Costa Rica: Selected Issues and Analytical Notes

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

VII. Financial Sector Issues1

This note assesses the stability of the financial system, with particular attention to the strength of the banking system and possible credit risks, particularly arising from borrowers with currency mismatches. The position of the banking system is analyzed by looking at the progress made in strengthening bank capital and liquidity, using the Basel III accord as a benchmark. Possible credit risks and related risks to financial stability are analyzed using a balance sheet approach which focuses on various types of mismatches in a country’s sectoral balance sheets. The main conclusion is that the financial system appears sound, though dollarization continues to be a source of vulnerability.

A. Strengthening Bank Capital and Liquidity in Central America: The Road to Basel III2

Strengthening Bank Capital and Liquidity in Central America: the Road to Basel III

This section relies on a study of regulatory progress and growth implications in the transition from Basel I to Basel III in Central America,3 Panama, and the Dominican Republic (CAPDR) to draw implications on the strength of the banking system in Costa Rica. In particular, the study assesses the strengthening of bank capital and liquidity achieved by the CAPDR supervisory authorities, using the Basel III accord as a benchmark. It also estimates the impact of introducing Basel III capital requirements on short-term growth, and discusses challenges ahead and appropriate steps to be taken. The main conclusion for Costa Rica is that the financial system comfortably meets current regulatory norms and largely complies with Basel III requirements.

The Case for CAPDR countries to implement Basel III Standards

1. The banking system in CAPDR is now more exposed to risk and competition. During the last decade, the banking system in CAPDR increased their exposure to counterparty risk. In addition, a growing presence of foreign banks and increase in competition led to the introduction of new financial products, compression of profit margins, and higher risk-taking by local banks.

CAPDR: Market Share of Foreign Banks 1/

(in percent of total assets, end-2011)

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Source: Supervisory authorities.

Excludes intra-regional banks.

2. Adopting Basel III will strengthen CAPDR financial systems. CAPDR countries would benefit from promptly starting to gradually implement the higher prudential standards of Basel III. In particular, it would strengthen supervisor’s skills and build up the regulatory and risk frameworks. It would also reduce profits associated with regulatory arbitrage and weaker supervisory capacity. Furthermore, it would strengthen the soundness of the regional financial system by anchoring the existing liquidity and capital buffers. Indeed, the current high levels of liquidity and capital buffers in the region could be largely explained by the slow recovery of domestic credit after the 2008-09 crises. An increase in loan demand could then lead to a quick drop in liquidity as well as in the risk weighted capital ratios below the minimum Basel III standards.

Compliance with Basel Framework in CAPDR

3. CAPDR countries are in compliance with most of the Basel I framework and making progress in complying with core principles for banking supervision.4 In terms of capital, most CAPDR countries have regulatory capital requirements above the minimum 8 percent of risk weighted assets (RWA). Furthermore, actual capital ratios are well above minimum regulatory requirements. In addition, Costa Rica, Nicaragua, and the Dominican Republic have instituted capital requirements for market risk, and Costa Rica has established requirements for operational risk. However, the use of credit risk models introduced by Basel II has not been implemented in the region. Regarding the capacity of supervision, progress has been made on the implementation of a Risk Based Supervision (RBS) approach, in which the assessment of capital soundness and risk management systems of financial institutions uses the “expert judgment” of the supervisor. Indeed, RBS techniques and broadening the supervisory perimeter have been the main priorities in banking supervision in most CAPDR countries in recent years (Delgado and Meza, 2011).

A07ufig1

Compliance with RBS

(Percent of best practices)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Source: IMF WP/11/299.1/ Basel Core Principles compliance (last FSAP available). Not available for Nicaragua.2/ Authorities’ self-assessment. as of end-2010
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Progress in Plan to Implement RBS Methodology 1/

(As of end-2011)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Source: Supervisory authorities.1/ Superintendencies’ self-assessment on progress in the adoption of the RBS methodology.

4. CAPDR countries are also adopting cross-border supervision. Since 2006, CAPDR countries have been working to adopt a cross-border consolidated supervision scheme (CBCS) that identifies the risks assumed by financial conglomerates in the region, through the Council of Superintendents of Financial Institutions of CAPDR (CCSBSO). A methodology for effective consolidated supervision has been developed, with technical assistance from CAPTAC-DR,5 and common standards have been adopted in each country. Delgado and Meza (2011) estimate that the implementation of the core principles for effective banking supervision of the Basel Committee on Banking Supervision (BCBS) averages 67 percent.

CAPDR Basel III Capital and liquidity gaps

5. The results show that when applying Basel III criteria, most countries in the region meet or exceed Basel III capital requirements for most categories. Capital ratios decline when adjusted by Basel III guidelines, due to adjustments in capital and RWA, but all countries in the region meet or are close to compliance with Basel III capital ratios. The exception is Guatemala, where all capital ratios (except leverage) are below Basel III minima. Several countries fall below the Basel II total capital adequacy requirement, but negative gaps are about or below 1 percent. Nonetheless, most banking systems in the region remain compliant with Basel III common equity and tier 1 capital requirements. Yet, in case supervisory authorities decide to implement a countercyclical buffer, a substantial strengthening of bank capital will be needed. In addition, there may be some heterogeneity, in particular in Costa Rica capital buffers overall appear lower in public banks, which also have weaker asset quality and earnings compared to private banks (Annex II). All of the banks in Costa Rica are in compliance with the leverage ratio though smaller private domestic banks appear more leveraged (Annex II).

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CAPDR: Estimated Basel III Capital Gap

(in percentage points of RWA, end-2011)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Source: Supervisory authorities and Fund staff estimates.

6. All the banking systems in the region meet or exceed Basel III minimum liquidity requirements. Even after adjusting for the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) methodologies, short-term liquidity exceeds more than double the Basel requirements in all countries, while long-term liquidity is particularly strong in Nicaragua and, to a lesser extent, in Panama, Guatemala, and El Salvador.6 Nonetheless, in Costa Rica liquidity buffers are smaller in public banks (Annex II), in particular, in the two largest ones, possibly reflecting the implicit government guarantee and the explicit government guarantee on deposits.

Macroeconomic Impact of the Transition to Higher Capital Requirements

7. Implementing Basel III capital requirements will have a low impact on GDP growth. Sensitivity analysis of GDP to shocks in CAR in CAPDR and estimates of the impact on GDP growth from increasing current CAR to meet Basel III minimum requirements show that the macroeconomic impact of the transition to Basel III total capital requirements is fairly low.7 Given the relatively low sensitivity of GDP growth to a CAR shock in the region and the high actual capital levels, the maximum at-peak impact will not exceed -0.02 percentage points of GDP growth (Guatemala). These results are in the low range of values for the macroeconomic impact of the transition to stronger capital and liquidity requirements for BIS countries compiled by the BIS Macroeconomic Analysis Group (MAG).

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At-Peak GDP Growth Impact of Implementing Basel III 1/

(In percentage points of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: Supervisory authorities and Fund staff estimates.1/ Costa Rica has no fiscal gap.

8. The response of GDP growth is valid for any reason the capital ratio increases. The econometric estimation of the impact on GDP growth of a CAR change does not hinge on the motivation for such change. Therefore, after any CAR increase is decided; for example, to match higher regulatory capital ratio levels for required buffers, or to comply with a leverage ratio requirement, one should observe an impact on GDP growth equal, on average, to the estimate obtained with the VAR approach.

Missing Steps for Basel III and Implementation Challenges

9. CAPDR countries should continue the pragmatic approach they have followed in the implementation of Basel standards.. The transition from one Basel accord to another should not be understood as a linear process. Thus, CAPDR countries will continue to focus on the implementation of those elements of Basel III that are more relevant for their financial markets,. For instance, the implementation of Basel II.5 regarding positions in derivatives and portfolio securitization has not been a short term priority since they represent a small share of CAPDR banks’ operations.

10. The elements of Basel III implementation that are more relevant for CAPDR financial markets and should have the highest short-term priority are: (i) adopt Basel III definitions of capital following standards of quality and transparency to allow a more meaningfull comparison of the capital position of banks; (ii) implement a capital conservation buffer; (iii) introduce a leverage ratio; and (iv) incorporate market and operational risk capital requirements. The capital and leverage requirements will strengthen soundness and avoid excessive risk taking. In the medium-term, priority should be put on: (v) aligning liquidity requirements with Basel III; and (vi) strengthening the supervisory process (Pillar II) and market discipline and transparency (Pillar III). In the long term, other elements might become important, such as: (vii) considering macroprudential instruments; and (viii) implementing capital charges for SIFIs.

11. There are several legal and industry-based challenges to Basel III implementation in CAPDR, yet they seem manageable. Implementing most Basel III elements require regulations that fall largely under the purview of the region’s supervisory authorities (with the exception of the Dominican Republic). At the industry level, the strong presence of large international financial groups in the region might lead to a “de facto” compliance with Basel III. However, supervisors are still concerned about the ability of some local and regional groups to adapt to the new regulatory framework because banks would need: (i) skilled staff; (ii) sound IT systems; and (iii) financial muscle to strengthen the capital base. In spite of high average capital buffers, supervisory authorities of five out of seven countries also consider increasing capital levels a challenge for the industry. This apparent paradox is explained because in some countries adjusted levels of tier 1 capital are relatively low (Guatemala), the adoption of specific capital charges for market and operational risk is a challenge (Honduras), and the authorities have a medium-term focus on the implementation of countercyclical capital buffer requirements (Nicaragua and Panama).

B. Balance Sheet Analysis8

This section of the financial sector issues note looks at risks to financial stability using balance sheet analysis of the Costa Rican economy. Particular attention is paid to the external position of the economy and currency mismatches that often play a key role in emerging market crises.9 The balance sheet of the aggregate economy has been weakened by the recent deterioration in the fiscal situation. The external position has also deteriorated, mostly as a result of increased reliance by commercial banks on external financing. However, external risks at the country level remain limited given the large stock of FDI liabilities relative to external debt as well as the sizeable official reserves relative to short-term debt. This study also finds that risks from currency and maturity mismatches are limited, concentrated in the non-financial public sector and financial sector respectively.

12. The Balance Sheet Analysis (BSA) was developed as a useful framework to help better understand the financial crises of the late 1990s and early 2000s. It was proposed by Allen et al. (2002) and has been applied to many emerging-market countries. The BSA studies the stocks of financial assets and liabilities and analyses the maturity and currency mismatches at the aggregate economy level and at each economic sector. It can highlight a country’s vulnerabilities to liquidity or solvency problems and reveal potential spillovers across sectors that can transmit the impact of economic shocks.

13. The main instrument for this analysis is the balance sheet matrix. It typically depicts five sectors: (i) the central bank; (ii) the non-financial public sector which includes the central government, state and local governments, public non-financial firms, and social security; (iii) the financial sector including other depository corporations and other financial firms (nonbanks); (iv) the non-financial private sector which includes non financial corporations and other domestic resident sector (largely households); and (v) the rest of the world or nonresidents. Within each sector, assets and liabilities are decomposed into foreign currency or domestic currency and some estimates can be made of maturity structure. The matrix shows the inter-sectoral claims and liabilities between each domestic sector and versus nonresidents (see Annex I for the basic structure of the matrix).

14. The overall balance sheet positions of the domestic economic sectors have changed moderately since 2010.10 The central bank remains a net debtor as the sterilization cost of the accumulation of foreign reserves continues to weigh on its balance sheet (Analytical Note IV). The non-financial public sector’s net debtor position has increased driven by large fiscal deficits of the central government (Analytical Note III). The financial sector’s net creditor position has switched from small creditor position to small debtor position following the increase in the sector’s external debt. Meanwhile, the private sector’s debtor position, which mainly reflects its large FDI liabilities, has declined somewhat reflecting continued increase in bank deposits and other savings instruments (Figure 1).

Figure 1.
Figure 1.

Costa Rica: Gross Financial Assets and Liabilities of Economic Sectors

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

15. External risks at the country level are limited given the dominance of FDI liabilities and the sizeable official reserves. Costa Rica has a total net external debtor position of about 35 percent of GDP in 2013, but this largely reflects large FDI liabilities, which are a sign of a strong capital structure at the country level. Excluding FDI liabilities, the economy has a small net creditor position of about 4 percent of GDP, implying reduced risks of capital account crises (Table 1).11 The economy as a whole also has limited vulnerability to currency risks, given its positive net FX debt position (Table 1).12 The existing currency risks are concentrated in the non-financial public sector, which would suffer the largest losses in the event of an exchange rate shock—about 4 percent of GDP with a 30 percent depreciation shock (Table 2). Vulnerabilities arising from maturity mismatches in FX exposures are also limited at the country level, given sizeable official reserves and private sector liquid foreign assets relative to short-term FX liabilities concentrated in the financial sector (Table 1).13

Table 1.

Costa Rica: External and Foreign Currency Positions

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Sources: Banco Central de Costa Rica, and Fund staff estimates.

Excluding net FDI position.

Table 2.

Costa Rica: Net Foreign Currency Debt Position and Exchange Rate Shocks

(In percent of GDP)

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Includes FX bank credit and deposits.

Includes FX bank credit and deposits, and net foreign assets of the private sector.

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Costa Rica: Capital Structure Mismatch

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: National authorities and Fund staff estimates.
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Costa Rica: Currency Mismatch

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: National authorities and Fund staff estimates.
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Costa Rica: Maturity Mismatch in FX Exposures

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: National authorities and Fund staff estimates.

16. The total public sector is exposed to risks from currency mismatches, although these have declined with the accumulation of official reserves. The public sector has a net external creditor position of about 3½ percent of GDP, reflecting sizeable central bank reserves relative to external debt of the central government and public enterprises (Table 1). However, the public sector has a net FX debtor position once FX-denominated domestic debt of the central government and commercial banks’ claims on central bank reserves—related to required reserves on FX deposits—are also taken into account. The public sector’s net FX debtor position has declined from 6 to 3 percent of GDP from 2010 to 2013 reflecting mostly the accumulation of central bank reserves over this period. The weakening of the fiscal situation of the central government in recent years has not substantially increased the country’s external vulnerabilities according to the BSA analysis, as the bulk of the increase in debt has been financed by the social security fund and the domestic financial sector.14 Maturity risks in FX exposures of the public sector are limited given the large size of official reserves and the typically long maturities of public sector external debt.

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Costa Rica: Claims on Central Government

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: National authorities and Fund staff estimates.

17. The financial sector maintains a net FX creditor position despite a significant increase in foreign borrowing. The net external debtor position of the financial sector, excluding net FDI exposures, has increased from 1 to 6 percent of GDP from 2010 to 2013 as financial corporations have increased reliance on foreign bank borrowing and ramped up bond issuance in international markets. That said, the financial sector maintains a modest net foreign currency creditor position—excluding net FDI exposures—of about 2 percent of GDP, as the sector channeled the additional external financing into domestic credit in FX, avoiding direct currency mismatches in their balance sheets on aggregate (Tables 1 and 2). The financial sector is the sector of the economy with the greatest maturity mismatches in FX exposures, consistent with the typical maturity transformation function of the sector.15

18. Vulnerabilities from currency risks in the non-financial private sector appear limited to positions vis-à-vis the banking sector. The private sector has a net FX debtor position of 5 percent vis-à-vis the domestic banking sector, implying a risk that currency mismatches in these positions could translate into credit quality issues for the banking sector in the event of currency depreciation. For example, the depreciation experienced in 2014 has generated losses of about 0.5 percent in private sector positions with the domestic banking sector (Table 2), and a larger 30 percent depreciation shock would cause losses of about 1.5 percent of GDP. The private sector, however, has an overall net FX creditor position of 5 percent of GDP once foreign assets held by the sector are also taken into account (Table 2). This implies that the private sector in aggregate benefits from currency depreciation. Maturity risks in FX positions of the private sector are minimal, given that short-term FX bank deposits are significantly larger than short-term FX liabilities (Table 1).16

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Costa Rica. Maturity Breakdown of FX debt liabilities

(Percent of GDP, 2013)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

Sources: Central Bank of Guatemala and Fund staff estimates.
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The Impact of 2014 Depreciation on The Net Foreign Exchange Debt Position of the Financial Sector and the Private Sector

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 030; 10.5089/9781475527025.002.A007

1/ Private sector net FX position with financial sector includes FX bank credit and deposits of non-financial corporations and households. Private sector net FX position also includes foreign assets of these sectors.

Annex I. Costa Rica: Net Intersectoral Asset and Liability Positions

Table A1.

Net Intersectoral Asset and Liability Positions, 2010

(In percent of GDP)

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Sources: Banco Central de Costa Rica, and staff estimates.
Table A2.

Net Intersectoral Asset and Liability Positions, 2013

(In percent of GDP)

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Sources: Banco Central de Costa Rica, and staff estimates.

Annex II. Costa Rica: Bank Heat Maps

Assets and Ownership of Costa Rican Banks

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Aggregate Bank Heat Maps1

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Individual Bank Heat Maps2

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