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COSTA RICA: Strengthening Systemic Risk Monitoring

When is a bank too big to fail? How can financial sector policymakers anticipate cascading domino effects, and how can they tame the innate boom bust tendencies in the financial sector? 

The global financial crisis highlighted the urgency to add a macro overlay to existing approaches to financial sector regulation and supervision, aimed at ensuring the safety and soundness of individual financial institutions. Macroprudential supervision is meant to fill the gap. It adopts a broader perspective on the financial system, including the linkages that support its functioning, and focuses on systemic risk, as opposed to the safety and soundness of individual financial institutions. 

Regionally, the Consejo Monetario Centroamericano (Central American Monetary Council) has encouraged its member countries to establish macroprudential frameworks, starting with the development of analytical tools and methodologies for the detection of systemic risk. It is against this backdrop that the Costa Rican authorities sought technical assistance from the World Bank and FIRST Initiative in 2013 to develop An Analytical Framework for Assessing Systemic Risk. Although the country had withstood the global financial crisis, the Central Bank of Costa Rica (BCCR) wanted to address the vulnerabilities within its financial system, and to develop a framework to improve the authorities’ capacity to detect emerging threats to financial stability.

The FIRST-funded project, on assessing systemic risk, was modelled after an earlier pilot project undertaken in El Salvador, and it delivered the following: 

1.    A methodology for the identification of domestic systemically important banks (D-SIBs)

2.    A matrix to highlight key linkages between financial institutions, markets, and the overall infrastructure within Costa Rica, and the risk of contagion

3.    A network model for analyzing interbank linkages and the transmission of shocks in the financial system

4.    A series of composite financial stability indices for monitoring the evolution of systemic risk over time  (the cobweb model)

The analytical framework is now fully implemented and being used by the BCCR to evaluate systemic risk, and has since enabled the Central Bank to improve systemic risk monitoring. In particular, the technical assistance has increased authorities’ capacity to manage systemic risk, and maintain the country’s financial stability. 

After the project, Mr. Julio Rosales-Tijerino, an Economic Advisor to the Governor of the Central Bank of Costa Rica (BCCR), highly rated the timeliness of the deliverables, as well as the framework, matrix, and other tools provided. He further explained, “The technical assistance was aimed to develop tools to improve our knowledge and capabilities to make analysis related to systemic risk and has been very useful for us.” 

The work was a joint effort of WB staff with a local project team from the BCCR, and the various financial regulators across banking, capital markets, pensions, and insurance; whom in return, deepened their own knowledge of systemic risk monitoring tools. Within the BCCR, the Financial Stability Unit increased its staff from 3 to 11, which greatly contributed to the success of this project. 

Going forward, the tools delivered through this project should contribute to more effective detection of incipient threats to financial stability in Costa Rica, and better position policymakers to pre-emptively mitigate risks through corrective policies. However, these tools are not static, and the central bank and related authorities will play a critical role in updating data and qualitative inputs in the contagion matrix, network model and cobweb analysis.

Strengthening financial stability has been a pillar of FIRST’s mission since its establishment. Since 2007, FIRST has spent over $15M on more than 90 projects specifically focused on macroprudential oversight, crisis preparedness, and safety nets. Within this portfolio, 15 projects have enabled systemic risk monitoring. By strengthening macroprudential oversight and increasing financial stability, these projects support the World Bank’s twin goals by reducing the probability of financial crises which disproportionately impact the poor.