Costa Rica: Selected Issues and Analytical Notes

Costa Rica: Selected Issues and Analytical Notes

Abstract

Costa Rica: Selected Issues and Analytical Notes

Financial Sector Vulnerabilities1

This note looks at the composition of the Costa Rican financial system and its vulnerabilities. We first study the level and evolution of a set of indicators of financial vulnerability to detect any sign of rising systemic risks. We then zoom in the soundness of the banking sector, which is dominant in the provision of credit to the economy, and report results from bank-level stress testing and contagion analysis. We finally assess the potential impact of inwards financial spillovers from stress in international banks. Results show that the financial sector is sound and could absorb a range of shocks, although low bank profitability and high FX exposure intensifies the system’s vulnerability to external shocks. Accordingly, spillovers from a severe stress scenario in international banks could have a significant impact on foreign credit availability in Costa Rica.

A. Financial System Structure and Trends

1. Although increasingly diversified, the Costa Rican financial system is centered on banking intermediation. The Costa Rica Financial system is composed by a total of 52 supervised institutions, of which 15 banks (4 state-owned, 3 private domestics, and 8 private foreign), 28 savings and loan cooperatives, and 9 other non-bank financial entities, including finance companies and mutual funds. Total gross asset and liabilities of the system amount to 90 and 86 percent of GDP respectively, with loans and deposits representing the lion share of the asset and liability portfolios. As the banking sector retains about 80 percent of the market share, the Costa Rican financial system is still highly concentrated.

Table 1.

Costa Rica: Structure of the Financial Sector

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Source: SUGEF.

2. The banking system is highly segmented and heavily dollarized. The public sector has a pervasive presence in the banking system, with public banks accounting for about half of both total assets and liabilities. About half of total deposits is denominated in foreign currency, mostly with private domestic and foreign banks, while state owned banks account for about 80 percent of deposits in national currency, not least due to the explicit unlimited state guarantee on all public bank deposit. The last is only one aspect of a broadly uneven regulatory and tax treatment across state owned and private banks which, along with a crowding out of colon credit by domestic public debt, has yielded high intermediation spreads, high market segmentation, and weakened monetary policy transmission.

3. Credit growth continues supporting economic activity with limited intensification of systemic risk, stemming from dollarization of loans and funding. Credit growth in both national and foreign currency has exceeded GDP growth over the past decade, lifting credit from 35 percent of GDP in 2005 to 60 percent in 2015. Staff project growth to accelerate to 12 percent in 2016 from 11 percent in 2015, consistent with the return of GDP to its potential. The heavy dollarization of credit in Costa Rica has amplified credit growth volatility due to the pass-through on exchange rate changes, like during the significant depreciation of the first half of 2014. Overall, staff considers that the recent trend is in line with healthy financial deepening, and projects credit growth to remain supportive of macroeconomic activity in the short and medium term (¶19). However, the widespread dollarization of both loans and deposits remains a persistent vulnerability.

Table 2.

Costa Rica: Financial Soundness Indicator Map

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Sources: BIS; FSIs; IMF IFS; and national authorities.

B. Bank-level Stress Test and Contagion Analysis

4. FSIs depict an overall well capitalized, liquid banking system with good asset quality, but low profitability and high dollarization increase vulnerabilities to shocks. Capital is well above regulatory requirements, liquidity indicators are robust, and NPLs are low, although unevenly distributed. In particular, state-owned banks have comparatively higher NPLs and lower provisions than private banks, and the tourism sectors records comparatively higher NPLs than the other main economic sectors. With return on assets and equity hovering below 1 and 6 percent respectively, profitability remains low by international peer comparison. High net foreign exposures of private banks—68 and 64 percent of capital respectively—increase the vulnerability of the whole system to rollover risk.

5. The financial sector seems well prepared to absorb a range of shocks. Staff carried out several stress tests to assess the likely impact of credit, interest, FX, liquidity, and interbank contagion shocks. Credit risk shocks included: (i) an aggregate NPL shock equivalent to 8 percent of currently performing loans; and (ii) a sectoral shock equivalent to 6 and 10 percent of currently performing loans to the construction and trade sectors respectively, which together account for more than 40 percent of total loans.2 The interest risk shocks included: (i) the flow impact from the gap between interest sensitive assets and liabilities; and (ii) the stock impact from bond repricing following a nominal interest rate increase of 3.5 percentage points (similar to the cumulative cut in the policy interest rate in 2015). The FX risk shock shows: (i) the direct exchange rate risk shock; and (ii) the indirect effect on credit quality following a 10 percent nominal depreciation, assuming that 60 percent (the share of FX loans to un-hedged borrowers) of currently performing FX loans would become non-performing following a 100 percent3 depreciation. All shocks, except those to the interest rate, are calibrated as two standard deviations above the historical mean since the 90s. The liquidity stress test models: a simple liquidity drain on all banks of a 10 and 8 percent per day withdrawal of demand deposits in domestic and foreign currency respectively; and a 5 and 3 percent per day withdrawal of time deposit in domestic and foreign currency respectively. The interbank contagion scenario uses banks exposure data to illustrate the second round effect of the modeled macro shocks. Finally, we perform a reverse test to determine what would have to be the NPL increase for: (i) the system-wide CAR to decline below the regulatory 10 percent threshold; (ii) at least 8 banks (about half of total) to fall below the regulatory CAR; and (iii) 50 percent of total bank market share to decline below the same threshold.

6. The impact of the single shocks, as well as the combination of them, is moderate and could be absorbed by existing capital buffers. The exercise shows that the system-wide post shock CAR remains above 10 percent even after an extremely negative combined shock which includes an aggregate credit shock, an increase in interest rates, and a FX depreciation4, and the system could withstand a liquidity drain for 5 days. The combined shock does not trigger any bank failure, although the CAR of nine banks falls below the regulatory threshold, which would require some balance-sheet adjustment. Given low historical profitability, profits would provide limited buffers and post-shock CAR would be only marginally higher when profits are used as a buffer for “defense”. The net effect of the interest rate shock is marginal, as the positive flow impact on interest sensitive assets partially offsets the negative repricing impact on the stock of bonds. The indirect FX shock through increased credit risk of un-hedged borrowers proves to be the most significant and could reduce the CAR of five privately owned and foreign banks below the regulatory threshold, given the higher exposure of these banks to dollarized loans. However, the market share of the affected banks is relatively small, and a set of reverse stress tests shows that the credit shock necessary to push the system-wide CAR, or half of it, below the regulatory threshold would be extreme and highly unlikely.

7. Interbank exposures are limited, and there are not second round contagion effects. With the exception of the deposits that private banks have to keep with the two public banks that manage the fund for development loans (Sistema de Banca para el Desarollo), and some funding in colones by public to private banks, the interbank market is thin as banks are mostly funded through deposits. As a consequence, both the direct vulnerability and contagion levels from both credit and funding shocks across banks are limited and there are not domino effects triggered by interbank obligations.

Figure 1.
Figure 1.

Costa Rica: Interbank Network Analysis

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A002

Sources: SUGEF; and staff estimates.Note: Calculations assume 100% of loss given default and funding shortfall, and 35 percent of lost funding being non -replaceable.
Figure 2.
Figure 2.

Costa Rica: St ress Test Results

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A002

Source: SUGEF, and IMF staff estimates.Note: The Credit Risk Shock assumes an increase in NPLs of 8 percent of performing loans; and a 25 percent provisioning rate. The Interest Rate Shock assumes a 3.5 percentage points nominal interest rate increase. The FX Shock assumes a 14 percent depreciation of the FX rate, leading to 6 percent of FX loans becoming NPL, and a 50 percent provisioning rate. The Liquidity Shock assumes a 10 and 8 percent per day withdrawal of demand deposits in domestic and foreign currency respectively; and a 5 and 3 percent per day withdrawal of time deposits in domestic and foreign currency respectively.
Table 3.

Costa Rica: Banking Sector Financial Soundness Indicators

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Source: SUGEF.

1=Low risk, 2=Increased risk, 3=High risk, 4=Very high risk.

Table 4.

Costa Rica: Stress Test Results

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Source: SUGEF; and IMF staff estimates.

Assumes an increase in NLP of 8 percent of performing loans; and a 25 percent provisioning rate. The sectoral shock to NLP assumes that 6 and 10 percent of the loan portfolio to the construction and trade sectors respectively become non-performing.

Assumes a 3.5 percentage points nominal interest rate increase.

Assumes a 14 percent depreciation of the FX rate, leading to 6 percent of FX loans becoming non-performing, and a 50 percent provisioning rate.

Assumes a 10 and 8 percent per day withdrawal of demand deposits in domestic and foreign currency respectively; and a 5 and 3 percent per day withdrawal of time deposit in domestic and foreign currency respectively.

Table 5.

Costa Rica: Summary of Stress Test Results

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Source: SUGEF; and IMF staff estimates.

Assumes an increase in NPLs of 8 percent of performing loans; and a 25 percent provisioning rate. The sectoral shock to NLP assumes that 6 and 10 percent of the loan portfolio to the construction and trade sectors respectively become non-performing.

Assumes a 14 percent depreciation of the FX rate, leading to 6 percent of FX loans becoming non-performing, and a 50 percent provisioning rate.

Assumes a 10 and 8 percent per day withdrawal of demand deposits in domestic and foreign currency respectively; and a 5 and 3 percent per day withdrawal of time deposits in domestic and foreign currency respectively.

C. Inwards Spillovers from Stress in International Banks

8. We used the IMF Bank Contagion Module to assess the impact of financial spillovers to Costa Rica from stress in international banks. Based on BIS banking statistics and bank-level data, the model estimates potential rollover risks for Costa Rica stemming from both foreign banks’ affiliates operating in Costa Rica and foreign banks’ direct cross-border lending to Costa Rica borrowers. 5 Rollover risks were triggered in the scenarios analyzed here by assuming bank losses in the value of private and public sector assets in certain countries and/or regions. If the banks do not have sufficient capital buffers to cover the losses triggered in a given scenario, they have to deleverage (reduce their foreign and domestic assets) to restore their capital-to-asset ratios,6 thus squeezing credit lines to Costa Rica and other countries. The estimated impact on losses in cross-border credit availability for Costa Rica also incorporates the transmission of shocks through Panama, given its central financial role in the region. The assumption is that cross-border lending from Panama to Costa Rica declines proportionally to the decline in cross-border lending to Panama from the banking systems where the shocks originate.7

9. Spillovers to Costa Rica from stress in international banks are larger than in regional peers. The impact on foreign credit availability in Costa Rica of the severe stress scenarios in asset values of BIS reporting banks, presented in the text figure and table below, is larger than in other countries in the region, with the exception of Panama and El Salvador. As of October 2015, the most sizable impact on claims on Costa Rican borrowers would stem from shocks in the US and Canada. Spillovers from a 10 percent shock to assets originating in the U.S. and Canada would reduce credit in Costa Rica by 6.3 percent of GDP (or 7.9 percent of total domestic and cross-border credit to the public and private sectors).8 In contrast, a similar shock would reduce credit in Guatemala and Honduras by only 2.7 and 1.4 percent of GDP respectively. More generally, the level of upstream exposures of Costa Rica to international banks9 implies an upper limit of rollover risks on external credit of about 11.6 percent of GDP (or 14.6 percent of total domestic and cross-border credit to the public and private sectors in Costa Rica).10 This upper limit would correspond to a worst case scenario without any replacement, either domestic or external, of the loss of credit by BIS reporting banks to Costa Rican borrowers.

A02ufig1

Spillovers from International Banks’ Exposures as of October 2015: Effect on Credit of 10% Loss in All Bank Assets of BIS-Reporting Banks, RES Bank Contagion Module

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 132; 10.5089/9781484362693.002.A002

1/ In Panama, the loss of credit includes credit by banks in the off-shore center with minimal links to the domestic economy.
Table 6.

Costa Rica: Spillovers from International Banks’ Exposures, as of October 2015

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Source: Research Department Macro-Financial Division Bank Contagion Module based on BIS, ECB, IFS,

Percent of on-balance sheet claims (all borrowing sectors) that default.

Reduction in foreign banks’ credit due to the impact of the shock on their balance sheet, assuming uniform deleveraging across domestic and external claims. All simulations are based on 2015Q3 data.

Greece, Ireland, and Portugal.

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

10. Spillovers from a shock originating in the U.S. assets only are significant, but financial regional integration is important in the transmission of shocks. The impact of a 10 percent loss in U.S. asset values on cross-border credit availability in Costa Rica would be 2.8 percent of GDP. This effect stems from the large share of U.S. banks in total foreign bank claims on Costa Rica, although the strengthening in international banks’ capital buffers and the cross-border deleveraging of assets after the global financial crisis is likely to have mitigated it. As of October 2015, a 10 percent loss on European assets would result in a reduction in credit availability to Costa Rica of about 2.4 percent of GDP.11 This result, however, is largely driven by the increasing importance of financial integration with other countries in the region. Indeed, almost one third of the estimated credit losses in Costa Rica (0.6 percent of GDP) resulting from a shock originating in Europe would be transmitted through cross-border lending from Panama, which is more dependent on European banks’ funding.

1

Prepared by Valentina Flamini.

2

A 75 percent haircut on collateral, and a 25 and 50 percent provisioning rate on new NPLs in domestic and foreign currency respectively are assumed.

3

The 100 percent depreciation is a benchmark used to calibrate the sensitivity. Hence, the assumed 10 percent depreciation would yield to 6 percent of FX performing loans becoming non-performing.

4

The components of the combined shock are calibrated in the same way as the individual shocks described in paragraph 5.

5

For methodological details see Cerutti, Eugenio, Stijn Claessens, and Patrick McGuire, 2012, “Systemic Risks in Global Banking: What can Available Data Tell Us and What More Dare are Needed?” BIS Working Paper 376, Bank for International Settlements. Banks exposures and spillover estimates were provided by Camelia Minoiu and Paola Ganum (RES).

6

Bank recapitalizations as well as other remedial policy actions (e.g., ring fencing, monetary policy, etc.) at the host and/or home country level are not assumed.

7

Panamanian banks have a more limited integration in the network analysis as they merely transmit the stress in international banks, rather than also being subjected to stress scenarios of losses in their asset values.

8

Spillovers from exposures to the USA increased significantly compared to the earlier (2013Q3) estimates of 0.29 percent of GDP because the latest simulations require advanced economy banking system to hold 8.5% capital ratio to be considered as “adequately capitalized” (in line with Basel III) compared to 6% in previous estimates. For any given shock to their balance sheets, this higher required minimum capital leads to a greater deleveraging by the banking system that receives the shock, and therefore to a higher funding risk exposure of the borrower country, in this case Costa Rica.

9

Based on consolidated claims on Costa Rica of BIS reporting banks—excluding domestic deposits of subsidiaries of these banks in Costa Rica.

10

Total credit to the non-bank sectors in Costa Rica is calculated by adding IFS local (both domestic and foreign owned) banks’ claims on non-bank borrowers and BIS reporting banks’ direct cross-border claims on non-bank sectors (BIS Locational Banking Statistics Table 6B).

11

Spillovers from exposures to large European banks are lower compared to the earlier (2013Q3) estimates of 4.04 percent of GDP because foreign claims decreased significantly, more than offsetting the deleveraging effect caused by the higher minimum capital requirement.

Costa Rica: Selected Issues and Analytical Notes
Author: International Monetary Fund. Western Hemisphere Dept.
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    Costa Rica: Interbank Network Analysis

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    Costa Rica: St ress Test Results

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    Spillovers from International Banks’ Exposures as of October 2015: Effect on Credit of 10% Loss in All Bank Assets of BIS-Reporting Banks, RES Bank Contagion Module

    (Percent of GDP)