A. Independence and Legal Protection of Supervisory Staff

1. Background. The 2012 FSAP found that while the Superintendencia Financiera de Colombia (SFC) had operational autonomy within a general framework established by the government, procedures for the appointment and dismissal of the Superintendent limited his independence and made him vulnerable to political pressure. Moreover, the law did not provide legal protection to the Superintendent and staff of the SFC against lawsuits for actions taken and/or omissions made while discharging their duties in good faith. It was recommended that the Superintendent be appointed for a fixed term or a public explanation be offered of the reasons for dismissal with high priority and within a short term. The legal framework was expected to limit circumstances in which private parties can sue with medium priority and within medium-term.

2. Actions. The authorities have sought to strengthen independence of the Superintendent and provide enhanced legal protection to SFC staff through a new draft law which was sent to Congress for approval. The Superintendent will be given greater autonomy by, among other things, being appointed for a fixed four-year term and a clear removal and replacement process will be set out for him or her. Moreover, a special legal protection system will be established for SFC staff to provide greater legal security in making decisions according to their duties and responsibilities, unless they are demonstrated to be acting in bad faith. In addition, budgetary funds will cover the cost of mounting a defense against lawsuits initiated as a result of acts of commission or omission by SFC civil servants in carrying out their duties.

3. Views. The increased transparency and clarification in the new draft Law in ensuring not only de facto but also de jure independence of the SFC and legal protection of its staff is welcome. In particular, the improvements to the appointment and accountability processes related to removal of the Superintendent of the SFC are useful in addressing the potential vulnerabilities that the post may be subject to in terms of political pressure. However, even with the law coming into force, future supervisory effectiveness of the SFC will need monitoring on an ongoing basis because legal provisions are not a sufficient condition for operational independence. Supervisory authorities will have to demonstrate their ability and willingness to act when needed, to translate legal provisions on independence and legal protection into effective supervision.

B. Macroprudential Policy: the Financial Security System

4. Background. Within a medium-term timeline and medium priority, the FSAP recommended strengthening the formal institutional arrangements for delivering financial stability by adopting a more formal structure of the financial system monitoring committee (CCSSF) role through an action plan to manage a systemic crisis while respecting the legal mandates of institutions (BR, SFC, MHCP and FOGAFIN) that make it up. The FSAP recommended that the CCSSF also be responsible for directing action plans related to systemic matters including resolution of D-SIBs, SIFIs including financial conglomerates and large non-bank financial institutions.

5. Actions. The authorities have sought to strengthen the work plan on prudential issues at both the macro and micro levels, including an assessment of systemic risks, by continuing to develop methodologies for monitoring SIFIs, at the individual level as well as across the board. The action plan includes continued strengthening of coordination procedures in times of crisis, including memorandums of understanding (MoU), and decision-making processes amongst institutions responsible for financial stability. Enhanced monitoring of the financial sector through an expanded Financial Stability Report (including stress tests) has already occurred and new analytical methodologies and indicators of systemic risk have been developed as part of the BR working paper series. Moreover, SFC is seeking to fully embed the move from compliance, rule-based supervision framework to a risk-based supervision utilizing technical capacity development from the Toronto Center based on the Office of the Superintendent of Financial Institutions (OSFI) risk-based supervisory approach. While progress on coordination has improved through formal MoUs, these may not be sufficient to ensure all confidential supervisory information is shared in all cases between institutions that make up the CCSSF and between home and host supervisors. Some enhancements for managing cross-border impacts on systemic risks have been made through new supervisory colleges, off-shore on-site visits with home supervisors of subsidiaries, MoUs, and coordinated work with Central American supervisory bodies. A more formal structure for CCSSF will be adopted through the issuance of a Decree (1974 of 2014), identifying some of the Committee’s activities: sharing information on risks that could affect financial stability; promoting the exchange of information, resolution and communication mechanisms among institutions making up the Committee so that they can be implemented at times of financial stress; and conducting studies on common interest topics.

6. Views. The CCSSF proposed enhancements will further help strengthen coordination and action in dealing with systemic risk. The CCSSF remains an institution through which authorities in charge of financial stability coordinate their work. While Colombia has a wide range of macroprudential tools to tackle incipient systemic risks, the challenge for the CCSSF remains in coordinating and communicating these policies with existing microprudential, macroprudential and macroeconomic policy tools to avoid conflicts and unintended impacts. Moreover neither the SFC nor the CCSSF have designated any bank as D-SIBs or as non-bank SIFIs, or identified common risks of non-systemic institutions which could become systemic. A D-SIB or D-SIFI designation would require enhanced supervision involving greater supervisory intensity and intrusiveness. Moreover, these entities would also be subject to the regulation by the macroprudential authority. This would require the calibrating and setting above minimum prudential (capital, liquidity, or leverage) requirements for systemic entities in line with best international practice. This may be made more explicit in the future when the processes of risk-based supervision and firm-specific prudential requirements by the SFC become fully embedded. The CCSSF could be provided with explicit decision making powers or, alternatively, with “semi-hard” powers to recommend actions, coupled with a ‘comply or explain’ mechanism. This would remove the need for the CCSSF to have direct control over policy instruments or over participating institutions. This arrangement would help preserve the operational autonomy of the participating agencies.

C. Holding Companies of Financial Conglomerates

7. Background. Within a medium term timeframe and high priority, the FSAP recommended that a law be approved that gives SFC supervisory and regulatory powers over the holding company of a financial conglomerate. The SFC’s legal powers cover banks and their subsidiaries but do not cover associated holding companies that are not regulated. There are no powers to change a financial conglomerate’s structure, and prudential requirements do not cover the entire banking group. Currently the assets of foreign subsidiaries of Colombian financial conglomerates account for about 18 percent of total assets of Colombian lending institutions, with 210 institutions having an international presence in over 20 countries, primarily in Central America.

8. Actions. A draft bill has been presented to Congress, jointly drafted by the MHCP and SFC. The bill will provide special rules for the supervision of financial conglomerates, providing the SFC necessary powers for a comprehensive monitoring and implementation of standards for conglomerates and financial holdings. The draft bill establishes: (i) the definition of financial holding conglomerates; (ii) the legal powers of the SFC regarding the establishment of prudential requirements that apply to said conglomerates, including provisions on corporate governance, solvency requirements, credit limits, concentration risks and transactions within the cluster and with related parties, among others; and (iii) the legal authority to order changes in the structure of the conglomerate, and to limit the activities that can be performed by the institutions or vehicles that make up this cluster, including the establishment and operation of offices abroad. Currently the SFC obtains information related to foreign subsidiaries directly from entities and parents subject to supervision. It has conducted on-site inspections of foreign subsidiaries, participated in supervisory colleges for large Colombian conglomerates, and signed 26 MoUs with authorities where Colombian banking groups and conglomerates are active. It is also implementing a new risk management methodology covering solo and consolidated levels.

9. Views. The consolidated supervision, risk monitoring and assessment of financial conglomerates by the SFC have been greatly enhanced and will continue to be enhanced in the coming years as new challenges are addressed. It is critical that the draft law on conglomerates is passed to allow needed powers over financial holding companies. These powers may not be sufficient with regard to mixed conglomerates, many of whom do not have a financial holding company structure, or are based offshore, outside regulatory and supervisory reach. The SFC should have enough regulatory powers over the non-financial institutions that form part of a mixed conglomerate to mitigate regulatory arbitrage within the group. It would be important to impose capital, liquidity, and risk management requirements at group-wide and solo levels but this may not translate into having the same level of “enforcement” powers over the non-financial institutions as over the financial ones within a group. Enhanced monitoring of such intra-group flows between regulated and unregulated entities should be undertaken involving the SFC and the Superintendencia de Sociedades (SS).

D. International Financial Reporting Standards (IFRS)

10. Background. Within a medium term and with medium priority, the FSAP has identified that Colombia had initiated a process of convergence toward IFRS and auditing standards and that it should continue its implementation of IFRS. It is expected that that most of the SFC’s supervised institutions, among other companies, will issue IFRS financial statements starting in 2015.

11. Actions. The SFC has conducted an impact evaluation of IFRS adoption on the financial institutions’ capital level and found that these adjustments could potentially distress equity of insurance companies, the level of coverage provisions of the loan portfolio of credit institutions, and the amount of capital held by cooperatives. The Decree 2973 of 2013 compelled insurance companies to keep catastrophic reserves for earthquake and workers compensations insurance. Even though these loss deviations and technical provisions are not allowed by IFRS4 (in as much as they are expected to be included in the capital), they were kept as a prudential measure. Another exception to IFRS4 was to allow 20 years for the transition to IFRS for life insurers to update the value of their annuities reserves due to the adjustment of the mortality tables in 2010. Another important area of IFRS impact relate to recognition of impairments for financial instruments. Under IFRS, using an incurred loss approach, too few losses would be recognized and too late. Exempting the application of IFRS for the portfolio of loans (loan portfolio) of credit institutions will ensure that the recognition of impairments continue to be calculated using the more conservative Colombian regulatory method of expected loss, that also embeds a countercyclical component. The application of the new version of this standard issued by the IASB in 2014 already allows the recognition of the impairment loss using the expected loss method. Also the application of IFRS9 relating to the portfolio of investments was exempted because the rule applicable in Colombia does not support the category of Investments Available for Sale as the rule of SFC does resembling more to the new standard for financial instruments, issued in 2014. Finally in the case of financial cooperatives, since 2013 it was possible that these entities included in their statutes the provision that all the capital required to operate as an supervised entity by the SFC will be understood as “Irreducible Minimum Capital”, which ensures that they can continue to register the amount of the contributions of its members as capital, in compliance for what is provided in IAS 32 and its interpretation.

12. Views. The move to IFRS and work undertaken by the SFC to enable supervised institutions to move to IFRS accounting is welcome. IFRS will enable a significant enhancement of accounting standards that would enable a more accurate representation of financial and nonfinancial institutions accounts and bring them into line with robust international accounting standards. The SFC has rigorously applied the convergence process for moving to IFRS throughout 2014 and has facilitated considerable progress in terms of adoption. Staff believe the SFC’s plan to review implementation of IFRS relative to the previous standards in 2015 will provide further opportunities to address any outstanding issues.

E. Standards for External Auditors

13. Background. Within the medium term and with medium priority, the FSAP found that external audit norms were general and did not cover all the aspects of the international audit standards. While the SFC has the authority to oversee external auditors, it needed to adopt more rigorous standards for independence. For example, an auditor was able to receive as much as 25 percent of its revenues from non-audit services from a firm it audits, without being disqualified. Moreover, disqualifications appeared to only apply to the term of the specific engagement.

14. Actions. There has been some progress with regard to greater transparency and disclosures. Decree 302 of 2015 will ensure external auditors abide by the following international standards by January 2016: (i) International standards on auditing; (ii) international standards on quality control; and (iii) code of ethics for professional public accounting. Implementation will follow from implementation of IFRS. Any delay in implementing IFRS will have adverse implications for implementation of needed external audit requirements to bring them in line with international audit standards. The supervisory process takes into account the reports of the Auditors and the deviations revealed by them, but the SFC has its own risk monitoring procedures that are applied in accordance with the scheme planned under the Integrated Supervisory Framework (MIS).

15. Views. Enhancements to external audit standards are welcome and will improve transparency and disclosure around financial institutions’ financial statements ensuring they remain robust in accurately defining its performance. Given that these enhancements are bound up together with the move to IFRS, delays could arise if IFRS implementation takes a longer period of time than initially expected. Moreover, the SFC should ensure, as it moves to its risk-based supervisory framework, that such enhancements to standards and disclosures by external auditors and audits are fully incorporated but do not reduce its own intrusive assessment and monitoring of financial institutions. The External Audits of Banks issued by the BCBS in March 2014 sets guidelines on audit committee’s responsibilities in overseeing the external audit function as well as prudential supervisor’s relationship with external auditors this could provide further international best practices for authorities to employ.

F. Basel II Pillar 2 Supervisory Framework

16. Background. Within a medium term and with high priority, the FSAP recommended the adoption of the Basel II, Pillar 2 supervisory framework to enable Colombia to move from a rules-based to a risk-based supervisory framework (RBS). The FSAP found that the SFC did have a sound framework for the supervision of individual risks but that a comprehensive RBS framework was still in development. This RBS framework would look not only at individual financial institution risks, but also at risks across the financial system including domestic and foreign. The RBS framework would enable the SFC to efficiently allocate its resources to key areas of financial institutions’ significant activities and risks (nature, size and complexity) and be more proactive and forward-looking with regard to identification of such risks. The FSAP identified that the SFC had since 2009 started to implement an RBS approach called the Integrated Supervision Framework (MIS), with the help from the Toronto Center, and modeled on Office of the Superintendent of Financial Institutions (OSFI’s) RBS methodology. As of 2014, the RBS methodology has been fully developed for lending institutions and insurance companies.

17. Actions. The SFC has been implementing an RBS framework for several years. Work is most advanced for banks and insurers, and is now in the implementation stage. RBS development for broker dealers, trust companies, and pension funds began in 2014. Comprehensive risk management and assessment of risk led to the creation of an analysis unit together with relationship managers for groups of institutions, enabling a detailed and ongoing update of institutions and conglomerates risk profile. The MIS enables the assessment of the soundness of capital, liquidity and the robustness of capital and liquidity management policies and methodologies, taking into account the international standards on ICAAP, risk identification, and risk measurement.

18. Views. Staff welcomes the move to the MIS by the SFC which is an RBS supervisory framework that will continue to evolve and develop over time. The MIS will help the SFC obtain a more comprehensive and forward-looking assessment of financial institutions’ significant activities and key risks, risk controls and the overall risk profile for each financial institution. The MIS, together with forward-looking stress tests and supervisory judgment, should also help the SFC determine the supervisory intensity and prudential requirements (Pillar 2 buffers) reflecting the size, complexity, and risk profile of each financial institution. The close working relationship and proactive involvement of the Toronto Center in helping the SFC to move to a RBS framework has been very beneficial. Feedback to supervised entities, even if from initial visits only, should be provided in a timely fashion to help institutions develop risk management processes, internal controls and governance frameworks to meet supervisory expectations. Work is still progressing in developing an RBS framework for broker-dealers, trust companies, and pension funds. Given that there are domestically systemic entities in this non-bank group, the RBS framework progress should be prioritized for these financial institutions. The development, implementation and use of a RBS framework by the SFC will take several years to be fully embedded. This will also require resources devoted to the development of policies and procedures aimed at producing comprehensive and consistent off-site reports, and conducting robust on-site examinations and effective enforcement actions. Ultimately, whether the move to an RBS framework can deliver safety and soundness of financial institutions and overall financial stability will depend on the SFC willingness to act on risk concerns.

G. Comprehensive Risk Management for Banks and Banking Groups

19. Background. Within the medium term and with a high priority, the FSAP found that a comprehensive risk management was not fully developed. The SFC had issued regulations relating to the standards for risk management of financial institutions (referred to as SARs for its initials in Spanish) on credit, market, liquidity, operational and anti-money laundering risks. The SFC had specialized risk units that had responsibility for the overall supervisory process of each of these risks, including autonomous powers to issue administrative orders and sanctions. However, the scope of application of the SARs were directed towards individual institutions and individual risks. While the SFC had a general requirement that supervised entities manage their risks in a comprehensive way, there were no further specifications with regards to the comprehensive risk management of banks and banking groups. Of particular concern was the absence of standards for the management of interest rate in the banking book, as well as country and transfer risks. These latter risks were originally considered low priority, but have become significant with the increase of variable interest loans in the banking book and the large scale expansion of Colombian banking groups abroad.

20. Actions. The SFC has strengthened the risk management framework of financial institutions (SARF in Spanish) that is in line with RBS. It has integrated individual risks into a comprehensive management of all risks. This has ensured the policies, principles, responsibilities, functions of management, oversight of entities, and instructions are applicable across the board to all risks. The SFC has established methodologies and/or procedures for assessing specific risks of financial intuitions, defining minimum elements for establishing identification, measurement, monitoring, and oversight by each financial institution. These actions were completed in 2014. Financial institutions are also expected to measure each risk linking methodologies (standard and internal model) to accounting aspects to fully identify risks. Work on linking risks to accounting aspects still remains in progress and is expected to be completed in 2015. The SFC has also required that financial groups put in place instructions for risk assessment across the group. This remains in progress and completion is expected in 2015. The SFC and BR are also undertaking a project with the World Bank/IMF as part of the FIRST initiative to equip the BR and SFC with tools and methodologies to monitor and supervise systemic and liquidity risks faced by financial conglomerates. The project would identify needed regulatory changes to existing regulation or new regulations. Liquidity risk for individual entities (including arising from foreign currency) is identified to determine consolidated liquidity risk of financial conglomerate. The work will also determine consolidated country and transfer risk, and interest rate risk on the banking book for financial conglomerates. Consolidated capital requirements for financial conglomerates will incorporate systemic risks. Systemic risk monitoring of financial conglomerates will identify systemic, foreign, and liquidity risks and prescribe measures to be taken by BR and SFC in this regard.

21. Views. Strengthening of the comprehensive risk capture and management of multiple risks for banking groups and financial conglomerates, both domestically and those expanding abroad, has been beyond expectations. The SFC has gone further in integrating the financial risk management of banking groups with the development and implementation of MIS. This will help the SFC obtain a thorough understanding of the risk profile of banks and banking groups at a solo and consolidated level. The creation of analysis units and relationship managers for institutions will help avoid any potential fragmentation of responsibilities among the various SFC supervisory departments in the implementation of an overarching risk management framework for banks. The development of key risk methodologies for financial conglomerates is still work in progress, and it will be important to implement it in a timely manner. Consolidated capital requirements for financial conglomerates addressing systemic, liquidity, and country risks would benefit from a clearly defined capital framework by the MHCP for domestic banks, banking groups, and financial conglomerates. The capital framework could articulate a clear transition plan to the Basel III capital adequacy measure and adoption of risk-based capital buffers to build additional loss absorbency for cross-border and domestic risks generated by financial conglomerate operations. Work on a comprehensive risk management framework for mixed conglomerates is not articulated. This is an area where functions, structure and operations of individual financial and non-financial entities of mixed conglomerate and intra-group flows between them generate risks that are not well understood. Joint work with the SFC and SS to understand family ownership and group structures, offshore registration—including of exposures of mixed conglomerates—will need to be identified and better understood to monitor risks and apply necessary prudential requirements over regulated entities of the mixed conglomerates.

H. Guidelines to Undertake ICAAP at Bank and Conglomerate Level

22. Background. In addition to the work undertaken by the SFC to move to RBS in line with Pillar 2, Basel II, the SFC was expected to ensure that banks have their own internal capital adequacy assessment processes (ICAAP) to complement Pillar 1, which are essentially minimum regulatory capital requirements covering credit, market and operational risk. This action was deemed of high priority, to be met within the medium term to Pillar 2 capital requirements would be in addition to Pillar 1 capital, and would reflect bank risk profiles and forward looking risks. Pillar 2 would also cover capital for addressing specific risks such as systemic, concentration, pension, and liquidity risk. The FSAP recommended that the SFC assess whether banks would be able to determine their overall capital adequacy by accounting for: capital held against the size and nature of their business, loan concentrations and risk exposures, strength of internal controls and accounting systems, and risk management systems and policies.

23. Actions. A decree will be released in the first part of 2015 that requires each credit institution to perform an internal capital adequacy assessment and identify the requisite level of capital adequate to support its risk exposure. The SFC will determine the sufficiency of this process using the MIS and may require credit institutions to strengthen internal risk management controls, hold additional levels of capital and liquidity, adjust their ICAAP, and may establish penalties if they fail to comply with new capital adequacy requirements. ICAAPs will be required on a solo or consolidated basis, and will incorporate stress testing to determine institution’s risk exposure and capital needs under adverse conditions. Regulations which contain the minimum elements required for the ICAAP will be completed in 2016. Credit institutions will be expected to identify and measure all key risks they are exposed, to including Pillar I and other risks. Credit Institutions will require an assessment of credit, operational, liquidity, reputational, strategic, off-balance sheet, and concentration risks. A stress testing framework draft has already been released and will be integrated into the ICAAP.

24. Views. It is welcome that the SFC is moving to implement ICAAP for banks on a solo and consolidated basis. However, ICAAP regulations and SFC capacity to assess banks’ ICAAPs is not yet complete. Completing this work should be prioritized in line with the SFC move to Pillar 2. Moreover, capital will be determined using quantitative and qualitative criteria and judgment-based approaches, especially for hard to quantify risks. It will be important for the SFC to ensure that the ICAAP has strong board and senior bank management involvement and oversight. Moreover that bank’ ICAAPs are able to determine capital adequacy on a forward-looking basis (including linked to own stress tests) which build sufficient adversity over prolonged periods and can vary with changes in bank’s strategic plans linked to capital planning and with the business cycle.

I. Large Exposure Limits, Number of Exceptions and Limits for Related Parties

25. Background. The FSAP recommended, over the medium term and with high priority, to increase scope and streamline the complex set of large exposure limits to help manage concentration risk. Moreover, related party lending limits needed to be strengthened to further control connected lending. More importantly, local affiliates were not consolidated and available unused credit lines were not taken into account in calculating large exposure limits or related party lending. In addition, for large exposures, a statement under oath of non-relation could exempt certain parties from the definition of connected parties. The SFC was also recommended to require that exposures to directors, senior management and key staff, their direct and related interests, and their close family in affiliated companies also comply with the limits on related party lending. The SFC was also recommended requiring banks to have policies in place for avoiding internal conflict and disallowing parties involved in the process for granting and managing exposure to benefit directly or indirectly from it.

26. Actions. The MHCP proposal on large exposures is being reviewed and the SFC is providing comments which builds on the BCBS methodology of large exposures. Authorities have suggested that the draft provides greater clarity to exposure limits, clearer instructions, and broadens the scope of the application of large exposures framework at a consolidated level (including local affiliates) and widens definitions of counterparties and connected group of counterparties. The draft will allow the SFC greater discretion in their application on a case-by-case basis. Staff would encourage authorities to make clear the details and actual limits and remaining exceptions to the large exposures regime. It is important that the large exposure proposal is issued without delay by end-2015 for public comments. As part of the current regime institutions are also expected to report any exposures equal or above to 10 percent of an entities eligible capital. Exceptions to the large exposures framework relate to exposures of sovereign and public institutions that help Colombia’s economic development including infrastructure projects for the fourth generation of highway projects and the development bank (Financiera de Desarollo Nacional).

27. Views. The SFC’s plan to modify individual exposure limits and reduce the number of exceptions is welcome. Since the FSAP for Colombia was undertaken the BCBS has issued a new standard for large exposures. The authorities should revise their drafts to align them with the new international standard. The new proposals need to ensure that approved credit lines are taken into account when calculating compliance with limits and ensure that for the purpose of limits and reports commitments are also taken into account. While it is encouraging that the SFC is working towards this key FSAP recommendation, implementation is not complete and progress momentum will need to be maintained. While authorities have allowed banks to exceed exposure limits (articulated by the BCBS) for the infrastructure projects, the SFC needs to ensure banks are able to cope with concentration, and maturity mismatch risks on their balance sheets due to the relaxation of regulatory rules. The banks intend to transfer credit, liquidity and concentration risks from the projects to the wider Colombian financial system through securitization. The SFC should be alert to growing concentration and interconnectedness risks in other parts of the financial system (insurers and pension funds) from such securitization and growth of the shadow banking system. They should also remain alert to hedging risks of such projects migrating to broader capital and derivatives markets in Colombia. The SFC should also make clear how it would seek to address sovereign exposures (domestic and foreign) and sovereign-banking adverse loops outside of the large exposures framework. One way to deal with them would be to consider them under the general concentration risk (Pillar 2) framework.

J. Notification of Public Meetings and Extraordinary Actions

28. Background. The FSAP found that, while the standards for issuance of securities and related disclosure were high, and substantial progress was made on corporate governance, some issues still required attention. For example, the SFC had made great strides to improve corporate governance by adopting a voluntary code, issuing a yearly report on compliance and related explanations by all affected companies, and requiring company compliance reports to be public information. However, there were still substantial gaps in the protection accorded to minority shareholders and their capacity to influence the decisions of financial entities within conglomerates. The FSAP found that the law applicable to corporate conduct was largely commercial/company law and that the protection of minority shareholders in the concentrated institutions in Colombia was more limited than desirable. Moreover, the time frames for notice of extraordinary actions and the annual general meeting (AGM) were extremely short, even though IOSCO standards did not provide specific guidance in this regard. The complexity of Colombian companies makes these deficiencies especially problematic, as there are assertions that the available protections have been circumvented by various strategies in practice. The FSAP recommended that in the medium term and with medium priority the rights of minority shareholders be improved. In particular, it was deemed necessary to increase the prior notice of public meetings and extraordinary actions, and improve overall compliance with the Codigo Pais (Country Code). There was also a need to strengthen the capacity to assure protection against takeovers and to detect improper related party transactions within complex conglomerates.

29. Actions. Representation of minority shareholders was allowed by Colombian law through the mechanism of the electoral quotient, which gives minority shareholders the right to be represented within the Board of Directors. In addition, in 2012, the SFC issued special dispositions in order to ensure the exercise of rights of foreign investors, shareholders of issuers listed on the national register (RNVE), by regulating the proxy voting mechanism. Concerning disclosure requirements for offerings or listings of equity and debt securities by foreign issuers, Colombian regulation states that both foreign and domestic issuers must comply with the same standards if they want to do a public offering of securities. In relation to the disclosure of information of directors, officers and employees, general information such as name, job position, and date of designation has to be revealed to the public through the RNVE. Since 2012, further enhancements have been put in place to strengthen protection of minority shareholder interests. The draft law on conglomerates provides SFC with new tools to ensure operations performed by financial conglomerates protect rights of investors from takeovers. Also the Codigo Pais ensures transparency and veracity of information provided to investors, recognition of rights of shareholders (significant or minority) and provides recommendations for managing conflicts between conglomerates and companies. There will also be a report on the implementation of the new National Code by issuers of securities. Issuers of securities are expected to evaluate legal changes to the Code of Good Governance, Code of Conduct, etc., so that new measures or recommendations can be incorporated within the National Code. Preparation began in 2015 and is expected to be completed in January 2016.

30. Views. Staff agrees that it is important that required shareholder protections be applied in practice, which would provide confidence to industry and regulators. The previous time frames for the annual general and extraordinary meetings were not sufficient but have now been extended by the SFC to address this deficiency. The draft law on financial conglomerates has yet to be passed and it is therefore unclear whether the Codigo Pais has obtained sufficient market adoption to ensure protection of minority shareholders and provide early notification of meetings. The danger remains that some entities could still circumvent the spirit of the mandatory take-over rules by aggressive structuring and other tactics. Some shareholders (and/or companies) could act in concert (at the expense of other minority shareholders). It is not clear whether the SFC has robust strategies or methodologies in place to test for misconduct in such circumstances. Furthermore, the work undertaken by the OECD on corporate governance suggests that more could be done with regard to disclosures of shareholders rights and reporting related to changes of ownership, independent of the size of that change in ownership. It would be useful for the SFC to ensure practices by entities meet such best practice principles.

K. Oversight of Broker-Dealers and Collective Investment Schemes

31. Background. The FSAP found that the Securities Law, adopted in 2005 together with subsequent amendments, had enhanced customer protection and the ability to combat market abuse. Since that period, the SFC has made substantial efforts to bring Colombia into compliance with international standards, in particular the standard for exchange of enforcement and surveillance information set by IOSCO, by signing the MoU in May 2012. It has also worked actively within the Colombian system to meet the new expectations contained in the IOSCO principles adopted in June 2010, relating various matters, including systemic risk and hedge funds. In this regard, the SFC has extraordinary administrative powers in the securities sector that exceed those of many jurisdictions, including the ability to freeze and seize assets (including assets of non-supervised entities and parties) and to intervene in the event of market disruption and defaults. Notwithstanding the significant progress, made with respect to consumer protection and market abuse, the FSAP suggested further improvements be made in relation to oversight of operators of collective investment vehicles and market intermediaries, including broker-dealers, to strengthen investor protection and improve the management of counterparty risks, including collateral management. This was to be carried out with a medium priority over the medium term.

32. Actions. Authorities have taken steps in 2014 to strengthen and standardize guidelines for collective investment funds administration, management, and distribution through issuance of multiple circulars and regulations that: (i) enhanced disclosures for investors; (ii) adopted a new authorization regime with additional requirements; and (iii) imposed new rules for agents in devising portfolios in line with international best practice. Market transparency and safeguards for investors have been improved by: (i) ensuring securities and cash are kept with independent safe-keeping services; (ii) making mandatory safe-keeping for collective investment funds but voluntary for third-part portfolios; and (iii) establishing authorization, risk management and custodial safe-keeping rules for entities providing safe-keeping services. Authorities have also tightened operating standards for e-trading systems for routing orders by adopting IOSCO standards and developing regulations and manuals. Risk management is also in place for broker-dealers in advising clients. To strengthen mechanisms for addressing counterparty risk for broker-dealers, and prevent the possibility of noncompliance by counterparties, especially those involved in their customers’ transactions, the authorities have: (i) made counterparty risk management system (SARIC) mandatory for own and third parties’ accounts; (ii) required broker-dealer systems to evaluate counterparties’ risk profile; and (iii) required broker-dealers to establish preventive and corrective measures to oversee risk, beyond those established by trading systems (ceilings, limits, additional guarantees, and mechanisms for executing guarantees, closing of positions).

33. Views. The substantial progress in updating standards and providing consumer and investor protection is welcome as well as efforts to strengthen oversight of broker-dealers. However, consumer protection should not divert resources from the safety and soundness mandate of the supervisors. Regulatory developments for collective investment funds, e-trading, safe-keeping custodial services and broker-dealer risk management have been brought into line with international (IOSCO) standards. The SFC should clearly articulate the activities, definition and growth of third-party portfolios and their interrelationships with collective investment funds to monitor investor and consumer protection. If investor protection is compromised due to these third party portfolios, the SFC should extend mandatory safe-keeping for such portfolios and funds. RBS using risk-matrices for brokers-dealers is expected to be implemented in December 2015. For e-trading, RBS involves monitoring, risk identification and assessment of risk management including operational, strategic and conduct risk. RBS for counterparty risk will focus on evaluations of policies implemented by broker-dealers such as monitoring, development, operations, commission agreements and property accounts. With regard to collective investment funds, the RBS approach will seek to determine significant activities, management capacities and risks of such funds, and targeting supervision intensity in relation to such activities and risks. The SFC will need to further clarify whether the RBS or adoption of new risk management standards for funds and broker-dealers also fully address portfolio management.

L. Bank Corrective Action and Resolution Framework: Legal Framework to Expedite Resolution and Internationally Accepted Principles

34. Background. The FSAP found that SFC had a broad range of corrective action powers that have been used effectively in the past. These measures included moral suasion and issuance of administrative orders, cease-and-desist orders, and sanctions. The SFC also had powers to take specific steps such as establishing an enhanced surveillance, under which the institution would follow the SFC requirements for its operation; coordinating actions with the deposit insurer; fostering the fiduciary administration of the assets and business by another authorized institution; ordering the recapitalization of the institution; fostering the partial or total transfer of the assets, liabilities or contracts, or the sale of its commercial establishments to another institution; ordering the merger of the institution; and ordering the adoption of a recovery plan. The FSAP found FOGAFIN to have a comprehensive set of resolution powers and suggested improvements in two key areas:

• Excessively long period of possession. Once a financial institution had been intervened, FOGAFIN had a period of two months (which can be extended) to decide on the resolution option. Such a long administration period added to the risks of shareholder lawsuits and a further loss of confidence in the institution, and the FSAP recommended that it be shortened.

• Too much flexibility in the choice of options. The FSAP found that given authorities could choose among a wide range of resolution options, this latitude could create pressures to select an option that unduly favors some shareholders or certain creditors. To avoid such bias, the authorities at the time of the FSAP were preparing a protocol to organize the resolution options using a decision tree that would separate systemic from non-systemic cases and identify the resolution options applicable in each case. The FSAP recommended that the protocol incorporate essential resolution principles (selection of the least cost option, minimize contagion risks, first losses to shareholders, transparency and fairness, prefer private solutions and quick response) and be public. The FSAP also recommended embedding the protocol in the legal framework to limit risks to the resolution process. The FSAP recommended that the corrective and resolution actions be completed with a medium priority over the medium term.

35. Actions. Authorities are adjusting the legal framework and establishing protocols to expedite resolution and ensure alignment with internationally accepted best practice resolution principles such as the FSB’s “Key Attributes of Effective Resolution Regimes”. Authorities have continued to develop the resolution protocol since the FSAP was carried out. It lays out clearly the importance of key principles—such as the systemic or non-systemic nature of the crisis the coordinating role of the CCSSF (and MoUs between its individual entities e.g. between the SFC and FOGAFIN) and various applications of resolution measures.

36. Views. Staff welcomes the enhancement and continued development of the resolution protocol, especially the desire by the authorities to reduce the risk of legal challenges by its codification into the legal framework. However as the protocols is not yet a law, the resolution powers, tools and resolution planning are not yet adequate. Moreover the authorities should clarify what set of principles would be applied in the event of a resolution, for example, whether the principles would be applied on least cost or a first loss allocation basis. Authorities have yet to make clear FOGAFIN’s administration periods, namely the time taken to make resolution decisions). Timings around resolution decisions will require FOGAFIN to account for variables such as the financial institutions conditions, the market situation and costs and effects of possible measures. Effective resolution and resolution planning requires up-to-date information sharing including confidential supervisory information amongst domestic, foreign institutions and authorities responsible for planning or carrying out resolution. It is not clear whether the draft law will allow domestic authorities to share all confidential information for resolution purposes with foreign authorities or whether there are limits to such information sharing. It is also not clear if Colombian authorities would have the authority to exercise their resolution powers over local operations of foreign institutions to support a foreign resolution action. Or, alternatively whether Colombian authorities would receive support from host authorities in their resolution efforts for Colombian conglomerates that have subsidiaries in foreign jurisdictions. However it must be stated that progress on cross-border recognition of resolution action remains limited worldwide and is not unique to Colombia. Without such a framework for domestic and cross-border information sharing and cooperation, the effective implementation of group-wide and cross-border resolution strategies (for systemic banks and nonbanks) could be compromised. Moreover the effective implementation of group-wide resolution strategies requires authorities to have appropriate powers to intervene at the level of financial holding companies and ensure continuation of services by non-regulated operational entities that are significant to the systemic functions carried out within the group. As articulated earlier (on FSAP recommendations related to financial holding companies), the draft law grants SFC powers to supervise financial holding companies but it is not clear whether these powers would be sufficient or broad enough in the context of resolution of mixed as well as financial conglomerates.

M. Financial Transaction Tax

37. Background. The FSAP recommended that any actions that limited the development of interbank money markets be removed to ensure smooth liquidity provision for the financial system for intermediation purposes and to facilitate implementation of monetary policy. A financial transaction tax could potentially limit financial transaction, such as repo trading, which could impact interbank general collateral (GC) repo markets that corporate could make use of to expand the range of funding availability. The FSAP recommended that this be carried out with a medium priority over the medium term.

38. Action. The 2014 tax reform approved by Congress postponed the phasing out of the financial transaction tax to 2019. The wealth tax rate was maintained at the previous level and will be phased out by 2018 gradually from 1.15 percent in 2015 to 1 percent in 2016 before falling to 0.4 percent in 2017.

39. Views. It is unclear how large a role the transaction tax has played in the development of money markets relative to other collateral and counterparty issues (see below). This tax remains a barrier to further development of money markets in Colombia and adds to wider financial disintermediation.

N. Issuance of Short-Term Government Securities

40. Background. The FSAP recommended with a medium priority and over the medium term increasing the range of eligible assets acceptable for development of more efficient and robust open market operations and repo markets. As noted above, the only assets which are eligible for use in routine open-market operations are longer-term government securities and (in principle) debt securities issued by the BR. Expanding issuance of short-term government securities would allow a better balance of long-term and short-term securities for increased flexibility in public debt management. Access to a wider range of collateral, especially short-term government securities, could also create a short-term pricing benchmark for issuance of commercial short-term securities (such as commercial bills, certificates of deposits, and commercial paper issued by financial and non-financial corporates) increasing the range of funding for these institutions and further facilitating financial intermediation and development of securities markets. Moreover, the development of such markets could in turn create a wider range of eligible collateral, reducing the eventual reliance on government securities in central bank operations and reducing the incentives for commercial entities to only hold government securities thereby increasing their exposure to sovereign risks.

41. Action. The authorities have taken steps to issue short-term securities in the 6-month, and 1–2 year ranges (called TES CM) used for liquidity absorption purposes and have differentiated them from the TES B longer-term securities (5-years and above) used for Budget financing. Shorter term TES B (less than 5-years maturity) issuances were also dropped to ensure TES CM and TES B shorter term bonds avoid competing for liquidity. Existing TES CM and outstanding TES B shorter-term bonds have helped develop the local yield curve and offer good benchmarks for agents willing to issue debt with similar maturities. The securities can be used by the market and the BR for repo and OMO purposes.

42. Views. The expanded issuance of short-term government securities to be used for liquidity absorption is welcome. Staff were unable to verify the increasing use of these short-term government securities as adding to the stability to the short-end of the local yield curve. However, market participants suggest that liquidity in money markets remains concentrated at the overnight market and money markets at longer maturities could be helped by increased issuance of TES CM. This feature may reflect a residue of counterparty credit risk that remains since the collapse of systemic broker-dealer, Interbolsa in 2012. If TES CM are issued regularly with a clear strategic objective underlying their issuance then over the medium-term these securities have the potential to become reliable benchmarks useful for enhancing the liquidity and depth of equivalent tenor private sector securities. In the longer run this should create opportunities for further expansion of OMO collateral beyond just long-term government securities. The BR should publish its haircut regime based on maturity and credit spectrum (public vs. private securities) and consider an expanded set of quality collateral in stressed conditions that does not falls below a predetermined level of credit and liquidity risk.

O. Range of Counterparties in Open Market Operations

43. Background. The FSAP found that participation in Colombia’s open-market operations was open not only to credit institutions, but also to broker-dealers, trust companies and pension funds. However participation was limited to 35 percent of deposits in the case of credit institutions, and to capital and reserves in the case of other companies. It is important for Colombian banks to have access to open-market operations, because of the liquidity risks they may run in the course of their business in terms of facilitating financial intermediation, and because of the serious systemic consequences of the lack of liquidity on their part. All central banks provide liquidity facilities of this kind to commercial banks. At the time of the FSAP there were also two non-bank broker-dealers which acted as primary dealers in government securities, accepting an obligation to make markets in government securities. The FSAP recommended that it was in the interest of the BR for these primary dealers to also have access to open-market operations as a quid pro quo for accepting a market-making obligation.⁴,⁵ There was no need for other counterparties (non-systemic brokers, trust companies, mutual funds) to have access to such liquidity under normal BR operations. This was to be undertaken as a medium priority over the medium term.

44. Actions. Authorities undertook an evaluation which was completed in January 2015 to decide whether financial agents should have access to BR operations. In line with the FSAP recommendations authorities have now restricted access to BR facilities to only credit establishments (mainly banks) and public primary debt dealers. Trust companies, non-primary public debt broker dealers or pension funds do not have access to these central bank operations and are able only to access BR liquidity through the payment system facility.

45. Views. Staff welcomes the clarification by authorities that only a restricted set of counterparties can access normal central bank operations in line with FSAP recommendations. However, when defining its set of eligible counterparties, best practice is for the central bank to first consider the objective behind the provision of liquidity, which may reflect a widening in its mandate beyond that of monetary policy implementation. In the case of monetary policy access by non-banks, consideration should also be given as to whether permanent access is warranted and or whether there is just a temporary need. Differentiating non-banks from banks in terms of access to facilities/operations may also be appropriate as this ensures competitive neutrality, allows for the management of moral hazard and the risks to the central bank balance sheet, while also reducing disintermediation risks. In the case of these non-banks, while emphasis should be placed on the systemic importance of the sector, as important is the ability for the central bank to regulate and direct the institutions. On the other hand, the provision of Lender-of-Last-Resort (LOLR) is at the discretion of the central bank and involves a case-by-case evaluation of the institution in question along with an assessment of the nature of the liquidity need. LOLR should only be provided to viable and solvent institutions, for a defined horizon, and subject to strict terms and conditions controlled, enforced and monitored by the central bank.

P. Liquidity Standards for Broker-Dealers and Other Non-Bank Financial Institutions (NBFIs)

46. Background. The FSAP found that liquidity problems for broker-dealers could create systemic liquidity concerns and other risks to the payment systems. Broker-dealers remain highly vulnerable to liquidity risks given that many have the potential to take on large net intraday exposures that vastly exceeds their capital and liquidity buffers. These institutions remain closely interconnected through money and derivative markets, payment relationships with other financial companies, leveraged exposures as well as group exposures when part of a larger conglomerate. The FSAP identified two broker-dealers as being among the ten financial institutions with the most interconnections in the payments system. In response, the BR stood ready to provide intra-day liquidity to broker-dealers to contain the possible contagion from a liquidity squeeze. However BR liquidity provision was limited by the institution’s holdings of eligible collateral government securities—although the BR had provided liquidity to other broker-dealers against corporate securities for a temporary period. Given that broker-dealers (unlike systemic banks) were not natural providers of liquidity in the financial system, the FSAP recommended that broker-dealers better manage their liquidity risks by tightening their liquidity requirements and advised supervisors to undertake more rigorous stress testing of these institutions. This was to be carried out with a medium priority over the medium term.

47. Actions. Authorities have confirmed that the liquidity risk indicator (LRI) will be applied to broker-dealers and NBFIs. Authorities have also and drawn on Basel III recommendations and further clarified the categories of liquid and high-quality assets, defined haircuts on liquid assets as key recommendations. With regard to supervisory enhancements, authorities require broker-dealers of NBFIs to transmit an adjustment plan to the SFC, or prohibit carrying out new transactions, or accept new customers if there is non-compliance with regard to liquidity limits or the Liquidity Risk Indicator (LRI).

48. Views. Staff welcomes the strengthening of liquidity requirements for broker-dealers and NBFIs given their interconnected exposures to other financial institutions in the payment system. The availability of BR liquidity provision to systemic broker-dealers should be provided only on an appropriately collateralized and carefully assessed basis. In the long-term, however greatly enhanced liquidity risk management by broker-dealers and NBFIs remains a more effective approach to mitigate systemic liquidity risks compared to an automatic provision of BR liquidity to institutions that are not natural liquidity providers to the financial system. The SFC should continue to strengthen liquidity standards going forward to mitigate such financial stability risks and moral hazard concerns. Authorities should address the financial stability risks from large intraday risk exposures by broker-dealers and NBFIs as a complement to the LRI drawing on work done by the BCBS on its Principles for Sound Liquidity Risk Management and Supervision (2008) and the joint work done on monitoring tools for intraday liquidity management by the BCBS and the Committee on Payment and Settlement Systems (CPSS) in 2013. While the SFC is able to share information with the BR on liquidity risk management for broker-dealers and NBFIs, it should clarify under what circumstances it would limit supervisory information disclosure and exchange of information with the BR, notwithstanding existing MoUs on an institutions true liquidity position. There could be a potential risk that public funds could be provided to a broker-dealer or NBFI by the BR without it being fully informed about the viability of that institution.

Q. Stress Testing of Broker-Dealers and Other NBFIs

49. Background. As discussed above, the FSAP suggested that stress tests for broker-dealers and NBFIs would help these institutions manage liquidity risks they imply to the rest of the financial system. This was to occur as a high priority over the medium term.

50. Actions. The SFC performs internal tests on an ongoing basis to identify institutions’ vulnerabilities, including: (i) assessing concentration of loans; (ii) using a vector error correction (VEC) model for nonperforming loans; and (iii) assessing bank and NBFIs resilience to liquidity and market risk shocks. The SFC intends to sequence planned stress tests for financial institutions, prioritizing banking institutions first. The scope for stress tests for regulated industries, such as broker-dealers and other NBFIs, will likely occur in the medium term. SFC does undertake stress test over the standard model for liquidity risk for broker-dealers since its implementation in November 2014.

51. Views. Staff welcomes the clarification of stress testing requirements for financial institutions. The authorities have started to provide results of stress tests for banks as part of Financial Stability Reports. Further enhancements to the stress testing regime and extension to broker-dealers and NBFIs should be made to ensure a consistent and transparent approach, and requirements should be communicated to the financial institutions which are subject to the stress testing exercises. Prudential measures that could be adopted from the results of the stress tests are not formalized yet but are under discussion. This would help ensure prudential actions are tied to stress tests in addition to other qualitative supervisory recommendations under RBS, or through supervisory judgment. Staff recommends authorities tailor stress tests for broker-dealers and other NBFIs to their underlying business model and risks. This may mean, for example, more developed liquidity stress tests for broker-dealers, with a clear articulation of adverse run-off, and drawdown rates for funding (liabilities) and more adverse haircuts for asset values. A contagion stress test which links broker-dealers and NBFIs to other financial institutions in the payment system and to wider securities markets in Colombia would also be useful to monitor and assess systemic risks posed by broker-dealers and NBFIs. Moreover in the current conjuncture foreign currency and commodity shocks could also be assessed.

R. Prudential Requirement and International Standards

52. Background. At the time of the FSAP, Colombia had not formally adhered to any of the Basel capital standards, even though the regulation followed many of the Basel I rules. The capital adequacy ratio was found to be higher than the minimum Basel I standard but there were some gaps in its scope of application and in the range of risks covered; and some of its components did not have the appropriate loss absorption capacity. In addition to recommendation for the enhancement of the capital adequacy rule, the FSAP recommended the move in the medium term to Pillar 2 of Basel II. The FSAP recommended also that, to safeguard prudent long-term funding at smaller banks, the authorities address liquidity risk at different time-horizons by adopting a version of the Basel III NSFR. While the FSAP talked positively of the Colombian system of countercyclical (dynamic) provisioning, it recommended extending provisioning requirements on consumer credit to the unused portions of credit lines and tailoring provisioning rates to the debt service of the borrower.

53. Actions. The authorities adopted a revised capital adequacy regulation that took effect on August 1, 2012 with a view to strengthen the quality of capital by incorporating some of the Basel III recommendations. The capital regulation adopted includes: (i) a minimum Tier I capital of 4.5 percent of risk weighted assets; (ii) deduction of new goodwill from Tier I capital with a grandfathering clause for existing goodwill; (iii) some restrictions for the inclusion of voluntary reserves and current profits, to include only those that are expected to be permanent; (iv) deferred tax assets and pension liabilities to be deducted from regulatory capital; (v) risk weights broadly in line with Basel I framework with capital requirements for market risk following Basel II recommendations; and (vi) amendments on the consideration of minority interests to mitigate the risk of multiple leveraging. Thanks to the transition period and favorable economic conditions credit institutions have been able to transition to the new rules without interrupting access to financial services. Authorities have also issued a decree in September 2014 that recognizes hybrid instruments as additional Tier 1 or Tier 2 instruments, taking into account Basel III recommendations. Authorities are also preparing to issue regulations to further strengthen the capital adequacy requirement to adopt Basel II Pillar 2-type buffers, conservation and potentially D-SIFI buffers based on the BIS methodology of a D-SIFI. Work is also underway to adequately define the methodology to calculate operational risk and with regard to pillar 2 to be able to undertake ICAAP reviews at individual and conglomerate level.

54. Views.

• The authorities took welcome steps after the FSAP to strengthen the capital adequacy measure of Colombian banks to bring it more into line with the Basel III measure. As expected, since the introduction of the new capital measure capital ratios declined across banks, both on a solo and consolidated basis. While the new Colombian capital regulation better defines Tier 1 capital, it still includes a broader recognition of Tier 2 (subordinated debt) as capital and is not as strict in terms of deduction of future intangibles and goodwill from base capital calculations relative to Basel III capital standards. Moreover Basel III requires goodwill to be deducted from Common Equity Tier 1 capital. The recognition of the capital conservation and countercyclical buffers in terms of new regulation at end-2015 should also help adjust banks’ capital in line with their risks over time. It should be made clear that the move to risk-based supervision is likely to take time before the SFC is fully able to settle on the approach to setting Pillar 2 buffers for Colombian banks. The level or the ranges that the SFC intends to set for either the capital conservation, countercyclical, and D-SIFI capital buffers (if any) and Pillar 2 capital buffers will be specified in the regulation to come from authorities at end-2015. Authorities have also not identified D-SIFIs yet though have decided on the D-SIFI methodology using the BIS approach. Staff would also welcome authorities’ normal approach to publish regulatory proposals ad technical supporting document relating to the capital proposal to enable banks, financial or mixed groups and conglomerates to have some clarity regarding their future capital needs. The authorities should make public their discussion and proposals in this regard, including any request for market feedback on such proposals.

• On liquidity risk, the SFC LRI measure is broadly in line with the LCR measure as part of Basel III. This development should enable the authorities to transition smoothly to the LCR in the future. Moreover, the SFC has put in place an enhanced liquidity risk management system (SARL) as well as the various liquidity risk measures and methodologies. Banks are also required to provide information on liquidity and foreign currency exposure on a solo and consolidated basis, including liquidity stress tests. In this regard it will be important for the SFC to connect up liquidity stress tests with solvency and contagion stress tests to map out systemic risk under adverse conditions, together with a contingent funding plan. Moreover, the SFC will need to ensure that intraday liquidity risk management and collateral are robust and banks public disclosure around these measures is made. This should improve as Colombia starts to implement IFRS and Pillar 3 of Basel II. The FSAP did recommend that, to safeguard prudent longer-term funding at smaller banks, the authorities should continue moving forward with their liquidity risk metrics and adopt a version of the Basel III Net Stable Funding Ratio. This would require banks to maintain a stable longer-term funding profile in relation to their on- and off-balance sheet activities, and limit over-reliance on short-term wholesale funding.

• The SFC has never objected to the use of an internal model for meeting capital or provisioning requirements, though no entity has yet decided to pursue this approach. Any assessment of use of internal models would require significant resources by the SFC to fully understand and assess the quantity and quality of data used for the models and whether risks were being fully captured by such models. If the SFC is using reference provisioning and loan loss models for certain portfolios (retail or commercial or others). The inputs into this exercise and parameters (stressed transition matrices) should continue to be updated regularly to ensure provisioning remains robust on a forward-looking basis.

• As the SFC transitions to IFRS, it remains alert to the differing provisioning standards between IFRS and those required by supervisors. It could be that IFRS adopted by Colombian banks still incorporates IAS39 which recognizes impairment losses based on an incurred loss-based model and which only permits recognition of credit losses supported by objective evidence. This could mean that, compared to the SFC expected loss approach, impairments could be too little and too late and provisions are also insufficient and too late. While the new standard IFRS9 has now replaced IAS39 and would be more aligned to the expected loss approach, it will take time for it to replace IAS39 (this could be as late as 2018). We are pleased that the SFC will ensure its supervisory loan classification and provisioning standards are able to recognize loan losses early, fully and such losses are robustly provisioned for. Staff is pleased to learn that the SFC will consider the new standards of IFRS 9 and plan to compare it with the current SFC provisioning scheme and determine whether under the new IFRS9 financial institutions have adequate provisions to address credit risk.

• It should be noted that the countercyclical loan loss provisioning scheme in Colombia allows each credit institution to create an additional buffer of loan loss reserves in good times, in order to cushion a rise in specific provisioning costs during a downturn. This system is capable of creating a broadly adequate buffer for a downturn. However, FSAP simulations showed that the countercyclical buffer may not be depleted fully during a moderately severe downturn episode, owing in part to an asymmetry between the rules for accumulation and draw down. The FSAP recommended that authorities consider phasing in countercyclical capital buffers to address systemic shocks. This was important to understand how such a (macroprudential) system would dovetail with the countercyclical (microprudential) loan loss provisioning. The SFC is working with the MHCP as part of the project to converge to Basel III standards where the countercyclical buffer will be one of the rated elements and the interaction of the countercyclical mechanism is built into the scheme of provisions.

• In addressing broader asset classification issues the SFC does not require banks to rate all credit exposures including off-balance sheet operations, such as letters of credit and bank collateral and sureties. Banks however are expected to report monthly data on portfolios as is reported to the credit bureau. While obtaining this additional credit risk information would be useful for the SFC, it could require significant resources and IT infrastructure to manipulate and interpret such large data sets. However, the SFC does require supervised entities to provide different credit information to determine asset quality such as monthly financial statements with provisions, detailed active credit operations by portfolio and debtor on a quarterly basis, and follow up activities on reporting loan quality month, every six months and at yearly intervals.

S. Financial Consumer Protection

55. Background. The FSAP talked generally about the importance of strengthening consumer protection for enhancing financial services markets and ensuring resources of the SFC were directed towards consumer protection matters. The establishment of comprehensive consumer protection systems, as described in Law 1328 of 2009, was a major step forward. Further improvements needed to be made by strengthening oversight of the activities of insurance agents. The FSAP suggested that consideration be given to establishing a basic public registration system for insurance agents, including basic suitability requirements, and minimum educational standards, and a code of conduct and training. The system should include a public database with information on those agents who have been formally disciplined for actions in the conduct of insurance business or disqualified from registration. The FSAP went further by recommending an industry based self regulating organization, overseen by SFC that benefits both industry and consumers.

56. Actions. Authorities have implemented several enhancements, such as financial consumer support system, to ensure supervised institutions create a customer service culture, providing more detailed information for the customer. The SFC has also used its jurisdictional powers responding to more requests to settle disputes between consumers and supervised institutions. The SFC is also committed to reviewing the Financial Consumer Ombudsman regime and to strengthening it based on international best practices. There are additional work streams in place by the SFC to address abusive clauses in contracts as well as ensuring the complaint procedures in addressing complaints from consumers robust.

57. Views. Staff welcomes the continued progress in strengthening consumer protection. Prudential supervisors around the world share a common goal to build or restore consumer confidence, in tandem with tightening prudential requirements, to deliver consumer protection initiatives that aim to promote responsible finance compatible with financial stability. Staff believes that Colombian authorities’ work in relation to consumer protection matters is directed to such a dual objective. Around 56 employees of the SFC deal with consumer protection matters also staff in charge of supervision are also involved in the process of handling complaints and enquiries even though this does not remain their primary activity. Staff reiterates that supervision which seeks to address and mitigate financial stability concerns should be prioritized above consumer protection issues. To ensure prioritization of supervision without sacrificing consumer protection objectives the SFC ensure that the customer service system (SAC) is used by the supervisory units of the SFC to input into risk-based supervision. This then allows the SFC to define the supervisory plan, resources and objectives to perform timely assessments of the SAC including the consumer protection department. The FSAP had also raised specific consumer protection issues in the area of insurance. There is currently a project to regulate the adequacy of insurance intermediaries and disclosure of information. There is also an additional project to create a registry of authorized products, sanctioned subjects and intermediaries authorized by insurers.

A. Introduction

1. A robust bank capital framework helps ensure financial stability and sustain bank lending during economic downturns. Bank provisions and profits are an important buffer that can be used to absorb expected losses. However, capital provides banks with a cushion to absorb unexpected losses, and has the potential to reduce the risk of bank failures and prevent interruption of banking services and financing to the real economy. Evidence based on a large sample of Italian firms’ during 2007–10 shows that a 10 percent decline in bank credit can curtail firms’ investment by 8–14 percent over four years through the bank lending channel (Cerruti, 2013).

2. Better capitalized banks weathered the 2008 global financial crisis with less difficulty. Banks in both advanced and emerging economies transmitted the funding and liquidity shocks of 2008 to the real economy. However, banks that had more high-quality capital had to curtail lending less, even when they relied strongly on wholesale funding and had low structural liquidity (Kapan and Minoiu, 2013). Moreover, recent evidence from Malaysia suggests that bank subsidiaries that are reliant on parent capital have lower own capital on the assumption that the parent will provide support in crises. These banks were found to do much worse in FSAP solvency stress tests than standalone banks that have higher and more robust capital.²

3. Certain banks, in particular domestically systemic banks or those operating internationally, can benefit from capital buffers above the minimum prescribed by the regulator that can take into account systemic risks as well as risks from cross-border operations. The minimum capital requirement can be used to absorb unexpected losses, stemming from credit, market, liquidity, or operational risks, which impact all banks. However, depending on the bank’s business model and specific risk profile, losses from additional risks may not be covered by minimum capital. This may be of particular relevance for systemically important financial institutions (SIFIs) and the externalities implied by their possible failure. In the language of Basel standards, Pillar 1 minimum risk-weighted capital requirements may be insufficient to guarantee banks’ solvency in situations of stress from systemic risks which are better addressed by Pillar 2 capital buffers.

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Bank loss function and loss absorption mitigants

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

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B. Colombian and Regional Banks Capital Comparison

4. Capital definitions differ across Central American countries and comparisons must be made with utmost caution. Some cross country differences in the computation of capital include, for example, the treatment of the revaluation of fixed assets; the accounting of profits from current or past accounting periods; treatment of investments in capital instruments or requirements on donated capital; and treatment of some deductions from capital (i.e. grandfathering of some capital components). Moreover, capital differs depending on the degree of consolidation undertaken, whether at individual (solo) bank level, banking group level, or at even higher at financial conglomerate level. Differences in the national definition of capital and accounting standards across Central America and Colombia imply that any direct comparison of total regulatory capitalization should be interpreted with caution.

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Bank Regulatory Capital to Risk-Weighted Assets, end-2014

(Percent)

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

Sources: Country authorities, and Fund staff calculations.

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5. Total regulatory capital in Colombia and other Central American countries is well above the regulatory minimum. Reported total regulatory capital, based on capital definitions specific to each Central American country where Colombian banks hold subsidiaries and in Colombia, is above the regulatory minimum at an individual bank level. Moreover, using the national definitions of total regulatory capital, Colombia’s capital is above that of its Central American peers.

6. However, systemic Colombian banks have lower levels of capital in excess of the regulatory minimum than some regional peers. Regulatory capital requirements differ across Latin American countries with some higher—Brazil (11 percent), Peru, Guatemala and Uruguay (10 percent)—and some lower than Colombia’s (9 percent)—Chile, Argentina and Mexico (8 percent). The decision to choose a given level of national minimum regulatory capital reflects a series of factors, including supervisory judgment and discretion. The four largest banks in Colombian have lower capital than the large banks in some other Latin American countries. Total capital ratios in excess of the regulatory minimum requirement, stood at 2.9 percent, the lower end of regional peer comparisons.³

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Regulatory Capital Requirement and Total Capital, end-2014

(Percent)

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

Source: Bankscope, company filings, country Financial Sector Stability Assessments, and Article IV reports.

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Colombian banks have lower levels of capital according to a market-based standardized higher quality of capital measure—the Standard and Poor’s risk-adjusted capital measure—which deducts all goodwill on the balance sheet from banks’ respective total adjusted capital. This measure is important inasmuch as Colombia has seen a large number the mergers and acquisitions following the financial crisis of the late 1990s that, together with the geographic expansion of the largest banks over the last few years, has created large amounts of goodwill assets.⁴

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RAC Ratio for the Largest Rated Latin America Banks, end-2013

(In Percent)

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

Source: Standard & Poor’s.

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7. However, lower level of high quality capital of Colombian banks is offset in part by strict loan-loss provisioning and robust asset quality. The supervisor—Superintendencia Financiera de Colombia (SFC)—, requires Colombian banks to undertake strict loan-loss provisioning, based on a forward-looking expected loss approach rather than a backward looking incurred loss approach, to ensure losses are recognized fully and timely. Indeed, the SFC has also made sure that Colombian banks continue provisioning on the stricter regulatory expected-loss approach rather than the weaker provisioning embedded in IFRS (see Chapter 7). These additional provisions and banks’ reserves add loss absorbency for Colombian bank’s balance sheets. Moreover, non-performing loans remain low (around 2 percent) further supporting Colombian bank’s loss absorbency. Another consideration is that risk weighting on credit is generally high in Colombia when compared to other peer countries. Most loans (excluding mortgages and financial leases) have 100 percent risk weightings, and even the risk weightings on mortgages (50 percent on un-restructured and 100 percent on all others) are higher than in many other countries pushing down capital ratios by a relatively larger amount.⁵ Finally, banks maintain an adequate level of liquid assets to meet liquidity requirements (contractual and non-contractual) and fulfill the 100 percent limit on the internal liquidity ratio over a period of 30 days.⁶

C. Macrofinancial Implications⁷

8. A cross-border spillover analysis was conducted to estimate the effects of stress to international banks that lend to Colombian borrowers (banks, corporates, and public institutions) which depend on banks’ capital levels. The analysis covers direct cross-border lending by internationally active banks as well as lending through affiliates. The exercise draws on the Bank Contagion Module of the IMF’s Research Department, based on bilateral banking statistics of the Bank for International Settlements (BIS). A first simulation considers losses on asset holdings of international banks that reduce (partially or fully) their capital, based the assumption of a decline in the value of different types of assets (e.g., claims on the public sector, the banking sector, and the non-bank private sector of an individual country or group of countries). After the asset loss shock, the second round of simulation assumes that banks restore their capital adequacy ratios through deleveraging (i.e., sale of assets or refusal to roll over existing loans), thus reducing credit to all borrowers, including those in Colombia. In the third round, as banks deleverage with respect to their borrowers, including other banks, the simulation allows for further fire sales and scaling back of credit given the losses experienced by banks with insufficient capital buffers. Final convergence in the model is achieved when no further deleveraging occurs as banks meet their capital adequacy requirements (Cerruti et al., 2012).

9. The model simulations suggest that foreign credit availability to Colombian borrowers could be significantly affected by losses on international banks assets. Based on the assumed decline in the value of banking system assets in a country or group of countries (10 percent in the exercise), the model estimates the capital shortfall of foreign banks and the consequences of their deleveraging for the provision of credit to Colombian borrowers. (This exercise makes the extreme assumption that other banks do not step in to fill the gap in credit, which has been the experience so far.) The impact distribution is assumed to be proportional to the existing share of local and cross-border claims in total foreign claims. The largest direct impact of this shock in terms of reduction of international banks’ credit to Colombian borrowers would stem from combined losses in the U.S. and Canadian banks’ assets (3.9 percent of GDP). Considering individual countries, the shocks that would generate the largest adverse effects on credit to Colombian borrowers would come from Canada (2.7 percent of GDP), Spain and U.S. (1.2 percent of GDP each), U.K. (0.2 percent of GDP), Japan (0.8 percent of GDP) and France (0.4 percent of GDP). Recent experience has, however, shown that international financial instability has not jeopardized the availability of domestic credit by Colombian banks.

Spillovers to Colombia from Shocks to International Banks’ Exposures, September 2014 ¹

(Percent of GDP)

Source: Research Department’s Bank Contagion Module based on BIS, ECB, IFS, and Bankscope data.

¹ Magnitude of the shock is 10 percent and applies to on-balance sheet claims of all borrowing sectors. Dashes indicate lack of disaggregated foreign claims data into cross-border vs. local claims.

² Reduction in foreign banks credit to Colombia due to the impact of the analyzed shock in their balance sheet, assuming uniform deleveraging across domestic and external claims.

³ Reduction in cross-border vs. local credit is assumed to be proportional to international bank’s cross-border and local claims, respectively.

⁴ Greece, Ireland, Portugal, Italy, Spain, France, Germany, Netherlands, and UK.

Spillovers to Colombia from Shocks to International Banks’ Exposures, September 2014 ¹

(Percent of GDP)

Country	Impact on Credit Availability 2	Impact on Cross-Border Credit Availability 2	Impact on Local Credit Availability 3
USA	−1.2	−0.7	−0.6
Canada	−2.7	−0.2	−2.4
USA and Canada	−3.9	−1.3	−2.7
UK	−0.2	−0.1	−0.1
Switzerland	0.0	–	–
Germany	0.0		–
France	−0.4	−0.3	0.0
Spain	−1.2	0.0	−1.1
Netherlands	0.0	0.0	0.0
Italy	0.0	0.0	0.0
Greece	0.0	–	–
Portugal	0.0	0.0	0.0
Japan	−0.8	−0.8	0.0
Korea	0.0	–	–
Taiwan (Prov. of China)	0.0	0.0	0.0
Selected European Countries 4	−1.7	−0.2	−1.5

Source: Research Department’s Bank Contagion Module based on BIS, ECB, IFS, and Bankscope data.

¹ Magnitude of the shock is 10 percent and applies to on-balance sheet claims of all borrowing sectors. Dashes indicate lack of disaggregated foreign claims data into cross-border vs. local claims.

² Reduction in foreign banks credit to Colombia due to the impact of the analyzed shock in their balance sheet, assuming uniform deleveraging across domestic and external claims.

³ Reduction in cross-border vs. local credit is assumed to be proportional to international bank’s cross-border and local claims, respectively.

⁴ Greece, Ireland, Portugal, Italy, Spain, France, Germany, Netherlands, and UK.

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Spillovers to Colombia from Shocks to International Banks’ Exposures, September 2014 ¹

(Percent of GDP)

Country	Impact on Credit Availability 2	Impact on Cross-Border Credit Availability 2	Impact on Local Credit Availability 3
USA	−1.2	−0.7	−0.6
Canada	−2.7	−0.2	−2.4
USA and Canada	−3.9	−1.3	−2.7
UK	−0.2	−0.1	−0.1
Switzerland	0.0	–	–
Germany	0.0		–
France	−0.4	−0.3	0.0
Spain	−1.2	0.0	−1.1
Netherlands	0.0	0.0	0.0
Italy	0.0	0.0	0.0
Greece	0.0	–	–
Portugal	0.0	0.0	0.0
Japan	−0.8	−0.8	0.0
Korea	0.0	–	–
Taiwan (Prov. of China)	0.0	0.0	0.0
Selected European Countries 4	−1.7	−0.2	−1.5

Source: Research Department’s Bank Contagion Module based on BIS, ECB, IFS, and Bankscope data.

¹ Magnitude of the shock is 10 percent and applies to on-balance sheet claims of all borrowing sectors. Dashes indicate lack of disaggregated foreign claims data into cross-border vs. local claims.

² Reduction in foreign banks credit to Colombia due to the impact of the analyzed shock in their balance sheet, assuming uniform deleveraging across domestic and external claims.

³ Reduction in cross-border vs. local credit is assumed to be proportional to international bank’s cross-border and local claims, respectively.

⁴ Greece, Ireland, Portugal, Italy, Spain, France, Germany, Netherlands, and UK.

10. The starting level of capital of individual banks is important for assessing robustness against shocks that spread through direct interbank linkages. The level of capital is essential in this analysis, as it represents the loss-absorbing capacity of each institution. For instance, with the same level of interbank exposure, a bank with relatively higher capital has a stronger resilience against direct and spillover effects from other banks. Although the dynamics of the RES contagion model is based on the quantity of banks’ capital, if capital quality is low it cannot be easily deployed in circumstances of stress and, therefore, the “true” capital quantity is lower. Incorporating a critical view of capital quality in the analysis would be importance, in particular for highly systemic and/or interconnected institutions that can act as conduits of shocks to the rest of the network if they are not well capitalized.⁸

D. Basel Standards and Sequencing of Capital Stacks

11. The capital stack refers to the capital structure of the banks and is designed to address different types of risks. The opportunity for jurisdictions to impose both risk-weighted minimum and above minimum capital requirements reflecting banks’ risk profiles can be traced to the Basel Accord. The most current version of those accords, Basel III, is the latest consolidated international standard in capital and liquidity regulation for banks. Basel III builds on the Basel II structure of three pillars. Pillar 1 sets standard and advanced options to calculate minimum capital for credit, market and operational risk. The Pillar 2 standards require banks to assess their capital adequacy as a whole and require supervisors to review, and if necessary amend, the banks’ own assessments and level of capital (Box). Pillar 3 sets transparency and disclosure standards.

12. The capital stack can be defined in terms of minimum regulatory capital plus above minimum capital (Figure 1). The additional capital levels are termed “buffers” and are “stacked” on top of each other as in Figure 1. In the language of Basel standards, the stacks are labeled as Pillar 1 minimum requirement, plus Pillar 2 capital buffers (first two columns from left), which are equivalent to the minimum requirement in Pillar 1 of Basel III capital buffers (last two columns). Pillar 1 standard (8 percent) Basel III requirement consist of 4.5 percent Common Equity Tier (CET), 1-1.5 percent non-core Tier 1, and 2 percent Tier 2 capital instruments. The additional stack, the capital conservation buffer (CCB), ensures that banks build up capital buffers outside of periods of stress that can be drawn down when losses are incurred, while the countercyclical buffer (CCyB) aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate, and is meant to be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risks. Finally, the domestic systemically important banks (D-SIB) buffer accounts for the size, complexity, and interconnectedness of banks and their greater tendency to trigger contagion and systemic risks for which additional capital requirements may be needed. Finally, based on supervisory discretion, banks may want to apply additional Pillar 2 capital planning buffers to cover risks on a forward-looking, planning basis (fifth column).

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Basel II and Basel III Capital Stacks

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

Sources: BCBS, and IMF staff calculations.

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13. Sequencing the move to an enhanced capital framework is not without challenges. Implementation challenges for emerging markets may involve, among others, the need to adjust legal frameworks and to replenish capital, the latter possibly through structured instruments, given that their economies are growing faster and are more reliant on bank funding while market volatility is also higher (Basel Committee, 2014). Many countries that are about to incorporate Pillar 2 buffers into their framework already apply a minimum capital requirement of more than 8 percent—typically between 9 and 12 percent. Colombia, for instance, imposes a minimum requirement of 9 percent on total capital and 4.5 percent on common Tier 1 capital. The question arises on how to attribute the current capital above minimum into additional buffers recommended by enhanced standards. Is the existing minimum capital equivalent to the 8 percent and therefore any Pillar 2 add-ons are incremental? Or does some or all of the difference between the 8 percent and the current capital adequacy requirement represent implicitly a Pillar 2 component?

14. Cross-country evidence suggests that countries have prioritized certain components while moving to Basel III. Through its Financial Sector Assessment Program (FSAP) and technical assistance (TA) work, the Fund has found that a gradual move to the better-quality capital measure defined under Basel III has worked well and has strengthened loss-absorbency for banks. Based on domestic circumstances, and existing capital frameworks, many emerging market countries have prioritized certain Basel II and III components above others when transitioning from Basel III (Figure 2). A number of countries have found that when domestic banks do not have complex exposures, requiring a simpler, standardized approach to risk-weighting, or adopting Pillar 2 capital buffers to account for risks not captured by Pillar 1 minimum capital, was desirable. Moreover, when transitioning to Basel III, countries have aimed to adopt the capital definition and conservation buffer ahead of some other Basel III elements, such as the liquidity and leverage ratios, or Basel II Pillar 3 disclosures.

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Prioritizing Basel Components

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

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E. Sequencing of Colombia’s Capital Stack

15. The FSAP Update in 2011–12 recommended strengthening Colombian banks’ capital and loss absorbency. At that time, Colombia had not formally adhered to any of the Basel capital standards, even though the regulation followed many of the Basel I rules. The capital adequacy ratio was found to be higher than the minimum Basel I standard but there were some gaps in its scope of application and in the range of risks covered; and some of its components did not have the appropriate loss absorption capacity. Banks were required to maintain a capital adequacy ratio of 9 percent of risk-weighted assets for credit and market risks on a solo and consolidated basis. Capital for market risk did not cover foreign subsidiaries and the SFC could not require capital for other risks. The definition of capital at the time included voluntary reserves and did not deduct goodwill and investments in unregulated subsidiaries. The FSAP also found that the risk weight applied for exposures with sovereigns was low and independent of risk (zero for the local government and 20 percent for foreign governments).

16. Since the FSAP, Colombia has developed a more robust capital framework. The Financial Regulation Unit (FRU) at the Ministry of Finance (MoF), together with the SFC, introduced a new enhanced capital measure in August 2012 (implemented in August 2013), which sought to enhance the quality of capital held by Colombian banks along Basel III lines. The following changes were introduced in the new capital framework:

• committed assets, such as pension liabilities (unamortized actuarial value calculation) and net deferred assets, as well as (ii) intangible assets, such as new goodwill are deducted from common Tier 1 capital. Existing goodwill up and until 2012 was grandfathered and could remain part of capital;

• the minimum CAR was set at 9 percent while the new minimum common Tier 1 capital was set at 4.5 percent;

• current profits (conditional on the irrevocable commitment to capitalize or increase legal reserves prior to SFC approval) could be included in the Tier 2 capital;

• voluntary reserves could be recognized as part of Tier 2 capital up to a limit of 10 percent of total regulatory capital conditional on a commitment to keep these reserves for at least 5 years and approved by the SFC;

• valuation of the real estate was excluded from the measure while valuation of some investments (in debt available for sale and equity, with a haircut) was reduced to 30 percent.⁹

17. The recognition of minority interests at a consolidated level further bolstered bank capital. The consolidated solvency ratio had to be met by all credit institutions (on a quarterly basis) and is calculated on the consolidated financial statements of all financial institutions, by netting out the equity of the financial group. Moreover, in the consolidation process, only the participation of minority investors who are unrelated parties were recognized as minority interest and could thus add to capital in which case unconsolidated investments were not deducted from the capital of related parties. These new regulations maintained the minimum regulatory capital at 9 percent of risk-weighted assets and created a new measure, the “Ordinary Basic Capital” which follows the criteria for classification as core tier 1 capital with the minimum requirement of common equity of 4.5 percent of the risk weighted assets.

18. As expected, following the introduction of the improved capital measure, capital ratios declined across banks and other financial institutions. During 2013, banks, financial corporations and finance companies increased their capital by Col$9.8 billion by issuing debt and equity and reached a technical worth of Col$53 billion by end-2013. Nevertheless, aggregate capital ratios fell from 17.2 percent in July 2013 to 15.2 percent at end-2013, closer to the ratio prevailing before capital enhancements, while regulatory common Tier 1 capital to risk-weighted assets declined from 12.6 percent to 10.2 percent. At the consolidated group level capital adequacy had also fallen bringing to light the strength of the new measure.

19. As the SFC was moving to risk-based supervision (RBS), the FSAP further recommended tailoring capital requirements of individual banks to their risk profile—i.e. the Pillar 2 of Basel II framework. At the time of the FSAP, the SFC did not have the authority to require higher capital for individual banks on the basis of their individual risk profile. The move towards RBS for banks and nonbanks by the SFC, which would help identify risks and allocate supervisory resources to where risks were greatest, could be complemented by above minimum, risk-weighted, Pillar 2 capital requirements. Pillar 2 capital would help align banks’ capital with their risk profile in the event the calculation of Pillar 1 capital does not fully capture all the risks banks are exposed to. In addition, as a powerful signaling tool, the application of Pillar 2 capital would help the SFC indicate to the Board and management where a reduction in the risk profile of a bank may be required.

20. While he new capital framework enhanced loss-absorbing capacity, it would benefit from moving forward with the implementation of Basel III. The current capital stack, which is predominantly based around minimum Pillar 1 requirements, is not as large or of as high quality as Basel III (Figure 3). The Colombian capital regulation has yet to fully define the size of Pillar 2 buffers (Pillar 2A and 2B) and the type of capital instruments that make them up (CET1 or Tier 1). Moreover, Basel III capital buffers (CCB and CCyB) and the D-SIB buffer remain undefined both in terms of quantity (as a percentage of risk-weighted assets) and quality (CET1 or Tier 1).

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Colombia’s Banks’ Current Capital Stack

Citation: IMF Staff Country Reports 2015, 143; 10.5089/9781513546261.002.A007

Sources: Superintendencia Financiera de Colombia (SFC), and Fund staff.Notes: This chart should be read from the bottom up. It outlines minimum capital requirements (as percentages of risk-weighted assets), additional firm specific requirements and capital buffers; (a) based on supervisory discretion; (b) based on supervisory discretion and forward-looking stress tests. Pillar 2B buffers are above Basel III buffers in some countries (UK, Sweden) while in some other Pillar 2B and Pillar 2A buffers are integrated into a single Pillar 2 buffer that sits below the Basel III buffers (EU and Netherlands).

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21. Recent decrees, and regulatory decrees to be finalized by end-2015, will bring the capital definition closer to Basel III standard and define Pillar 2, Basel III and D-SIB buffers. The authorities issued a decree in September 2014 to recognize hybrid instruments as additional Tier 1 or Tier 2 regulatory capital in line with Basel III and are also preparing to issue a decree to further strengthen the capital adequacy requirement by end-2015. The regulator (the FRU) has recently issued for public comments draft regulation that aims at strengthening instructions on tier 2 hybrid instruments loss absorption criteria and granting the SFC the authority to require higher capital for credit institutions on the basis of their risk profile in line with Basel II Pillar 2.¹⁰ Specifically, with regards to hybrid instruments, going forward, they will have equity-like features¹¹ while subordinated debt will be phased out from the capital beginning April 2016. Basel III CCB and CCyB, and potentially also D-SIB buffers based on the BIS/FSB methodology is also planned for this year. The regulator, will also seek to move fully to the Basel III capital definition and capital requirements. Work is also underway to define the methodology to calculate operational risk and undertake internal capital adequacy assessment reviews (ICAAP) at individual and conglomerate level.

22. Colombian authorities’ plans regarding capital definition and capital buffers are in line with international practice. The plan to implement the Basel III capital definition and Basel II Pillar capital buffers map well to many emerging market countries plans to move to Basel III. Building on the capital enhanced measures implemented in 2012, the plan would give a strong signal of additional loss-absorbency of the Colombian banking system. Indeed, the considerably higher proportion of Tier 1 capital (and common equity) required in the 8 percent minimum under Basel III, together with the new CCB and CCyB buffers, represents a substantial enhancement to capital compared to Basel II. Given that Colombia currently routinely applies capital requirements above the 8 percent, it could migrate to Basel III directly rebasing existing requirements on the framework minima. Banks that operate across jurisdictions would particularly welcome such a development because it would allow them to submit their ICAAP assessments on a standardized basis. In addition, a move to Basel III capital requirement would be particularly beneficial for foreign banks based in Colombia because it would bring them in line with regulatory treatment in advanced economies that have progressed further and faster towards Basel III, thereby avoiding dual reporting requirements.

23. In terms of sequencing, the Basel III capital definition could indeed be prioritized ahead of defining Pillar 2, Basel III and D-SIB buffers. This would improve the effectiveness of buffers and avoid the trouble of narrowing the definition of eligible capital later. The implementation of a CCyB should be unproblematic for banks given that there is already a countercyclical provision requirement in place. Moreover, the move to RBS will be supported by the Integral Supervisory Framework (MIS) which currently allows the SFC to assess the soundness of capital robustness and liquidity of individual banks and conglomerates. Market consultation and sufficiently long lead times, would communicate and ensure a smooth transition path for Colombian banks, and could be accompanied by quantitative studies revealing the impact of Basel III implementation.

F. Conclusion

24. Colombia has made substantial progress in strengthening capital buffers since the FSAP. An enhanced capital measure was introduced in August 2012 that has narrowed the scope of assets which qualify as capital (eliminating committed and intangible assets) while recognizing voluntary reserves and profits and bolstering the consolidated solvency ratio. However, while the new Colombian capital regulation better defines Tier 1 capital, it still includes a broader recognition of Tier 2 (subordinated debt) as capital and is not as strict in terms of deduction of future intangibles and goodwill from base capital calculations relative to Basel III capital standards. Indeed, while above the regulatory minima, Colombian capital is below the levels of some Latin American peers after adjusting for quality. However, Colombia has important mitigating factors which include strict, forward-looking, loan-loss provisioning, robust asset quality, and low non-performing loans which suggest that at the current juncture loss-absorbency is not a concern.

25. Notwithstanding the progress, the new capital measure could be further strengthened. The growth of financial and mixed conglomerates in Colombia and their cross-border expansion may have increased concentration, and amplified intra-group and cross-border country risk, stressing the need for further increasing capital buffers. Additional loss absorbency for Colombian banks and conglomerates could be granted by adopting a capital definition closer to the Basel III standard and providing the SFC with powers to impose above minimum capital requirements, when deemed necessary, in the form of various buffers, such as Pillar 2 buffers and Basel III buffers (CCyb and CCB) and D-SIB buffers. Proposals are already in place to announce a timeline for the formal transition to Basel III standards, and regulation introducing Basel II Pillar 2 was recently made available for public comments, while other reforms to build banks resilience are also ongoing including advancement with risk based supervision (see Chapter 7). Some additional reforms to strengthen banks’ resilience could include using forward-looking multi-year macro stress tests and macroprudential tools to address solvency and systemic risks; extending supervisory powers over financial holding companies of financial conglomerates and allowing imposition of capital at consolidated conglomerate level as well as at solo level; agreeing on common scope of supervision to minimize regulatory arbitrage across Central America; and prioritizing other Basel III measures on liquidity and leverage after strengthening the capital stack.