## 1. Venezuela and Selected Latin American Countries: Selected Monetary Indicators

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### Introduction and purpose
- Combines financial soundness indicators (FSIs) and stress-testing methodologies to assess the soundness of Venezuela’s banking sector, based on diagnosis of structural and transient shortcomings.
- FSIs are high at end-2005 but may mask vulnerabilities; realistic, diagnosis-driven shocks are necessary for informative stress testing.
- Conclusion: sector appears sound under favorable conditions but remains significantly vulnerable to cyclical downturns and is particularly exposed to interest rate and credit risks.

### Long-term trends and stylized facts (twenty-year view)
- Pro-cyclical volatility and money demand:
  - Real money demand contracted by as much as 40 percent (1989), 54 percent (1996), and 14 percent (2002–03).
  - Real money demand rebounded by more than 30 percent (1990), 10 percent (1997), and 24 percent (2004).
- Financial intermediation decline:
  - Broad money to GDP: 40 percent (1985) → 25 percent (2005).
  - Deposits with commercial banks: 60 percent of GDP (1985) → 25 percent of GDP (2005).
  - Domestic credit: 52 percent of GDP (1985) → 14 percent of GDP (2005).
- Structural changes since 1994–95:
  - Number of financial institutions decreased by nearly half, to 52 in December 2005.
  - Five major banks account for more than 55 percent of market share; ten largest institutions account for 74.1 percent of total assets.
- Non-traditional transactions and maturity structure:
  - Checking accounts >50 percent of total deposits at end-2005.
  - About two-thirds of time deposits mature in less than 60 days.
  - Off-balance-sheet operations rising, reaching more than 100 percent of assets and 130 percent of deposits in 2005.
- Offshore operations:
  - External assets of Venezuelan residents abroad reached US$51 billion in December 2005.
  - External liabilities were US$13.4 billion in 2005.
  - Net assets increased to US$37 billion in 2005 (from US$7.3 billion in 1994).

### Concentration and market structure (December 2005)
- Sector composition:
  - 31 private commercial and universal banks, 3 state-owned banks, and 1 development bank.
- Concentration metrics:
  - Five largest institutions: 55.9 percent of total assets; 55.3 percent of total capital; 57.2 percent of total deposits; 64.2 percent of total credit.
  - Ten largest institutions: 74.1 percent of total assets; 72.1 percent of total capital; 75.3 percent of total deposits; 80.3 percent of total credit.
  - Ten smallest institutions: 3.5 percent of total assets; 4.0 percent of total capital; 2.3 percent of total deposits; 1.7 percent of total credit.
  - Number of banks with market share superior to 5 percent: 6; between 1 and 5 percent: 15; inferior to 1 percent: 14.

### Off-balance-sheet operations and summary balance sheet (2001–2005, in billions of bolivares at current prices)
- Off-balance-sheet trust accounts (memorandum):
  - 2001: 10,617
  - 2002: 16,189
  - 2003: 21,918
  - 2004: 30,208
  - 2005: 83,661
- Off-balance-sheet in percent of total assets (selected years):
  - 49.1 (2001), 66.7 (2002), 60.9 (2003), 53.7 (2004), 99.0 (2005)
- Off-balance-sheet in percent of total deposits (selected years):
  - 65.9 (2001), 96.3 (2002), 78.1 (2003), 68.2 (2004), 123.4 (2005)
- Selected balance sheet items:
  - Total assets: 21,608 (2001); 24,278 (2002); 35,998 (2003); 56,273 (2004); 84,530 (2005)
  - Total liabilities: 18,587 (2001); 20,424 (2002); 30,839 (2003); 49,243 (2004); 75,149 (2005)
  - Capital: 3,020 (2001); 3,854 (2002); 5,159 (2003); 7,030 (2004); 9,381 (2005)
  - Deposits: 16,110 (2001); 16,805 (2002); 28,067 (2003); 44,301 (2004); 67,821 (2005)
  - Gross loans: 9,415 (2001); 9,153 (2002); 10,197 (2003); 21,284 (2004); 37,214 (2005)
  - Provisions: (656) (2001); (902) (2002); (890) (2003); (818) (2004); (927) (2005)
  - Public bonds (assets): 3,570 (2001); 6,080 (2002); 14,152 (2003); 18,987 (2004); 24,958 (2005)
- Implications:
  - Off-balance-sheet operations and lack of supervisory framework for them and for offshore operations, plus short-term deposit structure, raise liquidity and supervision concerns.
  - Traditional prudential indicators may understate exposures because large off-balance-sheet and offshore operations are excluded.

### Assets and liabilities of Venezuelan residents abroad (BIS reporting countries, in billions of U.S. dollars)
- External liabilities (selected years):
  - 1994: 20.7; 1995: 20.5; 1996: 23.8; 1998: 26.4; 2000: 26.4; 2002: 29.8; 2003: 28.7
- 2005 totals:
  - External assets: US$51 billion (December 2005)
  - External liabilities: US$13.4 billion (2005)
  - Net assets: US$37 billion (2005)

### Vulnerabilities, stress-testing insights, and policy-relevant observations
- Main vulnerabilities:
  - High exposure to the public sector.
  - Large and growing off-balance-sheet operations and offshore positions with weak supervisory coverage.
  - Predominance of short-term deposits and large checking-account share (>50 percent of deposits), increasing liquidity run risk.
  - Sensitivity to interest-rate and credit shocks given prior lending booms in periods of negative real interest rates.
- Stress-testing qualitative conclusion:
  - Under relatively conservative assumptions, a cyclical downturn could exhaust a large share of banks’ capital and threaten the least capitalized banks.
  - Strong FSIs at end-2005 may partly reflect a credit boom in the context of capital controls and real interest rates that are at or close to negative levels, which could reverse sharply under adverse shocks.

---

### Exposure to the public sector and disintermediation trend
- Claims to the private sector:
  - About 70 to 80 percent of total assets during the 1970s and 1980s.
  - Declined to about 51 percent of total assets in December 2005.
  - Trough of 32 percent during the banking crisis of 1994 and in early 2004; recovered to around 40 percent during periods of lax liquidity.
- Government deposits:
  - Accounted for 20 percent of total deposits in 2005.
  - Banks vulnerable to drawdown or transfer of these deposits (e.g., to Banco del Tesoro).

### Recent regulatory environment: overview and implications
- General observation:
  - President Chávez’s government pursued active social development and poverty reduction policies, including new measures on lending practices and bank soundness.
  - Some measures reinforce regulation and supervision; others increase government intervention in bank operations and impact banks’ income.
- Four main regulatory changes:
  1. Expansion and rapid change of legal/regulatory framework
     - Banking law passed November 2001; proposals in 2005 to incorporate microfinance institutions and cooperatives; two new laws on credit card transactions and foreign exchange operations.
     - Rapid adoption of new measures (interest rate regulation, limits on fees and commissions, new prudential requirements) created legal uncertainty.
  2. Increase in directed credit requirements (2005)
     - About a third of total lending set by regulation since 2005.
     - Sectoral minimum lending requirements:
       - Agricultural sector: at least 12½ percent of loan portfolio (effective January 2005); increased to 14½ percent in May and to 16 percent in June 2005.
       - Housing sector: minimum 10 percent share (new mortgage regulation, February 2005).
       - Micro-enterprise sector: at least 3 percent (to be increased up to 10 percent).
       - Tourism sector: minimum 2½ percent for private banks and 5 percent for public banks starting January 2006 (footnote: tourism loan quota expected effective December 31, 2006).
     - Potential effects: increased interest rate and liquidity risks, deterioration in portfolio quality, decline in profitability, reduced balance-sheet management flexibility, possible overall reduction in lending.
  3. Interest rate controls, higher reserve requirements, and stricter regulations on fees and commissions
     - Interest rate limits and caps:
       - Effective May 2005, lending rates may not exceed 28 percent.
       - Deposit floors: savings accounts not below 6½ percent; fixed-term deposits not below 10 percent.
       - Penalty surcharge for nonperforming loans capped at 3 percent.
     - Preferential interest provisions:
       - Housing: capped at 18 percent when average lending rate exceeds 40 percent; if average lending rate below 20 percent, banks may charge up to 65 percent of average for housing loans; low-income households eligible for subsidized rates at 5.16 percent and 7.31 percent depending on income.
       - Tourism: preferential rates of 12.96 percent (general) and 11.52 percent (designated zones).
       - Agricultural loans: banks cannot charge more than 80 percent of the commercial loan rate.
     - Central bank CDs — yields and maturities:
       - Effective February 1, 2006: central bank pays 10 percent for a 28-day CD and 9¼ percent for a 14-day CD.
       - Previously: 56-day CDs yielding 11¾ percent and 28-day CDs at 11½ percent.
     - Reserve requirements on ceded investments:
       - February 2006: new reserve requirement of 5 percent on ceded investments.
       - Requirement increases by ½ percentage point every 4 weeks up to 15 percent in September 2007.
     - Fees and commissions restrictions:
       - 5 percent cap on fees for cash advances on credit cards.
       - 3 percent cap on fees for factoring or leasing operations.
  4. Overall impacts of new regulations:
     - Relative price distortions likely to affect banks’ income structure and soundness.
     - Reduction in lending rates reduces profitability and encourages non-interest income pursuit.
     - Tightening of spread and high unremunerated reserve requirements may prevent banks from generating sufficient interest margins.
     - Regulated loan pricing creates potential moral hazard and raises sector risk.
     - Banks may reduce financial intermediation and access to credit as a defensive response.

---

### Expansion of public banks and objectives (public banking sector)
- Recapitalization and expansion:
  - Banco Industrial de Venezuela (BIV) and Banfoandes strengthened via recapitalization and extended activities.
  - New public institutions created, including a potentially very large Banco del Tesoro and several specialized banks (for women, the army).
  - Public financial institutions expanded internationally in 2006 (examples cited: Cuba, Bolivia, Uruguay).
- BIV 2005 loan allocation:
  - 46 percent to small enterprises
  - 38 percent to micro credits
  - 4 percent to cooperatives
- Objectives and risks:
  - Intended to foster social development, finance SMEs and microfinance, and extend international cooperation.
  - Risk of dilution of financial-performance focus and increased vulnerability to credit and market risks.

### Assessing soundness: FSIs and stress testing approach
- Two-step assessment:
  - FSIs to link banks’ soundness to macroeconomic, external, and capital account developments.
  - Stress testing to provide forward-looking complement given FSIs’ limitations.
- Key FSI findings (end-2005 unless noted):
  - Capital to risk-weighted assets: 15.5 (percent)
  - Capital to assets: 11.1 (percent)
  - Capital net of provisioning gap (NPLs - provisions) to risk-weighted assets: 15.9 (percent)
  - Retained earnings to capital: 49.0 (percent)
  - NPLs to total gross loans (reported): 1.3 (percent)
  - Provisions in percent of NPLs: 196.3 (percent)
  - Provisions to total gross loans: 2.4 (percent)
  - Public sector exposure to assets: 51.7 (percent)
  - Public sector deposits to total deposits: 19.7 (percent)
  - Return on average assets: 3.7 (percent)
  - Return on equity: 32.6 (percent)
  - Core liquid assets to total assets: 17.9 (percent)
  - Liquid asset ratio (broad) to total assets: 47.3 (percent)
  - Loans to assets: 44.0 (percent)
  - Credit to private sector (percent change) in 2005: 69.4 (percent)
  - Average lending rate in 2005: 16.6 (percent)
  - Average deposit rate in 2005: 11.6 (percent)
  - Interest rate spread in 2005: 5.0 (percent)

### Capital adequacy, asset quality, and liquidity observations
- Capital adequacy:
  - Average capital-to-risk-weighted-assets: above 15 percent (December 2005).
  - Capital-assets ratio: above 11 percent (December 2005).
  - Sudeban minimum requirements: risk-weighted capital-assets ratio of 12 percent and capital-to-asset ratio of 10 percent.
  - At end-2005: seven banks not compliant with capital-to-assets minimum; five banks did not meet minimum capital to risk-weighted assets ratio.
  - Inclusion of trust funds and investment funds in total assets would reduce capital-assets ratio to about 5½ percent.
- Asset quality:
  - Reported NPLs declined from an average of 11¼ percent in 2002 to 1¼ percent at end-2005.
  - Provisions accounted for 196 percent of NPLs at end-2005.
  - Provisions to total loans declined from 9 percent in 2002 to 2½ percent in 2005.
- Liquidity:
  - Core liquid assets: 18 percent of total assets; 23 percent of short-term liabilities.
  - Broad liquid asset ratio: 47¼ percent of total assets.
  - Interpretation: comfortable liquidity consistent with limited intermediation of long-term loans and predominance of short-term operations.

### Stress testing: rationale, shocks, and methodology
- Purpose: identify impacts of exceptional but plausible shocks on credit, market, and liquidity risks.
- Four main shocks considered:
  1. Fall in international price of oil.
  2. Deterioration in credit quality.
  3. Interest rate shock.
  4. Loss of confidence in the banking sector.
- Methods:
  - Single-variable sensitivity analyses and two scenario analyses (cyclical downturn and crisis scenario).
  - Static, bottom-up, bank-by-bank approach with aggregation; limitations include absence of sectoral loan breakdowns and net open FX positions for individual banks.

### Data limitations and off-balance-sheet exposures (stress-test caveats)
- Interbank market data not published; contagion tests not performed due to embryonic interbank market.
- Off-balance-sheet assets excluded to maintain consistency with prudential indicators used by Venezuelan authorities.
- Inclusion of off-balance-sheet assets in capital adequacy could reduce capital coverage by as much as 8 percentage points, on average.
- Adjusting for off-balance-sheet items would bring average capital adequacy ratio down to 7.6 percent, implying required recapitalization equivalent to 4.1 percent of 2005 GDP.
- Absence of long time series and bank-by-bank income statement data prevents macroeconomic model use; shocks calibrated qualitatively.

### Credit risk: calibration and results
- Assumptions: banks fully provision; additions to provisions reduce capital.
- Calibration:
  - Historic average NPL (1999–2003): 7.6 percent.
  - “Crisis level” NPL (1994–95 crisis): 15 percent.
- Aggregate results:
  - Aggregate system could withstand a 6 percent increase in the NPL ratio without capital adequacy ratio falling below the 12 percent minimum.
  - Crisis-level NPL (15 percent) would render sector undercapitalized by about 4 percent of risk-weighted assets.
- Distributional effects:
  - Public banks and least-capitalized banks more vulnerable.
  - Largest public bank at end-2005: capital adequacy ratio of 4 percent and NPLs of 27 percent of total loans.
  - Least-capitalized banks: capital adequacy ratios around 12 percent; return of NPLs to historic average would bring post-shock ratios close to 6 percent; crisis-level deterioration would nearly exhaust their capital.
  - Domestic banks more vulnerable to credit risk than foreign banks.
- Government paper default shocks:
  - Default on 50 percent of government debt obligations would reduce average capital adequacy ratio by about 2 percentage points.
  - Default on 75 percent would reduce it by 3.7 percentage points.
  - Conclusion: sector appears well capitalized against a partial government paper default.

### Interest rate risk: methodology and stress results
- Method: maturity mismatch (repricing gap) model using six Sudeban maturity buckets.
- Stress results:
  - Linear increase in interest rates:
    - 10 percentage points increase would reduce by almost half the average capital adequacy ratio; two banks would not withstand a 10 percentage point increase.
    - 20 percentage points increase would exhaust all banks’ capital.
    - Nine banks would have insufficient capital to withstand a 15 percentage point increase.
  - Spread narrowing and yield-curve flattening:
    - 2 percentage point narrowing of the interest rate spread lowers capital adequacy by 1½ percentage points.
    - 4 percent narrowing lowers it by 2.8 percentage points.
    - Flattening (5 percentage point increase in short-term rates while long-term rates unchanged) reduces average capital adequacy by 4 percentage points.
  - Combined shock:
    - Increase in nominal interest rates of 10 percent (with spread narrowing and flattening) would reduce average capital adequacy ratio to 5½ percent.
- Distributional effects:
  - Public and domestic private banks particularly affected due to large maturity mismatches; foreign private banks more resilient.
  - A 15 percentage point increase would bring capital adequacy ratios of ten least capitalized banks to negative levels.
  - A 10 percentage point increase would bring state-owned banks’ capital to zero; 20 percentage points would do the same for domestic private banks.
  - Foreign private banks would see severe reductions but are relatively more resilient.

### Liquidity risk: shocks and resilience
- Two liquidity shocks assessed:
  - Run on deposits: 25 percent run reduces liquid assets to 27 percent of total assets; liquid assets remain on average 45 percent of short-term liabilities and 30 percent of short-term liabilities and trust funds.
  - Run of 73 percent of total deposits required to exhaust liquid assets, on average.
  - Withdrawal of government paper: 50 percent withdrawal would reduce liquidity ratio from 47 percent to 32 percent of total assets.
- Conclusion: high liquidity and low loan-to-deposit ratios temper liquidity risks; liquid assets ~50 percent of total assets in December 2005.
- Distributional vulnerabilities: state-owned banks and, to a lesser extent, foreign private banks are more vulnerable to liquidity shocks.

### Compounded scenarios and results
- Two scenarios modeled:
  1. Cyclical downturn (return of key variables to historic averages; tighter liquidity; 10 percentage points increase in nominal interest rates; NPLs revert to 7.6 percent).
     - Average capital adequacy ratio (excluding state-owned banks) falls from 15.5 percent to 2.6 percent.
     - Domestic private banks post-shock capital adequacy: 1 percent.
     - Ten least capitalized banks: capital adequacy ratios turn negative.
  2. Crisis scenario (20 percentage point increase in nominal interest rates; NPLs at 15 percent).
     - Average capital adequacy ratio (excluding state-owned banks): -8 percent.
     - Domestic private banks: -11 percent.
     - Ten largest banks: -11½ percent on average.
     - Cost to recapitalize to minimum 12 percent ratio: greater than 4 percent of GDP.
- Stress-testing caveat: static framework excludes second-round effects, which would magnify estimated impacts.

### Key takeaways for policymakers and policy recommendations
- Supervision and coverage:
  - Focus supervision on off-balance-sheet and offshore operations: scale exceeds 100 percent of assets and 130 percent of deposits in 2005, with no well-defined supervisory framework.
  - Address absence of procedures for consolidated supervision of financial groups, weak monitoring of off-balance-sheet items, lack of oversight of offshore operations, and inadequate monitoring of connected lending.
- Liquidity risk monitoring:
  - Monitor short-term deposit structure: checking accounts >50 percent of deposits; two-thirds of time deposits mature in less than 60 days.
- Concentration and systemic risk:
  - Address concentration: five largest banks account for more than 55 percent of market share.
- Stress-test design:
  - Incorporate macro-financial linkages into stress tests: include sharp reversals in money demand, large increases in real lending rates, and contractions in credit.
- Regulatory stance:
  - Recognize that high FSIs in a boom can mask vulnerabilities; forward-looking, diagnosis-driven stress testing is necessary to identify weakest institutions before shocks materialize.
  - Account for downside risks when implementing public intervention and directed credit requirements.
- Long-term goals:
  - Improve banks’ resilience to external shocks and policy volatility.
  - Deepen financial intermediation by reducing non-lending activities and exposure to the public sector.
  - Ensure competitive operating environments to mitigate emerging risks and broaden access to banking services.

*Source: _wp06225 - 1. Venezuela and Selected Latin American Countries: Selected Monetary Indicators (December 2005).*

### 1. Venezuela and Selected Latin American Countries: Selected Monetary Indicators,

### _wp06225 - 1. Venezuela and Selected Latin American Countries: Selected Monetary Indicators

### Introduction and purpose
- Combines financial soundness indicators (FSIs) and stress-testing methodologies to assess the soundness of Venezuela’s banking sector, based on diagnosis of structural and transient shortcomings.
- Emphasizes that FSIs are high at end-2005 but may mask vulnerabilities; stresses the need for realistic, diagnosis-driven shocks for informative stress testing.
- Concludes that while the sector appears sound under favorable conditions, it remains significantly vulnerable to cyclical downturns and is particularly exposed to interest rate and credit risks.

### Long-term trends and stylized facts (twenty-year view)
- Banks have been vulnerable to economic volatility from oil price shocks and political instability:
  - Real money demand contracted by as much as 40 percent (1989), 54 percent (1996), and 14 percent (2002–03).
  - Real money demand rebounded by more than 30 percent (1990), 10 percent (1997), and 24 percent (2004).
  - Commercial bank credit to the private sector followed similar cycles.
- Pro-cyclical monetary conditions strongly affected lending behavior:
  - Reductions in interest rates to highly negative levels predated lending booms in 1990–91, 1995–96, and 2004–05.
  - Increases in real lending rates came with a lag, inducing sharp contractions in credit to the private sector.
- Financial intermediation is low and declining:
  - Broad money to GDP declined from 40 percent of GDP in 1985 down to 25 percent in 2005.
  - Deposits with commercial banks declined from 60 percent of GDP in 1985 to 25 percent of GDP in 2005.
  - Domestic credit declined from 52 percent of GDP in 1985 to 14 percent of GDP in 2005.
- Structural changes since the 1994–95 crisis:
  - Number of financial institutions decreased by nearly half, to 52 in December 2005.
  - Universal banks increased to dominate the sector.
  - The five major banks account for more than 55 percent of market share; ten largest institutions account for 74.1 percent of total assets.
- Growth of “non-traditional” transactions (off-balance-sheet, offshore, cash/checking):
  - Checking accounts constituted more than 50 percent of total deposits at end-2005.
  - About two-thirds of time deposits mature in less than 60 days.
  - Off-balance-sheet operations began rising at an accelerating pace, reaching more than 100 percent of assets and 130 percent of deposits in 2005.
- Large offshore operations despite capital controls:
  - External assets of Venezuelan residents abroad reached US$51 billion in December 2005.
  - External liabilities were US$13.4 billion in 2005.
  - Net assets increased to US$37 billion in 2005 (from US$7.3 billion in 1994).

### Concentration and market structure (December 2005)
- Sector composition:
  - 31 private commercial and universal banks, 3 state-owned banks, and 1 development bank.
- Concentration metrics:
  - Five largest institutions: 55.9 percent of total assets; 55.3 percent of total capital; 57.2 percent of total deposits; 64.2 percent of total credit.
  - Ten largest institutions: 74.1 percent of total assets; 72.1 percent of total capital; 75.3 percent of total deposits; 80.3 percent of total credit.
  - Ten smallest institutions: 3.5 percent of total assets; 4.0 percent of total capital; 2.3 percent of total deposits; 1.7 percent of total credit.
  - Number of banks with market share superior to 5 percent: 6; between 1 and 5 percent: 15; inferior to 1 percent: 14.

### Off-balance-sheet operations and summary balance sheet (2001–2005, in billions of bolivares at current prices)
- Off-balance-sheet trust accounts (memorandum items):
  - 2001: 10,617
  - 2002: 16,189
  - 2003: 21,918
  - 2004: 30,208
  - 2005: 83,661
  - In percent of total assets (selected years shown): 49.1 (2001), 66.7 (2002), 60.9 (2003), 53.7 (2004), 99.0 (2005)
  - In percent of total deposits (selected years shown): 65.9 (2001), 96.3 (2002), 78.1 (2003), 68.2 (2004), 123.4 (2005)
- Selected balance sheet items (2001–2005):
  - Total assets: 21,608 (2001); 24,278 (2002); 35,998 (2003); 56,273 (2004); 84,530 (2005)
  - Total liabilities: 18,587 (2001); 20,424 (2002); 30,839 (2003); 49,243 (2004); 75,149 (2005)
  - Capital: 3,020 (2001); 3,854 (2002); 5,159 (2003); 7,030 (2004); 9,381 (2005)
  - Deposits: 16,110 (2001); 16,805 (2002); 28,067 (2003); 44,301 (2004); 67,821 (2005)
  - Gross loans: 9,415 (2001); 9,153 (2002); 10,197 (2003); 21,284 (2004); 37,214 (2005)
  - Provisions: (656) (2001); (902) (2002); (890) (2003); (818) (2004); (927) (2005)
  - Public bonds (assets): 3,570 (2001); 6,080 (2002); 14,152 (2003); 18,987 (2004); 24,958 (2005)
  - Off-balance-sheet items exceed on-balance-sheet deposits in 2005 (off-balance-sheet in percent of deposits: 123.4 percent).
- Implications noted:
  - Off-balance-sheet operations, lack of supervisory framework for them and for offshore operations, and short-term deposit structure raise liquidity and supervision concerns.
  - Traditional prudential indicators may understate actual exposures because large off-balance-sheet and offshore operations are excluded.

### Assets and liabilities of Venezuelan residents abroad (BIS reporting countries, in billions of U.S. dollars)
- External liabilities (1994–2005, selected years):
  - 1994: 20.7
  - 1995: 20.5
  - 1996: 23.8
  - 1998: 26.4
  - 2000: 26.4
  - 2002: 29.8
  - 2003: 28.7
  - 2005: 50.5 (assets) and 13.4 (liabilities) — net assets 37.0
- 2005 totals:
  - External assets: US$51 billion (December 2005)
  - External liabilities: US$13.4 billion (2005)
  - Net assets: US$37 billion (2005)

### Vulnerabilities, stress-testing insights, and policy-relevant observations
- Main vulnerabilities identified:
  - High exposure to the public sector.
  - Large and growing off-balance-sheet operations and offshore positions with weak supervisory coverage.
  - Predominance of short-term deposits and large checking-account share (>50 percent of deposits), increasing liquidity run risk.
  - Sensitivity to interest-rate and credit shocks given prior lending booms in periods of negative real interest rates.
- Stress-testing conclusions (qualitative from the exercise):
  - Under relatively conservative assumptions, a cyclical downturn could exhaust a large share of banks’ capital and threaten the least capitalized banks.
  - Strong FSIs at end-2005 may partly reflect a credit boom in the context of capital controls and real interest rates that are at or close to negative levels, which could reverse sharply under adverse shocks.

### Key takeaways for policymakers
- Focus supervision on off-balance-sheet and offshore operations: the scale of these operations (more than 100 percent of assets and 130 percent of deposits in 2005) and the absence of a well-defined supervisory framework increase systemic risk.
- Monitor liquidity risk arising from short-term deposit structure: checking accounts >50 percent of deposits and two-thirds of time deposits maturing in less than 60 days heighten run risk.
- Address concentration and market structure risks: the five largest banks account for more than 55 percent of market share, creating potential systemic contagion channels.
- Incorporate macro-financial linkages into stress tests: pro-cyclicality of monetary conditions and past history of severe downturns imply stress scenarios should include sharp reversals in money demand, large increases in real lending rates, and contractions in credit.
- Recognize that high FSIs in a boom can mask vulnerabilities; forward-looking, diagnosis-driven stress testing is necessary to identify weakest institutions before shocks materialize.

*Source: _wp06225 - 1. Venezuela and Selected Latin American Countries: Selected Monetary Indicators (December 2005).*

### 6. The banking sector has high exposure to the public sector, which accounts for a large

### 6. The banking sector has high exposure to the public sector, which accounts for a large share of both deposits and total credit.

### Exposure to the public sector and disintermediation trend
- Claims to the private sector:
  - Accounted for about 70 to 80 percent of total assets during the 1970s and 1980s.
  - Declined to about 51 percent of total assets in December 2005.
  - Reached a trough of 32 percent during the banking crisis of 1994 and in early 2004, before recovering to around 40 percent of assets during periods of lax liquidity.
- Substitution by government-related assets has been a persistent trend since 1985, despite short-term variations.
- Government (public sector) deposits:
  - Accounted for 20 percent of total deposits in 2005.
  - Banks are vulnerable to a drawdown of these deposits or transfers of deposits to other financial institutions (for example, the newly created Banco del Tesoro).

### Recent regulatory environment: overview and implications
- General observation:
  - President Chávez’s government has pursued active social development and poverty reduction policies, including new measures on lending practices and bank soundness.
  - Some measures reinforce regulation and supervision; others increase government intervention in bank operations and have direct impacts on banks’ income.
- Four main regulatory changes affect banks’ ability to withstand downturns and shocks (especially when combined with long-term structural issues):
  1. Expansion and rapid change of the legal/regulatory framework
     - A banking law was passed in November 2001, enhancing the regulatory framework (defining financial institution types, modifying sanctions, establishing trust fund regulations).
     - In 2005, proposals for a new banking law were presented to incorporate microfinance institutions and cooperatives.
     - Two new laws addressed credit card transactions and foreign exchange operations.
     - Rapid adoption of new measures (interest rate regulation, limits on fees and commissions, new prudential requirements) has created legal uncertainty, which tends to make banks risk-averse and reduces financial intermediation.
  2. Increase in directed credit requirements (regulations passed in 2005)
     - The share of domestic credit set by regulation has gradually been augmented and, since 2005, amounts to about a third of total lending.
     - Sectoral minimum lending requirements:
       - Agricultural sector: banks must devote at least 12½ percent of their loan portfolio to agricultural businesses (effective January 2005); minimum increased to 14½ percent in May and to 16 percent in June 2005.
       - Housing sector: new mortgage regulation (February 2005) stipulates a minimum 10 percent share of housing sector loans in banks’ credit portfolios.
       - Micro-enterprise sector: banks must lend at least 3 percent of their loan portfolio to micro-businesses; the minimum is to be increased in the future, up to 10 percent.
       - Tourism sector: starting in January 2006, private banks must allocate a minimum of 2½ percent of their loan portfolio to the tourism sector; for public banks, the minimum is 5 percent.
         - Footnote: In fact, the tourism loan quota has not yet been implemented, and is expected to be effective starting in December 31, 2006.
     - Potential effects of directed credit on bank soundness:
       - Increased interest rate and liquidity risks due to possible maturity mismatch (short-term deposits vs. longer-term credit).
       - Deterioration in portfolio quality because regulation, rather than market assessment, drives credit allocation and banks may lack expertise in targeted sectors.
       - Decline in profitability since most directed credit is at regulated interest rates, reducing average spreads.
       - Reduced ability to manage balance sheets and shift assets in response to asymmetric sectoral shocks.
       - Possible overall reduction in lending if banks prefer to shrink portfolios rather than lend to high-risk directed sectors.
  3. Interest rate controls, higher reserve requirements, and stricter regulations on fees and commissions
     - Interest rate limits and caps:
       - Effective May 2005, banks may not charge lending rates above 28 percent.
       - Deposit floors: may not pay deposit rates below 6½ percent for savings accounts and 10 percent for fixed-term deposits.
       - Penalty surcharge for nonperforming loans was capped at 3 percent.
     - Preferential interest rate provisions:
       - Housing: banks may only charge a fraction of the average lending rate, capped at 18 percent when the average rate exceeds 40 percent.
         - Additional note: If the average lending rate (as calculated by the central bank) is below 20 percent, banks may charge up to 65 percent of the average for housing sector loans. The discount increases as the reference lending rate increases. In addition, low-income households may be eligible for subsidized interest rates at 5.16 percent and 7.31 percent depending on their income level.
       - Tourism: preferential rates of 12.96 percent for general projects and 11.52 percent for projects in designated zones.
       - Agricultural loans: banks cannot charge more than 80 percent of the commercial loan rate.
     - Central bank certificates of deposit (CDs) — yields and maturities:
       - Effective February 1, 2006: central bank pays 10 percent for a 28-day CD and 9¼ percent for a 14-day CD.
       - Previously: issued 56-day CDs yielding 11¾ percent and the rate on 28-day CDs was 11½ percent.
       - Combined effect of lower yields and shorter maturities could significantly reduce banks’ earnings on central bank securities.
     - Reserve requirements on ceded investments:
       - In February 2006, the central bank established a new reserve requirement of 5 percent on ceded investments.
       - The 5 percent requirement increases by ½ percentage point every 4 weeks up to 15 percent in September 2007 (bringing the requirement in line with that on checking, savings, and term deposits).
       - While limiting off-balance-sheet risks, this measure is likely to have a negative impact on bank profits.
     - Fees and commissions restrictions:
       - Regulations concerning fees and commissions issued in 2003; June 2005 central bank restrictions include:
         - 5 percent cap on fees for cash advances on credit cards.
         - 3 percent cap on fees for factoring or leasing operations.
       - Authorities are working on new regulations to reduce fees and commissions to the actual cost of providing the service.
- Overall impacts of the new regulations:
  - Introduce relative price distortions likely to affect banks’ income structure and soundness.
  - Reduction in lending rates reduces profitability of lending and encourages pursuit of non-interest-based revenue (investment income).
  - Tightening of the spread between deposit and lending rates, combined with high unremunerated reserve requirements, may prevent banks from generating sufficient interest margins to intermediate credit profitably.
  - Extension of reserve requirements and restrictions on fees and commissions further limit earning capacity.
  - Regulated interest rates disassociate loan pricing from borrower risk, creating potential moral hazard and raising overall sector risk.
  - Banks’ reactions to limit erosion of soundness may be associated with lower financial intermediation and reduced access to credit.

*Italic: Source: _wp06225 - 6. The banking sector has high exposure to the public sector, which accounts for a large share of both deposits and total credit.*

### 4. The public banking sector is increasing considerably in size and breadth.

### 4. The public banking sector is increasing considerably in size and breadth.

### Expansion of public banks
- Existing public banks have strengthened balance sheets through recapitalization (Banco Industrial de Venezuela (BIV) and Banfoandes) and an extension of activities.
- New public financial institutions have been created, including:
  - A potentially very large Banco del Tesoro with competencies ranging from being the fiscal agent of the government and managing all its treasury functions, to universal banking.
  - Several specialized banks (for example, for women and the army).
- Public financial institutions expanded internationally in 2006 (examples cited: Cuba, Bolivia, Uruguay).
- BIV in 2005 allocated loan portfolios as follows:
  - 46 percent of its loans to small enterprises
  - 38 percent to micro credits
  - 4 percent to cooperatives

### Objectives driving the expansion and attendant risks
- Intended national priorities for public banks:
  - Fostering social development, with an emphasis on financing small and medium-size enterprises and microfinance.
  - Extending international cooperation (capital contributions and expansion abroad).
- Risk implications:
  - Dilution of focus on financial performance increases sector risk.
  - Public banks may be more vulnerable to credit and market risks due to additional operating constraints and obligations.

### Assessing the soundness of the banking sector: approach
- Two-step assessment:
  - Use of Financial Soundness Indicators (FSIs) to link banks’ soundness to macroeconomic, external, and capital account developments.
  - Stress testing to provide a forward-looking complement given FSIs’ limitations.

### Key FSI findings (summary of Table 6 and text)
- General context:
  - After 2002 fragility, banking sector recovered; FSIs are strong as of December 2005.
  - Broad money rose by more than 20 percent in real terms in 2003, 2004, and 2005.
  - Real lending and deposit rates were negative and real credit to the private sector increased by 66 percent in 2004 and 50 percent in 2005, after contracting in 2002 and 2003.
- Selected indicators (end-2005 unless otherwise noted):
  - Capital to risk-weighted assets: 15.5 (percent)
  - Capital to assets: 11.1 (percent)
  - Capital net of provisioning gap (NPLs - provisions) to risk-weighted assets: 15.9 (percent)
  - Retained earnings to capital: 49.0 (percent)
  - NPLs to total gross loans (reported): 1.3 (percent)
  - Provisions in percent of NPLs: 196.3 (percent)
  - Provisions to total gross loans: 2.4 (percent)
  - Public sector exposure to assets: 51.7 (percent)
  - Public sector deposits to total deposits: 19.7 (percent)
  - Return on average assets: 3.7 (percent)
  - Return on equity: 32.6 (percent)
  - Core liquid assets to total assets: 17.9 (percent)
  - Liquid asset ratio (broad) to total assets: 47.3 (percent)
  - Loans to assets: 44.0 (percent)
  - Credit to private sector (percent change) in 2005: 69.4 (percent)
  - Average lending rate in 2005: 16.6 (percent)
  - Average deposit rate in 2005: 11.6 (percent)
  - Interest rate spread in 2005: 5.0 (percent)

### Capital adequacy: observations and vulnerabilities
- Average positions:
  - Average capital-to-risk-weighted-assets ratio stood above 15 percent in December 2005.
  - Capital-assets ratio was above 11 percent in December 2005.
  - These exceed Sudeban minimum requirements: risk-weighted capital-assets ratio of 12 percent and capital-to-asset ratio of 10 percent.
- Concentration and limits:
  - Capital adequacy ratios declined from end-2003 to end-2005 due to rapid asset growth.
  - At end-2005:
    - Seven banks did not comply with the capital-to-assets minimum requirement.
    - Five banks did not meet the minimum capital to risk-weighted assets ratio.
  - Further expansion may require recapitalization of a number of banks.
- Off-balance-sheet exposure:
  - Inclusion of trust funds and investment funds in total assets would reduce the capital-assets ratio to about 5½ percent.
  - Extremely large off-balance-sheet items present an indirect source of vulnerability due to implicit commitments to honor investment funds.

### Asset quality
- Improvement since 2002:
  - Reported nonperforming loans as a share of total loans declined from an average of 11¼ percent in 2002 to 1¼ percent at end-2005.
  - Banks are over-provisioning relative to NPLs: provisions accounted for 196 percent of nonperforming loans at end-2005.
- Caveat on provisioning:
  - The strong provisioning position is due solely to a drastic reduction in nonperforming loans.
  - Provisions to total loans declined from 9 percent in 2002 to 2½ percent in 2005.
  - Given the lag with which nonperforming loans materialize, increased provisioning may be warranted during large credit expansion.

### Public sector exposure
- Levels and trends:
  - Public sector exposure to total assets at end-2005: 52 percent (including central bank sterilization bills and monetary reserves).
  - This represents a decline from 73 percent at end-2003 but remains above pre-2002-crisis levels (~one third of total assets).
  - Public sector deposits to total deposits increased to about 20 percent in December 2005.
- Risks:
  - In the current environment risks associated with high public exposure seem limited.
  - Downside risk: potential transfer of public deposits to the new treasury bank could substantially affect banks’ balance sheets.

### Bank income and profitability
- Profitability metrics:
  - Return on assets at end-2005: 3¾ percent (3.7 percent reported in Table 6).
  - Return on equity at end-2005: 32½ percent (32.6 percent reported in Table 6).
  - These declined from 6¼ percent (return on assets) and 44 percent (return on equity) at end-2003.
- Factors behind reduced profitability:
  - Decline in lending rates reduced interest income on loans to total loans while interest expense to remunerated deposits increased.
  - Interest income on portfolio investment to average portfolio investment fell from 29 percent in 2002 to 13¾ percent in 2005.
  - Fees and commissions compensated for interest rate controls and directed credit; fees and commissions accounted for 67 percent of average bank profits in 2005, up from 55 percent in 2004.

### Liquidity
- Liquidity positions at end-2005:
  - Core liquid assets: 18 percent of total assets.
  - Core liquid assets: 23 percent of short-term liabilities.
  - Broad liquid asset ratio (including investment securities and government paper): 47¼ percent of total assets.
- Interpretation:
  - Comfortable liquidity consistent with limited intermediation of long-term loans and predominance of short-term operations.

### Overall assessment and structural concerns
- As of end-2005, banking sector indicators present a sound picture but are especially dependent on a favorable macroeconomic environment (high growth and excess liquidity).
- Key concerns:
  - Banks expanding operations to the limits of balance sheet capacity with dramatic increases in credit to the private sector.
  - Nonperforming loans may materialize with a lag.
  - New regulations are already reducing profitability.
  - Long-term structural problems persist: limited financial intermediation and banking competition; high exposure to the public sector and economic cycles; continued importance of “non-traditional” banking activities.

### Stress testing: rationale and scenarios
- Purpose:
  - Identify likely impacts of exceptional but plausible shocks on credit, market, and liquidity risks.
- Four main potential shocks considered:
  1. A fall in the international price of oil (historically sharpest impact on growth and government solvency).
  2. A deterioration in credit quality (lagged impact of sharp private-sector credit increase and multiplication of lending requirements).
  3. An interest rate shock (tightening of policy stance and impact of new regulations).
  4. A loss of confidence in the banking sector (bankruptcies, political uncertainty, or erosion of foreign exchange controls).
- Sensitivity analyses:
  - Single-variable shocks (e.g., NPL ratio changes or linear interest rate changes) assess credit, interest rate, and liquidity risk impacts.
  - Two scenario analyses:
    - Cyclical downturn: key variables assumed to return to historic averages.
    - Crisis scenario: overall deterioration in the macroeconomic environment.
- Methodology and data constraints:
  - Tests are static (no second-round effects, no portfolio behavior changes, no reallocation of portfolios).
  - Bottom-up, bank-by-bank approach with aggregation to sector level using detailed Sudeban data (balance sheets and income statements).
  - Data limitations:
    - No sectoral breakdown of loans (performing and nonperforming) or loan concentration data; assumption of symmetric sectoral impact.
    - Net open foreign exchange positions for individual banks unavailable; therefore FX vulnerability not stress tested (sector average net open FX position was not high at end-2005; FX deposits held by residents to total deposits in 2005: 0.2 percent).

*Source: IMF staff analysis in "4. The public banking sector is increasing considerably in size and breadth."*

### 0.2 percent of total deposits and foreign exchange loans for 0.5 percent of total loans.

### _wp06225 - 0.2 percent of total deposits and foreign exchange loans for 0.5 percent of total loans.

### Data limitations and off-balance-sheet exposures
- Interbank market data are not published; the study does not test for contagion risk because the interbank market is embryonic in Venezuela.
- Off-balance-sheet assets are large relative to total banking sector assets but are excluded from computations to maintain consistency with prudential indicators used by Venezuelan authorities.
- Inclusion of off-balance-sheet assets in capital adequacy calculations could reduce capital coverage by as much as 8 percentage points, on average, for the banking sector.
- Adjusting for off-balance-sheet items would bring the capital adequacy ratio for the average of all banks down to 7.6 percent, implying a required recapitalization equivalent to 4.1 percent of 2005 GDP.
- Absence of long time series for banking sector indicators and bank-by-bank balance sheet and income statement data prevents use of macroeconomic models to define the nature and magnitude of shocks; therefore shocks and scenarios are calibrated qualitatively based on history and recent developments.

### Credit risk: calibration, results, and distributional effects
- Assumption: banks fully provision; additions to provisions from higher nonperforming loans (NPLs) or tighter prudential standards reduce capital.
- Calibration:
  - Historic average NPL (1999–2003): 7.6 percent.
  - “Crisis level” NPL (1994–95 crisis): 15 percent.
- Aggregate results (see Table 7 and Figure 5 in source):
  - The aggregate system could withstand a 6 percent increase in the nonperforming loan ratio without the capital adequacy ratio falling below the 12 percent minimum requirement.
  - The average level of capital appears adequate for NPL levels close to historic averages.
  - If credit quality deteriorated to crisis levels (15 percent NPL), the banking sector, at an aggregate level, would become undercapitalized by about 4 percent of risk-weighted assets.
- Distributional vulnerabilities:
  - Public banks and a small number of least-capitalized banks are more vulnerable to deterioration in credit quality.
  - At end-2005, the largest public bank had a capital adequacy ratio of 4 percent and NPLs of 27 percent of total loans.
  - Least-capitalized banks had capital adequacy ratios around the 12 percent prudential requirement; a return of NPLs to the historic average would bring their post-shock capital adequacy ratio close to 6 percent; a crisis-level deterioration would nearly exhaust their capital.
  - Largest banks (by assets) appear more resilient.
  - Domestic banks are more vulnerable to credit risk than foreign banks, being less capitalized and having higher NPL ratios.
- Government paper default shocks:
  - A government default on 50 percent of its debt obligations would reduce the average capital adequacy ratio by about 2 percentage points.
  - A default on 75 percent of obligations would reduce the average capital adequacy ratio by 3.7 percentage points.
  - Conclusion: the banking sector appears well capitalized against a partial default on government paper.

### Interest rate risk: methodology and stress results
- Methodology: maturity mismatch (repricing gap) model using six maturity buckets from Sudeban; gaps computed for each time band and impacts on interest income/expense assessed.
- Key assumptions and data limitations are noted (see source footnotes): classification of time-sensitive assets/liabilities, assumption that central government paper maturities are ≤ three months, and using sector-wide shares for trading book government paper due to lack of bank-by-bank trading book data.
- Stress results:
  - A linear increase in interest rates:
    - An increase of 10 percentage points would reduce by almost half the average capital adequacy ratio for Venezuelan banks; two banks would not be able to withstand a 10 percentage point increase.
    - An increase of 20 percentage points would exhaust all banks’ capital.
    - Nine banks would have insufficient capital to withstand a 15 percentage point increase.
  - Narrowing of the spread and flattening of the yield curve:
    - A 2 percentage point narrowing of the interest rate spread would lower the capital adequacy ratio by 1½ percentage points.
    - A 4 percent narrowing would lower it by 2.8 percentage points.
    - A flattening of the yield curve (5 percentage point increase in short-term rates while long-term rates unchanged) would reduce the average capital adequacy ratio by 4 percentage points.
  - Combined shock:
    - An increase in nominal interest rates of 10 percent (combined with spread narrowing and yield-curve flattening) would reduce the average capital adequacy ratio to 5½ percent.
- Distributional effects:
  - Public and domestic private banks are particularly affected due to large maturity mismatches; foreign private banks are more resilient.
  - A 15 percentage point increase in nominal interest rates would bring the capital adequacy ratios of the ten least capitalized banks to negative levels, especially if combined with spread reduction and yield-curve flattening.
  - A 10 percentage point increase would bring state-owned banks’ capital to zero; a 20 percentage point increase would do the same for domestic private banks.
  - Foreign private banks would see severe capital reductions but are relatively more resilient due to smaller maturity mismatches.

### Liquidity risk: shocks and resilience
- Two liquidity shocks assessed: a run on deposits; a 50 percent withdrawal of government paper from liquid assets.
- Run on deposits:
  - A run affecting 25 percent of total deposits would reduce liquid assets to 27 percent of total assets.
  - Under that run, liquid assets would remain, on average, 45 percent of short-term liabilities and 30 percent of short-term liabilities and trust funds.
  - A run of 73 percent of total deposits would be needed to exhaust liquid assets, on average.
- Withdrawal of government paper:
  - A 50 percent withdrawal of government paper would reduce the liquidity ratio from 47 percent to 32 percent of total assets.
- Conclusion: High levels of liquidity and relatively low loan-to-deposit ratios temper liquidity risks; liquid assets accounted for almost 50 percent of total assets in December 2005.
- Distributional vulnerabilities: state-owned banks and, to a lesser extent, foreign private banks are more vulnerable to liquidity risks.

### Scenarios: compounded shocks (overview)
- Two scenarios are presented to assess compounded effects; results are reported in Table 7 in the source.
- First scenario (cyclical downturn) — summary of modeled effects:
  - Less favorable external conditions and slowdown in global growth lead to deterioration in terms of trade, Venezuela’s external position, and government revenue.
  - Tighter liquidity conditions accompany a 10 percentage points increase in nominal interest rates.
  - Slowdown in growth causes credit quality to worsen: nonperforming loans return to their historic average (7.6 percent).
- The source presents the compounded impacts of these shocks on capital adequacy and liquidity in Table 7.

*Source: _wp06225 - 0.2 percent of total deposits and foreign exchange loans for 0.5 percent of total loans. (PDF chapter/section).*

### 7.5 percent of total loans.

### 7.5 percent of total loans.

### Scenarios modeled
- Second (crisis) scenario:
  - Replicates a crisis situation from either external shocks (large deterioration in the terms of trade and/or global economic slowdown) or domestic shocks (sharp rise in interest rates following a period of lax liquidity conditions accompanied by a marked slowdown in economic growth).
  - Main parameters: a 20 percentage point increase in nominal interest rates and a worsening in credit quality.
  - Nonperforming loans reach crisis levels comparable to the 1994-95 crisis—estimated at 15 percent of total loans.
- Cyclical downturn scenario:
  - A downturn that reduces key macrofinancial variables and tests banks’ resilience.

### Cyclical downturn results
- Average capital adequacy ratio (banking sector, excluding state-owned banks):
  - Falls from an initial 15.5 percent to 2.6 percent.
- Domestic private banks:
  - Post-shock capital adequacy ratio: 1 percent.
  - Capital of domestic private banks would, on average, be almost entirely exhausted by increased provisions and interest rate shock losses.
- Ten least capitalized banks:
  - Would be unable to weather the downturn; capital adequacy ratios turn negative.
- Note: state-owned banks excluded from these results; their inclusion would worsen outcomes due to already higher NPL ratios and low capital base.

### Crisis scenario results
- Average capital adequacy ratio (banking sector, excluding state-owned banks):
  - Would reach negative levels, -8 percent.
- Domestic private banks:
  - Capital adequacy would decline to -11 percent.
- Ten largest Venezuelan banks:
  - Capital adequacy ratio would be brought to -11½ percent on average.
- Cost of recapitalization:
  - Overall cost to bring banks to the minimum ratio of 12 percent would be greater than 4 percent of GDP.

### Sensitivity and stress-test highlights
- Main threats identified:
  - Interest rate risk and credit risk are the principal threats to banking sector soundness.
  - Banks are particularly vulnerable to interest rate shocks because of a large maturity mismatch between assets and liabilities.
- Credit risk:
  - Not an immediate universal concern, but deterioration to historically experienced levels would expose a number of banks.
- Government default:
  - Banks appear well capitalized to face a default on government securities despite large exposure to the government.
- Liquidity risk:
  - Considered limited given banks typically lend short-term, are liquid, and have a fairly low loan-to-deposit ratio.
- Despite high pre-shock capital adequacy ratios, banks are very vulnerable to a cyclical downturn; the banking sector’s capital would not withstand a sharp deterioration in the macroeconomic environment.
- Stress testing caveat:
  - The exercise does not take second-round effects into account; such effects would magnify estimated impacts (confidence declines, increased liquidity risk, negative feedback on growth, interbank contagion).

### Long-term determinants and trends
- Two key determinant sets for sustainability:
  - Long-term issues: improve banks’ resilience to external shocks and policy volatility; deepen financial intermediation by reducing non-lending activities and exposure to the public sector.
  - Regulatory environment: new regulations create a more constrained operating environment with substantial implications for financial soundness.
- Historical patterns and risks:
  - Venezuelan banking sector exposed to high volatility in growth, liquidity conditions, and interest rate movements, producing cyclical credit and credit-quality patterns.
  - Drastic shifts in interest rates are frequent, especially following lending booms; nonperforming loans typically materialize with a lag.
  - Credit quality, notably mortgage and consumer credit, can deteriorate rapidly after expansion driven by negative real interest rates and excess liquidity.
- Government intervention risks:
  - Directed credit requirements, regulated interest rates, and non-market activities by public banks induce non-market lending assessments and moral hazard, affecting credit quality and reducing banks’ ability to manage balance-sheet risks.

### Policy implications and recommendations
- Public intervention and regulation must account for downside risks to the banking sector.
- Improvement of supervision is a welcome step; deficiencies to address include:
  - Absence of established procedures for consolidated supervision of financial groups.
  - Weak monitoring of off-balance-sheet items.
  - Lack of oversight of offshore operations of Venezuelan banks.
  - Inadequate monitoring of connected lending.
- Ensuring competitive operating environments where banks can mitigate emerging risks is key for long-term sustainability.
- Deepening financial intermediation is necessary to broaden access to banking services, support sustainable growth, and reduce poverty.

*Source: IMF Working Paper excerpt: Table and stress-test results for the Venezuelan banking system (selected figures and conclusions).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06225.pdf_