## _cr1444 — Executive Summary

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### Banking sector soundness and stress resilience
- Salvadoran banks were not directly exposed to the global financial crisis; parent banks of several major Salvadoran banks were hit and directed subsidiaries to conserve risk capital.
- Crisis effects and outcomes:
  - Sharp economic downturn tied to higher U.S. risk aversion, the U.S. recession, and 2009 election uncertainty.
  - Decline in both credit demand and supply; increased banks’ nonperforming loans; declined profitability.
  - Capitalization remained high despite the downturn.
  - Stress tests indicate most banks are resilient to severe macroeconomic, sectoral and liquidity shocks.
- Key metrics:
  - Bank credit outstanding: US$8 billion.
  - Credit-to-GDP: 40 percent of GDP.
  - System CAR: 16.5 percent.
  - Tier 1 capital: 13.7 percent of risk-weighted assets.
  - Tier 1 capital: 8.9 percent of on- and off-balance sheet assets.
  - NPLs: around 2 percent (2005–2007); rose to 3 ¾ in 2009.
  - Wider loans at risk measure: 10 percent of total loans (2009).
  - Return on average assets: 0.3 percent in 2009 (0.4 percent early 2010; 1.2 percent in 2007).
  - Liquid assets increased to over 40 percent of deposits during crisis period.

### Stress tests — scenarios and results
- Macroeconomic scenarios:
  - Baseline: IMF forecast of 1 percent real GDP growth in 2010 and 2.5 percent in 2010; assumes U.S. growth of 3.1 percent in 2010 and 2.4 percent in 2011.
  - Downside: slightly negative growth in the United States and Salvadoran real GDP growth of 0.1 percent in 2010 and 0.4 percent in 2011.
  - Extreme: Salvadoran real GDP declines by 5.4 percent in 2010 and 2.5 percent in 2011 (three standard deviations below the norm).
- Extreme scenario impacts:
  - Close to 50 percent of total loans could require provisioning by end-2011; almost 50 percent of loans become risky by end-2011.
  - Manufacturing, extractive and construction sector loans: between 60-80 percent would need provisioning.
  - In all scenarios system CAR remains above the regulatory minimum of 12 percent of risk-weighted assets.
  - Extreme scenario: five banks fall below the 12 percent minimum CAR; two of these five would be under 10 percent CAR; only one nonsystemic case is critically undercapitalized.
- Concentration and collateral tests:
  - Downgrading the 100 largest debtors by two grades causes CARs of six banks to fall substantially; all banks would retain CAR above 9 percent.
  - Outright default of the largest ten debtors could leave up to five banks undercapitalized; four banks falling below 10 percent CAR, with no bank critically undercapitalized.
  - Maximum value of collateral for provisioning purposes is 70 percent.
  - Reducing loan guarantees by 25 percent drops system CAR to 12.8 percent, with four banks falling below the regulatory minimum by between ½ and 1½ percentage points.
- Interest rate and liquidity shocks:
  - Repricing risk: a 3 percentage point increase causes system CAR to decline to 13.1 percent; three banks drop below 12 percent minimum; one non-systemic bank falls slightly below 10 percent CAR.
  - Liquidity withdrawal scenarios: 15 percent of total deposits within 30 days and 30 percent within 90 days.
  - Coverage by liquid assets is sufficient for most banks even with private domestic securities illiquid and a 25 percent haircut on eligible government securities.
  - In the largest shock, a few banks would need to access the third tranche of liquid reserves held at the BCR in the form of securities.

### Implementation of the 2004 FSAP update — progress and shortfalls
- Progress:
  - Supervisory frameworks for banks, insurance, and cross-border cooperation improved.
  - Loan classification and provisioning rules upgraded (new regulation effective 2007).
  - SSF reorganized in 2008; risk unit created; use of CAMELS models and Memoranda of Understanding with home supervisors implemented.
- Shortfalls / Not implemented items:
  - Important legal provisions to strengthen supervision and safety nets, and a corporate insolvency law, have not been approved.
  - Legal protection for Superintendent and SSF staff: Not Implemented.
  - Powers to suspend distribution of dividends and other preventive remedial powers: Not Implemented.
  - Reduction of consolidation threshold from 50 to 20 percent: Not Implemented.
  - Increase IGD reserves to 5 percent of insured deposits: Not Implemented (IGD funds: 4.2 percent of insured deposits; 1.1 percent of total deposits).
  - Excess (“free”) reserves build-up: Not Implemented (Dec. 2004: US$303 million; Feb 2010: US$251 million).

### Proposed Financial System Supervision and Regulation Law (FSSRL)
- Key features of FSSRL:
  - Merge supervisors of banks, insurance, pensions, and securities into one unified supervisor with stronger powers.
  - Shift regulatory power to the central bank (BCR); create a sole supervisor and a sole regulator expected to facilitate consolidated supervision and reduce regulatory gaps and regulatory arbitrage.
  - Establish a dedicated regulatory committee composed of BCR officials, BCR Board members and the Superintendent; establish a supervisory committee composed only of the Superintendent and the Intendents.
  - Include an appeal committee to ensure rights of the governed with respect to sanctions.
- Implementation caveats and remaining shortcomings:
  - Draft law only partially addresses legal protection for supervisors; protection remains insufficient.
  - SSF’s ability to act preemptively remains restricted; lacks power to restrict dividends, activities or purchases prior to regularization.
  - Separation of regulation (BCR) and supervision (SSF) requires strong cooperation; this separation may reduce compliance with international standards and BCP 1.3 Legal Framework.
  - BCR must acquire technical skills in prudential supervision; formal mechanisms needed to resolve interpretation differences between SSF and BCR.
  - Merger requires careful planning to integrate cultures, systems and processes; BCR and supervisory agencies should develop a detailed action plan.

### Remaining gaps in banking supervision, remedial framework, and safety nets
- Regulatory coverage gaps:
  - Missing regulation areas: corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate risk in the banking book, information technology, investment valuation and derivatives.
- Remedial action framework lacks preventive powers:
  - No explicit powers to limit distribution of dividends; constrain operations or acquisitions; enforce asset sales.
  - Lack of legal protection for supervisory staff exposes supervisors to litigation and reduces use of corrective powers.
- Asset classification and provisioning concerns:
  - Provisioning rules tightened in 2007 and broadly in line with international practices; SSF lacks authority to require banks to raise provisions above regulatory minima.
  - Corporate loan downgrade rules do not extend automatically to consumer and mortgage loans; recommendations to extend.
  - When a debtor with loans at multiple banks defaults on one loan, other banks often do not downgrade related loans—recommend a unified approach.
- Capital adequacy technicalities:
  - Intangible assets (mostly goodwill) are not subtracted from capital as required under Basel I; could become more significant with consolidation and investments.
  - Adjusting provision and risk-weight assumptions: e.g., adjusting government bonds’ risk weight from zero to 100 percent reduces system CAR to 14.7 percent; adjusting provisions for restructured agricultural loans reduces system CAR to 15.4 percent.
- Recommendations on supervisory practice and organization:
  - Include more qualitative judgment and forward-looking risk assessments.
  - Appoint dedicated relationship manager responsible for overall supervision of each bank.
  - Intensify supervision of credit concentration and debtor repayment capacity.
  - Require offsite supervisors assigned to specific banks/conglomerates and upgrade quantitative and qualitative capacity.
  - Consider creating a separate consumer protection department.

### Oversight of nonbank financial services and borrower information
- Market structure and participation:
  - A range of bank and non-bank institutions provide credit and deposit services; many small institutions fall below SSF thresholds.
  - Cooperatives: supervised if sum of member deposits and contributions exceeds US$84 million (or US$68.57 million in other sections); majority not subject to prudential regulation.
  - Pension funds assets under management: US$5.3 billion at end-March 2010; pension funds account for 24 percent of financial sector assets; 79.4 percent of pension fund investments in public sector securities.
- Recommendations:
  - Institutions that license and provide voluntary oversight should report to the SSF when thresholds exceeded.
  - Create an auxiliary supervision system through federations to strengthen oversight of unregulated institutions.
  - Consumer protection regulations requiring lenders to provide borrowers with information on the total cost of a loan to address over-indebtedness and promote transparency.
  - Reform the Banking Law to allow free circulation of credit information among all members of credit bureaus and reciprocity for nonbanks.

### Payments system, RTGS, and financial infrastructure
- Achievements:
  - RTGS launched in February 2010; substantially improved safety of large-value payments and reduced systemic risks.
- Remaining issues and reforms needed:
  - Ensure BCR has control over operational reserves and adequate oversight of the system.
  - Amend Central Bank Law to implement the Treaty on the Payment and Securities Settlement Systems for Central America and the Dominican Republic (amendment drafted).
  - BCR should define powers to collect information from system participants and adequately oversee payment systems, particularly retail.
  - Introduce liquidity scheme for RTGS, create alternate site for RTGS, and implement linkage between RTGS system and CEDEVAL.
  - Banking Law should be amended to allow free circulation of credit information among all credit bureaus and facilitate regional sharing.

### Systemic liquidity management and BCR constraints
- Legal and operational constraints:
  - In a dollarized economy BCR cannot issue its own currency; liquidity provision depends on excess international reserves or external borrowed funds.
  - Central Bank Law prohibits lending to banks (Art. 51); repos allowed only with BCR securities (Art. 47B) and with government/IGD securities only when government deposits expressly for this purpose (Art. 49B).
  - Implementing regulations for BCR powers not issued.
- Market structure effects:
  - Interbank market is very limited; legacy of a late-1990s default and supervisors’ negative perceptions impeded interbank activity.
  - Individual banks hold high liquid assets as self-insurance; costly for profitability and credit supply.
- Legal and policy recommendations:
  - Lift prohibition against lending to banks (Central Bank Law Art. 51) to allow BCR to channel excess reserves or borrowed funds as emergency liquidity assistance (ELA).
  - Approve article 130 of the FSSRL to support these powers; issue regulations to operationalize repos and purchases.
  - Design collateral policy and processes; review legal constraints that classify repos as government credit.
  - Consider allocating the SDR allocation granted in 2009 (half of it, or SDR69 million, currently deposited with the Treasury) to strengthen BCR balance sheet.
  - Over medium-term, government should seek to fully capitalize the BCR.
- Systemic liquidity policy and contingency planning:
  - Establish a high-level financial stability committee (MOF, BCR, SSF) to set medium-term objectives for stock and structure of systemic liquidity, tool use criteria, and contingency plans.
  - Consider creating a liquidity fund to pool resources, reduce individual banks' self-insurance costs, complement interbank market, and reduce volatility of domestic liquidity.
  - Short of a liquidity fund, require irrevocable letters of credit from parent banks as assurance of access to external liquidity.
  - Cross-reference: liquidity funds exist or are being considered in Ecuador and Panama.

### Problem bank resolution, deposit insurance, and crisis management
- Legal framework and operational gaps:
  - Bank Law establishes regularization and restructuring criteria; regularization term 90 days (extendable up to 180 days).
  - Triggers for regularization: CAR below 10 percent; use of the third liquidity tranche; other situations putting solvency/liquidity at risk.
  - 2002 BL amendments introduced P&A tools and IGD participation; supporting regulations (e.g., eligibility criteria for P&A) not issued.
  - Need comprehensive procedures, manuals, standardized contracts, and trained staff; lack of legal protection for supervisors may lead to asset dissipation.
- Deposit insurance (IGD) metrics and reforms:
  - IGD covers deposits up to $9,000 at 12 commercial banks and, as of 2010, at 6 cooperative banks and 2 savings and credit associations.
  - IGD funded by BCR loan (currently $13 million) and premiums equivalent to an annual rate of 0.10 percent of deposits.
  - IGD reserve fund: US$96 million or 1.1 percent of total deposits — sufficient to finance resolution of each of the 7 smallest banks and one saving and credit institution individually.
  - Recommendations: eliminate 3 day notification period for resolution measures; require removal of a bank’s board at judicial intervention; require least-cost resolution principle and increase IGD funding options/target fund; permit funding through pre-paid assessments on banks; issue regulation on contingency funding of IGD by BCR.
- Institutional coordination and crisis roles:
  - CISF exists but not formally established by legislation or decree; roles and responsibilities underdeveloped; tends to be reactive.
  - Recommendation: issue decree to formally establish CISF, clarify roles and objectives, and formalize procedures for information sharing and crisis management.
  - Assign systemic-risk assessment to an appropriate body (not IGD); CISF should establish methodology for defining systemic risk (size, interconnectedness, regional impact, contagion risk, payment system).
  - High-level stability committee (with MOF financing responsibility for systemic resolution) should decide systemic events and proceed according to defined roles; conduct comprehensive bank resolution simulation exercises.

### Financial sector structure, capital markets, and public banks
- Financial sector composition and figures:
  - Banking system assets (percent of total assets): 75.3 (2004), 76.6 (2005), 70.1 (2006), 68.7 (2007), 67.5 (2008), 64.2 (2009).
  - Pension funds (percent of total assets): 14.7 (2004), 19.1 (2005), 19.7 (2006), 20.6 (2007), 21.9 (2008), 24.5 (2009).
  - Market capitalization (US$ million): 3,683.0 (2005), 5,352.0 (2006), 6,048.0 (2007), 5,398.0 (2008), 5,195.0 (2009).
  - Government securities (US$ million): 4,478.2 (2005), 4,417.5 (2006), 4,634.5 (2007), 5,617.7 (2008), 6,054.9 (2009).
  - Corporate bonds outstanding volume (US$ million): 909.6 (2005), 823.0 (2006), 1,021.8 (2007), 1,052.8 (2008), 1,137.4 (2009).
  - Stock market capitalization: US$5.2 billion (24.6 percent of GDP) at end-2009; excluding largely foreign-controlled and hardly traded financial institution shares, remaining capitalization US$1.2 billion (5.6 percent of GDP).
  - Government securities outstanding: about US$6 billion (28.7 percent of GDP), with 67 percent represented by Eurobonds.
  - Private debt securities outstanding: 3 percent of GDP.
  - Institutional investors invest less than 10 percent of total assets in capital market instruments.
- Capital markets weaknesses and recommendations:
  - Reform paralysis left relatively low standards for securities supervision and constrained market development.
  - Securities exchange rules hamper market trading:
    - Mandatory listing/trading on exchange prevents OTC development.
    - Exchange channels all local secondary market transactions through its members; exclusive control of central depository limits competition and raises costs.
  - Policy recommendations from proposed Securities Law:
    - Eliminate obligation for listing and trading in the exchange; allow private placements targeted to institutional investors and OTC transactions; eliminate local rating requirements for foreign instruments rated in recognized jurisdictions; grant authorities powers to expedite regional integration (remote access, mutual recognition); minimize self-regulatory framework.
  - Investment Funds Law:
    - Investment Funds Law should be approved to broaden and diversify investor base and allow development of mutual fund industry.
    - Note: Investment funds’ assets decreased from US$700 million in 2006 to US$79 million in 2010, with only one independently-owned fund remaining.
    - Expected effects: broaden investor participation beyond pension funds and banks; reduce concentration limits impact (maximum participation limit of 35 percent); deepen capital markets.

### Macroeconomic developments and near-term outlook
- Pre-crisis growth and integration:
  - Real GDP growth averaged 3 ½ percent from 2005–2008 compared to 2 percent from 2001–2004.
- Crisis impact 2008–2009:
  - Partial use of a $400 million IDB line and reduction in the liquid asset requirement could not prevent credit to the private sector declining 4 ½ percent.
  - Investment and private consumption fell sharply; real GDP declined by 3 ½ percent in 2009.
  - Fiscal deficit rose to 5 ½ percent of GDP and public sector debt rose to 50 percent of GDP; sovereign downgraded by one notch.
- 2010 outlook and policy strategy:
  - For 2010, economic growth envisaged at 1 percent, aided by recovery in exports and modest recovery in remittances.
  - Authorities aim to increase key social spending and spur credit and private investment while safeguarding debt sustainability.
  - A new SBA with the IMF approved in March 2010 to signal commitment to macroeconomic stability and official dollarization.
  - Authorities envisage a fiscal pact with tax measures of at least 1½ percent of GDP for social spending and durable fiscal consolidation.
  - Strategic plan includes strengthening two small public commercial banks and creating a new government credit guarantee fund and economic development fund administered by a newly structured public development bank.
  - Approval of FSSRL and Investment Funds Law are key structural benchmarks under the SBA.
- Downside risks and financing:
  - Growth expected to remain below potential through 2012, picking up to 4 percent thereafter.
  - Major downside risks: political and external shocks (double-dip U.S. recession, deterioration in external markets, loss of political support for fiscal consolidation).
  - Financing risks: need to roll over a Eurobond in 2011 and liquidity risk; Risk Assessment Matrix details events.

### Pension-related contingent liabilities
- Funding and risk:
  - Funding requirements for pensioners on the old pay-as-you-go system are in the order of 1½ percent of GDP.
  - Lower-than-expected returns under the new defined contribution system may create a wedge between returns earned and the minimum pension that the current system grants, creating a potential contingent liability for the government.

### Main recommendations (selected; legal reform and non-legal)
- Main recommendations requiring legal reform (time frames noted in source: NT = Near Term, MT = Medium Term):
  - Approve the proposed FSSRL, amending the draft to include adequate legal protection for supervisors, and broader preventive powers prior to regularization. NT
  - Allow the BCR to lend to banks with its own or external funds in case of emergency. NT
  - Eliminate 3 day notification period for resolution measures; require removal of a bank’s board at judicial intervention; limit IGD to the least-cost solution; and increase IGD’s funding options and target fund. NT
  - Approve the proposed Investment Funds Law. NT
  - Approve a comprehensive overhaul of the securities markets law. MT
  - Amend the Pension Funds Law to increase the number and type of investments allowed. MT
  - Require federations to collect and report information to the SSF. NT
  - Allow for the transfer of an invoice to a third party. MT
  - Allow the free circulation of credit information among all members of private bureaus. MT
- Main recommendations not requiring legal reform (selected):
  - Issue regulations for key risks and corporate governance. NT
  - Bring qualitative assessments in line with international best practices and appoint dedicated relationship manager responsible for the overall supervision of each bank. NT
  - Intensify supervision of credit concentration and debtor repayment capacity. NT
  - Implement a comprehensive liquidity policy, including objectives and contingency plans. NT
  - Issue regulations to implement the BCR’s powers to provide liquidity. NT
  - MOF allocates the entire SDR allocation granted in 2009 to the BCR for ELA. NT
  - SSF, BCR, and IGD formalize procedures and manuals for banking resolution and crisis management. NT
  - SSF, BCR, IGD and MOF undertake a comprehensive bank resolution simulation exercise. NT
  - Rationalize the securities exchange’s role in the market. MT
  - Adopt an external yield curve (US yield curve) for valuation of portfolios. NT
  - Implement the action plan to comply with IOSCO principles. NT
  - Harmonize requirements for credit and registration of assets in exempting low-value transactions. MT
  - MOF creates coordination mechanisms among the three public banks. NT
  - SSF implements schedule of on-site visits and off site reviews of public banks’ financial information. NT
  - Public banks improve credit risk analysis and operative processes. NT
  - Consolidate and redefine the guarantee funds and scale up the mutual guarantee scheme (SGR). NT
  - BCR implements its oversight functions of the payment systems. NT
  - BCR introduces a liquidity scheme for the RTGS. NT
  - BCR creates an alternate site for the RTGS. NT
  - Implement linkage between RTGS system and CEDEVAL. NT

### Implementation status highlights (Appendix I)
- Role of Central Bank:
  - Treasury issued long-term bonds for US$704 million to securitize a government liability with the BCR (Partially Implemented).
  - Excess (“free”) reserves: Dec. 2004: US$303 million; Feb 2010: US$251 million (Not Implemented on building up reserves).
- Strengthening bank regulation and supervision:
  - Provide legal protection for Superintendent and SSF staff: Not Implemented.
  - Improve loan classification and provisioning rules: Implemented (new regulation effective 2007).
  - Follow up on MOUs with regional supervisors: Implemented.
  - Increase IGD reserves to 5 percent of insured deposits: Not Implemented (IGD funds: 4.2 percent of insured deposits; 1.1 percent of total deposits).
- Payments and infrastructure:
  - Introduce RTGS: Implemented (BCR started RTGS February 2010).
  - Implement full dematerialization of securities in CEDEVAL: Partially Implemented.

### Risk Assessment Matrix — main threats and expected impacts (selected entries)
- Sovereign fiscal risks if fiscal measures absent or fiscal pact fails:
  - Likelihood of Severe Realization (next 2 years): LOW to MEDIUM.
  - Key metrics: sovereign spreads increased by 100 bps in 2009; two of three credit rating agencies have negative outlook (BB/Ba1); gross financing needs 7 and 8 percent of GDP in 2010 and 2011; need to refinance a $600 million Eurobond in H2 2011.
  - Expected impact: MEDIUM to HIGH.
- Double-dip U.S. recession:
  - Likelihood: LOW to MEDIUM.
  - Key metrics: half of exports destined to the U.S.; remittances are 16 percent of GDP.
  - Expected impact: MEDIUM.
- Deposit runs from policy uncertainty or natural disaster:
  - Likelihood: LOW to MEDIUM.
  - Evidence: pre-election outflows in 2009 less than 3 percent in 3 weeks pre-election.
  - Expected impact: LOW to MEDIUM.
- Failure of a systemically important bank:
  - Likelihood: LOW.
  - Expected impact: HIGH — resolution costs could be large given IGD reserves around 1 percent of total deposits and limited BCR capacity.

*Source: _cr1444 — IMF Financial Sector Assessment Program, Executive Summary and selected sections as presented in the source document.*

### Executive Summary ......................................................................................................

### _cr1444 - Executive Summary

### Banking sector soundness and stress resilience
- Salvadoran banks were not directly exposed to the global financial crisis, though parent banks of several major Salvadoran banks were hit 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,
  - a decline in both credit demand and supply,
  - increased banks’ nonperforming loans,
  - declined profitability.
- Capitalization remained high despite the downturn.
- Stress tests indicate most banks are resilient to a severe macroeconomic, sectoral and liquidity shocks.

### Implementation of the 2004 FSAP update
- Progress:
  - Supervisory frameworks for banks, insurance, and cross-border cooperation were improved.
  - Partial progress in strengthening financial infrastructure, insolvency process, microfinance regulatory framework, and restructuring of state-owned banks.
  - Loan classification and provisioning rules were upgraded.
- Shortfalls:
  - Important legal provisions to strengthen supervision and safety nets, and a corporate insolvency law, have not been approved.
  - Important risk and corporate governance regulations for banks have yet to be issued.
- Appendix 1 documents limited implementation.

### Proposed Financial System Supervision and Regulation Law (FSSRL)
- The FSSRL would:
  - merge supervisors of banks and insurance, pensions, and securities into one unified supervisor with stronger powers,
  - shift regulatory power to the central bank,
  - create a sole supervisor and a sole regulator expected to facilitate consolidated supervision and reduce regulatory gaps and scope for regulatory arbitrage.
- Implementation caveats:
  - The merger of supervisors and institutional split between regulatory and supervisory powers will require careful planning and ongoing cooperation between the supervisor and the regulator to ensure effective supervision.

### Remaining gaps in banking supervision and safety nets
- Supervisory practice recommendations:
  - include more qualitative judgment and forward-looking risk assessments,
  - review the regulatory perimeter,
  - issue key banking regulation (e.g., on corporate governance as well as credit, market, interest and liquidity risks).
- Legal and institutional recommendations:
  - Proposed FSSRL should more comprehensively address shortcomings in legal protection and the remedial action framework.
  - Amend the Banking Law (BL) to strengthen the least-cost bank resolution framework and the deposit insurance fund.
  - Issue regulations implementing the central bank’s (limited) powers for emergency liquidity assistance (ELA) and the bank resolution process.
  - Passage of the proposed FSSRL would provide the BCR with more ELA powers, but authorities should also design and test comprehensive policies for systemic liquidity and banking crisis resolution.

### Oversight of nonbank financial services and borrower information
- A range of bank and non-bank institutions provide credit and deposit services to individuals and micro-, small- and medium-enterprises; below a certain size threshold some are not subject to SSF regulation and supervision.
- Recommendations:
  - Institutions that license and provide voluntary oversight of these institutions should report to the SSF when thresholds are exceeded.
  - Create a system of auxiliary supervision to strengthen oversight of unregulated institutions.
  - Consumer protection regulations could require lenders to provide borrowers with information on the total cost of a loan to address over-indebtedness and promote transparency.
  - Reform the Banking Law (BL) to allow the free circulation of credit information among all the members of credit bureaus.

### Payments system and financial infrastructure
- The Real Time Gross Settlement System (RTGS) launch has substantially improved safety of large-value payments.
- Reforms needed:
  - ensure the BCR has control over operational reserves and adequate oversight of the system,
  - amend the Central Bank Law to implement the regional treaty on payment and securities settlement systems,
  - strengthen control over the national payments system and enact integration with a regional payment and securities settlement system.

### Role and oversight of public banks
- Context:
  - Declining credit to the productive sector and a credit crunch prompted authorities to expand public banks’ activities and formulate a strategic plan.
- Recommendations:
  - Public banks’ activities should be appropriately focused and priced to avoid market distortion and maintain soundness.
  - Enhance government oversight and prudential supervision to ensure adequate governance, systems and controls, and risk management.

### Capital markets development
- Weaknesses:
  - Reform paralysis over the last decade left relatively low standards for securities supervision and constrained market development.
- Recommendations:
  - Passage of a new Investment Funds Law and comprehensive overhaul of capital markets legislation to expand investor base and facilitate regional integration.
  - Financial deepening through these reforms could increase private investment and growth and bolster resilience to shocks.

### Macroeconomic developments and near-term outlook
- Integration and pre-crisis growth:
  - Since 2004, favorable external environment, growing trade with the United States, and rising remittances helped real GDP grow by an average of 3 ½ percent from 2005–2008, compared to 2 percent from 2001–2004.
- Crisis impact 2008–2009:
  - Partial use of a $400 million Inter-American Development Bank (IDB) line—through which the central bank purchased high-quality loans from commercial banks—and reduction in the liquid asset requirement could not prevent credit to the private sector declining 4 ½ percent.
  - Investment and private consumption fell sharply; real GDP declined by 3 ½ percent.
  - The recession pushed the fiscal deficit to 5 ½ percent of GDP and public sector debt rose to 50 percent of GDP, leading credit rating agencies to downgrade the sovereign by one notch.
  - For 2010, economic growth is envisaged at 1 percent, aided by a robust recovery in exports and modest recovery in remittances.
- Policy priorities and fiscal strategy:
  - Authorities aim to increase key social spending and spur credit and private investment while safeguarding debt sustainability.
  - A new stand-by arrangement (SBA) with the IMF approved in March 2010 aims to signal commitment to macroeconomic stability and official dollarization.
  - Authorities envisage a fiscal pact containing tax measures of at least 1½ percent of GDP to support social program spending and durable fiscal consolidation.
  - Strategic plan to increase credit and investment includes strengthening two small public commercial banks and creating a new government credit guarantee fund and economic development fund administered by a newly structured public development bank.
  - Approval of laws to reform financial sector supervision and regulation, and to provide a framework for investment funds are key parts of the strategy and benchmarks for structural reforms under the SBA.
- Downside risks:
  - Growth expected to remain below potential through 2012, picking up to 4 percent thereafter.
  - Major downside risks arise from political and external shocks, including a double-dip recession in the United States, deterioration in external market conditions, or loss of political support for fiscal consolidation.
  - Financing risks include the need to roll over a Eurobond in 2011 and liquidity risk; these and other events are detailed in the Risk Assessment Matrix (Appendix 2).

### Main recommendations (selected, legal reform and non-legal)
- Main Recommendations Requiring Legal Reform (with time frames):
  - Approve the proposed FSSRL, amending the draft to include adequate legal protection for supervisors, and broader preventive powers prior to regularization. NT
  - Allow the BCR to lend to banks with its own or external funds in case of emergency. NT
  - Eliminate 3 day notification period for resolution measures; require removal of a bank’s board at judicial intervention; limit IGD to the least-cost solution; and increase IGD’s funding options and target fund. NT
  - Approve the proposed Investment Funds Law. NT
  - Approve a comprehensive overhaul of the securities markets law. MT
  - Amend the Pension Funds Law to increase the number and type of investments allowed. MT
  - Require federations to collect and report information to the SSF. NT
  - Allow for the transfer of an invoice to a third party. MT
  - Allow the free circulation of credit information among all members of private bureaus. MT
- Main Recommendations Not Requiring Legal Reform (selected):
  - Issue regulations for key risks and corporate governance. NT
  - Bring qualitative assessments in line with international best practices and appoint dedicated relationship manager responsible for the overall supervision of each bank. NT
  - Intensify supervision of credit concentration and debtor repayment capacity. NT
  - Implement a comprehensive liquidity policy, including objectives and contingency plans. NT
  - Issue regulations to implement the BCR’s powers to provide liquidity. NT
  - MOF allocates the entire SDR allocation granted in 2009 to the BCR for ELA. NT
  - SSF, BCR, and IGD formalize procedures and manuals for banking resolution and crisis management. NT
  - SSF, BCR, IGD and MOF undertake a comprehensive bank resolution simulation exercise. NT
  - Rationalize the securities exchange’s role in the market. MT
  - Adopt an external yield curve (US yield curve) for valuation of portfolios. NT
  - Implement the action plan to comply with IOSCO principles. NT
  - Harmonize requirements for credit and registration of assets in exempting low-value transactions. MT
  - MOF creates coordination mechanisms among the three public banks. NT
  - SSF implements schedule of on-site visits and off site reviews of public banks’ financial information. NT
  - Public banks improve credit risk analysis and operative processes. NT
  - Consolidate and redefine the guarantee funds and scale up the mutual guarantee scheme (SGR). NT
  - BCR implements its oversight functions of the payment systems. NT
  - BCR introduces a liquidity scheme for the RTGS. NT
  - BCR creates an alternate site for the RTGS. NT
  - Implement linkage between RTGS system and CEDEVAL. NT

*Executive Summary — _cr1444 (IMF Financial Sector Assessment Program, Executive Summary)*

### 5.      There are longer-term risks arising from pension-related contingent liabilities.

### 5.      There are longer-term risks arising from pension-related contingent liabilities.

### Pension-related contingent liabilities
- Funding requirements for pensioners on the old pay-as-you-go system are in the order of 1½ percent of GDP.
- Lower-than-expected returns under the new defined contribution system may create a wedge between returns earned and the minimum pension that the current system grants, creating a potential contingent liability for the government.

### Financial sector structure and developments
- The Salvadoran financial sector is bank-centered and growing more slowly than the regional average.
- Banking and credit:
  - Bank credit outstanding: US$8 billion.
  - Credit-to-GDP: 40 percent of GDP.
  - Credit-to-GDP has stagnated since the late 1990s banking crisis.
- Capital markets:
  - At end 2009, there were 40 listed stocks.
  - Stock market capitalization: US$5.2 billion (24.6 percent of GDP).
  - Excluding largely foreign-controlled and hardly traded financial institution shares, remaining capitalization: US$1.2 billion (5.6 percent of GDP).
  - Government securities outstanding: about US$6 billion (28.7 percent of GDP), with 67 percent represented by Eurobonds issued in the international market.
  - Private debt securities outstanding: 3 percent of GDP.
  - Institutional investors invest less than 10 percent of total assets in capital market instruments.
- Ownership:
  - Financial sector is almost fully foreign-owned following purchases/mergers between 2005 and 2007.
  - Two domestic banks (both state-owned) account for only 5 percent of banking assets.
- Credit patterns and consumer credit:
  - Consumer credit has grown faster than corporate credit; corporate credit has declined in real terms.
  - Between 2004 and 2009, the number of loans to individuals increased 33 percent.
  - Some lenders have exited the under US$1,000 market.
  - Proposed legislation would increase transparency about costs and interpret lack of clarity in favor of the client; a special loan workout unit would be created in the Salvadoran consumer defense agency.
- Brokerage and investment funds:
  - Investment funds’ assets decreased from US$700 million in 2006 to US$79 million in 2010, with only one independently-owned fund remaining.
- Pension funds:
  - Assets under management: US$5.3 billion at end-March 2010.
  - Pension funds account for 24 percent of financial sector assets.
  - Pension fund investments: 79.4 percent in public sector securities (fixed-return investments).

### Banking soundness and stability — Financial Soundness Indicators and Risk Exposures
- Capitalization and asset quality:
  - Minimum required capital adequacy ratio (CAR) increased to 12 percent in 2005.
  - Nonperforming loans (NPLs) were around 2 percent of total loans between 2005 and 2007.
  - Banks wrote-off about 2 percent of total loans during 2006–2007.
- Global crisis impacts:
  - Annual deposit growth was briefly negative in January 2009.
  - External borrowing declined close to 50 percent.
  - Liquid assets increased to over 40 percent of deposits.
- 2009 deterioration:
  - NPLs rose by less than 1 percentage point to 3 ¾.
  - A wider measure of loans at risk suggests deterioration to 10 percent of total loans.
  - Write-offs amounted to 2 ½ percent of the loan portfolio in 2009.
  - Return on average assets fell to 0.3 percent in 2009.
- Capital buffers:
  - System CAR: 16.5 percent.
  - Tier 1 capital: 13.7 percent of risk-weighted assets.
  - Tier 1 capital is 8.9 percent of on- and off-balance sheet assets.
  - Goodwill and intangibles overstate regulatory capital by about 1 percentage point.
  - Adjusting provisions for restructured agricultural loans would reduce system CAR to 15.4 percent.
  - Adjusting government bonds’ risk weight from zero to 100 percent reduces system CAR to 14.7 percent.
  - Most banks would still have at least a 1 percentage point buffer above the 12 percent minimum.
- Cross-border exposures:
  - Cross-border lending: about 4 percent of total loans and less than 20 percent of capital.
  - Deposits and investments held abroad equivalent to 54 percent of capital.
  - Exposure to foreign assets as of March 2010: less than 80 percent of capital.
  - Direct exposure to parents: about 12 percent of capital (up from 6 percent in March 2009).

### Stress tests — scenarios and results
- Macroeconomic scenarios developed:
  - Baseline scenario: IMF forecast of 1 percent real GDP growth in 2010 and 2.5 percent in 2010 (see Article IV staff report); assumes U.S. growth of 3.1 percent in 2010 and 2.4 percent in 2011.
  - Downside scenario: slightly negative growth in the United States and real GDP growth of 0.1 percent in 2010 and 0.4 percent in 2011 in El Salvador.
  - Extreme scenario: Salvadoran real GDP declines by 5.4 percent in 2010 and 2.5 percent in 2011—an outcome three standard deviations below the norm.
- Extreme scenario loan risk:
  - Close to 50 percent of total loans could require provisioning by end-2011.
  - By end-2011 almost 50 percent of loans become risky loans (classified special mention or worse).
  - Manufacturing, extractive and construction sector loans: between 60-80 percent would need to be provisioned.
- Capital impact and resilience:
  - In all scenarios the system’s CAR remains above the regulatory minimum of 12 percent of risk-weighted assets.
  - In the extreme scenario five banks fall below the minimum CAR; two of these five would be under 10 percent CAR, and only in one (nonsystemic) case is undercapitalization critical.
- Credit concentration and collateral:
  - Downgrading the system’s 100 largest debtors by two grades causes CARs of six banks to fall substantially; all banks would retain a CAR above 9 percent.
  - Outright default of the largest ten debtors could leave up to five banks undercapitalized; four banks falling below 10 percent CAR, with no bank critically undercapitalized.
  - Maximum value of collateral for provisioning purposes is 70 percent.
  - Reducing loan guarantees by 25 percent (to adjust for liquidation delays) drops system CAR to 12.8 percent, with four banks falling below the regulatory minimum by between ½ and 1½ percentage points.
- Interest rate risk:
  - Repricing risk sensitivity: increase in short-term interest rates by 1½ and 3 percentage points tested.
  - With a 3 percentage point increase, three banks drop below the 12 percent minimum CAR; system CAR declines to 13.1 percent.
  - Only 1 non-systemic bank falls slightly below 10 percent CAR in this test.
- Liquidity shocks:
  - Withdrawal scenarios: 15 percent of total deposits within 30 days and 30 percent within 90 days.
  - Coverage by liquid assets is sufficient for most banks, even assuming private domestic securities illiquid and a 25 percent haircut on eligible government securities.
  - In the largest shock, a few banks would need to access the third tranche of liquid reserves held at the BCR in the form of securities.
  - Costs of accessing the second and third tranches of liquid reserves would reduce profitability.
- Data and coordination gaps:
  - Remaining data gaps to address: loan collateral, cash-flows, remaining maturity structure of liabilities, and interest rates of securities and loans.
  - Recommendation: Risk analysis committee should unify and upgrade stress-testing approaches and conduct regular stress tests.
  - SSF should improve liquidity requirements by requiring information on the residual, not the contractual terms of all liabilities; domestic and foreign liabilities should be treated equally.

### Financial sector oversight — Banking
- SSF supervision:
  - SSF reorganized in 2008 to implement risk-based supervision and now has a risk unit.
  - SSF uses CAMELS models to establish bank-specific risk profiles.
  - Recommendation: Supervision should focus more on assessing the quality of risk management and internal controls, not just the existence of procedures and policies, and tailor assessments to bank risk characteristics (size, complexity, risk tolerance).

*Source: _cr1444 - 5.      There are longer-term risks arising from pension-related contingent liabilities.*

### 27.      The existing regulatory framework has significant gaps, which need to be filled

### _cr1444 - 27.      The existing regulatory framework has significant gaps, which need to be filled

### Regulatory gaps and supervisory constraints
- Regulation is lacking in: corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate risk in the banking book, information technology and investment valuation and derivatives.
- Many regulations are under development but face approval bottlenecks, including lengthy industry consultations and SSF’s executive council’s increasing involvement in operational matters to the detriment of strategic policy decisions.
- Lack of standards weakens the SSF’s ability to address imprudent behavior by banks and is aggravated by a lack of legal protection for supervisory staff; legal challenges distract resources and may reduce willingness to use corrective powers ex-ante.

### Remedial action framework and supervisory powers
- The SSF should have powers to require banks to take corrective actions before inadequate practices or vulnerabilities lead to undercapitalization.
- Current supervisory toolkit lacks powers to:
  - limit the distribution of dividends;
  - constrain existing or new operations and acquisitions;
  - enforce the sale of assets.

### Asset classification, provisioning, and credit concentration
- Asset classification and provisioning rules were tightened in 2007, and provisioning levels are now broadly in line with international practices.
- A credit risk regulation covering repayment capacity and concentration risks is still needed.
- The SSF monitors banks’ delinquent loan portfolio intensively, but given banks’ CAR sensitivity to concentration risk, the SSF should regulate and supervise the sum (aggregate) of individual large exposures, or loans linked by credit risk, more vigorously.
- Recommendations on classification:
  - Extend the requirement to downgrade corporate loans when debtor repayment capacity so warrants to consumer and mortgage loans.
  - When debtors with multiple loans with various banks default on one loan but stay current on others, the classification of the current loans should be downgraded.
  - Monitor the practice of granting several mortgages on the basis of one underlying asset more closely.

### Capital adequacy
- Intangible assets (mostly goodwill) are not subtracted from capital as required under Basel I. While currently of limited significance, further consolidation and investments could elevate these amounts.
- Over the medium-term, the law should be amended to bring capital requirements in line with Basel standards.

### Regulatory perimeter and nonbank entities
- Cooperatives taking deposits from the public or for which the sum of member deposits and members contributions to equity exceeds US$84 million are supervised by the SSF according to the Cooperative Banking Law; the majority of cooperatives are not subject to prudential regulation and SSF cannot determine when unregulated institutions pass the US$84 million threshold.
- Several other financial intermediaries (mortgage companies, factoring companies and consumer durables lenders) are not regulated and supervised and are not restrained by the definition of permissible activities that apply to regulated entities.
- Recommendations:
  - Strengthen licensing and voluntary oversight entities’ limited information systems and give them the power to penalize institutions that do not report required information.
  - Consider a system of auxiliary supervision through federations providing voluntary oversight, enabling those entities to perform supervisory tasks (data collection, processing and recommendations) on behalf of SSF—this may require significant strengthening of the voluntary oversight entities.
  - Introduce consumer protection regulations requiring lenders to provide borrowers with information on the total cost of a loan to address over-indebtedness and promote transparency.

### SSF human capacity and organizational issues
- Offsite responsibilities are split across two divisions (Risks and Analysis); the role and responsibilities of offsite supervision are not well-specified.
- Individual supervisory staff often have multiple roles, notably in the Risk Division where unit leaders are responsible for monitoring a specific risk across all banks and act as designated “relationship managers” for a financial conglomerate.
- Recommendations:
  - Assign offsite supervisors to specific banks and conglomerates, allowing unit heads to focus on assessing supervision adequacy and broader systemic risk assessment.
  - Further upgrade supervisory capacity in both quantitative and qualitative terms.
  - Consider creating a separate consumer protection department, as current increased consumer protection responsibilities assigned to the Supervisory Department divert resources from prudential supervision.

### Nonbank intermediaries: insurance and securities
- Insurance:
  - Supervision has improved with the launch of the CARAMEL system for insurance companies to identify potential difficulties.
  - SSF should continue developing risk-based supervision beyond compliance assessment and increase on-site visits to individual insurers to complement conglomerate focus.
- Securities:
  - Securities supervisory framework requires comprehensive reform to comply with international standards (IOSCO principles).
  - Past assessments (IOSCO secretariat, FINRA) in 2004–2005 highlighted very low compliance; priority reform areas identified included: mitigating investor and systemic risks in brokerage funds; updating laws and rules; implementing risk-oriented supervision; strengthening brokers’ supervision and market surveillance.
  - Although mitigation of investor and systemic risks in brokerage funds is no longer an issue, other areas still require significant work and an action plan to comply with IOSCO principles, including comprehensive reform of the securities market law.

### Consolidated supervision and cross-border cooperation
- SSF has made progress in consolidated supervision and coordinates with other local supervisors for information gathering and simultaneous onsite exams, but deeper analysis is needed to translate outcomes into impacts on capital and liquidity.
- The threshold for consolidation used in practice (50 percent of capital) is quite high.
- Cross-border cooperation:
  - SSF has signed Memoranda of Understanding with all home supervisors in response to changing ownership structures; home supervisors report satisfactory access to information on Salvadoran operations, and SSF is satisfied with information on overall financial condition of cross-border conglomerates.
  - Comité de Enlace of Central American supervisors (CECAS) has stepped up regional coordination with quarterly meetings and monthly teleconferences; SSF participated in a regional crisis simulation exercise organized by the World Bank.
  - Recommendation: BCR and IGD should be incorporated into cross-border crisis cooperation given their roles in banking resolution.
- Crisis preparedness:
  - Despite continuous communication with home supervisors, no crisis MOUs or contingency plans to manage a crisis in coordination with foreign supervisors are in place.
  - Recommendation: Establish arrangements between home and host supervisors to avoid and mitigate potential crises by assessing information needs and establishing communication strategies.

### AML/CFT and FIU capacity
- Legislation criminalizing ML and FT complies with the FATF standard; the law has enabled successful prosecutions and international cooperation.
- Weaknesses:
  - Number of convictions is low relative to the number of predicate crimes; prosecutions mostly relate to cash smuggling rather than more complex schemes.
  - Effectiveness of seizing and freezing measures is limited; precautionary asset seizures were imposed in less than half of the investigations.
  - Some financial activities—particularly money remittance and all designated non-financial businesses and professions—fall outside any regulatory and supervisory framework.
- FIU concerns:
  - The Financial Investigations Unit (FIU), established within the Public Prosecutions Agency, is the lead agency with authority to issue enforceable regulations and to investigate and prosecute most cases, but it lacks expertise, resources and operational autonomy.
  - Concentration of functions (FIU, regulator and lead prosecutor) within the unit appears excessive and inappropriate.

### Payment systems, BCR oversight, and legal framework
- Legal gaps:
  - Central Bank Law should be amended to fully implement the Treaty on the Payment and Securities Settlement Systems for Central America and the Dominican Republic; the amendment is already drafted and would provide the BCR with powers to regulate fees and sanctions in the payments system.
  - BCR would still need to develop a new regulatory framework for payment services.
- BCR oversight weaknesses and recommendations:
  - Current information is provided by private sector on a voluntary basis; BCR should define, possibly through regulation, powers to collect information from system participants and adequately oversee payment systems—particularly at retail level—by specifying methodologies and requesting periodic reports.
  - To retain control over national payments operations and oversight, BCR should consider providing services banks value (e.g., tools to facilitate high quality cash management by treasurers and perhaps an intra-day liquidity facility for the RTGS system such as a specially designed intra-day repo facility with regular operations).
  - To ensure control, banks should be required to maintain the first tranche of the reserve at the BCR while part of the last tranche, for exceptional use, could be maintained abroad.

### Overhaul of the supervisory landscape: draft FSSR law
- A draft law on Financial System Supervision and Regulation (FSSR) is currently with the Congress and should be passed this year; the law will:
  - merge the superintendencies of banks, insurance, securities firms, and pension funds to create a sole supervisory authority with enhanced powers;
  - transfer the right to issue regulation from the new SSF to the BCR to balance the power of the integrated supervisor and focus oversight on a financial stability objective;
  - create an appeal committee to ensure the rights of the governed with respect to sanctions.
- Expected benefits when approved:
  - Enhance timeliness of supervisory and regulatory decisions, improve consolidated supervision and reduce scope for regulatory arbitrage, and strengthen banks’ corporate governance.
  - Specific features:
    - Broadens and clarifies supervisory powers, governance and operational independence; includes a comprehensive definition of supervision and establishes a new supervisory committee composed only of the Superintendent and the Intendents to limit political interference and speed up supervisory decisions; strengthens the Superintendent’s independence and legal protection with respect to resolution decisions.
    - Establishes a dedicated regulatory committee composed of BCR officials, BCR Board members and the Superintendent of the new SSF to improve timeliness of issuing regulation and facilitate harmonization of regulations across institutions.
    - Requires enhanced intra-agency cooperation between SSF and BCR to allow a more macroprudential perspective.
    - Spells out responsibilities of bank directors, managers and staff regarding disclosure, management and internal controls to enhance corporate governance.
- Remaining shortcomings and risks:
  - The draft law only partially addresses legal protection for supervisors; protection remains insufficient against litigation for supervisory actions undertaken in good faith.
  - SSF’s ability to act preemptively remains restricted; lacks power to restrict dividends, activities or purchases prior to regularization.
  - No requirement for a financial institution’s board to inform the SSF of material operational problems.
  - Separation of regulation (BCR) and supervision (SSF) requires strong cooperation; this separation is not typical and may reduce compliance with international standards and with one of the essential criteria for the BCP 1.3 Legal Framework.
  - BCR must acquire technical skills in prudential supervision and work closely with SSF supervisors; prompt cooperation is essential to finalize long-overdue draft regulations.
  - Need to establish responsibility for responding to industry consultations on interpretation of regulations and mechanisms for resolving interpretation differences between SSF and banks and between SSF and BCR; BCR and supervisory agencies should develop formal mechanisms to address these challenges.
- Integration challenges and implementation
  - Merger expected to reduce supervisory gaps and improve consolidated supervision, but integration requires attention to the entire financial sector, not only banks posing highest systemic risk.
  - The merger will demand sustained attention of key SSF staff over a long period and requires careful planning to integrate cultures, systems and processes.
  - Recommendation: BCR, in coordination with supervisory agencies, should develop a detailed action plan to address integration challenges.

*Italic: Source: _cr1444 - 27.      The existing regulatory framework has significant gaps, which need to be filled*

### 47.      The BCR’s systemic liquidity management is constrained by the limited range of

### _cr1444 - 47.      The BCR’s systemic liquidity management is constrained by the limited range of

### Systemic liquidity management — constraints and legal framework
- The BCR cannot issue its own currency in a dollarized economy and therefore cannot provide liquidity in the same way as other central banks.
- Possible liquidity sources: excess (“free”) international reserves or borrowed external funds.
- Current legal restrictions:
  - BCR is prohibited from lending to banks (Central Bank Law Art. 51).
  - Law allows BCR to conduct repos with securities held as part of the required liquid reserves (Art. 47B of the Banking Law) — currently limited to BCR securities.
  - Repos permitted with BCR, government, and IGD securities only when the government has deposited funds expressly for this purpose (Art. 49B of Banking Law (BL)).
  - A 2000 amendment to the Organic Law of the BCR allows the central bank to sell or buy investments and loans from banks (Art. 49(b)), but this has proven cumbersome in practice.
- Implementing regulations for the CBR’s powers have not been issued.

### Market structure, interbank market, and cost of liquidity
- Legacy of a bank default in the late 1990s and supervisors’ negative perception of interbank transactions: domestic interbank market is very limited and does not function efficiently or effectively.
- Banks’ foreign parents could extend liquidity to subsidiaries, but this may occur only in exceptional circumstances or when there is certainty about future macroeconomic policies (e.g., under an IMF program).
- Individual liquid assets are high as self-insurance against liquidity shocks.
- Cost implications:
  - High individual liquid assets are costly for banks’ profitability and for the system in terms of foregone credit.
  - Stress tests show banks appear sufficient to withstand large withdrawals of 30 percent of deposits and no rollover of other liabilities coming due in one month, but some banks would rely on the BCR having government funds in order to repo government securities.

### Legal and operational reforms recommended for emergency liquidity assistance
- Lift the prohibition against lending to banks (Central Bank Law Art. 51) so the BCR can temporarily channel excess reserves or external borrowed funds to solvent banks in line with best practices on emergency liquidity assistance.
- Approve article 130 of the FSSRL to support these powers.
- Issue regulations to implement existing options (e.g., repos, outright purchases) the BCR currently has for providing and managing systemic liquidity.
- Review legal constraints to conducting repos with government securities: under the commercial code definition of repos they are considered government credit and thus prohibited unless done with funds provided by the government itself.
- Design a collateral policy and clearly define processes to carry out permissible operations.
- Clarify that currently the SSF is charged with regulating this requirement; this would change under the proposed FSSRL.

### Resources, capitalization, and recommended balance-sheet actions for the BCR
- El Salvador’s excess (“free”) reserves are low relative to other dollarized economies in the region.
- Additional excess reserves would enhance the BCR’s ability to provide liquidity during systemic stress (e.g., to purchase less liquid securities or, if possible, lend using these assets as collateral).
- Consider allocating the SDR allocation granted in 2009 (half of it, or SDR69 million, currently deposited with the Treasury) to strengthen the BCR’s balance sheet.
- Over the medium-term, the government should seek to fully capitalize the BCR.
- Contextual note: The Treasury issued long-term bonds for US$704 million to securitize a government liability with the BCR, but there is still an outstanding issue of bank resolution trust fund (FOSAFI) debt arising from the purchase of failed bank assets from the late 1990s that the government should honor.

### Systemic liquidity policy, contingency planning, and liquidity fund
- Authorities should establish and implement a comprehensive systemic liquidity policy including contingency plans and consideration of a liquidity fund.
- Proposals:
  - A high-level financial stability committee, consisting of the MOF, BCR and SSF, should establish medium-term objectives for the stock and structure of systemic liquidity, criteria for the use of tools for different stages of individual bank or systemic liquidity problems, and contingency plans.
  - Setting up a liquidity fund (under consideration by the financial cabinet) would reduce costs of liquidity protection for individual banks and the economy by pooling liquid resources, complementing the incipient interbank market and limited BCR capacity.
  - The pooled resources could reduce volatility of domestic liquidity for individual banks and reduce the need for self-insurance.
  - Short of a liquidity fund, the SSF could require irrevocable letters of credit from parent banks to provide additional assurance of access to external liquidity.
- Cross-reference: Liquidity funds are already in place or being considered in other dollarized economies in the region, i.e., in Ecuador and Panama, respectively.

### Problem bank resolution and deposit insurance — findings
- Bank Law (BL) establishes criteria for regularization and restructuring, but timely action may be hampered by lack of regulations and legal protection.
- Main triggers for regularization:
  - (i) a CAR below 10 percent;
  - (ii) use of the third liquidity tranche;
  - (iii) other situations that put at risk the bank’s solvency and liquidity (e.g., deficient risk management).
- Regularization term: 90 days, but can be extended up to a total of 180 days under certain circumstances.
- During regularization, the SSF can take a wide range of corrective actions.
- Failure to present or comply with a regularization plan triggers restructuring; shareholders must adequately capitalize banks within 30 days or the SSF may use other mechanisms.
- Gaps:
  - Lack of regulations on various risks and on sanctions limits enforcement of regularization criteria.
  - SSF has not formally defined responsibilities and intensity of follow-up of corrective actions based on risks.
  - Lack of legal protection for supervisors may lead to asset dissipation and higher costs for the deposit insurance fund or government in a systemic crisis.

### Problem bank resolution — operational gaps and required arrangements
- 2002 BL amendments introduced tools for bank resolution (purchase and assumptions — P&A) and IGD participation to protect guaranteed deposits.
- Supporting regulations have not been issued: eligibility criteria for participating in a P&A are missing.
- Need for comprehensive procedures, manuals, standardized contracts (e.g., for trust funds constituted for P&A), and trained staff.
- These procedures should be discussed and mutually agreed by all safety net providers (SSF, BCR and IGD).

### Legal amendments and deposit insurance reforms recommended
- Amend the legal framework to:
  - Eliminate the requirement to notify a bank three days prior to suspension of operations or other resolution measures.
  - Introduce the least-cost solution (total amount of guaranteed deposits) as the measure of the maximum support by the IGD for a bank resolution; remove qualitative, unbounded cost-benefit variables.
  - Remove the bank’s Board upon commencement of a bank’s judicial intervention to avoid co-governing conflicts with the judicial receiver.
  - Allow a larger exclusion of assets than liabilities under the P&A process to conserve IGD resources and increase willingness of banks to assume deposits.
  - Establish a deposit insurance reserve target and adopt measures to reinforce its funding:
    - Current deposit insurance fee is one of the lowest in the region.
    - Consider raising it, consistent with a reserve fund target calibrated to account for the Salvadoran financial system’s characteristics (officially dollarized and highly concentrated).
    - Permit funding through collection of pre-paid assessments on banks.
    - Issue a regulation on the contingency funding of the IGD by the BCR.

### Financial stability and crisis management — coordination and roles
- An Inter-Institutional Financial System Committee (CISF) exists (representatives from BCR, IGD and financial sector superintendencies organized into technical working groups), but is not formally established by legislation or decree.
- Current weaknesses:
  - Roles and responsibilities are not fully developed; CISF tends to be reactive.
  - Projects are not formalized and technical findings do not generate coordinated strategic decisions.
  - Issues like regulatory arbitrage, monitoring unregulated intermediaries, market transactions, and potential stress scenarios are not regular priorities.
- Proposed improvements:
  - Under proposed FSSRL BCR and SSF would be required to coordinate on financial stability, but specific policies and procedures for information sharing, systemic risk monitoring and crisis management should be mutually agreed, formalized and implemented.
  - BCR should focus on macroprudential policies and monitoring; SSF on microprudential issues; IGD on least-cost resolution — with clear, transparent communication.
  - A decree formally establishing the CISF and specifying its objective would be useful.

### Roles and responsibilities for systemic crisis resolution
- Current assignment of systemic-risk assessment to IGD is inappropriate given deposit insurer mandate.
- CISF should establish a methodology for defining systemic risk based on variables (size, interconnectedness, regional impact, contagion risk, payment system, etc.).
- A high-level stability committee, with technical inputs from the CISF, should decide whether a systemic risk situation exists and proceed according to well-defined roles and responsibilities.
- The MOF should take responsibility for financing systemic bank resolution, with appropriate transparency and accountability for use of public funds.
- Authorities should conduct a comprehensive bank resolution simulation exercise involving all agencies and different stress scenarios; results should inform legal, regulatory, and procedural changes.

### Financial sector infrastructure — RTGS and credit information
- RTGS launch reduced systemic risks and improved integration between the BCR and banks for large-value payments, but:
  - Constraints on BCR’s liquidity provision expose the system to settlement logjams if one bank cannot settle.
  - Lack of a contingency site to guarantee business continuity exposes the system to operational risks.
- Banking Law should be amended to allow free circulation of credit information among all credit bureaus, including regional sharing.
  - Currently banks can access information from all sources (including credit unions, leasing companies), while nonbanks cannot access information provided by banks.
  - Nonbanks should have reciprocity to ensure a comprehensive view of a client’s debts.
  - Long-term objective: greater information sharing among existing databases in El Salvador and regionally given strong Central American market integration.

### Financial sector development — public banks and capital markets
- Public banks role:
  - Authorities are formulating a strategy for the public banking sector to limit dependence on foreign banks for funding productive activities.
  - State-owned first tier public banks were encouraged to expand credit in 2009 to partially compensate for foreign bank credit contraction.
  - Plans include increasing capital of first-tier banks and establishing a development fund intermediated by the second-tier bank; funding sources under discussion.
- Recommendations for public banks:
  - Establish a clearly defined strategy, consistent business plans, and performance measures.
  - Define development objectives, create coordination mechanisms among three public banks to ensure complementarities in strategies, funding, processes, and product lines.
  - Formulate business plans and adopt performance measurement systems combining financial and social objectives.
  - Government should be unequivocally committed to preserve public banks’ sustainability and monitor and hold managers accountable.
  - Any subsidy components should be clearly accounted for in the budget.
  - Public banks should be under the same regulatory conditions and supervision as other banks; define on-site visit schedules and off-site review processes.
  - Historical context: BFA and BH required multiple recapitalizations amounting to more than US$300 million since 1991 due to past governmental loan forgiveness programs for agriculture.
- Capital markets:
  - Weak and incomplete legal framework constrains local capital market development and regional integration.
  - Except for the Securitization Law (2007), legal framework has not changed in the last decade.
  - Investment Funds Law has been in the making for more than 10 years.
  - Project to modernize capital markets framework on hold since 2005 due to differences between government and stock exchange.
  - Regional integration constrained by differing regulatory frameworks; El Salvador has relatively weaker standards among larger countries in the region (Panama and Costa Rica).

*Source: IMF staff report content (excerpt). *

### 65.      The current market rules and role of the stock exchange hampers market trading

### 65.      The current market rules and role of the stock exchange hampers market trading

### Findings
- All products and players are required by regulation to be listed and traded on the domestic securities exchange, preventing the development of over-the-counter (OTC) markets.
- The exchange channels all local secondary market transactions through its members (supporting their brokerage services).
- The securities exchange’s exclusive control of the only central depository limits competition, which raises trading costs.
- This includes unnecessary costs for transactions where brokerages add little value (e.g. the buying and selling of foreign securities between brokers and their clients).
- The limited trading reduces potential issuers’ access to institutional investors, other than through initial public offerings, as these investors require more liquidity and transparency of market prices.

### Policy recommendations (from proposed Securities Law)
- A new and comprehensive Securities Law that elevate the standards of the market should:
  - Eliminate the obligation for listing and trading in the exchange;  
  - Allow private placements targeted to institutional investors (registered in the SV) as well as OTC transactions; 
  - Eliminate the local rating requirements for foreign instruments rated in recognized jurisdictions;  
  - Grant the authorities powers to  make the regulatory changes needed to  expedite the regional integration (e.g. remote access, mutual recognition); and 
  - Minimize the self -regulatory framework given the small size of the market and the demutualization of the exchange.

*Source: _cr1444 - 65.      The current market rules and role of the stock exchange hampers market trading*

### 67.      The Investment Funds Law should be approved to broaden and diversify the

### The Investment Funds Law should be approved to broaden and diversify the investor base

### Recommendation
- The Investment Funds Law should be approved to broaden and diversify the investor base.
- Passage of the law would allow for the development of the mutual fund industry.

### Rationale and immediate policy objective
- Developing a mutual fund industry would "greatly help issuers given the current reliance on two main institutional investors (pension funds and banks) and the maximum established limit of 35 percent for participation in security issuances."
- Expanding collective investment schemes would reduce concentration risk in security issuances tied to the dominance of pension funds and banks.

### Context from financial system structure and capital markets (selected figures preserved exactly as in source)
- Banking system assets (percent of total assets): 75.3 (2004), 76.6 (2005), 70.1 (2006), 68.7 (2007), 67.5 (2008), 64.2 (2009).
- Pension funds (percent of total assets): 14.7 (2004), 19.1 (2005), 19.7 (2006), 20.6 (2007), 21.9 (2008), 24.5 (2009).
- Note from source: "There are no records of collective investment schemes such as mututal f unds, investment trusts and investment managers."
- Market capitalization (US$ million): 3,683.0 (2005), 5,352.0 (2006), 6,048.0 (2007), 5,398.0 (2008), 5,195.0 (2009).
- Government securities (US$ million): 4,478.2 (2005), 4,417.5 (2006), 4,634.5 (2007), 5,617.7 (2008), 6,054.9 (2009).
- Corporate bonds outstanding volume (US$ million): 909.6 (2005), 823.0 (2006), 1,021.8 (2007), 1,052.8 (2008), 1,137.4 (2009).

### Expected effects and policy implications
- A functioning mutual fund industry would:
  - Broaden investor participation beyond the dominant institutional investors (pension funds and banks).
  - Potentially reduce concentration limits binding on issuers (currently a maximum participation limit of 35 percent).
  - Deepen capital markets by creating demand for a wider range of securities and supporting market capitalization and corporate bond markets.

### Implementation considerations
- Legal enactment and regulatory framework to enable mutual funds and other collective investment schemes, noting current absence of records for such schemes in the financial system.
- Coordination with securities market regulators to ensure market infrastructure, transparency, and investor protection accompany the launch of mutual funds.

*Italic: IMF staff analysis and supporting data as presented in the source document.*

### Appendix I. El Salvador: Implementation of the 2004 FSAP Recommendations

### Appendix I. El Salvador: Implementation of the 2004 FSAP Recommendations

### A. Role of the Central Bank — Key recommendations and current status
- Capitalize central bank paper and government deposits at the BCR  
  - Partially Implemented: The Treasury issued long-term bonds for US$704 million to securitize a government liability with the BCR, but there is still an outstanding issue of bank resolution trust fund (FOSAFI) debt, arising from the purchase of failed bank assets from the late 1990s, that the government by law should honor.
- Build up international reserves  
  - Not Implemented: Excess (“free”) reserves (i.e., net international reserves minus Monetary Base):  
    - Dec. 2004: US$303 million.  
    - Feb 2010: US$251 million
- Assess the personnel deployment and functions of the BCR  
  - Partially implemented: Assessed for national accounts, statistics and balance of payments tasks.

### B. Strengthening bank regulation and supervision — Key recommendations and current status
- Provide legal protection for Superintendent and SSF staff  
  - Not Implemented: Legal framework is unchanged. The draft law includes provisions on legal protection for bank resolution, but is not adequate.
- Establish the tenure and terms for removal of the Superintendent of the SSF  
  - Not Implemented: legal framework is unchanged.
- Adopt enforcement policy, graduating sanctions according to gravity of breaches  
  - Not Implemented: legal framework is unchanged.
- Specify division of powers between Superintendent and SSF Board  
  - Not Implemented: legal framework is unchanged.
- Provide powers to suspend distribution of dividends  
  - Not Implemented: legal framework is unchanged.
- Improve loan classification  
  - Implemented: new regulation effective as of 2007.
- Bring provisioning rules more in line with international good practice  
  - Implemented: new regulation effective as of 2007.
- Reduce participation threshold from 50 to 20 percent to require consolidation of accounts  
  - Not implemented: Legal framework is unchanged.
- Follow up on MoUs with other regional supervisors to share information on conglomerates  
  - Implemented: use of regional committee and MOUs observed in practice.
- Provide powers to inspect the books of non-financial related parties  
  - Not implemented: Legal framework is unchanged.
- Increase reserves of the deposit insurance fund to 5 percent of insured deposits  
  - Not implemented*: IGD funds as percent of:  
    - insured deposits are 4.2 percent; and  
    - total deposits are 1.1 percent.  
  - *Status should be compared to total deposit, consistent with paragraph 44 of 2004 FSAP.
- Adopt contingency plans to coordinate official action among BCR, IGD, and SSF on weak bank resolution  
  - Partially Implemented: BCR, SSF and IGD coordinate with respect to sharing information on stress tests and early warning indicators, but better coordination is hampered by the lack of regulation, procedures and manuals, as well as training.
- Limit rights of investors to assets owned by off-balance sheet vehicles  
  - Not implemented: No further action undertaken.
- Require regular and transparent reporting of information on bank trusts  
  - Implemented: According to Art 68 of the Bank Law, banks must report to the SSF. However, these are no longer a major issue.
- Prevent regulatory arbitrage through the repo market  
  - Not implemented: No further action undertaken, but not a major issue as repo market is very limited.

### C. Strengthening microfinance — Key recommendations and current status
- Limit public action to providing an appropriate regulatory framework  
  - Partially Implemented: Ley de Bancos Cooperativos and Sociedades de Ahorro y Crédito enacted. Some direct public action in microfinance remains via government funds (e.g., FOSOFAMILIA).
- Adjust capital requirements to systemic risk factors  
  - Partially Implemented: the above law establishes minimum capital requirements for different categories of microfinance institutions. No requirements exist for unregulated microfinance institutions.
- Regulate comprehensively the purchasing and financing of loan portfolios  
  - Partially Implemented: Regulations exist that have facilitated bond issuances by microfinance providers.
- Incorporate an explicit insurance component in BMI second-floor lending  
  - Not Implemented: As the domestic presence of international banks increased, BMI lost its role as a second floor liquidity provider as BMI's cost of funds is higher than the foreign-owned banks.

### D. Enhancing the insolvency and creditor rights system — Key recommendations and current status
- Draft and enact unified insolvency law and liquidation proceedings  
  - Partially Implemented: The law was drafted but it was not enacted. The discussions on the Insolvency Law were on hold for some time, but re-started under the current government. However, there is no concrete time frame for voting on the law.
- Reform procedural legislation for efficient enforcement proceedings  
  - Not Implemented: There is an on-going debate on laws and reforms that would contribute to efficient enforcement proceedings (Ley de Garantías, Ley de Insolvencia).
- Complete reform of real estate registry system  
  - Partially Implemented: The Central Nacional de Registros (CNR) (with support from the WB) completed the first reform phase, creating a centralized electronic registration of all properties in 6 departments. The CNR is currently starting to implement the second phase of the reform. This phase is expected to complete the registration of all properties in the remaining 8 departments.
- Create and implement a single registry for securities on movable assets  
  - Implemented: The CNR manages collateral registries for both movable and immovable assets.
- Build institutional capacity and modernize commercial courts  
  - Not Implemented: Despite the significant administrative reforms on the justice system, commercial courts still face the same constrains. Lack of adequate institutional capacity prevents efficiency gains, particularly in an environment of increasing demand for commercial courts (disputes increased from 60 per months in 2009 to more than 110 per month in 2010).
- Create an enabling environment for voluntary out-of-court workouts  
  - Partially Implemented: A Consejo de Mediación y Arbitraje was created in Cámara de Comercio e Industria. However, the number of out-of court workouts is still small.

### E. Improving the supervisory framework — Key recommendations and current status
- Assess expertise, background, training, and compensation of SSF staff  
  - Partially Implemented: Periodic compensation and skills assessments are done.
- Carry out an in-depth review of current and expected operational work load of SSF  
  - Partially Implemented: The SSF makes use of annual inspection plans.
- Train examiners to assess credit, fiduciary, and operational risks  
  - Implemented: SSF staff is sent to specialized training.
- Adopt procedures to review and evaluate the business of financial conglomerates  
  - Not Implemented: No new regulation, nor special procedures established for financial conglomerates.
- Combine qualitative with quantitative analysis to better assess risk and motivate prompt corrective action  
  - Partially Implemented: Greater use of qualitative judgment is required.
- Organize dedicated teams of examiners for conglomerates  
  - Not Implemented.

### F. Strengthening risk management by financial institutions — Key recommendations and current status
- Regulate non-dollar foreign exchange risk and interest rate risk (BCP 12)  
  - Not Implemented: no new regulation issued on foreign exchange and interest rate risks.
- Provide guidance on systems to identify, measure, monitor, and control risks (BCP 13)  
  - Not Implemented: no new regulation issued specifying corporate governance.
- Fully implement Article 63 of the banking law on governance, risk management and controls, and provide best practice standards  
  - Not Implemented: no new regulation issued.

### G. Developing early warning systems and conducting stress tests — Key recommendations and current status
- Conduct regular stress tests on bank asset quality and liquidity  
  - Partially Implemented: The safety net providers (BCR, SSF and IGD) have each made laudable progress in analyzing banking risks, and an interagency risk committee has been established. Even so, the current stress test methodology is not fully in line with best practices, and activities are not well coordinated across the safety net providers. The newly-formed committee should therefore focus on unifying and upgrading the approach with a view to conducting stress tests regularly.
- Collect and analyze data on size and concentration of deposits and on maturity ladders of assets and liabilities  
  - Partially Implemented: Data on size, concentration and maturity of deposits are still not available.

### H. Developing the money market and strengthening the payments system — Key recommendations and current status
- Introduce an RTGS system  
  - Implemented: BCR started operating an RTGS system in February 2010.
- Strengthen unwinding procedures  
  - N/A: The implementation of the RTGS system avoids the need for unwinding procedures.
- Implement full dematerialization of securities in CEDEVAL  
  - Partially Implemented: Most securities have been dematerialized, but the majority of the securities of bank conglomerates are still in physical form.
- Establish a “National Payments Council”  
  - Not Implemented: Not established.

### I. Insurance supervision and state-owned banks — Key recommendations and current status
- Strengthen supervision of insurance companies and reduce duplication of efforts  
  - Partially Implemented: SSF launched a new qualification system (CARAMEL) to assess solvency, assets and liabilities, reinsurance, profitability and admin costs of insurance companies. On-site visits with risk personnel and coordinated visits for conglomerates are under way. The SSF is still developing risk-based mechanisms to move beyond accounting rules.
- Restructure and privatize state-owned banks  
  - Partially Implemented: none of the state-owned banks have been privatized or divested. On the other hand, they have been restructured and cost-to-income ratios have declined.

---

### Appendix II. El Salvador: Risk Assessment Matrix — Main threats, likelihood, and expected impact

- Overall Level of Concern: (matrix entries summarized below)

1) Absent strong fiscal measures, public debt levels are highly sensitive to interest rate and growth shocks; failure to pass a fiscal pact could cause concerns about sustainability and rollover of market debt.  
  - Likelihood of Severe Realization (in the next 2 years): LOW to MEDIUM  
  - Key evidence and metrics:  
    - In 2009, sovereign spreads increased by 100 bps relative to regional average and the sovereign rating was downgraded 1-2 notches below investment grade due to uncertainty about government policies. However, El Salvador was able to successfully place an $800 billion Eurobond.  
    - Two of three international credit rating agencies have a negative outlook for the sovereign credit rating (BB/Ba1).  
    - Gross financing needs (7 and 8 percent of GDP in 2010 and 2011) include refinancing a $600 million Eurobond (2 percent of GDP) in the second half of 2011.  
    - Net financing of 1½ percent of GDP per year is automatically generated by private pension funds. In addition, banks hold excess reserves (about 1 percent of GDP).  
  - Expected Impact on Financial Stability if Realized: MEDIUM to HIGH  
    - Stress tests show most banks resilient to an interest rate shock of 3.0 percentage points (double the 99th percentile change) over 6 months.  
    - The system could absorb increased government reliance on domestic funding given net financing needs and excess liquidity, but concerns about sustainability could lower investment, credit and growth, increasing NPLs and reducing profitability.  
    - Deposit withdrawals and capital flight could occur, and without SBA funds to provide liquidity, banks could run down liquid assets, potentially leading to bank(s) failure.

2) A double dip recession in the United States causes a sharp decline in Salvadoran economic activity.  
  - Likelihood: LOW to MEDIUM  
  - Key evidence and metrics:  
    - Half of exports are destined to the United States; a third go to other Central American markets.  
    - Workers’ remittances are 16 percent of GDP.  
  - Expected Impact: MEDIUM  
    - Bank profitability already hit by current recession; some banks still have negative profits, although CAR remains relatively high.  
    - Extreme scenario stress tests: three banks could fall below 10 percent CAR; only one small bank would be critically undercapitalized.  
    - If the SBA goes off track, sovereign downgrade and reduced external financing could further harm banks.

3) Uncertainty about government policies or natural disaster causes a significant decline in confidence and deposit withdrawals.  
  - Likelihood: LOW to MEDIUM  
  - Key evidence and metrics:  
    - Policies to date, including the 3-year SBA, support macro stability, but recent legislative proposals and executive decrees have increased concerns about legal security and independence of key institutions.  
    - Pre-election uncertainty in 2009 led to some deposit outflows (less than 3 percent in the 3 weeks leading up to the election).  
  - Expected Impact: LOW to MEDIUM  
    - Banks have high levels of liquidity (around 40 percent of deposits) and historically outflows have been less than 30 percent of deposits.  
    - Nonetheless, outflows could raise interest rates, reduce credit, increase NPLs, and decrease profitability.

4) Natural disaster causes a significant increase in public debt, reduced growth and a decline in confidence.  
  - Likelihood: LOW to MEDIUM  
  - Key evidence and metrics:  
    - Historically natural disasters have cost the government 3 percent of GDP on average; the last major event (earthquakes in 2001) caused damage estimated at around 12 percent of GDP with fiscal costs of around 7 percent of GDP.  
  - Expected Impact: LOW to MEDIUM  
    - Systemic liquidity could initially decline but may be offset by increased transfers and IFI disaster-related lending; stress tests show only one small bank may fall below the required 12 percent CAR if growth stagnates.

5) Failure of a systemically important bank.  
  - Likelihood: LOW  
  - Key evidence and metrics:  
    - Stress tests indicate no large banks would become severely undercapitalized in large macro or sectoral shocks; liquid assets appear sufficient to withstand large deposit outflows.  
  - Expected Impact: HIGH  
    - Direct impact may be low due to limited interbank exposure, but deficiencies in the resolution framework could increase resolution costs.  
    - Deposit insurance fund reserves are around 1 percent of total deposits and lack resources to resolve a large bank.  
    - BCR lending to IGD is limited by relatively low excess reserves; government fiscal constraints reduce credibility of blanket guarantees.

### Annex: Basel Core Principles assessment — introductory notes
- Assessment conducted as part of the FSAP update evaluation of the El Salvador financial system from April 22 – May 10, 2010.  
- Supervisory framework assessed against the BCP methodology issued in October 2006.  
- Assessment team: Mr. Miquel Dijkman (World Bank) and Socorro Heysen (consultant for the IMF).

*Appendix I. El Salvador: Implementation of the 2004 FSAP Recommendations — source PDF content.*

### 2.      The authorities provided the assessment team with key documentation, including a self-

### _cr1444 - 2.      The authorities provided the assessment team with key documentation, including a self-

### Assessment process and methodology
- The authorities provided: a self-assessment of compliance with the 25 Basel Core Principles, the legal and regulatory framework for banking supervision, off-site monitoring reports and various other reporting schedules submitted by the banks.
- Extensive discussions held with supervisory staff of the Superintendencia del Sistema Financiero (SSF).
- Meetings held with representatives from the Banco Central de Reserva (BCR), a number of external auditors, and private bankers.
- As part of the assessment of home-host relationships, a telephone interview was held with two home supervisors of major Salvadoran banks.
- Compliance assessment approach:
  - Qualitative basis using a four-part assessment system: compliant; largely compliant; materially non-compliant; and non-compliant.
  - Ratings are not comparable to the 2000 FSAP due to a higher effectiveness bar and new/redefined criteria.

### Institutional and macroeconomic setting and market structure—overview
- Banking sector composition (SSF supervised “scheduled banks”):
  - 9 private banks, 2 state banks, 2 foreign branches, 2 savings and loan associations and 6 cooperative banks.
- Bank ownership changes:
  - All private domestic banks have been bought by international or regional banks (e.g., Citibank Cuscatlán, HSBC Banistmo, Scotia, Bancolombia Agrícola, and BAC).
  - At end-2005 the four largest groups (HSBC, Citibank, UNO and Bancolombia) represented 31 percent of the financial company assets in the region.
- Size and market shares:
  - As of end-2009, banks’ assets amounted to over US$ 13 billion, equivalent to about 64 percent of total financial assets, compared to US$ 11 billion or 74 percent in 2004.
  - Private pension funds expanded from US$ 2.2 billion to US$ 5.2 billion (14.7 percent to 25.2 percent of financial assets).
- Credit composition trends:
  - Consumption and mortgage credit have increased at the expense of corporate loans; credit to firms has dropped continuously.
- Banking sector soundness indicators (post-global financial crisis):
  - Capital adequacy levels slightly increased and currently averages nearly 17 percent.
  - Non-performing loans (NPL) amount to 3.8 percent of total loans, up from about 2 percent before the crisis.
  - Specific provisions currently cover some 110 percent of total NPLs (NPLs defined as loans more than 90 days overdue).
  - Return on assets fell from 1.2 percent in 2007 to 0.4 percent in early 2010.
- Supervisory organization and cross-border cooperation:
  - SSF reorganized in 2008 with a Dirección de Riesgos staffed by risk specialists.
  - SSF signed Memoranda of Understanding with all home supervisors.
  - Comité de Enlace of Central American supervisors (CECAS) holds quarterly meetings and monthly teleconferences.

### Legislative and enforcement developments
- Draft Law (Ley de Supervisión y Regulación del Sistema Financiero) under discussion in the Asamblea:
  - Aims to separate powers of regulation, supervision and sanctioning by: (i) transferring the right to issue regulation from the Superintendency of Banks (SSF) to the central bank (BCR); (ii) merging the superintendencies of banks, securities firms, and pension funds into a sole supervisory authority; and (iii) establishing an independent sanctions committee.
- Enforcement and legal constraints:
  - Lack of legal protection for supervisors; litigation can and does occur.
  - Gaps in regulatory framework in areas: corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate in the banking book, information technology and investment valuation and derivatives.
  - Remedial action framework limitations: no explicit powers to limit distribution of dividends, constrain existing or new operations and acquisitions, or enforce the sale of assets.

### Human resources and supervisory capacity
- SSF faces human resource constraints; supervisory capacity appears stretched.
- New tasks, notably consumer protection, have been added to supervisors’ responsibilities.
- Recommendation: priority should be given to upgrading supervisory capacity, both quantitatively and qualitatively.

### Preconditions for effective bank supervision
- Exchange rate and external links:
  - Full dollarization since 2001; tight links to the United States.
  - Merchandise exports to the United States amount to 12 percent of GDP, over half of total shipments.
  - Remittances receipts were over 17 percent of GDP from 2003-2007 and come mainly from the United States.
- Growth and inflation:
  - Real GDP growth averaged 3.6 percent from 2005-2008 (compared to 2.1 percent from 2001-2004).
  - Inflation has averaged about 4 percent, anchored by dollarization.
- 2009 economic impact:
  - Real GDP declined by 3.5 percent in 2009, after growing by 2.4 percent in 2008.
- Accounting, audit and public infrastructure:
  - More than 4000 chartered accountant individuals and firms operate in El Salvador, including representatives of the five large international firms.
  - Accounting and Auditing Oversight Board (CVCA) oversees the accounting profession.
  - Transition to IFRS initiated in 2004 but still in progress.
  - Starting on 2011, all listed companies (except those in the financial sector) required to issue financial statements using IFRS; all unlisted companies will use IFRS for small and medium entities.
  - CVCA has limited resources and little oversight regarding compliance.
- Credit information and collateral:
  - SSF Central de Riesgo collects credit information provided by supervised institutions only; private companies collect credit information for debt provided by unsupervised institutions.
  - Functioning central registry records liens on collateral; multiple mortgage loans on a single asset can occur if total mortgages do not exceed asset value.
  - Periodic real estate valuations are mandatory and conducted by certified specialists.
- Efficiency and sector dynamism:
  - Salvadoran banking shows dynamism with ownership changes and new entrants.
  - Salvadorian banks present the lowest administrative costs in Central America.
- Deposit insurance fund (IGD):
  - Created in 1999; currently covers deposits of up to $9,000 at 12 commercial banks and, as of 2010, at 6 cooperative banks and 2 savings and loan associations.
  - IGD funded by a loan from the BCR (currently $13 million) and premiums equivalent to an annual rate of 0.10 percent of deposits paid quarterly by member banks.
  - IGD’s current reserve fund from BCR and bank contributions is US$96 million or 1.1% of total deposits — enough to finance the resolution of each of the 7 smallest banks and one saving and credit institution individually.
  - Exception: IGD does not insure BFA deposits as the BFA is government owned.
- Systemic liquidity arrangements:
  - High liquidity ratios exist but interbank market is lacking.
  - BCR is by law prohibited to lend to the banking sector; lender of last resort function limited to repurchase of its own or government securities (government securities repurchase only if government funds have been deposited expressly for this purpose) or purchase of securities or loans.
  - BCR preparing to enhance ability to provide systemic liquidity.

### Main findings (summary)
- Since the 2004 FSAP SSF initiatives include creation of a risk unit and enhanced cross-border cooperation.
- Major impediment: lack of regulation in practically all risk categories.
- Combination of lack of standards, legal protection shortfalls, and deficiencies in remedial action framework limits SSF’s ability to address imprudent bank behavior.
- Transition to risk-based supervision is incomplete; supervisory procedures remain primarily compliance-based, focusing on existence of policies rather than appropriateness for bank size and activities.

### Detailed findings — Objectives, independence, powers, transparency and cooperation (CP1)
- SSF responsibilities and strengths:
  - Responsible for licensing, supervision and regulation of the banking sector via on-site inspections and off-site supervision.
  - Institutional assets include prestige, trust of the Salvadoran government, and dedicated technical staff.
- Key deficiencies:
  - Lack of regulation in corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate in the banking book, information technology and investment valuation and derivatives.
  - Lack of legal protection for supervisory staff; litigation impacts willingness to use corrective powers.
  - Remedial action toolkit lacks preventive powers (dividend limits, operational constraints, forced asset sales).
- Resource constraints:
  - Supervisory resources stretched; consumer protection responsibilities add workload.
  - Recommendation: prioritize upgrading supervisory capacity quantitatively and qualitatively.

### Detailed findings — Licensing and structure (CPs 2-5)
- Legal definitions and supervision:
  - ‘Bank’ defined in law; cooperative banks authorized by SSF to accept deposits and automatically regulated and supervised by SSF as established in the Law on Cooperative Banks.
  - Cooperatives with assets exceeding US$ 68.57 million are subject to mandatory supervision.
  - Many cooperatives attract deposits under the description “member contributions” and are below the US$ 68.57 million threshold; effective supervision and oversight of this segment is lacking.
- Entry and fit-and-proper:
  - SSF must authorize public call to buy shares before starting a bank; founders then request authorization to set up a corporation.
  - Main criteria: fit and proper test of shareholders representing more than 1 percent ownership and assessment of submitted financial projections and business plans.
  - Current Bank Law does not explicitly allow SSF to revoke a license if it was based on false information.
  - Lack of corporate governance regulation means no clear norms for startup banks in governance.
- Ownership transfers and beneficial ownership:
  - SSF applies thresholds of 1 and 10 percent for prior authorization; fit and proper tests apply.
  - SSF noted it did not always manage to identify ultimate beneficial owners; relies on home supervisors for banks with sizable operations in El Salvador.
  - Shareholders in 1–10 percent bracket who are no longer fit should be prevented from exercising shareholder rights as for shareholders owning more than 10 percent.
  - Recommendation: require proactive notification by shareholders of events affecting suitability, in addition to annual sworn declarations.
- Acquisitions and investments:
  - SSF can review major acquisitions or investments; invested amount may not exceed 50 percent of the equity fund or 10 percent of the loan portfolio, whichever is greater.
  - Scope to enhance legal criteria used by SSF to assess acquisitions/investments, including explicit risk assessment and checks on whether proposed investments impede effective supervision.

### Detailed findings — Prudential regulation and requirements (CPs 6-18)
- Capital adequacy and regulatory alignment:
  - Statutory required capital adequacy level is 12 percent, higher than other Central American countries.
  - Capital adequacy framework not fully in line with international standards.
  - Statutory minimum must be seen against a liberal treatment of intangible assets (mostly goodwill), which are not subtracted from capital as required under Basel I.
  - Risk weights currently provide little differentiation for the risk profile of the asset base.

*Source: _cr1444 - 2.      The authorities provided the assessment team with key documentation, including a self-*

### 32.      A tightening of the asset classification and provisioning rules has contributed to an

### _cr1444 - 32.      A tightening of the asset classification and provisioning rules has contributed to an

### Problem assets, provisioning, and asset classification (paras 32–33, CP 9)
- A tightening of the asset classification and provisioning rules has contributed to an improvement in the management of problem assets.
- Provisioning levels are now broadly in line with international practices.
- The SSF monitors banks’ delinquent loan portfolio intensively.
- The SSF currently lacks the authority to oblige banks to raise provisioning levels over and above the levels that are required according to regulation.
- Specific gaps and supervisory concerns:
  - Banks are required to downgrade corporate loans on the basis of past-due days, with an obligation to further downgrades if the repayment capacity of the debtor so warrants; this obligation only applies to corporate debtors, i.e. not to consumer or mortgage loans.
  - When debtors with multiple loans with various banks default on one loan, but stay current on others, the non-affected loans are not automatically downgraded at all banks.
  - The practice of granting several mortgages on the basis of one underlying asset warrants monitoring.
- Recommended priority action (CP 9):
  - The SSF should be given authority to oblige banks to raise provisions over and above the levels that are required according to regulation.
  - Consider extending mandatory periodic reassessment of debtors’ repayment capacity (currently only for corporate credit) to consumer and mortgage sector credit (requires regulatory changes).
  - In cases where a debtor with multiple debts is delinquent on one loan, all other loans (including ones at non-affected banks) should receive similar classification and provisioning treatment as the delinquent one.

### Regulatory gaps and corporate governance (paras 33, Annex CPs 7, 14, 15, 16, 17)
- Important gaps exist in the regulatory framework; considerable regulation is under development but slow to be released.
- Areas lacking regulation include: corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate in the banking book, information technology and investment valuation and derivatives.
- Supervisory practices in these areas have improved and reputable foreign banks have raised risk management standards, but the lack of standards limits the SSF’s ability to coerce compliance.
- Urgent need for SSF to issue standards on key risk categories, most urgent for credit risk, liquidity risk and corporate governance.
- Key regulatory content to specify: responsibilities of banks’ directors regarding oversight of management and the internal controls system relative to risks and complexity of operations.
- The upcoming overhaul transferring authority to issue regulation to the BCR must not delay issuance; BCR should build on SSF draft regulations under development.
- Recommended actions from Annex:
  - CP 7 Risk Management Process: As a matter of priority, issue the appropriate regulation.
  - CP 13 Market risks: Issue a regulation on market risks.
  - CP 14 Liquidity risk: Issue a regulation on liquidity risks, including requirements on concentration controls, stress testing and contingency plans.
  - CP 15 Operational risk: Issue a regulation on operational risks and a specific norm on information technology risks; increase staff of the operational risk unit.
  - CP 16 Interest rate risk in the banking book: Issue a regulation including reports required for off-site supervision follow up.
  - CP 17 Internal control and audit: Issue a corporate governance regulation establishing clear Board responsibilities regarding adequacy of the internal control system.

### Methods of ongoing supervision and transition to risk-based supervision (paras 34–36, CPs 19–21)
- The transition towards risk based supervision needs enhancement by upgrading supervisory techniques and practices.
- The SSF currently uses CAMELS models to generate bank-specific risk profiles and assesses effectiveness of risk mitigants to determine residual risk.
- Need to bring in more qualitative judgment to assess quality of risk management beyond checking existence of procedures and policies.
- Supervisory assessment of adequacy of risk management should consider bank characteristics such as size, complexity and risk appetite.
- Human capacity constraints and organizational issues:
  - Offsite responsibilities are split over two divisions (Risks and Analysis); role and responsibilities of offsite supervision are not well-specified.
  - Individual supervisory staff often have multiple roles, notably in the Risk Division where unit leaders are responsible for a specific risk for all banks and are designated “relationship managers” for a financial conglomerate.
  - Supervisory Department is resource-constrained; increased consumer protection responsibilities have been assigned to this department, diverting resources from prudential supervision.
- Recommended actions:
  - Give priority to further upgrading supervisory capacity, both in quantitative and qualitative terms.
  - CP 19 Supervisory approach: Enhance qualitative assessments of banks’ risk management practices; focus on adequacy of policies given risk characteristics; broaden scope of the financial system report to include unsupervised entities (cooperatives); appoint dedicated relationship managers responsible for overall supervision of each bank.
  - CP 20 Supervisory techniques: Provide specialized training on supervision of risks and risk management.
  - CP 21 Supervisory reporting: Include in draft SSF law a requirement that the Board and managers report to the SSF all events that are material.

### Accounting, disclosure, and reporting (para 37, CP 22)
- The SSF receives a fairly comprehensive set of information on banks and banking groups, except for relevant data on market and interest rate risks.
- The accounting manual used as the basis for reports and audited financials is prudent but outdated and does not conform to international standards.
- Differences from international accounting standards exist in calculation of loan loss provisions, valuation of investments, deferred taxes and the extent to which risks and other material issues are revealed.
- Recommended action (CP 22):
  - Revise the accounting manual to improve disclosure of risks and introduce rules on derivatives and investments.

### Corrective and remedial powers, legal protection, and sanctions (paras 38–39, Annex CP 1.4, CP 1.5, CP 23)
- The remedial action framework includes only limited powers for the SSF to take preventive action at an early stage before inadequate practices lead to undercapitalization.
- Toolkit does not include powers to limit distribution of dividends, constrain existing or new operations and acquisitions, or enforce sale of assets—measures needed for early improvements in management and to penalize minor transgressions before regularization.
- Lack of legal protection for supervisory staff; litigation can and does occur, distracting resources and impacting willingness to use corrective powers.
- The SSF has not issued regulation on sanctions to define severity of violations and scale of sanctions; absence reduces transparency of sanctioning process for supervised entities and individuals.
- Recommended actions:
  - CP 1.4 Legal powers: Further refine remedial action framework to enhance SSF’s powers to act at an early (preventive) stage.
  - CP 1.5 Legal protection: Provide SSF staff with legal protection for actions undertaken in good faith; use upcoming overhaul as window to address.
  - CP 23 Corrective and remedial powers: Include in draft SSF law a broader range of preventive measures prior to regularization (restrictions on distribution of dividends, bonuses, new acquisitions, sales of assets or specific operations); issue a regulation on sanctions to typify severity and scale of sanctions.

### Consolidated and cross-border supervision (para 40, CP 24)
- SSF has stepped up cross-border cooperation bilaterally and regionally, signing Memoranda of Understanding with all home supervisors to cover exchange of information for ongoing supervision.
- Comité de Enlace of Central American supervisors (CECAS) has increased regional coordination with quarterly meetings and monthly teleconferences to present relevant information, risks and concerns.
- Some progress made in coordination with local supervisors of entities belonging to conglomerates to gather information and conduct simultaneous onsite exams.
- Additional efforts needed to establish a comprehensive framework to assess risks that non-banking local activities conducted by a bank or banking group may pose to the bank or banking group.
- Recommended action (CP 24):
  - Establish a comprehensive framework to assess the risks from non-banking local activities conducted by a bank or banking group.

### Recommended action plan and authorities’ response (paras 41–44, Annex summary)
- Immediate-term recommendations (para 41):
  - Use the window of opportunity in revision of the SSF Law to consider necessary amendments not included in current drafts:
    - Legal protection for bank supervisors.
    - Wider supervisory powers before the regularization stage (i.e. restrict distribution of dividends and acquisitions or activities).
    - Broaden the requirement that the Board reports on aspects that could affect the stability of the bank to include other material aspects and events that could affect the bank, short of threatening insolvency or illiquidity.
- Short-term recommendation (para 42):
  - Expedite regulatory process to issue important drafts necessary to enable enforcement of necessary supervisory actions.
- Annex Table 1 presents specific recommendations mapped to Basel Core Principles across CP 1.1–CP 24 (high-level highlights captured above).
- Authorities’ response (para 44):
  - The SSF agreed with the assessment.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1444.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1444.pdf_