Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
IMF Survey: Tailoring Regulation for Central America
November 26, 2007
- Growing regional financial integration calls for harmonized supervision
- Proposed prudential regulations tailored to Central American realities, needs
- Next step is for supervisory authorities to implement agreed set of guidelines
Over the past two years, governments in Central America have been working with the IMF to strengthen the cross-border consolidated supervision of financial institutions.
Panama Canal: planned canal expansion has helped stimulate cross-border mergers of Central American financial institutions (photo: Yang Jianhua/SIPA)
IMF TECHNICAL ASSISTANCE
With the help of IMF-supported technical expertise—partially funded by Spain—the governments of Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and Panama have identified the main risks stemming from growing financial conglomeration in the region. They assessed the adequacy of the existing prudential regulations, and have now designed a strategy for introducing appropriate regional prudential regulations and supervisory arrangements.
The next step is for supervisory authorities across the region to implement an agreed set of guidelines.
Growing integration
Facilitated by an improved economic outlook, free trade agreements with the United States, and the announcement of the Panama Canal expansion, cross-border mergers of financial institutions and acquisition of local and regional groups by international banks have become a common feature in Central America.
Currently, there are 30 financial conglomerates in the region—some of which have systemic importance in their respective countries of origin— with assets equivalent to almost 50 percent of regional banking assets.
The creation of financial conglomerates brings with it several benefits. It offers financial institutions more opportunities to manage and diversify their risks and realize economies of scale, which enhances their efficiency and allows them to lower their costs. But deeper financial integration also brings with it more complexity and, in turn, transforms the nature of risks. Intensified cross-border links, for example, can heighten the risk of contagion, and a growing number of ever-larger financial institutions, in case of failure, can magnify systemic risk.
Supervisory authorities, whose responsibility it is to prevent and manage such risks, can respond by taking a consolidated approach. This approach seeks to evaluate the strength of an entire group, taking into account all the risks that may affect a financial institution, regardless of whether these risks are carried in the books of the institution itself or related entities.
Central American plan
For the Central American authorities, the main challenge was to identify the risks stemming from financial conglomerates operating throughout the region, assess the adequacy of the existing prudential regulations, and design an appropriate set of regional prudential regulations and supervisory arrangements. Despite technical complexities and heterogeneous practices in the countries involved, these challenges have been met.
Supervisory authorities across the region are now set to implement an action plan, consisting of about 60 recommendations, to improve cross-border supervision. Most of these recommendations are aimed at ensuring that supervisors have adequate information on the corporate structure of the groups, the qualifications of shareholders, and their risk management practices.
In addition, supervisors are encouraged to deal with financial groups as a whole, as opposed to focusing on individual institutions, so as to have better control of related lending and other transactions. They are also persuaded to collaborate among themselves to exchange information and take common action to ensure adequate supervision of financial conglomerates.
Ingredients for success
Success was achieved through a combination of authorities' commitment to the project; continuous dialogue and coordination among the authorities, the World Bank (in charge of a related project), and the IMF; and the invaluable input of a team of 15 external experts, including bank supervisors and lawyers.
As part of the diagnostic phase of the project, these experts visited each of the countries to collect information on the financial conglomerates, country legislation, and supervisory practices in the region. Then the experts discussed the proposed recommendations. While adhering to international best practices, the recommendations contained in the plan of action are tailored to Central American realities and needs.
The project was fully supported not only by the supervisory authorities—organized within the Central American Council of Supervisors—but also by ministers of finance and central bank presidents of the region. The authorities' stated desire to improve supervision at the regional level, along with their input, were crucial for identifying the regulatory challenges posed by financial integration and for developing criteria and guidelines to be implemented at the national and regional levels.
Among the main challenges that supervisors face are the need to eliminate the overstatement of capital, promote regulatory and supervisory harmonization across the region, foster coordination among regional supervisors to deal with regional financial conglomerates, and deal with contagion risk that could spread among the commonly-controlled entities.
Next phase
While many challenges remain, the authorities are now prepared to move on to the implementation phase. In an encouraging first step, they have agreed to take specific supervisory actions in a collective manner to deal with regional financial conglomerates. In fact, Central American supervisors, as a group, met with representatives of a bank to enforce transparency in offshore operations.
Furthermore, supervisors in charge of more sophisticated and developed financial systems are actively collaborating with those with less experience to share best practices to control related-party lending, improve accounting standards, and establish common principles for the exchange of information. They have also requested additional technical assistance to implement the recommendations, and have recently signed a regional memorandum of understanding that will be the cornerstone of harmonized and coordinated consolidated supervision in the future.
On the IMF's side, consideration is being given to stationing a resident advisor to support the authorities' reform plans in this area. This approach forms part of a broader strategy to assist in Central America's economic integration by providing technical assistance in the IMF's core areas of macroeconomic expertise, in partnership with donor financing.