## 1. Accounting Treatment of Provisions and Capital ## Source details **Canonical URL:** [1. Accounting Treatment of Provisions and Capital](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11159.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11159.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11159.pdf.json) --- ### Policy context and motivation - EMEs, including Latin America, face easy external financing conducive to credit exuberance, asset price bubbles, and excess demand booms, increasing risk of sudden reversal (IMF, 2011c). - Traditional macroeconomic instruments can be constrained or inefficient: - Interest rate hikes to contain exuberance can trigger more capital flows. - Foreign exchange intervention may have only temporary effects and impose large quasi-fiscal costs (IMF 2011c). - Macroprudential (MaP) tools complement monetary policy and microprudential (MiP) policy to manage the financial cycle and reduce boom-bust probability (IMF, 2010a, 2010c; Eyzaguirre et al, 2011). - Key MaP design issues: definition and measurement of systemic risk, granularity, rules vs. discretion, institutional arrangements and mandates, coordination in supervision (IMF, 2010c and 2011d). ### Instruments reviewed in the volume (examples up to March 2011) - Capital requirements, dynamic provisioning and leverage ratios. - Liquidity requirements. - Debt-to-income ratios. - Loan-to-value ratios. - Reserve requirements on bank liabilities (deposits and nondeposits). - Instruments to manage and limit systemic foreign exchange risk. - Reserve requirements or taxes on capital inflows. - Selected country examples: - Countercyclical capital requirements: Basel III; Brazil (Auto loans-December 2010). Buffer ranging between 0-2.5% to be introduced when aggregate credit is growing too fast. - Dynamic provisioning: Bolivia (2008), Colombia (2007), Peru (2008), Uruguay (2001). - Leverage ratios: Basel III. - LTV ratios: Canada (Mortgage market-April 2010, March/April 2011). - DTI ratios: Korea (August 2010-March 2011). - Liquidity requirements: Colombia (2008); New Zealand (2010); and Basel III. - Reserve requirements on bank deposits: Peru (January and April, 2011); Brazil (December 2010); China (January – March 2011); Turkey (2009- 2011). - Tools to manage foreign exchange credit risk: Peru (July 2010), Uruguay. - Limits to foreign exchange positions: Colombia (2007); Korea (limits on forward contracts-June 2010); Israel (restrictions on banks derivatives transaction-2011). - Reserve requirements on financial external liabilities: Peru (2010-11) — applies to external liabilities with maturity of less than 2 years. - Tax on capital inflows: Brazil (IOF tax-2010-11). ### Provisions and capital: definitions and roles - Provisions: - General provisions: account for expected losses in the portfolio that have yet to be identified. - Specific provisions: account for losses from specific impaired loans and write-offs. - Capital: - Buffers unexpected losses beyond expected loss estimates. - Composed of Tier-1 capital and Tier-2 capital. - Tier-1 capital, including common equity, allows a bank to absorb losses while remaining a going concern. - Tier-2 capital, including subordinated debt, provides loss absorption on a gone-concern basis. - Adequacy of provisions and capital depends on the reliability of the estimated loss distribution. ### Accounting treatment and incentives (Box 2.1) - Accounting classification: - General provisions: appropriations of retained earnings; increases reduce bank capital. - Specific provisions: current expense and can be deducted from taxes. - Incentives: - Tax differential (specific provisions tax-deductible; general provisions reduce capital) incentivizes minimizing general provisions and under-provisioning relative to expected future losses. - Basel II numeric allowance: - Under Basel II, general provisions could count towards Tier II capital up to a maximum of 1.25 percent of risk-weighted assets. ### Basel III and quantitative capital and leverage benchmarks - Basel III objectives and calibration: - Requires banks to hold common equity and total capital in excess of 7 and 10½ percent respectively. - Shifts toward higher levels of common equity because non-core Tier-2 capital can be very volatile. - Table 1 excerpt — "Basel II and Basel III: Capital Requirements (In percent of risk-weighted assets)": - Basel II row: 2.0 n.a. n.a. 4.0 n.a. 8.0 n.a. n.a. - Basel III row: 4.5 2.5 7.0 6.0 8.5 8.0 10.5 0 - 2.5 - Source: Caruana (2010). - Minimum leverage ratio: - Basel III proposes a minimum leverage ratio of 3 percent during a trial period from January 2013 to January 2017. ### Countercyclical capital buffers and dynamic provisions - Countercyclical capital buffer: - Builds extra common equity during upswing. - Basel III proposes buffer range of 0 to 2½ percent, triggered by changes in an aggregate credit indicator; applies system-wide. - Dynamic (statistical) provisions: - Require buildup of provisions during expansion to offset later loan losses. - Generally bank-specific and calibrated to a bank’s lending activity. - Comparative effects on credit: - Countercyclical capital buffers raise cost of credit and reduce demand. - Dynamic provisions reduce resources available for funding loans and help restrain credit growth. ### Trade-offs, implementation challenges, and next steps - No single MaP instrument addresses all systemic risk aspects; combination tailored to country needs required. - Potential risks and costs: - Activity may shift to nonregulated financial system. - Measures may impose excessive burdens and distort financial deepening. - Implementation challenges: - Lack of adequate theoretical frameworks, especially in general equilibrium. - Calibration unclear; reliance on judgment and trial and error. - Necessary actions: - Close information gaps and develop analytical toolkit. - Establish effective institutional frameworks at micro- and macro-prudential levels (see IMF, 2011d). - Improve information on housing, corporate sectors, and derivatives markets (see Cubeddu and Tovar, 2011). - Develop special instruments and regulatory governance to operationalize MaP policy; modify MiP regulations to account for global reforms. - Assess new financial products and technologies. --- ### Dynamic Provisions, LTV/DTI, and Sectoral Macroprudential Tools ### Dynamic provisioning: country designs and calibrations (Box 2.2) - Peru — countercyclical provisioning rule: - Activation (any one condition holds): - a) "the annualized average percent change of GDP during the past 30 months reaches or exceeds 5 percent from below"; - b) "the annualized average percent change of GDP during the past 30 months is above 5 percent and the average annualized percent change of GDP during the past 12 months exceeds by 2 percentage points its value one year before"; - c) "the annualized average percent change of GDP during the past 30 months is above 5 percent and 18 months have elapsed since the rule was deactivated by second deactivation condition." - Deactivation (any one condition holds): - a) "the annualized average percent change of GDP during the last 30 months falls to or below 5 percent"; - b) "the annualized average percent change of GDP during the last 12 months is lower by at least 4 percentage points than its value one year before." - Minimum countercyclical provisions by loan type: - corporate clients: 0.4 percent - large enterprises: 0.45 percent - medium-sized corporates: 0.3 percent - small and micro-corporates: 0.50 percent - revolving consumer loans: 1.5 percent - nonrevolving consumer loans: 1 percent - mortgage loans: 0.4 percent - Reference: SBS, 2008, Resolución S.B.S. No. 1356, November 19. - Uruguay — dynamic provisions introduced in 2001: - Monthly contribution: ∆DP_t = Σ_{i=1}^{12} α_i C_{t-i} − LL_t (formula as presented). - α_i: expected rate of loss for five loan categories, ranging from 0.1 percent to 1.8 percent. - Net loan loss, LL_t: cost of additional specific provisions net of deactivations and recoveries. - Calibration: beta parameters distributed around average annual loan loss during 1990-2000, which was 1 percent of loans. - Dynamic provisions fund bounded between 0 and 3 percent of total loans. - Reference: Wezel (2010). - System-wide dynamic provisions: - Triggered when growth of economic activity exceeds regulatory threshold (usually potential output growth) or if year-on-year growth accelerates rapidly. - Deactivation when growth falls below potential or economy slows substantially. - Trade-offs: could reduce procyclicality but may impair efficiency and competition (Fernandez de Lis and García-Herrero, 2010). ### Conclusions on countercyclical tools and dynamic provisions - Potential benefits: - Countercyclical capital requirements and leverage ratios could restrain excessive credit growth by raising cost of capital. - Complement MaP tools (LTV limits, reserve requirements) in cases of capital flows-driven credit growth. - Implementation challenges and limitations: - May require raising capital requirements and leverage ratios above Basel III recommendations. - Effectiveness impaired if credit flows outside banking system or banks accept lower return on equity. - Success of dynamic provisions depends on reliable long-run expected loss estimates and balance between rules and discretion. - Peru’s reliance on 1990s crisis data may be overly conservative; calibration based on historical data may fail to capture forward-looking dynamics and should be complemented with discretionary judgment. - Literature and debate: - Balance between rules and discretion remains a challenge (Ocampo, 2003; Turner Review, 2009; Griffith-Jones and Ocampo with Ortiz, 2009). - Repullo (2010) provides arguments against effectiveness of countercyclical buffers. ### LTV and DTI rules: design, evidence, and country examples - Implementation forms and practical considerations: - Can be countercyclical and applied differentially by loan characteristics (owner-occupied vs buy-to-let; high-end vs lower-priced; currency denomination; loan duration). - Mortgage insurance can allow limited LTV breaches (Canada, Hong Kong SAR). - LTV rules often complemented with DTI ceilings, higher stamp duties, or other measures. - Practical constraints: measurement difficulties, loopholes, migration of high-LTV loans beyond supervision, backdoor arrangements, and socio-political tensions. - Alternatives: higher capital charges or provisioning for higher-LTV mortgages; tight LTV limits only for mortgages used as collateral for covered bonds. - Evidence on effectiveness: - Mixed but growing empirical literature: - Gerlach and Peng (2005): LTV caps reduced sensitivity of credit to property prices in Hong Kong SAR. - Almeida et al. (2006): tighter LTV limits lower sensitivity of housing prices and mortgage credit to income shocks. - Crowe et al. (forthcoming): maximum LTV limits positively correlated with house price appreciation between 2000 and 2007. - Wong et al. (2011) and Igan and Kang (forthcoming): evidence of shielding or moderating effects; net social benefits not always assessed. - Recent country moves: - Canada: conventional mortgage LTV limit 80 percent; insurance allowed up to 95 percent; insured mortgages up to 47 percent of outstanding mortgage loans held by chartered banks. April 2010 tightening on refinanced and buy-to-let insured mortgages; subsequent measures to lower refinancing LTV to 85 percent (to take effect in March 2011) and reduce maximum amortization to 30 years from 35. - Brazil (auto loans): Auto loans at 140 billion reais (or 4½ percent of GDP), rising about 50 percent y/y. December 2010: higher risk weights for high-LTV, longer-maturity auto loans and other measures; immediate market response: auto loan interest rates increased by 2½ percentage points in the same month; domestic car sales change flat in January 2011, down from 24 percent in December 2010. --- ### Liquidity Requirements for Macroprudential Purposes (Basel III LCR and NSFR) ### Motivation and objectives - Crisis lessons: illiquidity amplified crisis; excess reliance on wholesale and cross-border funding hindered rollover. - Policy goals: build liquidity buffers, improve funding structure, reduce systemic risk, and dampen credit cycle in upswing. - Liquidity dimensions: - Funding liquidity: ability to raise cash by borrowing or asset sales. - Market liquidity: ability to trade an asset at short notice with little price impact. - Liquidity crisis: sudden evaporation of market and funding liquidity with systemic consequences. - Approaches: limits on liquidity indicators, countercyclical management, leverage ratios, reserve requirements; Basel III introduces LCR and NSFR. ### Liquidity Coverage Ratio (LCR) - Purpose: - Ensure banks can survive one month (30-day horizon) of stressed funding conditions; unencumbered high quality liquid assets / net expected cash outflows > 100 percent. - Timeline: - Observation starting in 2011; minimum standard in 2015. - Main components: - Stress-test scenario includes downgrade, retail deposit run-off, funding disruptions, collateral quality deterioration, unscheduled draws, etc. - High quality liquid assets: unencumbered, convertible into cash at little or no loss; stocks weighted by liquidity. - Net expected cash flow = cumulative expected cash outflows − cumulative expected cash inflows (inflows capped at 75 percent of total expected cash outflows). - Reporting and currency: - LCR expected to be met and reported in a single currency; LCR by currency monitored. ### Net Stable Funding Ratio (NSFR) - Purpose and timeline: - Address longer-term structural maturity mismatches over a one-year horizon; observation starting in 2011; introduced in 2018. - ASF / RSF > 100 percent. - Main components: - Stress scenario considers significant decline in profitability/solvency, downgrades, reputation events; extended central bank borrowing outside regular operations not considered. - ASF: equity, long-term preferred stock, secured/unsecured borrowings with maturity ≥ one year, portions of wholesale funding and deposits expected in stress; categories weighted. - RSF: assets and off-balance exposures adjusted by supervisory factors capturing non-monetizable portion during one-year liquidity event. ### Quantitative and economic impact - Observed shortfalls (BCBS, end-2009 sample): - Average LCR: 83 percent for large banks and 98 percent for remaining banks → implied liquidity shortfall of EUR 1.7 trillion. - NSFR: 93 percent for large banks and 103 percent for remaining banks → estimated shortfall of stable funding of EUR 2.9 trillion. - Economic effects: - LCR and NSFR likely force banks to lengthen funding, increase average funding costs, widen lending spreads, and reduce credit supply, especially long-term credit. - Cost estimates: - Using BCBS QIS data: banks would need to increase average lending spreads by 24 bps for banks to converge to required NSFR (King, 2010). - Spread declines to 12 bps or less when additional Basel III measures are included. - Signalling capacity and limitations: - NSFR may signal liquidity problems inconsistently prior to 2007–08 crisis; average NSFR worsened in 2008 (slightly below 0.95) and improved in 2009. - Liquidity problems surfaced in half of banks with NSFR below 80 percent; failed banks were evenly distributed across NSFR range for a cross-section of 60 globally oriented banks. ### Conclusions on liquidity requirements - Role and benefits: - Fundamental microprudential tools improving individual institution resilience and funding structure; can reduce procyclicality by increasing funding cost. - Basel III LCR and NSFR and BCBS "Principles for sound liquidity risk management and supervision" provide minimum standards and higher standards for bank-specific analysis. - Implementation considerations: - Experiences in Australia, Colombia and New Zealand provide practical avenues for stress-based liquidity frameworks. - Impact moderate on average interest rates; larger banks more affected than smaller deposit-funded banks (exception: some EMEs like Brazil). - New Zealand example: funding costs relative to policy rate increased by equivalent policy tightening of "100–150 basis points". - Limitations and future work: - LCR and NSFR are microprudential and not specifically designed to address systemic liquidity risk; dedicated framework desirable. - Need to examine liquidity risks outside regulatory perimeter and strengthen disclosure of liquidity risk measures. --- ### Country Experiences: New Zealand, Colombia, Chile, and Australia (selected highlights) ### New Zealand (RBNZ) - Liquidity rules introduced April 2010: Liquidity Mismatch Ratio (LMR) and Core Funding Ratio (CFR). - Goal: primarily microprudential; can dampen credit growth by limiting short-term off-shore funding. - Operational features: - Mismatch ratio covers cash flows over a week and over a month. - Adjustments for small economy: definition of highly liquid assets, proxying run-off rates, smoothing ASF category transitions. - Effects: - Shift to longer-term funding tended to increase lending rates by "10–20 bps" for any given policy rate. - Announcement increased banks’ willingness to pay more to attract retail deposits. - Bank funding costs relative to the policy rate increased by an equivalent policy tightening of "100bps". - All banks comply with minimum liquidity requirements; LMRs well above regulatory minimum of "0 percent". - Banks hold funding buffers exceeding CFR of "65 percent" (initial) and expected new requirement of "75 percent". - Notes: - RBNZ may adjust CFR periodically and monitor effects before using it countercyclically. ### Colombia - SARL introduced April 2009 for liquidity risk management; weekly reporting standard of mandatory compliance but no mandatory limits. - Central bank’s financial stability report presents liquidity risk indicator (IRL) and stress tests. - Stress scenario: deposit run equivalent to "4 percent" of current and savings accounts; marginal effects for commercial banks. ### Chile - Central Bank calculates approximations of LCR and NSFR; Chilean banking system exceeds minimum requirements despite Basel I–based regulations. ### Australia (RBA/APRA) - LCR context: shortage of high quality marketable securities. - RBA/APRA facility (Dec 2010): ADIs may establish committed secure liquidity facility with RBA to cover LCR shortfall; market-based commitment fee to be charged. - Only larger ADIs (around "40") eligible. - ADIs must demonstrate steps taken to meet LCR through own balance-sheet before relying on RBA facility. - Consultation during "2011 and 2012". - APRA determination (as of February "2011"): - Level 1 assets: cash; balances with Reserve Bank of Australia; Commonwealth Government and semi-government securities. - No assets qualify as Level 2 assets as of February "2011". --- ### Reserve Requirements (RRs) and Taxes on Capital Inflows ### Reserve requirements: nature, designs, macroprudential purposes - RRs require banks to hold a fraction of deposits/liabilities as reserves at central bank. - Design choices: target liabilities, holding period, remuneration, RR rate, reference base; can be marginal (new deposits) or broad. - Macroprudential purposes: - Countercyclical: hike RRs in upswing to increase lending rates, slow credit, limit leverage. - Improve funding structure: RRs on foreign/domestic borrowing reduce dependence on short-term external financing. - Credit allocation: asymmetric RRs can direct credit to sectors. - Complement to capital requirements and substitute for monetary policy in some circumstances. - Costs and limitations: - Can act as tax if remunerated below market, prompting higher spreads and disintermediation. - Calibration complexities and incentives for regulatory arbitrage. - Effect depends on market structure and monetary regime; imperfect substitutability between deposits and central bank credit is necessary for RRs to affect credit volumes. ### Effect of changes in RRs on active interest rates (Box 6.1) - Estimation methodology: - Impact estimated as change in required reserves times spread between deposit and RR remunerated rates relative to portion of deposits not affected by RRs. - Defines bank net margin, nm, and derives effect of RR changes on active rates required to maintain nm (formula as presented). - Empirical findings: - RRs can raise marginal cost of funds and alter deposit composition. - Colombia: tax equivalent of reserve requirements constructed to consider average and marginal RRs (Vargas et al., 2010). - Brazil: changes in RRs on time deposits affected stocks returns of banking system; tax burden borne by shareholders (Carvalho and Azevedo, 2008). - Colombia (2002–09): positive long run relationship between policy rates and market rates (except mortgage rates); marginal RRs on CDs significant in long term despite CDs having zero RRs. - Conclusions and policy implications: - RRs are flexible and effective MaP tool to address procyclicality and interconnectedness. - Benefits: build buffer in good times, deploy liquidity in bad times; target nondeposit liabilities; avoid distortion in unaffected markets. - Costs: disintermediation, lowered credit availability, calibration difficulty, need complementing measures to avoid risk shifting. - Calibration considerations: RR coverage, scope expansion to loans from domestic non-monetary corporations, monitoring of funding diversions. - Country-specific highlights (selected numbers preserved): - Peru: a 1 percentage point increase in RRs has equivalent effect over the output gap as a 25 bps increase in the policy rate; a 1 percentage point increase in RR raises one-year interest rates by 0.24 percentage point. - China: central bank hiked RRs 100 bps since January 2011 to 20 percent for large banks and 18 percent for small banks (estimated equivalent to reduction of Y360 billion in deposits, 0.9 percent of 2010 GDP). - Turkey: new measures expected to reduce market liquidity by approximately TL7.6 billion and US$200 million (0.7 percent of 2010 GDP). - Korea: one-off interest of W500.2 billion on RRs (0.05 percent of GDP) in December 2008 to capitalize the banking system. ### RRs on noncore liabilities and country experiences (Annex 2) - Peru: exempted long-term foreign borrowing from RR in Sep 2007; foreign long-term liabilities rose from 22 percent in Sep 2007 to 58 percent in Sep 2008 and 82 percent in Sep 2009; RR on short-term foreign liabilities increased and then eliminated in late-2008; re-installed in early 2010. Operational features: - Minimum RR of 6 percent for liabilities in domestic and foreign currency and marginal RR of 30 percent for foreign currency domestic liabilities. - Reserve maintenance period: One month. - Remuneration: minimum RR zero; additional RR in foreign currency remunerated at 60 percent of one month US Dollar LIBOR. - Regional and cross-country operational highlights preserved in tables (selected values): - Peru (February 2011): In domestic currency: Legal rate (unremunerated) 9; Marginal Rate 25; Effective Rate 12.3; Remuneration Overnight rate-100 bps. In foreign currency: Legal rate 9; Marginal Rate 55; Effective Rate 35.2; Remuneration 0.6*Libor (1 month). Marginal rate for nonresidents is 120 percent. - Uruguay: domestic currency 2% annual; US dollars 0.025% annual; Euros 0.20% annual. - Brazil: demand deposits 42%; time deposits 13.5%; savings deposits 20%; additional requirement 5%/4%/10% mix; maintenance periods vary. ### Reserve requirements on capital inflows and IOF-like taxes - RRs on capital inflows: fraction u of private capital inflows required to be deposited at central bank; often unremunerated (URR). - RRs act as price-based capital account restriction, penalizing short-term investments and shifting maturity composition. - Theoretical tax-equivalent framing: - Tax-equivalent of RR μ_k depends on deposit rate, holding period h, foreign interest rate i*, and fraction u. - Table of tax-equivalent values (selected entries preserved): - Libor = 1, Reserve requirement = 15: Loan Maturity 1 month: 2.1; 3 months: 0.7; 6 months: 0.4; 12 months: 0.2. - Libor = 2.1, Reserve requirement = 25: Loan Maturity 1 month: 4.0; 3 months: 1.3; 6 months: 0.7; 12 months: 0.3. - Libor = 3, Reserve requirement = 30: Loan Maturity 1 month: 5.1; 3 months: 1.7; 6 months: 0.9; 12 months: 0.4. - Libor = 3, Reserve requirement = 25: Loan Maturity 1 month: 12.0; 3 months: 4.0; 6 months: 2.0; 12 months: 1.0. - Libor = 3, Reserve requirement = 30: Loan Maturity 1 month: 15.4; 3 months: 5.1; 6 months: 2.6; 12 months: 1.3. - Empirical evidence: - RRs alter composition toward longer maturities; evidence on reducing overall inflow volume is mixed. - Chile, Colombia, and other country URR histories show compositional effects and mixed volume/exchange rate impacts. - Policy implications: - RRs raise cost of foreign financing, penalize short-term borrowing, tilt composition to longer maturities, and can help reduce vulnerability to sudden reversals. - Effectiveness transitory; circumvention and multilateral legal constraints exist. - Preference for measures not discriminating by residency when feasible. --- ### FX Credit Risk, Limits on FX Positions, and Country Case Studies ### Motivation and risks of FX credit risk - FX credit risk arises when lenders extend FX-denominated credit to un-hedged borrowers or when domestic-currency lending occurs to borrowers with FX exposures. - Vulnerabilities increase after sharp FX depreciation; borrower-level information gaps on currency and maturity hinder assessment. - Household sector may be most vulnerable. ### Country prudential measures and experiences - Peru: - Highly dollarized: deposit dollarization 47 percent and credit dollarization 44 percent (Oct 2010). - Less than 20 percent of total credit potentially exposed to FX credit risk as of June 2010; identified FX credit exposure about 18 percent of total credit. - Provisioning for FX credit risk since 2006: 0.25 percent, 0.5 percent, 1 percent depending on guarantees; exemptions if minimum requirements met. - Additional capital requirement since July 2010: 2.5 percent of total FX exposure if cannot incorporate FX risk into overall credit risk assessment; capital add-on about 1 percentage point of total capital requirements. - Supervisory requirements: identification of exposed clients; stress tests with at least 10 and 20 percent real depreciation scenarios. - Uruguay: - Credit dollarization ~52 percent; deposit dollarization ~76 percent (2010Q3). - Capital and provisioning: risk weight 125 percent for loans to un-hedged borrowers; higher provisioning; borrower assessments under peso depreciation of 20 and 60 percent with provisioning outcomes of 0.5 percent, 3 percent, and 7 percent depending on capacity to pay. - Consumer loans: peso-denominated nondelinquent loans classified normal if payments ≤ 30 percent of income; for FX loans threshold is 15 percent (implied 50 percent depreciation), making FX mortgages effectively banned for peso-income borrowers. - Romania: - 2005 measures limited overall FX lending to un-hedged borrowers to less than 300 percent of banks’ own funds; regulation binding for 13 of 39 banks at implementation. - Tightened loan classification to consider FX risk; NPLs rose from 8.1 percent end-2004 to 9.4 percent Sep-2005. - FX credit growth slowed from 56 percent y/y Sep-2005 to 30 percent Feb-2006; 3-month FX credit flow fell from 5 percent of GDP (Aug 2005) to 1.7 percent (Dec). ### Derivatives exposures and corporate losses (Brazil, Mexico) - Pre-August 2008 low currency volatility induced corporates to increase off-balance sheet FX exposure via derivatives; knock-out / knock-in structures caused large losses after depreciation. - Derivatives losses: - Mexico: US$4 billion in Q4 2008. - Brazil: losses as high as US$25 billion. - Examples: Comercial Mexicana losses up to US$1.1 billion; Vitro SAB part of $227 million losses. - Policy responses: - Colombia (May 2007): maximum leverage position on forwards over financial entities' net worth. - Brazil (since 2009): registration of derivative exposures. - Mexico (since 2009): disclosure and risk assessment requirements for derivative contracts. ### Limits on FX positions as macroprudential tool - Measurement and design: - Net open FX position = net spot position + net derivative position. - Limits often expressed as share of capital; may be symmetric or asymmetric; applied continuously or at reporting dates. - FX open position limits (selected LAC examples as presented): - Brazil: 30 (Spot plus derivatives). - Colombia: 20 (Spot plus derivatives); short vs. long: Short is 5 percent. - Mexico: 15 (Spot plus derivatives). - Peru: various short/long caps (e.g., Short is 15 percent; Long 100 percent; Short 10 percent in table notes). - Uruguay: 150 (Spot plus derivatives). - Benefits and risks: - Spot position limits protect banks against sudden appreciation and reduce speculative carry trades. - Derivatives position limits and unremunerated reserve requirements on forward positions may reduce carry-trade incentives. - Risks: forward position limits may affect spot prices, can be circumvented, and may hinder derivatives market development. - Implementation priorities: - Compile borrower-level FX exposure data, enhance supervision, encourage hedging by households and corporates. - Careful calibration to avoid impairing genuine hedging needs. ### Case studies: Korea, Brazil, Colombia, Israel (selected figures) - Korea: - Measures included capping currency forward trades by domestic banks at 50 percent of bank’s equity capital and foreign banks to 250 of equity capital (June 17, 2010 package). - Long-term financing ratio for FX loans raised to 100 percent (from 90 percent). - Increase in total external debt during 2006–07: US$195 billion; almost half attributed to FX forward purchases by banks. - Expected implementation of levy on nondeposit foreign currency liabilities starting second half of 2011. - Brazil: - At end November (2010): FDI US$33 billion; foreign equity inflows US$36 billion; foreign fixed income investment US$26 billion. - Banks external liabilities increased by US$24 billion year-on-year at end October 2010. - IOF tax hikes: fixed income IOF raised from 2 percent to 6 percent in Oct–Nov 2010; tax on daily margin adjustments on foreign positions raised from 0.38 percent to 6 percent. - Central bank required banks to deposit equivalent of 60 percent of short spot dollar positions in cash at the central bank for amounts exceeding US$3 billion or Tier I capital, whichever is lower. - Net open position limit: 30 percent of capital. - Colombia: - May 6, 2007: gross currency derivative positions limited to 500 percent of capital on both short and long sides; URR imposed and later adjusted/eliminated for inflows. - Studies found mixed success in limiting exchange rate appreciation but gross position limits may constrain arbitrage. - Israel: - January 20, 2011: restrictions on banks' currency derivatives transactions with nonresidents effective January 27, 2011; derivatives transactions subject to 10 percent reserve requirement. - Implementation followed by exchange rate depreciation and widening forward premium; derivatives transaction volumes declined. --- *Source: IMF Working Paper content unit — 1. Accounting Treatment of Provisions and Capital (excerpted from _wp11159_).* ### 1. Accounting Treatment of Provisions and Capital ....................................................12 ### 1. Accounting Treatment of Provisions and Capital ....................................................12 ### Policy context and motivation - Emerging market economies (EMEs), including Latin America, face easy external financing conditions conducive to credit exuberance, asset price bubbles, and excess demand booms, increasing the risk of a sudden reversal (IMF, 2011c). - Traditional macroeconomic instruments (monetary policy, foreign exchange intervention) may be constrained or inefficient in confronting such external environments: - Interest rate hikes to contain financial exuberance can trigger more capital flows. - Foreign exchange intervention may have only temporary effects and impose large quasi-fiscal costs (IMF 2011c). - Macroprudential (MaP) tools and regulations are a complement to traditional macroeconomic policies and microprudential (MiP) policies to manage the financial cycle and reduce the probability of boom-bust cycles (IMF, 2010a, 2010c; Eyzaguirre et al, 2011). - Key MaP policy design issues include: definition and measurement of systemic risk, granularity, rules vs. discretion, institutional arrangements and mandates, coordination in supervision (IMF, 2010c and 2011d). ### Instruments reviewed in the volume - The notes examine the following instruments and country examples (up to March 2011): - Capital requirements, dynamic provisioning and leverage ratios. - Liquidity requirements. - Debt-to-income ratios. - Loan-to-value ratios. - Reserve requirements on bank liabilities (deposits and nondeposits). - Instruments to manage and limit systemic foreign exchange risk. - Reserve requirements or taxes on capital inflows. - Examples cited (selected from the overview and Table 1): - Countercyclical capital requirements: Basel III; Brazil (Auto loans-December 2010). Buffer ranging between 0-2.5% to be introduced when aggregate credit is growing too fast. - Dynamic provisioning: Bolivia (2008), Colombia (2007), Peru (2008), and Uruguay (2001). - Leverage ratios: Basel III. - LTV ratios: Canada (Mortgage market-April 2010, March/April 2011). - DTI ratios: Korea (August 2010-March 2011). - Liquidity requirements: Colombia (2008); New Zealand (2010); and Basel III. - Reserve requirements on bank deposits: Peru (January and April, 2011); Brazil (December 2010); China (January – March 2011); and Turkey (2009- 2011). - Tools to manage foreign exchange credit risk: Peru (July 2010), Uruguay. - Limits to foreign exchange positions: Colombia (2007); Korea (limits on forward contracts-June 2010); Israel (restrictions on banks derivatives transaction-2011). - Reserve requirements on financial external liabilities: Peru (2010-11) — applies to external liabilities with maturity of less than 2 years. - Tax on capital inflows: Brazil (IOF tax-2010-11). ### Provisions and capital: definitions and roles - Provisions: - General provisions: account for expected losses in the portfolio that have yet to be identified. - Specific provisions: account for losses from specific impaired loans and write-offs. - Capital: - Buffers unexpected losses beyond expected loss estimates. - Composed of Tier-1 capital and Tier-2 capital (high quality and lower quality). - Tier-1 capital, including common equity, allows a bank to absorb losses while remaining a going concern. - Tier-2 capital, including subordinated debt, provides loss absorption on a gone-concern basis. - The adequacy of provisions and capital depends on the reliability of the estimated loss distribution. ### Basel III and quantitative capital and leverage benchmarks - Basel III capital objectives and calibration (as described in the note): - Because of substantial capital losses during the financial crisis, Basel III requires banks to hold common equity and total capital in excess of 7 and 10½ percent respectively. - Basel III shifts towards higher levels of common equity because non-core Tier-2 capital can be very volatile during periods of distress. - Table 1 (as presented in the source) — "Basel II and Basel III: Capital Requirements (In percent of risk-weighted assets)": - Basel II row (as shown): 2.0 n.a. n.a. 4.0 n.a. 8.0 n.a. n.a. - Basel III row (as shown): 4.5 2.5 7.0 6.0 8.5 8.0 10.5 0 - 2.5 - Source: Caruana (2010). - Minimum leverage ratio: - Basel III proposes a minimum leverage ratio of 3 percent during a trial period from January 2013 to January 2017. ### Countercyclical capital buffers and dynamic provisions - Countercyclical capital buffer: - Requires banks to build an extra layer of common equity during the upswing of the cycle. - Aimed to ensure the banking sector in aggregate can help maintain the flow of credit during a downturn. - Basel III proposes a countercyclical capital buffer in the range of 0 to 2½ percent, triggered by changes in an aggregate credit indicator; applies system-wide. - Dynamic (statistical) provisions: - Require banks to build up provisions during an economic expansion that would later offset loan losses when the economy slows down or contracts. - Generally bank-specific and calibrated according to the bank’s lending activity. - Comparative effects on credit: - Countercyclical capital buffers raise the cost of credit, reducing its demand. - Dynamic provisions, by requiring higher provisions, reduce resources available for funding loans and help restrain credit growth. ### Trade-offs, implementation challenges, and next steps - No single MaP instrument addresses all aspects of systemic risk; a combination tailored to country-specific needs is required. - Potential risks and costs: - Measures may shift activities to the nonregulated financial system. - Measures may impose excessive burdens and distortions, possibly impeding financial deepening. - Implementation challenges: - Lack of adequate theoretical frameworks to evaluate effectiveness, especially in a general equilibrium setting. - Calibration remains unclear in many cases, implying judgment and trial and error in practice. - Necessary actions going forward: - Close information gaps and develop a robust analytical toolkit. - Put in place effective institutional frameworks at micro- and macro-prudential levels (see IMF, 2011d). - Improve information to assess underlying systemic risks in housing, corporate sectors, and derivatives markets (see Cubeddu and Tovar, 2011). - Develop special instruments and regulatory governance to make MaP policy operational; modify MiP regulations to account for regulatory reforms worldwide. - Assess new financial products and technologies. *Source: IMF Working Paper content unit — 1. Accounting Treatment of Provisions and Capital (excerpted).* ### Box 2.1. Accounting Treatment of Provisions and Capital ### Box 2.1. Accounting Treatment of Provisions and Capital ### Accounting classification of provisions - Provisions can be either general or specific. - General provisions: account for expected losses in the portfolio that have yet to be identified since they have not realized yet. - Specific provisions: account for losses from specific impaired loans and write-offs. ### Accounting and capital impact - General provisions are considered appropriations of retained earnings, so their increase reduces the capital of the bank. - Specific provisions are considered a current expense and can be deducted from taxes. ### Incentives created by tax and accounting treatment - The differential tax treatment (specific provisions being tax-deductible while general provisions reduce capital) provides banks with incentives to minimize general provisions and end under-provisioned relative to expected future losses. ### Basel II allowance and numeric limit - Under Basel II, the incentive to under-provision was partly offset by the allowance to count general provisions towards Tier II capital up to a maximum of 1.25 percent of risk-weighted assets. *Source: Box 2.1, _wp11159 - Accounting Treatment of Provisions and Capital.* ### Box 2.2. Dynamic Provisions in Spain and Latin America (continued) ### Box 2.2. Dynamic Provisions in Spain and Latin America (continued) ### Peru — Countercyclical provisioning rule - Activation conditions (rule is activated when any one condition holds): - a) "the annualized average percent change of GDP during the past 30 months reaches or exceeds 5 percent from below"; - b) "the annualized average percent change of GDP during the past 30 months is above 5 percent and the average annualized percent change of GDP during the past 12 months exceeds by 2 percentage points its value one year before"; - c) "the annualized average percent change of GDP during the past 30 months is above 5 percent and 18 months have elapsed since the rule was deactivated by second deactivation condition." - Deactivation conditions (rule is deactivated when any one condition holds): - a) "the annualized average percent change of GDP during the last 30 months falls to or below 5 percent"; - b) "the annualized average percent change of GDP during the last 12 months is lower by at least 4 percentage points than its value one year before." - Minimum countercyclical provisions by loan type: - corporate clients: 0.4 percent - large enterprises: 0.45 percent - medium-sized corporates: 0.3 percent - small and micro-corporates: 0.50 percent - revolving consumer loans: 1.5 percent - nonrevolving consumer loans: 1 percent - mortgage loans: 0.4 percent - Reference: SBS, 2008, Resolución S.B.S. No. 1356, November 19. ### Uruguay — Dynamic provisions introduced in 2001 - Monthly contribution to individual dynamic provisioning fund, DP_t, equals the difference between monthly statistical net losses on loans to the nonfinancial private sector (NFPS) and the realized net loan loss in that month: - ∆DP_t = Σ_{i=1}^{12} α_i C_{t-i} − LL_t (formula as presented in source) - Statistical losses: - Derived by multiplying 1/12 of the expected rate of loss for five loan categories, α_i, ranging from 0.1 percent for low-risk loans to 1.8 percent for credit card loans, by respective loan volumes, C_t. - Net loan loss, LL_t: - Calculated as the cost of additional specific provisions recorded in the profit and loss statement, net of deactivations of specific provisions (reclassifications of loans toward higher categories) and recoveries of defaulted loans already written off. - Calibration and bounds: - At inception, beta parameters were reportedly distributed around the average annual loan loss during 1990-2000, which was 1 percent of loans. - The dynamic provisions fund of each bank is bounded between 0 and 3 percent of total loans to be provisioned. - Reference: Wezel (2010). ### System-wide dynamic provisions triggered by aggregate economic activity - Rationale and design: - System-wide dynamic provisions triggered by changes in aggregate economic activity could be more effective in restraining credit growth because they force all banks to increase provisions regardless of individual lending expansions. - Peru implemented such a system in 2008. - Operational trigger logic (as described): - Dynamic, countercyclical provisions in excess of general and specific provisions are required when growth of economic activity exceeds a regulatory threshold (usually set at growth rate of potential output) or if year-on-year growth accelerates rapidly. - Deactivation occurs when economic growth falls below potential or the economy slows substantially. - Trade-offs and caveats: - System-wide provisions lean against the wind similar to countercyclical capital buffers; findings from BCBS (2010c) suggest aggregate-indicator-triggered buffers could reduce procyclicality. - Aggregate-indicator-based provisions could impair efficiency and competition in the banking system (Fernandez de Lis and García-Herrero, 2010). ### D. Conclusions on dynamic provisions and countercyclical tools - Potential benefits: - Countercyclical capital requirements and leverage ratios could help restrain excessive credit growth in Latin America by raising the cost of capital. - In cases of capital flows-driven credit growth, these measures can complement macroprudential tools like LTV limits and reserve requirements and facilitate monetary and fiscal policy. - Implementation challenges and limitations: - May require raising capital requirements and leverage ratios well above levels recommended in Basel III. - Effectiveness impaired if substantial share of credit flows outside banking system or if banks accept lower return on equity instead of passing costs to borrowers. - Success of dynamic provisions depends on reliable estimates of long-run expected loss and an adequate balance between rules and discretion. - Estimating long-run expected losses is challenging; Peru’s reliance on 1990s banking crisis data may be overly conservative and disadvantage domestic banks. - Calibration based on historical data may fail to capture forward-looking dynamics and should be complemented with discretionary judgment. - Literature and debate: - Adequate balance between rules and discretion remains a challenge (Ocampo, 2003; Turner Review, 2009; Griffith-Jones and Ocampo with Ortiz, 2009). - Note: Repullo (2010) provides arguments against the effectiveness of countercyclical buffers. --- ### III. LIQUIDITY REQUIREMENTS FOR MACROPRUDENTIAL PURPOSES ### A. Motivation - Crisis lessons and objectives: - Illiquidity amplified depth and severity of the global crisis; excess reliance on wholesale and cross border funding contributed to inability to roll-over funding. - Liquidity risk management is now a regulatory priority with goals to build liquidity buffers and improve funding structure to reduce systemic risk and dampen credit cycle in upswing. - Dimensions of liquidity risk: - Funding liquidity: ability to raise cash by borrowing or asset sales. - Market liquidity: ability to trade an asset at short notice with little price impact; includes tightness, depth, immediacy, and resilience. - Liquidity crisis: sudden, prolonged evaporation of market and funding liquidity with systemic consequences ("liquidity black holes"). - Policy approaches: - Manage idiosyncratic and systemic liquidity risks via limits on liquidity indicators and countercyclical management (traditional liquidity, core funding, noncore funding, leverage ratios, reserve requirements). - Basel III introduces stressed liquidity requirements: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). - Robust methodologies for measuring systemic liquidity risk are still being developed. ### B. The Liquidity Coverage Ratio (LCR) - Purpose: - Ensure banks have liquidity to survive one month (30-day horizon) of stressed funding conditions; ratio of unencumbered high quality liquid assets to net expected cash outflows must exceed 100 percent. - Timeline: - LCR in observation starting in 2011; introduced as a minimum standard in 2015. - Main components: - Stress-test scenario: - Considers downgrade in institution credit rating, run-off of retail deposits, disruptions in secure and unsecured funding, market disruptions affecting collateral quality, unscheduled draws on credit and liquidity facilities. - Definition of high quality liquid assets: - Unencumbered, immediately convertible into cash at little or no loss; eligible for central bank operations in severe market stress; stocks weighted by liquidity. - Net expected cash flow: - Cumulative expected cash outflows minus cumulative expected cash inflows under stress; inflows capped at 75 percent of total expected cash outflows. - Reporting and currency: - LCR expected to be met and reported in a single currency; LCR by currency expected to be monitored and reported to track currency mismatches. ### C. Net Stable Funding Ratio (NSFR) - Purpose and timeline: - Complement to LCR addressing longer-term structural maturity liquidity mismatches over a one-year horizon; NSFR in observation starting in 2011; introduced in 2018. - Ratio of available stable funding (ASF) to required stable funding (RSF) must exceed 100 percent. - Main components: - Stress scenario: - Considers significant decline in profitability or solvency, downgrades in ratings, reputation/credit quality events; extended central bank borrowing outside regular operations not considered. - Available Stable Funding (ASF): - Equity, long-term preferred stock, secured/unsecured borrowings and liabilities with effective maturities ≥ one year, proportion of stable wholesale funding and deposits expected to remain in stress; ASF weights categories by factor. - Required Stable Funding (RSF): - Sum of assets and off-balance sheet exposures adjusted by supervisory factors capturing the portion not monetizable during a one-year liquidity event. ### D. Quantitative and Economic Impact of LCR and NSFR - Observed shortfalls (BCBS, end-2009 sample): - Average LCR: 83 percent for large banks and 98 percent for remaining banks → implied liquidity shortfall of EUR 1.7 trillion. - NSFR: 93 percent for large banks and 103 percent for remaining banks → estimated shortfall of stable funding of EUR 2.9 trillion. - Economic effects: - LCR and NSFR likely force banks to lengthen term funding, increasing average funding costs and potentially widening lending spreads and reducing credit supply, particularly long-term credit. - Cost estimates: - Study using BCBS Quantitative Impact Study data: banks would need to increase average lending spreads by 24 bps for banks to converge to required NSFR (King, 2010). - Spread declines to 12 bps or less when additional Basel III measures are included (holding higher quality investment lowers risk-weighted assets and capital requirements). - Signalling capacity and limitations: - NSFR may signal liquidity problems inconsistently prior to 2007–08 crisis. - Evidence: average NSFR worsened in 2008 (slightly below 0.95) and improved in 2009; liquidity problems surfaced in half of banks with NSFR below 80 percent. - Weakness: failed banks were evenly distributed across NSFR range for cross-section of 60 globally oriented banks. ### E. Conclusions on liquidity requirements - Role and benefits: - Liquidity requirements are fundamental microprudential tools that improve resilience of individual institutions and funding structures and can help reduce procyclicality by increasing cost of funding. - Basel III LCR and NSFR, together with BCBS "Principles for sound liquidity risk management and supervision" (BCBS, 2008), provide minimum standards and higher standards for bank-specific analysis, governance, and supervision. - Implementation considerations: - Experiences in Australia, Colombia and New Zealand provide practical avenues for immediate implementation of stress-based liquidity frameworks. - Impact likely moderate on average interest rates; larger banks more likely affected than smaller deposit-funded banks (exception: some EMEs like Brazil where large banks rely more on deposits). - Example: In New Zealand, funding costs relative to the policy rate increased by an equivalent policy tightening of 100–150 basis points. - Limitations and future work: - LCR and NSFR are microprudential and not specifically designed to address systemic liquidity risk; a dedicated framework to mitigate systemic liquidity risk is desirable but not straightforward. - Need to examine liquidity risks outside the regulatory perimeter and mechanisms to ring-fence the core financial system; more work needed to strengthen disclosure of detailed liquidity risk measures inside and outside the financial system. *Source: Box 2.2 and subsequent sections as presented in the provided content unit.* ### Annex 1. Country Experiences: New Zealand, Colombia, Chile, and Australia ### Annex 1. Country Experiences: New Zealand, Colombia, Chile, and Australia ### New Zealand - Policy actions - The Reserve Bank of New Zealand (RBNZ) introduced in April 2010 liquidity rules: the Liquidity Mismatch Ratio (LMR) and Core Funding Ratio (CFR). - Goal: primarily microprudential—increase banks’ resilience to funding and liquidity shocks experienced in 2008–09; can also dampen credit growth by limiting use of short-term off-shore funding. - Full compliance requires banks to shift from short-term (mostly off-shore) funding to long-term maturities or retail deposits. - Design features and operational considerations - The RBNZ introduces a mismatch ratio covering cash flows over a week and over a month to ensure sufficient liquid assets throughout the month. - Operational adjustments for a small economy: definition of highly liquid assets, proxying run-off rates using a grading system, and factors that smooth transition of instruments changing ASF categories. - Effects and outcomes - The shift to longer-term funding tended to increase lending rates by "10–20 bps" for any given policy rate depending on spreads. - Announcement increased banks’ willingness to pay more to attract retail deposits. - Bank funding costs relative to the policy rate increased by an equivalent policy tightening of "100bps", leading to an increase in lending rates relative to benchmark rates. - Currently all banks comply with minimum liquidity requirements; LMRs are well above the regulatory minimum of zero. - Banks hold funding buffers that exceed the current minimum CFR of "65 percent" and the expected new requirement of "75 percent". - Notes - The RBNZ has left open the possibility of adjusting the CFR periodically and recognizes the need to monitor its effects on the credit cycle before using it in a countercyclical manner. ### Colombia - Policy actions - The supervisory authority introduced in April 2009 a liquidity risk management system (SARL). - SARL aims at identifying, measuring, controlling, and monitoring liquidity risk in the trading book and on- and off-balance sheet. - Defines a liquidity risk weekly reporting standard of mandatory compliance with no mandatory limits. - Credit institutions and upper-level financial cooperatives may design their own systems consistent with supervisory guidelines. - Monitoring and stress testing - The central bank’s financial stability report presents a liquidity risk indicator (IRL) and additional stress test scenarios. - Evidence shows no liquidity shortages in the system (i.e., no negative IRLs across banks). - Stress scenario: deposit run equivalent to "4 percent" of current and savings accounts. - Under that stress scenario only marginal effects were found for commercial banks relative to the benchmark. - Notes - Calibration of the stress scenario remains an issue to consider. ### Chile - Monitoring and disclosure - The Central Bank of Chile calculates approximations of the LCR and NSFR in its Financial Stability Report. - Findings show the Chilean banking system exceeds the minimum requirements. - These estimates were disclosed despite regulations being based on Basel I. ### Australia - LCR context and supply constraints - The LCR requires holding high quality liquid assets to offset net cash flows over a 30-day period. - High quality marketable securities are in short supply in Australia for reasons such as fiscal prudence. - Basel III incorporates alternative treatments, including allowing a contractual committed liquidity facility provided by the central bank (subject to a fee) to count toward the LCR. - RBA/APRA facility and terms - In December 2010 the RBA and APRA decided an authorized deposit-taking institution (ADI) may establish a committed secure liquidity facility with the RBA sufficient to cover any shortfall between the ADI’s holdings of high-quality liquid assets and the LCR requirement. - Qualifying collateral: all assets eligible for repurchase transactions with the RBA under normal market operations. - The RBA will charge a market-based commitment fee on institutions that establish a facility; the fee aims to provide incentives comparable to jurisdictions with ample high quality liquid assets. Further details of the fee are yet to be determined. - Only the larger ADIs (around "40") will be eligible for the facility. - Eligible ADIs must demonstrate to APRA that all steps have been taken to meet LCR requirements through their own balance sheet management before relying on the RBA facility. - Details of the RBA liquidity facility and APRA's prudential standard on liquidity risk management were to be subject to consultation during "2011 and 2012". - Assets qualifying as high-quality liquid assets - APRA review (as of February "2011") determined that the only assets that qualify as Level 1 assets are: - cash, - balances held with the Reserve Bank of Australia, - Commonwealth Government and semi-government securities. - APRA determined there are no assets that qualify as Level 2 assets as of February "2011". ### Annex tables and ratio highlights (as presented) - Liquidity Coverage Ratio (LCR) — key points - Definition: amount of unencumbered, high quality, liquid assets that can be employed to offset cash outflows. - Goal: ensure adequate funding liquidity to survive one month of stress funding conditions. - Total net cash outflow = outflows - min{inflows; "75 percent" outflows}. - Stress features include: a three-notch downgrade; run-off proportion of retail deposits; loss of unsecured wholesale funding; loss of secured short-term financing except for high quality liquid assets; increases in market volatilities; unscheduled draws on committed but unused credit and liquidity facilities; need to fund balance sheet growth from noncontractual obligations. - Level 1 assets (100%): cash; Central Bank reserves (to the extent drawable in stress); marketable securities representing claims on or guaranteed by sovereigns, central banks, BIS, IMF, or other multilateral development banks meeting specified conditions. - Level 2 assets (85% after a 15 percent haircut) cannot comprise more than "40 percent" of the overall stock after haircut; includes certain government/central bank debt and low risk corporate and covered bonds with additional constraints. - Net Stable Funding Ratio (NSFR) — key points - Definition: addresses maturity mismatches between assets and liabilities. - Goal: set a minimum acceptable amount of stable funding based on the liquidity characteristics of a bank’s assets over a one-year horizon. - Available Stable Funding (examples and factors): - "100%" factor: capital (tier 1 and 2); preferred stock (maturity >= one year); secured and unsecured borrowings and liabilities with effective maturities >= one year. - "90%" factor: “Stable” nonmaturity (demand) deposits and/or term deposits with residual maturities < one year provided by retail customers and small business customers. - "80%", "65%", "50%", "20%", "5%", "0%" factors applied to other categories as specified in the table. - Extended borrowing from central bank lending facilities outside regular open market operations are not considered in the ratio. - New Zealand LMR specifics - Goal: increase banks’ resilience to liquidity shocks by requiring sufficient cash and liquid assets to maintain short-term funding requirements. - Requirement: mismatch ratio no less than the minimum specified at the end of each business day; minimum requirement = "0 percent". - One-week mismatch dollar amount components include: primary liquid assets after haircuts + "75 percent" of undrawn committed lines available within one week - 100 percent of market funding withdrawable at sight or with residual contractual term within one week – nonmarket funding withdrawable at sight or with residual contractual term within one week – other contractual outflows due within one week – "15 percent" of the undrawn balance of committed lines granted by the bank drawable within one week. - One-month mismatch dollar amount components include: primary liquid assets after haircuts + secondary liquid assets after haircuts + contractual inflows due within one month + "75 percent" of undrawn committed lines available within one month - analogous outflows and "15 percent" treatment for undrawn revolving facilities. *Source: IMF staff (Annex 1 of the provided content).* ### ANNEX TABLE 4: NEW ZEALAND - CORE FUNDING RATIO (CFR) ### ANNEX TABLE 4: NEW ZEALAND - CORE FUNDING RATIO (CFR) ### Goal - Increase bank’s resilience to funding shocks by requiring banks to maintain sufficient cash and liquid assets to maintain short-term funding requirements. ### Definition - Requires banks to hold its one-year core funding ratio at not less than the minimum specified at the end of each business day. ### Formula - ൬כൌ100 ܴܨܥ ݐ݊ݑ݋݉ܽݎ݈݈ܽ݋݀݃݊݅݀݊ݑ݂݁ݎ݋ܿݎܽ݁ݕെ݁݊݋ ݏ݁ܿ݊ܽݒ݀ܽ݀݊ܽݏ݊ܽ݋݈݈ܽݐ݋ܶ ൰ ### Requirement - 65 percent on initial implementation, but it will increase to 75 percent in stages over time, after a review process. ### Components - One-year core funding dollar amount = - all funding with residual maturity longer than one year - + 50 percent of any tradable debt securities issued by the bank with original maturity of two years or more and with residual maturity at the reporting date of more than six months and not more than a year - + non-market funding that is withdrawable at sight or with residual maturity less than or equal to a year, applying decreasing percentages that decline with the size of the fund tier 1 capital. - Footnote: - 1 Including subordinated debt and related party funding. ### Notes - Ratio is consistent with the BCBS’s Net Stable Funding Ratio. *Source: IMF staff on the basis of RBZN.* ### Annex 1 on a case study of Hong Kong SAR highlights some practical considerations in LTV rule ### Annex 1 on a case study of Hong Kong SAR highlights some practical considerations in LTV rule implementation, and also discusses the effects of the recent LTV tightening there. ### Implementation forms and practical considerations - Implementation can be countercyclical to lean against swings in credit supply and asset demand. - LTV caps can be applied differentially to loans with different characteristics: owner-occupied vs. buy-to-lets; high-end vs. lower-priced; “hot” vs. peripheral locations; local currency vs. FX mortgages; longer duration vs. shorter-term loans. - Government-supported mortgage insurance can allow limited breaches of LTV caps (example: Canada, Hong Kong SAR). - LTV rules are often complemented with other regulatory measures: - Debt servicing to income ratio (DTI) ceilings (example: Korea, Hong Kong SAR). - Higher stamp duty to discourage “flipping” and speculation (example: Singapore, Hong Kong SAR). - Practical constraints and implementation challenges: - Measurement difficulty and potential loopholes (e.g., migration of high LTV loans to parts of the financial sector beyond direct prudential oversight, including offshore banks). - Evasion through backdoor arrangements (additional loans disguised as personal loans, “top-ups”). - Targeted nature can create unintended spillovers by pushing financial excess to non-targeted sectors. - Lack of well-developed analytical framework for calibrating LTV restrictions to cyclical position; the Korean experience illustrates difficulty in determining appropriate LTV levels. - Socio-political tensions where promoting home ownership (including mortgage interest tax deductibility) clashes with restricting LTVs. - Efficiency trade-off: too-strict LTV caps could unduly reduce welfare by prioritizing stability over financial deepening. - Regulatory alternatives to absolute LTV caps: - Higher capital charges or provisioning requirements for higher-LTV mortgages (examples: Norway, Switzerland, the UK, Spain, Israel). - Tight LTV limits applied only to mortgages used as collateral for covered bonds (examples: Peru, Germany, Switzerland). - Many regulators prefer to discourage rather than strictly rule out high LTVs. ### Existing evidence on effectiveness - Empirical literature is relatively limited but growing. - Selected empirical findings cited: - Gerlach and Peng (2005): after LTV caps, credit expansion in Hong Kong SAR became less sensitive to property prices. - Almeida et al. (2006): in a panel, sensitivity of housing prices and mortgage credit to income shocks is lower when LTV limits are tighter. - Crowe et al. (forthcoming): maximum LTV limits are positively correlated with house price appreciation between 2000 and 2007 in a cross-section of countries. - Wong et al. (2011): banks in countries with explicit LTV restrictions seem more shielded from house price and macro developments. - Igan and Kang (forthcoming): Korea’s LTV policy might have helped moderate the housing cycle by influencing households’ expectations, though net social benefits are not assessed. - No consensus: some authorities report usefulness, others report mixed analytical results, reflecting empirical difficulty in identifying multiple simultaneous factors (CGFS, 2010 May). ### Recent examples in the Americas — Canada - Regulatory framework and statistics: - LTV limit on conventional mortgages is set at 80 percent. - Lenders required to obtain insurance for mortgages with LTVs above 80 percent. - Mortgage insurance allowed to back mortgages of LTVs only up to 95 percent. - Insured mortgages represent as much as 47 percent of total outstanding mortgage loans held by chartered banks. - Recent policy moves (April 2010 and subsequent announcements): - In April 2010, tightened LTV limits for insured mortgages that are refinanced or used for buy-to-let purchases; conventional mortgages and other insured mortgages unchanged. - LTV limit on refinanced insured mortgages lowered from 95 to 90 percent (April 2010). - LTV limit on insured mortgages for buy-to-let properties reduced from 95 to 80 percent (April 2010). - Minimum DTI criterion tightened: borrowers must meet income standards for a five-year fixed rate mortgage even if choosing lower interest rate and/or shorter term. - Announced further tightening: LTV limit on refinancing of insured mortgages will be lowered to 85 percent (to take effect in March 2011). - Government will withdraw existing insurance backing on non-amortizing home equity lines of credit. - Maximum amortization period allowed for new insured mortgages will be reduced from 35 to 30 years. - Context and rationale: - Few overt signs of overheating (house prices increased by a moderate 4 percent y/y in April 2010). - Measures aimed to discourage home equity–financed consumption and promote larger buffers against downturns, and to dampen speculative activity. ### Recent examples in the Americas — Brazil (auto loans) - Market size and dynamics: - Auto loans at 140 billion reais (or 4½ percent of GDP), rising at about 50 percent y/y. - Auto loans account for nearly half of the 29 percent year-on-year growth of total non-earmarked loans to individuals. - Recent lengthening in average maturity of auto loans to 19 months and reduction in lending spreads raised concerns about laxer risk control. - Regulatory tightening (early December 2010): - Greater risk weights on high-LTV auto loans for given maturities: - Risk weight of 150 percent (vs. 100 percent before) imposed on auto loans with LTVs higher than 80 percent for the 2 to 3-year tenor. - Risk weight of 150 percent imposed on loans with LTVs higher than 70 percent for the 3 to 4-year tenor. - Risk weight of 150 percent imposed on loans with LTVs higher than 60 percent for the 4 to 5-year tenor. - Other measures: heavier capital charge on long-duration payroll-deducted personal loans and a higher reserve requirement. - Immediate market responses (tentative): - Auto loan interest rates increased by 2½ percentage points in the same month of the rule change. - Year-on-year change in the volume of domestic car sales was flat in January 2011, down from 24 percent in December 2010. - Macroeconomic reasoning: - Similar qualitative effects to tightening mortgage LTVs: restrain domestic demand pressures and mitigate lender fragility. - Differences in channels: car prices relatively insensitive to economic cycles; rapid auto loan growth affects domestic demand via direct car purchases and increased liquidity. - Data caveat: a more complete assessment awaits further data on volume and average maturity of auto loans. ### Conclusion and policy implications - Usefulness of mortgage LTV restrictions: - More likely to be useful where the housing sector has greater systemic consequences for the macroeconomy (e.g., high share of household wealth in housing, prevalent home equity withdrawal, large capital inflows to the housing sector). - LTV restrictions could reduce amplitude of housing cycles and weaken macroeconomic impacts. - In regions with shallow mortgage markets (many Latin American countries), LTV restrictions exist but are not typically adjusted along cycles; exception: Chile lowered LTV requirements in 2009 for highly rated banks. - Countercyclical LTV regulation can play an important prudential role when mortgage market expansion is rapid, fueled by capital inflows, or accompanied by falling lending standards. - Complementarity: because mortgage LTV caps narrowly target housing, they should be complemented with wider measures if exuberance is widespread beyond residential real estate. - Applicability beyond housing: - LTV rules can be useful in non-housing asset markets (example: auto loans in Brazil) to moderate domestic demand cycles and shield lenders from downturns. - Calibration considerations: - Appropriate LTV level depends on credit market structure and trends (e.g., lenders’ funding reliance, profitability, recourse nature of loans). - Stronger signs of overheating may warrant steeper tightening, but abrupt/aggressive moves risk excessive market correction (illustrated by Korea’s sharp reversal after tightening). - Gradual adjustments allow better assessment of impacts and evolving market trends before further action. ### Annex: Hong Kong SAR case study (high-level points) - Motivation for case study: - Long experience with LTV rules and strong link between housing market and macroeconomy. - Key contextual features: - Currency board arrangement and a small government: monetary policy absent and fiscal tool constrained, giving a more prominent role to macroprudential measures. - Openness to international capital markets and close tie to mainland China contribute to volatility; demand from international investors seeking exposure to China and mainland Chinese diversification into Hong Kong SAR have made the housing market a speculation hotspot. - Banks typically highly capitalized with low loan-to-deposit ratio. - Residential mortgages represented about 27 percent of bank loans in 2010. - LTV policy history: - Restriction at 70 percent first introduced in 1991 on a voluntary basis, followed by formal guidance (text ends here). *Source: _wp11159 - Annex 1 on a case study of Hong Kong SAR highlights some practical considerations in LTV rule implementation, and also discusses the effects of the recent LTV tightening there_* ### 1994. The denominator of the cap refers to the lower of the actual transaction price and ### _wp11159 - 1994. The denominator of the cap refers to the lower of the actual transaction price and ### Hong Kong SAR: LTV cap design, governance, and enforcement - LTV cap denominator: the lower of the actual transaction price and professional surveyor’s valuation (the latter tends to be significantly less than the former during booms). - Complementary borrower limits: - DTI limit at 50–60 percent (with the upper limit applied to high earners). - It is “recommended” that each bank keeps mortgage loans below 40 percent of its total loans. - Scope of the cap: - The cap applies to both newly originated mortgages and refinancing, except for those refinancing cases involving negative home equity. - Mortgage insurance exceptions and premiums: - Borrowers are allowed to exceed the LTV cap by a limited margin if they purchase mortgage insurance. - In Hong Kong SAR, LTV was allowed to go up to 90 percent if accompanied by mortgage insurance (vs. 70 percent without). - Standard premium on insurance provided by HKMC is about 3 percent on total loan value for mortgages with 90 percent LTV. - In comparison, in Canada LTV for new mortgages is allowed to go up to 95 percent with purchase of mortgage insurance (vs. 80 percent without). - Standard premium of insurance provided by CMHC is 2 percent on total loan value for mortgages with 90 percent LTV and 2.75 percent for those with 95 percent LTV. - In both places, the insurance premium can be amortized over the life of the mortgage loan. - Regulatory authority and enforcement: - Hong Kong Monetary Authority (HKMA) is responsible for the formulation and enforcement of the LTV cap. - HKMA is the sole prudential overseer of banks and mortgage products; while the LTV cap is not statutory, violations would result in HKMA questioning the bank’s risk management practice. - Enforcement mechanisms include on-site spot checks and off-site reviews. - HKMA has acted to close loopholes (e.g., disallowing certain personal loan top-ups by limiting the drawdown window and maturity of personal loans). ### Countercyclical management and specific policy adjustments (Hong Kong SAR) - HKMA adjustments over time: - Tightening in the run-up to the 1997–98 Asian crisis. - October 2009: HKMA lowered the LTV cap to 60 percent for homes above HK$ million (or US$2.5 million, or about 6 times the average home price in Hong Kong SAR). - August 2010: HKMA broadened the tighter 60 percent cap to properties above HK$12 million and all buy-to-lets. - As complementary measures in August 2010: - Reduced the DTI limit to 50 percent for all borrowers. - Required banks to grant loans only to those whose DTI would stay below 60 percent even if mortgage interest rates rise 2 percentage points. - November 2010: - Tightened the LTV cap to 50 percent for properties above HK$12 million and all buy-to-lets. - Tightened to 60 percent for properties between HK$8 million and HK$12 million. - November 2010 also: authorities imposed stricter restriction on the use of mortgage insurance to bypass the LTV cap (HKMC suspended its provision of mortgage insurance for properties above HK$6.8 million). ### Early evidence on impact of LTV measures (Hong Kong SAR) - Observed outcomes after new measures: - The weighted average of new loan LTVs fell—to the lowest level since at least 2001, when tracking of such data became available—probably reflecting a dropout of high LTV loans for high-end purchases. - Suggestive declines in mortgage credit expansion and market turnover, with the targeted high-end segment particularly affected. - The rise in average home prices continued, but the relative increase in high-end home prices seems to have moderated somewhat following the new LTV rules. - Cautions on interpretation: - High volatility of the data and simultaneous developments of many other relevant factors suggest caution in interpreting the outturns. - Some believe that strong demand from mainland Chinese was a key factor boosting prices of high-end properties in Hong Kong SAR; as mainland Chinese buyers do not usually take out mortgage loans from Hong Kong SAR banks, the LTV measures might not have directly affected their demand. ### Cross-country examples of LTV restrictions (Annex snapshot) - Korea (Jul ’09; Oct ‘09): 40–50 percent for mortgages for the capital region; looser limits for other regions (also DTI at 40–50 percent for the capital region). - Hungary (Mar ‘10): 75 percent for local currency mortgages; 45–60 percent for FX mortgages. - China (Apr ’10; Jan ‘11): 70 percent for large first homes (>90 sqm), and 40 percent for second homes. - Norway (Mar ‘10): 90 percent for all new mortgages. - Sweden (Oct ‘10): 85 percent for all new mortgages. - Malaysia (Nov ‘10): 70 percent for third homes. - Hong Kong SAR (Oct ’09; Aug ’10; Nov ‘10): 50–60 percent for high-end purchase (>HK$8 million) and 50 percent for buy-to-lets (also tighter DTI at 50 percent, and bank stress test required on interest rate rise). - India (Dec ‘10): 80 percent for higher-priced homes (>Rs 20 lakh); 90 percent for others (also higher risk weight for large mortgage loans (>Rs 75 lakh)). - Brazil (Dec ‘10): Higher capital charges on longer-duration, higher-LTV auto loans. - Singapore (Feb ’10; Aug ’10): 80 percent for buyers with no existing mortgages; 60 percent for other (also higher stamp duty for quickly resold properties). - Thailand (Jan ‘11): 95 percent for low-rise homes; 90 percent for most condos (<10 million bahts). - Canada (Apr ’10; Mar ‘11): 85 percent for refinancing of insured mortgages; 80 percent for buy-to- (also shorter maximum amortization period). - Sources for the table: various newswires and national authorities. ### Reserve requirements (RRs) on bank liabilities as a macroprudential tool — roles and trade-offs - Nature and design of RRs: - RRs require banking institutions to hold a fraction of their deposits/liabilities as liquid reserves, normally held at the central bank in the form of cash or government securities. - RRs may vary by deposit type (e.g., demand or time deposit) and currency denomination (domestic or foreign). - RRs can be applied to new deposits only (marginal RRs), to domestic or foreign (non-deposit) liabilities, or on assets rather than liabilities. - Design choices include targeting which liabilities, holding period, whether remunerated, the RR rate itself, and the reference base (lagged or contemporaneous). - Macroprudential purposes served by active management of RRs: - Countercyclical role: hikes in RRs during upswings may increase lending rates, slow credit, and limit excess leverage; in downswings RRs can ease liquidity constraints and serve as a liquidity buffer. - Improve funding structure: RRs on foreign or domestic borrowing can reduce dependence on short-term external financing or wholesale domestic funding (e.g., Peru’s active management of RRs on foreign liabilities with maturity lower than 2 years). - Credit allocation: asymmetric use of RRs across instruments, sectors, and institutions can direct credit to ease liquidity constraints in specific sectors (e.g., Brazil). - Complement to capital requirements: useful where valuation of assets is uncertain due to lack of liquid secondary markets. - Bank capitalization tool: governments can increase RR remuneration to help capitalize banks in times of stress (example: Korea). - Substitute for monetary policy in specific circumstances: RRs can be used instead of policy interest rate increases when large capital inflows foster rapid credit expansion (example: Peru). - Costs, distortions, and limitations: - RRs can act as a tax on banks if remunerated below market rates, prompting banks to raise spreads and potentially stimulate disintermediation and nonbank financing. - RRs can reduce credit availability, especially if binding for banks lacking sufficient reserves. - Incentives for regulatory arbitrage may arise, including proliferation of weakly regulated “bank-like” institutions or off-shore banks. - Calibration complexities: balancing monetary and financial stability goals, choosing reference periods, determining marginal vs. broader RRs, and assessing heterogeneous effects across institutions. - Theoretical and regime-dependent considerations: - Effects of RRs on cost and availability of credit depend on banking market structure, degree of financial development, and RR design. - In monetary aggregates regimes, RRs directly affect the money multiplier; in inflation-targeting regimes, effects are less obvious because central banks supply liquidity to clear markets at the policy rate. - Imperfect substitutability between deposits and central bank credit is a necessary condition for RRs to affect credit volumes and lending rates. - RRs can help bring interbank rates close to policy rates in situations of excessive liquidity or stress, provided deposits and central bank credit are imperfect substitutes. - Empirical evidence: - Empirical support for RRs as a macroprudential tool is scarce despite wide use; more analysis is required, particularly in general equilibrium settings. *Italic: IMF staff paper content as provided in the source PDF excerpt.* ### Box 6.1. Effect of Changes in RRs on Active Interest Rates ### Box 6.1. Effect of Changes in RRs on Active Interest Rates ### Estimation methodology - The impact of RRs on active interest rates is estimated by taking the change in the required reserves times the spread between deposit and RRs remunerated rates relative to the portion of deposits not affected by RRs. - Define a bank’s net margin, nm, as the return of each monetary unit lent at an active rate, i_a, net of reserve requirements (1-r_j), plus the return obtained by the reserve requirement itself, i_r, and adjusting it by the portion of unremunerated reserve requirements, i.e. i_r*(r_j-r_jnr), minus the passive rate. Then, the effect of changes in RRs on active rates required to maintain the net margin is: - ݅∆  ௔ ൌ ∆௡௠ା∆௥ ೕ ሺ ௜ ೌ ି௜ ೝ ሻ ൫ଵି௥ ೕ ൯ ### Empirical findings and mechanisms - RRs can affect active interest rates by raising the marginal cost of funds and altering deposit composition. - Vargas et al. (2010) construct for Colombia a tax equivalent of reserve requirements based on observed required reserve ratio, allowing simultaneous consideration of average and marginal reserve requirements. - Empirical evidence for Brazil suggests changes in RRs on time deposits had effects on the stocks returns of the banking system; non financial corporations were the most affected, implying the tax burden can be borne by bank shareholders (Carvalho and Azevedo, 2008). - Econometric evidence for Colombia (2002–09) indicates: - A positive long run relationship between policy rates and market rates (except for mortgage rates). - Marginal RRs on CDs have a significant impact in the longer term and on average CD rates, even though CDs have zero RRs (suggesting shifts in deposit structure). ### Conclusions and policy implications - RRs are a flexible and effective macroprudential tool to address procyclicality and, to some extent, interconnectedness of systemic risk. - Benefits: - Build a buffer in good times and deploy liquidity in bad times. - When targeted at nondeposit liabilities, help improve funding structure and reduce interconnectedness exposure. - Allow targeted intervention to avoid distortion in markets not affected by exuberance. - Can substitute or complement monetary policy goals even in IT regimes when monetary and financial stability goals conflict. - Costs and limitations: - Can induce disintermediation by raising lending interest rates and lowering credit availability. - Difficult to calibrate; exorbitant RR rates applicable to deposits can quickly lead to disintermediation. - Use needs complementing measures to avoid risk shifting to unregulated segments or sectors. - Calibration and scope considerations: - RR coverage should be part of RR design. - Diversion of bank funding toward non-deposit/innovative sources (e.g., credit lines from non-banking financial institutions) can limit effectiveness. - Expanding coverage to loans from domestic non-monetary corporations could limit excessive reliance and reduce network risks. - Country experiences confirm countercyclical effectiveness: authorities have raised RRs during upswing and lowered during downswing to ease liquidity constraints; RRs have been applied to specific sectors at specific junctures. ### Country-specific summaries and key statistics - Brazil - Historically high and complex RRs; coverage varies over deposit instruments; compliance can be with cash and in some instances with government securities. - During the crisis, Central Bank of Brazil (BCB) used RRs to support financial stability via liquidity provision and credit reallocation. - Measures included exemptions and reductions (e.g., large banks exempted from RRs on term deposits if they purchased assets of smaller banks; discount 20 percent of RRs if purchasing foreign currency at the central bank). - Examples from Table A1 (percent): August 2003 — 45 15 20 8 8 10; May 2008 — 45 15 20 20 8 8 10; January 2009 — 42 15 20 15 5 4 10; December 2010 — 43 20 20 16 12 12 10. - In January 2011, BCB introduced RRs to limit short dollar positions of banks in the spot market. - Colombia - Banco de la República introduced marginal RRs on domestic deposits in May 2007 to contain rapid credit growth. - RRs on domestic deposits were complemented with RRs on foreign indebtedness and higher loan provisioning requirements. - During the global crisis, RRs were lowered and marginal RRs were eliminated in Q3 2008; further easing in 2009. - Range of deposits subject includes checking accounts, simple accounts, savings, real savings, special savings, centralized accounts, repo transfer agreements, some term deposits, some bonds, certificate deposits, and other specific items. - Peru - RRs used proactively on prudential grounds and as complement to monetary policy during upswing; credit growth peaked at about 40 percent y/y. - During the crisis, reductions in RRs preserved liquidity and reduced interbank rate deviations from the policy rate. - Policy rates hiked from 1.25 percent in early 2010 to 3.5 in February 2011. - In January 2011, central bank included credit channeled through off-shore branches of domestic financial institutions into RR computation. - Table A3. Peru: Deposit Reserve Requirements, February 2011: - In domestic currency: Legal rate (unremunerated) 9; Marginal Rate 25; Effective Rate 12.3; Remuneration Overnight rate-100 bps. - In foreign currency: Legal rate (unremunerated) 9; Marginal Rate 55; Effective Rate 35.2; Remuneration 0.6*Libor (1 month). - Note: For residents. The marginal rate for nonresidents is 120 percent. - Peruvian authorities report: - A 1 percentage point increase in RRs rate has an equivalent effect over the output gap as a 25 bps increase in the policy rate. - A 1 percentage point increase in the RR raises one-year interest rates by 0.24 percentage point and decreases passive interest rates. - China - In 2010 and early 2011, Chinese authorities raised RRs amid concerns about accelerating inflation and rapid money and credit growth. - Central bank hiked RRs 100 bps since January 2011 to 20 percent for large banks and 18 percent for small banks (estimated equivalent to a reduction of Y360 billion in deposits, 0.9 percent of 2010 GDP). - Goldman Sachs estimated excess reserve ratio between 1.5 percent and 2 percent; analysts expected at least 200 bps in RR hikes over the year due to surging FX inflows, price pressures, and bank lending. - Turkey - In December 2010, Central Bank of Turkey increased and broadened domestic currency RRs to increase cost of short-term funding and limit domestic credit expansion. - Scope widened to include some repo operations; RRs ratios differentiated across maturities to encourage long-term funding. - New measures expected to reduce market liquidity by approximately TL7.6 billion and US$200 million (0.7 percent of 2010 GDP, 2.3 percent of 2009 total claims to the private sector). - Korea - Bank of Korea used RRs in December 2008 as a tool to capitalize the banking system by paying a one-off interest of W500.2 billion on RRs (0.05 percent of GDP), immediately improving bank balance sheets instead of simply lowering RRs. *Source: Box 6.1. Effect of Changes in RRs on Active Interest Rates, _wp11159.* ### Annex 2. Country Experiences with Reserve Requirements on (noncore) Liabilities ### Annex 2. Country Experiences with Reserve Requirements on (noncore) Liabilities ### Peru: experience managing reserve requirements on banks’ foreign borrowing - In September 2007 the central bank exempted long-term foreign borrowing from the reserve requirement—30 percent at the time—that applied to banks foreign liabilities. - Composition of banks’ foreign liabilities: - Foreign long-term liabilities as a percentage of total foreign bank liabilities increased from 22 percent in September 2007 to 58 percent in September 2008, and further to 82 percent in September 2009. - During 2008: - The RR on short-term foreign liabilities was increased and then eliminated in late-2008 to ease liquidity pressures from the global financial crisis. - In early 2010 renewed inflows led the central bank to re-install the RRs on short-term foreign liabilities. - Figure/annotation notes: - "1 In January 2011, reduced to 60 Percent from 75 percent, while extending the coverage to foreign liabilities through off-short branches of domestic banks." - "2 More than 2 years." - Operational features (as reported in Table 1 for Peru): - Minimum RR of 6 percent for liabilities in domestic and foreign currency and marginal reserve requirement of 30 percent for foreign currency domestic liabilities. - Reserve maintenance period: One month. - Remuneration: The remuneration for the minimum RR is zero. The actual rate of remuneration for the additional RR in foreign currency (associated to the marginal RR) is 60 percent of the one month US Dollar LIBOR rate. ### Regional operational features of reserve requirements (selected findings) - Latin America (selected operational highlights from Table 1, as of early 2010): - Peru: Minimum RR 6 percent; marginal RR 30 percent on foreign currency domestic liabilities; remuneration as above. - Uruguay: In domestic currency, 2% annual; In US dollars, 0.025% annual; In Euros, 0.20% annual; For government deposits, 0%. Maintenance: 30 days of two months ago for domestic currency and 30 days computed currently for foreign currency. - Brazil: Demand deposits 42%; time deposits 13.5%; savings deposits 20%; additional requirement: 5% (demand dep.), 4% (time dep.), 10% (savings dep.). Maintenance periods: demand deposits 2 weeks, time dep. 1 week, savings dep. 1 week, additional requirement 1 week. - Dominican Republic: Deposits in CB in local currency: 17% (Commercial Banks 12.5%; Bank and Credit, Saving Loan Associations, Corporate Credit 10%; Other Financial Institutions 20%); Foreign Currency Deposits. Maintenance frequencies vary (Daily, Weekly, Two Week). - Notes on remuneration: Many countries report zero remuneration on required reserves; others set specific formulas (e.g., Peru’s additional RR linked to 60 percent of one month US Dollar LIBOR). - Asia (selected operational highlights from Table 2, as of early 2010): - China: Large financial institutions’ reserve ratio 16%, medium and small 14%; maintenance period 10 days; remuneration of legal required reserves for financial institutions is 1.62%. - India: Reserve ratio 5.75% of net demand and liabilities (NDTL); maintenance: Fortnight; remuneration: Zero. - Indonesia: IDR: 7.5% (5% primary; 2.5% secondary); Forex: 1%; Daily maintenance; remuneration: 0. - Korea: Detailed tiered reserve ratios by instrument and currency (examples: liabilities denominated in national currency — 0% for certain long-term savings; 7% for other deposits; foreign currency liabilities have a mix including 1.2%, 7%, 3.1% depending on instrument). - Philippines: 8% for commercial banks; penalty and reserve computations based on a seven (7)-day week; stated partial remuneration scheme: 4% (applied to 40% of the required regular reserves or on the bank’s actual average daily balances in their Demand Deposit Accounts, whichever is lower). - Europe (selected operational highlights from Table 3, as of early 2010): - Bulgaria: 0% on government deposits; 5% on non-resident deposits; 10% on resident deposits; maintenance period one month; remuneration 0%. - Czech Republic: Reserve ratio 2%; maintenance period specified as starting first Thursday and ending the Wednesday before the first Thursday of the following month; remuneration not specified beyond schedule. - Romania: Complex maturity- and currency-based reserve ratios: 15% for RON-denominated liabilities with residual maturity of up to 2 years and for RON-denominated liabilities with residual maturity of over 2 years with an early repayment clause - 0% for RON-denominated liabilities with residual maturity of over 2 years, without an early repayment clause - 25% for FX-denominated liabilities with residual maturity of up to 2 years and for FX-denominated liabilities with residual maturity of over 2 years with an early repayment clause - 0% for FX-denominated liabilities with residual maturity of over 2 years, without an early repayment clause. Maintenance: 1 month. - Russia: Reserve ratio 2.5% for all types of liabilities; maintenance period 1 month; maintenance window "From the 10th date of month after accounting month to 10th date of the second month after accounting month included." - United Kingdom / ECB / other jurisdictions: maintenance periods typically tied to policy decision calendars (4–5 weeks) and remuneration of actual reserves often set at or related to policy rates where applicable. ### FX credit risk: motivation, country practice, and effectiveness of measures - Motivation and risks: - FX credit risk arises when financial institutions lend to un-hedged borrowers with currency mismatches; it can generate systemic risk via increased borrower default following large FX depreciation. - FX credit risks include direct exposure (bank extends FX-denominated credit to un-hedged borrowers) and indirect exposure (bank extends domestic-currency lending to a borrower already exposed to FX risks). - Lack of borrower-level information on currency and maturity of debt and exposures to derivatives hinders effective assessment of FX credit risk. - The household sector may be most vulnerable, though FX deposits in dollarized economies can mitigate this risk. - Country experiences with prudential measures: - Reserve requirements on FX liabilities and limits on FX exposure or FX lending as a percent of capital in Emerging Europe prior to the global financial crisis were not very effective and were circumvented during periods of easy external financing. - Recent measures emphasize additional provisioning and capital requirements; their effectiveness is still uncertain. - Two country examples of targeted capital measures: - Peru establishes a capital add-on taking into account the FX exposure. - Uruguay establishes a higher risk weight for loans extended in foreign currency to un-hedged borrowers. - Comparative effectiveness and instrument design: - Debt-to-income limits on borrowers may be more effective than bank-level credit limits as a percent of capital. Example: Romania’s limits on domestic FX lending as a percent of capital had temporary effects that faded as financial institutions raised capital under easy conditions. - Debt-to-income limits for individual FX loans can be more stringent than those for domestic-currency loans and may effectively ban FX lending for particular instruments (e.g., mortgages), by imposing implicit assessments of borrower ability to service debt under assumed depreciation scenarios (see Uruguay example). - Additional provisioning is preferable to account for expected losses from FX credit risks (for identified direct FX exposures); additional capital requirements can address unexpected losses from unidentified FX exposure or indirect exposures. - Higher risk weights for FX loans to un-hedged borrowers may be a more transparent way to impose additional capital requirements given calibration difficulties. - Information, supervision, and implementation priorities: - Authorities need to compile detailed, systematic information on corporate and household financing structures with emphasis on FX mismatches and exposure to derivatives; information required includes FX position, FX sales, and percentage of short-term liabilities in foreign currency from borrowers. - Enhanced supervision is required: supervisors should ensure financial institutions identify and monitor FX credit risks and adapt regulation as needed. A homogenous framework across the financial system would enable benchmarking of FX risk evaluation across institutions. - Measures to encourage adequate use of FX hedging by households and corporates would be complementary and welcome. - Historical lessons: - Limitations in borrower-level information exacerbated the impact of the global financial crisis; examples include Brazil and Mexico in 2008 when large corporate losses materialized due to FX operations in the FX derivative market. *Source: IMF staff compilation from “Annex 2. Country Experiences with Reserve Requirements on (noncore) Liabilities” (extracted tables and text as provided).* ### Annex 1. Country Experiences in Managing FX Credit Risk ### Annex 1. Country Experiences in Managing FX Credit Risk ### Overview - Survey of experiences with prudential measures managing FX credit risks. - Key challenges: - Ensuring financial institutions have internal mechanisms to qualify, define, and manage credit risks associated with lending to unhedged borrowers. - Close monitoring and supervision to ensure correct internalization of FX credit risk. - Encouraging adequate use of FX hedging among household and corporate sectors. - Data needs emphasized: - Detailed information on financing structure of corporate and household sectors, with emphasis on FX mismatches and exposure to derivatives. - Information required on FX position, FX sales and percentage of short-term liabilities in foreign currency of borrowers. - Behavioral note: - At times of easy external financing, corporates and households tend to increase indebtedness and FX mismatches due to more attractive financial terms. ### A. Peru - Context: - Highly dollarized economy; pursued market-driven financial de-dollarization. - As of October 2010, deposit dollarization at 47 percent and credit dollarization at 44 percent. - Less than 20 percent of total credit potentially exposed to FX credit risk as of June 2010. - According to the Superintendency of Banks (SBS), 1½ percent of total credit is unidentified in terms of exposure to FX credit risks. - Of total credit outstanding, 18 percent is identified as exposed to FX credit risk. - Mortgages report highest level of exposure within identified FX credit risk, though the stock is very low and not systemic at this juncture. - Identified FX credit exposure by type (clients classified as Normal, in percent): - Banks: Dec-06 28.53; Dec-07 26.14; Dec-08 27.23; Dec-09 29.14; Jun-10 27.81 - Commercial: Dec-06 49.74; Dec-07 56.55; Dec-08 64.24; Dec-09 65.87; Jun-10 53.75 - Consumer: Dec-06 42.1; Dec-07 59.28; Dec-08 60.66; Dec-09 60.11; Jun-10 46.19 - Mortgages: Dec-06 23.79; Dec-07 44.08; Dec-08 45.3; Dec-09 45.35; Jun-10 49.67 - SMEs: Dec-06 31.89; Dec-07 32.44; Dec-08 33.12; Dec-09 34.49; Jun-10 31.19 - Source: SBS. - Supervisory and internal requirements: - Financial institutions must implement internal mechanisms to qualify, define and monitor direct credit in foreign currency, including: - Identification of exposed and non-exposed clients to FX credit risk. - Requirements for extending credit in foreign currency and exclusion of credit operations with associated FX risk. - Stress testing with at least two scenarios that embed real depreciation of, at least, 10 and 20 percent respectively. - Corrective actions over changes in credit qualification or credit conditions. - Banks’ Boards must be informed at least bi-annually with a summary of aggregate FX credit risk exposure, potential losses (by type of credit), and evaluation of internal procedures. - Current evaluation of FX exposure is done according to each institution’s methodology (cash flows, capacity to pay under exchange rate shock, borrower income). A more standardized approach is recommended. - Regulatory measures: - Provisioning for FX credit risk (effective since 2006) applies to direct credit and financial leasing, except those with automatic guarantees. Applies to loans classified as normal and is in addition to general provisions. Provision requirements: - 0.25 percent for credit operations covered with guarantees of rapid execution. - 0.5 percent for FX credit with preferred guarantees. - 1 percent for the rest of FX credit. - Financial institutions exempted from provisioning if minimum requirements and risk assessment practices are fulfilled. - Provisioning associated with FX credit risks currently amounts to about S/. 4 million (about 0.001 percent of GDP). - Additional capital requirement (since July 2010): - If a financial institution cannot incorporate FX risk assessment into overall credit risk assessment, it must include an additional capital requirement of 2.5 percent of total FX exposure. - Financial institutions are currently applying the 2.5 percent capital add-on, as all use the standard methodology for credit risk identification. - According to SBS, the capital add-on amounts to about 1 percentage point of total capital requirements of the financial system. - Policy direction: - Peru is moving toward a system where banks would incorporate FX credit risk in overall credit assessment through higher internal ratings. ### B. Uruguay - Context: - Highly dollarized economy with market-driven financial de-dollarization. - Credit dollarization about 52 percent and deposit dollarization about 76 percent as of 2010Q3. - Capital and provisioning treatment: - Capital requirements for credit/market risks on FX loans carry a differentiated risk weight: loans to un-hedged borrowers carry a 125 percent risk weight (rather than 100 percent) in CAR calculation. - Provisioning for loan losses is higher for FX loans irrespective of hedging status. - Provisioning required not only when loan is past due but also when borrower shows signs of difficulty to pay in short/medium term. - Commercial loans assessment rules: - Banks must assess borrower ability to pay in case of peso depreciation of 20 percent and 60 percent. - Classification and provisioning outcomes: - If borrower ability not substantially altered by peso depreciation of 60 percent: classified as normal (provisioning of 0.5 percent). - If borrower can continue paying after a 20 percent devaluation but not after 60 percent: provision of 3 percent. - If borrower cannot pay without debt restructuring after a 20 percent devaluation: provisioning raised to 7 percent. - Consumer loans treatment: - If loans granted in pesos, nondelinquent loan classified as normal if monthly projected payments do not exceed 30 percent of borrower's income; exceeding that requires loss provision of 20 percent. - If loan is granted in foreign currency the threshold on borrower’s income becomes 15 percent, which implies an implied depreciation of 50 percent for the peso. - Effects and intent: - Loan provisions act as deterrent to FX credit risk rather than perfect valuation. - Penalization on consumer credit (20 percent provision) has larger effect than on commercial credit (3–7 percent), effectively banning mortgages in dollars for borrowers with income in pesos. - Measures result in a virtual banning of credit in dollars to "nontradable sectors" for commercial credit. ### C. Romania - Measures in 2005: - Prudential measures aimed at reducing currency-mismatch risk from excessive foreign-currency lending. - Limits and reserves: - Requirement limiting credit institutions’ overall FX lending to un-hedged borrowers to less than 300 percent of banks’ own funds. - Regulation was binding for 13 out of 39 banks at implementation. - Loan classification: - Tightened norms explicitly requiring banks to consider FX risk when classifying loans to individuals. - Banks required to downgrade classification of unhedged borrowers regardless of financial position or collateral. - Immediate impact: - Nonperforming loans increased from 8.1 percent at end-2004 to 9.4 percent in September 2005, forcing banks to increase provisions. - Short-term effectiveness and subsequent fade: - Year-on-year growth rate in FX credit fell from 56 percent in September 2005 to 30 percent in February 2006. - Dramatic shift away from FX loans toward local-currency lending, markedly for consumer lending. - The 3-month FX credit flow went from a peak of 5 percent of GDP in August 2005 to 1.7 percent by end-December. - Local-currency credit flows increased from 3.7 percent of GDP to [text truncated in source]. *Source: Annex 1. Country Experiences in Managing FX Credit Risk (IMF).* ### 7.0 percent over the same period. Overall, credit declined from 9 percent of GDP to 5.3 ### _wp11159 - 7.0 percent over the same period. Overall, credit declined from 9 percent of GDP to 5.3 ### FX credit exposures and banking-sector vulnerabilities (Eastern Europe / Romania example) - Overall credit declined from 9 percent of GDP to 5.3 percent in December. - Corporate access to foreign credit rose from a net of 4 percent of GDP in 2005 to nearly 11 percent in 2007. - The 300 percent capital binding rule led some banks, especially foreign, to increase capital to resume FX lending. - 2005–08: the share of lending to households in FX rose from 44 to 59 percent. - 2005–08: the share of lending to nonfinancial firms in FX declined slightly, from 59 to 57 percent. - Direct bank net open FX positions were low because foreign currency borrowings were almost entirely offset by FX lending to households and nonfinancial firms. - Both household and corporate balance sheets faced significant exposure to movements in the euro exchange rate and interest rates on euro loans. - Large firms’ direct borrowing from abroad increased corporate sector currency exposure (equivalent to nearly 11 percent in 2007). ### Derivative exposures and corporate losses (Brazil, Mexico, and other emerging markets) - Low currency volatility and nominal appreciation before August 2008 induced corporates to increase off-balance sheet FX exposure via derivatives (selling FX options in offshore markets). - Knock-out / knock-in structures led corporates to deliver dollars at a loss when domestic currencies depreciated past thresholds. - One month after the Lehman Brothers default, Mexico and Brazil currencies depreciated by more than 30 percent. - Derivatives losses: - Mexico: derivatives losses reached US$4 billion in Q4 2008. - Brazil: losses were as high as US$25 billion. - Specific corporate losses cited: - Comercial Mexicana sought bankruptcy protection in October 2008 with losses up to US$1.1 billion on NDF contracts. - Vitro SAB reported a large part of $227 million of derivatives losses came from natural gas forwards. - Consequences: - Elevated systemic risk as companies faced large losses and potential inability to pay banks. - Contributed to reduced liquidity in interbank operations and accentuated reduction of credit to productive firms. - Lack of transparency: many companies did not disclose derivative positions. - Policy responses and examples: - Colombia (May 2007): central bank established a maximum leverage position on forwards over financial entities’ net worth (initially criticized, later proved to reduce crisis impact). - Brazil (since 2009): all financial institutions must register exposures via derivative markets. - Mexico (since 2009): equity, long-term debt or equity issuers must document market, credit and liquidity risks associated with derivative contracts and assess their importance to the company’s financial position and results. - Some corporate derivatives use cases reduced vulnerabilities (example: Pemex oil price hedge and currency swaps helped stabilize its 2009 budget). ### Limiting foreign exchange positions as a macroprudential tool - Rationale: - Abrupt exchange rate adjustments can create balance sheet problems across the economy and induce capital losses for banks with FX short positions. - Even if banks are hedged, exchange rate volatility harms lenders if borrowers have currency mismatches. - Limits on FX positions can reduce financial risk from rapid FX movements and can help curb carry trades and capital inflows that fuel credit and asset-price booms. - Measurement and design: - Net open FX position = net spot position + net derivative position. - Gross FX positions include gross short (liabilities) or gross long (assets); can be computed separately for spot and derivatives. - Limits often expressed as a share of capital (Tier 1 or working capital). Limits may be symmetric or asymmetric; apply continuously, overnight, or at week/month-end. - Some authorities include assets/liabilities indexed to a foreign currency when calculating net open positions. - FX open position limits in selected LAC countries (as presented) - Brazil: 30 (Spot plus derivatives) — Short vs. Long: Same — Recent change: No - Colombia: 20 (Spot plus derivatives) — Short vs. Long: Short is 5 percent — Recent change: Yes * - Mexico: 15 (Spot plus derivatives) — Short vs. Long: Same — Recent change: No - Paraguay: 50 (Spot plus derivatives) — Short vs. Long: Same — Recent change: Yes (30 percent) - Peru: 75 (Spot plus derivatives) — Short vs. Long: Short is 15 percent; Long (100 percent), Short (10 percent) - Uruguay: 150 (Spot plus derivatives) — Short vs. Long: Same — Recent change: No - Note: * In May 2007, a limit on the gross foreign exchange derivative position of banks was introduced. - Potential macroprudential benefits: - Spot position limits protect banks against sudden appreciation and reduce scope for speculative attacks. - Derivatives position limits (net or gross) and measures (margin/provisioning changes, taxes, unremunerated reserve requirements) may reduce carry-trade incentives and limit systemic risks from derivatives. - Limits on forward market operations can reduce banks’ facilitation of speculative behavior and overhedging by corporates. - Unremunerated reserve requirements based on forward positions may be more efficient than outright limits. - Gross derivatives position limits, possibly combined with net FX limits, can target specific risks like derivatives carry-trade risk. - Risks and costs: - Forward position limits may affect spot prices in unintended directions (appreciation rather than depreciation). - Restrictions imposed in isolation may be circumvented and lead to capital inflow arbitrage. - Heavy-handed restrictions can impair the development of domestic derivatives markets and hinder financial deepening. - Regulatory design must avoid disrupting genuine hedging needs of corporates and economic agents. - Conclusions: - Limits on FX spot positions are valid macroprudential tools to curb exchange rate volatility and moderate capital inflows. - Macroprudential restrictions in forward markets have limited empirical evaluation but show potential for protecting financial stability and shifting incentives away from arbitrage and carry trades. - Careful calibration and design of limits, charges, or reserve requirements is crucial to balance financial stability and market development. *Prepared by Carlos Fernández Valdovinos and Chris Walker; drawn from the supplied document content.* ### Annex 1. Country Experiences and Case Studies ### Annex 1. Country Experiences and Case Studies ### Korea - Context and motivation: - Export-based economy with a partially open capital account; frequent use of macro-prudential restrictions on banks' derivative positions in response to capital inflows. - Strong demand for foreign currency hedging from Korean shipbuilders, often selling dollars forward and buying Korean won with horizons up to five years; onshore banks, mainly foreign bank branches, have been dominant FX hedging providers. - To fund hedging positions, banks borrowed U.S. dollars offshore, exchanged them for won in the spot market, and invested in Korean won interest rate products onshore. - Measures and chronology: - January 15, 2004: restriction on domestic banks' access to the offshore nondeliverable forward (NDF) market in Korean won. - 2005: restriction reversed during capital account liberalization; by 2007 banks could buy FX derivatives contracts without any limits. - June 17, 2010: package of measures including ceilings on FX derivative positions, tighter restrictions on provision of FX-denominated bank loans, and stricter liquidity ratios (raise ratio of long-term financing for FX loans to 100 percent from 90 percent). - Currency forward trades by domestic banks capped in value at 50 percent of the bank’s equity capital. - Foreign banks' positions restricted to 250 of equity capital. - December 2010: announcement that a levy will be imposed on nondeposit foreign currency liabilities held by domestic and foreign banks, with a higher rate for short term debt than longer debt; expected implementation starting the second half of 2011. - Outcomes and evaluation: - The 2004 NDF restriction did not have the intended effect: removal of domestic banks from the NDF supply reduced supply of notional won and the won appreciated in the forward market; result was won appreciation in the spot market and more pronounced appreciation in the forward market. - The 2006–07 liberalization and lack of limits contributed to a substantial rise in short-term overseas borrowing and external debt during 2006–07; official sources attribute almost half of the increase in total external debt of US$195 billion during 2006–07 to the increase in FX forward purchases by banks. - The 2010 measures succeeded in preventing banks' external debt from returning to precrisis levels and were somewhat more successful in stemming appreciation, possibly because they were more comprehensive. - After the 2010 measures, the forward premium held fairly steady, limiting arbitrage incentives. - Key statistics and figures preserved: - Five year hedging horizon (typical for shipbuilders). - Long-term financing ratio for FX loans raised to 100 percent (from 90 percent). - Domestic banks capped at 50 percent of equity capital for currency forward trades. - Foreign banks restricted to 250 of equity capital. - Increase in total external debt during 2006–07: US$195 billion; almost half attributed to FX forward purchases by banks. - Implementation expectation: levy to be implemented starting the second half of 2011. ### Brazil - Context and motivation: - Low interest rates in advanced economies and returning risk appetite triggered a surge in capital flows; Brazil attractive due to sound macroeconomic policies, good growth prospects and large interest rate differentials. - Capital inflows at record highs in 2010, entering mainly through equity market and FDI. - At end November (2010): FDI reached US$33 billion; foreign equity inflows US$36 billion; and foreign fixed income investment US$26 billion. - Financial sector mechanics and risks: - Carry-trade mechanics similar to Korea: foreigners short dollar position in the futures market (sold U.S. dollars forward); local banks took the opposite long position buying US$ forward; banks hedged using the cash market and external credit lines (not subject to IOF tax), sold proceeds to the central bank and invested in onshore BRL assets. - Banks earned an arbitrage profit proportional to the spread between the domestic dollar rate implied by domestic futures market (cupom cambial) and the offshore dollar rate (Libor rate plus a spread). - Banks’ external liabilities increased sharply: at end October 2010, banks external liabilities had increased by US$24 billion year-on-year; the rise was equivalent to about half of central bank FX market intervention during that period. - Regulatory framework and gaps: - Existing regulation: a bank’s net open position, including spot and derivative transactions, should be at most 30 percent of capital. - The carry-trade transactions involved both a long (futures market) and short (spot market) FX position, which cancel out when calculating net open positions; net open position limits were not binding. - The net open position of the banking system usually remained below 6 percent of capital since 2008 (contextual note). - Policy responses implemented: - October 2009: re-imposed a moderate tax on foreign inflows to the bond market at 2 percent, extended the tax to equity inflows. - October 2010: raised the tax (“IOF”) on fixed income investments in two consecutive hikes from 2 percent to 6 percent and raised the tax on daily margin adjustments on foreign positions in FX and interest rate forward contracts from 0.38 percent to 6 percent. - Tax on equity investment stayed at 2 percent, while FDI (including external borrowing by Brazilian banks and firms) continued to be exempted. - November 2010: announced measures to strengthen prudential framework including an increase in capital requirements on long-term consumer loans and an increase in reserve requirement rates on sight and time deposits. - Brazilian central bank measure (described in text): requiring banks to deposit the equivalent of 60 percent of their short spot dollar positions in cash at the central bank, at no interest. This requirement applies to the amount that exceeds US$3 billion or Tier I capital, whichever is lower. - Policy discussion and alternatives: - Changes could target banks' ability to increase their short spot position in the FX market or their net FX derivative position. - Possible alternatives include: - A general tax on banks' derivatives margin positions. - A limit on gross derivatives positions. - A tax on gross derivatives positions. - Effects: such measures would reduce arbitrage, make synthetic dollar borrowing operations less attractive by widening the basis spread (increase in the interest-rate-adjusted forward premium), or directly target FX futures mechanics. - Alternative: impose a levy on foreign borrowing or apply unremunerated reserve requirements on external funds (noted disadvantage: would affect total external borrowing and make hedging more costly for all agents, including exporters). - Key statistics preserved: - At end November (2010): FDI US$33 billion; foreign equity inflows US$36 billion; foreign fixed income investment US$26 billion. - At end October 2010: banks external liabilities increased by US$24 billion year-on-year. - IOF tax changes: from 2 percent to 6 percent on fixed income investments; daily margin adjustments tax from 0.38 percent to 6 percent. - Reserve/cash requirement: deposit equivalent of 60 percent of short spot dollar positions in cash at the central bank; threshold applies to amount exceeding US$3 billion or Tier I capital, whichever is lower. - Net open position limit: 30 percent of capital. ### Colombia - Measures and rationale: - May 6, 2007: restriction on banks’ gross currency derivative positions, limiting them to 500 percent of capital on both the short and long sides. - Simultaneously, the central bank imposed an unremunerated reserve requirement (URR) on banks’ external borrowing. - Subsequent policy actions: central bank extended the URR to portfolio inflows, adjusted the URR, and eventually eliminated it; limits on gross derivatives positions were maintained. - Outcomes and evaluation: - The combined measures did not appear to have an immediate effect on arbitrage between spot and forward markets; they were followed by continued appreciation of the Colombian peso. - Studies including Clements and Kamil (2009) concluded the measures were unsuccessful in limiting exchange rate appreciation. - However, the sharp divergence of the adjusted forward premium from its “parity” value of zero in 2010 suggests that the gross position limits may still be working to constrain arbitrage between spot and forward markets. - Key statistics preserved: - Gross currency derivative position limits set at 500 percent of capital for both short and long sides. - Reference to adjusted forward premium diverging from a “parity” value of zero in 2010. ### Israel - Measures and timing: - January 20, 2011: announced restrictions on banks' currency derivatives transactions with nonresidents; effective January 27, 2011. - Derivatives transactions to be subject to a 10 percent reserve requirement, presumably on the basis of the market value of the position. - The measure discriminates on the basis of residency of counterparties (derivatives transactions with nonresidents). - Outcomes and evaluation: - Initial impact consistent with policy objectives: implementation followed by exchange rate depreciation and by a widening of the forward market premium, reflecting a weakening of interest rate arbitrage. - Volume of derivatives transactions declined after the measures were implemented, indicating weakening arbitrage. - Note: although this regulation discriminates by residency and thus would not qualify strictly as macroprudential by some definitions, an overall reserve requirement not distinguishing on residency would likely have similar effects. - Key statistics preserved: - Reserve requirement on derivatives positions: 10 percent. - Announcement date: January 20, 2011; effective date: January 27, 2011. *Source: Annex 1. Country Experiences and Case Studies (content unit provided).* ### 1. Foreign investors (BRA) or exporters (KOR) ### _wp11159 - 1. Foreign investors (BRA) or exporters (KOR) ### Reserve requirements and taxes on capital inflows — Introduction - Reserve requirements (RRs) on capital inflows: fraction of private capital inflows from nonresidents required to be deposited at the central bank for a period; reimbursed at end of holding period with any applicable remuneration. - RRs are usually unremunerated (URR). - RRs act as a price-based capital account restriction, increasing the cost of cross-border financing and particularly penalizing short-term investments. - RRs can be operationalized with an option for investors to pay an up-front fee (equivalent or marginally higher than foregone interest) for early withdrawal. - Analogy: RR cost can be expressed as a tax-equivalent, analogous to explicit taxes on nonresident flows, such as the Brazilian Imposto de Operações Financeiras (IOF). - Typical design choices: coverage (all flows vs. differentiated by flow type), holding period, fraction u of flow to be deposited, remuneration rate (if any), and currency denomination. - Common practice: RRs on inflows have usually been introduced together with other measures to limit capital inflows. ### Reserve requirements — Intended macroprudential objectives - Countercyclical impact during periods of easy and transitory global financing: if applied broadly and successful in reducing total inflows, RRs could limit excessive foreign leverage and reduce flow absorption pressures. - Contain systemic and liquidity risk by tilting foreign funding toward longer maturities and improving corporate funding structure. - Allow central bank room to raise domestic interest rates without encouraging massive capital inflows by severing arbitrage between domestic and international rates. - Reduce or eliminate quasi-fiscal costs associated with sterilized foreign-exchange intervention. ### Reserve requirements — Costs and limitations - Effectiveness is often transitory as investors may find alternative channels to bypass regulations; ongoing tightening and administration may be needed. - Circumvention can lead to buildup of vulnerabilities via alternative instruments. - Design and administration are complex. - Perception risk: RRs may be seen as a regime change, triggering sudden declines in foreign financing and diversion of flows. - Multilateral considerations: RRs discriminate by residency and may be restricted by international arrangements; permitted only temporarily in some agreements (OECD, EU, GATs, BITS) in cases of "serious economic and financial disturbances" or "serious balance of payments". - Policy preference: other measures that do not discriminate on residency should be preferred when possible. ### Theoretical considerations and tax-equivalent framing - RR raises cost of foreign borrowing; tax-equivalent permits comparison of RR cost with inflow taxes (e.g., IOF). - Tax-equivalent of RRs is a function of: - deposit rate at the central bank, - ratio of holding period h to maturity of foreign borrowing, - foreign interest rate i*. - When investors choose currency denomination, RR cost is minimized if the investor chooses the currency expected to appreciate or with lower interest rate. - Simplified Box 9.1 expression (as provided): the tax-equivalent of the RR on capital inflows μ_k can be expressed as: 1 (where i* is the cost of borrowing abroad for k months; and u is the fraction of the flow that has to be deposited at the central bank during a holding period of h months). (This simplified expression assumes no exchange rate risk and that the RR is the only tax.) - Key comparative implications: - Tax-equivalent of RR is positively related to the foreign interest rate; lower foreign borrowing costs reduce tax-equivalent. - For a given holding period h, RR cost decreases with loan maturity — RRs penalize short-term borrowing more heavily, altering term structure of foreign liabilities. ### Empirical evidence and literature overview - Literature confirms RRs alter composition of capital inflows toward longer maturities, but evidence on reduction in overall volume of inflows and on exchange rate pressures is mixed. - Effectiveness depends on elasticity of total capital flows to short-term flows and on measure specifics. - Reference: Magud, N., C. Reinhart, and K. Rogoff, 2005 — review supports compositional effects but inconclusive volume effects. ### Table 1 (Tax-equivalent of Reserve Requirement) — selected values from author’s calculations - Table shows tax-equivalent values for combinations of Libor (percent), Reserve requirement (percent), and Loan Maturity (months). Selected entries: - Libor = 1, Reserve requirement = 15: - Loan Maturity 1 month: 2.1 - 3 months: 0.7 - 6 months: 0.4 - 9 months: 0.2 - 12 months: 0.2 - 18 months: 0.1 - 24 months: 0.1 - 36 months: 0.1 - Libor = 2.1, Reserve requirement = 25: - Loan Maturity 1 month: 4.0 - 3 months: 1.3 - 6 months: 0.7 - 9 months: 0.4 - 12 months: 0.3 - 18 months: 0.2 - 24 months: 0.2 - 36 months: 0.1 - Libor = 3, Reserve requirement = 30: - Loan Maturity 1 month: 5.1 - 3 months: 1.7 - 6 months: 0.9 - 9 months: 0.6 - 12 months: 0.4 - 18 months: 0.3 - 24 months: 0.2 - 36 months: 0.1 - Libor = 3, Reserve requirement = 15: - Loan Maturity 1 month: 6.4 - 3 months: 2.1 - 6 months: 1.1 - 9 months: 0.7 - 12 months: 0.5 - 18 months: 0.4 - 24 months: 0.3 - 36 months: 0.2 - Libor = 3, Reserve requirement = 25: - Loan Maturity 1 month: 12.0 - 3 months: 4.0 - 6 months: 2.0 - 9 months: 1.3 - 12 months: 1.0 - 18 months: 0.7 - 24 months: 0.5 - 36 months: 0.3 - Libor = 3, Reserve requirement = 30: - Loan Maturity 1 month: 15.4 - 3 months: 5.1 - 6 months: 2.6 - 9 months: 1.7 - 12 months: 1.3 - 18 months: 0.9 - 24 months: 0.6 - 36 months: 0.4 - Source note: "Author's calculations considering different libor, reserve requirement rates and borrowing terms." ### Conclusions — policy implications - RRs have been part of policy responses to ample global financing episodes to address macroeconomic and prudential concerns. - Typical impacts: - Raise cost of foreign financing; - Penalize short-term borrowing more heavily; - Tilt composition of foreign inflows toward longer maturities; - Help reduce vulnerability to sudden capital reversals. - Evidence on countercyclical impact via reduction in volume of inflows is inconclusive due to circumvention and erosion of effectiveness over time. - Use of RRs is subject to multilateral rules and perceptions; they discriminate by residency and thus may be constrained by international agreements or permitted only temporarily. - Additional costs: incentives to use alternative complex instruments and possible perception of regime change reducing stable long-term flows. - Policy recommendation: prefer measures that do not discriminate on the basis of residency where feasible. ### Annex — Country experiences (selected) - Chile: - URRs on all new foreign borrowing during 1991–98 to address real appreciation pressures. - Initial design: 20 percent URR deposited in non interest-bearing account at central bank; holding period ranged between 90 days and one year depending on term; reimbursed in same currency. - Administrative changes included: - Jun. 1991: 20 percent URR introduced on all new credit; holding currency same as credit; holding period Min (max (credit maturity, 3), 12). - May 1992: Holding period fixed at 1 year. - Aug. 1992: URR rate raised to 30 percent. - Jan. 1995: Holding currency only US dollars. - Jul. 1995: Extended to secondary American depository receipts (ADR). - Sep. 1995: Period to liquidate USD from secondary ADR tightened. - Dec. 1995: Foreign borrowing to be used externally exempted. - Dec. 1996: Foreign borrowing < US$200,000 (500,000 in a year) exempted. - Mar. 1997: Foreign borrowing < US$100,000 (100,000 in a year) exempted. - Jun. 1998: URR rate reduced to 10 percent. - Sep. 1998: URR rate set at zero. - Empirical outcomes: persistent effect on maturity composition (toward longer maturities); overall inflows largely unaffected in some studies; small real exchange depreciation of about 2.5 percent reported in De Gregorio, Edwards, and Valdés, 2000 for 30 percent URR. - Colombia: - URRs used in 1990s and again in 2006–07. - Sep. 1993: URR of 47 percent on short-term (less than 18-month maturity) foreign loans different from trade financing; deposit kept 12 months or redeemed with discount reflecting opportunity cost. - URR parameters actively managed during 1993–2000; URR set to zero (but not eliminated) in April 2000. - 2007 episode: URR of 40 percent with holding period of 6 months imposed on foreign borrowing and portfolio inflows of all maturities; early withdrawal penalties ranged from 9.4 percent of the RR (immediate withdrawals) to 1.6 percent (if held for 5 months). - URRs loosened and tightened multiple times in 2007–2008; URR rate set to zero in October 2008. - Table B.1 example entries: - Sep. 1993: Maximum Term for Loan Subject to Deposit (Months) = 18; Reserve Requirements (Percent) = 47; Holding Period (Months) = 12; Currency = USD. - Mar. 1994: Maximum Term = 36; Reserve Requirements included 93 for loans with maturities up to 1 year (Holding Period 12; USD), 64 for loans up to 2 years (Holding Period 18; USD), 50 for loans up to 3 years (Holding Period 24; USD). - Exemptions: Colombian institutional funds, including pension funds, were exempted; equities issued abroad exempted in Jun. 2007 (ADR issuances exempted). *Source: IMF Working Paper content on “RESERVE REQUIREMENTS AND TAXES ON CAPITAL INFLOWS” (chapter IX) as provided in the supplied PDF content.* ### 42.8 for loans maturing in 60 ### _wp11159 - 42.8 for loans maturing in 60 ### Colombia — URR (Unremunerated Reserve Requirements) experience - Policy actions (selected): - Feb. 1996: 48 / 85 / 6 USD (table fragment shown). - Mar. 1996: 36 / 50 / 18 USD (table fragment shown). - Mar. 1997: 60 / 50 / 18 USD (table fragment shown). - Mar. 1997 All: 30 / 18 USD & Pesos. - Jan. 1998 All: 25 / 12 Pesos. - Sep. 1998 All: 10 / 6 Pesos. - Apr. 2000 All: 0 / 0 ---. - May 2007 All: 40 / 6 Pesos. - May 2008 All: 50 / 6 Pesos. - Oct. 2008 All: 0 / 0 ---. - Complementary measure: - January 1997: an explicit (Tobin) tax on all capital flows was introduced; it was decreed unconstitutional in March 1007.1 - Empirical findings: - Colombia’s experience with URRs was successful in altering the composition of capital inflows, but did not have a significant impact on reducing the volume of inflows or modifying the level of the exchange. - Most studies on the 1990s URRs conclude they were effective in reducing short-term flows with mixed results on total capital flows. - Ocampo and Tovar (2003) argue restrictions diminished not only short-term but also long-term capital flows. - Studies on the 2007 experience find a significant effect on short-term capital inflows. - Clements and Kamil (2009) find significant reductions in foreign borrowing and non-resident portfolio inflows, and no impact on total net private capital movements. - Clements and Kamil (2009) and Rincon and Toro (2010) find increased exchange rate volatility but no evidence of diminished appreciation pressures. - Additional notes: - In December 2007, penalties for early withdrawal of funds were reduced and IPOs of equities were exempted from the URR. - URR on portfolio inflows was raised from 40 to 50 percent in May 2008; in June, the penalty for early withdrawal of deposits was raised. - In September 2008, URR was loosened as purchases of equities were exempted. ### Peru — Reserve Requirements on non-resident bank deposits - Policy actions and timeline: - Central bank actively used RRs on bank deposits from non-resident financial institutions during 2008 and again since early-2010. - Amid the surge in capital inflows during 2008, the central bank increased the minimum and marginal reserve requirements on deposits, with higher marginal rates applying to deposits from: financial institutions, hedge funds, pension funds, brokers, mutual funds and investment banks. - Measures eliminated in late 2008 following Lehmann’s collapse. - Early 2010: marginal reserve requirement on deposits from non-resident financial institutions re-imposed at levels similar to mid-2008. - Empirical findings: - Peru’s use of RRs was effective in altering the composition of bank liabilities: the amount of non-resident deposits declined sharply in response to changes to reserve requirements during 2008. - Implementation details (from figures and notes): - RR on bank deposits includes deposits and bank CDs. - Marginal RR in S/. for non-residents applies to non-resident financial institutions. - Neither the minimum RR on bank deposits nor the marginal RR on non-resident deposits are remunerated. - Remuneración encaje marginal reported for S/. and US$ in figures. ### Brazil — IOF (Imposto de Operações Financeiras) and related measures - Policy actions and timeline: - October 2009: IOF re-introduced; tax rate set at 2 percent on local bonds and equity inflows (direct investment and external borrowing by Brazilian banks and firms not directly affected). - October 2010: IOF tax on foreign investment in local bonds raised to 4 percent from 2 percent; tax rate for purchase of Brazilian stocks by foreigners left at 2 percent. - A few weeks later (after Oct. 2010): tax rate on fixed-income raised again to 6 percent from 4 percent. - March 2011: IOF tax on short-term foreign borrowing by residents increased to 6 percent on loans of up to 360 days, from a previous rate of 5.38 percent on loans of up to 90 days and zero rate when the operation exceeded 3 months. - Historical IOF note: IOF tax on short-term foreign borrowing used to be 5 percent since 2007 and was increased to 5.38 percent in January 2008. - Immediate market responses: - On the day following IOF reintroduction in Oct. 2009, the Brazilian real, which had appreciated by 35 percent against the U.S. dollar since the beginning of this year, depreciated by about 2 percent (to R$1.75 to the dollar) but then resumed appreciation. - Empirical findings and interactions: - The re-introduction of the IOF may have changed the composition of capital inflows; its impact on total volume of capital inflows was debatable (Walker, 2010). - Equity flows diminished after IOF reintroduction in October 2009; inflows into domestic bonds remained robust. - Walker (2010) shows IOF had some impact, although small, in inserting a wedge between domestic and foreign fixed-income markets. - IOF combined with macroprudential measures may have stimulated foreign borrowing, motivating extension of IOF to short-term foreign borrowing. - IOF led to a widening spread between onshore and offshore funding rates. - Introduction of a reserve requirement limiting short dollar positions created an incentive to issue debt abroad and bring dollars into the country, contributing to external short-term debt in Brazil doubling between December 2010 and February 2011. - The IOF remains zero for foreign borrowing exceeding 360 days, while overseas corporate 1-year bonds will be subject to the IOF. - Mechanism note: - If IOF is binding and full arbitrage existed before IOF, IOF introduction would create a difference between implied interest rates offshore (NDF market) and onshore in reais; Walker (2010) finds offshore NDFs strengthened relative to onshore currency forwards and the NDF-implied basis spread widened, although by only a fraction of the 2 percent that would occur on instruments with a one-year maturity if the IOF were fully binding. *Source: Rincon, and Toro, 2010, and Ocampo and Tovar, 2003 (excerpts and figures as provided).* ### References ### References ### Full list of cited works - Allen, M., C. 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