The Basel Committee for Banking Supervision (BCBS), through its 1998 Capital Accord and guidance material on risk management, established a comprehensive framework for the oversight of banking activities. This framework was revised in the context of Basel II (the revised international capital framework issued in 2004 and updated in 2005; see Basel Committee, 2005). The revised accord aligns the capital measurement with sound and contemporary practices in banking and promotes further improvements in risk management. The specific documents on the management and supervision of the main banking risks, including credit market and liquidity risks, in principle are applicable to all banking systems.
The purpose of this paper is to contribute to the design of a prudential regulatory framework for banks operating in partially dollarized economies, with the discussion being anchored conceptually in the framework of the comprehensive BCBS guidance on risk management. This paper does not address issues related to the causes of or solutions to dollarization. Causes are invariably related to macroeconomic and institutional factors, and accordingly, solutions are likely to focus on macroeconomic and institutional policies instead of microeconomic prudential regulations. Instead, the paper addresses the fact that financial systems and banks in most dollarized countries face higher risks that are reinforced by moral hazard. The resulting exposures create systemic vulnerabilities to which, from the standpoint of financial stability, supervisory regimes need to adapt.
Partial dollarization increases the vulnerability of financial systems to solvency and liquidity risks. Increased solvency risks result mainly from foreign currency mismatches in the event of large movements of the exchange rate. In these countries, banks often provide foreign currency loans to unhedged borrowers expecting that the government will be willing and able to absorb exchange rate volatility. Banks’ currency mismatches expose them to foreign exchange risk, while their borrowers currency mismatches expose them to foreign currency-induced credit risk. Liquidity risk constitutes an additional source of risk, that stems from the potentially limited backing of banks’ dollar liabilities and is often associated by (or triggered by) solvency risk.
Contents
I. Introduction
II. Supervisory Practices
III. Towards Good practices
- A. Foreign Exchange Risks
B. Credit Risks
C. Liquidity Risks
D. Implementation Issues
Boxes
1. How Does a Devaluation Affect the Capital Adequacy Ratio (CAR) of a Bank, Depending on its Foreign Exchange Position and Asset Dollarization?
2. Quantitative Assessment of Currency-Induced Credit Risk and its Application for Off-Site Supervision: The Case of Peru
3. Costs and Benefits of Prudential Requirements to Control Liquidity Risk: The Case of Peru
Appendices
I. Country Practices: Survey Results
II. Currency-Induced Credit Risk in Selected Banking Systems
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Toward an Effective Supervision of Partially Dollarized Banking Systems
