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Issues for the Caribbean Shelton Nicholls Resident Adviser on Financial Stability Caribbean Regional Technical Assistance Centre (CARTAC) Credit Union Workshop St. Vincent and the Grenadines August 20-22, 2014. Sunset Shores Hotel, St. Vincent and the Grenadines

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1.Financial Stability: An Important Mandate 2.Key Elements of a Financial Stability Risk Architecture for the Caribbean 3.Financial Stability- State of Play 4.Key Financial Stability Matters for Policy Focus: An Agenda for the Region 5.Conclusion

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What is Financial Stability? Much discussion, but no single definition around which there is unanimity. A financial system is in a range of stability whenever it is capable of facilitating (rather than impeding) the performance of an economy, and of dissipating financial imbalances that arise endogenously or as a result of significant adverse and unanticipated events (Gary Schinasi, 2004). Financial Stability is a multi-dimensional Concept.

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Facilitate efficient and smooth allocation of resources inter-temporally and spatially between savers and investors. Efficient and Smooth Allocation of Resources Enable forward-looking risks to be continuously assessed, reasonably priced and effectively managed. Effective Management of Forward-looking Risks Be able to contain and absorb financial and economic shocks with minimal disruption to financial and economic activity. Absorption and Dissipation of financial and economic shocks Some Consensus around Schinasis Principles

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Financial Stability and Monetary Stability therefore share an interdependent relationship: A stable financial system is necessary for sustainable GDP growth and low inflation. Sustainable growth in the economy with stable prices will also make the economy less prone to financial instability.

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Decline in National Output and Incomes Increased Fiscal Expenditures Balance of Payments Deficits Exchange Rate Instability

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Global financial crisis and the reverberations from the collapse of a key regional financial conglomerate (CL Financial) have brought to the fore the importance of systemic risks and the need to develop a macro-prudential policy framework in the Caribbean region. Systemic Risks: The risk that an event could trigger a loss of value or confidence in a substantial portion of the financial system resulting in adverse nation-wide and region-wide effects. No fully agreed upon risk assessment framework for financial stability exists globally. Various elements needed for a unified framework are still being elaborated and developed by international bodies (IMF, BIS, ECB, FSI) and academic institutions.

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Banks Ins. Comp/Pens. Funds Credit Unions Securities Firms Interbank Mkt Forex Mkt. Capital Mkts (Equity, Debt) Legal/Regulatory Systems Payments Systems Clearance Systems Deposit Insurance Financial Institutions Financial Markets Financial Infra Structure Financial Sector Components Financial Sector Components Sources of Risk Sources of Risk Endogeneous Risks Exogeneous Risks Endogeneous Risks Exogeneous Risks Endogeneous Risks Exogeneous Risks Risk Assessment Micro-Prudential Macro-Prudential Micro-Prudential Macro-Prudential Micro-Prudential Macro-Prudential Major Risks Major Risks Credit Liquidity Reputational Credit Liquidity Reputational Counterparty Asset Price Misalignment Market Reputational Counterparty Asset Price Misalignment Market Reputational Payment Operational Regulatory Reputational Payment Operational Regulatory Reputational Risk Metrics Risk Metrics FSIs EWIs Stress Tests Flow of Funds FSIs EWIs Stress Tests Flow of Funds Contagion Matrices Financial Model (Macro, DSGE) Network Analysis Contagion Matrices Financial Model (Macro, DSGE) Network Analysis Risk Mitigation Risk Mitigation Crisis Management Regulatory System (Single, Multiple) Crisis Management Regulatory System (Single, Multiple) Business Continuity Robust Network and ICT Platform Business Continuity Robust Network and ICT Platform Source: Prepared by Shelton Nicholls.

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Endogeneous Risks Institutions-Based: Financial Risks (Credit, Market, Liquidity, Interest Rate, Currency). Other Risks (Operational, Concentration, Reputational, Business Strategy, Capital Adequacy). Market-Based: Counterparty risks, credit risks, contagion risks. Infrastructure-Based: Clearance, Payment and Settlement Risks. Macroeconomic Risks Macroeconomic Imbalances (Fiscal Deficits, Balance of Payment Deficits) Event Risks Natural Disasters, Political Events, Large business failures Exogeneous Risks Source: Schinasi (2006)

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Risk Assessment of Financial system requires: Identification of major sources of risks Endogeneous (shocks generated and amplified within financial system) Exogeneous (shocks arising from outside the system) Assessment of Nature of the Risk Macro-prudential (driven by common exposures, interconnectedness, interdependence from Endog. and Exog. Shocks). Micro-prudential (addresses risks in individual financial institutions arising from Endog. and Exog. Shocks).

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Measurement of Risk (Risk Metrics) Micro-Prudential Measures (CAMEL, CARAMEL, PEARLS for individual financial institutions) Macro-Prudential Measures FSIs, EWS Macro-Stress Tests Network and Interconnection Matrices and Maps Macro-econometric Link Models, DSGE Models Financial Contagion Matrices

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Effective Risk Mitigation through: Complementary macro-prudential and micro-prudential regulation (a major blindspot). Crisis Preparedness Plan and Strategy. Robust Information, Communication and Technology platform (including robust computer networks and flexible databases). Business Continuity framework and Plan for the financial sector.

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Region is making some progress with putting in place FSI indicators (both core and enhanced) for the Banking sector. Significant effort is however required in developing and compiling FSIs and EWIs for non-banks, life and non-life insurance companies, credit unions and pension funds. Systemic risk and macro-prudential regulation of the system as a whole remains a potential Achilles heel unless more rapid progress is made with macro-prudential surveillance.

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Stress Tests have been conducted in the banking systems of most Caribbean countries - Trinidad and Tobago, Barbados, Suriname, Jamaica, Belize, OECS, Guyana. Most of the Stress Tests have been directed at single factor shocks with an emphasis on one component of the financial system (banking). [Exception: Jamaica has conducted stress tests of insurance and credit union sectors]. No combined stress tests have been developed that examine the impact of Endog. Shocks (e.g. interest rate declines) on the entire financial system (banking, insurance, pension funds and credit union sectors) in national financial system s and across the region.

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Banking Sector : Economic stagnation has led to a sharp rise in the Non- Performing Loans to Total Loans (NPL/TL) ratio which hovered at just under 10.0% in 2012. But Banks maintained sufficient liquidity and had robust capital adequacy provisions. High NPL/TL ratios in Belize, Barbados, ECCB and the Bahamas.

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Credit Union Sector: FSIs collected for the credit union sector remain quite sparse although this sector is quite important in some regional jurisdictions such as Barbados and the ECCU. Even sparse data show that credit risk in this sector is above the PEARLS target.

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Life Insurance Segment: Medium underwriting and asset quality risks for the life insurance sector. Data remain sparse and difficult to compare meaningfully across the region. Non-Life Segment: High combined ratios (loss ratio and expense ratio) may be signaling some difficulty in an environment of low investment yields.

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Short Term: Rapidly improve collaborative efforts in building FSIs for non-banks, insurance, credit unions and securities firms that operate in onshore national and regional economy. Build integrated database for regional financial conglomerates and SIFIs and develop consolidated FSI database for the Caribbean. Develop a financial interdependency matrix to map interconnections of SIFIs at both a national and regional level.

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Short Term (contd): Establish an appropriate institutional framework and support structure for macro-prudential surveillance, regulation and policy making). Develop and extend macro stress tests beyond banking sector to other key areas, especially insurance and the securities market. Conduct at least one significant region-wide stress test for banking and insurance sectors. Develop appropriate Communication Strategy to report and warn of impending risks (FSRs, Conferences/Workshops, etc).

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KEY AREASACTIONS 1. Legal Regulatory/Mandate Need to Ensure Legal Mandate for Financial Stability is established. 2. Organisational/Institutional Arrangements Need for a System-wide Oversight Committee or Regulatory Policy Council that is focused on macro-prudential policy and financial stability. 3. Macro-Prudential Policy FrameworkNeed to establish a macro-prudential policy framework with clear terms of reference. Building capital buffers Contain build-up of vulnerabilities over time, in sectors and across the system.

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KEY AREASACTIONS 4. Operating Framework for Financial Stability Assessing Systemic Risk (Assess imbalances, Map out linkages in the system) Design Macro-prudential tools to contain systemic risks (countercyclical capital buffers and provisions, sectoral capital requirements, Loan-to-value limits, Debt-to- income limits, risk-weighting of highly connected sectors, liquidity coverage ratios, net stable funding ratios, reserve requirements, ) 5. Financial Safety Net/Crisis Preparedness Plans Design appropriate financial safety net (deposit insurance, financial stability fund or levy) Preparation of national crisis preparedness plans.

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IMF BASLE COMMITTEE BASLE COMMITTEE IAIS IOSCO WOCCU IOPS FATF REGIONAL CENTRAL BANKS REGIONAL CENTRAL BANKS OTHER REGULATORY BODIES CAIR CAPS CGSR CACS CFATF CGBS CCMF RFSCC CCBG COFAP REGIONAL REGULATORY STRUCTURE IN RELATION TO INTERNATIONAL FINANCIAL STABILITY ARCHITECTURE

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Long Term: Re-establish national flow of funds matrices and build an integrated flow of funds matrix for the region. Develop a financial contagion matrix for the region. Build a quarterly regional link model (dynamic macro- econometric financial model) to detail linkages between the national and regional financial sectors and the regional economic system.

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Regulators may not be able to prevent the emergence of the next financial crisis, but must place themselves in a position to mitigate its destabilizing effect. Developing a Risk Assessment Framework for the Caribbean regional financial sector based on Macro-Prudential principles is the place to start and the way to go.

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CARTAC stands ready to help countries enhance their financial stability and macro- prudential frameworks.

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END OF PRESENTATION