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February 22, 2019

IMF published a working paper on credit cycle and capital buffers in Central America, Panama, and the Dominican Republic (CAPDR). The paper reviews the financial and credit developments in CAPDR countries, provides a comparative assessment of the credit cycle in the region, and discusses the possible use of countercyclical capital buffer (CCyB) in the region as a tool to enhance the resilience of the banking system.

The paper describes the current state of financial developments in the region, highlighting that banks are well-capitalized, with good credit quality and a solid deposit base. Banking systems in CAPDR have capital ratios comfortably above the minimum requirements while NPLs are low—ranging from about 1% of total loans in Nicaragua to about 2.5% in Honduras and Guatemala—and typically over-provisioned. Credit is mostly financed by costumer deposits, which account, on an average, for 80% of total (non-interbank) loans. The paper then presents the methodology used to estimate the credit-to-GDP gap, starting from the approach proposed by BCBS, which is adjusted to account for the fast credit growth environment of developing economies. Next, the paper presents the empirical analysis that estimates the credit gap, tests its ability to signal impeding financial distress for each country in the region, and discusses implications for setting CCyB and capital adequacy requirements. In the paper, the authors estimate the credit cycle in CAPDR and find that the credit gap is a powerful predictor of systemic vulnerability in the region. They also simulate the activation of the Basel III CCyB and discuss the macro-prudential policy implications of the results, arguing that countercyclical macro-prudential policies based on the credit gap could prove useful to enhance the resilience of the region’s financial sector.

However, the authors conclude that activation of macro-prudential instruments should be informed by the development of other macro-financial variables and by expert judgment. It is recommended that formalizing an analytical framework to assess the applicability of CCyB in CAPDR should be considered to enhance the stability of the banking system. The signaling power of the credit gap suggests that authorities could consider introducing CCyB in their policy toolkit. CCyB would be a useful policy instrument to strengthen the resilience of the banking system through the financial cycle and limit the procyclicality of lending. Decisions on the CCyB should be based on a deep assessment of the credit developments. Qualitative information and judgment should also be used to analyze the changes in lending standards and credit conditions. Ultimately, the policy makers need to ensure that any expansion in credit is healthy and understand the reasons behind any credit contraction. Credit deepening must go hand-in-hand with measures that facilitate a healthy credit expansion such as effective legal frameworks for the creation, mobilization, and realization of collateral and effective insolvency proceedings.

 

Related Link: Working Paper

 

Keywords: Americas, Banking, Credit Cycle, Basel III, CCyB, Macro-Prudential Policy, Capital Adequacy, Systemic Risk, CAPDR, IMF

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