An Analytical Framework for Assessing Systemic Risk in Costa Rica
Project Development Objective (PDO)
This project aims to develop a framework for the analysis of systemic risks, which would help authorities improve their capacity to detect threats to financial stability.
Although the financial sector in Costa Rica has become stronger and more diversified, with institutional investors (mainly pension and investment funds) continuing to gain market share, it continues to be dominated by banks that operate at the center of financial conglomerates. The sector is moderately concentrated with the three largest banks representing 59 percent of banking assets. As of the end of 2012, the market share of international banks subsidiaries was about one-third of the banking sector’s total assets. Costa Rica’s financial system has well withstood the impact of the global financial crisis, though dollarization continues to be a source of vulnerability. Capital adequacy is well above regulatory requirements and liquidity remains robust. Profitability has been stable, albeit somewhat below that of regional peers, and nonperforming loans are at manageable levels. Although foreign banks represent about one-third of the financial system, reliance on foreign funding is small and exposure to foreign assets is modest.
Despite recent progress, the macro-prudential analysis remains a challenging area because risks to financial stability are not easily measurable or quantifiable. Currently, Costa Rica does not have a comprehensive methodology on which systemic risk can be monitored and incipient threats to financial stability can be assessed.
In particular, Costa Rica does not have a definition of systemic risk and there is no well-established systemic risk monitoring function in place. Relevant legislation does not define systemic risk or responsibilities to deal with it. And although members of the safety net (Central Bank, Council for Financial Supervision [CONASSIF], and superintendencies) monitor financial institutions closely, the safety-net providers have not agreed on a methodology and procedures for calculating and monitoring systemic risk.
The main activity for the project is a framework for the analysis of systemic risk, comprising the following:
1. Criteria for the identification of systemically important banks and financial institutions
2. Costa Rican–tailored contagion matrix highlighting key links between financial institutions,
financial markets, and financial infrastructure, thereby highlighting interconnectedness within the
3. Simple network model for analyzing interbank links between banks
4. Analytical framework for macro-prudential analysis, through the use of cobweb methodology (The
latter will serve as a basis for the Financial Stability Review.)
The project aims to strengthen the country’s capacity in the area of systemic risk monitoring.
The development and implementation of a framework to evaluate systemic risk for Costa Rica will improve systemic risk monitoring and in particular increase authorities’ capacity to timely respond to the buildup of systemic vulnerabilities. This project would thus contribute to a more effective detection of incipient threats to financial stability. Such detection would better position policy makers to preemptively mitigate threats by enacting corrective (macro-prudential) policies. To effectively mitigate systemic risk, it is necessary to be able to measure it or monitor it.