EXECUTIVE SUMMARY Despite the global and domestic shocks of 2008–2009, the banking sector remains sound. Salvadoran banks were not directly exposed to the global financial crisis. However, the parent banks of several major Salvadoran banks were hit hard and directed subsidiaries to conserve risk capital. The higher risk aversion and recession in the United States, combined with uncertainty about the 2009 elections, led to a sharp economic downturn, and a decline in both credit demand and supply. Banks nonperforming loans increased and profitability declined. Even so, capitalization remained high. Stress tests indicate most banks are resilient to a severe macroeconomic, sectoral and liquidity shocks. Implementation of the 2004 FSAP update recommendations has been limited (Appendix 1). The supervisory frameworks for banks, insurance, and cross-border cooperation were improved and partial progress was made in strengthening the financial infrastructure, insolvency process, microfinance regulatory framework, and restructuring of state-owned banks. However, important legal provisions to strengthen supervision and safety nets, as well as a corporate insolvency law have not yet been approved. Furthermore, while loan classification and provisioning rules were upgraded, important risk and corporate governance regulations for banks have yet to be issued. The proposed Financial System Supervision and Regulation Law (FSSRL) could improve consolidated supervision and reduce the scope for regulatory arbitrage, but will require careful implementation. The FSSRL would merge the supervisors of banks and insurance, pensions, and securities to create one unified supervisor, with stronger powers. To balance this, the FSSRL would shift regulatory power to the central bank. A sole supervisor and a sole regulator are expected to facilitate consolidated supervision, as well as reduce regulatory gaps and the scope for regulatory arbitrage. However, the merger of supervisors and the institutional split between regulatory and supervisory powers will require a great deal of planning and ongoing cooperation between the supervisor and the regulator to ensure effective supervision. Remaining gaps in banking supervision and the safety net should be addressed. Supervisory practices should include more qualitative judgment and forward-looking risk assessments, and the regulatory perimeter should be reviewed. Key banking regulation (e.g., on corporate governance as well as credit, market, interest and liquidity risks) must be issued and the proposed FSSRL should more comprehensively address shortcomings in legal protection and the remedial action framework. The banking law should also be amended to strengthen the least-cost bank resolution framework as well as the deposit insurance fund. Regulations implementing the central bank’s (limited) powers for emergency liquidity assistance (ELA), as well as the bank resolution process are also needed. Passage of the proposed FSSRL would provide the BCR with more ELA powers, although the authorities should also design and test comprehensive policies for systemic liquidity and banking crisis resolution.