SBP shall consider them as a single person. Descriptions of what constitutes an economic group, including ownership and control criteria, are specified in legislation. The financial consolidation of subsidiaries for regulatory and financial reporting purposes is required. An economic group of banks with a general banking license must maintain at all times a global index of capital adequacy equal to the sum of the capital requirements for all the companies comprising the group. The SBP may set prudential requirements on banks and members of the economic group on an individual basis and on the entire economic group of which a bank is a member. However, powers of the SBP concerning capital adequacy and other prudential requirements appear more limited with regard to banks with an international banking license. The SBP has the power to supervise operations, on a consolidated basis, of branches and subsidiaries of Panamanian banks established in foreign jurisdictions. For the opening of bank branches and subsidiaries in Panama, the SBP may require certification issued by the home country supervisor, indicating its assurance that consolidated cross-border supervision of the applicant would occur and the frequency and extent of the on-site examinations in Panama. It appears that this requirement is applied at the discretion of the SBP on a case-by-case basis.

Regional Initiatives

Cooperation through memoranda of understanding

The implementation of arrangements between supervisory authorities in the region shows limited progress. A general arrangement sponsored by the CCS was signed in 1998. Subsequently, specific memoranda of understanding were signed between 2000 and 2003 to motivate bilateral cooperation, especially on exchange of information. However, the lack of a central authority, legal restrictions in some cases (in particular, secrecy provisions), unclear focus on what information is to be exchanged, and reported reluctance of supervisors to provide timely and detailed information have conspired against a smooth exchange of information. Sharing of findings of off-site analysis is incomplete, and joint inspections have been rare.

Coordination in the Council of Superintendents of Banks, Insurance, and Other Financial Institutions

The CCS has been instrumental in promoting an exchange of views among regional supervisors on the need for cross-border consolidated supervision. The CCS was founded in 1976 with the goal of encouraging cooperation and exchange of information among regional superintendencies, and facilitating the implementation of regional agreements. Discussions on plans to harmonize regulation across countries in the region have taken place with the Inter- American Development Bank, with the main goal of identifying the gaps in the application of international standards for banking supervision. The coordination needed to implement International Financial Reporting System criteria was assisted by the Central American Bank for Economic Integration. Steps to improve regional banking supervision include the preparation of assessments and action plans to be implemented in the second half of 2005. The CCS is at a crucial juncture in defining a roadmap and priorities to show effective progress in improving consolidated supervision of regional financial institutions.

Conclusions and Elements of an Action Plan

Minimum Standards

International experience (e.g., the European Union, the Nordic countries, the East Caribbean Currency Union, the West African Economic and Monetary Union (WAEMU), and the Central African Economic and Monetary Community (CEMAC)), can be used as a reference for consolidated supervision in Central America only to a limited extent (Box 2.5). The experience of the Nordic countries would seem most applicable to Central America, because both operate outside the framework of a currency union. In most cases, financial integration has progressed in parallel with political integration at least to the extent necessary to have a common supervisory authority. Central America not only lacks the political integration to establish a common supervisory authority but also it has limited experience with minimum standards in the face of enforcement difficulties. The exchange of information through a memorandum of understanding is less than what would be necessary to compensate for the lack of a common authority. Moreover, the choice of a home supervisor for a group is left to the group, providing for opportunities to seek out a weak supervisory regime in the context of a fairly heterogeneous supervisory framework.

The minimum standards for the supervision of international banking groups established by the Basel Committee on Banking Supervision stipulate that (1) all international banks should be supervised by a home country authority that capably performs consolidated supervision; (2) the creation of a cross-border banking establishment should receive the prior consent of both the host country and the home country authority; (3) home country authorities should possess the right to gather information from cross-border banking establishments subject to their supervision; and (4) if the host country authority determines that any of these three standards is not being met, it could impose restrictive measures or prohibit the establishment of banking offices.

In Central America, the performance of consolidated supervision is most advanced in Panama. An assessment of how capably supervision is performed is beyond the scope of this book. Strengths of Panama’s supervisory framework include experience in dealing with financial groups, sufficient resources, and the requirement of international accounting standards. However, the presence of banks that do not consolidate financial statements and the likely substantial mind and management in the home country of shareholders of RFCs are areas to be addressed within the framework of a regional approach.

International Experience with Cross-Border Consolidated Supervision1

European Union

Regulation and supervision of cross-border banking groups in the European Union (EU) take place in the context of a regional market for financial services that has to a significant extent been unified, but where—despite increasing harmonization—licensing, regulation, and supervision of financial institutions remain organized essentially at the national level.

The single European market for banking services is based on the principle of a single banking license or “passport.” This principle implies that any financial institution licensed to provide certain financial services in one EU country, and actually providing those services in that country, can provide the same services throughout the EU, by means of cross-border transactions or foreign branches. To prevent regulatory arbitrage, minimum licensing standards have been set at the European level, using the same procedures as those for minimum regulatory standards (see below). However, actual licensing is done by the relevant national authorities, which may opt to apply stricter licensing criteria than the minimum standards. Banking subsidiaries set up by EU banks in other EU countries need to be licensed separately by the host country.

National authorities remain in charge of setting bank regulation, though this is subject to increasingly specific minimum standards agreed at the European level. For banks that operate cross-border, the principle of home country control applies, that is, banks are subject to the regulations of their home country, even when operating in other EU countries.

Until recently, EU-wide minimum regulatory standards were established as regular EU legislation, on the basis of proposals made by the European Commission that had to be approved by the Council and the European Parliament. In preparing such legislation, the Commission was advised by the Banking Advisory Committee, which comprised representatives of the national supervisory agencies and ministries of finance of the different member states. In certain technical areas, the Committee was able to amend EU banking legislation without having to go through the above-described legislative procedure.

In part to avoid excessive delays in adapting the regulatory framework to a rapidly changing financial environment, and in order to further streamline and harmonize regulations, the EU decided in December 2002 to extend the Lamfalussy approach to the area of bank regulation.2 Under the Lamfalussy approach, regulatory framework principles are established in the form of formal directives or regulations (“primary legislation”) through the normal EU legislative procedures (Level 1). On the basis of these framework principles, more detailed technical implementing rules (“secondary legislation”) are prepared by the European Commission, on the basis of consultations with sectoral committees consisting of the relevant authorities, and subject to the approval of a regulatory committee (the European Banking Committee—EBC) comprising representatives of the member states (Level 2). The consistent implementation of harmonized regulations throughout the EU is the objective of another committee (the Committee of European Banking Supervisors—CEBS), which brings together high-level representatives of European banking supervisory agencies and central banks (Level 3).

To ensure effective and harmonious supervision in the context of an EU-wide single market in which responsibility for supervision remains with national agencies, a number of basic principles have been established. These are (1) mutual recognition of the way supervision is conducted in the different member states, (2) an obligation for supervisors to cooperate with each other, (3) harmonization of supervisory practices, and (4) home country control as the basic approach in consolidated supervision.

In this context, responsibilities for the supervision of cross-border bank activities have been allocated as follows: (1) the home country supervisor is responsible for consolidated supervision of a banking group as a whole; (2) branches of EU banks in other EU countries are supervised by the home country supervisor; and (3) subsidiaries of EU banks in other EU countries are supervised by host country supervisors as separate entities, and as part of the consolidated banking group by the home country supervisor.

Cooperation between the different national supervisors is essential to make this framework function smoothly. Nevertheless, individual agencies have been left with a significant degree of freedom in organizing this cooperation (in particular, the exchange of information), through the conclusion of bilateral memorandums of understanding (MOUs). Such MOUs specify the modalities for information exchange (including confidentiality issues) and other forms of cooperation and outline the commitments agencies make vis-à-vis each other. These bilateral MOUs are supplemented by a number of multilateral MOUs, often dealing with specific multinational banking institutions. Cooperation has been strengthened further with the establishment of the CEBS, which has among its objectives to serve as a forum for the exchange of information, a role that was previously fulfilled to a lesser extent by the “Groupe de Contact” and the Banking Supervision Committee of the European System of Central Banks (ESCB).

Within the Lamfalussy framework, harmonization/convergence of supervisory practices is a role allocated to the CEBS and, to a lesser extent, to the EBC.

Nordic Region

There is a long-standing tradition of cooperation among Nordic (i.e., Denmark, Finland, Iceland, Norway, and Sweden) central banks as well as among Nordic banking supervisory authorities.3 In 2003, the Governors of the Nordic central banks agreed on an MOU that outlines the procedures followed in the event of a banking crisis with cross-border implications. It specifies the details of crisis management and possible emergency liquidity support. They regarded a non-legally-binding MOU as the appropriate tool for organizing cooperation among the central banks. An MOU among the banking supervisory authorities was first signed in 1989, and was renewed in 1994 and 2000. The Swedish Financial Supervisory Authority acts as the secretariat of the group. The memorandum specifies the cooperation related to cross-border supervisory activities. It defines the home and host country responsibilities, information sharing, and cooperation on conducting on-site examination, consolidated supervision, and cross-border financial services. Special attention is given in a separate MOU to the supervision of the Nordea Group, a financial conglomerate active in four of the five Nordic countries. The establishment of a joint supervisory group for Nordea was a major step toward ensuring effective consolidated supervision.


The eight member countries and territories of the Eastern Caribbean Currency Union (ECCU) are Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines, which are all independent states and members of the IMF; and Anguilla and Montserrat, which are territories of the United Kingdom. In 1983 they created the Eastern Caribbean Central Bank (ECCB) and adopted the ECCB Agreement Act. The financial system in the ECCU comprises domestic banks, offshore banks, credit unions, insurance companies, national development foundations, development finance institutions, building and loan associations, and finance companies.

The regulatory framework of the domestic banking system includes the ECCB Agreement Act of 1983 and its amendments as well as the Banking Acts of the various member states. The Agreement Act gives the bank the power to “regulate banking business on behalf of and in collaboration with participating Governments.” Between 1988 and 1992, new banking legislation, referred to as the Uniform Banking Act, was enacted in each of the member states. This legislation sets the stage for the harmonization of financial intermediaries within the ECCB area and the standardization of the ECCB’s supervisory and regulatory framework.

The Uniform Banking Act reaffirms the ECCB as the region’s central bank with responsibility for the supervision of the financial system. The ultimate authority in the application of the Act is vested in the minister of finance of each individual country, who is required to act in consultation with, and on the recommendation of, the ECCB. All commercial banks and other banking business institutions are required to be licensed under the Uniform Banking Act. As part of the continuing supervision, licensed financial institutions are required to submit monthly, quarterly, and annual reports to the ECCB.

The deficiencies of the Uniform Banking Act are being partly addressed, including weak central bank authority to enforce banking regulations. This would be particularly relevant where key supervisory decisions lie outside of the supervisory authorities, and where such decisions can be politically influenced.

The offshore financial services sector, regulated by the Offshore Banking Acts in the respective countries, is primarily the responsibility of the national regulators. In the cases of Dominica, St. Kitts and Nevis, and St. Vincent and the Grenadines, the Offshore Banking Acts have been amended to allow for varying degrees of participation in the regulation and supervision of the offshore sector by the ECCB. The ECCB provides support to the national regulators in the other territories in supervising the sector.


The West African Economic and Monetary Union (WAEMU) and the Central African Economic and Monetary Union (CEMAC) are monetary unions with a single currency, the CFA franc. The WAEMU treaty established a single currency and a regional central bank (Banque Centrale des États de l’Afrique de l’Ouest—BCEAO) in 1962. The eight member countries of WAEMU are Benin, Burkina Faso, Càte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo. The Governor of the BCEAO is the President of the Banking Commission, which was created in 1990 to strengthen regional banking supervision and authorize uniform licensing. The Banking Commission is responsible for the organization and supervision of banks and financial institutions in the eight member states. The 1995 law on savings and credit institutions (Projet d’Appui à la Réglementation sur les Mutuelles d’Epargne et de Crédit) laid the basis for a regulatory framework for cooperative financial institutions in the region. Both government authorities and the BCEAO are responsible for supervising microfinance institutions. Pensions funds, the stock market, and insurance companies are supervised by separate regional institutions. There are reforms underway to expand the Banking Commission’s authority to also regulate these markets as well as to be able to withdraw banking licenses, which until now has been subject to the approval of the minister of finance of each country.

CEMAC encompasses six countries (Cameroon, Central African Republic, Chad, the Republic of Congo, Equatorial Guinea, and Gabon). The Commission Bancaire de l’Afrique Centrale (COBAC) has been assigned nearly the full range of powers that national supervisory agencies have in individual countries. It conducts off-site and on-site supervision and issues prudential regulations. It shares responsibility with the national ministries of finance for the licensing of new banks. It also has the authority to sanction credit institutions, to revoke banking licenses, and to decide on the liquidation of banks. Although legally independent, COBAC is closely related to the Bank of Central African States (BEAC). The Governor of the BEAC is also the Chairman of COBAC. COBAC depends on the BEAC for its financial and human resources. The 1992 Convention provides joint responsibility for issuing banking licenses between national authorities and COBAC. While the latter has de jure overriding responsibility, in practice COBAC has to rely on the respective national authorities’ cooperation to implement and enforce its decisions. The 2000 FSAP for Cameroon found that through good handling of a number of crises, COBAC has become a well-respected institution. Regional initiatives, such as the harmonization of the commercial code and regional payment systems, are expected to promote cross-border financial intermediation, trade, and investment, and thus generate higher economic growth.

1 Prepared by Jens Clausen, Marco Espinosa, and Wim Fonteyne.2 The Lamfalussy approach was originally proposed in 2001 for the regulation of securities markets, by a Committee of Wise Men led by Baron Alexandre Lamfalussy. A discussion of the Lamfalussy approach in bank regulation can be found in the November 2004 issue of the ECB’s Monthly Bulletin.3 See Majaha-Jartby and Olafsson (2005).

Prior consent to authorize operations of banks in different jurisdictions was made without paying attention to the lack of consolidated supervision. Most institutions were established in different countries as domestic banks, and therefore they were primarily subject to supervision only of the individual entity.

Provision of information to the home country supervisor (Panama) seems to be generally adequate. However, supervisors in other countries feel that the substantial presence of mind and management in their jurisdictions justifies the provision of information from the home to the host country supervisor.

Standards do not call for a specific supervisory technique.44 In Central America, more than one approach seems necessary because different problems need to be addressed:(1) regional financial conglomerates with mind and management outside Panama consolidating in Panama; (2) parallel banks being supervised on a nonconsolidated basis taking advantage of the absence of a common enforcement of consolidation; and (3) offshore activities of booking offices that are not being reported to any supervisory authority are being phased out too slowly.

Regional Initiative to Improve Consolidated Supervision

In the context of discussions within the CCS, Panama has prepared a regional initiative for consolidated and cross-border supervision. The main objectives are to (1) eliminate opportunities to elude supervision; (2) use adequate prudential standards; (3) define the structure, ownership, and management of conglomerates; (4) establish adequate capital requirements on a consolidated basis; (5) assess asset and liability management, including credit management; (6) identify global risks of conglomerates; (7) ensure transparency of information; (8) establish links to transmit risks; (9) determine contagion risks; and (10) verify compliance with the legal framework.

The proposed regulation would be implemented through a series of bilateral arrangements between the supervisory authorities in Panama and other superintendencies. A model umbrella memorandum of understanding would be developed. In addition, the proposal includes a standardized questionnaire to be used in inspections of a conglomerate. Moreover, the proposal discusses other elements that are pertinent for improving the effectiveness of consolidated supervision, such as allowing for a major role for the home country when the host country does not have adequate resources, ensuring adequate flow of information, uniform criteria for on-site inspections, and adequacy of the legal framework. The proposed agreement has the following main features:

  • the host supervisor would notify the home supervisor of requests to obtain licenses, and the home country would report on compliance with laws and regulations in the home country of the requesting financial group;

  • information exchange would be open, with the exception of the identification of depositors;

  • supervisors commit to provide assistance to onsite inspections of other country supervisors; and

  • cooperation would be promoted, especially on AML/CFT issues.

Additional actions that could be considered to strengthen Panama’s initiative are (1) a no-objection letter from the home regulator be required prior to the granting of licenses in another country in the region; (2) information on depositors be made available to the home supervisors on an exceptional basis, for example, to identify group exposures and concentration; (3) cooperation on AML/CFT issues be specified to allow for specific gateways, such as for testing compliance with the applicable group requirements and in relation to suspicious activity reports.

Strategy to Improve Consolidated Cross-Border Supervision

The strategy to be adopted should take as a starting point the endogenous response of financial groups to consolidate in Panama. To be most effective, the strategy should aim at maximizing the potential benefits that consolidating in a jurisdiction within the region may bring, while reinforcing the mechanisms that would allow more effective identification, monitoring, and mitigation of risks in each country.

As a first step, all countries should commit to a plan to effectively integrate operations of parallel banks and booking offices into their financial groups with a common deadline to be enforced by regional ring fences. This will help enable supervisors to integrate information from offices operating offshore without adequate supervision. More generally, for the Basel Committee on Banking Supervision, “there is a presumption that in principle (parallel banks) should not be permitted.”45 A reasonable period of regularization would be considered, after which a lead supervisor might be appointed in the context of coordination within the CCS to act under the presumption of the existence of a conglomerate in the absence of a formal arrangement, which will be applicable in all jurisdictions. According to the Basel Committee on Banking Supervision, “if a bank exhibits one or more of these characteristics, the supervisors should conduct additional inquiries to ascertain whether a parallel-owned banking structure is in fact in place:

  • An individual or group of individuals acting in concert who control a foreign bank also controls any class of voting shares of a domestic bank; or financing for persons owning or controlling the shares is received from, or arranged by, a foreign bank, especially if the shares of the domestic bank are collateral for the stock purchase loan.

  • A domestic bank has adopted particular or unique policies or strategies similar to those of a foreign bank, such as common or joint marketing strategies, sharing of customer information, cross-selling of products, or linked websites.

  • An officer or director of a domestic bank either serves as an officer or director of a foreign bank, controls a foreign bank, or is a member of a group of individuals acting in concert or with common ties that control a foreign bank.

  • There is an unusually high level of reciprocal correspondent banking and other facilities between a domestic bank and a foreign bank.

  • The name of a domestic bank is the same as or is similar to that of a foreign bank.”46

The role of host supervisors in the process of consolidated supervision should be strengthened. The strategy to be followed should be mindful of the strong mind-and-management presence in the country of origin of RFC shareholders. Consideration should be given to a two-way exchange of information, with the home country providing feedback to host supervisors on selected risks that require careful cross-border monitoring. A system based on a principle of “host country conditional deference,” which would operate like the “home country rule” system in the European Union, could be put in place, but host country supervisors, while deferring to home country supervisors, would reserve the right, when warranted by the circumstances, to resume a more active role.47 In principle, there are three types of information to be provided by the home supervisor to the host authority. These are (1) information specific to the local office supervised by the host supervisor; (2) information on the overall framework of supervision in which its banking group operates; and (3) significant problems that arise in the head office of the group as a whole. The most sensitive issue normally is material on adverse changes in the global condition of banking groups operating in the host supervisors’ jurisdictions.48

A minimum set of risks considered priority issues should be addressed in a first stage. Risks associated with related-party lending and loan concentrations, loan classification and provisioning, and capital requirements seem to be candidates to be addressed in the first instance, establishing minimum standards and a timetable to make them more stringent. This could be accompanied by an effort to start promptly work on the formation of a regional credit risk bureau. Risks associated with AML/CFT and country risk could also be targeted as priorities. There may be a case to allow for differential limits for large exposures in countries where economic diversification is limited (Box 2.6).

Harmonization of Supervision of AML/CFT Requirements

Supervisory systems and practices for anti–money laundering and countering the financing of terrorism (AML/CFT) vary widely across the region. As for prudential supervision, such systems have not kept pace with the increasing development of financial groups operating across the region, particularly given the divergence in prudential requirements applied to banks and nonbank financial institutions, resulting in an uneven application of AML/CFT risk management practices and supervision across countries and within financial groups. The evolving financial landscape therefore calls for a refocusing of AML/CFT risk supervision in a way that (1) requires the application of AML/CFT policies, procedures, and practices on a groupwide basis. For banks, this would be consistent with the Basel paper on consolidated AML/CFT risk management and supervision and with the applicable Financial Action Task Force (FATF) recommendations; (2) harmonizes the AML/CFT supervisory procedures across the region for both off- and on-site supervision; and (3) applies a risk-based approach to AML/CFT supervision consistent with the FATF recommendations. Development of enhanced AML/CFT risk supervision should be consistent with the broader effort to implement regionwide consolidated supervision in other areas.

More stringent enforcement and implementation of AML/CFT requirements, in particular in the offshore financial centers in the region, may contribute to encouraging regional financial groups to reorganize or conduct their offshore business in a manner that allows for effective supervision. Over time, this may lead to a reduction in the number of parallel banks as offshore operations are either discontinued or converted to subsidiaries.

On unregulated risks, monitoring currency mismatches and exposure to sovereign risk should be intensified. An effort should be made in gathering information and promptly detecting cases where individual institutions or groups take excessive risk relative to the average. On lending to unhedged borrowers, all countries could implement a policy of incorporating information on foreign currency hedging by borrowers as an element to decide on loan classification.

It is difficult to find alternative schemes for deposit insurance protection that minimize the transfer of obligations in the event of a crisis. Alternatives such as differential protection or deposit insurance premiums for financial institutions or groups based on compliance with a schedule for consolidation might be considered.

Cross-border cooperation needs enhancement. Central America has a history of formal MOUs that lack effective follow-up. An assessment of comparative experiences would be useful to ensure that MOUs could produce better results, noted in the context of the umbrella MOU proposed in the CCS. National authorities could consider making public information on contacts and gateways to exchange information. A clear sequencing and prioritization should start with the sharing of inspection and off-site reports. Thereafter, risks regarded as priority should be the focus of more intensive use of joint inspections at the beginning, while joint global inspections should only be considered once inspections of specific risks have been successfully concluded. While the Basel Committee on Banking Supervision recommends to allow hosts the option but not the duty to accompany the home supervisor during the inspections, the need to overcome deficiencies in Central America would appear to justify a more proactive approach.49

Transitional arrangements appear to be necessary. More stringent requirements for opening new offices in the region while consolidation of large groups is completed could be considered. Also, a common understanding about the choices of organizational structures seems necessary. A clear common definition of financial group should be a priority.

Finally, to promote the contribution of financial integration to economic growth, fundamental improvements of the institutional framework are required. Political stability, enforcement of property rights, and effective legal protection of supervisors when performing their duties in good faith are all basic requirements.

Addressing Systemic Risks in Central America

The growth of cross-border banking activities poses significant challenges for banking resolution.50 In the event of failure, regional financial groups may be split into their national legal entities, each subject to different bankruptcy proceedings.51 As a result, fair treatment of creditors may be hampered if creditors in one jurisdiction receive higher compensation than similar creditors in other locations. In addition, lack of harmonization in key resolution procedures and poor communication between regulators are obstacles to coordinated intervention and resolution of different entities within the same failed international group.

Ring fences can affect regulators’ ability to resolve cross-border banks in an manner that is fair to all creditors. In jurisdictions where ring fencing is allowed, branches of foreign banks are treated as separate legal entities and, if necessary, are wound up as such (separate-entity approach). The purpose of ring fencing is to ensure that local creditors receive preferential treatment over foreign creditors, and under this approach, the various parts of the financial institution located in different jurisdictions will be subject to separate legal proceedings. In contrast, in jurisdictions following a single-entity approach, there is only one set of insolvency proceedings in which the financial institution is treated as one entity, and its assets, no matter where they are located, will be included in a single liquidation or reorganization process. Under this approach, all creditors, no matter where situated, are entitled to lodge their claims in the single set of proceedings and receive the same treatment as all other creditors within their class. There is no “best practice” as to which approach should be followed in the legislation governing bank insolvencies.

While progress has been substantial in upgrading the legal framework for banking resolution, differences in approach remain that hamper coordinated resolution of cross-border entities within the same failed group. For instance, supervisors in different jurisdictions may not be able to intervene branches and subsidiaries of a failed group in a coordinated fashion due to differences in the legal definition of bank insolvency or in the legally mandated minimum period before liquidation. Different treatment of shareholders also prevents consistency in dealing with the same class of stakeholders across borders and, in some cases, can prevent orderly resolution.

Continuous coordination and communication between regulators is also critical to ensure orderly resolution. A decision to intervene or close a domestic bank with operations abroad or a subsidiary of a foreign bank could have unintended, but significant, consequences for other countries.52 Thus, bank supervisors should coordinate their actions with a view to containing cross-border contagion as a result of problems in an international financial group.

Regional Initiatives

Although the six Central American countries are signatories on a regional convention on cross-border bankruptcy proceedings, further efforts are needed. The 1928 Convention on International Private Law (the “Bustamante Code” or “Havana Convention”) only sets certain principles applicable to cross-border bankruptcy proceedings as to the extraterritoriality of a bankruptcy order. In the absence of an international agreement specifically governing cross-border bank insolvency, the authorities may want to consider entering into a regional treaty that would set specific rules and procedures applicable to cross-border bank insolvency proceedings, particularly aimed at dealing with regional banking problems to help ensure fair, timely, and transparent treatment of claims from depositors and other creditors.

Specifically, international experience on cross-border bank insolvency and the analysis of current legislation points to the following key areas requiring further strengthening:

  • specific procedures applicable to cross-border bank bankruptcy proceedings. The objective is to avoid the different approaches to, for instance, ring fencing, that result in inconsistent and unfair treatment of creditors of the same financial group based on their location. Such procedures would also need to address the issue of seniority of claims of deposit insurance agencies over foreign creditors and intercompany accounts, which is common in Central American countries and may play against the fair treatment of depositors in other locations;

  • explicit agreement on coordination and information sharing between national regulators and liquidators to facilitate orderly cross-border resolutions. For instance, agreement of regulators from a number of locations may be needed to finalize the restructuring of an international financial conglomerate; and

  • measures to reduce the risk that assets and liabilities be shifted across bank subsidiaries in the event of problems. A particular concern in the region relates to the possibility that, prior to a bank failure, insider or other deposits might be moved to locations with higher deposit insurance coverage.53 Harmonization of deposit insurance regimes across the region would mitigate this risk.

Upgrading National Legal Frameworks

In recent years, the legal framework for banking resolution in most countries within the region has been strengthened significantly (Table 2.8). Among other measures, many countries have (1) introduced prompt corrective actions to address banking problems at an early stage, including the requirement that shareholders of weak, but viable, banks submit rehabilitation plans; (2) approved triggers to induce bank intervention in case of insolvency; (3) introduced bank resolution tools, including merger, and purchase and assumption (P& A), schemes; and (4) enhanced and clarified the role of deposit insurance agencies in bank resolution.

Table 2.8

Overview of Legal Framework for Banking Resolution in Central America

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Further coordination and harmonization of treatment is needed in a number of areas, however, to ensure equitable treatment of all parties in banking resolution:

  • Triggers for bank intervention. A uniform definition of insolvency—currently ranging from 2 to 8 percent of risk-weighted assets—would allow the authorities to coordinate the timing of intervention of members of a financial group across countries, thereby minimizing the risk of contagion and asset stripping.54

  • Duration of bank intervention. Consistency regarding the length of time a bank may be subject to official administration would facilitate orderly resolution of cross-border entities when a single-entity approach is followed. Intervention can vary in duration, however. It can range from 30–90 days in Nicaragua and Panama to up to one year in Costa Rica. The time limit is not well defined in Nicaragua, Honduras, and El Salvador, and does not exist in Guatemala.

  • Rights of shareholders. Shareholders’ rights should be suspended as part of bank intervention. In Costa Rica, El Salvador, Honduras, and Panama, the law is ambiguous with respect to the shareholders’ rights during a bank intervention, which could be a serious obstacle for bank resolution. In the case of Costa Rica, the law is not only silent with respect to the status of shareholders’ rights during bank intervention (suggesting that they maintain ownership rights during such period) but also specifically establishes that the bank’s shareholders may be part of a bankruptcy committee together with the authorities and creditors.

  • Treatment of bank managers. If a single-entity approach is followed, managers in all subsidiaries and branches of a failed group should be prevented from participating in key bank resolutions decisions to ensure fairness. That is not always the case in Central American countries, however. In Guatemala and Nicaragua, bank managers are dismissed when the authorities declare a bank under official administration. In the other Central American countries, it is unclear whether the authorities can keep incumbent bank managers from participating in key decisions regarding bank resolution. For instance, in Honduras, the supervisor has only limited powers to reverse bank management decisions during the regularization phase.

  • Asset valuation rules. If a single-entity approach is followed, different rules on the valuation of assets could undermine the use of P&A transactions. Assets must usually be valued according to local rules before they are transferred to another institution or trust fund. The valuation of claims against nonresidents and assets abroad could create difficulty in bank restructuring.

Weaknesses hampering quick bank resolutions should also be addressed because speed in the adoption of resolution measures is key to containing losses. Three major issues may play against the early identification of problem banks and proper implementation of the legal framework for banking resolution:

  • lack of independence and discretionary powers of bank supervisors to act at an early stage. In some jurisdictions, as a result of legal limitations or the political process, bank supervisors cannot act independently and may hesitate to impose early remedial actions on weak banks;

  • weak legal protection for bank supervisors. The risk of legal challenges from former bank shareholders in court, together with weak protection from recourse against individual bank supervisors, may discourage early bank resolution measures by banking supervisors; and

  • limitations in detecting bank insolvency. Despite the progress made in strengthening bank supervision, in some cases, bank insolvency may remain undetected as a result of: (1) lack of effective monitoring of credit to insiders (the bank’s capital may have already been diluted through credit to related parties or affiliated entities); and (2) the use of inaccurate asset valuation rules. Failure to correctly assess the borrower’s future repayment capacity, over-reliance on loan collateral, and excessive regulatory forbearance could, in some cases, postpone the recognition of bank losses.


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The authors would like to thank Katharine Christopherson, Jens Clausen, Luis Cortavarría, Marco Espinosa, Wim Fonteyne, Antonio Hyman-Boucherau, Ross Leckow, Maike B. Luedersen, Gabriela Rosenberg, Moni SenGupta, and Debbie Siegel for contributing sections of this chapter.


For purposes of this chapter, the countries of Central America are Costa Rica, El Salvador, Honduras, Guatemala, Nicaragua, and Panama.


A review by Fitch concludes among other things that because of “de facto barriers of entry (including corruption, poor contract enforcement, and weak credit cultures), large international financial players have, up until now, shown little interest in having a larger and/or retail presence in these countries” (Fitch Ratings, 2004), p. 1.


Fitch rates the capacity to meet foreign currency commitments of Panamanian and Salvadoran banks as BB+ (higher than Brazil, Ecuador, and Uruguay, lower than Chile and Mexico).


Offshore financial transactions that originate in the international banking center are not subject to income tax in Panama. There are also corporate income tax exemptions on interest earned when borrowed funds are used abroad, even when capital and interest are repaid in Panama. The local-source-based tax structure in Panama treats the distribution of dividends from foreign earnings as not taxable.


See International Monetary Fund (2004a and 2004b).


This book focuses on financial conglomerates involving at least one bank.


Basel Committee on Banking Supervision (2003a, 2003b).


Basel Committee on Banking Supervision (2003a), p. 5, “Controllers” refer to the persons in control of the bank.


The Basel Committee on Banking Supervision defines “meaningful mind and management” located within a jurisdiction as “physical presence.” The existence simply of a local agent or a low-level staff will not constitute physical presence. Management is used to include administration, that is, books and records. See Basel Committee on Banking Supervision (2003b).


Only financial institutions owned by shareholders domiciled in the region are analyzed in this section; subsidiaries of foreign banks are not included.


The Panamanian Primer Banco del Itsmo recently started to expand operations in the region, and has already obtained a license to operate in Nicaragua. This study does not deal with fraudulent parallel booking of the type uncovered during the 2001–02 banking crisis in the Dominican Republic.


Public banks benefit from a blanket government guarantee, monopoly in the attention of government agencies as customers, and exemption from a 17 percent required reserve on sight deposits.


Financial information was aggregated using individual bank data because consolidated financial statements are not available for all groups.


As of September 2004, about 21 percent of assets in the international banking center were outside Latin America.


Data processed using the format required for this study was only available for the period above indicated. To that extent, conclusions based on this information are tentative at this stage.


“International players have found it better to serve the larger regional corporates from financial hubs in other latitudes, mainly Miami. Some of the main foreign players providing cross-border lending to Central American corporates are Citibank, Wachovia, International Bank of Miami, Scotiabank, Dresdner Bank Latein Amerika and Barclays Bank” (Fitch Ratings, 2004), p. 5.


“Some of the hurdles that will have to be addressed ... are the existence of corporate/financial groups, where the corporate component may be even more sizable than the financial portion” (Fitch Ratings, 2004 p. 8).


Although nonbank financial institutions are generally of no systemic importance, there is experience in the region of crisis episodes associated with them. In Costa Rica, inappropriate recording of security transactions masked the failure of Banco Anglo in 1994.


Basel Committee on Banking Supervision (1996).


See Basel Committee on Banking Supervision (1996).


This section was prepared by Luis Cortavarría.


For instance, in certain circumstances, the intervention and closure of a small subsidiary of a foreign bank by a host bank supervisor may have no major impact on the stability of the local banking system, but it may create severe consequences for the parent bank’s credibility and ultimately create a banking crisis in that location.


Except Panama, all Central American countries have explicit deposit insurance, but the coverage varies.


Generally, the banking authorities may put a bank under official administration in the event of insolvency, suspension of payments, and/or failure to submit or comply with a rehabilitation plan.

Structural Foundations for Regional Financial Integration