El Salvador
Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Publication Date:
11 Feb 2014
eISBN:
9781475513790
ISBN:
9781475513790
Language:
English
Keywords:
ISCR; CR; central bank; capital adequacy ratio; banking law; financial system; interest rate
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This paper presents an assessment of financial sector stability in El Salvador. The findings reveal that the financial system of El Salvador was resilient in the face of the global shocks and political uncertainty that took a toll on the economy in 2009. The new stand-by arrangement with the IMF bolstered confidence in the new authority’s policies and eased concern over the limited lender-of-last-resort capacity of the central bank. Despite the adverse economic environment of 2009, banks’ capitalization and liquidity remain high, and stress tests indicate that most banks could withstand severe shocks. Regulated nonbanks are also sound, but pension funds’ poor profitability could pose a problem in the longer term.

Abstract

This paper presents an assessment of financial sector stability in El Salvador. The findings reveal that the financial system of El Salvador was resilient in the face of the global shocks and political uncertainty that took a toll on the economy in 2009. The new stand-by arrangement with the IMF bolstered confidence in the new authority’s policies and eased concern over the limited lender-of-last-resort capacity of the central bank. Despite the adverse economic environment of 2009, banks’ capitalization and liquidity remain high, and stress tests indicate that most banks could withstand severe shocks. Regulated nonbanks are also sound, but pension funds’ poor profitability could pose a problem in the longer term.

© 2014 International Monetary Fund

February 2014

IMF Country Report No. 14/44

El Salvador: Financial System Stability Assessment

This paper on El Salvador was prepared by a staff team of the International Monetary Fund. It is based on the information available at the time it was completed in May 2010.

Copies of this report are available to the public from:

International Monetary Fund • Publication Services

700 19th Street, N.W. • Washington, D.C. 20431

Telephone: (202) 623-7430 • Telefax: (202) 623-7201

E-mail: publications@imf.org Internet: http://www.imf.org

International Monetary Fund

Washington, D.C.

INTERNATIONAL MONETARY FUND

El Salvador

Financial System Stability Assessment

Prepared by the Monetary and Capital Markets and WHD Departments

Approved by Mr. Viñals and Mr. Eyzaguirre

August 30, 2010

This Financial Sector Stability Assessment (FSSA) is based on the work of a joint IMF-World Bank Financial Sector Assessment Program (FSAP) Update mission to San Salvador from April 27–May 10, 2010.

The main findings are:

  • The financial system was resilient in the face of the global shocks and political uncertainty that took a toll on the economy in 2009. The new stand-by arrangement (SBA) with the IMF bolstered confidence in the new authority’s policies and also eased concerns over the limited lender of last resort capacity of the central bank.

  • Despite the adverse economic environment of 2009, banks’ capitalization and liquidity remain high and stress tests indicate most banks could withstand severe shocks. Regulated non-banks are also sound, but pension funds’ poor profitability could pose a problem in the longer-term.

  • Implementation of the 2004 FSAP update recommendations has been limited, largely because key laws and regulations have yet to be approved. However, the supervisory framework for banks, insurance, and cross-border cooperation were improved, and partial progress was made in strengthening financial infrastructure, the microfinance regulatory framework, and restructuring of state-owned banks.

  • Going forward, strengthening supervisory powers and risk assessments, closing regulatory gaps, and enhancing the safety net are priorities to promote financial stability. Passage of the proposed financial system supervision and regulation law would merge supervisory agencies and strengthen supervisory powers, but requires careful implementation and cooperation on regulation, and should also be accompanied by comprehensive crisis management policies and arrangements.

The Update team comprised Eva Gutierrez (Mission Chief, WB); Pamela Madrid (Mission Chief, IMF); Jordi Prat, Andrew Swiston, and Torsten Wezel (all IMF); Patricia Caraballo, Carlo Corazza, Barbara Cunha, Miquel Dijkman, Rekha Reddy, Monica Rivero, Eduardo Urdapilleta, and Clemente Luis del Valle (all WB); Javier Bolzico, Socorro Heysen, and Jose Rutman (all IMF Consultants); and Hugo Secondini (WB Consultant).

The main author of this report is Pamela Madrid with input from other members of the FSAP team.

FSAP assessments are designed to assess the stability of the financial system as a whole and not that of individual institutions. They have been developed to help countries identify and remedy weaknesses in their financial sector structure, thereby enhancing their resilience to macroeconomic shocks and cross-border contagion. FSAP assessments do not cover risks that are specific to individual institutions such as asset quality, operational or legal risks, or fraud.

Contents

Glossary

AML/CFT

Anti-Money Laundering/Combating the Financing of Terrorism

BCR

Central Bank of El Salvador (Banco Central de la Reserva)

BFA

Banco de Fomento Agrario

BL

Banking Law

BMI

Banco Multisectorial de Inversiones

BH

Banco Hipotecario

CAR

Capital Adequacy Ratio

CEDEVAL

Central Securities Depository

CNR

National Registry (Central Nacional de Registros)

CPSS

Committee on Payment and Settlement Systems

FINRA

Financial Industry Regulatory Agency

FSAP

Financial Sector Assessment Program

FSSRL

Financial System Supervision and Regulation Law

GDP

Gross Domestic Product

IDB

Inter-American Development Bank

IGD

Deposit Insurance Fund (Instituto de Garantía de Depósitos)

IFRS

International Financial Reporting Standards

IMF

International Monetary Fund

IOSCO

International Organization of Securities Commissions

LOLR

Lender-of-Last-Resort

NPL

Non-Performing Loan

MIL

Monetary Integration Law

OTC

Over-the-Counter

P&A

Purchase and Assumption

ROA

Return on Assets

ROE

Return on Equity

ROSC

Report on Standards and Codes

RTGS

Real Time Gross Settlement

SDR

Special Drawing Rights

SSF

Financial System Superintendence (Superintendencia del Sistema Financiero)

SV

Securities Superintendence (Superintendencia de Valores)

Executive Summary

Despite the global and domestic shocks of 2008–2009, the banking sector remains sound. Salvadoran banks were not directly exposed to the global financial crisis. However, the parent banks of several major Salvadoran banks were hit hard and directed subsidiaries to conserve risk capital. The higher risk aversion and recession in the United States, combined with uncertainty about the 2009 elections, led to a sharp economic downturn, and a decline in both credit demand and supply. Banks nonperforming loans increased and profitability declined. Even so, capitalization remained high. Stress tests indicate most banks are resilient to a severe macroeconomic, sectoral and liquidity shocks.

Implementation of the 2004 FSAP update recommendations has been limited (Appendix 1). The supervisory frameworks for banks, insurance, and cross-border cooperation were improved and partial progress was made in strengthening the financial infrastructure, insolvency process, microfinance regulatory framework, and restructuring of state-owned banks. However, important legal provisions to strengthen supervision and safety nets, as well as a corporate insolvency law have not yet been approved. Furthermore, while loan classification and provisioning rules were upgraded, important risk and corporate governance regulations for banks have yet to be issued.

The proposed Financial System Supervision and Regulation Law (FSSRL) could improve consolidated supervision and reduce the scope for regulatory arbitrage, but will require careful implementation. The FSSRL would merge the supervisors of banks and insurance, pensions, and securities to create one unified supervisor, with stronger powers. To balance this, the FSSRL would shift regulatory power to the central bank. A sole supervisor and a sole regulator are expected to facilitate consolidated supervision, as well as reduce regulatory gaps and the scope for regulatory arbitrage. However, the merger of supervisors and the institutional split between regulatory and supervisory powers will require a great deal of planning and ongoing cooperation between the supervisor and the regulator to ensure effective supervision.

Remaining gaps in banking supervision and the safety net should be addressed. Supervisory practices should include more qualitative judgment and forward-looking risk assessments, and the regulatory perimeter should be reviewed. Key banking regulation (e.g., on corporate governance as well as credit, market, interest and liquidity risks) must be issued and the proposed FSSRL should more comprehensively address shortcomings in legal protection and the remedial action framework. The banking law should also be amended to strengthen the least-cost bank resolution framework as well as the deposit insurance fund. Regulations implementing the central bank’s (limited) powers for emergency liquidity assistance (ELA), as well as the bank resolution process are also needed. Passage of the proposed FSSRL would provide the BCR with more ELA powers, although the authorities should also design and test comprehensive policies for systemic liquidity and banking crisis resolution.

Oversight of financial services provided by entities not subject to prudential regulation should be strengthened, as should the availability of information on borrowers. A range of bank and non-bank institutions provide credit and deposit services to individuals and micro-small- and medium-enterprises. However, below a certain size threshold some are not subject to regulation and supervision by the SSF. Institutions that license and provide voluntary oversight of these institutions should report to the SSF when thresholds are exceeded. A system of auxiliary supervision could also strengthen oversight of these unregulated institutions. To address concerns of over-indebtedness and promote transparency, consumer protection regulations could require lenders to provide borrowers with information on the total cost of a loan. The Banking Law (BL) should be reformed in order to allow the free circulation of credit information among all the members of credit bureaus.

Control over the national payments system should be strengthened, and integration with a regional payment and securities settlement system enacted. The launch of the Real Time Gross Settlement System (RTGS) has substantially improved the safety of large-value payments. However, reforms are needed to ensure the BCR has control over operational reserves and adequate oversight of the system. The Central Bank Law should be amended to implement the regional treaty on payment and securities settlement systems.

Public banks may play an increasingly important role in diversifying and expanding sources of funding for small businesses and infrastructure, but this should be accompanied by enhanced oversight. In the wake of declining credit to the productive sector and the current credit crunch, the Salvadoran authorities have announced an expansion in public banks’ activities and are formulating a strategic plan for the sector. So as to not distort the market and maintain their soundness, public banks’ activities should be appropriately focused and priced, and government oversight and prudential supervision of these enhanced to ensure adequate governance, systems and controls, and risk management.

Sound capital markets development could bolster the economy’s resilience to shocks by diversifying and expanding the sources of funding for corporations, but requires comprehensive reforms. As a result of reform paralysis over the last decade, El Salvador has relatively low standards for securities supervision, and market development has been constrained. The passage of a new Investment Funds Law and comprehensive reform of capital markets legislation would help expand the investor base and facilitate regional integration. This financial deepening may allow for increased private investment and growth, which could bolster the economies resilience to shocks.

Main Recommendations of the 2010 FSAP Update

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FSAP recommendations that do not directly impact near-term stability are not discussed in the FSSA.

Near-Term (NT) is one to three years and medium-term (MT) is three to five years. This is the period during which it is would be feasible to complete implementation of the high-priority recommendations.

I. Macroeconomic Developments

1. Between the 2004 FSAP Update and the global financial crisis of 2008, economic growth accelerated and financial integration with the United States increased. The Salvadoran economy is highly linked with that of the United States (Figure 1). Since 2004, a favorable external environment, growing trade with the United States, and rising remittances helped real GDP grow by an average of 3 ½ percent from 2005–2008, compared to 2 percent from 2001–2004 (Table 1). Nonetheless, growth remained below the regional average, weighed down by low private investment and saving (Figure 2).

Figure 1.
Figure 1.

El Salvador: Economic Integration with United States

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: Bank for International Settlements; Haver Analytics; IMF, Direction of Trade Statistics; IMF, World Economic Outlook; National Sources; and FSAP Analysis.
Table 1.

El Salvador: Selected Economic Indicators

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Sources: Central Reserve Bank of El Salvador; Ministry of Finance; and Fund staff estimates.

Over last ten years.

Includes gross debt of the nonfinancial public sector and external debt of the central bank.

Figure 2.
Figure 2.

El Salvador: Macroeconomic Fundamentals

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: IMF, World Economic Outlook; Central Reserve Bank of El Salvador; Ministry of Finance; and FSAP Analysis.1/ Excludes Honduras and Nicaragua on account of breaks in the series due to debt forgiveness.

2. In 2008–2009, the economy was hit by a number of shocks, tipping the economy into a recession from which it started to recover in 2010. With the intensification of the global financial crisis in late-2008 and uncertainty about economic policies in advance of the 2009 elections, the sovereign spread rose sharply and banks’ liquid assets and lending interest rates increased, while credit and deposit growth decelerated sharply.1 The deterioration in global growth—especially in the United States—and increased uncertainty about economic prospects sharply reduced trade, remittances, and private capital flows in 2009 (Figure 3). Despite the partial use a $400 million Inter-American Development Bank (IDB) line—through which the central bank purchased high-quality loans from commercial banks—as well as reduction in the liquid asset requirement, credit to the private sector declined 4 ½ percent. Investment and private consumption fell sharply, and real GDP declined by 3 ½ percent. The recession pushed the fiscal deficit to 5 ½ percent of GDP and public sector debt rose to 50 percent of GDP, leading credit rating agencies to downgrade the sovereign by one notch.2 For 2010, economic growth is envisaged at 1 percent, aided by a robust recovery in exports and modest recovery in remittances.

Figure 3.
Figure 3.
Figure 3.

El Salvador: Recent Macroeconomic Developments

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: Haver Analytics; National Sources; IMF, World Economic Outlook; and FSAP Analysis.1/ Includes Costa Rica, the Dominican Republic, Nicaragua, and Panama for quarterly real GDP and adds Guatemala and Honduras for consumer prices.

3. The authorities’ policy priorities are to increase key social spending and spur credit and private investment within a framework that safeguards debt sustainability. A new stand-by arrangement (SBA) with the IMF approved in March 2010 aims to signal a continued commitment to macroeconomic stability and official dollarization.3 The authorities envisage a fiscal pact containing tax measures of at least 1½ percent of GDP to support key social program spending as well as durable fiscal consolidation. Furthermore, the authorities have developed a strategic plan to increase credit and investment, including by strengthening two small public commercial banks and through a new government credit guarantee fund and economic development fund, both administered by a newly structured public development bank. Approval of laws to reform financial sector supervision and regulation, and to provide a framework for investment funds are key parts of the strategy (as well as benchmarks for financial sector structural reforms under the SBA).

4. Downside risks to the baseline growth forecast and near-term macroeconomic stability arise mainly from exposures to political and external shocks. Growth is expected to remain below potential through 2012, as the fiscal stimulus is withdrawn and credit recovers slowly, but pick-up to 4 percent thereafter. However, a double-dip recession in the United States could lead to an economic downturn that endangers the fiscal targets. Furthermore, fiscal sustainability hinges on timely congressional approval of financing and on broad-based political support for further fiscal consolidation. Deterioration in either external market conditions or political support could raise financing risks—including from the need to roll over a Eurobond in 2011—as well as liquidity risk. These and other events that would have a significant negative impact on the macroeconomic environment and could impact financial stability are discussed further in the Risk Assessment Matrix (Appendix 2).

5. There are longer-term risks arising from pension-related contingent liabilities. Funding requirements for pensioners on the old pay-as-you-go system are in the order of 1½ percent of GDP. Lower-than-expected returns under the new defined contribution system may create a wedge between returns earned and the minimum pension that the current system grants, which creates a potential contingent liability for the government.

II. Financial Sector Structure and Developments

6. El Salvador’s bank-centered financial sector is growing more slowly than the regional average. The Salvadoran financial sector is dominated by banks (Table 2). Since the banking crisis of the late 1990s, credit-to-GDP has stagnated. Some financial intermediation is taking place through many small and unregulated entities, which are not captured in official statistics. Nonetheless, with US$8 billion in bank credit outstanding and credit-to-GDP at 40 percent of GDP, El Salvador is now lagging behind the regional average (Figure 4).

Table 2.

El Salvador: Financial System Structure

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Source: Superintendencia del Sistema Financiero. Note: 1. Information correspond to regulated institutions only. 2. There are no records of collective investment schemes such as mututal funds, investment trusts and investment managers. * includes cooperative banks and regulated federations of cooperatives (2004- 2009) and 2 savings and loans societies (starting in 2009)
Figure 4.
Figure 4.

El Salvador: Evolution of the Financial Sector

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Source: Worldbank FINSTATS, and Superintendencias Financieras

7. Capital markets in El Salvador remain small and relatively underdeveloped. At end 2009, there were only 40 listed stocks and a few private corporate bond issuers (Table 3). Stock market capitalization of US$5.2 billion (24.6 percent of GDP) was slightly above the regional average (Figure 4). However, excluding the shares of the financial institutions that are largely controlled by foreign institutions and hardly traded, remaining capitalization was only US$1.2 billion (5.6 percent of GDP). About US$6 billion (28.7 percent of GDP) in government securities are outstanding, but 67 percent of this is represented by Eurobonds issued in the international market. Private debt securities outstanding equal only 3 percent of GDP, below the regional average. Overall, institutional investors (mainly banks and pension funds) invest less than 10 percent of their total assets in capital market instruments.

Table 3.

El Salvador: Capital Markets

(US$ million, unless otherwise stated)

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Source: BCR and El Salvador Securities Commission.

8. The ownership of the financial sector has changed dramatically in recent years and is now almost fully foreign-owned. Foreign ownership expanded with the purchase of or merger with the four largest banks by regional and international financial groups between 2005 and 2007. Currently, El Salvador has the largest presence of foreign banks among Central American countries, with two domestic banks (both state-owned) accounting for only 5 percent of banking assets. As before, financial groups (i.e., those including a combination of banks, insurance, and securities companies), remain an important feature of the financial sector, but now have an increasingly international and regional dimension.

9. Foreign-owned banks have restructured their credit portfolios and several have reduced credit to firms, as in other parts of the region. Most larger private banks expanded credit during the economic upswing that began in 2004 and prior to their sale to international banks. Following the change in ownership, the foreign-owned banks increased write-offs and rationalized credit lines according to the stricter policies of their parents. The global financial crisis and ensuing economic downturn led to a continued downward trend in credit at some of foreign banks, although one internationally owned bank increased credit sharply as did public banks (Figure 5). As in other parts of the region, consumer credit has grown faster than corporate credit, which has actually declined in real terms.

Figure 5.
Figure 5.

El Salvador: Credit Trends at Large and Public Banks

(Credit-to-GDP)

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Source: SSF and staff calculations.

10. Increased consumer credit has been accompanied by concerns of over-indebtedness, prompting legislation on loan workouts and stronger consumer protection provisions. Between 2004 and 2009, the number of loans to individuals increased 33 percent. Lack of complete credit history information available to non-regulated financial institutions, which service mostly the lower end of the market, may be exacerbating the problem among small debtors. Some lenders have exited the under US$1,000 market, which they view as increasingly risky. A recently proposed law would require increased transparency about costs and any lack of clarify in a loan contract should be interpreted in favor of the client. A special loan work out unit would be created in the Salvadoran consumer defense agency to assist borrowers in loan restructurings. This may increase banks legal risks.

11. Brokerage houses owned by foreign banks have eliminated their fund management activities, reducing their exposure to liquidity and legal risks. There is no mutual fund industry in El Salvador due to the lack of a proper regulatory framework, but brokers had traditionally provided fund management services. However, these broker funds have been effectively phased-out following the purchase of the domestic financial groups by international and regional banks. The risks created by inadequate regulation—which do not require mark-to-market valuations, nor clear separation of the fund’s assets—as well as the marketing of these funds as though they were sight bank deposits, redeemable on demand at face value, were deemed too high. As a result, investment funds’ assets decreased from US$700 million in 2006 to only US$79 million in 2010, with only one, independently-owned, fund remaining.

12. In contrast, pension funds have accumulated a greater share of total financial assets, although these are mainly invested in government securities. Pension funds, originally set up in 1998, have expanded rapidly due to mandatory contributions and as younger workers joined the new capitalization system. Assets under management (US$5.3 billion at end-March 2010), account for 24 percent of financial sector assets. These are invested in fixed-return investments, mostly public sector securities (79.4 percent).

III. Banking Soundness and Stability

A. Financial Soundness Indicators and Risk Exposures

13. Since the 2004 FSAP Update, banks’ capitalization has strengthened, while asset quality improved through 2007 due to the cyclical upturn and write-offs. The minimum required capital adequacy ratio (CAR) was increased to 12 percent in 2005 and most banks currently maintain significant additional capital buffers (Table 4). The largest (foreign-owned) banks introduced more stringent corporate credit underwriting in line with their parent company policies. Nonperforming loans (NPLs) remained relatively low (around 2 percent of total loans) between 2005 and 2007, helped by the cyclical upswing. Furthermore, banks wrote-off about 2 percent of total loans during 2006–2007.

Table 4.

El Salvador: Financial Soundness Indicators

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Source: BCR, SSF and staff calculations.

Included in the “core and encouraged set” of FSIs.

Includes public commercial banks

Tier 1 capital to total on- and off-balance sheet assets.

Excluding Belize and Panama.

Loans past-due more than 90 days.

Including restructured and refinanced loans.

Liquid reserves plus liquid asset to deposits and other bank liabilities.

14. While banks were not directly exposed to toxic assets or heavily dependent on wholesale funding, the global financial crisis along with the start of the electoral period led to shedding of riskier assets. Some Salvadoran subsidiaries of international banks were restricted by their headquarters in the use of risk capital and faced reductions in external credit lines, despite these subsidiaries being well-capitalized. Fortunately, confidence in these subsidiaries was bolstered by the support that was provided to the parent financial group by their home governments. However, coupled with uncertainty regarding economic policies prior to the elections in mid-2009, annual deposit growth was briefly negative in January 2009. Amid this increased and widespread risk aversion, external borrowing declined close to 50 percent, and liquid assets increased to over 40 percent of deposits (Figure 6).

Figure 6.
Figure 6.

El Salvador: Banking Sector Developments

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: SSF; BCR; Haver Analytics; and Fund staff calculations.

15. With the ensuing credit crunch and recession of 2009, asset quality and profitability deteriorated. NPLs rose by less than 1 percentage point to 3 ¾, but in line with the stronger downturn in El Salvador the ratio rose by more than in the rest of Central America (Table 5).4 A wider measure of loans at risk, incorporating restructured and refinanced loans suggests a stronger deterioration in asset quality to 10 percent of total loans. Furthermore, write-offs amounted to 2 ½ percent of the loan portfolio in 2009. The additional provisions—offset to some extent by higher interest rate margins—weighed on already low bank profitability, with the return on average assets falling to 0.3 percent in 2009, well below the rest of the region.

Table 5.

El Salvador: Regional Comparisons of FSIs

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Sources: National Sources; and Central American Monetary Council.

Simple average of Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua, and Panama.

Cash and investments as percent of immediate liabilities and deposits.

16. Despite this deterioration, most banks remain highly capitalized. Although a few banks are close to the regulatory minimum, the system’s capital adequacy ratio of 16.5 percent is relatively high. This high level of capitalization reflects an increase in liquid assets, which carry a low risk-weight, as well as capital injections in some banks. The quality of capital is also high (Tier 1 capital amounts to 13.7 percent of risk-weighted assets and consists mostly of retained earnings), and the leverage ratio is low (Tier 1 capital is 8.9 percent of on- and off-balance sheet assets). Regulatory capital (Basel definition) is slightly overstated at a number of banks due to the inclusion of goodwill resulting from the acquisition of banks and other intangible assets, but the amounts are not material (only about 1 percentage point of capital). Similarly, adjusting provisions to a debtor’s lowest risk classification slightly affected the CARs of only a couple of small banks, with almost no impact for the total system. Adjusting for possible underprovisioning of restructured agricultural loans held off-balance sheet in a trust (Ficafe), would not result in any bank being undercapitalized, with the system CAR declining to 15.4 percent.5 Furthermore, adjusting for government bonds’ risk weight (from zero to 100 percent) reduces the system CAR to 14.7 percent, and most banks still have a comfortable buffer of at least 1 percentage point above the minimum 12 percent.

17. Banks’ direct cross-border exposures are limited by bank policies and regulation, and ownership linkages appear to have only had marginal impacts on these. Cross-border lending accounts for only about 4 percent of total loans and less than 20 percent of capital (Tables 5 and 7). Banks’ deposits and investments held abroad are mostly low-risk investments held to comply with reserve requirements. Equivalent to 54 percent of capital, these are not a large exposure for banks; and at 7 percent of liabilities, these are equal to banks’ external borrowing. This reflects parent banks’ policies that require their subsidiaries to mostly fund and lend domestically. Regulatory requirements also contain cross-border risks.6 In total, as of March 2010, exposure to foreign assets was equal to less than 80 percent of capital, and the direct exposure to parents was only about 12 percent of capital (up from 6 percent in March 2009). Reputational risk from identification with the parent financial group currently has been limited, as international banks have had sovereign support. While, foreign-owned banks may be required by their headquarters to respond if the group is under stress (e.g., by saving on risk capital, repatriating dividends, and even providing liquidity or lending to the parents), this appears to have been limited (and are well within prudential limits).

Table 6.

El Salvador: Commercial Banking System Liquidity

(as of Feb. 2010)

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Sources: IMF, International Financial Statistics ; and Fund staff calculations.
Table 7.

El Salvador: Bank Exposure to Foreign Assets

(In millions of U.S. dollars, unless otherwise stated)

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Sources: BCR, SSF and staff calculations.

B. Stress Tests

18. Three macroeconomic scenarios were developed to gauge the sensitivity of banks’ loan portfolio to various macro and sectoral shocks.7

  • The baseline scenario is the current IMF forecast of 1 percent real GDP growth in 2010 and 2.5 percent in 2010 (see Article IV staff report). This is predicated on a solid recovery in U.S. growth of 3.1 percent in 2010 and 2.4 percent in 2011.

  • The downside scenario assumes slightly negative growth in the United States and real GDP growth of only 0.1 percent in 2010 and 0.4 percent in 2011 in El Salvador.8

  • The extreme scenario assumes Salvadoran real GDP declines significantly by 5.4 percent in 2010 and 2.5 percent in 2011—an outcome three standard deviations below the norm.

19. In the extreme scenario, close to 50 percent of total loans could require provisioning be end-2011. Using panel data, the responsiveness of NPLs to shocks was estimated for each of the main sectoral credit classifications, i.e., consumer, mortgage, manufacturing, extraction, construction, retail, transportation, and other services. The definition of NPLs included all impaired loans, ranging from special mention to loss loans, as well as loans written off, in order to take full account of the provisioning requirements from asset deterioration. Based on the estimated model, NPLs depend largely on the trend (lagged levels) in NPLs, as well as lagged output or employment. For loans to the household sector, remittances are also an important variable, while for loans to the productive sectors input prices (e.g., oil or construction prices) also are significant. In the extreme scenario, by end-2011 almost 50 percent of loans become risky loans (i.e., classified special mention or worse) that require provisioning (Table 8). The impact of the extreme shock is most severe for manufacturing, extractive and construction sector loans, where between 60-80 percent would need to be provisioned.

Table 8.

El Salvador: Actual and Stressed NPLs by Sector

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Source: SSF and staff estimates.

20. Nonetheless, most banks’ profit and capital buffers are large enough to withstand the severe deterioration in credit quality under the extreme scenario. In all the macroeconomic scenarios, the system’s CAR remains above the regulatory minimum of 12 percent of risk-weighted assets, however, in the extreme scenario five banks fall below the minimum CAR (Table 9). These five banks are those with a higher concentration of loans in riskier segments, notably construction that has experienced a protracted downturn. While two of the five banks would be under 10 percent CAR in the extreme scenario—and thus require a regularization program with the SSF—only in one (nonsystemic) case is this undercapitalization critical.9

Table 9.

El Salvador: Stress Tests Results

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Sources: BCR, SSF and staff estimates.

Over either 1 year period.

21. Banks’ capital adequacy is more sensitive to credit concentration risk, but losses are limited by the loan-to-value limit. Large firms and borrowers were strongly affected by the economic slowdown: profit margins fell, and the average risk classification for the largest debtors increased more than those of smaller corporate debtors (Figure 7). Downgrading the classification of the system’s 100 largest debtors by two grades causes the CARs of six banks to fall substantially, although all banks would retain a CAR above 9 percent. In the case of an outright default of the largest ten debtors, up to five banks become undercapitalized, with four banks falling below 10 percent CAR (but with no bank becoming critically undercapitalized). Losses are limited given the maximum value of collateral for provisioning purposes is 70 percent.10

Figure 7.
Figure 7.

El Salvador: Non-Financial Corporate Sector Financing and Selected FSIs

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: Superintendency of Securities; Superintendency of the Financial System; Central Reserve Bank of El Salvador; and FSAP Analysis.

22. Declines in the collateral values of large borrowers, however, appear manageable. The value of loan guarantees was reduced by 25 percent to adjust the present value of these for the lengthy liquidation process.11 This haircut results in a drop of the system’s CAR to 12.8 percent, with four banks falling below the regulatory minimum ratio by between ½ and 1½ percentage points.

23. Banks’ interest rate risk also appears manageable. A sensitivity analysis assessing repricing risk assumes an increase in short-term interest rates by 1½ and 3 percentage points. In the latter case, three banks drop below the 12 percent minimum required CAR, and the system’s CAR declines to only 13.1 percent. However, only 1 non-systemic bank falls slightly below 10 percent CAR. Based on the results of the estimated NPL model, the impact of indirect interest rate risk (i.e., interest rate induced credit risk) would also not be significant.

24. Most banks could withstand a large liquidity shock without resorting to central bank liquidity support. The test assessed the coverage provided by banks’ liquid assets in the case of a withdrawal of 15 and 30 percent of total deposits within 30 and 90 days, respectively, also assuming a lack of rollover of other liabilities maturing in these periods. The coverage provided by such liquid assets (Figure 8) is sufficient for most banks, even assuming all private domestic securities are illiquid and applying a 25 percent haircut to the face value of eligible government securities.12 The overall magnitude of the largest shock assumed is larger than the largest individual withdrawal last experienced in the run-up to the 2004 presidential election (Figure 9). That said, in this scenario a few banks would need to access the third tranche of liquid reserves held at the BCR in the form of securities. Furthermore, the costs of accessing the second and third tranches of liquid reserves would reduce profitability.

Figure 8.
Figure 8.

El Salvador: Banks’ Liquidity Ratios /1

(percent of deposits)

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Source: BCR1/ Excludes branches.2/ Required liquidity reserves plus required liquid assets.
Figure 9.
Figure 9.

El Salvador: Deposit Withdrawals During 2004 Election Period

(Percent of deposits)

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Source: BCR.

25. The authorities’ stress testing capabilities are improving, but some important data gaps should be addressed and interagency coordination strengthened. The three safety net providers (BCR, SSF, and IGD) have each made laudable progress in analyzing banking risks, including by creating an interagency committee for risk analysis. Even so, the current stress test methodology could be enhanced, and activities better coordinated across the institutions. The risk analysis committee should therefore focus on unifying and upgrading the approach with a view to conducting regular stress tests. To improve the capacity to analyze risks, the remaining gaps in data provision—notably, loan collateral, cash-flows, the remaining maturity structure of liabilities13, and interest rates of securities and loans—should be addressed.

IV. Financial Sector Oversight

A. Banking14

26. SSF supervision should focus more on assessing the quality of risk management and internal controls. The SSF was reorganized in 2008 in order to implement risk-based supervision. It now has a risk unit so that the supervisory teams may tap specialized expertise in various risk areas, which has helped strengthen supervisory practices. The SSF currently uses CAMELS models in order to establish bank-specific risk profiles. However, more qualitative assessments of risk management are needed. In particular, besides checking whether procedures and policies are in place, the SSF should also assess the quality of risk management and internal controls given the bank’s risk characteristics (e.g., size, complexity, and risk tolerance capacity).

27. The existing regulatory framework has significant gaps, which need to be filled urgently. Regulation is lacking in such areas as corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate risk in the banking book, information technology and investment valuation and derivatives. Many of these are under development, but have faced bottlenecks in the approval process, including lengthy industry consultations and SSF’s executive council’s increasing involvement in operational matters to the detriment of strategic policy decisions. Although supervisory practices in these areas have improved, the lack of standards puts the SSF at a disadvantage in addressing imprudent behavior by banks. This is aggravated by a lack of legal protection for supervisory staff. Legal challenges not only distract supervisory resources from where they are needed most, they may also diminish the willingness of the SSF to use its corrective powers ex-ante in order to avoid dealing with these challenges.

28. The remedial action framework should allow the SSF to respond proactively to emerging risks. In particular, the SSF should have powers to require banks to take corrective actions before inadequate practices or vulnerabilities lead to undercapitalization. In particular, the toolkit does not include powers for the supervisor to limit the distribution of dividends, constrain existing or new operations and acquisitions, or enforce the sale of assets.

29. While asset classification and provisioning rules were tightened in 2007, a credit risk regulation covering repayment capacity and concentration risks is still needed. Provisioning levels are now broadly in line with international practices, and the SSF monitors banks’ delinquent loan portfolio intensively. However, given the sensitivity of banks’ CAR to concentration risk, the SSF should regulate and supervise the sum (aggregate) of individual large exposures, or loans linked by credit risk, more vigorously. Furthermore, the requirement to downgrade corporate loans if the repayment capacity of the debtor so warrants should be extended to consumer and mortgage loans. Also, when debtors with multiple loans with various banks default on one loan, but stay current on others, the classification of the current loans should be downgraded. Lastly, the practice of granting several mortgages on the basis of one underlying asset should be monitored more closely.

30. The capital adequacy framework should be brought fully in line with international standards. Intangible assets (mostly goodwill), are not subtracted from capital as required under Basel I. While these are currently of limited significance, further consolidation and investments in the system could elevate these amounts. Over the medium-term, the law should be amended to bring capital requirements in line with Basel standards.

31. The regulatory perimeter should be reviewed to ensure adequate oversight of the cooperative sector, and other credit entities not subject to SSF regulation and supervision. Cooperatives that take deposits from the public or for which the sum of member deposits and members contributions to equity exceeds US$84 million are supervised by the SSF according to the Cooperative Banking Law. The majority of cooperatives, however, are not subject to prudential regulation and supervision, and SSF has no way of determining when unregulated institutions pass the US$84 million threshold. Several other financial intermediaries such as mortgage companies, factoring companies and consumer durables lenders are also not regulated and supervised. These unregulated and unsupervised entities are not restrained by the definition of permissible activities that apply to regulated entities. The licensing and voluntary oversight entities should strengthened their limited information systems and have the power to penalize institutions that do not report required information. A system of auxiliary supervision through the federations that provide voluntary oversight of their member institutions could enable these entities to perform supervisory tasks—such as data collection, processing and recommendations of procedures—on behalf of SSF. However, this may require significant strengthening of these voluntary oversight entities. To address concerns of over-indebtedness and promote transparency, consumer protection regulations could require lenders to provide borrowers with information on the total cost of a loan.

32. The SSF faces human capacity constraints, due to organizational issues and a lack of resources (both quantitatively and qualitatively). Offsite responsibilities are currently split over two divisions (Risks and Analysis), and the role and responsibilities of offsite supervision are not well-specified. In addition, individual supervisory staff is often given a number of different roles, which is most problematic in the Risk Division. The unit leaders of this Division are responsible not only for monitoring a specific risk across all banks, but are also the designated “relationship managers” for a financial conglomerate. Offsite supervisors should be assigned to specific banks and conglomerates, allowing unit heads to focus on assessing the adequacy of this supervision and putting together a broader assessment of risks in the banking system. To strengthen the supervisory review process it is essential to further upgrade supervisory capacity, both in quantitative and in qualitative terms. Furthermore, the Supervisory Department is resource-constrained, as the increased consumer protection responsibilities entrusted to the SSF have been assigned to this department, diverting supervisory resources away from prudential supervision. Consideration should be given to creating a separate consumer protection department.

B. Nonbank Intermediaries

33. Supervision of the insurance sector has improved in the recent years, but a more risk-based approach and more on-site supervision are needed. The SSF developed and launched the CARAMEL system for insurance companies, which is used to identify areas of potential difficulty in the insurance sector.15 Going forward, the SSF should continue developing risk-based supervision to move beyond assessment of compliance with existing rules, and increase their on-site visits to individual insurers to complement the current focus on conglomerates.

34. The securities supervisory framework requires a comprehensive reform to comply with the international standards. While securities were not assessed in the 2004 FSAP update, detailed assessments of the regulatory and supervisory framework were conducted by the IOSCO secretariat and by the U.S. self-regulatory organization (FINRA) in 2004 and 2005. These assessments highlighted very low compliance with international standards (IOSCO principles). Priority areas identified for reform included (i) mitigation of investor and systemic risks in brokerage funds, (ii) the need to update the overall regulatory framework (laws and rules), (iii) implementing risk oriented supervision, and (iv) strengthening the supervision of the brokers and market surveillance. While the first item is no longer an issue, the other areas still require significant work and require implementation of an action plan to comply with IOSCO principles that includes a comprehensive reform of the securities market law (see Section VII.B).

C. Cross-Sectoral and Cross-Border Issues

35. The SSF has made some progress in consolidated supervision, but additional efforts are needed to better assess the risks presented by non-banking local activities at the group level. The SSF now coordinates with other local supervisors of financial entities, to gather information and to conduct simultaneous onsite exams. However, there remains considerable scope for deepening the analysis and translating the outcomes in terms of potential impacts on capital and liquidity. In addition, the threshold for consolidation used in practice (50 percent of capital), is quite high.16

36. The SSF has stepped up its efforts to enhance cross-border cooperation, including on crisis management issues, but these should also involve the other safety net providers. In response to the changing ownership structures in the Salvadoran banking sector, it has signed Memoranda of Understanding with all home supervisors. Discussions with the SSF and with two home supervisors confirmed that these agreements have strengthened the exchange of relevant information: the home supervisors expressed satisfaction with their access to information on Salvadoran banking operations, and the SSF is satisfied with the information they receive on the overall financial condition of the cross-border conglomerates. These agreements primarily cover exchange of information in the context of ongoing supervision. In addition, the Comité de Enlace of Central American supervisors (CECAS) has stepped up regional coordination. CECAS has quarterly meetings and monthly teleconferences where supervisors present relevant information, risks and concerns about the banks operating under their jurisdictions. Recently, the SSF participated in a regional crisis simulation exercise organized by the World Bank. The BCR and IGD should also be incorporated given they are also involved in banking resolution.

37. While there is continuous communication with banks’ home supervisors, more specific cross-border crisis prevention and management arrangements should be established. The frequency and channels of communication seems adequate for the assessment of the bank’s cross-border risks. However, no crisis MOUs or contingency plans to manage a crisis in coordination with foreign supervisors are in place. Arrangements between home and host supervisors with the aim of avoiding and mitigating the effects of a potential crisis should be established by assessing information needs and establishing appropriate communication strategies.

38. The legislation criminalizing money laundering (ML) and the financing of terrorism (FT) complies with the FATF standard, but preventive measures and the supervisory framework require an overhaul.17 The law has allowed the country to prosecute successfully several cases and cooperate with other countries. Nevertheless, the number of convictions is low relative to the number of crimes that generate proceeds, and prosecutions mostly relate to cash smuggling rather than more complex or higher-impact schemes. The effectiveness of seizing and freezing measures is limited, with precautionary asset seizures imposed in less than half of the investigations. Also, some financial activities—particularly money remittance and all designated non-financial businesses and professions—fall outside of any regulatory and the supervisory framework. The Financial Investigations Unit (FIU), established within the Public Prosecutions Agency, is the lead agency in the fight against Ml/FT—it is able to issue enforceable regulations, and responsible for investigating and prosecuting most cases. However, it lacks the necessary expertise, resources and operational autonomy to carry out its functions effectively. Moreover, the concentration of functions (FIU, regulator and lead prosecutor) within the unit seems excessive and inappropriate.

39. Gaps in the legal and regulatory framework for payment systems should be addressed promptly. The Central Bank Law should be amended to fully implement the Treaty on the Payment and Securities Settlement Systems for Central America and the Dominican Republic. The amendment, which is already drafted, would provide the BCR with the adequate powers to regulate fees and sanctions in the payments system. However, the BCR would still need to develop a new regulatory framework for payment services.

40. The BCR should also strengthen its oversight of the national payment systems. Currently, information is provided by the private sector on a voluntary basis. The BCR should define more clearly, possibly through regulation, its powers to collect information from system participants and to adequately oversee the payment systems, particularly at the retail level, by specifying methodologies and requesting periodic reports.

41. The BCR should be able to ensure that it retains control over the operations and oversight of the national payments system. If banks find it more convenient to settle their inter-bank payments abroad in an offshore settlement bank or system, the BCR may not be able to control risks to the payments systems. It could lack access to essential information abroad and, furthermore, the default of an overseas counterparty could lead to logjams in settlements in El Salvador. To avoid this, the BCR should consider providing services that banks value, such as an array of tools to facilitate high quality cash management by the Treasurers of financial institutions, and perhaps an intra-day liquidity facility for the RTGS system (e.g., via a specially designed intra-day repo facility, with operations to be conducted on a regular basis). To ensure control over the payment systems, banks should be required to maintain the first tranche of the reserve at the BCR while part of the last tranche, for exceptional use, could be maintained abroad.

D. Overhaul of the Supervisory Landscape

42. The Salvadoran authorities have proposed an overhaul of the supervisory and regulatory architecture. A draft law on Financial System Supervision and Regulation (FSSR) is currently with the Congress and it should be passed this year. The law will: (i) merge the superintendencies of banks, insurance, securities firms, and pension funds, thus creating a sole supervisory authority with enhanced powers and, (ii) transfer the right to issue regulation from the new SSF to the BCR, to balance the power of the integrated supervisor, while focusing the oversight system on a financial stability objective. It also creates an appeal committee to ensure the rights of the governed with respect to sanctions.

43. When approved, the law would could enhance the timeliness of supervisory and regulatory decisions, improve consolidated supervision and reduce the scope for regulatory arbitrage, as well as and strengthen banks’ corporate governance. In particular, the law:

  • Broadens and clarifies the supervisory powers of the new SSF, as well as its governance and operational independence. It includes a comprehensive definition of supervision, encompassing inspection, control and a broader the range of corrective actions. It also establishes a new supervisory committee composed of only the Superintendent and the Intendents, which greatly limits potential political interference and may speed up supervisory decisions18, and it strengthens the Superintendent’s independence and legal protection with respect to resolution decisions. An integrated supervisory agency could improve consolidated supervision.

  • Establishes a dedicated regulatory committee composed of BCR officials, BCR Board members and the Superintendent of the new SSF, which may improve the timeliness of issuing regulation.19 A sole regulator should facilitate the harmonization of regulations for similar risks taken by different types of financial institutions and thus reduce the scope for regulatory arbitrage.

  • Requires enhanced intra-agency cooperation between the SSF and BCR with respect to the financial stability objective, which could allow for a more macroprudential perspective in regulation and supervision.

  • Spells out the responsibilities of bank directors, managers and staff regarding disclosure, and management and internal controls to enhance banks’ corporate governance.

44. Still, the current draft would benefit from stronger legal protection for supervisors and preemptive measures. The law only partially addresses the current lack of legal protection for supervisors, which still would be insufficient against litigation for supervisory actions undertaken in good faith. Also, despite the improvements in the remedial action framework, the SSF’s room to maneuver preemptively remains restricted. In particular, it lacks the power to restrict dividends, activities or purchases prior to regularization. Furthermore, there is no requirement for a financial institution’s board to inform the SSF of material operational problems.

45. The separation of regulatory and supervisory functions will require strong effective cooperation and coordination between the SSF and BCR. Under the proposed law, the BCR is the regulatory authority, while the new SSF provides inputs and proposals for regulations. However, the separation of regulation and supervision in two different authorities, while serving to check and balance the power of the integrated supervisory agency, is not typical and may reduce compliance with international standards.20 To avoid hampering the effectiveness of supervision, it is essential that the BCR acquire technical skills in the area of prudential supervision, and that BCR regulators work closely with SSF supervisors. This cooperation and coordination needs to be put into effect promptly in order to finalize existing draft regulations whose issuance is long overdue. Lastly, the SSF and BCR will need to establish who is responsible for responding to industry consultations on the interpretation of regulations, as well as how to resolve differences of interpretation between the SSF and banks as well as between the SSF and the BCR. The BCR, in coordination with the supervisory agencies, should develop formal mechanisms for addressing these challenges.

46. In time, the merger of the three supervisory institutions is expected to reduce supervisory gaps, but the integration process is not free from challenges. The merger should facilitate consolidated supervision and provide a more comprehensive view of the risks of the financial system. However, with the integration, it is important to not only pay attention to the banks that represent the highest risk to financial stability, but also to the rest of the financial sector to ensure sound financial development. The merger in itself will require the attention of key staff of the SSF over a long period of time, and a great deal of planning and careful implementation is needed to achieve a successful reorganization and integration of the cultures, systems and processes. The BCR, in coordination with the supervisory agencies, should develop a detailed action plan for addressing these challenges.

V. Safety Nets

A. Systemic Liquidity and Emergency Liquidity Assistance

47. The BCR’s systemic liquidity management is constrained by the limited range of instruments with which it can effectively operate and lack of implementing regulations. Central banks in dollarized economies cannot provide liquidity in the same way as other central banks, as they cannot issue their own currency. However, they could use excess (“free”) international reserves or borrowed external funds to inject liquidity into the system. The BCR is currently prohibited from lending to banks. Rather, the law only allows the BCR to conduct repos with securities held as part of the required liquid reserves (Art. 47B of the Banking Law)—currently limited to BCR securities—as well as with BCR, government, and IGD securities when the government has deposited funds expressly for this purposed (Art. 49B of Banking Law (BL)). A 2000 amendment to the Organic Law of the BCR, also allows the central bank to sell or buy investments and loans from banks (Art. 49(b)), but the latter has proven very cumbersome in practice. However, regulations implementing the CBR’s powers have not been issued.

48. The system operates with high (and costly) levels of individual liquid assets. As a legacy of a bank default in the late 1990s and the negative perception of interbank transactions held by supervisors, the domestic interbank is very limited and does not function efficiently or effectively.21 Furthermore, while banks’ foreign parents could extend liquidity to their subsidiaries, this may not always be forthcoming unless it is an exceptional circumstance and there is certainty about future macroeconomic policies (e.g., under an IMF program). In this context, individual liquid assets are high to provide self-insurance against liquidity shocks.22 However, this is very costly both for banks in terms of profitability and for the system in terms of foregone credit.

49. Several legal and operational constraints in providing liquidity assistance should be addressed to allow for timely emergency liquidity assistance. The prohibition against lending to banks (Central Bank Law Art. 51) should be lifted so that the BCR can temporarily channel excess reserves or external borrowed funds to solvent banks in line with best practices on emergency liquidity assistance. The approval of article 130 of the FSSRL would be useful in this respect. Furthermore, the BCR should issue the necessary regulations to implement the few options (e.g., repos, outright purchases) it currently has for providing and managing systemic liquidity.23 Also, the authorities should review the legal constraints to conducting repos with government securities, which under the commercial code definition of repos are considered government credit and thus prohibited (if not done with funds provided by the government itself). Finally, the BCR should design a collateral policy and define clearly the processes to carry out permissible operations.

50. Furthermore, the government should provide resources to increase the BCR’s capacity to deal with systemic liquidity shocks. El Salvador’s excess (“free”) reserves are low relative to other dollarized economies in the region (Figure 10).25 Additional excess reserves would enhance the BCR’s ability to provide liquidity to individual banks in situations of systemic liquidity stress (e.g., in order to purchase less liquid securities and assets or, if possible, lend using these assets as collateral). If possible, the authorities should consider allocating the SDR allocation granted in 2009 (half of it, or SDR69 million, currently deposited with the Treasury) to strengthen the BCR’s balance sheet. Over the medium-term, the government should seek to fully capitalize the BCR.26

Figure 10.
Figure 10.

El Salvador: Liquidity in Dollarized Economies

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Sources: IMF, International Financial Statistics, and Fund staff calculations.1/ Net international reserves in excess of commercial bank claims on the monetary authority.2/ Commercial bank holdings of central government securities.3/ Deposits at the monetary authority, central bank securities, and deposits abroad.

51. The authorities should establish and implement a comprehensive systemic liquidity policy, which should include contingency plans and consideration of a liquidity fund. A high-level financial stability committee,27 consisting of the MOF, BCR and SSF, should establish medium-term objectives for the stock and structure of systemic liquidity, criteria for the use of tools or mechanisms for the different stages of individual bank or systemic liquidity problems, and contingency plans.28 Setting up a liquidity fund, currently under consideration by the financial cabinet, would reduce the costs of liquidity protection for individual banks as well as for the economy.29 The liquidity fund would allow for pooling liquid resources, and would complement the still incipient interbank market and the limited capacity of the BCR to provide systemic liquidity. The availability of the pooled resources could reduce the volatility of domestic liquidity for individual banks and in turn reduce the need for self-insurance against liquidity shocks, while providing an additional buffer prior to accessing scarce public funds. Short of this, the SSF could require irrevocable letters of credit from parent banks to provide additional assurance of access to external liquidity.

B. Problem Bank Resolution and Deposit Insurance

52. The Bank Law (BL) establishes criteria for regularization and restructuring of a troubled financial institution, but timely action maybe hampered by lack of regulations and legal protection. The main triggers for regularization are: (i) a CAR below 10 percent; (ii) use of the third liquidity tranche; and (iii) other situations that put at risk the bank’s solvency and liquidity (e.g. deficient risk management). During regularization—which has a term of 90 days but can be extended up to a total of 180 days under certain circumstances—the law authorizes the SSF to take a wide range of corrective actions.30 Failure to present a regularization plan, or noncompliance with a plan, would trigger restructuring (although the SSF can also impose a restructuring whenever the bank’s situation puts depositors at risk). At this point, shareholders must adequately capitalize the banks within 30 days or else the SSF may use other mechanisms (see below) to resolve the bank.31 However, the lack of regulations on various risks and on sanctions—to clearly classify the severity of violations—limits enforcement of the regularization criteria. Furthermore, the SSF has not formally defined the responsibilities and intensity of follow-up of corrective actions, based on risks. These gaps may delay regularization or restructuring, in particular given the lack of legal protection for supervisors, which are in turn likely to lead to greater asset dissipation and higher costs for the deposit insurance fund or for the government in case of a systemic banking crisis.

53. Furthermore, the bank resolution process also lacks implementing regulations and supportive institutional arrangements. In 2002, the BL incorporated new tools for bank resolution, allowing the SSF to use purchase and assumptions (P&A) of assets and liabilities to resolve a bank, and allowing the participation of the Deposit Guarantee Fund (Instituto de Garantía de Depósitos, IGD) in these operations when it is necessary to protect guaranteed deposits. Since then, only one small bank was required to present a regularization plan, with no need to go through a resolution process since a private solution (it was acquired by a new bank). Nonetheless, supporting regulations such as establishing the eligibility criteria for participating in a P&A have not been issued. Comprehensive procedures, manuals and standardized contracts (e.g. for trust funds constituted for P&A), and staff trained in these procedures are also needed to facilitate an effective resolution. These should be discussed and mutually agreed by all the safety net providers involved in the resolution process (SSF, BCR and IGD).

54. The authorities should amend the legal framework to:

  • Eliminate the requirement to notify a bank three days prior to the suspension of operations or other resolution measures. Such notification constitutes a significant obstacle to achieving a successful resolution (i.e., the preservation of the institution’s cash and other valuable resources, such as contracts, registries, etc.)

  • Introduce the least-cost solution (total amount of guaranteed deposits) as the measure of the maximum support by the IGD for a bank resolution. The current cost-benefit analysis requirement includes qualitative variables, such as the stability and confidence of the financial system. It is thus not bounded and exposes the IGD to legal challenges of its qualitative assessment.

  • Remove the bank’s Board upon the commencement of a bank’s judicial intervention. The judicial receiver of an entity only has powers to transfer excluded assets and liabilities (determined by the SSF and IGD), while co-governing the bank with the Board. This could lead to potential conflicts, rending the resolution process unworkable.

  • Allow a larger exclusion of assets than liabilities under the P&A process to conserve scarce IGD resources. Valuing assets in a resolution process is subject to a high degree of uncertainty. Providing more upside potential increases the willingness of banks to assume deposits, as it minimizes the expected loss, and reduces the need for IGD support.

  • Establish a deposit insurance reserve target and adopt measures to reinforce its funding. The current deposit insurance fee is one of the lowest in the region (Figure 11). Authorities should consider raising it, consistent with a reserve fund target calibrated to take account the characteristics and structure of the Salvadoran financial system (which is officially dollarized and highly concentrated). The fund should be able to make payouts of guaranteed deposits at all non-systemic banks that could fail over a given horizon. Furthermore, funding through the collection of pre-paid assessments on banks should be permitted and a regulation on the contingency funding of the IGD by the BCR should be issued.

Figure 11.
Figure 11.

El Salvador: Deposit Insurance Minimum Contribution Rate, as of January 2010

Citation: IMF Staff Country Reports 2014, 044; 10.5089/9781475513790.002.A001

Source: IADI.

C. Financial Stability and Crisis Management Arrangements

55. Coordination among the safety net providers should be strengthened and a financial stability strategy developed. An Inter-Institutional Financial System Committee (CISF)—composed of representatives from BCR, IGD and financial sector superintendencies and organized along several technical working groups—exists (although not established formally by legislation or decree). However, roles and responsibilities are not fully developed and as a result the committee tends to be reactive to specific stress event. Projects are not formalized and the technical findings of the working groups do not generate coordinated strategic decisions. Furthermore, issues such as regulatory arbitrage, monitoring of unregulated financial intermediaries or market transactions, potential stress scenarios, among others that may impact financial stability, are not a regular part of the priorities of the various inter-institutional working groups. While the proposed law FSSRL would require the BCR and SSF to coordinate with respect to financial stability, specific policies and procedures for information sharing, systemic risk monitoring and crisis management still should be mutually agreed, formalized and implemented by all the safety net providers. The BCR should focus on macroprudential policies and monitoring, the SSF on microprudential issues, and the IGD on least-cost resolution, with clear, transparent and candid communication between them. A decree formally establishing the CISF and specifying its objective would be useful in this respect.

56. Appropriate roles and responsibilities for resolving a systemic banking crisis should also be established. Currently, the IGD must assess whether a bank failure could create systemic risk and financial instability, a role and responsibility beyond the mandate and competencies of the deposit insurer. Rather, the CISF should establish a methodology for defining systemic risk, based on different variables (size, interconnectedness, regional impact, contagion risk, payment system, etc.). A high-level stability committee, with technical inputs from the CISF, should decide on whether a systemic risk situation exists and how to proceed according to well defined roles and responsibilities. In particular, the MOF should take responsibility for financing systemic bank resolution, with appropriate transparency and accountability for the use of public funds.

57. The authorities should carry out a comprehensive bank resolution simulation exercise. All the agencies involved in the process of bank resolution should be incorporated. Different stress scenarios should be considered and the results should be a used to make necessary legal, regulatory, and procedural changes.

VI. Financial Sector Infrastructure

58. The recent launch of the RTGS system has reduced systemic risks, although the system is still exposed to operational risks. The RTGS system improved the integration between the BCR and banks and other financial institutions, allowing for a growing share of large-value payments to be channeled through this safer payments mechanism. However, the constraints on the BCR in providing liquidity expose the system to logjams if one bank cannot settle, and the lack of a contingency site to guarantee business continuity exposes the system to operational risks.

59. The Banking Law should be amended to allow for the free circulation of credit information among all the credit bureaus, as well as regionally. Currently, banks can access information gathered from the credit bureaus from all the sources (including credit unions, leasing companies, etc.), while nonbanks cannot access information provided by banks. Nonbanks should have reciprocity in order to ensure a comprehensive view of a client’s debts. Over the long-term, more ambitious objectives could be set in terms of information sharing among the different existing databases in El Salvador, as well as in the region given the strong integration among Central American markets.

VII. Financial Sector Development Agenda32

A. Role of Public Banks33

60. The global financial crisis and ensuing credit crunch has revived the discussion on the role of public banks as a counter-cyclical and developmental tool. Salvadorian authorities are in the process of formulating a strategy for the public banking sector with a view to using these to limit the economy’s dependence on foreign banks for funding domestic productive activities. State-owned first tier public banks were encouraged to expanded credit in 2009 to partially compensate for the credit contraction of some foreign banks (Figure 5). The authorities would like to further expand public banks’ activities, in part by increasing the capital of first-tier banks and establishing a development fund to be intermediated by the second-tier bank. The source of these funds is still under discussion, however.

61. A clearly defined strategy, consistent business plans, and performance measures should be established for public banks. The government should define development objectives for the public banking sector and create coordination mechanisms among the three public banks to ensure complementarities of their business strategies, sources of funding, operational processes, and product lines. The business focus and strategy, industry and customer segments, and specific financial products of each bank should be a derived from these objectives. To clearly define targets and facilitate accountability, public financial institutions should formulate business plans and adopt performance measurement systems that combine both financial and social objectives.

62. In addition, public governance should ensure these banks preserve their recently restored financial solvency. In the past, public banks’ portfolio quality has been substantially affected by governmental loan forgiveness programs for the agricultural sector, and the BFA and BH have required multiple recapitalizations, amounting to more than US$300 million since 1991. To avoid the mistakes of the past, the government, as the owner of the public banks, should be unequivocally committed to preserve public banks’ sustainability, by monitoring and holding bank managers accountable for results. Any subsidy component in the banks’ operations should be clearly accounted for in the budget.

63. Risk management and supervision of public banks should be strengthened to accompany their planned growth. Public banks should be under the same regulatory conditions and supervision as any other bank in the system to ensure a level playing field and early identification of problems. A clear on-site schedule of visits and off site review of their financial information should be defined.

B. Capital Markets

64. A weak and incomplete legal framework constrains local capital market development, including through further integration with regional capital markets. Except for the Securitization Law (2007), the legal framework has not changed in the last decade. The Investment Funds Law has been in the making for more than 10 years, and the project to modernize the capital markets framework has been put on hold since 2005 due to differences between the government and the stock exchange. Further regional integration is constrained given differences in regulatory frameworks, with El Salvador having relatively weaker standards among the larger countries in the region (Panama and Costa Rica).

65. The current market rules and role of the stock exchange hampers market trading and the greater participation by institutional investors in securities markets. All products and players are required by regulation to be listed and traded on the domestic securities exchange, preventing the development of over-the-counter (OTC) markets. Furthermore, the exchange channels all local secondary market transactions through its members (supporting their brokerage services). Combined with the securities exchange’s exclusive control of the only central depository, competition is limited, which raises trading costs. This includes unnecessary costs for transactions where brokerages add little value (e.g. the buying and selling of foreign securities between brokers and their clients). The limited trading reduces potential issuers’ access to institutional investors, other than through initial public offerings, as these investors require more liquidity and transparency of market prices.

66. To promote efficiency and sound development, the regulatory framework must be updated and the role of the exchange must be rationalized. A new and comprehensive Securities Law that elevate the standards of the market should:

  • Eliminate the obligation for listing and trading in the exchange;

  • Allow private placements targeted to institutional investors (registered in the SV) as well as OTC transactions;

  • Eliminate the local rating requirements for foreign instruments rated in recognized jurisdictions;

  • Grant the authorities powers to make the regulatory changes needed to expedite the regional integration (e.g. remote access, mutual recognition); and

  • Minimize the self -regulatory framework given the small size of the market and the demutualization of the exchange.

67. The Investment Funds Law should be approved to broaden and diversify the investor base. Passage of the law would allow for the development of the mutual fund industry. This would greatly help issuers given the current reliance on two main institutional investors (pension funds and banks) and the maximum established limit of 35 percent for participation in security issuances.

Same Series

Other IMF Content

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Cover IMF Staff Country Reports
El Salvador: Financial System Stability Assessment
Author: International Monetary Fund. Monetary and Capital Markets Department
Volume/Issue:
Volume 2014: Issue 044
Publisher:
International Monetary Fund
ISBN:
9781475513790
ISSN:
1934-7685
Pages:
65
DOI:
https://doi.org/10.5089/9781475513790.002