Toward an Effective Supervision of Partially Dollarized Banking Systems by Antonio Garcia Garcia Pascual

I. INTRODUCTION
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. 
Following international standards, partially dollarized countries control banks’ foreign 
exchange risks by imposing limits or minimum capital requirements on foreign exchange 
exposures. While international standards provide an adequate framework for countries with 
significant exposure to foreign currency, one particular aspect that deserves special

consideration in countries with a high level of dollarization is the definition of a riskless 
position in foreign currency that is used when establishing prudential rules to control 
corresponding risks (capital charges and limits). This paper shows that a matched foreign 
exchange position is not riskless in a highly dollarized country because in the event of a 
depreciation, the capital adequacy ratio tends to fall more, the higher the rate of dollarization. 
Banks’ actions to contain the foreign exchange risk arising from intermediating dollar 
liabilities, often lead them to take higher credit risks. To reduce their foreign currency 
mismatches, banks acquire dollar denominated assets through granting foreign currency 
loans to domestic clients whose cash flow is in domestic currency. While effectively 
transferring the foreign exchange risk to the borrowers, banks retain the credit risk resulting 
from the possibility that the borrowers’ currency mismatches affect their capacity to repay 
the loan in the face of adverse exchange rate fluctuations. Exposure to credit risk also 
increases if the value of the collateral backing the loan obligation—denominated in domestic 
currency—declines consequent on the exchange rate movement. 
Implicit or explicit government guarantees distort pricing decisions and increase the demand 
and supply of foreign-exchange-denominated transactions.Borrowers, operating in the 
context of fixed exchange rate or “fear of floating” regimes, expect that the exchange rate 
risk will not materialize within the maturity of their loans in the face of prevalent short-term 
lending and spreads that are generally lower for intermediation in foreign currency relative to 
domestic currency. As a consequence, borrowers perceive that costs entailed in holding a 
currency mismatch in their balance sheets are lower in “normal” times than intermediating in 
a weak domestic currency where spreads and volatility tend to be higher. In some cases 
government guarantees further encourage foreign currency lending and borrowing. The 
limited availability of hedging instruments in many emerging markets and the shallowness of 
domestic credit markets may also provide a rationale for unhedged foreign currency lending. 
The facts are that the risk of large unexpected exchange rate movements is not priced in, 
large amounts of unhedged foreign currency loans are granted and banks tend to hold 
insufficient reserves—in the form of provisions or capital—to protect them. This is a 
problem that bank supervisors need to address. 
Limited backing of banks’ foreign currency liabilities by foreign currency and their 
convertibility at par create systemic liquidity risks. Systemic liquidity problems in dollarized 
economies arise when the demand for local assets falls, due to a perceived increase in 
country risk or banking risk, prompting depositors to convert their deposits into foreign 
currency, cash or to transfer them abroad and/or foreign banks to recall short-term lines of 

Toward an Effective Supervision of Partially Dollarized Banking Systems by Antonio Garcia Garcia Pascual