EXECUTIVE SUMMARY Barbados has a relatively well-developed financial system, including a large offshore sector.1 The onshore system is dominated by large, regionally active banks. Banking services to the population are also provided by the credit union sector. The system also includes a mature but concentrated insurance sector with extensive international affiliates, and other non-bank financial institutions provide credit and other instruments for savers. The offshore sector is financially segregated from the domestic economy and is dominated by international banks mainly conducting treasury and wealth management operations. The financial system has increasingly been funding the government and residential mortgages, reflecting fiscal pressures and the limits imposed by capital controls on investments abroad. Systemic risks With a deteriorating fiscal situation and weak growth prospects, Barbados faces considerable macroeconomic vulnerabilities. Sovereign risk is a concern, given a large public debt, high fiscal deficits, and slow growth, and policy options are limited by a fixed exchange rate regime. While long-standing capital controls provide some protection against disorderly scenarios, they are likely to become less effective over time unless fiscal vulnerabilities are addressed. The authorities are committed to the announced fiscal consolidation plan, but full efforts should be deployed to secure timely and successful implementation. While the financial system does not appear to be a source of immediate risk, its position appears to be deteriorating, with implications for systemic stability. Credit quality of domestic banks and credit unions has weakened considerably since the global crisis and, with growth expected to remain slow in the years ahead, is projected to deteriorate further. Weaker bank balance sheets could dampen credit supply, amplify the economic decline, and exacerbate broader macroeconomic vulnerabilities. Moreover, stress-tests illustrate that the financial system would be vulnerable in the face of severe shocks. Relatively large capital and liquidity buffers mean that onshore banks can generally withstand moderate shocks without breaching regulatory requirements. However, vulnerabilities emerge in the case of severe shocks, particularly in a branch of a strong foreign bank and in the credit union sector. The latter is also vulnerable to medium-sized liquidity shocks. The offshore financial sector does not appear to be a major source of risk given that it is prevented from carrying out financial transactions with domestic residents, but common ownership links and reputational risks should be monitored closely.