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IMF Country Report No. 23/335

ECUADOR

FINANCIAL SYSTEM STABILITY ASSESSMENT

September 2023

This paper on Ecuador was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in August 2023.

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PRESS RELEASE

PR23/317

IMF Executive Board Concludes Financial System Stability Assessment with Ecuador

FOR IMMEDIATE RELEASE

Washington, DC - September 21, 2023: The Executive Board of the International Monetary Fund (IMF) concluded the Financial Sector Assessment Program (FSAP) [¹] with Ecuador on August 29, 2023 without convening formal discussions. [²] The Financial Sector Stability Assessment [SD1] (FSSA) report was completed on July 31,2023. The report is based on the work of joint IMF/World Bank FSAP missions to Ecuador during November-December 2022 and April-May 2023.

Ecuador’s financial system is dominated by banks and credit cooperatives. While dollarization provides an important anchor for the Ecuadorean economy, systemic liquidity risks are high due to the limited capacity of the central bank to provide liquidity. The financial sector is overall resilient to adverse macrofinancial shocks but some institutions have meaningful solvency and liquidity vulnerabilities. To preserve confidence it is key to enhance capitalization, promptly recognize loan losses, and address unviable institutions.

The FSSA concluded that institutional framework for financial sector oversight is complex, uncoordinated, and prone to political intervention. Reforms are needed to enhance supervisory independence, prioritize safety and soundness, separate prudential supervision from other functions, and substantially strengthen the supervisory approach. The macroprudential framework needs further progress by developing stronger financial sector-wide analytical capacity, improving information sharing and coordination, and clarifying the roles between multiple agencies.

Similarly, the legal framework for bank resolution should be enhanced by establishing clearer responsibilities for the involved agencies, expanding the resolution toolkit, and ensuring that resolution decisions are not reversed. The deposit insurer’s access to information and back-up funding should be improved, and the existing arrangements should be reviewed to provide more flexible emergency liquidity assistance. Governance and internal controls of public banks also need urgent strengthening and interest rate caps should migrate to a usury rate.

Title Page

ECUADOR

FINANCIAL SYSTEM STABILITY ASSESSMENT

August 4, 2023

KEY ISSUES

• Context: Ecuador’s financial system is dominated by banks and credit cooperatives. Its exposure to macrofinancial risks is shaped by its fully dollarized economy and its position as an oil exporter. The institutional framework for financial sector oversight is complex, uncoordinated, and prone to political intervention, which results in sub-optimal policies.

• Findings: While dollarization provides an important anchor for the Ecuadorean economy, systemic liquidity risks are high due to the limited capacity of the central bank to provide liquidity. A sharp tightening of monetary policy in the United States, an abrupt slowdown in China, falling oil prices, and political instability could reduce economic activity and impact both asset quality and liquidity of the system. Banks and credit cooperatives have yet to fully absorb pandemic-related credit losses and liquidity conditions have tightened.

• Policy advice: Reforms are needed to enhance supervisory independence, prioritize safety and soundness, separate prudential supervision from other functions, and substantially strengthen the supervisory approach. The macroprudential framework needs further progress by developing stronger financial sector-wide analytical capacity, improving information sharing and coordination, and clarifying the roles between the multiple agencies involved. Similarly, the legal framework for bank resolution should be enhanced by establishing clearer responsibilities for the agencies involved, expanding the resolution toolkit, and ensuring that resolution measures are not reversed. The deposit insurer’s access to information and back-up funding should be improved and, although dollarization prevents the central bank from providing a full emergency liquidity assistance facility, the existing arrangements should be reviewed to provide more flexible liquidity insurance. Governance and internal controls of public banks need urgent strengthening and interest rates caps should migrate to a usury rate.

Approved By

May Khamis and James Morsink

Prepared By

Monetary and Capital Markets Department

• The FSAP team was led by Caio Ferreira, IMF, and Douglas Pearce, World Bank, and included Mark Adams (IMF deputy mission chief), Federico Diaz Kalan (World Bank deputy mission chief), Sergei Dodzin, Niels-Jakob Hansen, Carolina Lopes-Quiles, Santiago Texidor Mora, Francisco Vazquez, Caroline Wu (all IMF staff), Luis Martin Auqui, Jose Garcia Barroso, David Hoelscher (IMF external experts), Leyla Castillo, Maria Teresa Chimienti, Pasquale Di Benedetta, Eva Gutierrez, Oliver Masetti, Faruk Miguel, Anderson Caputo Silva, Diego Sourrouille (all World Bank staff) and Antonio Velandia-Rubiano (World Bank external expert). Carol Franco and Srujana Sammeta (IMF) provided administrative support.

• The mission met with senior officials at the Central Bank, Ministry of Economy and Finance, regulatory and supervisory agencies, as well as staff in private and development financial institutions, and several other stakeholders. The team would like to thank the authorities for their hospitality and the excellent cooperation and fruitful discussions.

• FSAPs assess the stability of the financial system as a whole and not that of individual institutions. It is intended to help countries identify key sources of systemic risk in the financial sector and recommend policies to enhance its resilience to shocks and contagion. Certain categories of risk affecting financial institutions, such as operational, legal, and risk related to fraud, are not covered in FSAPs.

• This report was prepared by Caio Ferreira and Mark Adams with contributions from the FSAP team.

Contents

• Glossary

• EXECUTIVE SUMMARY

• BACKGROUND

• A. Macrofinancial Context

• B. Financial Sector Structure and Recent Developments

• C. Financial Repression

• D. Liquidity Risk

• SYSTEMIC RISK ASSESSMENT

• A. Vulnerabilities and Risks

• B. Bank Solvency Stress Tests

• C. Cooperatives Stress Tests

• D. Liquidity Stress Testing

• E. Nonfinancial Corporates

• F. Climate-Related Risks

• FINANCIAL SECTOR OVERSIGHT

• A. Cross-cutting Issues

• B. Macroprudential Framework

• C. Banking Regulation and Supervision

• D. Cooperative Regulation and Supervision

• E. Financial Integrity (AML/CFT)

• FINANCIAL CRISIS MANAGEMENT AND RESOLUTION

• FINANCIAL SECTOR DEVELOPMENT

• A. Role of the State

• B. Capital Markets Development

• AUTHORITIES’ VIEWS

• FIGURES

• 1. Recent Economic Developments

• 2. Financial Sector Structure

• 3. Financial Soundness Indicators

• 4. Financial Sector Balance Sheet Structure

• 5. Adverse Scenario Benchmark

• 6. Baseline and Stressed Scenarios

• 7. Selected Results of Bank Solvency Analysis

• 8. Cooperative Credit Solvency Analysis

• 9. Structure of Bank Balance Sheets

• 10. Selected Results of Liquidity Stress Tests

• 11. Selected Results of the Nonfinancial Corporate Stress Test

• 12. Financial Sector Exposure to Climate Physical and Transition Risk

• 13. State-Owned Financial Institutions in Latin America

• TABLES

• 1. 2023 FSAP Key Recommendations

• 2. Institutional Framework for Financial Sector Oversight

• 3. Selected Economic and Financial Indicators, 2020-28

• 4. Structure of Financial System, December 2022

• 5. Financial Soundness Indicators (2017-22)

• 6. Implementation Status of Key Recommendations from the 2004 FSAP

• 7. Risk Assessment Matrix

• APPENDIX

• I. Stress Testing Matrix (STeM)

Glossary

Executive Summary

The Ecuadorian financial sector has remained stable, and credit continued to grow through the pandemic, but the tightening of global financial conditions presents new challenges. Since mid-2022 credit growth has slowed, and liquidity conditions have tightened considerably. In the first quarter of 2023 real GDP growth moderated to 0.7 percent; coupled with other indicators, this points to a sharp and broad-based slowdown and an increase in downside risks. Higher international interest rates and competition for deposits have increased funding costs which, combined with caps on lending rates, has led to margin compression.

The institutional framework for financial sector oversight is complex and prone to political intervention, which results in sub-optimal policies. The large number of institutions playing a role in financial sector issues puts a premium on effective coordination, which is lacking. Requirements for financial institutions to maintain liquid assets in Ecuador and minimum investments in government securities and public banks at non-market prices facilitate domestic financing to the government at the expense of risk diversification at the systemic level. Interest rate caps hinder financial inclusion and shift credit away from productive purposes.

Stress tests suggest that the financial sector is overall resilient to adverse macro-financial shocks but has institutions with meaningful vulnerabilities. The FSAP considered a scenario of a sharper-than-expected global slowdown and tightening of US interest rates combined with falling oil prices, reflecting risks from Ecuador’s fully dollarized economy and its position as an oil exporter. Under stress, 9 out of the 27 banks, mostly small, would present capital ratios below the 9 percent regulatory minimum, although the resulting capital shortfall is small (0.2 percent of GDP in 2025). Losses could be higher if the interest caps on loans do not adjust to reflect funding costs. The stress tests also suggest that the large cooperative sector, which comprises 20 percent of the financial system assets, also has a substantial number of institutions facing asset quality and profitability challenges. It is key to enhance capitalization, promptly recognize loan losses, and address unviable institutions to preserve confidence.

Managing liquidity risk is a critical challenge for Ecuador’s financial system. While dollarization provides an important anchor for the Ecuadorian economy, liquidity risks are high due to the limited capacity of the central bank to provide liquidity. Interbank funding markets are thin, and the central bank doesn’t offer liquidity facilities. The private liquidity fund offers some liquidity support, but it is limited in size and rarely used. Financial institutions must therefore self-insure against liquidity risk but there are few domestic assets that can be reliably monetized. Liquidity analysis shows that, currently, several important financial institutions do not hold enough liquid assets to comply with international liquidity standards. To reduce financial stability risks, it is key to establish sound liquidity requirements, remove impediments to banks’ investments in global liquid assets, reform the liquidity fund, and further develop the interbank and securities markets. These reforms will need to be sequenced carefully in tandem with addressing ongoing fiscal and macroeconomic conditions.

Against this background, it is urgent to improve financial sector supervision. Authorities are committed to strengthen the prudential framework, but institutional shortcomings, insufficiently trained staff, and lack of coordination impair sound supervision. Closing the large gap between current practices and international standards requires a comprehensive plan including actions to:

• Substantially enhance the technical and analytical capacity of financial sector authorities. Lack of a career plan and a sound training program and high turnover of staff and management has significantly hindered the acquisition and retention of talent.

• Set safety and soundness as the primary goal of supervisory agencies. In practice, agencies often prioritize their broader responsibilities over prudential goals. There is also a need to remove constraints to their independence and enhance their powers, including to facilitate preventative supervisory actions before regulatory breaches.

• Develop processes, organizational arrangements, and tools to monitor, assess and mitigate systemic risks. The establishment of a Financial Stability Committee could facilitate these tasks. It is important to clarify macroprudential objectives and functions of the different agencies. Basel III buffers and borrower-based measures should be implemented.

• Strengthen the supervisory approach. Examinations and monitoring of individual financial institutions are mostly descriptive. Supervisors need to further focus on risks and be equipped to exercise judgement. Enhanced supervisory plans and guidance, a regular stress testing program, and more attention to climate related risks are also necessary.

• Enactment of the New Organic Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) Law in line with international standards. Supervisors and the Financial Intelligence Unit (FIU) also need to be adequately resourced.

Reinforcing the financial sector safety net is also a priority, given the presence of several weak institutions. The supervisory agencies and the deposit insurer should urgently improve their coordination, information-sharing, and joint planning to deal with weak institutions. The legal framework for bank resolution should be updated to expand the resolution toolkit and remove limitations of the existing tools, and deposit insurance payout times should be shortened. The lender of last resort function could be strengthened through reform, although it will remain constrained by dollarization.

Enhancing policies to develop the financial system is also essential.

• To enhance efficiency and impact, public credit support programs should be redesigned, and expectations of debt forgiveness removed. Supervision and enforcement for state-owned financial institutions (SOFIs) needs to be intensified and weaknesses in their balance sheets and operations addressed. Interest rate caps should migrate to a usury rate.

• To develop the capital market, the Ministry of Economy and Finance (MEF) should transition to market mechanisms for placement of government securities and, in subsequent phases, seek to develop the repo and secondary markets and broaden the investor base.

Table 1.

Ecuador: 2023 FSAP Key Recommendations

Notes:

¹All: Ecuadorian financial authorities. Note that the names of responsible agencies are listed in alphabetic order.

²I: immediate (less than one year), NT: short term (1-2 years), MT: medium term (3-5 years).

Table 1.

Ecuador: 2023 FSAP Key Recommendations

Recommendations	Authorities1	Time2
Systemic Risk and Financial Sector Resilience
Enhance capitalization, promptly recognize loan losses, and address unviable financial institutions.	SBs, SEPS	I
Improve credit information: (i) transmit data on BIESS to credit bureaus; (ii) grant access to the credit registry data to BCE and SEPS.	JPRF, SB, SEPS, BCE	I
Gradually remove requirements for banks to hold liquid assets domestically.	MEF, JPRF, JPRM	NT
Financial Sector Oversight
Develop processes, organizational arrangements, and tools to monitor, assess and mitigate systemic risks.	MEF, JPRF, JPRM SB, SEPS, BCE	I
Clarify responsibilities, functions, and powers of different agencies, and consider the establishment of a Financial Stability Committee.	MEF, JPRF, JPRM, SB, SEPS, BCE	NT
Implement Basel III buffers (conservation, countercyclical, D-SIB) and borrower-based measures.	MEF, JPRF, SB, SEPS	NT
Enhance technical and analytical capacity of supervisory agencies by establishing a career plan, sound training program, and adequate resources.	SB, SEPS, MEF, UAFE, CONALAFT	I
Strengthen the institutional framework for supervision by making safety and soundness the primary goal of the superintendencies and enhancing their independence.	MEF, SB, SEPS	MT
Strengthen the supervisory approach, consolidated supervision, and corporate governance requirements and ensure convergence of supervisory and regulatory standards for large cooperatives and both public and private banks.	SB, SEPS, JPRF	NT
Align capital and liquidity requirements with Basel III.	SB, SEPS, JPRF	NT
Improve the legal basis for corrective actions and sanctioning powers.	SB, SEPS, MEF	NT
Ensure timely enactment of the New Organic AML/CFT Law.	CONALAFT	I
Financial Safety Net and Crisis Preparedness
Separate supervisory and resolution functions and overhaul legal framework for resolution.	MEF, SB, SEPS, COSEDE	MT
Address operational barriers to deposit insurance payout and strengthen COSEDE governance and resources.	MEF, COSEDE	MT
Reform the Liquidity Fund’s lender-of-last resort function, including governance and information-sharing, ease of collateral posting, size of the fund, relations with the BCE, and terms of lending.	MEF, COSEDE	NT
Market Development
Address vulnerabilities in public banks, implement AQR provisioning recommendations, and intensify prudential supervision of SOFIs.	MEF, SB, IESS	I
Redesign credit support programs, remove expectations of debt forgiveness, and migrate interest rate caps to a usury rate.	MEF, JPRM, JPRF	NT
Streamline the supply of government securities and transition to regular auctions, promote the development of the repo and secondary markets and broadening of the investor base.	MEF, JPRF, SB, BCE, SCVS	NT

Notes:

¹All: Ecuadorian financial authorities. Note that the names of responsible agencies are listed in alphabetic order.

²I: immediate (less than one year), NT: short term (1-2 years), MT: medium term (3-5 years).

View Table

Table 1.

Ecuador: 2023 FSAP Key Recommendations

Recommendations	Authorities1	Time2
Systemic Risk and Financial Sector Resilience
Enhance capitalization, promptly recognize loan losses, and address unviable financial institutions.	SBs, SEPS	I
Improve credit information: (i) transmit data on BIESS to credit bureaus; (ii) grant access to the credit registry data to BCE and SEPS.	JPRF, SB, SEPS, BCE	I
Gradually remove requirements for banks to hold liquid assets domestically.	MEF, JPRF, JPRM	NT
Financial Sector Oversight
Develop processes, organizational arrangements, and tools to monitor, assess and mitigate systemic risks.	MEF, JPRF, JPRM SB, SEPS, BCE	I
Clarify responsibilities, functions, and powers of different agencies, and consider the establishment of a Financial Stability Committee.	MEF, JPRF, JPRM, SB, SEPS, BCE	NT
Implement Basel III buffers (conservation, countercyclical, D-SIB) and borrower-based measures.	MEF, JPRF, SB, SEPS	NT
Enhance technical and analytical capacity of supervisory agencies by establishing a career plan, sound training program, and adequate resources.	SB, SEPS, MEF, UAFE, CONALAFT	I
Strengthen the institutional framework for supervision by making safety and soundness the primary goal of the superintendencies and enhancing their independence.	MEF, SB, SEPS	MT
Strengthen the supervisory approach, consolidated supervision, and corporate governance requirements and ensure convergence of supervisory and regulatory standards for large cooperatives and both public and private banks.	SB, SEPS, JPRF	NT
Align capital and liquidity requirements with Basel III.	SB, SEPS, JPRF	NT
Improve the legal basis for corrective actions and sanctioning powers.	SB, SEPS, MEF	NT
Ensure timely enactment of the New Organic AML/CFT Law.	CONALAFT	I
Financial Safety Net and Crisis Preparedness
Separate supervisory and resolution functions and overhaul legal framework for resolution.	MEF, SB, SEPS, COSEDE	MT
Address operational barriers to deposit insurance payout and strengthen COSEDE governance and resources.	MEF, COSEDE	MT
Reform the Liquidity Fund’s lender-of-last resort function, including governance and information-sharing, ease of collateral posting, size of the fund, relations with the BCE, and terms of lending.	MEF, COSEDE	NT
Market Development
Address vulnerabilities in public banks, implement AQR provisioning recommendations, and intensify prudential supervision of SOFIs.	MEF, SB, IESS	I
Redesign credit support programs, remove expectations of debt forgiveness, and migrate interest rate caps to a usury rate.	MEF, JPRM, JPRF	NT
Streamline the supply of government securities and transition to regular auctions, promote the development of the repo and secondary markets and broadening of the investor base.	MEF, JPRF, SB, BCE, SCVS	NT

Notes:

¹All: Ecuadorian financial authorities. Note that the names of responsible agencies are listed in alphabetic order.

²I: immediate (less than one year), NT: short term (1-2 years), MT: medium term (3-5 years).