## _spn0919 - EXECUTIVE SUMMARY

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### Regional resilience and reform context
- Findings:
  - The Latin America and Caribbean (LAC) region "has weathered the global financial crisis reasonably well so far," though "tighter global financial conditions began to take their toll on trade, capital flows and economic growth in late 2008."
  - Resilience reflects reforms over the past decade to "strengthen financial supervision and adopt sound macroeconomic policies."
  - Current reform agenda aims to "improve compliance with the Basel Core Principles of Banking Supervision and to broaden and deepen domestic financial markets."
  - The global debate led by the Financial Stability Board (FSB) and the G20, with IMF participation, is shaping the region’s agenda; ministers are advised to "begin thinking" about these issues early to build political consensus and plan for possible resource needs.
- Key statistics:
  - Capital adequacy ratios for banks are "close to 15 percent on average" throughout the region, with Caribbean banks having a slightly larger cushion.
  - Nonperforming loans "have been falling over the last few years, although these rose somewhat in a number of countries during 2008."
  - Credit is funded largely through domestic deposits and other domestic sources; external sources play a much smaller role than in regions such as Central and Eastern Europe.
  - The region had "low direct exposure to subprime-related structured credit products" and "limited role that structured financial products have played in the region’s financial activity."
  - Countries moving toward Basel II include "Brazil, Mexico, Chile, Colombia, Panama, and Peru."
  - International banks account for "more than 40 percent of total banking system deposits in a number of countries."
  - Mortgage market features in Canada (Box 1): "Only 5 percent of mortgages are non-prime." "25 percent of mortgages are securitized." Leverage ratio limited to 5 percent of total assets.

### Key priorities and issues to consider
- Enumerated priorities:
  - Expand the perimeter of regulation by re-evaluating what is considered a systemic institution.
  - Improve consolidated supervision (cross-functional and cross-border).
  - Reduce the procyclicality of prudential regulations.
  - Improve public disclosure of information.
  - Give greater flexibility to central banks in responding to financial stability concerns.

### I. Expand the perimeter of regulation
- Background findings:
  - Consensus that strong regulation should apply to any financial institution, not just banks, that can threaten the financial system.
  - A systemic institution definition would generally include: any large financial institution (including off-balance-sheet items), institutions that play a key role in financial infrastructure, or those with high leverage; possibly also groups of small institutions that are collectively systemic.
  - LAC systems are often bank-centered with fairly broad regulatory perimeters, but "there is the potential for systemic risk from many non-bank financial institutions, including insurance companies, financial conglomerates, cooperatives, investment and mutual funds and retail chains (such as supermarkets) that issue credit cards."
- Policy options:
  - Improve methodologies for assessing systemic risks across all types of financial institutions.
  - Subject systemic institutions, which may include non-banks, to additional prudential requirements on capital adequacy, leverage and liquidity.
  - Set up a single regulator responsible for supervising systemic risk (or a systemic risk authority working with existing regulators).
  - Continue oversight of non-systemic institutions with micro-prudential supervision for non-systemic banks and lighter regulation plus minimum information disclosure for other institutions.
  - Hedge funds above some minimum size should be subject to registration and disclosure requirements (as recommended by the April 2009 G20 declaration).

### II. Make consolidated supervision more effective
- Background findings:
  - Supervisors in advanced countries lacked information and capacity to see cross-functional and cross-border links, especially for large complex financial institutions.
  - In LAC, legal frameworks for consolidated supervision have been strengthened but suffer two shortcomings:
    - The scope often does not allow monitoring of all institutions within a financial conglomerate, contributing to difficulties with offshore operations.
    - Supervisors often lack uniform enforcement powers and the ability to require prompt corrective action across all affiliates.
  - Cross-border supervision matters where international banks have a significant presence, "accounting for more than 40 percent of total banking system deposits in a number of countries."
- Policy recommendations:
  - Strengthen legal frameworks for consolidated cross-functional supervision by applying prudential requirements to all parts of a financial group and mandating the exchange of information among supervisors.
  - Set up institutional mechanisms to build closer cooperation among supervisors (MOUs, regular technical meetings, minister- or central-bank-led coordination).
  - Create more effective cross-border supervision of global banks by forming regulatory colleges composed of supervisors in countries where the banks operate to enable full information sharing, harmonization of norms and clear assignment of responsibilities.
  - Consider establishing a lead supervisor in countries with multiple supervisors and require joint inspections.
  - Harmonize deposit insurance, resolution procedures and safety nets across jurisdictions to ease crisis management.

### III. Reduce the procyclicality of prudential regulations
- Background findings:
  - Procyclicality sources include: Pillar 1 of Basel II (risk-weighted assets reliant on recent history and ratings), backward-looking loan loss provisioning, and fair value accounting (FVA) that forces mark-to-market losses in illiquid periods.
  - LAC regulatory features that can be procyclical: backward-looking loan loss provisions, collateral-based lending, use of FVA in several countries.
  - Basel I versus Basel II: Basel I uses fixed risk weights; several countries in the region are moving toward Basel II (Brazil, Mexico, Chile, Colombia, Peru, Panama).
  - FVA is used in Brazil, Mexico, Colombia, Peru, Costa Rica, Bolivia and Jamaica.
- Policy options:
  - Make capital adequacy requirements countercyclical by defining two CAR levels: a publicly disclosed minimum enforced at all times and an extra capital cushion to be raised during strong growth and reduced during downturns, with CAR remaining above the minimum of 8 percent throughout the cycle.
  - Introduce dynamic/forward-looking provisioning requirements (examples: Spain, Bolivia, Colombia, Peru, Uruguay).
  - Retain FVA for traded assets but introduce buffers or limited flexibility to value illiquid assets (allow judgmental methods for level 2 and level 3 assets; build valuation reserves; value assets at average prices over some period or use lower of current and average price).
  - Consider contingent capital instruments (debt that converts into equity under specified conditions).

### Box 4 — Forward Looking Provisioning in the LAC Region (highlights)
- Design overview and examples:
  - Spain: statistical provision based on internal models or regulator rates between 0–1.5 percent; statistical provisions equal the difference between estimated underlying risk over the cycle and specific provisions.
  - Bolivia: October 2008 rule requires provisions ranging from 1.5 to 5.5 percent of outstanding loans, in addition to specific provisions; use limited to 50 percent of required specific provisions in a downturn and subject to three usage conditions.
  - Colombia: from mid-2007/mid-2008 introduced countercyclical components based on default probabilities for an adverse scenario; supervisor determines cycle phase at its discretion.
  - Peru: November 2008 mandatory countercyclical provisions with rates between 0.4–1.0 percent; supervisor determines cycle phase using GDP growth thresholds.
  - Uruguay: dynamic provisions from September 2001 requiring provisions ranging from 0.1 to 1.8 percent until dynamic provisions reach 3 percent of total loans.
- Findings and implications:
  - Forward-looking provisioning schemes provide a mechanism to reduce earnings volatility and create buffers for downturns.
  - Explicit rate ranges and phased rules vary by country (0–1.5 percent in Spain; 1.5 to 5.5 percent in Bolivia; 0.4–1.0 percent in Peru; 0.1 to 1.8 percent up to 3 percent of total loans in Uruguay).
  - Effectiveness in curbing credit growth is uncertain (Spain experienced sharp credit growth from 1999 to 2007), but the buildup of provisions has provided significant cushions during the global crisis.
  - Design features facilitating controlled release include explicit usage limits (e.g., Bolivia) and supervisor-determined cycle phase (e.g., Colombia, Peru).

### IV. Improve public disclosure of information
- Background findings:
  - Supervisors and the public need much more detailed information on exposures and linkages across borders and markets; the crisis revealed gaps in financial data disclosure.
  - In most of the region, balance sheets and financial statements of banks and private pension funds are publicly available, typically on a monthly or quarterly basis.
  - Most countries require little or no reporting of other financial operations: off-balance-sheet operations of banks; transactions by non-bank affiliates of financial conglomerates; activities of lightly regulated non-banks.
  - Policymakers typically lack information on prices of residential and commercial real estate and other non-financial assets and household indebtedness.
- Policy options:
  - Develop much better information on linkages between macroeconomic developments and the financial sector.
  - Strengthen public disclosure practices of systemic financial institutions.
  - Revamp and broaden the coverage of financial soundness indicators.
  - For Basel II adopters, require disclosure of risk management practices and models used to value risk.
  - Improve transparency in OTC derivatives markets (supervisors in Chile, Colombia and Mexico could improve OTC derivatives market transparency and require exchange trading of derivatives).

### V. Greater flexibility for central banks
- Background findings:
  - Many central banks, including several in LAC, have injected liquidity to prevent a complete seizure in financial markets, "often innovating to overcome institutional limitations."
  - Debate exists on whether central banks should broaden mandates to safeguard financial stability in addition to maintaining low inflation.
  - Under a broader mandate, central banks would try to arrest excessive credit expansion and sharp runups in asset prices.
- Policy guidance:
  - Central banks in the region should continue to work within existing institutional frameworks to limit the risk to credibility from exceptional liquidity support.
  - The task of halting bubbles in credit or asset prices is suggested to be best left to the financial supervisor.

### Box 1 — Relative Financial Calm in Canada (selected points)
- Prudential framework and strengths:
  - Canada’s minimum capital requirements are tougher than called for by Basel II, and all other G-7 bank regulators.
  - Leverage ratio is limited to 5 percent of total assets.
  - Tier 1 and 2 Capital Requirements as a Percent of Risk-Weighted Assets:
    - Tier 1 Capital: Basel II 4; Canada 7; U.S.A. 4; France 4; Germany 4; Italy 4; Japan* 4/2; U.K. 4
    - Total Capital: Basel II 8; Canada 10; U.S.A. 8; France 8; Germany 8; Italy 8; Japan* 8/4; U.K. 8
    - *Higher (lower) requirements apply to internationally active (domestically-oriented) banks.
- Mortgage market indicators:
  - "Only 5 percent of mortgages are non-prime."
  - "25 percent of mortgages are securitized."
  - "Almost half of residential loans are guaranteed."
  - Remaining residential loans have a loan-to-value ratio below 80 percent.
- Policy response highlights:
  - Authorities expanded liquidity facilities, provided liability guarantees, purchased government-insured mortgage portfolios, and stood ready to inject public capital into banks if needed.

### Concluding reform priorities and institutional considerations
- Recommended reforms (summary):
  - Broaden the regulatory perimeter and apply prudential regulations to systemic institutions, including non-banks where appropriate.
  - Resolve legal shortcomings to improve consolidated supervision and institutionalize MOUs and supervisory cooperation (including supervisory colleges).
  - Reduce regulatory procyclicality through forward-looking provisioning and countercyclical capital measures.
  - Improve disclosure and data to better link macroeconomic developments and financial vulnerabilities.
  - Central banks should limit exceptional liquidity support to existing institutional frameworks to preserve credibility; supervisors should lead in halting bubbles.
- Political and resource imperatives:
  - Strong political commitment and de facto independence for regulators are prerequisites for effective financial supervision.
  - Ensure adequate resources for regulators, with prioritization in small or low-income countries.

*Source: _spn0919 - Executive Summary (PDF), pages and contents as listed in the provided table of contents.*

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

### Executive Summary

### I. Introduction
- Section listed on page 8.

### II. Broadening the Regulatory Perimeter
- Section listed on page 12.
- Related Box: 1. Relative Financial Calm in Canada (page reference within Boxes list).
- Related Table: 1. Regulatory Perimeter in Selected Latin American and Caribbean Countries (listed under Tables).
- Related Figures: 2. Compliance with Basel Core Principles (listed under Figures).

### III. Improving Consolidated Supervision
- Section listed on page 24.
- Related Boxes:
  - 2. Brazil—Regulations to Strengthen Consolidated Supervision
  - 3. Adapting to a New Regulatory Environment—The Role of Foreign Banks?
- Related Table: 2. Financial Sector Overview, 2008 (listed under Tables).

### IV. Reducing Procyclicality in Financial Systems
- Section listed on page 29.
- Related Box: 4. Forward Looking Provisioning in the LAC Region (listed under Boxes).

### V. Improving Public Disclosure of Information
- Section listed on page 32.
- Related Figures:
  - 3. Compliance with International Organization of Securities Commissions Objectives and Principles of Securities Regulation
  - 4. Compliance with International Association of Insurance Supervisors Core Principles

### VI. Greater Flexibility for Central Banks
- Section listed on page 33.

### Concluding Remarks
- Section listed on page 37.

### References
- Section listed on page 39.

### Figures and Tables Inventory (as listed)
- Figures:
  - 1. Latin America and Caribbean: Financial Soundness Indicators, 2000-2008
  - 2. Compliance with Basel Core Principles
  - 3. Compliance with International Organization of Securities Commissions Objectives and Principles of Securities Regulation
  - 4. Compliance with International Association of Insurance Supervisors Core Principles
- Tables:
  - 1. Regulatory Perimeter in Selected Latin American and Caribbean Countries
  - 2. Financial Sector Overview, 2008
  - 3. Latin America: Monetary and Financial Sector Policy Responses to the Global Crisis

*Source: _spn0919 - Executive Summary (PDF), pages and contents as listed in the provided table of contents.*

### EXECUTIVE SUMMARY

### _spn0919 - EXECUTIVE SUMMARY

### Regional resilience and reform context
- The Latin America and Caribbean (LAC) region "has weathered the global financial crisis reasonably well so far," though "tighter global financial conditions began to take their toll on trade, capital flows and economic growth in late 2008."
- Resilience reflects reforms over the past decade to "strengthen financial supervision and adopt sound macroeconomic policies."
- Current reform agenda aims to "improve compliance with the Basel Core Principles of Banking Supervision and to broaden and deepen domestic financial markets."
- The global debate led by the Financial Stability Board (FSB) and the G20, with IMF participation, is shaping the region’s agenda; ministers are advised to "begin thinking" about these issues early to build political consensus and plan for possible resource needs.

### Key priorities and issues to consider (summary)
- Expand the perimeter of regulation by re-evaluating what is considered a systemic institution.
- Improve consolidated supervision (cross-functional and cross-border).
- Reduce the procyclicality of prudential regulations.
- Improve public disclosure of information.
- Give greater flexibility to central banks in responding to financial stability concerns.

### I. Expand the perimeter of regulation
Background findings
- There is a consensus that strong regulation should apply to any financial institution, not just banks, that can threaten the financial system.
- A systemic institution definition would generally include: any large financial institution (including off-balance-sheet items), institutions that play a key role in financial infrastructure, or those with high leverage; possibly also groups of small institutions that are collectively systemic.
- LAC systems are often bank-centered with fairly broad regulatory perimeters, but "there is the potential for systemic risk from many non-bank financial institutions, including insurance companies, financial conglomerates, cooperatives, investment and mutual funds and retail chains (such as supermarkets) that issue credit cards."
- This issue may be more pressing in countries with sizable non-bank financial institutions and domestic capital markets, but even less developed capital markets face external risks.

Policy options
- Improve methodologies for assessing systemic risks, especially across all types of financial institutions.
- Subject systemic institutions, which may include non-banks, to additional prudential requirements on capital adequacy, leverage and liquidity.
- Set up a single regulator responsible for supervising systemic risk.
- Continue oversight of non-systemic institutions; the G20 has called for tighter prudential standards on all financial institutions, and hedge funds would be subject to registration and disclosure requirements.

### II. Make consolidated supervision more effective
Background findings
- Supervisors in advanced countries lacked information and capacity to see cross-functional and cross-border links, especially for large complex financial institutions.
- In LAC, legal frameworks for consolidated supervision have been strengthened but suffer two shortcomings:
  - The scope often does not allow monitoring of all institutions within a financial conglomerate, contributing to difficulties with offshore operations.
  - Supervisors often lack uniform enforcement powers and the ability to require prompt corrective action across all affiliates.
- Cross-border supervision matters where international banks have a significant presence, "accounting for more than 40 percent of total banking system deposits in a number of countries."

Policy options
- Strengthen legal frameworks for consolidated cross-functional supervision by:
  - applying prudential requirements to all parts of a financial group, and
  - mandating the exchange of information among supervisors.
- Set up institutional mechanisms to build closer cooperation among supervisors.
- Create more effective cross-border supervision of global banks by forming regulatory colleges composed of supervisors in countries where the banks operate, enabling full information sharing, harmonization of norms and clear assignment of responsibilities.

### III. Reduce the procyclicality of prudential regulations
Background findings
- Excessive credit growth prior to the crisis and rapid deleveraging may have been exacerbated by procyclical features of regulatory frameworks (e.g., Pillar 1 of Basel II, backward-looking loan loss provisioning, fair value accounting).
- LAC regulatory systems have features that give rise to procyclicality: backward-looking loan loss provisions, collateral-based lending; capital adequacy requirements and the use of fair value accounting could also introduce procyclicality.

Policy options
- Make capital adequacy requirements countercyclical, possibly through adjustments of capital charges required by the supervisor or issuance of debt that would convert into equity under certain conditions.
- Introduce dynamic provisioning requirements, as in Spain, Bolivia, Colombia, Peru and Uruguay.
- Retain fair value accounting (marking to market), while introducing buffers or limited flexibility to value illiquid assets.

### IV. Improve public disclosure of information
Background findings
- Supervisors and the public need much more detailed information on exposures and linkages across borders and markets; the crisis revealed gaps in financial data disclosure.
- In most of the region, balance sheets and financial statements of banks and private pension funds are publicly available, typically on a monthly or quarterly basis.
- Most countries require little or no reporting of other financial operations: off-balance-sheet operations of banks; transactions by non-bank affiliates of financial conglomerates; activities of lightly regulated non-banks.
- Policymakers typically lack information on prices of residential and commercial real estate and other non-financial assets and household indebtedness—key to assessing effects of financial vulnerabilities on growth and inflation.

Policy options
- Develop much better information on the linkages between macroeconomic developments and the financial sector.
- Strengthen public disclosure practices of systemic financial institutions.
- Revamp and broaden the coverage of financial soundness indicators.
- For countries moving toward Basel II, systemic financial institutions need to disclose risk management practices and models used to value risk.
- Supervisors in Chile, Colombia and Mexico could improve OTC derivatives market transparency and require exchange trading of derivatives.

### V. Greater flexibility for central banks
Background findings
- Many central banks, including several in LAC, have injected liquidity to prevent a complete seizure in financial markets, "often innovating to overcome institutional limitations."
- There is debate on whether central banks should broaden mandates to safeguard financial stability as well as maintain low inflation.
- Under a broader mandate, central banks would try to arrest excessive credit expansion and sharp runups in asset prices.

Policy options
- Central banks in the region should continue to work within existing institutional frameworks to limit the risk to credibility from exceptional liquidity support.
- The task of halting bubbles in credit or asset prices is suggested to be best left to the financial supervisor.

### Additional key empirical points from the introduction
- Capital adequacy ratios for banks are "close to 15 percent on average" throughout the region, with Caribbean banks having a slightly larger cushion.
- Nonperforming loans "have been falling over the last few years, although these rose somewhat in a number of countries during 2008."
- Credit is funded largely through domestic deposits and other domestic sources; external sources play a much smaller role than in regions such as Central and Eastern Europe.
- The region had "low direct exposure to subprime-related structured credit products" and "limited role that structured financial products have played in the region’s financial activity."
- Countries moving toward Basel II include "Brazil, Mexico, Chile, Colombia, Panama, and Peru."
- Figures and comparisons reported include:
  - International banks account for "more than 40 percent of total banking system deposits in a number of countries."
  - The document includes financial soundness indicator charts and compliance metrics with the Basel Core Principles.

*Source: _spn0919 - EXECUTIVE SUMMARY*

### Section III improving consolidated supervision, Section IV reducing procyclicality, Section

### Section III improving consolidated supervision, Section IV reducing procyclicality, Section V strengthening public disclosure of information, and Section VI greater flexibility for central banks. Section VII presents concluding remarks.

### Broadening the Regulatory Perimeter
- Recommended Reform:
  - Any financial institution, not just banks, that can threaten the financial system should come under an inner perimeter of strong regulation.
  - Non-systemic financial institutions would fall under an outer perimeter, which would entail:
    - micro-prudential supervision of non-systemic banks to protect depositors and deposit insurance funds; and
    - lighter regulation and minimum information disclosure for other institutions.
  - Institutions in the outer perimeter would have more flexibility and scope for innovation.
  - Supervisors would need to manage the perimeter flexibly to:
    - bring less regulated institutions into the inner perimeter if they become systemic; and
    - allow systemic institutions to shift to the outer perimeter if they no longer pose risks for the system.
- Rationale:
  - The previous approach centered on strong supervision of just banks and left the system overexposed to risks.
  - Market discipline, self-regulation, and some disclosure of information were previously relied on to contain risks from non-bank financial institutions such as investment banks, insurance companies, and private pools of capital (hedge and private equity funds).

### Crisis dynamics: run on non-banks and systemic spillovers
- Key findings from the U.S. and other advanced countries:
  - The crisis can be viewed as a run on non-banks—not considered systemic—that contaminated the entire financial system.
  - In the U.S., non-bank institutions:
    - took highly-leveraged positions in long-term, illiquid assets relying on funding from short-term debt markets;
    - were highly interconnected with banks;
    - were more exposed to a run on their liabilities than banks, which were protected by the financial safety net.
  - Timeline and transmission mechanisms described:
    - Early 2007: weakening U.S. housing market led many small non-bank mortgage lenders to lose access to wholesale funding and shut down.
    - Fall in the value of mortgage backed securities spilled over to structured investment vehicles (SIV) that:
      - were linked to banks through off-balance-sheet activities;
      - held instruments built from securitized mortgages and other assets; and
      - were backed by contingent credit lines from banks.
    - Contamination of the market for commercial paper backed by assets, including mortgages.
    - Banks were forced to bring SIVs onto their balance sheets and absorb the losses.
    - As the commercial paper market deteriorated, counterparty risk surged and banks curtailed lending.
    - Funding problems spread to independent broker-dealers, money-market funds, hedge funds and other institutions dependent on short-term financing.
  - Note: some advanced countries, such as Canada, avoided serious financial system dislocations, even though growth is slowing sharply (Box 1).
- Reference:
  - Acharya and Richardson (2009) provide an excellent description of how the crisis in the United States unfolded.

### Implications for the LAC Region
- Current perimeter characteristics:
  - Most countries in the region have broad regulatory perimeters (Table 1), yet most could benefit from re-evaluating them.
  - Typically, virtually all financial institutions are subject to some form of regulation, although the intensity varies with the type of institution.
  - The strongest supervision applies to banks, which:
    - dominate financial systems in the region; and
    - are the only financial institutions with access to liquidity facilities and other aspects of the financial safety net.
  - Remaining financial institutions are often subject to less stringent supervision, even though they might have systemic implications.
  - This perimeter is very similar to the pre-crisis perimeters in the United States and some other advanced countries.

*Source: _spn0919 - Section III improving consolidated supervision, Section IV reducing procyclicality, Section V strengthening public disclosure of information, and Section VI greater flexibility for central banks. Section VII presents concluding remarks.*

### Box 1. Relative Financial Calm in Canada

### Box 1. Relative Financial Calm in Canada

### Overview
- Canada’s banking system has displayed remarkable stability amid the global turbulence, owing mostly to stringent supervision and regulation.
- The financial crisis affected Canada by widening credit and money-market spreads to unprecedented levels, raising bank-risk indicators, and hurting pensions and insurers (particularly exposed to U.S. mortgage-related writedowns and the equity crash).
- No Canadian financial institution has failed or required public capital injections.

### Prudential framework and banking-sector strengths
- Stringent supervision and regulation, and conservative business practices, allowed banks to enter the crisis with strong balance sheets.
- Key features of the prudential framework include:
  - Tighter capital regulations applying to banks’ consolidated commercial and securities operations.
  - Canada’s minimum capital requirements are tougher than called for by Basel II, and all other G-7 bank regulators.
  - The leverage ratio is limited to 5 percent of total assets.
- Tier 1 and 2 Capital Requirements as a Percent of Risk-Weighted Assets:
  - Tier 1 Capital: Basel II 4; Canada 7; U.S.A. 4; France 4; Germany 4; Italy 4; Japan* 4/2; U.K. 4
  - Total Capital: Basel II 8; Canada 10; U.S.A. 8; France 8; Germany 8; Italy 8; Japan* 8/4; U.K. 8
  - *Higher (lower) requirements apply to internationally active (domestically-oriented) banks.
- Other features:
  - Financial regulation reviews every five years to keep pace with financial innovation.
  - Rigorous exchange of information across supervisory agencies, which meet regularly to discuss issues affecting the financial sector, including solvency, last-resort lending, and the risk of deposit-insurance payouts.

### Mortgage market and retail focus
- The banking sector emphasizes a profitable and stable domestic retail market, with a low risk tolerance.
- Mortgage-market characteristics:
  - Only 5 percent of mortgages are non-prime.
  - 25 percent of mortgages are securitized (compared with 25 percent and 60 percent, respectively, in the United States).
  - Almost half of residential loans are guaranteed.
  - The remaining residential loans have a loan-to-value ratio below 80 percent.
  - Mortgage interest is not deductible from income taxes, encouraging quick repayment.

### Authorities’ policy response to market strains
- Canadian authorities have responded proactively by:
  - Expanding liquidity facilities.
  - Providing liability guarantees.
  - Purchasing (already government-insured) mortgage portfolios.
  - Standing ready to inject public capital into banks, if needed.

*Source: Box 1. Relative Financial Calm in Canada (IMF).*

### Chapter 2 of the IMF’s April 2009 Global Financial Stability Report explains several of these approaches to

### Chapter 2 of the IMF’s April 2009 Global Financial Stability Report explains several of these approaches to measuring systemic risk.

### Systemic risk perimeter, oversight, and treatment of non-systemic institutions
- Approaches proposed include creating a systemic risk authority to: track exposures that cut across firms and markets; oversee systemic institutions and financial infrastructure; focus on consolidated operations of systemic institutions to close regulatory gaps.
- Two institutional variants described:
  - A systemic risk authority that works with existing regulators (existing regulators continue to focus on individual institutions).
  - A single regulator for systemic institutions that require special attention because of their size, complexity, and ability to exploit regulatory cracks.
- Non-systemic institutions:
  - Some oversight warranted; nonbank institutions (mutual funds, brokerage entities, insurance companies, investment banks) often subject to weaker regulation in Latin America.
  - Could be required to disclose information to safeguard investors while facing less stringent prudential requirements to allow innovation.
  - April 2009 G20 declaration recommends stronger prudential standards for all financial institutions once global economy recovers from the current crisis; recommends hedge funds above some minimum size be subject to registration and disclosure so supervisors can assess their contribution to systemic risk and ensure sound risk management; countries should share this information because many hedge funds operate in many countries.
- Movement between perimeters:
  - Supervisors may need to move institutions from outer to inner perimeter when they approach systemic importance; decisions require sufficient information.
  - Example: Chile moves supervision and control of credit cooperatives to the bank supervisor when their equity exceeds a certain threshold.
  - Possible trigger parameters: size of deposits, assets, exposures to other financial intermediaries.

### Improving consolidated supervision — recommended reforms and regional implications
- Recommended reforms:
  - Better information sharing and closer harmonization to limit regulatory arbitrage and facilitate crisis resolution.
  - Need to see cross-functional (within-country links across institution types and instruments) and cross-border links.
  - Harmonized regulations on deposit insurance, resolution procedures and safety nets, and international understandings on responsibilities for resolving multinational banks would ease crisis management.
- Implications for LAC region:
  - Need explicit legal frameworks for stronger cross-functional consolidated supervision to see connections across conglomerates (often foreign-owned or bank holding companies).
  - Two common shortcomings in current frameworks:
    - Scope of consolidated supervision often does not allow monitoring of all institutions within a financial conglomerate, contributing to difficulties with offshore operations.
    - Supervisors often lack uniform powers to enforce regulations and require prompt corrective action for all institutions within a conglomerate.
  - Cross-border supervision matters where international banks account for more than 40 percent of total banking system deposits in some countries.
  - In Central America, regional banks account for about 15 percent of total bank deposits and have complex structures (parallel and offshore banks), creating legal gaps that limit effective supervision.

### Key issues and specific legal/operational powers suggested
- Strengthening the legal framework for consolidated cross-functional supervision could include giving supervisors the ability to:
  - (i) set capital requirements for the bank as well as all other affiliates of the group;
  - (ii) monitor and apply remedies to all institutions within a conglomerate;
  - (iii) establish clear rules that mandate exchange of information among supervisors.
- Additional measures:
  - Establish a lead supervisor in countries with multiple supervisors and require joint inspections involving all relevant supervisors.
  - Law or supporting regulations should spell out triggers for intervention of systemic institutions and clarify arrangements for emergency liquidity support.
  - Harmonize prudential requirements across different types of financial institutions to limit opportunities for regulatory arbitrage.

### Box 2 — Brazil: regulations to strengthen consolidated supervision (highlights)
- Banking regulations require consolidated financial statements that include direct or indirect, solo or joint, investments; consolidation required if supervised institution can:
  - (i) elect or dismiss management of the invested entity;
  - (ii) exercise effective operational control;
  - (iii) exercise shareholder control, directly or indirectly, even through mutual funds.
- Unsupervised institutions deemed controlled de facto must be consolidated even without investment.
- Consolidated financial statements are subject to external audits; complete external audits of financial institutions must be performed twice a year.
- Securities regulations also require consolidated financial statements for listed companies and parent companies of groups that include a listed company; SPVs whose activities are in principle controlled must be consolidated unless not material.
- SPVs subject to capital charges matching comparable balance sheet positions.
- Receivables Investment Funds (FIDC) not consolidated, but capital is required for risk exposure of positions to reflect credit and market risks.
- Accounting and disclosure norms (conforming to international financial reporting standards) require that securitized loans remain on originator balance sheet unless there is a significant and final transfer of risk, profits, and control.
- Capital requirements on off-balance-sheet guarantees match factors used for comparable on-balance credit operations; Brazil does not rely on rating agencies.

### Box 3 — Role and implications of foreign banks in LAC
- Since 2005, foreign bank lending to the LAC region expanded rapidly, accounting for a significant share of banking activity by 2008.
- Benefits: strengthen risk management and corporate governance in host countries.
- Challenges: foreign banks respond to home and host country conditions; in Q4 2008, lending by foreign banks to LAC slowed rapidly amid freezing of global money markets and doubts after the collapse of Lehman.
- Observations:
  - Local subsidiaries account for roughly two-thirds of total foreign bank lending to LAC.
  - Subsidiaries must comply with host country regulations to ensure a level playing field; example: Banco Santander’s subsidiary in Chile must meet minimum capital requirement of 11 percent set by Chilean supervisor because of its large size in Chile’s financial system.
  - Home country prudential norms typically apply to domestic operations, not entire global balance sheet.
- Proposals for new regulatory framework:
  - More effective consolidated cross-border supervision for systemic global banks to reduce regulatory arbitrage — prudential norms applying to consolidated global operations.
  - Creation of regulatory colleges of supervisors for full information sharing, harmonization, and clear assignment of responsibilities.
- Uncertainties and practical implications:
  - At this stage, premature to draw strong conclusions about effects on subsidiaries.
  - Foreign bank subsidiaries will continue to comply with host country prudential framework.
  - Many details of cross-border supervision remain to be developed; parent banks may have latitude in satisfying new global requirements (e.g., selling shares in home markets vs. requiring subsidiaries to curtail credit growth).
  - Complications could arise if host country regulations are less strict than home country rules, potentially opening loopholes.

### Institutional cooperation, MOUs, and supervisory colleges
- Domestic cooperation:
  - MOUs used to define responsibilities and operational rules for information exchange and supervisory decision making, but experience is mixed.
  - Institutionalize cooperation via regular technical meetings of superintendents, collaborative reports, and minister of finance or central bank convening regular meetings.
- Cross-border cooperation:
  - MOUs with counterparts in US, UK, Spain, etc. useful but limited.
  - Institutional mechanisms like colleges of supervisors may be more effective.
  - For countries with free cross-border depositor movement, harmonization of deposit insurance schemes can be crucial.
  - Regional cooperation (e.g., Central America) could include agreements on bank resolution frameworks (loss-sharing arrangements) and lender of last resort facilities.

### Cross-functional supervision structure: single vs. multiple supervisors
- Single-agency model:
  - Example: Colombia supervises all financial activities through a single agency.
  - Advantages: reduces regulatory arbitrage, easier information sharing, economies of scale and scope.
  - Drawbacks: can become unwieldy in complex/large systems; may reduce specialized expertise; consolidating different regulatory cultures may be counterproductive.
- Many LAC countries (including Brazil and Chile) continue with multiple functional supervisors.

### Reducing procyclicality in financial systems — recommended reforms and options
- Problem sources:
  - Pillar 1 of Basel II: risk-weighted assets use procyclical factors such as credit agency ratings and banks’ internal models that focus on recent past.
  - Loan loss provisioning linked to payment history tends to be stronger in booms, encouraging expansion of lending.
  - Fair value accounting (FVA) can be procyclical: requires marking assets to market, registering losses during downturns, intensifying funding problems and pressure to sell assets, causing further price falls; aggravated by low liquidity.
  - Exemption for assets held to maturity can mitigate some effects by allowing amortized cost reporting.
- Regional features:
  - Some countries link loan loss provisions to loan quality and past payment history; others use forward-looking criteria and judgment.
  - Lending often based on collateral whose value can fluctuate sharply given thin secondary markets.
  - Capital adequacy standards in the region generally conform to Basel I, though Brazil, Mexico, Chile, Colombia, Peru, and Panama are moving towards Basel II.
  - Basel I uses fixed risk weights stable through the cycle; minimum capital asset ratio (CAR) under Basel I could induce procyclicality if banks curtail lending to keep CAR above minimum, but average CAR in the region is well above the minimum.
  - FVA is used in Brazil, Mexico, Colombia, Peru, Costa Rica, Bolivia and Jamaica.
- Options to reduce procyclicality:
  - Mitigate marking-to-market effects and apply more conservative valuations for collateral.
  - Preserve FVA for traded assets but allow judgmental methods for illiquid assets (level 2 and level 3 assets); US FASB approved three amendments to FVA to give firms more discretion in mark-to-model valuations for illiquid securities.
  - Possible improvements:
    - Allow institutions to build valuation reserves for trading book effects.
    - Value assets at average prices over some period or use the lower of current price and average price over recent period (example: last 5 years).
    - Any changes must be consistent with a country’s accounting framework and consider transparency effects on revenue and earnings.
  - Make provisioning requirements more forward-looking (losses over the cycle); Bolivia, Colombia, Peru and Uruguay follow Spain’s example with forward-looking provisioning systems.
  - Make capital adequacy requirements countercyclical by defining two regulatory CAR levels:
    - A publicly disclosed minimum enforced at all times.
    - An extra capital cushion to be raised during periods of strong growth and reduced during downturns.
    - CAR would remain above the minimum of 8 percent throughout the cycle.
    - Cyclical adjustments should follow a clear rule to promote transparency, credibility, and protect supervisors from political pressures.
  - Other proposals: contingent capital with debt that converts into equity under certain conditions.

*Source: Chapter 2 of the IMF’s April 2009 Global Financial Stability Report (excerpt).*

### Box 4. Forward Looking Provisioning in the LAC Region

### Box 4. Forward Looking Provisioning in the LAC Region

### Overview
- Several countries have tried to make banks set provisions taking into account the risk profile of the loan portfolio over the entire cycle. Spain pioneered this approach in 2000; more recently, Bolivia, Colombia, Peru, and Uruguay have introduced similar schemes.
- Objective: create countercyclical buffers so that statistical/dynamic provisions accumulate during upturns and can be used to absorb higher specific provisions during downturns, ameliorating income-statement volatility.

### Country cases
- Spain
  - Introduced a statistical provision in 2000 to act as a buffer while specific provisions fluctuate during the cycle.
  - Statistical provision is based on a bank’s internal models (based on data spanning at least an entire economic cycle) or a set of rates, between 0–1.5 percent, established by the regulator.
  - Statistical provisions equal the difference between the estimated underlying risk over the entire cycle and the specific provisions.
  - During high growth periods: specific provisions fall but statistical provisions rise; during poor credit quality: banks raise specific provisions and can draw down statistical provisions.
  - Unclear whether this approach helped curb credit growth (which increased sharply from 1999 to 2007). The build up of provisions has been quite significant, providing an important cushion in the current global crisis.

- Bolivia
  - In October 2008, regulator established a countercyclical provisioning rule.
  - Required provisions range from 1.5 to 5.5 percent of outstanding loans, varying depending on the classification and type of loan, and are in addition to standard specific provisions.
  - Use of these provisions is limited to 50 percent of the required specific provisions that would arise during a downturn.
  - Banks can make use of them only when (i) required specific provisions have increased for 6 consecutive months, (ii) banks have met the total targeted amount of countercyclical provisions, and (iii) there is no objection of the regulatory authority.

- Colombia
  - Starting in mid-2007 for commercial loans, and mid-2008 for consumer loans, provisions have a countercyclical as well as a specific component.
  - During an upturn, banks must fund the countercyclical component according to default probabilities for an adverse scenario estimated by the financial supervisor, for use if needed during a downturn.
  - The supervisor determines the phase of the cycle at its discretion.

- Peru
  - In November 2008, authorities established mandatory countercyclical provisions to complement specific and general provisions.
  - Regulator established a set of rates, between 0.4–1.0 percent, according to the type of loan.
  - During the upturn, banks must accumulate countercyclical provisions and reallocate them to specific provisions for nonperforming loans if needed in a downturn.
  - The supervisor determines the phase of the cycle based on a series of thresholds for GDP growth.

- Uruguay
  - Dynamic provisions created in September 2001 along the lines of the Spanish model.
  - Banks must make provisions ranging from 0.1 to 1.8 percent (depending on the loan classification category) of their average loan portfolios net of specific loan loss provisions until the sum of the dynamic provisions reaches 3 percent of total loans.

### Key findings and implications for the LAC region
- Forward-looking provisioning schemes (Spain, Bolivia, Colombia, Peru, Uruguay) provide a mechanism to reduce earnings volatility and create buffers for downturns.
- Provisioning characteristics and triggers vary by country: explicit rate ranges and phased rules (e.g., 0–1.5 percent in Spain; 1.5 to 5.5 percent in Bolivia; 0.4–1.0 percent in Peru; 0.1 to 1.8 percent up to 3 percent of total loans in Uruguay).
- Effectiveness in curbing credit growth is uncertain (notably Spain where credit grew sharply from 1999 to 2007), but buildup of provisions has provided significant cushions during the global crisis.
- Design features that enable controlled release of buffers include explicit usage limits (e.g., Bolivia: limited to 50 percent of required specific provisions in a downturn) and phase determination by supervisors (e.g., Colombia and Peru).

### Recommended reforms and policy considerations (from concluding remarks)
- Consider broadening the regulatory perimeter and rethinking how to assess systemic risk and apply prudential regulations to systemic institutions, especially to guard against excessive leverage.
- Resolve shortcomings in the legal framework to improve consolidated supervision and make MOUs effective by creating mechanisms that institutionalize information sharing and cooperation.
- Reduce procyclicality of regulations:
  - Many provisioning requirements tend to be backward looking; systems to establish forward-looking provisions in Bolivia, Colombia, Peru and Uruguay may serve as examples for the rest of the region.
  - Shifting to countercyclical capital adequacy requirements may be another effective option.
- Improve disclosure and data:
  - Region needs much better disclosure of information and better linkage between macroeconomic developments and the financial sector.
- Central bank and institutional considerations:
  - Continue to work within existing institutional frameworks to limit credibility risks; avoid broadening central bank mandates beyond their core objectives.
- Political and resource imperatives:
  - Strong political commitment and de facto independence for regulators are prerequisites for effective financial supervision.
  - Ensure adequate resources for regulators, with prioritization in small or low-income countries.

*Source: Box titled "Forward Looking Provisioning in the LAC Region" from the supplied IMF content unit.*

### REFERENCES

### _spn0919 - REFERENCES

### Books, Edited Volumes, and Reports
- Acharya, Viral V., and M. Richardson, 2008, “Restoring Financial Stability: How to Repair a Failed System” (New York University Stern School of Business).
- Brunnermeier, Markus, A. Crockett, C. Goodhart, A. D. Persaud and H. Shin, 2009, “The Fundamental Principles of Financial Regulation,” Geneva Reports on the World Economy – Preliminary Conference Draft (ICMB International Center for Monetary and Banking Studies).
- De Larosiere, Jacques, and others, 2009, “Report of the High Level Group on Financial Supervision in the EU (Brussels: European Commission).
- Financial Services Authority, 2009, “The Turner Review: A Regulatory Response to the Global Banking Crisis,” March (London: Financial Services Authority).
- Group of Twenty (G20), April 2009, “Declaration on Strengthening the Financial System.”
- Group of Thirty, 2009, “Financial Reform: A Framework for Financial Stability.”
- Squam Lake Working Group on Financial Regulation, 2009, “Reforming Capital Requirements for Financial Institutions,” April (New York: Council on Foreign Relations).
- U.S. Department of the Treasury, 2009, “Treasury Outlines Framework for Regulatory Reform,” March.

### Central Bank and Standard-Setting Publications
- Bank for International Settlements (BIS), 2009, “Basel Committee on Banking Supervision, Consultative Document—Proposed Enhancements to the Basel II Framework,” January (Basel, Bank for International Settlements).
- Bank for International Settlements (BIS), 2006, “Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards ,” June (Basel, Bank for International Settlements).

### Academic and Working Papers
- Armone, Marco, S. M. Darbar, and A. Gambini, 2007, “Banking Supervision: Quality and Governance,” IMF Working Paper No. 07/82 (Washington: International Monetary Fund).
- Cihák, Martin, and A. Tieman, 2008, “Quality of Financial Sector Regulation and Supervision Around the World,” IMF Working Paper No. 08/190 (Washington: International Monetary Fund).
- Counterparty Risk Management Policy Group, 2008, “Containing Systemic Risk: The Road to Reform,” August (Counterparty Risk Management Policy Group).
- Kamil, Herman, and Kulwant Rai, 2009, “Will International Banks Transmit the Global Credit Crunch to Latin American and Caribbean Countries?” Regional Economic Outlook: Western Hemisphere—Stronger Fundamentals Payoff (Washington: International Monetary Fund), May.
- Manuelito, Sandra, Filipa Correa, and Luis Felipe Jimenez, 2009, “La Crisis Subprime en Estados Unidos y la Regulación y Supervisión Financiera: Lecciones para América Latina y el Caribe,” February (Santiago, Chile: Comisión Económica para América Latina).

### IMF Publications and Financial Sector Assessments
- International Monetary Fund (IMF), 2002, “Brazil—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2003a, “Bolivia—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2003b, “Honduras—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2004a, “Chile—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2004b, “Ecuador—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2004c, “El Salvador—Financial System Stability Assessment—Update” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2004d, “Nicaragua—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2005a, “Colombia—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2005b, “Peru—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2005c, “Trinidad and Tobago—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2006a, “Jamaica—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2006b, “Paraguay—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2006c, “Uruguay—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2007a, Costa Rica—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2007b, “Guatemala—Financial System Stability Assessment” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2007c, “Mexico: Publication of Financial Sector Assessment Program—Update—Technical Note on Organizational Arrangements for Effective Financial System Regulation, Supervision and Policymaking” (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2009a, “Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets,” Monetary and Capital Markets Department (Washington: International Monetary Fund).
- International Monetary Fund (IMF), 2009b, Global Financial Stability Report (Washington: International Monetary Fund), forthcoming.

*Source: _spn0919 - REFERENCES*

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