Banking policies needed to support the Caribbean through and beyond COVID-19 — IDB study

Banking policies needed to support the Caribbean through and beyond COVID-19 — IDB study

BY ABBION ROBINSON
Business reporter
robinsona@jamaicaobserver.com

Wednesday, September 23, 2020

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WHILE most central banks have lowered policy interest rates and provided liquidity, and have even intervened in foreign exchange markets due to the economic fallout from COVID-19, better banking policies are essential for financial systems to play an effective role in supporting economic recovery, according to an Inter-American Development Bank (IDB) working group report.

Sound Banks for Healthy Economies: Challenges for Policymakers in Latin America and the Caribbean in Times of Coronavirus, which was released last week, outlines a series of challenges that threaten the stability of the financial sector and details recommendations for regional policymakers.

CURRENCY MISMATCHES

In the event of strong portfolios or other outflows — as happened in March due to the COVID-19 outbreak — the exchange rate can overshoot with a sharp depreciation. This volatility can create risks for financial systems, especially in the presence of currency mismatches, the report stated.

Mismatches are commonly analysed in situations pertaining to asset and liability management and refer to instances when assets and liabilities do not correspond with one another.

According to the report, the Caribbean has faced significant vulnerabilities given currency mismatches on both public and private sector balance sheets. In periods of growth or stable exchange rates mismatches are not an issue, but during periods of economic downturn if dollar liabilities are high relative to assets, the depreciation of a currency will increase the debt burden of countries and firms.

“Historically, currency mismatches in the private sector were driven largely by firms in the non-tradable sector that contracted debt in foreign currency. Firms operating in the tradable sector with dollar income are regularly considered to have a natural hedge against currency movements,” the study indicated.

“However, since the eruption of the pandemic, firms in the tradable sector have lost much of their foreign currency revenue. Firms exporting commodities have seen commodity prices fall. The value of the natural hedge for such firms has thus decreased. On the one hand, they suffered the income loss and on the other, their foreign currency debt has risen as a percentage of local assets, given currency depreciations.”

To blunt the impact, the report proposed that central banks ensure all foreign currency-denominated transactions are reported so the risks can be assessed.

“They should take a holistic view, perhaps by developing new stress tests to model corporates' rollover and solvency risks and how they may impact banks and other financial institutions, and the likelihood that smaller firms will be crowded out of credit markets. Still, as shown by the current crisis, these regulations do not protect exporting firms from losing dollar receipts if they are commodity exporters and commodity prices fall. Some countries ask all firms to report all debt issued in foreign currency and all foreign exchange transactions, including swaps and forward contracts. This is a good first step so authorities can monitor the risks,” the report advised.

SAFETY NETS, FISCAL TRANSFERS AND FINANCIAL INCLUSIONS

While the report focused on ensuring the effective contribution of financial systems during the pandemic while safeguarding their stability, it does not comprehensively review all the fiscal policy actions being taken across the region. Suffice it to say, fiscal authorities have attempted to provide relief to families and firms, given the financial constraints caused by COVID-19 pandemic.

“The average fiscal package introduced due to the COVID-19 crisis is around three per cent of [gross domestic product] but there is considerable heterogeneity across countries, with some correlation between the size of the announced package and the available fiscal space,” the study revealed.

It further indicated that while announced fiscal packages are on average around the above-metioned three per cent of gross domestic product, actual fiscal deficits will not necessarily increase by this amount.

Regarding actual policies, money transfer programmes to assist the most vulnerable have been created, and then expanded.

However, governments in some Caribbean countries have had trouble reaching the poorest segments of the population because of inadequate financial inclusion and underdeveloped payment systems.

Notwithstanding, some transfer programmes implemented or expanded since the onset of the pandemic have the potential to boost financial inclusion.

The report recommended Caribbean countries implement initiatives to boost financial inclusion by using electronic payment methods, and then complement these efforts with programmes of financial education.

“The region lags in terms of financial inclusion, and harnessing transfer payments in this fashion could bring significant benefits — allowing unbanked families and firms access to financial services, providing a silver lining to the crisis,” the report stated.

EXIT RULES FOR BANKS

Given the magnitude of the recessions and the loss in income to firms and to families, many corporate bankruptcies are likely to happen, while some banks and other financial institutions will need to be closed. Most countries have deposit insurance systems in place and many have improved bank resolution legislation since the crises of the 1980s and 1990s.

For example, Argentina in 1995 established a new regime for bank liquidation which illustrates these issues and that regime turned out to be crucial in successfully managing the systemic banking crisis that ensued in Argentina following the 1994 Mexican Peso Crisis. The currency crisis was a sudden devaluation of the Mexican peso, which caused other currencies in Latin America to decline as well.

According to the report, this regime was efficiently applied in practice, with versions copied in other countries, suggesting that elements could also be applied to others.

“Policymakers should ensure such frameworks are operative — not only should the laws be in place but they should be regulated appropriately so they can be used if required. The region also lags in terms of the legal protections afforded to supervisors. If passing new legislation for this purpose is not feasible then, at a minimum, central banks and bank supervisors should have a clear strategy and adequate resources to mount a rigorous defence against any cases brought in the wake of supervisors performing their legal duties to resolve financial institutions, if and when required,” the study proposed.

It further added that governments and central banks should carefully monitor the evolving risks in the financial system and plan accordingly. Since bank resolution frameworks are focused, by and large, on resolving issues within each individual institution rather than contemplating systemic risks, contingency plans should be developed if multiple institutions — including some larger institutions — begin to suffer from solvency risks.


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