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Strengthening Pacific Island countries’ financial sector amid Covid-19

By Katia D'Hulster, Geof Mortlock and Owen Nie

The pandemic has severely affected several Pacific Island countries (PICs). In addition to the impact on public health, some of these countries had to grapple with the economic effects of Covid-19 on the tourism sector while dealing with natural disasters and political uncertainty.

In the financial sector, bank asset quality deteriorated rapidly as a result of credit exposures to small and medium-sized enterprises and households. In addition, narrowing interest margins weakened bank and non-bank lender profits.

To help PICs better understand and manage risks and ultimately limit the impact of economic shocks on the region’s financial stability, the World Bank started in early 2020 to monitor financial sector indicators in the region. In a recent report, we provide an assessment of financial stability issues, discuss policy responses so far, and identify key areas in financial supervision that could be improved.

Despite the economic impact of the pandemic and natural disasters, PIC financial systems have remained largely resilient to date. Average bank non-performing loans (NPLs) in PICs edged up only slightly during 2020, and loan-loss provisioning appears to be largely adequate.

As of the fourth quarter of 2020, average NPLs as a share of total bank loan exposures in PICs stood at 3.8 percent, slightly higher than the 3.1 percent observed a year ago. Most PICs have average bank-impaired loans around or below 4 percent.

One jurisdiction with particularly large bank exposure to the tourism sector has seen a marked increase in special mention loans, a forward-looking indicator of bank asset quality, highlighting an important transmission channel of economic shocks to bank balance sheets in the region. This is relevant for all the PICs to varying degrees, given that banks’ credit exposure to the tourism sector is high in many of these countries.

It is likely that loan impairment will increase, particularly as the temporary borrower support arrangements and government financial assistance measures are progressively phased out. It will be important for the supervisory authorities in the region to maintain a close watch on banks’ and non-bank lenders’ asset quality and loan remediation processes in order to assess the full impact of adverse economic shocks on asset quality, bank profits, and capital.

Most banks in the PICs entered the pandemic with strong capital and liquidity buffers. Bank capital ratios are generally very high by international norms, and some banks benefit from strong foreign parentage. Yet, as the pandemic unfolded, profitability has remained generally low.

Despite the relative resilience of the banking sector in the region, there is potential for financial system pressures to emerge over 2021 and beyond. This is partly because of the delayed recognition of NPLs. The effects of natural disasters in some countries reduced net interest margins, and subdued risk appetite could also come into play.

Another complicating factor is the withdrawal of some foreign banks, such as Westpac Banking Corporation (Westpac), from the region, a trend observed over recent years and expected to accelerate this year. This creates a risk of reduced financial depth and competitiveness in the region and potentially increased risk of instability, as the banking sector becomes more concentrated.

As the pandemic-induced economic shocks continue to influence the Pacific Islands, supervisory authorities should consider providing additional guidance to lenders on asset classification and provisioning, strengthening supervisory surveillance of lenders with enhanced off-site monitoring and on-site assessment, and carrying out stress testing.

Assuring that early intervention arrangement, including contingency plans and recovery plans, are in place for dealing with any situations of emerging stress, and domestic coordination of relevant agencies and cross-border cooperation and coordination would also benefit the region.

In addition, a strong legal and institutional framework for insolvency and debtor/creditor rights is critical to support the speed and efficiency of banks’ recoveries and the resolution of distress to minimize economic damage and financial market disruptions. (World Bank)

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