Toward An Effective Supervision of Partially Dollarized Banking Systems
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

The paper presents a supervisory framework that addresses the vulnerabilities of partially dollarized banking systems. The tendency to underprice systemic liquidity risk and currency-induced credit risk creates vulnerabilities that need supervisory responses. The framework seeks to induce agents to better internalize risks by implementing a risk based approach to supervision, following the risk management guidelines of the Basel Committee, and by establishing buffers to cover higher liquidity and solvency risks. The paper also shows that most dollarized countries have addressed their liquidity vulnerabilities, but few have addressed those arising from currency-induced credit risks.

Abstract

The paper presents a supervisory framework that addresses the vulnerabilities of partially dollarized banking systems. The tendency to underprice systemic liquidity risk and currency-induced credit risk creates vulnerabilities that need supervisory responses. The framework seeks to induce agents to better internalize risks by implementing a risk based approach to supervision, following the risk management guidelines of the Basel Committee, and by establishing buffers to cover higher liquidity and solvency risks. The paper also shows that most dollarized countries have addressed their liquidity vulnerabilities, but few have addressed those arising from currency-induced credit risks.

I. Introduction

The Basel Committee for Banking Supervision (BCBS), through its 1998 Capital Accord and guidance material on risk management, established a comprehensive framework for the oversight of banking activities. This framework was revised in the context of Basel II (the revised international capital framework issued in 2004 and updated in 2005; see Basel Committee, 2005). The revised accord aligns the capital measurement with sound and contemporary practices in banking and promotes further improvements in risk management. The specific documents on the management and supervision of the main banking risks, including credit market and liquidity risks, in principle are applicable to all banking systems.

The purpose of this paper is to contribute to the design of a prudential regulatory framework for banks operating in partially dollarized economies, with the discussion being anchored conceptually in the framework of the comprehensive BCBS guidance on risk management. This paper does not address issues related to the causes of or solutions to dollarization. Causes are invariably related to macroeconomic and institutional factors,2 and accordingly, solutions are likely to focus on macroeconomic and institutional policies instead of microeconomic prudential regulations. Instead, the paper addresses the fact that financial systems and banks in most dollarized countries face higher risks that are reinforced by moral hazard. The resulting exposures create systemic vulnerabilities to which, from the standpoint of financial stability, supervisory regimes need to adapt.3

Partial dollarization increases the vulnerability of financial systems to solvency and liquidity risks4. Increased solvency risks result mainly from foreign currency mismatches in the event of large movements of the exchange rate. In these countries, banks often provide foreign currency loans to unhedged borrowers expecting that the government will be willing and able to absorb exchange rate volatility. Banks’ currency mismatches expose them to foreign exchange risk, while their borrowers currency mismatches expose them to foreign currency-induced credit risk. Liquidity risk constitutes an additional source of risk, that stems from the potentially limited backing of banks’ dollar liabilities and is often associated by (or triggered by) solvency risk.

Following international standards, partially dollarized countries control banks’ foreign exchange risks by imposing limits or minimum capital requirements on foreign exchange exposures. While international standards provide an adequate framework for countries with significant exposure to foreign currency, one particular aspect that deserves special consideration in countries with a high level of dollarization is the definition of a riskless position in foreign currency that is used when establishing prudential rules to control corresponding risks (capital charges and limits). This paper shows that a matched foreign exchange position is not riskless in a highly dollarized country because in the event of a depreciation, the capital adequacy ratio tends to fall more, the higher the rate of dollarization.

Banks’ actions to contain the foreign exchange risk arising from intermediating dollar liabilities, often lead them to take higher credit risks. To reduce their foreign currency mismatches, banks acquire dollar denominated assets through granting foreign currency loans to domestic clients whose cash flow is in domestic currency. While effectively transferring the foreign exchange risk to the borrowers, banks retain the credit risk resulting from the possibility that the borrowers’ currency mismatches affect their capacity to repay the loan in the face of adverse exchange rate fluctuations. Exposure to credit risk also increases if the value of the collateral backing the loan obligation—denominated in domestic currency—declines consequent on the exchange rate movement.

Implicit or explicit government guarantees distort pricing decisions and increase the demand and supply of foreign-exchange-denominated transactions. Borrowers, operating in the context of fixed exchange rate or “fear of floating”5 regimes, expect that the exchange rate risk will not materialize within the maturity of their loans in the face of prevalent short-term lending and spreads that are generally lower for intermediation in foreign currency relative to domestic currency. As a consequence, borrowers perceive that costs entailed in holding a currency mismatch in their balance sheets are lower in “normal” times than intermediating in a weak domestic currency where spreads and volatility tend to be higher. In some cases government guarantees further encourage foreign currency lending and borrowing.6 The limited availability of hedging instruments in many emerging markets and the shallowness of domestic credit markets may also provide a rationale for unhedged foreign currency lending. The facts are that the risk of large unexpected exchange rate movements is not priced in, large amounts of unhedged foreign currency loans are granted and banks tend to hold insufficient reserves—in the form of provisions or capital—to protect them. This is a problem that bank supervisors need to address.

Limited backing of banks’ foreign currency liabilities by foreign currency and their convertibility at par create systemic liquidity risks. Systemic liquidity problems in dollarized economies arise when the demand for local assets falls, due to a perceived increase in country risk or banking risk, prompting depositors to convert their deposits into foreign currency, cash or to transfer them abroad and/or foreign banks to recall short-term lines of credit. Unless there are sufficient liquid foreign currency assets to back liquid foreign currency liabilities, banks may run out of foreign currency liquid reserves and be unable to pay off foreign currency deposits. Similarly, central banks may run out of international reserves to provide foreign currency lender of last resort support to distressed banks. When this happens, deposit (or loan) contracts may need to be broken and disruptive or confiscatory measures taken, thereby validating creditors’ fears and justifying the run. These systemic risks are often overlooked by banks, which prefer that the cost of holding additional liquid assets be borne by central banks. The regulatory framework governing liquidity in a dollarized economy should take into account that, regardless of the currency of deposits, liquidity risk is twofold: (i) individual bank risk due to isolated deposit withdrawals; and (ii) systemic risk in case of widespread deposit withdrawals.

In sum, one consequence of these moral hazards and institutional factors is that both, currency-induced credit risks and liquidity risks are underpriced and insufficiently hedged, including through adequate buffers to shocks. The combination of under pricing of risks and insufficient buffers can have serious consequences in the event of large unexpected shocks, not only for individual banks but for the financial system as a whole. In the context of the supervisory principle that the primary responsibility for bank solvency and liquidity rests on its shareholders and management, the prudential objective has to be to ensure that these risks are internalized appropriately. To this end, it is key that countries fully implement the Basel guidelines on the management of risks, paying special attention to the specific vulnerabilities that arise in a dollarized environment. However, qualitative guidance encouraging banks to adequately manage risks, while necessary, is unlikely to be sufficient in many partially dollarized emerging countries. Supervisors need to take an activist role to ensure that banks have adequate buffers to cover their risks, in the event of exceptional shocks. Prudential measures are needed in the form of higher capital or provisioning requirements to cover solvency risks arising from borrowers’ currency mismatches and higher liquid assets to cover liquidity risks.

The paper is organized as follows. Section II provides evidence of current supervisory practices, showing that several partially dollarized countries have adopted measures to reduce vulnerabilities from foreign exchange and liquidity risks, but few have addressed those arising from currency-induced credit risks. Shortcomings in addressing vulnerabilities arise from both, the lack of full implementation of the Basel guidelines on risk management as well as the absence of necessary buffers to cover the solvency and liquidity risks taken by banks. Section III presents a framework to reduce the vulnerabilities of partially dollarized economies and discusses issues associated with its implementation. The framework suggests how Basel guidelines on risk management should be read to ensure that the vulnerabilities of highly dollarized financial systems are addressed and recommends the application of additional buffers to cover risks. Two appendices review current practices and country risk levels, respectively.

II. Supervisory Practices

Current practices in most partially dollarized countries are not effectively addressing the vulnerabilities of dollarized environments. This shortcoming stems from two sources. First, many highly dollarized countries fall short of fully implementing the BCBS guidelines for the management of key risks.7 Second, few supervisors have taken provisions to ensure that the adequate buffers are in place to cover the higher solvency risks of these banking systems. Many countries have implemented measures to achieve adequate protection from foreign exchange and liquidity risks, but few have sought to ensure adequate protection to cover currency-induced credit risks. These observations are based on the results of a survey conducted between June and September 2004, in 17 countries in different parts of the world and at different levels of dollarization. The details are presented in Appendix I.8

All surveyed countries have implemented prudential regulations based on current international standards for controlling foreign exchange risks. Regulations include limits on or capital requirements for foreign exchange exposure. Many countries have switched from having limits on foreign exchange open positions to requiring capital for these positions and several have adopted both. In some cases, these regulations entail a structural open position (Lebanon) or asymmetric limits on open positions that allow relatively large long open positions (Bolivia and Peru). As is shown in the next section, in highly dollarized countries, asymmetric limits and structural open positions are generally better than symmetric ones in safeguarding banks’ capital adequacy ratios in the event of a currency depreciation, but to fully protect banks’ solvency, regulators would gain from redefining what constitutes a riskless foreign exchange position.

Most countries have implemented prudential measures to reduce the vulnerabilities of financial systems to liquidity risks. Following BCBS guidelines for the management of liquidity risks, they require banks to manage these risks, to conduct stress tests on a variety of scenarios and to implement contingency plans to address liquidity problems. These scenarios are generally based on the estimation of maturity gaps, which are in many cases currency specific. A handful of countries have introduced limits on maturity mismatches. Many highly dollarized countries utilize, additionally, a combination of prudential measures, mostly minimum liquidity ratios and reserve requirements to ensure that banks, and the banking system as a whole, have an adequate buffer of liquid assets to face stressful conditions.9

These minimum requirements tend to be relatively high, with rates ranging from 10 to 40 percent, and may include high marginal rates for some liability types. Many countries also apply higher requirements for foreign currency relative to domestic currency liabilities, including some countries that apply liquidity requirements only for foreign currency liabilities (Croatia, Honduras, and Slovenia).

In contrast, the extent to which the countries’ prudential regulatory framework deals with currency-induced risk is limited and very recent. Two-thirds of the surveyed countries with moderate to high dollarization have neither required banks to manage their currency-induced credit risks nor conducted stress tests that allow them to identify the relevance of this risk for their supervised banks. The remaining third of these countries, plus two former highly dollarized countries (Argentina and Poland), have generally focused their efforts towards requiring banks to manage their currency-induced credit risks and ensuring that they are measured through stress testing. Few have achieved progress to ensure that these risks are adequately priced and covered with a sufficient buffer. Only one of the responding countries (Uruguay) has recently required higher capital for foreign currency assets.10 Only one country (Peru) reports requiring higher provisions for foreign currency loans relative to domestic currency ones. Besides Peru, five other countries (Singapore, Poland, Lebanon, Argentina, and Chile) report that banks are expected to assign a higher risk rating to debtors whose capacity to repay is sensitive to exchange rate movements, in the context of their overall risk assessment of borrowers. It is interesting to note, however, that several highly dollarized countries have recognized that the 8 percent minimum capital standard does not provide sufficient cover from the credit risks they face and have implemented higher requirements. The most notable cases are Lebanon and Romania, which require a 12 percent minimum capital adequacy ratio.

It is not a coincidence that some countries with low dollarization levels (Argentina, Brazil, Chile) have taken administrative measures to control credit risks stemming from the use of foreign currencies, whereas highly dollarized countries have avoided them. The effectiveness of limits or prohibitions to grant foreign currency credit to unhedged borrowers is likely to be lower and the costs higher in countries that are already dollarized. The risk that these measures may cause disintermediation and that banks seek to exploit regulatory arbitrage to elude them would be higher once the dollar has been well established as an alternative currency in the financial system. Moreover, it is generally easier to take preventive action when dollarization is low than when it is already high. There is no easy solution for supervisors of highly dollarized countries, particularly with regards to controlling currency- induced credit risks. However, it is encouraging that some of them are taking steps in the right direction by devising plans to adapt their regulatory frameworks with a view to better internalizing risks stemming from partial dollarization and taking measures to insure against these risks.

III. Towards Good Practices

The tendency to underprice risks that make most partially dollarized banking systems more vulnerable warrants a proactive approach to prudential regulation and supervision. This proactive approach has to consider two key elements:

  • The first element entails the implementation of risk-based supervision, along the lines of the Basel Core Principles for Effective Supervision (BCBS, 1997) and the guidelines for the management of credit, liquidity, and market risks, and taking into account their implications for highly dollarized financial systems. The guiding principle behind this is that the responsibility for managing risks lies in banking institutions. However, supervisors can use their powers to induce banks to better manage their risks by setting high standards for risk management. In a dollarized environment, this implies that the supervisory processes should seek to ensure that banks adequately manage all their risks, including currency-induced credit risk and liquidity risks of a systemic origin. These aspects are frequently overlooked by supervisors of highly dollarized countries.

  • The second element requires that supervisors ensure that banks have adequate buffers to protect their solvency and liquidity from these risks, including a reasonable protection for large low-probability shocks. These large shocks would be left largely uncovered if unregulated and could have serious consequences, not only for individual banks, but for the banking system as a whole and, thus, for financial stability. Reasonable buffers should be calculated based on an assessment of the shocks that could occur and their potential impact on bank solvency and liquidity. The main goals would be to compensate for the underlying distortions that lead to the underpricing of risks, as close as possible to their source and to induce agents to better internalize and price the risks of operating in a dollarized environment. Minimum capital and provisioning requirements should be used to create the reasonable buffer to protect banks solvency from all credit risks, including currency- induced credit risks. In turn, minimum liquidity standards are recommended to create a buffer for liquidity risks.

The framework presented below is consistent with international standards, but the discussion goes into details not covered in these standards. In some instances, full implementation of current international standards, as reflected in Basel I, would not suffice to adequately address the vulnerabilities of a dollarized banking system. These cases are associated with the combination of policies to achieve the necessary buffers to cover risks from dollarization and are explicitly acknowledged and discussed. Some countries may face restrictions that prevent them from addressing their vulnerabilities while at the same time adhering to international standards. These cases are also discussed. The rest of the section presents the proposed measures to address foreign exchange, credit, and liquidity risks in dollarized financial systems and issues associated with their implementation.

A. Foreign Exchange Risks

International standards to manage and control market risk provide an adequate framework for countries with significant exposure in foreign currency. These standards stress that banking supervisors must be satisfied that banks have in place systems that accurately measure and monitor and adequately control market risks. Supervisors should have powers to impose specific limits and /or a specific capital charge on market risk exposures, including on foreign exchange business, if warranted.

Determination of a “risk-free position” is necessary before deciding whether foreign exchange risks are to be priced and/or limited. Traditionally, a net currency position is measured as assets minus liabilities for each currency. A position in which assets and liabilities are matched in each currency (net open position = 0) is considered to be a risk-free position. This traditional method assumes that a risky position occurs only when an exchange rate movement may result in accounting losses or gains, which would happen either in case of a long net position (foreign currency assets > foreign currency liabilities) or a short net position (foreign currency assets < foreign currency liabilities).

While a matched foreign open position will protect the level of a bank’s capital, expressed in domestic currency, in the event of exchange rate movements, it does not always protect the capital adequacy ratio (CAR). In fact, in highly dollarized systems, exchange rate movements could have a significant impact on the CAR of banks with a perfectly matched foreign open position. As shown in Box 1, the larger the difference between the ratio of dollarization and the foreign exchange position as a percent of capital, the higher the impact of an exchange rate movement on the CAR. In the example, a 20 percent depreciation lowers the CAR from 10 percent to 8.8 percent for a bank with a 67 percent dollarization which keeps a matched foreign open position. In turn, if this bank kept a foreign open position equivalent to its rate of dollarization, it would maintain its CAR at the 10 percent initial level.

This problem is mitigated, but not fully resolved, by the structural position allowed by the Basel Committee (BCBS, 1998). According to the Basel Committee, banks may be allowed to protect their CAR by excluding from the calculation of their net open position, any position they have deliberately taken to hedge partially or totally against the adverse effect of the exchange rate. For this exclusion, three conditions have to be met: (i) the positions have to be of a non-dealing nature; (ii) the position does no more than protect the bank’s adequacy ratio; and (iii) any exclusion needs to be applied consistently during the life of the asset. Thus, banks can choose a structural position, thereby determining the degree of protection of their CAR.

It would be desirable to have a prudential approach aiming to protect the CAR. To control foreign exchange risks, supervisors may wish to center the calculation of capital charges and/or limits on the actual level of dollarization of each bank. Under this approach, banks would be required to fully hedge their CAR ratio from exchange rate movements, and the structural position would not be a choice. For this approach to effectively hedge capital, gains in the open position should be tax exempt. As an example, should a bank have 30 percent of its assets in foreign currency, and supervisors establish a limit of 20 percent of risk-tolerance, the corresponding limit for this bank would be a band of 20 percent both below and above its current dollarization level, which results in an open position not below 10 percent of capital, nor above 50 percent of capital (see Box 1 for details).

How does a devaluation affect the capital adequacy ratio (CAR) of a bank, depending on its foreign exchange position and asset dollarization?

The example below is a simple way to illustrate that the capital adequacy ratio of a bank will fall/grow with a depreciation/appreciation of the local currency (LC), if its foreign exchange (FX) open position, as a proportion of capital, differs from the level of dollarization of its assets. Let’s assume the following initial situation:

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As shown above, the presence of the high level of dollarization of total bank assets makes it necessary to carefully assess the convenience of having regulatory requirements in which limits or capital charges are based upon the belief that a matched net position is risk-free and a mismatched position is not.

B. Credit Risks

Unexpected exchange rate movements generate currency-induced credit risks that, in partially dollarized banking systems, tend to be highly underpriced. Banks and borrowers, operating in fixed exchange rate or “fear of floating” regimes, expect that the exchange rate risk will not materialize within the maturity of their loans in the face of prevalent spreads that are generally lower for intermediation in foreign currency relative to domestic currency. As a consequence, borrowers perceive that costs entailed in holding a currency mismatch in their balance sheets are lower in “normal” times than intermediating in a weak domestic currency where spreads and volatility tend to be higher. However, when a large unexpected movement of the exchange rate does occur, these currency mismatches affect borrowers’ capacity to repay and cause large losses for banking institutions. Because of these losses, central banks tend to avoid a sharp depreciation of the currency as long as they can.11 Thus, most of the time, banks’ and borrowers’ expectations are validated by the behavior of the central bank, and the currency-induced credit risk stays under priced, large amounts of unhedged foreign currency loans are granted and banks tend to hold insufficient reserves—in the form of provisions or capital—to protect them from this event. This section presents a prudential framework that addresses this problem.

An effective approach to the supervision of credit risks in a highly dollarized environment needs to consider two elements: (i) a supervision that pays attention to currency-induced credit risks; (ii) the constitution of a reasonable buffer to cover all credit risks, including those stemming from large unexpected shocks to the exchange rate. The first element should be based on a thorough implementation of the BCBS Principles for the Management of Credit Risk (BCBS, 1999), considering the implications of these principles in a dollarized environment. The second element should be based on an assessment of the shocks that could occur and their potential impact on banks’ solvency. The main goal of this approach is to induce agents to better internalize and price the risks of operating in a dollarized environment. Minimum capital and provisioning requirements should be used to create the reasonable buffer to protect banks’ solvency from all credit risks, including currency-induced credit risks. Generally, capital covers unexpected losses, while provisions are constituted to cover expected losses, either identified (covered by specific provisions) or latent losses not yet identified (covered by general provisions). Alternative options, to be considered when the preferred policy distribution is not be possible, are also discussed.

Supervision of Credit Risks and Credit Risk Management

International standards provide a solid basis for ensuring that financial institutions of dollarized economies manage their credit risks properly. The BCBS Principles for the Management of Credit Risk (BCBS, 1999) state that banks should operate under sound, well-defined credit granting criteria, that should include a thorough understanding of the borrower, as well as the purpose and structure of the credit, and its source of repayment (Principle 4). Banks should also have information systems and analytical techniques which allow them to measure the credit risk inherent in all activities (Principle 11). Additionally, banks should consider the potential impact of future changes in economic conditions when assessing individual credits and credit portfolios, under normal and stressful conditions (Principle 13). Moreover, it is also explicitly noted that the contingent nature of market-sensitive-exposures, such as foreign exchange contracts, requires that banks have the ability to assess the probability distribution of the size of actual exposure in the future and its impact on both the borrower’s and the bank’s leverage and liquidity.

In countries with significant lending in foreign currencies, these principles imply that banks should pay particular attention to currency-induced credit risk. Issuing a regulation or guidelines on credit risk management that makes explicit reference to currency-induced credit risks could be of great assistance in ensuring that banks adequately manage these risks. This regulation should establish high minimum standards for credit risk management as well as responsibilities of directors and managers and disclosure requirements. Building up supervisory capacities to assess the adequacy of banks’ credit risk management and exercising supervisory powers to ensure banks’ compliance with these standards are essential. The main ingredients of the approach to the supervision of currency-induced credit risk are presented below.

Supervisors should ensure that banks gather enough information to measure the sensitivity of a borrower’s capacity to repay under changing exchange rates. Banks could be required to gather information on borrowers’ cash flows and balance sheets, distinguishing between domestic and foreign currencies for all relevant exposures. Even if a bank lends only in domestic currency, its borrowers’ capacity to repay could be hampered in the event of a depreciation of the local currency if the borrower has significant liabilities in foreign currency with other counterparts. Also, credit bureaus could be encouraged to provide currency specific information on all debts, highlighting also (if relevant) debts indexed to the domestic price index or the exchange rate.

Separating assets and liabilities and revenues and expenditures by currencies is not a trivial exercise; it requires banks to have a deep knowledge of their customers and the markets where they operate. For instance, an importer who prices his products in dollars may still see his capacity to repay hindered by a depreciation if this causes a contraction in the demand for these products. An exporter who also sells in the domestic market could be negatively affected by a depreciation. In turn, a worker who earns domestic currency but receives remittances from abroad could maintain his capacity to repay in the event of a depreciation, particularly if the remittances come through the bank and are defined as the source of repayment.

While the exchange rate is expected to be the main source of indirect credit risk in dollarized financial systems, the significance of changes in interest rates should not be overlooked. Borrowers with domestic currency loans and floating interest rates or with a maturity mismatch could be an added source of credit risk, especially under fixed exchange rate or “fear of floating” regimes.12 In these cases, domestic currency interest rates tend to be more volatile, affecting the borrower’s capacity to repay and the bank’s exposure to credit risk.

Supervisors should make sure that banks’ policies and procedures for the management of credit risks consider their exposure to currency-induced credit risks. Banks should define internal policies regarding their exposures to borrowers whose capacity to repay is sensitive to changes in the exchange rate and other market variables. These could include internal limits for these exposures and, in countries where these exposures are high, internal targets to reduce their risk from these exposures. The risk reduction could be achieved by reducing the exposure to these borrowers or by encouraging borrowers to reduce their currency mismatches. Offering hedging products or charging interest rates that better reflect the currency-induced credit risks could be used for this purpose. Banks should assess their loan pricing policies to ensure that they adequately reflect overall credit risk. Special attention could be given to setting policies regarding granting foreign currency loans to individuals (for consumer goods or housing).

Banks should be required to assess the sensitivity of their borrowers’ capacity to repay in the event of changes in exchange rates, interest rates, and output and should base their credit decisions on such assessments. These assessments could be done individually for larger borrowers using information on currency specific cash flows and balance sheets to project their capacity to repay under changing conditions. For smaller borrowers which have homogeneous characteristics, such as individuals or small firms in a particular sector, the assessment could be done on a group basis. The information on currency specific cash flows and balance sheets may not be available for small businesses. Unless better information is available, it would be prudent to assume that all the income of these borrowers and of individuals is denominated in domestic currency.

The selection of scenarios and assumptions for the shocks to be tested are key to assessing the credit risk embedded in the bank portfolio. Supervisors could let banks define the scenarios and changes in the main market variables and assess them at the time of the supervisory review. Alternatively, supervisors could choose to provide assumptions for these changes (exchange rate, interest rate, output). This latter option has the advantage of making the results of the stress tests comparable and easier to review by supervisors. Admittedly, however, under certain circumstances, these assumptions could be interpreted as signals and produce undesirable responses.

Banks should be able to calculate the expected losses from their loan portfolios, including those that could arise from borrowers’ currency, interest rate, or maturity mismatches. These will depend on the borrowers’ probability of default, on the bank’s exposure at the time of default and on the bank’s loss-given-default. While it may not be realistic to expect that all banks in all countries will have the capability to estimate default probabilities, the above- mentioned assessment of capacity to repay should provide a basis for estimating expected losses. In turn, to estimate loss-given-default, banks should be able to assess the recovery value of collateral, which depends on the market value of collateral and on the costs of recovery (taking into account the time it takes to foreclose and fully recover the collateral).

As the recovery value of collateral can also be affected by market conditions, banks should assess this value for changing market conditions. Availability of information on most asset prices is a difficulty that would need to be overcome in most countries. When collateral is difficult to recover, highly illiquid, or its price cannot be estimated, it may be advisable to disregard such collateral. In other cases, frequent appraisals of relevant collateral are an option, albeit costly, for obtaining this information. Alternatively, previously appraised collateral values could be adjusted frequently, using simplified methods to be reviewed by supervisors. For instance, the foreign currency value of real estate collateral could be expected to fall in the event of a depreciation of the domestic currency. In the absence of better information, banks could assume that real estate prices are set in domestic currency, and thus their fall would be proportional to the depreciation of the currency. This method would probably provide a worst-case scenario.

Banks should be required to disclose to the public their policies on credit risk management, and their main exposures, including currency-induced credit risks. This disclosure should be required at least annually, as part of audited financial statements. The availability of this information to the public could foster market discipline as sophisticated creditors would penalize banks that take higher risks, increasing their costs of raising equity or funds, and thus, perhaps encouraging more prudent behavior. However, to prevent disclosure from causing a loss of confidence, disclosure requirements could be phased in so as to give time for improvements in risk management.

Supervisors should conduct independent assessments of banks’ exposure to credit risks, including currency-induced credit risks. These assessments should be done for individual banks and for the overall banking system. Stress testing techniques could be used to estimate banks’ exposure to credit risks under changing market conditions. These stress tests could be conducted with information regularly provided by banks and available in the supervisory data bases. Supervisors should have access to detailed information at the borrower level, of a credit bureau type, for the purpose of conducting these stress tests. Alternatively, supervisors should always have the option to define specific stress test scenarios, and require banks to run them. These off-site assessments should be complemented with an on-site evaluation of banks’ main exposures to credit risks. Box 2 presents an example of simple stress tests that could be applied by supervisors. A more detailed presentation of these tests and the results is included in Appendix II.

While imposing direct limits or prohibitions on granting foreign currency loans to unhedged borrowers seems to have worked for some countries, such as Brazil or Chile, their application to highly dollarized financial systems may not be advisable. It is worth noting that these measures tend to be used by countries where high dollarization has not yet become a problem. Their applicability in countries that are already highly dollarized is likely to be limited. Administrative measures tend to introduce distortions and have high costs of their own, particularly in countries where the use of the dollar in the financial system is well engrained. On efficiency grounds it seems preferable to let banks manage their own risks. Besides, these measures tend to create the largest incentives to seek mechanisms to avoid them, such as regulatory arbitrage. Their application should be carefully evaluated to avoid incurring high costs.

Loan classification and provisioning for expected losses

Banks should be required to have loan classification systems that reflect the borrowers’ capacity to repay and to take into account sensitivity to expected changes in market conditions (e.g., exchange rate, interest rates, output). Loan classification rules in some partially dollarized emerging countries are still based on past payments performance. These need to be phased out and replaced by more forward-looking rules. In particular, a borrower should be downgraded, even if he has always been current on all payments, if his projected cash flow is not adequate to fully service all his debts under expected market conditions. The degree of downgrading should also be related to the extent of the impairment of the borrower’s repayment capacity under likely scenarios. Note that this approach does not imply that foreign currency borrowers who do not have a foreign currency income should be automatically downgraded.

Loan loss provisions should reflect the above-mentioned impairment of borrowers’ capacity to repay arising from expected changes in market conditions. This requirement would tend to produce higher provisioning requirements for foreign currency borrowers whose cash flow is negatively affected by a depreciation of the domestic currency. In this regard, it would also induce banks to better internalize the risks of lending in foreign currency to unhedged borrowers. A combination of specific and general provisions could be applied for this purpose. Specific provisions could be applied when expected losses are estimated for individual borrowers, and general provisions when the estimation of expected losses results from aggregate tests.

The application of loan classification and provisioning rules, based on the capacity to repay and expected losses, requires banks and supervisors to have analytical capabilities that may not currently be in place in some countries. As developing these capabilities takes time, in the meantime, two simplified options could be explored:

  • The first one is a prescriptive approach, whereby the loan classification and provisioning regulation could establish automatic downgrades (and higher provisions) for particular borrower types, whose capacity to repay is perceived to be highly sensitive to expected changes in the exchange rate. These rules would have to be designed for each particular country, taking into account its specific market conditions and institutions. For instance, if individuals are significantly leveraged with foreign currency liabilities, a small depreciation of the currency could have a large impact on their repayment capacity and, hence, authorities could single out foreign currency loans to individuals and require a higher provision. In other countries, corporates that borrow in dollars and specialize in the nontradable sector could be perceived as a problem, and additional provisions could be prescribed for these borrowers, except those for whom banks can show that their capacity to repay would withstand some threshold shock regarding the exchange rate. While simple to implement, this prescriptive approach has a number of drawbacks, as it creates arbitrary divisions between types of borrowers, may create incentives to try to avoid the added costs and, if badly designed, may not help to better internalize risks.

  • The second one requires banks to develop the above-mentioned systems and capabilities to classify and determine provisions for debtors on the basis of expected losses. Those banks that, in the view of the supervisory authority, do not have appropriate systems in place, would be required to have an additional general provision on their overall foreign currency portfolio. Provided that this provision is set at a high enough level, this approach has the advantages of creating the right incentive for banks to develop their systems and capabilities to assess their credit risks, and of providing a buffer that could cover potential shocks. The size of this provision would have to be carefully set to be higher than (or similar to) estimated specific provisions under an expected loss provisioning system.

A buffer to cover unexpected losses

Supervisors of highly dollarized banking systems also need to make sure that banks hold enough capital to cover from credit risk caused by unexpected changes in the exchange rate. Authorities must decide the size of the buffer that would provide this protection, and the policy combination to achieve it. The buffer should: (i) provide reasonable cover for large, low-probability shocks to the exchange rate; and (ii) be risk-sensitive to induce agents to better internalize currency-induced credit risks. Preferably, the added requirement should apply only to assets originating currency-induced credit risks, i.e., operations with debtors whose capacity to repay is hampered with a depreciation (unhedged borrowers). Under international standards, capital would be required to cover unexpected losses, and provisions would only be required to cover expected losses. However, for reasons to be discussed below, some authorities may choose provisions instead of capital to create a buffer to cover the above-mentioned unexpected losses. For simplicity, the decision about the size of the buffer is presented independently of the one about the policy choices.

The size of the buffer

The size of the regulatory buffer to cover currency-induced credit risks would depend on: (i) the impact of the exchange rate shocks on the value of banks’ portfolios, (ii) the probability distribution of exchange rate shocks, and (iii) the degree of protection authorities are comfortable with. Since the shocks and their impact on the value of portfolios are subject to a large degree of uncertainty, the decision will be affected by the availability of information and by assumptions made. In turn, the degree of protection sought by policymakers should take into account that higher protection increases the cost of conducting banking business. These three elements are discussed:

  • Impact of exchange rate shocks on the value of banks’ portfolios. The quantitative assessment of currency-induced credit risk typically involves (i) econometric estimation of the relationship between exchange rate movements and a measure of credit risk, using either aggregate bank data or the financial information of the borrowers, or (ii) forward-looking assessment of the impact of a devaluation on the repayment capacity of the borrower measured by its interest coverage ratio or other financial indicator. The first methodology relies on past information that may not provide a good indicator of the effect of a future depreciation in the event of changes in regulation or changes in the underlying quality of borrowers. The second methodology requires information on the currency composition of the borrowers’ balance sheet and income statement that might not always be available. Both methods rely on the quality of information available and the adequacy of the period of time covered by such information. For instance, currency-induced credit risk could be underestimated if the data available corresponds to a period of economic prosperity (i.e., the upturn of an economic cycle). An example of an assessment of this risk, under the first method, is presented in Box 2, where it is used to examine the size of the buffer needed to cover currency-induced credit risk of various depreciation levels (details are presented in Appendix II).

  • Probability distribution of exchange rate shocks.13 To estimate the probability distribution of exchange rate movements, authorities may refer to past information on exchange rates in the local economy. This approach has the drawback that past information regarding exchange rate changes may not be a good predictor of future changes, particularly for countries with fixed or managed exchange rates, where imbalances have only recently arisen.14 An alternative option could be using historical information from similar countries that have experienced exchange rate shocks or simulations using a macroeconomic model that captures the accumulating imbalances or the distribution of exchange rate changes in a country with similar characteristics. Care must be taken by supervisory authorities to prevent simulations of exchange rate shocks being regarded as a signal of a change in the exchange rate regime or a decision to pursue policies inconsistent with maintaining this regime.15 In all cases the resulting probability distribution would also be affected by the selection of the sample period.

  • The desired level of protection from currency-induced credit risk. Authorities would have to decide their risk tolerance level for currency-induced credit risk. In particular, from what level of depreciation should banks be protected (covered)? Should they be protected from 99 percent of possible levels of depreciation or only from 95 percent of them? The larger the depreciation they want protection from, the larger the buffer that banks would have to hold and, thus, the higher the cost of doing banking business. Therefore, authorities should gauge the benefits from additional protection—measured as the reduction of risks from depreciation—against the additional costs of conducting banking business. The additional costs of conducting banking business (Ci) caused when protecting against an “i” percent devaluation can be measured as the product of the size of the buffer (Bi) required to protect against an “i” percent devaluation times the opportunity cost of capital (r) in percent of output (GDP) or bank profits (P) 16

Ci=r* Bi/GDPorCi=r*Bi/P.
The policy choice: capital versus provisions

The decision on the policy choice to achieve the buffer is not an easy one. Increasing capital to cover unexpected losses may not be feasible in many emerging countries. First, in a Basle I framework, capital requirements are rather inflexible and provisions allow for a better targeted approach—more sensitive to risks—and thus could produce better results in terms of internalizing currency-induced credit risks.17 Second, in most emerging countries, a capital increase would demand a change in legislation, and thus would require more time and coordination. For these reasons, some authorities may prefer to require higher provisions instead of higher capital.

When capital is the policy choice, the challenge for authorities is to make these requirements as risk-sensitive as possible in a Basel I framework. An increase in capital requirements across the board will not do this job. The same objection applies to an increase in capital or provisioning requirements for all foreign currency assets. The use of higher risk weights for assets that are sensitive to currency-induced credit risk would be the best way to do that.

When provisions are the policy choice, the added requirement can be incorporated into the loan classification and provisioning approaches presented above. Adding the buffer requires the use of the particular depreciation that corresponds to the desired level of protection for the analysis of the sensitivity of borrowers’ capacity to repay. Under this option, there is no need to distinguish between expected and unexpected exchange rate movements. Specific provisions could be required when the sensitivity analysis is conducted individually, and general provisions could be required when borrowers are assessed as a pool.

The use of provisions to cover losses in the event of unexpected exchange rate movements departs from International Financial Reporting Standards (IFRS), shortly to be adopted by many developed and emerging countries. In fact, under International Accounting Standard (IAS) 39, assets should be subject to specific provisions when they are impaired, i.e., when there is a known event causing the impairment of the loan. Strictly speaking, a future unexpected depreciation does not qualify as a “known event”.

General provisions, on the other hand, can be required for losses that can be estimated in a pool and have not yet been individualized. Thus, under IAS 39, banks would not hold specific or general provisions to cover for the sensitivity of a borrower’s capacity to repay in the event of an unexpected depreciation. These potential losses would have to be covered by capital requirements. However, authorities that face difficulties in modifying capital requirements can choose to depart from IFRS on this particular subject, for prudential reasons.

Quantitative Assessment of Currency-Induced Credit Risk: The Case of Peru

The impact of exchange rate shocks on the foreign (FX) loan portfolio (see Appendix II for details). In the case of Peru, the econometric estimation of the relationship between provisions and depreciation show that a 1 percent depreciation results in a 1.9 percent increase in the growth of provisions on FX loans:

Growth(FX_loan_provisions/FX_loans)=1.9*Depreciation+f[GDP growth; Lending Rate; Inflation].

The probability distribution of exchange rate shocks and the desired level of protection against currency-induced credit risk. With these econometric estimates, a bank supervisor can assess the minimum capital buffer for a bank to withstand, for example, a 99th percentile exchange-rate shock. The historical distribution of exchange-rate shocks in Peru since mid 1992 shows that the 99th percentile corresponds to a depreciation of 43 percent. Clearly, the larger the shock the supervisor would like to protect against, the more costly in terms of bank capital. Consequently, the supervisor may consider capital buffers against more moderate shocks, such as a 20 percent depreciation (90th percentile shock).

The capital buffer will depend on the size of the exposures, including the FX loan portfolio, and can be set in terms of additional provisions on FX loans or additional capital charges. The figure below shows (i) the capital buffer against an annual depreciation of “x” percent and, as an alternative measure (ii) the risk weight on FX loans that would ensure compliance with the minimum regulatory CAR of 9.2 percent. The buffer has been calibrated to the level of RWA and FX loans of Peru’s banking system. The calculation of the capital buffer assumes that the net FX open position in the banking system is similar to the degree of loan dollarization, however, if the degree of loan dollarization is above the net open position, a larger capital buffer would be needed (see Box 1 for details).

C. Liquidity Risks

Liquidity risks are twofold: (i) idiosyncratic, affecting individual banks and generally related to their own behavior; and (ii) systemic, in case of widespread liquidity problems, generally stemming from macroeconomic fundamentals, contagion or generalized panic. While both risks are present in all financial systems, dollarized financial systems tend to be more vulnerable to systemic liquidity risks. Systemic liquidity problems arise when the demand for local assets falls, due to a perceived increase in country risk or banking risk, prompting depositors to convert their deposits into foreign currency or cash or to transfer them abroad, and/or foreign banks to recall short-term lines of credit. Unless there are sufficient liquid foreign currency assets to back liquid foreign currency liabilities, banks may run out of foreign currency liquid reserves and central banks may run out of international reserves, creating the conditions for a self-fulfilling run. Central banks can print domestic currency to provide lender of last resort (LOLR) facilities, however in foreign currency the LOLR capacity is limited by their holdings of international reserves. Ize, Kiguel and Levi Yeyati (2005) have shown that requiring banks to hold a minimum level of foreign currency liquidity in proportion to their foreign currency liabilities is a second best policy that would ensure that banks do not free ride on the central bank LOLR, transferring the cost of holding liquidity to the public sector and that weaker risk-prone banks do not benefit from the LOLR facilities at the expense of the more prudent banks.

Because of these added risks, the supervisory framework of a highly dollarized banking system should include two elements: (i) a risk based supervision of liquidity risks and their management; and (ii) some type of minimum liquidity requirement to ensure that banks internalize the liquidity risks of operating in a dollarized environment. The first element should be based on the BCBS guidelines on liquidity risk management, taking into account the higher relevance of currency specific and systemic liquidity risks. The second element could be designed as a minimum liquidity requirement or as a minimum reserve requirement.18 Since the goal is to induce banks to better internalize the costs of the liquidity risks, the level of these requirements has to be designed with this objective in mind. An alternative instrument, limits on maturity gaps, is effective for the management of idiosyncratic risks, but may not be as effective in ensuring adequate levels of foreign currency liquid assets in the event of systemic liquidity problems. These issues are discussed below.

Supervision of liquidity risk and liquidity risk management

The international standards on liquidity management, presented in Sound Practices for Managing Liquidity in Banking Organizations (BCBS, 2000) are a key reference for bank supervisors and are applicable to highly dollarized financial systems. These practices state that banks should have a strategy for the management of liquidity (Principle 1) with policies approved by the Board (Principle 2). Banks should also establish a process for the ongoing measurement and monitoring of net funding requirements, analyze liquidity under a variety of “what if” scenarios, review their assumptions frequently to ensure they continue to be valid and have contingency plans to handle liquidity crises (Principles 5, 6, 7 and 9). Moreover, currency-specific issues, which are a key concern in dollarized financial systems, are also explicitly addressed. Thus, banks are expected to have a system to measure, monitor and control their liquidity position in the major currencies in which they are active, and should undertake a separate analysis of their strategy for each currency individually (Principle 10). Based on this analysis, banks are expected to set and review internal limits on the size of their cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which they operate (Principle 11).

Banks’ processes for the ongoing determination and monitoring of net funding requirements should identify funding needs in the main currencies in which they conduct operations. This entails measuring all cash inflows against all cash outflows in each main currency, from all possible sources, including off-balance-sheet items. Immediate funding requirements, as well as future needs, should be determined. A variety of methods can be used for this purpose, but banks should consider not only contractual maturity but observed behavior. Careful profiling of behavior is essential for banks to adequately assess funding requirements under changing market conditions and make sound liquidity decisions. This approach should also be used to monitor compliance with internal limits as well as regulatory limits or cash requirements.

Liquidity analysis should consider a variety of stress tests of individual as well as system-wide disturbances, including the two main specific sources of liquidity risks for dollarized financial systems. First, scenarios should assess the impact on liquidity of changes in market conditions, such as a currency depreciation or rising interest rates, taking into account a bank’s exposure to currency-induced and interest-rate-induced credit risk. These indirect credit risks will affect a bank’s liquidity, as assets may not be repaid under their original terms and may also be difficult and costly to sell under stressful conditions. Moreover, the resulting solvency vulnerability increase the probability of a deposit run against all the banks that are perceived to share this problem, and may lead to systemic liquidity problems. Second, scenarios should model the impact on liquidity of currency specific asset and liability volatility experienced in the past or likely to occur, including possible cases of capital flight. The evolution of a bank’s currency-specific and overall liquidity profile—as measured by a maturity ladder or by ratios of liquid assets—under a variety of scenarios can be a useful benchmark for assessing the bank’s liquidity and for determining the action to be taken to improve the bank’s performance under those conditions.

Banks’ contingency plans should: (i) address their strategy for handling individual as well as system-wide liquidity crises; and (ii) establish procedures for making up cash-flow shortfalls in emergency situations, including currency-specific shortfalls and cash shortfalls in foreign currency (bills). These plans have to consider market and institutional restrictions that may exist under crisis situations. While central banks are the natural providers of domestic currency liquidity, their capacity to provide liquidity in foreign currencies may be limited, and foreign currency liquidity facilities may be unavailable or restricted. While, the issue of currency-specific shortages can normally be solved in foreign exchange markets, these may not be operational under certain circumstances. Moreover, the problem of shortfalls in foreign currency bills is costly to overcome at short notice and under stress. Some central banks of dollarized countries store certain amounts of foreign currency bills, but others may not be willing to assume the costs of storing, shipping, and/or insuring the large amounts of foreign currency bills that could be demanded in a crisis situation. Banks should have clear procedures to solve shortages of foreign currency bills at short notice. Small depositors are more likely to withdraw their deposits in cash, while large creditors are likely to wire them abroad. Therefore banks with a broad deposit base are likely to require proportionally more dollar bills, than banks with a concentrated deposit base. Under systemic crisis scenarios, the strategies should also consider possible limitations of access to key sources of funding (e.g., debt issues in domestic or foreign markets, domestic or foreign interbank funds) and market disturbances affecting the liquidity of markets for domestic assets normally regarded as liquid (e.g., domestic corporate equity or bonds, government paper).

Supervisors should assess the adequacy of banks’ liquidity risk strategies, policies and procedures to withstand the types of disturbances that are likely to occur in the financial system in which they operate. In this regard, the supervisory review should examine whether banks’ plans, policies, and actions take into account the specific sources of liquidity risk of operating in a dollarized financial system, such as currency-induced credit risk, the absence of a lender of last resort and the added potential of systemic liquidity crunches. The review of banks’ contingency plans should take into account the adequacy of the banks’ strategy to address shortfalls of foreign currency liquid assets and foreign currency cash. The supervisory assessment of banks’ exposure to liquidity risks, should take into account liquidity risks derived from currency-induced credit risks. Based on this assessment, supervisors should require corrective measures as necessary, including changes to liquidity risk management policies and practices, additional holdings of liquid assets or lower maturity mismatches, and reduction of exposure to liquidity risks stemming from currency-induced credit risk.

A buffer for liquidity risks

Systemic liquidity risks associated with foreign currency deposits, and banks’ tendency to underprice them, create a need to have a buffer to protect individual banks and the banking system. There is tension between banks and monetary authorities as to who pays for the costs of holding high foreign currency liquid assets. In dollarized financial systems, most banks—if left alone—will hold fewer liquid assets than necessary to withstand likely shocks, expecting that the monetary authority will provide needed liquidity assistance. In this context, minimum liquidity or reserve requirements are preferred to more market-based measures, such as limits on maturity gaps. Limits on maturity gaps are more risk sensitive and, as they allow banks more freedom on how to manage their liquidity, are also less costly than liquidity (or reserve) requirements, and, hence, could be preferable to control liquidity risks in most financial systems. However, they are unlikely to provide an adequate buffer to protect banks and the financial system from liquidity risks in dollarized systems. First, they depend on bank assumptions about creditor and debtor behavior and, in particular about the liquidity of assets and liabilities. Second, under a systemic liquidity crisis, assets that are normally liquid may not be so liquid, and liabilities that are normally stable may not be so stable. This is particularly true if early withdrawal of time deposits and other liabilities is possible. Thus, under a systemic liquidity crisis, liquid assets may be used to repay obligations of a wide maturity range.

Currency specific minimum liquidity (or reserve) requirements could be used to account for the higher liquidity risks of foreign currency liabilities. To ensure that banks internalize these risks, required foreign currency liquid assets should be held in foreign currency and their rates may be set higher than domestic currency requirements. The specific design of the minimum requirements has to be tailored to the needs of each particular country. However, the following general considerations should be noted:

  • Liquid assets eligible to comply with these requirements should be liquid even under stressful market conditions. In some countries this restricts the range of eligible assets to cash, deposits at the central bank, and liquid deposits in investment grade financial institutions abroad. In others, the range of liquid assets could be somewhat wider. If pressures are likely to mount to use central bank international reserves for other purposes (e.g., fiscal), it may be advisable to have liquidity requirements, instead of reserve requirements. In turn, if there are difficulties in ensuring that bank liquid assets are in fact liquid (e.g., they may be pledged as collateral for bank operations), reserve requirements may be preferable. An alternative option would be to set up a trust fund abroad, with the sole purpose of being used as collateral for central bank facilities to the contributing banks. The trust fund would be protected from both pressures to divert it for fiscal purposes and the possibility that risk-prone banks elude liquidity requirements by pledging their liquid assets.

  • The liability base should include the broadest range of liabilities likely to be volatile under stressful market conditions. This reduces the scope for arbitraging the regulation by booking some liabilities so that they are excluded from the minimum requirements.

  • When setting the minimum rates, authorities would have to assess the costs of these requirements against the benefits of the insurance they provide by protecting the financial system from potential shocks. Insuring against all possible shocks would not be desirable as the excessive costs would encourage regulatory arbitrage. An example of a simplified way in which the costs and benefits of these requirements can be assessed is presented in Box 3.

Costs and Benefits of Prudential Requirements to Control Liquidity Risk: The Case of Peru

This box estimates the costs and benefits of two overlapping prudential requirements used in Peru to control liquidity risks: reserve requirements and liquidity requirements.

Prudential Norms

Reserve requirements: Required reserves are held as vault cash or deposits at the central bank in the deposits currency denomination. In addition to a 6 percent non-remunerated reserve requirement applied to all deposits, foreign currency deposits (FCDs) are subject to 30 percent marginal reserve requirement (down from 45 percent in 1998, but up from 20 percent in early 2004). This regulation was recently modified to subject more credits from banks abroad to reserve requirements. Thus, average required reserves on FCDs are currently 29.5 percent. The central bank pays a fixed rate of 2.25 percent on foreign currency reserves above the 6 percent level.

Liquidity requirements: Banks are required by the supervisory authorities to hold liquid assets equivalent to at least 8 percent and 20 percent of all their liabilities maturing during the next 12 months, in domestic currency and foreign currency, respectively. Eligible assets include vault cash, deposits at the central bank, central bank certificates of deposit, deposits in first-rate foreign banks, and investments in securities negotiated in centralized markets and rated as investment grade by international agencies.

Costs

Both liquidity and reserve requirements affect banks’ profits, as liquid prime assets normally earn lower returns than less liquid assets and reserve requirements are remunerated as below market rates. Assuming that, in the absence of liquidity or reserve requirements, banks would only hold liquid assets equivalent to 5.5 percent of local currency liabilities and 3.6 percent of foreign currency liabilities, costs would amount to 1.60 percent of liabilities in foreign currency (1.5 percent for reserve requirements and 0.7 percent for liquidity requirements) and 0.45 percent of liabilities in domestic currency (0.2 for reserve requirements and 0.4 percent for liquidity requirements).

Benefits

The marginal contribution of the liquidity and reserve requirements to limiting liquidity risk can be estimated by subtracting the liquid assets that banks would hold voluntarily from the required liquid assets, which amounts to 15 percent of total bank liabilities. This figure is substantially above the maximum run experienced by the Peruvian banking system from 1993 to June 2002 (maximum losses for the banking system range from 2.0 percent to 8.3 percent). However, since runs have been generally accompanied by some flight to quality, this buffer would not protect against—and perhaps should not be expected to protect against—the largest run at the individual bank level.

  • As a prudential tool, these requirements should not be set to unduly tax banks’ operations or to create a captive demand for government debt. If liquid assets are required to be held in the form of central bank liabilities—such as deposits at the central bank or central bank securities—these should pay market interest rates.

D. Implementation Issues

The implementation of the proposed framework to strengthen the supervisory framework for dollarized financial systems would give rise to a number of challenges for bank supervisors.

How, when, and to what extent the above-mentioned adaptations should be implemented are not easy decisions. The specific characteristics of the financial system, the economy in which it operates, and the market infrastructure and institutions have to be taken into account. The following questions are at the center of the decision process:

  • Who needs this framework anyway?

  • How much risk reduction is desirable?

  • What is the best sequence of implementation for the financial system?

  • How can regulatory arbitrage be avoided?

  • Is the implementation of this framework independent of the actions of other national authorities? Or should it be regarded as part of a broader national plan to reduce the vulnerabilities from dollarization, and therefore, be coordinated with other authorities, such as fiscal or monetary authorities?

  • How can these measures be integrated into the broader plans of supervisory and regulatory improvements?

There is no unique dollarization threshold beyond which countries should implement the proposed measures. It is important to note that these recommendations are not to be regarded as an all-or-nothing package. Some countries may need all of them, others may need some of them, yet others may need none. Clearly, countries with dollarization levels above 50 percent, or with somewhat lower but increasing levels of dollarization, should seriously consider the risks discussed in this paper. On the other hand, countries with dollarization levels below 15 percent need not invest resources in adapting their supervisory frameworks. In many countries, however, it may not be easy to decide if it is worth investing time and resources to insure against risks that may or may not materialize. The recommendation for those countries in the gray area is to first gather information that will allow an assessment of their exposure to these risks. Stress tests, such as the ones presented in Appendix II, can assist the authorities in determining how sensitive the solvency and liquidity of their financial systems are to an exchange rate depreciation and other market disruptions associated with dollarization. In some countries, high exposure to dollarization risks could be concentrated on one business segment, such as mortgage or consumer loans, and so it would be best to address these risks separately.

The costs of controlling the risks of dollarization could be high for highly dollarized financial systems. In fact, the costs of implementing the proposed measures would be high if the risks that need to be addressed are also high. The measurement of the additional risks from dollarization, the estimated risk reduction achieved by a specific prudential measure and its costs are key for the design of prudential requirements. How much protection against the risks of dollarization is desirable has to be gauged against the costs of this protection. Calculations such as the ones presented in Boxes 2 and 3 could be of assistance for this purpose. The objective of these prudential requirements cannot be to eliminate all risks, as the enormous costs would create huge incentives for arbitrage. In some cases, a carefully phased implementation would be necessary to achieve the desired risk reduction without making the business unprofitable. A road map for implementation needs to be tailored to the specific needs, the level of bank supervision, and the condition of the banking system of each particular country.

While the optimal sequence of implementation cannot be defined independently of the country’s institutions, supervisory framework, and the condition of its financial system, there are two general recommendations:

  • Currency-induced credit risk is a specific type of credit risk. Supervisory measures that attempt to address this risk, without having addressed the more general weaknesses of overall credit risk management, are not likely to prevent the next financial crisis. More precisely, if banks do not have adequate overall credit risk management, they are unlikely to have good currency-induced credit risk management.

  • Better disclosure of risk exposures and management policies can promote market discipline; however, when applied in vulnerable financial systems and weak risk management, it could also create confidence problems. The timing of disclosure requirements has to be carefully considered to prevent this from happening.

Tightening prudential regulation in the banking system may create incentives for regulatory arbitrage. Banks could be induced to transfer risks to, or register transactions in, other entities—domestic or foreign—that are not subject to the new prudential requirements. In designing these measures, authorities should try to reduce the scope for regulatory arbitrage. This is particularly important when designing provisioning or capital requirements, minimum liquidity requirements, and limits or prohibitions on certain mismatches or transactions. Changes may need to be accompanied by measures geared at avoiding circumvention of such regulations. For instance, supervisors should be aware that tightening norms on currency- induced credit risk may lead banks to increase intermediation in local currency with much shorter maturities, trading one risk for another (i.e., when long term projects are financed with short term domestic currency loans, the currency-induced credit risk is traded by a direct credit risk). The possibility of increasing risks in the domestic currency loan portfolio should not be overlooked. Also, whenever possible, the regulations should be applied to all members of a conglomerate. For this purpose, effective consolidated supervision is necessary. It is noted, however, that in some of the countries surveyed, consolidated supervision of conglomerates is incomplete and ineffective. Moreover, authorities may lack the power to impose prudential requirements beyond the domestic borders, particularly if the cross-border members of the conglomerate are not branches of the domestic bank. Additionally, regulatory arbitrage is not a static problem. In fact, the effectiveness of some measures may erode over time as banks find ways to elude their costs, and thus supervisors should often review them to ensure their continued effectiveness.

The recommendations discussed in this paper can be easily integrated into the current improvement plans of most supervisory agencies. The proposed adaptations to the supervisory framework are based on the Basel I framework, but are also consistent with a transition towards Basel II. In fact, being in compliance with Basel Core Principles for Effective Banking Supervision and implementing other elements of the Basel I or Basel II supervisory framework would help to improve the effectiveness of the proposed measures.

Since prudential supervision can only mitigate some of the risks arising from dollarization, prudential measures may need to be part of a broader medium-term plan designed to promote the use of the domestic currency. The plan would include measures such as: keeping inflation low, removing administrative ceilings on interest rates, reducing high unremunerated reserve requirements for local currency deposits, developing markets for local currency-denominated public securities, and improving the efficiency of the payments system.19 While most of the prudential measures to strengthen the supervisory framework could be implemented independently of other national authorities, coordination between monetary and prudential authorities is advisable to improve the effectiveness of their plans.