Argentina - Banking Sector Adjustment Loan

Document of The World Bank FOR OFFICIAL USE ONLY Report No. F-4700-AR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A BANKING SECTOR LOAN IN AN AMOUNT EQUIVALENT TO USt400 MILLION TO THE REPUBLIC 3F ARGENTINA February 29, 1988 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EOUIVALENTS Currency Unit - Austral (A) US$1 - A 0.800 (June 14, 1985 to April 8, 1986) US$1 - A 1.255 (December 31, 1986) US$1 - A 3.500 (fixed rate for foreign trade) US$1 - A 3.950 (floating rate) (October 15, 1987) GLOSSARY OF ABBREVIATIONS BANADE - National Development Bank BHN - National Mortgage Bank CBA - Central Bank of Argentina FIs - Forced Investments in Non-Negotiable CBA Bonds GDP - Gross Domestic Product IMF - International Monetary Fund M1 - Money M2 - Ml plus quasi-money M3 - M2 plus bankers acceptances M4 - M3 plus indexed deposits NBFIs - Non-Bank Financial Institutions RRs - Reserve Requirements REPUBLIC OF ARGENTINA FISCAL YEAR January 1 - December 31 FOR OFFICIAL USE ONLY BANKING SECTOR LOAN Table of Contents Paie No. LOAN AND PROGRAM SUMMARY .......... - PART I - THE ECONOMY ..........1 PART II - THE FINANCIAL SECTOR......................................4 2.1 Recent Trends......... ..............4 2.2 Present Financial Sector Structure............................6 PART III - MAIN BANKING SECTOR ISSUES...............................7 3.1 Lack of Confidence in the Financial System....................7 3.1.1 Shallow Financial Sector..............................8 3.1.2 Inadequate Prudential Regulation......................10 3.1.3 Veak Financial Condition of Banks.....................13 3.2 Over-regulation and Segmentation............................16 J.2.1 Segmentation of Deposit and Credit Markets............16 3.2.2 Credit Allocation Through Central Bank Rediscount Lines.....................................18 3.3 High Cost of Credit............................... .........21 PART IV - THE PROPOSED BANKING SECTOR LOAN.........................24 4.1 Objectives of the Loan and Mair Components...................24 4.2 Description of Main Roforms.................................24 4.2.1 Increasing Deposit Mobilization and Confidence in the Banking System.....................24 4 .2.2 Improving Credit Allocation......................... 4.2.3 Reducing the Cost of Credit..........................28 PART V - LOAN FEATURES............................................30 5.1 History.............................................. .....30 5.2 Loan Amount, Borrower and Implementing Agency.................30 5.3 Letter of Financial Policy..................................30 5.4 Tranche Release............................................30 5.5 Disbursement and Procurement Mechanisms.....................31 5.6 Benefits and Risks.........................................31 PART VI - BANK GROUP OPERATIONS AND STRATEGY.......................32 PART VII - COLLABORATION WITH THE IMF..............................34 PART VIII - RECOMMENDATION........................................34 This document has a restricted dijtribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank aut' . TABLE OF CONTENTS (contd.) Page No. TEXT TABLES 1. Monthly Real Interest Rates and Financial Depth.................9 2. Loan Portfolio Quality Indicators..............................14 3. Percentage Share of Unprofit!JOe Banks, 1986...................15 4. Structure of Deposit Liabilities in the Banking System.........17 5. Breakdown of Credit by Type....................................18 6. Rediscounts as a Percentage of Total Deposits..................19 7. Recent Evolution of CBA Rediscount Lines.......................19 8. Rediscounts, Reserve Requirements and Forced Investments Net Position with Central Bank (as of March 31, 1987)..........20 9. Real Interest Rates, 1982-87................ ..................22 TEXT GRAPHS 1. Selected Financial Indicators....................................5 2. Real M3 and Real Deposit Rates................................10 3. Real Annualized Spreads........................................23 ANNEXES I - Key Macroeconomic Indicators..................................35 II - Balance of Payments, 1980-1995................................36 III - Supplementary Loan Data 3heet.................................37 IV - Status of Bank Group Operations...............................39 V - Letter of Financial Policy ...................................41 VI - Policy Matrix.................................................52 VII - Technical Assistance Component................................55 SAWKING SECTOR LOAN Loan and Proaram 8aary Borrower: Republic of Argentina Amunt: US$400 million T[erms: 15 years, including 3 years of grace at the standard variable rate. Loan Obiectives: The main objectives of the Banking Sector Loan are: (i) increasing deposit mobilization and confidence in the banking system; (ii) improving credit allocation; and (iii) reducing the cost of credit. Achievement of these objectives will increase the overall efficiency of Argentina's financial sector and enhance its ability to finance investment and growth. L2Mn Description: The proposed loan consists of two componints: a policy component and a technical assistance component. The policy component involves a set of reforms directed at reaching the three above-mentioned objectives. The reforms aimed at increasing dey,sit mobilization and confidence in the banking system include: (i) liberalization of deposit interest rates; (ii) enactment of stringent regulations on loan portfolio classification according to risk of default, provisions for potential loan losses, and interest accruals on problem loans; (iii) establishment of a Deposit Insurance Corporation for the rehabilitation or liquidaticn of problem banks; (iv) public disclosure of bar,king institutions' balance sheets and income statements; and (v) a macroeconomic program consistent with a reduction in the rate of inflation and the maintenance of a realistic exchange rate. The reforms aimed at improving credit allocation include: (i) reduction of reserve requirements and elimination of forced investments on incremental deposits; and (ii) rationalization of Central Bank rediscounts (restrictions on their growth, treatment of rediscounts with the same transparency as other fiscal expenditures, reduction of subsidies, and streamlining of rediscount portfolio administration). The reforms aimed at reducing the cost of credit include: (i) reduction of the consolidated public sector deficit; (ii) rationalization of public banks, including action - ii - programs to allow them to adjust to the reduced availability of Central Bank rediscounts; and (iii) speeding up the liquidation of failed financial institutions. The increase in deposit mobilization, the redimensioning of the banking system as a conseqtance of more stringent reguletions, and the reduction in the level of reserve requiremeits on incremental deposits will also help to reduce the ccst of credit. The technical assis ;aga component is geared to strengthen the banking superintendency's capabilities on both credit risk analysis and assessment of the overall financial condition of banking institutions. This will allow it to take timely actions to stop unsound financial practices, or if necessary, to force insolvent institutions to exit the market at an early stage of insolvency. Proiect Risks: The major risk asscciated with this loan relates to the possibility of setbacks in macroeconomic policies that would interfere with the implementation of needed structural reforms, including the banking sector reforms supported by the proposed loan. These risks are mitigated by the commitment to stabilize the economy and to proceed with a program of structural reforms which the Government continues to show, as demonstrated by its October 1987 reform package. The multi-year rescheduling of the external debt, the new money facility for 1987/88, and the standby arrangement with the IMF also reduce these risks. Disbursements: The loan would essentially be disbursed in two trancles. It is anticipated that the first tranche (US$199.5 million) would be disbursed soon after loan effectiveness. The second tranche (US$200.0 million) would be released about nine months after loan effectiveness, subject to a review of the adjustment program and an assessment of the macroeconomic situation. The technical assistance component (US$0.5 million) would be disbursed over a period not to exceed two years. REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A BANKING SECTOR LOAN TO THE ARGENTINE REFUBLIC 1. I submit the following report and recommendation on a proposed loan to the Republic of Argentina for the equivalent of US$400.0 million in support of a Banking Sector Adjustment Program. The loan would have a term of 15 years, including 3 years of grace, at the Bank's standard variable interest rate. PART I -TEECOOM 2. Argentina's recent economic history has been characterized by large and rapid fluctuations in GDP, the public sector deficit, Inflation, real exchange rate, external balance, real interest rates, and wages. This instability has resulted from frequent changes in policy, low public confidence and persistent structural imbalances. 3. High and rising inflation, physical and technological deterioration of the country's productive capacity and huge external debt service requirements resulted in general economic stagnation, such that the 1986 per capita GDP was 6% lower than in 1970. Gross investment fell from 21.6% of GDP in 1976 to 11.8% in 1986. Heavy borrowing in the late 1970s multiplied sevenfold the country's external debt as a share of GDP, from 10% to 68 . Unfortunately, very little of this debt increase went to augment the productive base of the nation. Today, interest payments on the external debt absorb about 7% of GDP and about 70% of merchandise export earnings. 4. The productive sectors, particularly manufacturing, are beset by major structural and financial problems. Most manufacturing firms have a depleted capital stock and lack access to sufficient working capital at acceptable interest rates as financial speculators compete for these funds. Financial intermediation is costly and inefficient while interest rates are high both in nominal and real terms. 5. When the current democratically elected Government took office at the end of 1983, it faced spiralling inflation and growing balance of payments difficulties. Also, the aftereffects of an industrial recession were threatening the solvency of the financial system. 6. Toward the end of 1984, the Government entered into a 15-month Standby Agreement with the IMF and rescheduled its external debt with commercial and official creditors. However, during the first quarter of 1985, as the economy remained sluggish and political pressures mounted, adherence to the program slackened, and the review scheduled for March 1985 was delayed to July 1985 after the June introduction of the Plan Austral. 7. The high inflation tax and negative interest rates during 1982/83 had demonetized the economy and led to a process of financial disintermediation unprecedented in Argentina's history. During the second quarter of 1985, economic conditions worsened significantly. The Government made important efforts to achieve economic adjustment in the context of the Plan Austral and its subsequent corrections. The ZLA - 2 - Austral was an economic stabilization program which included a major tightening of fiscal and monetary policies, a wage and prize freeze, and the pegging of the domestic currency to the US dollar. The program initially succeeded in reducing inflation from 30% per month in June 1985 to an average of 2% per month for the second hall of 1985. These stabilization efforts were complemented by a program of structural reform, including fiscal and trade reform, public sector rationalization, and a program of incentives to expand the role of the private rector. However, it did not succeed in maintaining inflation at the initially targeted monthly rate of 3%. Much still remains to be done to achieve the goal of sustained economic stability. Neither improvements under the Elan Austral nor high real interest rates have been sufficient to remonetize the economy to the levels of the 1970s (M3/GDP, which stood at about 30% in 1976, currently stands at about 17%), indicating that financial markets' confidence in Government policies has yet to be testored. 8. In March 1986, the Government began to phase out the wage and price freeze and replaced it by a system of administered prices. In April, it introduced crawling peg type adjustments in the exchange rate system and in public tariffs, and adopted a program to step up tax collection. The final tranche of the Standby Agreement was disbursed in June 1986 following the Government's presentation to the Fund of a lmtter setting out its proposed economic policy objectives for the second half of the year. The Government also received the final scheduled disbursements of new money under the 1985 agreement with the commercial banks. 9. Prices began to rise again in mid-1986, reachIng a monthly rate increase of 8.8% in August. Inflationary pressures were rekindled by an excessive growth of the money supply, the phasing out of the wage/price freeze, and a sharp rise in the price of beef which weighs heavily in the consumer price index. In response to these developments, the Government tightened monetary and fiscal policies and reintroduced price controls, adjusting prices in line with a targeted decline in the rate of inflation. These measures were combined with selective liberalization of imports. As a result of the new measures, inflation again began to subside. 10. During 1986, the real economy rebounded strongly from the sharp decline in real output in 19b5. Both invescment and consumption expenditures expanded in 1986. Although the tight monetary policy introduced during the last quarter of 1986 dampened the upturn in economic activity, real CDP rose by about 5.5% for the year, fueled by a strong recovery in the industrial sector. The upsurge in economic activity produced an estimated 24% rise in the value of merchandise imports above the depressed level of the previous year. The total value of merchandise exports, on the other hand, reflecting a deterioration in world grain and oilseed prices, fell by 17%. As a consequence, the deficit in the current account of the balance of payments increased to about US$2.6 billion (3.8% of GDP), compared to US$1 billion (1.5% of GDP) a year earlier. 11. In 1987, after a first quarter growth of over 4% of GDP on an annualized basis the economy slowed down considerably. During the first semester, consumer prices increased by 6.3% per month on average (more than double the increase of the first semester of 1986), reflecting the political pressures on the fiscal deficit created by approaching elections - 3 - and the phase of the beef cycle. The resurgence of double-digit monthly inflatiGn in July caused grave concern. In July, a new agreement with the IMF was signed, which implied a severe tightening of both monetary and fiscal variables immediately after the elections of September 1987. The public sector deficit limit for the second s?mester was set at 2.1% of GDP (as compared to 6.4% in the first semester) with most improvement to be achieved on the revenue side. The Central Bank was to keep regulated interest rates above inflation and the expansion of the money supply at a fraction of inflation. 12. The July IMF program was combined with the announcement of a set of medium-term structural reform measures. These were related to che fuller liberalization of the hydrocarbons sector, transport and communications, divestiture of industrial public enterprises, restructuring of public banks, and a more rigorous supervision of private financial institutions. 13. However, shortly after the program was agreed, economic conditions and performance began to deteriorate once again and continued to do so for the remainder of the year, so that: (a) External. Mainly as a result of factors beyond Government control Lhe trade surplus for 1987 ropped to US$850 million, about US$1.5 billion lower than expected earlier in the year; in spite of the very substantial capital inflows, the authorities wcre obliged to virtually deplete their reserves and even run up some arrears. The trade account surplus for 1988 Is expected to be over US$2 billion, buoyed by recent increases in commodity prices (in dollar terms). However, with interest obligations of about US$4.5 billion a year, a need to rebuild reserves, and after allowing for other capital inflows, a new external financing need for 1988 of around US$3 billion is anticipated. (b) Fisl. The deficit of the consolidated public sector for 1987 was 7%. In October 1987, the authorities proposed a package of meesures to address the issue. A compromise solution was approved by Congress in early January 1988 (a welcome advance from previous approaches to resolving such problems) which is expected to result in a reduction of the deficit by 3% to 4% of GDP in 1988. 14. The IMF is expected to release the third tranche (around US$225 million) of the orgoing Standby Agreement by mid-March. The commercial banks would release an associated tranche of US$550 million from their 1987 US$1.95 billion new money package. To qualify for the IMF third tranche release, Argentina met October 1987 performance criteria and agreed on detailed quarterly peiformance criteria through mid-1988 and indicative targets for the remainder of the year. The main features of this new plan are the revenue package approved by Congress in January, expected to reduce the deficit for 1988 to about 3* of GDP. and additional measures to be adopted to reduce the deficit further. Argentina and the IMF have agreed on the need for a longer-term support arrangement based on a medium-term policy framework for structural adjustment. This is a welcome new development which the World Bank intends to support fully through a program of sectoral adjustment and investment loans. Several major reform programs, particularly in agriculture, external trade policy, and banking are already under way and are supported by Bank loans. The Banking Sector Loan submitted for approval at this time is part of Argentina's economic and financial reform program. 15. This program now needs to be extended and refined, particularly in the areas of industrial modernization (requiring major changes in fiscal incentives and deregulation), public enterprise reform (requiring major financial, budgetary, managerial, and staffing changes as well as privatization), and social sector reform in public housing, social security, health and education. Once Argentina's current liquidity crisis has been addresred and while the Government successfully implements the ongoing Standby Agreement, it is reasonable to expect that public confidence will gradually return and that sustained improvement in macro- economic conditions needeo for achieving the objectives of the Banking Sector Loan will materialize. A new medium-term external financing plan also involving the commercial banks remains to be worked out. Serious work on this cannot be expected to start until a new medium-term policy framework for structural adjustment has been further detailed. Meanwhile, Argentina may again have to run up arrears with commercial bank creditors. PART II - THE FINANCIAL SECTOR 16. Argentina's financial system is composed primarily of banking institutions, while the capital. markets, insurance business and non-bank financial intermediaries (NBFIs) are relatively less important. Commercial banks account for 42% of total financial assets, the Central Bank for 34%, marketable securities constitute 12% (of which only 3% is equity), and NBFIs and institutional investors account for the remaining 12%. 2.1 RECENT TRENDS 17. In the last 15 years, Argentina's financial sector has been subject to extreme instability and drastic policy reversals and has operated in an overall framework of macroeconomic instability. Policies went from extreme regulation, with an effective nationalization of deposits and an allocation of credit exclusively through the Central Bank (1973 to mid-1977), to total liberalization of interest rates, credit allocation and entry into the system (mid-1977 to mid-1982), to a return to financial repression and substantial reliancq on Central Bank credit (mid-1982 to early 1985), to, most recently, gredual movements toward a more liberal system. These policy shifts, coupled with macroeconomic instability, have resulted in a weakened financial sector characterized by high real interest rates, large spreads, shallowness and segmentation. 18. In this context, the number and composition of financial institutions have undergone substantial changes. After the 1977 financial reform a large number of NBFIs were liquidated, merged or transformed into commercial banks. As a result, the number of financial institutions was reduced by half between 1978 and 1984, while the number of banks rose from 150 to 203. The number of institutions, including commercial banks, continued to decline thereafter, and currently there are 294 institutions compared to 721 in 1978. Some institutions, particularly those which specialized in long-term lending, such as finance companies, credit unions, - 5 - and savings and loan institutions, have either folded or have beent forced to merge or change their line of business to survive. Many of these institutions converted into banks in the period between 1977 and 1980 to take advantage of a larger scope of operations. The demonetization process started in 1981 made it clear that the banking system was overdimensioned and a steady process of concentration began. Thus, the reduction in the number of financial institutions also cluded commercial banks. The number of commercial banks has declined from 207 in 1980 to 183 at present. However, considering the low level of monetization, compared to that of the mid-197Cs, there is still room for further concentration. GRAPH 1 SELECTED FINANCIAL INDICATORS (1978=160) 180 160-- 148- Credit I 120 ni 188 o -- Real M3 e 80 w- Branches e x 60 0- Personnel 40__ 20 78 79 80 81 82 83 84 85 86 Year 19. While solving the banks' problems should have priority because of their relative importance in the Argentine financial market, issues affecting other financial institutions and financial markets should also be tackled. The Bank is currently carrying out a study of the country's capital markets, insurance business and NBFIs which couid lead to a follow- up operation in the financial sector. Many of these institutions and markets are financially weak and thus contribute to the overall fragility of the financial system, already overburdened by major difficulties on the banking side. The securities markets, and the stock exchanges in particular, are characterized by: (i) he slow growth in transactions and their volatility; (ii) the small importance of the market relative to the size of the economy; (iii) the limited role of private instruments; and (iv) the high average trading cost by international standards. 20. Similarly, pension funding in Argentina, which is a State monopoly, is going through a major structural crisis, characterized by severe financial difficulties. The Government ir aware of these - 6 - difficulties, and initial steps have been taken to improvc this situation, such as allowing the establishment of private insurance companies which will specialize in pension funding (available to the public on a voluntary basis and as a supplement to the public pension system). Improved management and finances of the National Social Security System and efficient private pension funds could provide the capital markets with badly needed institutional investors. 21. Argentina's economic crisis has also permeated the insurance market. The Government is a r . participant in the insurance market both through its role as regulat .nd supervisor, and more directly as the owner of various insurance COL ies and of the quasi-monopolistic National Reinsurance Institute (INDER). Inflation has been a major hindrance to the development of the insurance business and an important reason for its currently weak financial condition. In addition to inflation, the insurance business has also been affected by: (i) the excessive number of insurance companies; (ii) the poor financial situatinn of many of them, partly as a result of price controls; (iii) the inability of the insurance superintendency to monitor and control developments in the sector; (iv) the large degree of losses in the business which appear to be related -o the lack of supervision and fraud; and (v) the monopolistic role of INDER which has become very costly to the country. 2.2 PRESENT FINANCIAL SECTOR STRUCTURE 22. As of March 1987, there were 294 institutions in operation in the institutional financial system. This included 189 banks, 64 finance companies, 11 savings and loan associations, and 30 credit unions. Banking institutions include 183 commercial banks, 2 development banks, 2 investment bank., 1 mortgage bank, and 1 Government-ow,.d savings and insurance bank. Of these, 37 were public and 152 private. The institutional financial system operates through a network of about 4,400 branches, and employs about 144,000 persons, of which 56% are working at public banks, 42% at private banks, and the remaining 2% at NBFIs. 23. The public banks consist of 2 national commercial banks (including Banco de la Nacion, the largest commercial bank in the country which accounts for about 19% of total deposits); a houring bank (Banco Hipatecario Nacional, the third largest bank with 5% of total deposits); 2 development banks (of which the most important is BANADE, the industrial development bank); 25 provincial banks (of which Banco "' la Provincia de Buenos Aires is the largest with over 10% of total deposits); 5 municipal banks; a savings and insurance bank, mostly engaged in providing insurance; and a small investment bank. Public banks control 50% of the banking system's total deposits. On the asset side, they grant 58% of the value of total loans. 24. Private commercial banks are quite heterogeneous. There are 31 foreign banks and 121 domestically owned banks. Private banks control 48% of total bank deposits. On the lending side, private commercial banks grant 39% of total bank loans. Finally, while the NBFIs are large in number, they account for only 2% of the system's total deposits and 3% of the system's total loans. - 7 - 25. The equity base of the Argentine institutional financial system amounted to US$4.6 billion as of January 31, 1987. Of this 57% belonged to public banks, 40% to private banks and 3% to NBFIs. The book ratio of the system's total deposits to its equity appears to be extremely low (3:1). However, the capital of the banks is grossly overstated for the fcllowing reaso,s: (i) real estate amounts to about 75% of the system's equity, but is carried on the books at prices well above actual market values; and (ii) the quality of the system's loan portfolio has deteriorated, compromising a substantial proportion of its capital and reserves (for which adequate provisions have not been made). 26. As of August 31, 1987, there were also 20 institutions under Central Bank intervention and 180 in liquidation. The number and size of the liquidations have imposed a substantial cost and operational burden for which the CBA was not prepared. 27. In addition to banks and NBFIs, the financial system is composed of 241 insurance companies, a Government-owned reinsurance company, 5 stock exchanges (of which the largest is in Buenos Aires accounting for about 97% of total transactions), private brokerage firms and investment companies (mutual funds), and a Government-owned pension fund. Furthermore, there are informal markets whici perform over-the-counter trading in securities and provide financial services such as linking companies with excess funds to others requiring funding and providing guarantees. These markets are known as the "extra-bursatil" market and the "intercompany" market. Both have grown rapidly in recent years, the latter at the expense of the formal banking system. PART III - MAIN BANKING SECTOR ISSUES 28. The main issues affecting the banking system are: (a) the lack of confidence in economic policy and in the soundness of financial institutions which has resulted in the shallowness of the financial system; (b) the over-regulation of the system which has led to the segmentation of deposit and lending markets, high forced investments, reserve requirements and a large intermediation role of the Central Bank; and (c) high banking costs and interest rates resulting in a high cost of credit. 3.1 LACK OF CONFIDENCE IN THE FINANCIAL SYSTEM 29. The economic and financial difficulties of the recent past have had a strong impact on Argentina's financial sector. The macroeconomic instability has not only demonetized the economy, but has also resulted in disintermediation affecting banks, non-bank financial intermediaries and the securities markets. The rapid growth of the informal market is an indicator of this disintermediation process. Not only have real financial savings declined, but the maturity of financial assets has shortened dramatically. At present, maturities of over 30 days are considered long term in Argentina. As a result, the use of capital market instruments has been discouraged. High and fluctuating inflation has been a major hindrance to the development of Argentina's securities markets and institutional investors. The public pension fund system and the insurance business have been severely affected by inflation. Sluggish economic growth and high inflation and interest rates, together with uncertainty - 8 - over future economic and political developments, led to reductions in investment needs, and encouraged firms to limit their indebtedness and finance their operations with internally generated resources. 30. In addition to inflation, inappropriate exchange rate policies also help explain the disintermediation process that characterizes the Argentine financial sector. The overvaluation of the domestic currency in the late 1970s and its ultimate consequences--capital flight and successive devaluations- -have made domestic asset holders wary of policies that fix exchange rates in a scenario of high inflation. Therefore, the maintenance of low and stable rates of inflation, together with a realistic exchange rate, are key elements in any program to foster resource mobilization throughout domestic markets. 3.1.1 Shallow Financial Sector 31. Financial depth can be measured by the ratio of a monetary aggrega*- (such as M3 or M4) to GDP, with M3 defined to include money, quasi-moi,ey, and bankers acceptances, while M4 also includes deposits indexed to inflation; and also by following real trends in these monetary aggregates. These aggregates have fluctuated widely since the early 1970s. M3/GDP peaked at 30% in the third quarter of 1974 and reached its val:ey at 8% in the second quarter of 1976. After recovering to 25% in 1980, M3/GDP experienced an almost continual decline through the second quarter of 19R5 (9%) when the Plan Austral was launched. The Plan Austral brotight high real rates and boosted confidence which produced a substantial rise in the stock of real deposits. As a result, M3/GDP increased significantly, averaging 17% during the last three quarters of 1986. The data also shows similar trends for M4/GDP and for real M3 and M4. These trends highlight the disintermediation which has occurred in the Argentine economy in recent years. Depositors realized that the real value of their financial assets was being eroded by inflation. As a consequence, many of them shifted their assets either out of the country or out of the finaacial sector. A related indicator of the disintermediation process is the significant reduction in total credit outstanding as a percentage of GDP. Credit outstanding declined from 29.5% of GDP in 1982 to 12.4% in 1985 before rebounding to 16% in 1986. -9 - Tabl.e1: NOIrms REAL ITIRST RATES AND FINARCIAL DEPTS 1980 1981 1982 1983 1984 1985 1986 1987 In percentages: Reg. dep. rate Al 0.3 0.1 -3.7 -2.8 -3.7 -1.8 -0.5 -1.0 Free dep. rate A/ 0.3 0.5 -2.5 1.4 0.6 1.4 1.1 1.0 M3/GDP 25 24 17 11 12 12 17 K4/GDP 32 29 21 13 14 17 20 In March 1985 billion Australes: Real M3 8.5 7.5 5.8 4.4 4.0 3.9 5.7 Real M4 10.9 9.1 7.2 5.2 4.7 5.5 6.7 &I Quarterly average of monthly rate (deflated by combined index of WPI and CPI). Fourth quarter data for all years excluding 1987. Second quarter data for 1987. Source: Central Bank of Argenttna. 32, The impact of interest rates on resource mobilization can be measured by comparirg trends in interest rates with those of monetary aggregates, which are used as a proxy to estimate the financial depth of the economy (Table 1 and Graph 2). The comparison of real interest rates and monetary aggregates for the 1980s shows that financial savings do respond to the real level of interest rates, even though the return to positive interest rates (for non-regulated deposits) since 1985 has not fully reversed the reduction in the ratios of M3 and M4 to GDP or that of real M3 and real M4. This would suggest that the public either expects higher inflation in the future (and, therefore, deflating current nominal rates by ex post inflation probably overestimates real rates) or that the differential between returns on austral-denominated assets and that on foreign assets is not large enough to compensate for the risk of unexpected more rapid devaluation of the austral. In any event, to restore depositors' confidence and increase mobilization of domestic resources, it will be necessary to maintain positive real rates while lowering the rate and variability of inflation. - 10 - GRAPH 2 REAL M3 & REAL DEPOSIT RATES (1985 Bill. Aust., x) 10 6 4- - Real 113 -2 8 II - Reg. Rates - --Free Rates 78 79 80 81 82 83 84 85 86 Quarters 3.1.2 Inadequate Prudential Regulation 33. The problems of the banking system have been compounded in recent years by the weak position of the Central Bank and its organizational deficiencies. Major problems have been found in banking supervision (particuiarly in the loan portfolio classification system, accounting rules, information disclosure, and supervision of public banks), and in the intervention and liquidation of problem banks. Banking Supervision and Regulations 34. Insufficient Banking Supervision. The major problem affecting banking supervision is the lack of focus in assessing the overall solvency of the financial institutions. The banking superintendency-- organizationally part of CBA--has traditionally concentrated on compliance with the complicated CBA rules on reserve requirements, forced investments and interest rates, while analysis of loan portfolio quality and operating efficiency has been largely overlooked. This has limited the banking superintendency's capacity to take timely actions to stop unsound financial practices. Similarly, the inability to force insolvent institutions to exit the market at an early stage of insolvency has resulted in substantial losses to CBA and weakened depositors' confidence. In particular, the following shortcomings can be highlighted: (a) Inadequate Loan Portfolio Classification System. The most serious problem is the lack of an adequate loan portfolio classification system according to risk of default. The current system does not - 11 - have a precise definition of the different risk categories, leaving the interpretation to the financial institutions. In addition, the present classification is not reviewed periodically through on-site inspections (on average each institution is visited once in three years, with cases wh-re institutions have not been visited in more than five years). The banking superintendency also has insufficient information on loans to related parties. All of this causes the banking superintendency to have a limited knowledge of the solvency situation of each intermediary; this limits its capacity to require timely corrective actions or to predict possible failures. It also limits the Central Bank's capacity to attract potential buyers of ailing institutions since the amount of losses that have to be absorbed is not clear. (b) Distorted Accounting Rules. According to current rules, it is up to each bank to decide whether the accrual of interest income on doubtful loans should be discontinued. In practice, most banks continue accruing interest on loans in arrears until the borrower's bankruptcy, thus distorting their income statements. Similarly, loan loss provisions become obligatory only after a borrower has been declared bankrupt. Another problem lies in the revaluation of fixed assets according to the wholesale price index rather than based on market values, leading to an overvaluation of real estate assets. (c) Lack of Information Disclosure. Publicly available information on the performance of individual banks is severely limited. A monthly Central Bank publication (available with a three- to four- month lag) contains balance sheet figures of individual institutions but does not show income statements or information of loans in arrears. Balance sheets and income statements are being published once a year in the Government's official gazette but with little disaggregation. This lack of information limits both the capacity of depositors to discriminate between institutions and the capacity of the Central Bank to force depositors to assume at least part of the losses of failing banks. (d) Difficulties in Controlling Public Banks. The banking superintendency has severe difficulties when trying to control public banks (especially provincial banks) either because of their political power or legal autonomy. This not only limits the capacity of the banking superintendency to require sound practices from public banks but is also a form of discrimination against private banks. This is especially true when considering compliance with reserve requirements or similar regulations. Dealing with Problem Banks 35. Intervention1 and liquidation cum deposit insurance have been the more common ways to deal with the large number of problem banks in Intervention means the removal of existing management by the Central Bank and appointment of a "delegate" as its representative. . 12 - Argentina in the last few years. CBA's objective has been to maintain stability and confidence in the system while attempting to strengthen the financial sector and promote its redimensioning. To attain this objective, CBA is financing almost all deposit protection actions, and the lengthy and ineffective processes of intervention and liquidation, as well as the recapitalization of banks that are sold to other institutions. Financing these actions involves sizeable losses for CBA. However, confidence in the system is not being maintained and the system is only gradually being redimensioned. 36. The present policy of CBA is to give priority to interventions rather than to liquidations, in order to maintain the stability of the system. However, since the public knows that most interventions lead to a liquidation, the run on deposits, mainly by unprotected depositors, is dramatic. In some of the recent interventions, withdrawals amounted to 90% of total deposits. When an institution is intervened all deposits and withdrawals, whether protected or not by current deposit insurance regulations, are covered by CBA. Since 1980, 77 banks and other financial institutions, all of them private, have been intervened by CBA (8 institutions were intervened in the first semester of 1987). Most of them were later liquidated. 37. The management of intervened banks is entrusted by CBA to 2-3 "delegates" per bank, hired to that effect. The "delegates" do not receive instructions from CBA as to the policies they should apply, except for ceposit interest rates, which are to bc kept at market levels. Both recruitment difficulties and lack of management directives lead to a bureaucratic approach to the management of intervened institutions. The real economic situation of the intervened bank is not always verified, minor management restructuring measures are applied (other than sale of real estate) and commercial activities are neglected. The possibility of selling an intervened bank is seriously hampered by the small number of sound potential buyers among domestic banks and by discrimination against foreign banks. All this makes the sale of intervened banks difficult, extends the duration of the intervention period, and frequently dooms the banks to late and costly liquidations. 38. If a liquidation is decided, the existing deposit insurance fund Is drawn upon to cover deposits up to a limit of A 60,000 for current accounts and A 15,000 for savings and time deposits. This fund is only an account in the Central Bank, funded by those private banks which choose to be members of this deposit protection scheme. Their monthly contribution is 0.003% of total deposits. If the fund is depleted or CBA decides to cover deposits beyond the limits set by the current regulations, CBA itself provides the fi-nding to pay off depositors. CBA also finances salaries and overhead of banks in liquidation as well as miscellaneous expenditures (legal procedures, severance pay. etc.). Up to the October 1987 reform that eliminated all controls on deposit interest rates, only regulated deposits--i.e., those subject to interest rate controls--were eligible for deposit insurance. 39. Until recently, the administration of failed financial institutions by CBA has been lengthy and ineffective, basically because of: (i) lack of experienced staff and management; (ii) legal and bureaucratic * 13 - constraints; (iii) lack of proper accounting and information systems, including adequate computerization; (iv) legal actions by the previous shareholders to block or reverse the liquidation process; and (v) ineffective recovery of the loan portfolio (over 90% of the assets to be liquidated). Of the 180 financial institutions presently under liquidation, including banks and other financial institutions, 15 have been going on for over 10 years and 75 for over 5 years. Twelve liquidations were started in 1986/87 (six each year). 40. The staff of the banks in liquidation in the last few years has been reduced from 20,216 to 2,813 thriugh severance and sale of branches to other banking institutions. Most of the real estate of banks in liquidation has been sold (about 1,6C0 properties were liquidated in the last two years); and a new management team appointed in 1986 is improving considerably the effectiveness of the liquidation process. However, the key issue continues to be the slow recovery of the loan portfolio which maintains a large number of borrowers in an uncertain situation and unnecessarily increases CBA losses. 41. The need for improvements in the system of intervention and liquidation is urgent, since the achievement of sound sales and mergers, alongside efficient liquidations, is the key element for a successful policy of restructuring and redimensioning of the system. The overall treatment of private problem banks should follow a different strategy, and use different institutional me' -nisms to overcome the serious handicaps constraining proper sales and mE ,ers. 3.1.3 Weak Financial Condition of Banks 42. The country's economic and financial difficulties of recent years have contributed to low operating returns to most banks. The analysis of annual information for a large sample of banks covering 1982 through 1986, and of more detailed information for all banks during 1986, shows a continuous decline in their return on equity and a weakening of their loan portfolios. However, the actual situation is even worse since published financial statements contain insufficient provisions for potential loan losses and include accrued but unpaid interest on doubtful loans. 43. As of March 1987, out of 152 private banks in operation (excluding NBFIs), 9 were under CBA intervention, 18 were committed to a CBA- controlled financial strengthening plan, 8 were deemed to need the adoption of a similar plan, and 36 were on a special watchlist due to potential solvency and/or liquidity problems. Adjusted figures that portray the status of the loan portfolio more realistically show that banks representing nearly 26% of total banking assets have lost at least 50% of their equity, while institutions accounting for 41% of total banking assets have had negative real returns on equity in 1986. This combination of negative net worth and negative return on equity is worrisome, reflecting technical bankruptcy and inability to generate resources internally to recapitalize. The financial difficulties of many banks--besides the negative impact of the reserve requirements and forced investments which will be analyzed in the following section--result from their large irregular loan portfolios and high operating costs. - 14 - 44. Irregular Loans. The banking system reports irregular loans2 amounting to about 92% of its total net worth, with 25% of net worth for private banks and 141% for public banks. These figures probably understate the magnitude of potential losses because of the inadequacy of the loan portfolio classification system. Furthermore, aggregate figures for the groups conceal the magnitude of the loan portfolio weakness for specific institutions. For instance, as of March 1987, 36 banks (23 public and 13 private), representing 45% of total banking system assets, reported irregular loans larger than their net worths. The situation gets compounded when the ratio of "problem" loans to net worth is estimated, where problem loans are defined as the sum of irregular loans and refinanced loans. As shown in Table 2, provincial and municipal banks show the worst performance. If provisions for doubtful loans are deducted, the percentage of irregular loans to net worth drops from 92% to 14%. However, there is reasonable evidence indicating that risky loans are underestimated and that net worth is overestimated (due to overvaluation of fixed assets). While the insolvency of private banks is particularly worrisome because it may result in public panic and deposit runs, that of public banks is too because of the effect of CBA bailouts on the quasi-fiscal deficit. Table 2: LOAN PORTFOLIO QUALITY INDICATORS a/ (as of March 1987, percenta%es) Irregular Irregular Problem loans net of loans/ loans/ provisions/ net worth net worth net worth Official banks: National 133.0 172.0 7.0 Provincial/municipal 174.0 202.0 58.0 Total 141.0 176.0 17.0 Private banks: Domestic 32.0 41.0 13.0 Foreign 9.0 11.0 6.0 Cooperative 25.0 30.0 14.0 Total 25.0 32.0 11.0 ital banking system 92.0 116.0 14.0 I EZxcludes institutions with negative or insignificant net worth. Source: Central Bank and IBRD staff estimates. 45. Concerning profitability, Table 3 indicates the importance in the market of unprofitable banks. The analysis has been made using return on equity (ROE) ratios computed on the basis of both reported figures and 1 Irregular loans, according to Argentina's loan portfolio classification system, include past-due loans, loans to potentially insolvent borrowers, loans to borrowers under legal proceedings, and loans to bankrupt borrowers or borrowers facing liquidation. Only normal loans and refinanced loans are excluded. - 15 - adjusted figures. Average reported figures per group of institutions are reasonably good. However, the ratios vary greatly across institutions. A total of 43 institutions, representing 15% of total banking assets, show negative ratios: 1 public national bank, 7 provincial/municipal banks, 10 private domestic banks, 6 foreign banks, and 19 cooperative banks. Furtlermore, many institutions report overestimated results due to the inclusion of accrued but unpaid interest on doubtful loans. Figures were adjusted to correct for this overestimation of profits.3 Adjusted figures bring the number of unprofitable banks to 86. The significance of the market share of the institutions with negative adjusted ROEs--41% of total banking assets--is a clear indication of the crisis characterizing the Argentine banking system. Table 3: PEPCENTAGZ SHARE OF UIPROFITABLE BAWKS, 1986 According to According to reported figures adiusted figures Banks in Unprofitable X in group Unprofitable I in group operation banks assets banks assets Public banks: National 5 1 4 2 35 Provinciallimunicipal 29 7 25 18 60 Total 34 8 9 20 41 Private banks: Domestic 58 10 21 23 39 Foreign 31 6 24 10 44 Cooperative 54 19 36 33 53 Total 143 35 24 66 42 Total banking system 177 43 15 86 41 Sources: Central Bank and IBRD staff estimates. 46. Operating Costs. Operating costs are extremely high in Argentina. The monthly ratio of operating costs to average total deposits stood at 1.77% in March 1987 for the whole financial system. These are extremely high figures by international standards (about four to five times higher than the average OECD and non-inflationary LDCs). These costs increased dramatically between 1981 and 1985 (from 0.87% of total deposits a month to about 1.80% of total deposits a month, respectively), and have remained fairly stable at this level since then. 47. There are three major reasons why operating costs are so high in Argentina: 2/ Adjusted figures have been computed (i) estimating the 1986 average percentage of irregular loans net of provisions to total loans; (ii) applying this percentage to the value of 1986 financial income; and (iii) subtracting the resulting figure from total net results to obtain net adjusted results. - 16 - (a) the substantial demonetization and disintermediation of funds experienced by Argentina's financial institutions, particularly after the reforms of July 1982 (across-the-board debt relief through negative real interest rates), has caused operating costs to represent a growing proportion of intermediated resources; as a result of the process of disintermediation there is an excessive number of financial institutions and branches, given the present size of the Argentine financial market; (b) the short maturity of financial contracts which is typical of economies characterized by high and variable inflation and uncertainty; in the case of Argentina, there are practically no deposits with maturities longer than 30 days (with an average of about 19 days after the positive effects of the Plan Austral). The continuous rollover of most operations represents an extra burden on administrative costs (cemputer processing) and staffing; and (c) the excessive expansion of banks' branches even when the process of demonetization and disintermediation was in full swing during 1982/83; this can be explained as an attempt to capture a greater portion of the inflation tax, hedge against hyperinflation, or increase market shares due to the expectation that reforms might lead to restrictions on branch expansion. 3.2 OVER-REGULATION AND SEGMENTATION 48. Notwithstanding the significant steps towards liberalization taken in the last 12 months, the Government still controls important aspects of the banking intermediation process. The most pervasive elements of the regulatory framework are the substantial reserve requirements and forced investments on banks' deposits and the large influence of the Central Bank in credit allocation through a large rediscount program. Through extremely high reserve requirements and forced investments in non-negotiable Central Bank bonds, the Central Bank was able to appropriate an equivalent 66% of total banking deposits as of March 1987 (20% in the form of reserve requirements and 46% in the form of forced investments). This not only has a negative impact on banks' profitability but severely limits the banking system's role in the allocation of credit. An important portion of these funds, in turn, is recycled mostly to public banks in the form of multiple Central Bank rediscount lines (Central Bank rediscounts amounted to an equivalent 35% of total deposits as of March 1987). The explanation behind this srgmentation is that the banking system has traditionally been used as an important source of public sector deficit financing in Argentina. Such financing has been done through high reserve requirements and forced investments. 3.2.1 Seimentation of Deposit and Credit Markets 49. Up to the recent October 1987 reform that removed all controls on interest rates, deposit and credit markets could be divided into three segments: the regulated segment subject to interest rate controls on deposit and lending instruments, the unregulated or free segment which since September 1986 was not subject to interest rate controls, and the - 17 - indexed segment (inflation- or foreign exchange-adjusted deposits and loans). Since the Plan AustrAl, banks are not allowed to accept indexed deposits; therefore their relative importance in total deposit liabilities has declined significantly (Table 4). The Government has increasingly liberalized its stance toward free deposits in the last three years and as a result the proportion of free deposits to total deposits has increased from less than 10% in December 1984 to over 50% in April 1987 (Table 4). The Government succeeded in maintaining this segmentation through the use of quotas on bankE' ability to accept free deposits, by putting a floor on the minimum amount required to make a free deposit and by discriminating against free deposits on the access to deposit insurance. Table 4: STRUCTURE OF DEPOSIT LIABILITIES IN THE BANKING SYSTEM (in percentages) Regulated Time deposits sLLht deposits Regulated Free Indexed Total December 1984 21.9 52.6 8.2 17.3 100.0 June 1985 22.7 51.1 15.9 10.3 100.0 December 1985 16.5 34.7 37.4 1.3 100.0 June 1986 23.9 33.9 41.4 0.8 100.0 December 1986 20.8 30.1 48.3 0.8 100.0 April 1987 15.1 10.7 53.3 0.8 100.0 Source: Central Bank of Argentini. Reserve Requirements 50. Reserve requirements on regulated deposits varied according to maturity and bank type. Demand deposits were subject to RRs amounting to 89.5%. Reserve requirements on time deposits ranged between 16% (for deposits between 7-14 days) and 8% (for deposits over 30 days). Most public provincial and municipal banks were not subject to these RRs. 51. On September 30, 1986, the Central Bank implemented a reform which lowered RRs on free deposits and eliminated forced investments on their incremental growth. RRs were lowered to 3% for free deposits with maturities between 7 and 29 days, 1.5% for those with maturities from 30 to 89 days, and zero for those with maturities over 89 days from a previous level of 7.5%. The Central Bank has not been able to maintain these lower RRs on a continuous basis since this is one of the few tools it currently has to effect monetary control in a speedy manner. The October 1987 reform not only eliminated regulated deposits but also extended these lower RRs to all incremental time deposits. RRs on demand deposits were not changed. Forced Investments 52. In addition to reserve requirem.nts, banks had to keep certain varying percentages of their deposits as forced investments (FIs) in non- negotiable Central Bank bonds. There were two types of FIs: (a) those which were a function of the total amount of deposits, thus vatying in - 18 - direct proportion to changes in the respective deposit base (these FIs can be regarded as remunerated RRs); and (b) those imposed on stocks of deposits as of specific dates. The largest first type of FIs was BONIN which as of March 1987 amounted to about 5% of total deposits. The second type of FIs consisted basically of Deposito Indisponible and DENOR which as of March 1987 represented 18% and 23% of total deposits, respectively. After the October 1987 reform, the Central Bank is consolidating all FIs in a single instrument which is expected to have some degree of negotiability. 3.2.2 Credit Allocation Thronh Central Bank Rediscount Lines 53. The main issue regarding the allocation of credit in Argentina is the pervasive role of the Central Bank as financial intermediary. Through its policy of high RRs/FIs and rediscounts, the Central Bank directs a large proportion of total credit in the financial system and in the process it affects its allocation and the finances of the various banks. Banks' finances in some cases are improved because of preferential access to these rediscounts, while in other cases they are worsened because of high RRs/FIs and limited access to rediscount facilities. Provincial banks and some public nati nal banks have been the principal beneficiaries of the large volume of rediscounts granted by the Central Bank. Since about two thirds of the rediscounts are granted to the public banks, the effective immobilization of resources is substantially greater for private commercial banks than for public banks. The data in Table 5 show the considerable importance of rediscounted credit in total credit. While this proportion has been gradually going down, at 42.4% of total credit it is still very high. Table5: BREAKDOWN OF CREDIT BY TYPE (as a percentage of total credit) Regulated Indexed Free Rediscounted Total 1985 (December) 1.6 9.9 39.2 49.3 100 1986 (November) 11.5 4.1 40.6 43.7 100 1987 (March) 11.9 2.5 43.1 42.4 100 Sources: Central Bank of Argentina and World Bank estimates. 54. There are three major types of rediscounts: (i) rediscounts for export financing; (ii) rediscounts to support financial institutions under intervention or liquidation; and (iii) other local currency rediscounts (about 115 different lines, with various mechanisms for adjusting principal and interest, representing about 75% of CBA's rediscount portfolio). All rediscounts are austral-denominated although rediscounts for export financing adjust according to the exchange rate. As shown in Table 6, as of March 1987, CBA's rediscounts amounted to about A 6.5 billion (including principal and capitalized interest and adjustments). About 70% of the rediscounts in australes are concentrated in 11 major lines. These lines include the following: lines to support Banco Hipotecario'p operations and finances, credits to provincial banks, seasonal agricultural credits, and - 19 - consolidated loan (to support banks' losses caused by the massive rescheduling of liabilities in 1982). Jklit MISCOUNTS AS A PERCENTAGE OF TOTAL DEPOSITS (Mat.). 31. 1987) Rediscountst Deposits ediacoumts deposits ---- (in A million) --- (ia 1) Public banks 8,362 4,684 54.0 Private financial institutions 10,77k 1.796 16.7 Total 18,307 6,480 35.4 Source: Central Bank of Argentina. 55. The evolution of rediscounts over time is another interesting trend to follow. Rediscounts started to be used in an important manner by the Central Bank in 1982, however, they only grew explosively between late 1984 and mid-1986. Total rediscounts grew as a result of additional new lines granted, extensions of existing lines, capitalization of unpaid interest and inflation adjustments. Since mid-1986, which corresponds with a new management at the Central Bank, the real growth of rediscounts has been stemmed. The data show that curtailing the growth of rediscounts will not only require reducing new rediscounts, but also tackling the inertial growth of the existing stock of rediscounts. Table 7: MECENT EVOLUTION OF CIA REDISCOUNT LINES (in A million of June 1985) Principal Accruals Total December 1984 228.6 721.7 950.3 June 1985 815.3 1,805.3 2,620.6 December 1985 1,877.2 2,181.6 4,058.8 June 1986 2,037.5 2,315.2 4,352.7 December 1986 1,759.0 2,423.7 4,182.7 February 1987 1,654.1 2,570.1 4,224.2 Source: Central Bank of ArSentLna. 56. Inadequate Administration of Rediscounts. The Central Bank has relied until very recently on information obtained from the individual financial institutions to determine the exact stock of rediscounts, forced investments and reserve requirements. The result has been a poorly managed rediscount portfolio which has increased Central Bank losses. The Central Bank is embarked on a program to modernize its procedures to manage its portfolio of rediscounts. It has recently implemented a computerized system which will allow it to cross-check the accuracy of this information. The Bank has been assisting It in this program, and a Project Preparation - 20 - Facility was provided for this purpose. Once the processing of rediscounts is fully computerized, the Central Bank will be able to maintain up-to-date records of its portfolio, and therefore know with certainty its exposure to individual banks. 57. Bankwise Analysis of Net Position with Central Bank. As a result of the large intermediation role of CBA, many banks are net borrowers from CBA (in the sense that the rediscounts obtained from CBA exceed their RRs and FIs), while others are net lenders to it. An analysis of the net position and it.s composition by individual anks is critical to preparing a viable proposal for reducing the Central Bank's role. 58. A breakdown of financial institutions by type of ownership and indebtedness to CBA shows that out of the 294 institutions, 65 were net borrowers from the Central Bank. The total net debt of these 65 institutions amounted to A 3.7 billion. Table 8 provides detailed information on the composition of the net debt by type of institution and a breakdown of its major components (rediscounts, forced investments and reserve requirements). Net indebtedness to the Central Bank, however, is not evenly spread among them. Banco Hipotecario and BANADE are the largest debtors with 29.7% and 5.6% of CBA's net lending, respectively, followed by an intervened private bank with 4% and three provincial banks with debts totalling 9% of CBA's net lending to the financial system. Thus, almost 50% of CBA's net lending to the financial system is concentrated in six large institutions. Table : REDISCOUNTS, RESERVE REQUIREMENTS AND FORCED INVESTMENTS NET POSITION WITS CENTRAL BANK (AS OF MARCH 31, 1987) (in A million and percentages) As Percentage of Total Deposits Reserve require- ment + Reserve Forced Total Total Reserve Forced forced Total require- invest- redis- Net redis- require- Invest- invest- Bank group deposits ant ment count position count ment ment ment Fublic national banks L Bank of Provincia Buenos Aires 6,479.7 1,334.9 3,427.2 3,448.3 -1,313.8 53.2 20.6 52.9 73.5 Provincial & anicipal banks 1,882.7 0.0 15.3 1,236.0 1,220.7 65.7 0.0 0.8 0.8 Local private banks 5.258.0 834.7 3,006.8 1,212.8 -2,628.7 23.1 15.9 57.2 73.1 Foreign banks 2,610.1 395.6 1,355.7 325.7 -1,425.5 12.5 15.2 51.9 67.1 Cooperative banks 1,584.5 297.4 990.2 87.5 -1,200.1 5.5 18.8 62.5 81.3 Finance companies 351.5 18.7 217.0 86.0 -149.7 24.5 5.3 61.7 67.0 Savings & loan associations 96.6 6.4 98.1 70.0 -34.5 72.5 6.7 101.5 108.2 Credit companies 38.0 2.4 32.0 10.5 -23.9 27.8 6.4 84.2 90.6 Investment banks 6.1 0.3 6.1 3.1 -3.4 50.7 5.4 100.1 105.5 Total banks 18,307.2 2,890.4 9,148.5 6,480.0 -5,558.9 35.4 15.8 50.0 65.8 Source: Central Bank of Argentina. - 21 - 59. Implications. The regulatory regime described in the previous paragraphs- -reserve requirements, forced investments and CBA rediscounts-- has several important implications: (a) The high level of RRs and FIs severely limits discretionary lending by the banking system. The CBA, in turn, has a preponderant role in credit allocation through the rediscount mechanism. (b) The present set of regulations has contributed to the high interest rates on banks' free loans and to the poor returns on bank equity. The banks' lending capacity is reduced by the large amount of FIs and RRs, generating pressures on the spread between deposit and lending rates. A sensitivity analysis made by Bank staff using November 1986 figures shows that, under the present set of regulations, banks would have to charge nearly 5% a month in real terms on free loans to get . reasonable return on equity (a return on equity similar to opportunity costs). (c) From a macroeconomic standpoint, the Central Bank runs large los3es in its intermediation role, since the average interest rate it pays on FIs is higher than the interest rate it charges on its rediscounts. For example, in November 1986, the average difference between these rates was about 1.5% (per month). The resulting loss is a major cause of the Central Bank's quasi-fiscal deficit (if we simply annualize this loss, we obtain an estimated loss of more than 1% of GDP). (d) This degree of segmentation generates important transfers among agents in the financial system that are difficult to quantify, although the broad groups of winners and losers can be identified. The recipients of rediscounted loans at preferential interest rates belong to the most favored group. The recipients of regulated loans do nearly as well. The burden of these transfers falls upon the banks' shareholders, borrowers at free rates, and the holders of regulated demand and time deposits. (e) The performance of Argentine banks is very sensi-ive to the relative amounts of FIs and RRs, as well as to the yield on these investments. Since these instruments are a form of taxation, the higher their relative amounts or the lower their yields, the stronger is the upward pressure on spreads or the lower the returns on bank equity. Furthermore, the impact of the mechanism when rediscounts are included is uneven. This is clear if we consider that public banks are the largest rediscount recipients. 3.3 HIGH COST OF CREDIT 60. A major issue affecting Argentina's economic recovery is the high cost of credit. As shown in Table 9, monthly real interest rates, particularly free lending rates, have been very high for most of the last two years (excluding the third quarter of 1986 when rates became sharply negativ, because of an unexpected surge in inflation). high lending rates, which reflect both high deposit rates and large spreads, hinder the resumption of investment. - 22 - ZANO: REAL INTEZST RATES, 1982-87 Al (monthly averages for the quarter: percentage) Real reaulated interest rates Real free interest rates Annualized Annualised Lending Deposit Spread spread Lending Deposit Spread spread 1982 1 0.67 -0.54 1.21 15.49 0.28 -0.38 0.66 8.25 II 0.87 -0.34 1.21 15.51 1.05 0.01 1.04 13.24 III -10.14 -10.90 0.76 9.49 -7.03 -8.88 1.80 23.85 IV -2.64 -3.09 0.45 5.52 1.40 -0.91 2.30 31.42 1983 I -1.88 -2.59 0.71 8.82 1.08 -0.11 1.18 15.18 II -0.43 -1.33 0.90 11.35 3.31 1.27 2.04 27.43 III -3.84 -4.69 0.85 10.70 2.80 1.52 1.28 16.44 IV -1.76 -2.61 0.85 10.70 3.88 2.89 0.99 12.58 1984 I -3.77 -4.64 0.86 10.86 -1.90 -2.77 0.86 10.86 iI -3.49 -4.34 0.85 10.65 1.00 0.09 0.90 11.39 III -3.91 -5.14 1.23 15.83 -1.53 -2.46 0.93 11.76 IV 0.97 -0.73 1.70 22.38 8.70 7.58 1.12 14.30 1985 I -2.15 -3.77 1.62 21.33 1.21 0.40 0.81 10.19 II -4.87 -6.39 1.52 19.82 1.25 -2.67 3.92 58.66 III 2.97 1.50 1.47 19.15 5.33 4.45 0.88 11.12 IV 2.81 1.43 1.38 17.84 4.06 3.53 0.52 6.48 1986 I 2.52 1.14 1.37 17.78 3.45 2.70 0.75 9.37 II 0.59 -0.75 1.35 17.41 0.62 0.30 0.3e 3.92 III -1.38 -2.75 1.37 17.68 -0.98 -1.32 0.34 4.18 IV 1.80 0.37 1.43 18.57 2.37 2.75 -0.38 -4.48 1987 I -1.01 -2.13 1.12 14.31 0.30 -0.54 0.84 10.57 II 1.17 0.22 0.95 12.06 3.24 2.70 0.54 6.72 a/ Deflated by the percantage change of the quarterly average of the WPI and CPI. Sources: G.P. Macroeconomia and IBRD staff estimates. 61. High deposit re-es are mainly the result of: (i) the domestic financing of large public sector deficits which sets a very high floor for domestic interest rates (in the last few months Government bonds have implied a return to investors of not less than 20% a year in real terms); (ii) the public's fears of abrupt devaluations or explosive inflation, resulting in additional pressures over interest rates in the form of risk premiums; and (iii) the financial system's weak financial condition which also implies an element of extra risk in depositors' decisions. Large spreads, in turn, are basically explained by: (i) the high reserve requirements and substantial forced investments resulting from the use of the financial system as an important source of public sector deficit financing, including the financing of Central Bank losses (quasi-fiscal deficit); (ii) an important proportion of non-earning assets in the financial system (non-performing loans and fixed essets); and (iii) the - 23 - financial system's high operating costs, which result from the strong demonetization and the extremely short-term nature of most financial operations. 62. As discussed earlier, up to the recent October 1987 reform, financial resources flow mainly through two broad segments: free and regulated. Accordingly, there were two important intermediation spreads. Graph 3 depicts the evolution of the annualized real intermediation spreads for these two segments between 1982 and 1987. Larger spreads in the regulated segment are po6sibly explained as an attempt by CBA to compensate banking institutions for the substantial reserve requirements and forced investments imposed on regulated deposits. GRAPH 3 REAL ANNUALIZED SPREADS (Percentages) 50 48 30 Regulated 20. - Free -101 82 83 84 85 86 87 Quarters 63. There has also been a wide dispersion of interest rates on deposits, rediscounts, FIs an4 loans across segments. Interest rates on regulated deposits were kept at levels closs to inflation for most of the Plan Austral. Interest rates on non-regulated deposits were allowed to fluctuate freely, and were generally positive in real terms. CBA rediscounts, on average, carried interest rat-s very similar to regulated deposit rates. Rates on FIs in the regulated segment were above the rates on regulated deposits, while on the non-regulated segment they were roughly equal to the free deposit rate. Regulated and rediscounted loans had rates slightly above inflation. Finally, interest rates on free loans were extremely high in real terms (over 3% a month above inflation during several months). - 24 - PART IV - THE PROPOSED JANKING SECTOR LOAN 4.1 OBJECTIVES OF THE LOAN AND MAIN COMPONENTS 64. Argentina's banking system is hindering the country's economic recovery. Low monetization and resource mobilization through the banking system, serious financial difficulties in a large number of banking institutions, large segmentation of deposit and credit markets together with scarce and costly credit for the private sector, make it difficult to achieve efficiency in investment and growth. To help solve these problems, the proposed Banking Sector Loan contains a set of reforms designed to achieve the following objectives: (i) increase deposit mobilization and confidence in the banking system; (ii) improve the allocation of credit; and (iii) reduce the cost of credit. The proposed loan has two main components: a policy component and a technical assistance component. The policy component involves reforms aimed at achieving the three previously mentioned objectives. The technical assistance component includes support in various aspects of banking supervision and control. A policy matrix spelling out the objectives of the proposed loan, major issues, measures already taken by the Government, measures to be taken under the loan, and proposed timing, is contained in Annex VI. 65. The Government is aware of the serious problems affecting the banking system and since September 1986 has been implementing important reforms to solve them. The proposed Banking Sector Loan would give credit for these refurms and would also support additional reforms as described in the following section. The complex nature of financial sector reforms makes it advisable to proceed in a gradual way. For this reason, the present loan focuses on improving the structure of incentives (regulations) that govern banking markets. Possible future loans could focus on further restructuring certain public and provincial banks and on the development of capital markets (with special emphasis on insurance companies, pension funds, and equity financing). 4.2 DESCRIPTION OF MAIN REFORMS 4.2.1 Increasing Deposit Mobilization and Confidence in the Banking System 66. Liberalization of Deposit Rates. With the purpose of increasing deposit mobilization through domestic markets, the Government has recently announced the elimination of all controls on savings and time deposit interest rates (October 1987). This reform completes a process of deregulation of deposit rates initiated in September/October 1986 when controls on the growth of free deposits were substantially reduced. Free deposits have been experiencing an important growth since then. As a consequence of this reform, lending rates on all loans financed with deposits are also free. This reform is a major step in the deregulation of the banking industry. 67. Improving Prudential Regulation. With the purpose of gradually forcing banks to show their real condition in their financial statements and thus expediting the rationalization of the system, the Government has amended key accounting regulations. The loan classification system has been redesigned to provide more objective classification criteria, and - 25 - interest accruals are not possible on non-performing loans. In addition, the Government will enact a new regulation establishing a revised system of loan loss provisions to cover more adequately the risk of default associated with each loan. At present, provisions are mandatory only with respect to borrowers that have declared bankruptcy. The revised regulation will expand the provisioning criteria to cover all non-performing loans, including past-due loans. This new regulation will be enacted by the time of loan effectiveness. Through the tightening of these regulations, problem banks will be forced to recognize already existing losses in their balance sheets and income statements and adjust their equity accordingly. If the resulting adjusted equity were to be lower than the capital adequacy standards established by the Central Bank, banks would be forced to raise new capital, merge, enter into the deposit insurance scheme mentioned below, or leave the market. 68. Establishment of a Deposit Insurance Corporation. In order to expedite--in the most cost-effective way--the solution of both the overdimension and the widespread solvency problems affecting the banking system, it is important for the Government to have an effective mechanism to handle ailing banks. For this purpose, the Government will establish an autonomous Deposit Insurance Corporation- -similar to the American FDIC or the Spanish Deposit Guarantee Fund--to assist the process of bank rehabilitation. The main objective of the corporation would be to restructure insolvent banks, if so decided, or alternatively to liquidate them. The corporation would be financed by fees from participating banks, complemented, if required, by advances from the Central Bank. The corporation would Le entitled to perform a wide gamut of activities to rehabilitate or liquidate banks with a view to minimizing costs. Rehabilitation activities would include lending, purchase of assets, and recapitalization. In the latter case, existing shareholders would lose their invested capital and control of the bank. The corporation would then assume ownership and control until new owners are found. These owners could either be domestic or foreign. 69. In the case of a liquidation, deposit insurance would be restricted to small deposits. This would reduce the corporation's losses and enhance depositors' discipline. In the October 1987 reform, the Government ratified its policy to insure only small deposits and, in line witn Bank recommendations, it expanded this limited insurance to all small deposits (previously, only regulated deposits were eligible for insurance). The Government will send the draft law establishing the Deposit Insurance Corporation for Bank comments by May 31, 1988. The Bank has already provided the Central Bank with a note describing the main characteristics that, in its view, should govern such a corporation. A summary of these characteristics has been incorporated in the Government's Letter of Financial Policy (Annex V). The Bank will review the draft legislation to ensure consistency with the Letter of Financial Policy before it is submitted to the Borrower's Congress which is a condition for second tranche release. Until the establishment of this Corporation, the Central Bank will implement and maintain in effect adequate procedures and measures for the restructuring or liquidation of insolvent banking institutions. These procedures and measures will be consistent with the draft law establishing the Deposit Insurance Corporation now under preparation. - 26 - 70. Information Disclosure. The Government will increase information disclosure on the financial condition of banking institutions. This will help to increase public scrutiny on both public and private banks and allow depositors to discriminate among different institutions. CBA has already instructed banks to keep at their premises information for the public on their assets and liabilities, loans to related parties, main shareholders or other persons with voting decision, members of the board of directors, and external auditors. Before second tranche release, CBA will formally communicate to all banking institutions that it will publish their respective financial statements, including balance sheets and detailed statements of income and expenses, semianually in its monthly bulletin, such publication to commence with the June 1989 issue. 71. Inflation and Exchange Rates. In order to reduce the negative impact on deposit mobilization of high and variable rates of inflation and unstable exchange rates, the Government is committed to a macroeconomic program consistent with a reduction in the inflation rate and the maintenance of a current account deficit compatible with available foreign financing. As a condition of loan effectiveness and second tranche release, the Bank has to be satisfied that the macroeconomic policy framework of the Borrower- -including its fiscal, monetary, and exchange rate policies--is consistent with the objectives of the banking sector reform. 4.2.2 Improving Credit Allocation 72. Reduction in Reserve Requirements and Elimination of Forced Investments on Incremental Time Deposits. In order to increase the banking system's discretionary lending and reduce the tax imposed on banking intermediation, in September 1986 the Government substantially reduced minimum legal reserve requirements and eliminated forced investments on incremental non-regulated deposits. Incremental deposits are defined as deposit increases in real terms. In the recent reform package of October 1987, the Government expanded these lower RRs to all incremental time deposits. Accordingly, reserve requirements on incremental deposits are 3% for deposits with maturities between 7-29 days; 1.5% for deposits between 30-89 days; and zero for deposits over 89 days. Forced investments on incremental deposits are zero. As a result of this reform, average RRs and FIs will gradually come down as deposits increase in real terms. This reform has caused an important transfer of resources from the informal markets to the institutionalized banking system, since the latter is now in a much better competitive situation when deposit increases in real terms take place. It has been agreed with the Central Bank that RRs on incremental deposits can be increased on a temporary basis by no more than 5 percentage points for monetary management purposes. 73. Rationalization of Central Bank Rediscounts. Rationalization of CBA rediscounts is a key condition for restoring the banking system's capacity to intermediate and allocate resources efficiently. The program to rationalize rediscounts includes the following: (a) The net flow of Central Bank rediscounts to be extended during calendar year 1988 (i.e., new rediscounts less total repayments of previously extended rediscounts) has to be negative. This implies - 27 - that the Central Bank will not have to raise reserve requirements or forced investments to finance the new rediscounts to be extended in 1988. The Central Bank will provide the Bank with the rediscount program for 1988--in form and substance satisfactory to the Bank--before loan effectiveness. Compliance with this program is a condition of second tranche release. The following rediscounts will not be included in the program: (i) rediscounts extended to financial institutions for the purposes of either maintaining their liquidity or improving their financial position to comply with requirements of the banking superintendency; and (ii) rediscounts either financed from external multilateral sources or required, by agreements reached before the date of this loan, as counterpart funding by external multilateral financing sources. The rediscounts ev-1-Ael -r% finanrnl institutions to maintain their liquidity are related to the traditional functions of central banks as lenders of last resort. They are strictly short term and designed to help financial institutions overcome temporary cash-flow problems. The rediscounts extended to financial institutions to improve their financial position to comply with requirements of the banking superintendency would be granted only in the context of specific restructuring plans for individual institutions. In no case can these rediscounts be used to finance specific lending activities or granted without the existence of a restructuring program. (b) During calendar year 1988 the Central Bank will cancel/consolidate an amount of rediscounts equal to at least 15% of the Central Bank rediscounts outstanding as of December 31, 1.987, by applying to these rediscounts an equivalent amount of the forced investments maintained by banking institutions with the Central Bank. Although further reductions in the stock of rediscounts would be desirable, they are difficult because: (i) the long-term nature of many loans financed with redisrounts means that a substantial portion of the existing stock of rediscounts will dissipate only over time; and (ii) an important proportion of the rediscount portfolio may never be recovered because it was given to public banks in financial difficulties, or directed to borrowers with uncertain repayment capacity. Rediscounts to institutions now under liquidation as well as those extended to currently operating institutions to support specific restructuring plans are excluded from this consolidation process. In the first case, there are no forced investments against which consolidation can be made. In the second case, the restructuring plans now under way would be disrupted by this consolidation. Compliance with this measure is a condition for second tranche release. (c) All Central Bank rediscounts to be extended during calendar year 1988 will be presented to Congress, together with the nation's general budget. This presentation will identify each rediscount line together with its cost to the Central Bank. This reform will incresse transparency and subject CBA rediscounts to similar congressional scrutiny as other fiscal expenditures. This is especially needed in the cases of rediscounts provided to BHN (Banco Hipotecario) and provincial banks. These rediscounts, in - 28 - most cases, are simply financing Government programs in housing and provincial government deficits. Presentation of the rediscount program to Congress is a condition of loan effectiveness. Rediscounts to financial institutions to support their liquidity or restructuring, and rediscounts associated with external credit lines, will not be included in this presentation. (d) As a result of the October 1987 reform that eliminated regulated deposits, 50% of CBA rediscounts that previously had an interest rate based on the regulated deposit rate now have an interest rate based on free market deposits. In most periods, the regulated deposit rate was either negative or zero in real terms. This reform discourages the use of CBA rediscounts and reduces CBA fiscal deficit) are reduced by an amount equivalent to 0.5% of GDP per year as a c onseauence of this reform. The estimated average interest rate tn be charged by CBA to financial institutions in the 1988 rediscount program is 9.1% per year in real terms. Only three lines--related to emergency situations in the rural sector and to support small-sized rural cooperatives--still have negative interest rates in real terms. Nevertheless, these lines amount to less than 1% of the 1988 rediscount program. (e) Streamlining of rediscount management. Inadequate rediscount management has resulted in significant losses for the CBA. With the support of the Bank, an information system has now been designed that enables the computerized processing of the different lines. (A US$100,000 Project Preparation Facility has been granted by the World Bank to support the whole process.) The implementation of this information system is an important step toward a streamlined rediscount administration. 4.2.3 Reducing the Cost of Credit 74. Reduction of the Consolidated Public Sector Deficit. A key element in explaining the high cost of credit in Argentina is the large consolidated- -fiscal and quasi-fiscal- -public sector deficit. Domestic financing requirements of this deficit set a high floor for deposit interest rates. These deposit rates, in turn, are increased by the large spreads charged by the banking industry to compensate for the tax represented by reserve requirements, the large proportion of non-earning assets, and the substantial operating costs. The result is a lending rate to final borrowers that in several months has exceeded 40% a year in real terms. 75. The Government is committed to a reduction in the consolidated public sector deficit. The October 1987 reform package included new taxes and higher public utility rates. According to Government's estimates, these measures should bring the consolidated deficit from 7% of GDP in 1987 to 4% of GDP in 1988. As previously mentioned, for loan effectiveness and second tranche release, the Bank has to be satisfied that the macroeconomic policy framework of the Borrower- -including its fiscal policy--is consistent with the objectives of the banking sector reform. - 29 - 76. The proposed loan will also help in reducing the rate of interest by supporting: (i) an increase in deposit mobilization; (ii) redimensioning of the system and subsequent reductions in operating costs; (iii) gradual reduction in average reserve requirements and forced investments; (iv) rationalization of public banks; and (v) reduction of Central Bank losses associated with subsidized rediscount lines and the liquidation of failed financial institutions. 77. Rationalization of Public Banks. To advance the rationalization of public banks, the proposed loan contains two measures: (a) Action plans for certain public banks. The eight public banks with the largest overdrafts in their Central Bank accounts during calendar year 1987 will have to submit to the Central Bank action plans providing, respectively, for specific policies, actions and measures to enable such public banks to repay these overdrafts and to adjust to the reduced availability of Central Bank rediscounts. These action plans shall be requested from these institutions by the Central Bank by May 31, 1988, and submitted to the Bank for comment by August 31, 1988. Reasonable progress in the implementation of these action plans, which have to take into account the Bank's comments, is a condition for second tranche release. The Central Bank has already begun taking measures to face this problem. Starting November 1987, any provincial bank incurring new overdrafts in its Central Bank account is automati,ally excluded from the clearinghouse. In December 1987 the CenLral Bank took over, on a temporary basis, the administration of BHN (Banco Hipotecario), which is the public bank with the largest overdrafts during 1987 and the single largest recipient of Central Bank rediscounts. The Bank is -onsidering a possible operation aimed at both restructuring BHN and improving its effectiveness in house financing. (b) Restruf:turiny of BANADE. The Government decided to convert BANADE's debt to the Central Bank (rediscounts) into equity and to eliminate BANADE's access to short-term deposits as of August 1, 1987. Thi.s will strengthen BANADE's financial condition and will further mov: it towards second-tier operations. Discontinuing BANADE's access to short-term dposits will imply a reduction in its branching network and personnel. This, in turn, will reduce BANADE's operating costs. Further steps in the restructuring of BANADE will be taken in the context of a Bank loan to BANADE now under preparation. 78. Liquidation of Failed Institutions. In order to expedite the liquidation of already failed financial institutions, the CBA has authorized the sale of these institutions' loan portfolios. The sale of these loan portfolios- -which represent over 90% of the total assets of the 180 financial institutions currently under liquidation--is being done through public tenders. Expediting the liquidation of failed financial institutions will help reduce the large Central Bank losses resulting from its role as a recnivei of these institutions. - 30 - 79. Technical Assistance; Strengthening of Banking Supervision. A Technical Assistance Component (TAC) has been designed to strengthen the banking superintendency's capabilities on both credit risk analysis and assessment of the overall financial condition of banking institutions. This will allow it to take timely actions to stop unsound financial practices or, if necessary, force insolvent institutions to exit the market at an early stage of insolvency, minimizing potential losses for the CBA and depositors. The TAG consists of three building blocks: (i) support from consultants on specific areas and issues; (ii) training; and (iii) purchase of computer equipment. The total cost of the technical assistance component is estimated at US$500,000. Details of the TAC are provided in Annex VII attached. PART V - LOAN FEATURES 5.1 HISTORY 80. The proposed loan is the result of a program of financial sector work which the Bank initiated in FY86. As a consequence of this program, extensive discussions on financial sector issues have been held with Government officials since early 1986. A first report--on Argentina's banking sector--was issued in December 1986 (Green Cover). The Government reacted favorably to this report and its main recommendations, and requested Bank assistance to implement them. A second report--on Argentina's capital market and institutional investors--is under preparation and will provide the basis for a possible subsequent operation in the financial sector. 5.2 LOAN AMOUNT, BORROWER AND IMPLEMENTING AGENCY 81. A quick-disbursing loan of US$400 million is proposed in support of the si gnificant advances which the Government has made and has undertaken to make in adjusting its banking sector. The loan would include the financing of complementary computer and technical assistance. The borrower would be the Republic of Argentina; the implementing agency would be the Central Bank. The loan would reimburse 100% of the foreign exchange cost of eligible imports. 5.3 LETTER OF FINANCIAL POLICY 82. The baris for the loan is provided by a Letter of Financial Policy (Annex V) in which the Government declares its commitment to adopt and implement the previously mentioned reforms. This letter describes the Government's macroeconomic and banking sector objectives and indicates the reforms intended to meet these objectives. 5.4 TRANCHE RELEASE 83. The proposed loan would essentially be disbursed in two tranches. The first-tranche disbursement (US$199.5 million) would be available upon loan effectiveness. The loan will become effective when: (i) all legal requirements are met: (ii) all conditions for loan effectiveness included in Annex III have been complied with; and (iii) the Bank has been furnished evidence satisfactory to it that the Government's macroeconomic policy - 31 - framework is consistent with the reform program being supported by this loan. 84. The release of the second tranche (US$200.0 million), projected co be disbursed about nine months after loan effectiveness, would be contingent upon: (i) the Bank being furnished satisfactory evidence that 'he Government's macroeconomic policy framework continues to be consistent with the banking sector reform program; and (ii) all conditions for second- tranche release included in Annex III have been complied with. 5.5 DISBURSEMENT AND PROCUREMENT MECHANISMS 85. The bulk of the loan (US$399.5 million) would be applied to 100% of the c.i.f. costs of eligible private and public sector imports. Eligible imports woili bo ll gnoris exeept thn.q normally excluded under Bank policy-based lending, such as alcohol, tobacco, and armaments: and goods financed by other Bank loans. Retroactive financing up to 20% of the loan amount from November 1, 1987, would be permitted. The remainder of the loan (US$0.5 million) would be disbursed to purchase computer equipment for CBA and for technical assistance, including training and consultants' services. Disbursement of this latter part of the loan would be independent of tranche releases and over a period not to exceed two years. The closing date of the loan would be November 30, 1989. 86. Consultants to be financed with the proceeds of the loan will be enployed in accordance with the principles and procedures set forth in the "Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" published by the Bank in August 1981. Private sector importers would use normal commercial practices while public sector importers would follow standard Government practices, which ensure reasonable prices. All disbursements would be made against a statement of expenditures to be submitted by the CBA. CBA, in turn, is expected to undertake the screen4ng process to ascertain that the above conditions have been met and to request disbursement of the loan on the basis of documented import payments from the commercial banks. 87. CBA will maintain separate accounts to record and monitor loan disbursements and repayments. All records and accounts related to expenditures financed under the proposed loan, including those for statement of expenditures, would be audited each year in accordance with sound auditing principles by independent auditors acceptable to the Bank. 5.6 BENEFITS AND RISKS 88. Benefits. The proposed operation will increase the overall efficiency of the barking industry to finance investment and growth. This will result from: (i) increased deposit mobilization and confidence in the banking system; (ii) improved credit allocation; and (iii) lower cost of credit. Deposit mobilization will be increased as a result of the lifing of controls on deposit interest rates, the strengthening of banking supervision and control, the increased transparency ani reliability of financial statements, the establishment of an efficient mechanism to rehabilitate troubled banks, the insurance coverage for all small deposits, and the lower rate of inflation together with the mainterance of a - 32 - realistic exchange rate. Credit allocation will be improved as a consequence of the increased discretionary lending by banking intermediaries as well as the reduction of the volume and subsidies of Central Bank rediscounts. Finally, the cost of credit is expected to decline gradually as a result of the reduction of both the fiscal deficit and the Central Bank losses, the increase in deposit mobilization, the redimensioning of the system and the subsequent reduction of operating costs, the reduction of reserve requirements and forced investments, and the increased efficiency of some public banks. 89. The proposed loan is also expected to have positive social effects by improving income distribution and employment. Small depositors will largely benefit from the elimination of regulated deposits which did not have positive interest rates in real terms and which were the only available alternative for small-sized deposits (only deposits exceeding the equivalent of US$5,000 could be placed as free short-term deposits at market interest rates). Similarly, the reduction of interest rate subsidies that primarily benefit high-income recipients, the decrease in the regressive inflation tax, and a better insurance protection for small deposits are efficient methods whereby the loan will contribute to reducing the concentration of wealth and income. Moreover, the expected rise in the quality of investment should help improve the growth and stability of employment. However, this latter effect can be offset in the shcrt term for expected layoffs that would take place as a consequence of the redimensioning of the banking system. 902. Risks. There is a risk that given the complexity and poliLical implications of many of the proposed reforms, the Government might not be able to carry out the whole program with the required speed and thoroughness. More stringent accounting regulations, improved supervision and information disclosure, and tighter CBA rediscount policy will put stress on problem private and public banks, and on borrowers at subsidized rates. A further risk is that failure to maintain macroeconomic stability :could endanger the success of financial sector reforms. These risks are mitigated by the safety net represented by the expanded deposit insurance coverage, The esnablishment of an adequate mechanism to rehabilitate failng banks, the greater availability of financial resources as a result of increased deposit mobilization, and the commitment to stabilize the economy which the Government continues to show. Moreover, the proposed loan stipulates that for loan effectiveness and second-tranche release, the Bank would have to be satisfied that the macroeconomic policy framework is consistent with the Government's financial sector reform objectives. PART VI - BANK GROUP OPERATIONS AND STRATEGY 91 Past Bank lending to Argentina has been sporadic because of periodic macroeconomic and sectoral difficulties. In the period FY79-85, the Bank made loans for ten projects totaling US$1,045 million. Bank lendJing sinre FY85 totaled US$1,509.5 million, and has focused on the improvement of water supply services, development of the hydrocarbon and power sectors, support for structural reforms in agriculture and trade, and assistance in improving public sector management. The implementation of Ban *'k-assisted projects in Argentina has suffered in the past. from policy re vti,aG cumbersome bureaucratic procedures, curbs on public investments - 33 - stemming from the need for fiscal austerity, and the private sector's reluctance to invest in an uncertain economic environment. The Government shares the Bank's concern about this situation, which in some cases has resulted in unexpectedly slow disbursements. In response, several existing projects have been restructured to improve their execution. The Bank has also instituted procedures for monitoring monthly disbursements, and for periodic project implementation reviews with the Government. As a result, disbursements under Bank loans tripled in 1986 compared to 1985, and doubled again in 1987. 92. Serious efforts by the Government to tackle Argentina's thorny economic problems give the Bank an opportunity to play a key role in the country's economic recovery and future development. The Government has requested the Bank's help in implementing a structural adjustment program and in paving the way for renewed long-term economic growth. Over the short term, the Government is seeking help with economic analysis and expanded lending operations designed to enhance the efficiency of resource use and to increase the availability of foreign exchange. The Government has presented to the Bank its framework for a medium-term economic policy reform and development program. This framework is envisaged as laying the groundwork for new external lending to foster economic growth and strengthen Argentina's debt servicing capacity. 93. Bank analytical work and lending will be used to support Government efforts to achieve sustained and satisfactory rates of economic growth. The effort is directed at enhancing Argentina's international competitiveness, improving public sector management, expanding private sector activities, increasing domestic resource mobilization, and strengthening external finances. Key areas for cooperation are reforms of: (i) the Government's role in the economy--including public investment, public sector pricing, public enterprise management, divestiture of public assets, transfer of services, and central-provincial government interaction; and (ii) private sector incentives, including the trade regime, credit availability, fiscal subsidies, participation in Government- controlled activities, deregulation of the financial system, and industrial restructuring. 94. The Bank's lending strategy for Argentina has several distinctive characteristics. First, it is focused on policy-based lending and the associated analytical framework. Second, it is diversified to encompass essentially all areas in which the Bank can support important structural reforms. Third, the program has been designed as an integrated whole; while the loans are associated with individual reforms, they are sequenced for synergistic effects. 95. The Bank's ESW has a strong operations orientation designed to support a continued expansion in our lending program. We intend to follow up on our recommendations in the Public Sector Investment Program Review for making public sector investment more cost effective, to assist in the formulation of a medium-term public investment program, and to support Government efforts to improve resource management through an analysis of public sector expenditures. Sector work is concentrated on financial, industrial and transport issues. The analytical requirements involved will be demanding, because of the complexity of the needed policy reforms. We - 34 - will therefore coordinate our own activities with the work undertaken under the Technical Assistance Loan for Public Sector Management, so as to extend our analytical leverage and obtain the thorough knowledge necessary for successful policy-based lending. 96. IFC has made 27 investments in Argentina, amounting to US$287 million, of which US$161 million has been repaid, cancelled or sold. A summary of its investments is shown in Annex IV. Promotional efforts are geared to export or import substitution-oriented projects, with emphasis in oil, petrochemicals and related sectors. IFC will also continue to seek investments in projects in which its presence would facilitate the formation of joint ventures with foreign participation and act as a catalyst to attract higher levels of commercial financing. PART VII - COLLABORATION WITH THE IMF 97. The IMF has been supporting Argentina's stabilization efforts since 1984. The initial 15-month standby arrangement was extended and became fully drawn in June 1986. In February 1987, a second 15-month standby arrangement was approved in principle by the IMF in an amount of SDR 1,113. The arrangement became effective in July 1987. 98. The Bank will continue the collaboration that it has followed with the IMF in the previous stages of this project. There have been detailed discussions with Fund staff on the previously mentioned banking sector report and on the proposed loan. The L'ank will also pay special attention to the findings and position of the IMF when reviewing macroeconomic performance for loan effectiveness and second tranche release. PART VIII - RECOMMENDATION 99. I am satisfied that the propo;ed loan would comply with the Articles of Agreement of the Bank arid recommend that the Executive Directors approve the proposed loan. Barber Conable President Attachments Washington, DC February 29, 1988 *5* mil MV m IM-I Projected Im W I IO Sm 1109 1990 1991 EDP growth rate 1. 4.5 U .6 3.7 3.7 3.7 SOY growth rate 3.4 *.9 .0 M. L? 3.9 4.3 3.8 SOY per capita, growth rate 1.0 -.3 2.9 -.0 Ij 2.4 2.7 2.3 Consumption per capita, 9ruMt rate 4.0 4.2 .0 0.0 *2.1 1.3 1.4 1.4 Debt Service ALT 1/ IMo "a Ilb 001 1191 6301 6844 Debt Service MLT/I6S 1%) 1161 t.2 M.3 *A.? St.0 51.1 50.9 52.2 Debt Service MLT/63 .. ) 3. 1A 7 *L3 7.7 7.6 7.6 7.6 Bross Investment/6P (1) 21 8.4 11.1 U.9 S2.3 53.5 14.4 15.3 16.1 Gross Doestic Savings/W (1) 87.1 14 11.6 53.3 U.1 17.0 18.1 18.8 National Savings/SP, comstmet priefs MI 9.1 0. 9.5 LID U.1 12.5 13.6 14.6 Margial Wational Savit's kate *I *$.A 1A *. a. .43 0.39 0.38 Public Investmer 31 6.1 6.1 Ll $A 5.9 6.2 6.5 6.8 Public Savings/k / *.3 1.9 3 3.3 L6 4.3 4.6 5.0 Private Investment...r (1) 21 6.3 4.0 6.6 6.7 7. 8.2 8.8 9.3 Private Savings/SDP (1) 19.0 5.7 II.0 9.9 53.5 12.7 13.5 13.8 Public Invtoent/Private lawstmot 3 1.0 1.1 0.7 0. 0.6 0.1 0.7 0.7 Government Revenul (1) 32.9 27.3 2.9 214 27.6 27.3 27.3 27.8 Bovernment Expenditure/W (i 3I.2 31.o 2. 32.2 3m1.1 29.3 29.3 29.8 hon-Financial Publ.c Sector licit/UW IS 4.3 4.1 -2.7 *5.0 *LS -2.0 -1.5 -2.0 Central Bank Detficit/W I) *2.$ *2.2 *1.6 .0 *1.S -1.0 -0.5 Total Public Sector Deficit as I of W *0.1 4.3 4.3 *7.0 *.0 -3.0 -2.0 -2.0 Exports SMFS, growth rate 5/ 0.1 10.6 9.9 *3.3 10.7 3.6 3.1 3.1 Exports SNFS/SDP (1) 61 50.7 a5*0 I3.5 IJA 5.3 14.6 14.8 14.6 Isports 6NFS, groth rate 51 44 -13.9 I.9 9.9 4.0 6.2 5.6 5.1 lmports 6NFS/GDP (1) 6/ 9.9 9. 0.6 U.9 ISA 12.4 12.2 12.2 Current Account Balance 1/ -39" *53 -2k 4100 -330 -3161 -3141 -3078 Current Account Salance/W (1) 4 -.5 4.2 -5.7 *4.4 -3.2 -2.9 -2.5 Interest KLT/Exports of Wn 0.16 .(6 044 0.47 0.0 0.40 0.40 0.37 ------------------------------.------ - - ------------------- Source: LA4CO. 11 At current mill. US dollars. 2i Includes changes i stocks. 3/ Public investet a gasrmgat topttal 1aggAto . 4/ Non-financial public acter. 5/ At constant prices. 6/ At current prices. 一36- 創巴鹽讓工工 -!&！排排要柑等‘綴’&’一“舉，醒賽”&&&& ::: !!&1&&&,&&,&&&”一，’•”•”&&&,&,,&&&! ―裊！發｝墾唱鳥寺祖話呈毒響’華涌號’柴”&”華”華：;;:：萋巨醒濺：&&&- I里11一i 12}11 ！〕’-’話，‘薇‘”弓’革“•‘’•”&,&：華“,“巨，’〔一〔〕 。【！發！寺讓婪話寫巨‘藝藝甲華疲日’雜”’巨丰三；二華：：基旦巨姿’乏‘三！ t,:;I&‘一！ 進要！!!____: 留i！。―讓醒參黠縴巨婪響審’蘊審丰’禁鬍譽．，望•：：平；；垂要薇薇‘悲蓄近｝ 豐透！-&!&____! 蘊鏖！―壁！轎呂“黃鳥弓華婪’華蓬•’邊華學‘華養華“︰華“：垂奏巨狙一乏‘悲〕 ，。！。！& 症重！｝。！。。；，。二，。；一，，。·，。；；。·。：:::：。。，。一；:,，騙 話‘一！I廷！薑居計日響雙要蘇籐一’華黑濺一織零季寫琴一卑“,“讓日絕黑：一：；。 ．〕I!!g ！、！,！籐•；。籐。症。柴，，。“&,,&&,：寡：&：︰”垂：。：一：,:：合 l潺；一l一‘－一”一，&，一－一丁必一〕日 〕痲｝｛〕． -!,！。。，：。。。：。。。，。·，。，，。·，::;;：廷。，，一：。悲；屆 1 11；實 ―〕，!::,,,:,,，。；，。•。。。。，·，::::：。，.，一：二：！【 -！壁―董森界垂亂果琴華婪‘華響•’發華孼寺究’乏；:&;：雙荒‘邊’，聲：！。。豐韋 11:&i奮寫．t雙 ;；一i祠認；蓄•忠于， ：】洽1．里二．盒I，言，．細 ::，召鬥玉低他化：•召鳥，蓄 :；屆屆必．，莖二t；二召變必， ::.,”二召15面自．：豐，亡卞． ::－一•乙－一念煙不呂．,‘畫雙1鼻：伯三：必： i:：常，里萬二莖．記。甚膩柚廈！f二奮他，徑萬i負奮寧廈互 1！豐，豐，二，面雹呈萬震一登．卜靈二召‘．薑麩二：：萬酒，蓬l日參藪煙“ ！權薛l鑰，小11鉉．戰I｝龍i痲羹：:l【’;!11〔I〕l挪！ I&：邊邊：丰必渥：,，整。1江月‘:；言蒲里蔥洛：蘿中離審不里雙邊，匹匹酒召BJ：。屆．亡露 l；奮，七奮，七•．化！a。•唱一屆．”屆蒲，蠱，擠蔆，多了1召必蔆“屆．：夏一訕i－一居h. {;：必臼：酒汙豐任右F：註：日：召，三不占孓奮要萬豐萬他6，藝廈蒙二【【．畫蔆症I藝當言怔廳 !！基n誹1韋結彥辭弱奮此蠶汰豐川“蓬症重州j莖識；n北莖 - 37 - ANNEX III Page 1 of 2 pages ARGENTINA - BANKING SECTOR IQM SUPPLQME= L40AN DATA SHEET I. Timetable of Key Events (a) Time taken by the country to prepare the loan: 18 months (b) Loan prepared by: cv;iltral Bank Of (c) First presentation to the Bank: December 1986 (d) Departure of appraisal mission: June 1987 (e) Completion of negotiations: January 1988 (f) Date for effectiveness (estimated): April 1988 II. Conditions for Loan Effectiveness (a) The Central Bank shall have initiated a program to strengthen the banking superintendency's capabilities in the areas of credit risk analysis and assessment of the overall financial condition of banking institutions, such program to consist of: (i) technical support from consultants and/or experts; (ii) training of staff; and (iii) acquisition and utilization of computer equipment. (b) The Central Bank shall have provided the Bank with a program, for calendar year 1988, satisfactory to the Bank, for cancellation/ consolidation of an amount of Central Bank rediscounts equal to at least 15% of the Central Bank rediscounts outstanding as of December 31, 1987, by applying to these rediscounts an equivalel't amount of the forced investments maintained by banking institutions with the Central Bank. Rediscounts to institutions now under liquidation as well as those extended to currently operating institutions to support specific restructuring plans are excluded from this consolidation process. (c) The Central Bank shall have provided the Bank with the program of rediscounts for calendar year 1988. This program has to be satisfactory to the Bank. The rediscount program for calendar year 1988 should result in a negative net flow for that year (total new rediscounts extended shall be less than total repayments or other recoveries of previously extended rediscounts). There shall be excluded from such calrulation: (i) rediscounts extended to financial institutions for the purposes of either maintaining their liquidity or improving their financial position to comply with requirements of the banking superintendency; and (ii) rediscounts either financed from external official or multilateral sources, or required, by agreements reached before the date of this loan, as counterpart funding by external official or multilateral financing sources. (d) The program of all new Central Bank rediscounts to be extended in calendar year 1988, with the same two exceptions mentioned in (c) above, shall have been presented to the Congress, together with the nation's general budget. - 38 - - 38 -ANNEX III Page 2 of 2 pages (e) The Central Bank shall have taken measures adequate to cause the eight public banks having the largest overdrafts in their Central Bank accounts in 1987 not to increase their use of overdrafts during 1988. (f) The Central Bank shall have issued a new regulation, acceptable to the Bank, establishing a revised system of loan loss provisions to cover more adequately the risk of default associated with each loan. (g) The Bank shall be satisfied that the macroeconomic policy framework of the Borrower- -including its fiscal, monetary and exchange rate policies--is consistent with the objectives of the banking sector reforms. III. Conditions for Second Tranche Release (a) The Central Bank shall have formally communicated to all financial institutions that it will publish semiannually in its monthly bulletin entitled "Estado de las Entidades Financieras," starting with the June 1988 issue, their respective financial statements, including balance sheets and detailed statements of income. (b) The Central Bank shall have complied with the program for cancellation of rediscounts referred to in Section II(b) of this Annex. (c) The Central Bank shall be complying with the rediscount program for calendar year 1988 referred to in Section II(c) of this Annex. (d) The draft legislation providing for the establishment of an autonomous agency, corporation or other entity which shall: (i) administer and implement the restructuring or liquidatIon of insolvent banking institutions; and (ii) guarantee or insure small-sized deposits, shall have been submitted to the Borrower's Congress. This draft legislation shall be furnished to the Bank for its comment by May 31, 1988. The main characteristics of such an agency or corporation have been incorporated in the Borrower's Letter of Financial Policy. (e) The eight public banks referred to in Section II(e) of this Annex shall have made reasonable pro ,ress in carrying out their respective action plans providi:6, respectively, for specific policies, actions and measures to enable such public banks to repay their overdrafts and to adjust to the reduced availability of Central Bank rediscounts. These action plans shall be requested from these institutions by the Central Bank by May 31, 1988, furnished to the Bank for its comment by August 31, 1988, and carried out taking into account the Bank's comments. (f) The Bank shall be satisfied that the macroeconomic policy framework of the Borrower- -including its fiscal, monetary and exchange rate policies--is consistent with the objectives of the banking sector reforms. - 39 - ANNEX IV Page 1 of 2 pages THE STATUS OF BANK GROUP OPERATIONS A. STATEMENT OF BANK LOANS AND IDA CREDITS (As of December 31, 1987) ARGENTINA Amount less Loan No. Year Borrower Purpose Cancellations Undisbursed (US$ aillion) Fully disbursed loans (18) 901.6 1521 1978 Argentina Grain Storage 87.0 27.5 1761 1979 Argentina Yacyreta Power 210.0 12.9 2031 1981 Banco Nacional Oil and Gas 100.0 55.2 de Desarrollo Credit 2032 1981 Yacimientos Refinery 200.0 3.1 Petroliferos Conversion Fiscales 2063 1981 Banco Nacional Industrial 100.0 36.4 de Desarrollo Credit II 2296 1983 Argentina Highway 100.0 30.2 2592 1985 Yacimientos Gas Utilization 180.0 166.6 Petroliferos and Technical Fiscales Assistance 2032-1 1986 Yacimientos Refinery 116.0 30.9 Petroliferos Conversion Fiscales 2641 1986 Argentina Water Supply 60.0 59.7 2675 1986 Argantina Agricultural 350.0 173.1 Sector Loan 2712 1986 Argentina Public Sector Mgt. 18.5 13.6 2751 1986 Argentina Power 14.0 14.0 Engineering 2793/1 1987 Argentina Small and Mediua 125.0 125.0 Scale Industry Credit 2805 /2 1987 Argentina Port 50.0 50.0 2815 1987 Argentina Trade Policy 500.0 4.0 2854 /2 1987 Servicios Power 276.0 276.0 Electricos Distribution Gran B.A. TOTAL 3,388.1 Of which has been repaid 680.3 2,700.8 Amount Sold 12.8 Of which has been repaid 12.8 Total now held by Bank 2,688.0 Total undisbursed 1,076.0 1/ Not yet effective. 2/ Not yet signed. - 40 - ANNEX IV B. STATEMENT OF jFC INVESTMENTS Page 2 of 2 pages (As of November 30, 1987) ARGENTINA Amount in US$ million Year Obligor Type of Business Equity Loans 1960 Acindar Industria Steel Products 3.7 - 3.7 Argentina de Aceros, S.A. 1960 Papelera Rio Parana, S.A. Pulp and Paper 3.0 - 3.0 Engranajes, S.A.I.C. 1961 Fabrica Argentina de Automotive 1.5 - 1.5 1962 PASA, Petroquimica Petrochemicals 3.0 - 3.0 Argentina, S.A.I.C. 1965/ 72 Celulosa Argentina, S.A. Pulp and Paper 12.5 - 12.5 1969/ 75 Dalmine Siderca, S.A. Steel Products 17.0 - 17.0 1969 Editocial Codex, S.A. Printing and 7.0 2.0 5.0 Publishing 1971/ Calera Avellaneda, S.A. Cement 5.5 - 5.5 73 1977/ Alpargatas S.A.I.C. Textiles & Fibers 30.4 2.0 28.4 84 1977 Soyex S.A. Soybean Processing 25.0 - 25.0 Plant 1978 Massub, S.A. Pulp and Paper 15.8 2.3 13.5 1978/ Juan Minetti, S.A. Cement and 103.0 - 103.0 81/82/87 Construction 1978/ Ipako-Industrias Chemicals and 20.3 2.0 18.3 79/82 Petroquimicas Petrochenicals 87 Argentinas S.A. 1979/ Alpesca S.A. Fisheries 6.8 1.6 5.2 83/84 1984/ Pet-oquimica Cuyo SAIC Chemicals and 45.8 4.0 41.8 86 Petrcchemicals 1986 Inversiones Industriales Money aa- Capital 1.3 1.3 - S.A. and Roberts Markets Participaciones, S.A. 1986 Atanor S.A.M. Chemicals and 8.0 1.0 7.0 Petrochemicals 1986 BRSA Money and Capital 10.0 - 10.0 Market 1987 Hidra Oil Chemicals and 80.0 - 80.0 Petrochemicals 1987 Garovaglio Food & Food Proc. 13.0 - 13.0 1987 Terminal 6 Port, Storage 5.5 - 5.5 1988 Bunge y Born Food & Food Proc. 40.0 - 40.0 1988 Arcor Food & Food Proc. 12.0 - 12.0 1988 BRLP Dev. Finance 30.0 - 30.0 Total Gross Commitments 500.1 16.2 483.9 Less Cancellations, Terminations Repayments and Sales 221.2 2.0 219.3 Total Commitments Now Held by IFC 278.8 14.2 264.6 Total Undisbursed (IFC only) 130.7 4.1 126.6 - 41 - ANNEX V Page 1 of 11 January 31, 1988 Mr. Barber B. Conable President International Bank for Reconstruction and Development 1818 H Street, N.W. Washington, DC 20433 USA Mr. President: The Government of Argentina is currently engaged in carrying forward a program of economic structural reforms for the country as a prerequisite for achieving conditions of stability and sustained economic growth. The financial sector will play a major role in generating these conditions because it, along with the capital markets, needs to allocate financing efficiently into the investment required to achieve the new phase of growth. For that role to be carried out in an efficient way, the financial system must increase public confidence so it can attract growing financial savings, regulations that discourage institutionalized financial activity must be curtailed and the intermediation margin must be reduced so that the cost of credit goes down significantly. The Government has looked into a number of actions that address these points. To ensure continuity from these changes and support this stage of the reform program, the Argentine Republic requests a loan from the World Bank to be granted under the framework of the Structural Reform Lending Program agreed with the Bank for disbursement in 1988. If this request is to be evaluated adequately, we believe it necessary to offer a brief description of the Economic Stabilization and Structural Reform Program that the Government is implementing, considering that financial reforms constitute one of its leading components. The Government is certain that the success of reforms in the financial sector is intimately linked to the existence of an appropriate macroeconomic policy. In this sense, and for the purpose of furthering the development of these conditions and to promote economic growth, the Government proposes: to reduce the current fiscal and quasi-fiscal deficits of the public sector, to lower the current rate of inflation in the economy, and to improve the external accounts. The Economic Reform Plan The economic program put into effect on June 14, 1985, consisted of a combination of monetary and fiscal measures implemented with monetary reform and an income administration policy. - 42 - ANNEX V Page 2 of 11 Accordingly, the measures put into practice were of three different orders. First, as a basic element of the plan, measures were taken to cut the fiscal deficit. The substantial drop in inflation alone led to an important increase in the real value of tax revenues. The imposition of forced savings and new taxes on foreign trade, along with higher public utility rates, strengthened the Government's new financing scheme by supplanting the "inflation tax." The deficit left after these measures was to be financed exclusively out of external credit. Furthermore, it was explicitly decided that covering the fiscal gap by Central Bank loans to the Treasury was not a desirable alternative. Second, a freeze was put into effect on prices, wages and exchange rates. In the area of prices, the freeze was ordered for goods coming basically from the secondary sector and regulations were imposed on the sales margins (without freezing them) of products whose prices were more sensitive to changes in supply and demand (fruits and vegetables, among others). Also frozen was the exchange rate, in which the austral was set at 80 cents to the dollar. Third, a monetary ref m was implemented. This reform eliminated the Argentine peso and put t austral in its place, and established a "conversion scale" aimed at apening the inflationary expectations embodied in contracts in effect at the time of the reform. The initial results of this plan brought inflation (as measured by the CPI) down from an annualized rate of 1,000% in the first half of 1985 to 40% in the second half of that same year. The public sector deficit fell from 12.5% of gross domestic product to 4.3% during that same period, primarily becau.e of greater fiscal revenues from higher prices and rates and increased real revenue as a result of less inflation. The balance of trade figure came to US$4,400 million. Starting in the second quarter of 1986, as more flexible income and exchange policies took effect, inflation was pushed upward by stronger demand. To bring conditions back to greater stability, a price and wage guideline system was implemented during the second half of 1986 in combination with a monetary policy whose clear purpose was to curb the growth of domestic credit. As a consequence, the CPI fell from a 9% monthly rise in August to 5% in December 1986. Simultaneously, GDP rose 6% for the year, under the influence of a 13% gain in gross industrial output. The positive results from the inflation plan were not reflected in the final balance of payments figures where the deficit rose as a result of deteriorating terms of trade, weather factors affecting production of goods for export, and greater imports and lower exportable surpluses because of higher domestic demand. In January 1987, a new standby agreement was signed with the IMF as part of an economic policy aimed at making adjustments primarily in the fiscal area and achieving, thereby, a more stable framework that would help - 43 - ANNEX V Page 3 of 11 ensure a growing economy, lower inflation and a stronger external sector. Other agreements were reached at the same time with commercial ba-aks and international lending agencies to provide the external financial iupport essential for normal development of the economy. Despite the measures implemented in this sense and even though timely efforts have been made to reduce the consolidated fiscal deficit and implant firmly a monetary policy that secures price stability, the price increases that have been seen in the recent past show that the Argentine economy tends to propagate almost systematically the disequilibria that lead to resurgence of inflation and deterioration of external accounts. The only way to eliminate this perverse behavior is to combine short-term stabilization policies with structural reforms that will make the stability permanent and bring sustained growth with it. The measures put into practice by the Government from last October 14 onward, while they seek to bring inflation to a prompt halt, also entail energetic action to reduce the fiscal deficit, accompanied by a group of decisions relating to a growth strategy based on private initiative that integrates Argentina with the world. To bring the fiscal deficit down to a level in harmony with the stability and growth objectives, the Government ordered a number of tax- related measures combined with higher public utility rates and tighter controls on tax evasion. Furthermore, important structural changes are being made in the public finances that are intended to define clearly the relationship between the central administration, on the one hand, and the provinces, the public enterprises, and the social security system, on tht. other hand. Along with the tax measures and the rate adjustments, the Argentine Government will continue working to contain and reduce unproductive piblic sector spending. The Government intends to move further afield into restructuring state enterprises and eliminating monopolies in several areas. New rules in effect for oil production will offer private capital more incentive to allocate resources for the working of reserves by allowing earnings equivalent to the international price for this output. Further steps will be taken with the so-called "Houston Plan" whose purpose is to discover new reserves. In the area of communications, operating permits will be granted to private firms. In the immediate future, authorization will be given for a private service in the Buenos Aires financial area. This service will be connected to the private system. A competitive bidding will be called for a private mobile telephone service in Buenos Aires and La Plata. The implementation of more liberal policies in effect for foreign exchange transactions is a significant step toward improving Argentina's external competitiveness and more rapid and efficient national involvement in the world market. Regulations have also been issued to add 700 import tariff positions to the system in effect for temporary automatic clearance of semifinished goods and raw materials used to produce industrial exports, so as to improve cost and supply conditions and raise the quality of Argentine goods for export, along with other import tariff measures aimed at expanding international trade. - 44 - ANNEX V Page 4 of 11 It is thought that the modifications introduced to the external debt capitalization scheme for the financing of new projects will promote more private investment and afford easier access to local investors. The draft laws sent to the Congress relating to a new industrial promotion regimen, elimination of state public utility monopolies and the establishment of a new Federal Tax Sharing Regimen are aimed at stimulating competition and rationalizing public administration. Along with these measures, substantial modifications have been made to the regulations applicable to the financial system. These are part of an action program started in September 1986, which we will now explain. Financial Sector Reforms The need to finance growing rediscounts and fiscal and quasi- fiscal disequilibria led the Central Bank to issue many restrictive regulations on institutional financial activity which have constrained progress in this area, particularly the use of its lending capacity. Simultaneously, the Central Bank increasingly assumed a leading role in resource allocation and thus became part of the machinery for channeling public subsidies and spending. The regulations that were in effect in September 1986 provided for a strongly segmented market. In this the Central Bank set deposit and lending interest rates for the so-called "regulated" segment, growth restric-:ions on the free segment, and high remunerated aid unremunerated reserve requirements on all deposits. There were also many financial transactions prohibited to intermediaries resulting in an active and growing informal financial market. From the end of September 1986 until the program announced last October was adopted, the financial system has been steadily deregulated. The principal decisions during this period have entailed drastic elimination of reserve requirements on free deposits, greater flexibility for holdings cf remunerated reserve requirements, a greater variety of financial instruments available in the free segment and thorough improvements in the system following the intervention and ultimate liquidation of several entities that had been experiencing serious solvency and liquidity problems. Elimination of the Regulated Segment As of October 15, 1987, financial institutions were authorized to accept savings and time deposits in all cases at whatever rate they freely agreed with their customers. As a consequence of this measure, several regulations were voided. Among them were the quantitative restrictions on the credit portfolio at the regulated rate, the quotas on deposits at the free rate and the rules establishing minimum amounts for ftee-rate deposits. - 45 - ANNEX V Page 5 of 11 The only restriction applicable to the sum of deposits and other liabilities was made as a function of the computable net equity (Responsabilidad Patrimonial Computable) of each entity; this was set at 15 times the aforementioned indicator. Along with these, it was provided that interest rates charged on lending transactions financed by deposits, equity resources or "non- directed" rediscount lines were to be arranged freely between banks and customers. Besides these, all transactions under "directed" rediscount lines would maintain their relative differences but they would take as their reference the interest rate shown by a survey of free deposit rates paid by the financial institutions ("financial index"). Thus, rates of 1.5% to 2.5% monthly were set over the survey rate, explaining the virtual elimination of subsidies afforded by rediscount operations. Additionally, the deposit insu,:ance system was expanded to make it more comprehensive. While its partial character was retained, the system now protected all deposits, in the following proportions: - Demand and term deposits: 100% up to A 20,000, or 99% in the case of legal persons; 75% for amounts in excess of A 20,000, up to A 50,000; 50% for amounts in excess of A 50,000, up to A 100,000; and - Current account deposits: 100% up to A 100,000, or 99% for legal persons. Reduction of Reserve Requirements The Government's policy for this area is to keep incremental remunerated and unremunerated reserve requirements low so as to reduce gradually average reserve requirements to levels that permit growing financing of private sector activities. In October 1986, the Government introduced a significant reform in this direction by eliminating incremental remunerated reserve requirements on free deposits and reducing incremental unremunerated reserve requirements for these same deposits to levels between 0% and 3%, depending on their maturities. In this way, during the last quarter of 1986, the institutionalized financial system handled operations for A 1,500 million--28% of the volume of deposits at the free rate as of the end of September of that year--which had been channeled until that time through non-institutionalized financial circuits. This criterion was extended to all incremental term deposits effective with the reform of October 15, 1987 that eliminated regulated deposits. The objective of enhancing the ability to compete of the institutionalized financial system implies giving a privileged posit'on to open market operations as a tool for short-term monetary control so that additional reserve requirements--even remunerated--would not be needed. It is for this reason that, compared with the preceding period, the Central Bank stepped up during the last year its use of open market instruments as a monetary absorption mechanism, particularly through - 46 - ANNEX V Page 6 of 11 operations involving public securities issued by the National freasury. Nevertheless, the development of open market operations has still not reached a magnitude that guarantees attainment of periodic monetary goals and for this reason, in 1987, the Central Bank had to place additional temporary reserve requirements on the free segment of 4eposits. However, their magnitude has been held to a minimum both in quantitative terms and in terms of length of time so that, during the period January-December 1987, the simple monthly average Lf additional reserve requirements was 1.9 percentage points. The marked seasonality of money demand by the public is another factor which prevents the use of open market operations as the only instrument to secure short-term monetary equilibrium. For this reason, it will be necessary to continue imposing marginal reserve requirements even though the Central Bank will avoid any permanent increase in legal reserve requirements on deposits, thereby limiting in magnitude and time the impact that these compulsory requirements have on the supply of credit and banking financial costs. It is thought that in no month will these exceed five percentage points. Besides this, the great dispersion brought about by the uneven distribution of rediscounts and reserve requirements has led to substantial differences in the efforts required of the different financial institutions in connection with their nonvoluntary investments in the Central Bank. The Central Bank, as part of its efforts to deregulate financial intermediation, established a mechanism by which it freed forced investments of institutions where the implicit reserve requirements took on particularly high values. Forced Investments in the Central Bank of the Republic of Argentina Under the October 1986 reform, remunerated reserve requirements were replaced by a forced investment ("Deposito Indisponible") that was equivalent from the monetary standpoint and one whose performance is independent of changes in financial system deposits. On that occasion, neither the maturity nor the liquidity characteristics of this forced investment were stated but it was agreed that at least 15% of the monthly interest would be paid. Simultaneously, authorization was given for transfer between financial institutions of up to 15% of the investment. These conditions mean that even though this investment is adequately remunerated, maintaining the investment is not a voluntary choice for the institutions. For the same purpose, it was announced that a forced investment would be established, as part of the measures of October 15, 1987, to absorb all the remunerated reserve requirements put up by the financial institutions in the regulated and free segments of the pre-existing financial market. This forced investment--unlike previous ones--would have a determined maturity and better conditions of liquidity. The amortization would be defined as a function of the outlook for net recovery of the credits granted by the Central Bank and the general situation of the economy while the improvement in liquidity conditions would depend on increases in transferability of the investment and determination of maturity. - 47 - ANNEX V Page 7 of 11 Reduction of Central Bank Credit Activity The Argentine economy has certain economic activities whose financii.g is particularly troublesome under current conditions. Activities such an the housing supply, regional productive activities that are seasonal in nature, certain types of exports for which financing is a critical component of their ability to compete, and certain investments all have in common high requirements of financial resources at longer terms than those available in the Argentine financial market today and at real interest rates lower than the current. It is very difficult for this type of activity to be serviced adequately by the financial market and therefore, it is natural to think that the state ought to contribute under present circumstances to improve their chances of competing or subsisting until such time as the long-term capital markets rebuild themselves in a stable economy. The official banking system, the Central Bank included, has traditionally allocated the financial resources that the state has made available for this purpose. However, the magnitude that these activities have attained has made it necessary to place numerous regulations on financial intermediation, thus significantly limiting the lending capacity of the private system. In addition, the magnitude of thepe activities has resulted in heavy Central Bank losses, which in general terms do not have a different impact than that generated by public spending. As a consequence of thv concerns arising from this situation, in February 1987, the President of the Central Bank announced to the Budget Committee of the Chamber of Deputies of the Nation the formulation of a rediscount progr&m for 1987 which would lead to reductions in credit assistance from the Central Bank compared with that of previous years and, in turn, to the exercise of adequate control over the volume and use of that assistance. Although the rediscount program for 1987 was not totally complied with, the Central Bank has continued working to set the basis for a reduced credit assistance in the future. Special efforts have been made to solve the problem of those institutions having the largest overdrafts with -he Central Bank and to develop autonomous and stable sources of financin, for Banco Hipotecario. For the same purpose, the Board of Directors of the Central Bank is instructing financial institutions to request from their customers of new credits drawn from Central Bank resources authorization to publicize these credits so as to supplement the efforts by the Government and the Congress addressing the social awareness that is made possible by adequate information. To deregulate credit allocation and reduce the role of the Central Bank from both the standpoint of its operational disequilibrium (quasi- fiscal deficit) and the magnitude of its participation in the credit market, the Government announced in July 1987 that budget items to finance the "quasi-fiscal" spending would be included in the draft budget law and that any changes necessary in the balance sheet of the Central Bank would - 48 - ANNEX V Page 8 of 11 be made so as to bring about an adequate level of public information regarding this matter. In the next few weeks the Government will present to Congress--together with the nation's budget--a detailed program with all Central Bank rediscounts to be extended during calendar year 1988. Only rediscounts related to financial institutions' temporary liquidity problems and those associated with external credit lines will be excluded. The Government thinks that the efforts described above will gradually establish the control channels necessary so that the credit activity of the Central Bank will recognize the real magnitude of the budget limitations that are currently faced. The Government will start a program aimed at cancelling Central Bank rediscounts by applying to these rediscounts equal amounts of forced investments that financial institutions have in the Central Bank. During 1988, as a first step, the Central Bank will cancel at least 15% of the rediscounts outstanding as of December 31, 1987 (approximately A 3.3 billion). The Government also aims at achieving and maintaining a negative flow of Central Bank rediscounts during 1988, so that during that year total new rediscounts extended shall be less than total repayments or other recoveries of previously extended rediscounts. Furthermore, to ensure that the rediscount reduction program is carried out, the Central Bank will require the banking institutions that incurred continuous overdrafts during 1987 to submit to it action plans providing for specific policies, actions and measures to enable such banks to repay their overdrafts and to adjust to the reduced availability of Central Bank rediscounts. Improved Regulation of the Financial System The Government has made significant advances (intervention, liquidation and merger) in solving the problems associated with insolvent private banking institutions. To continue advancing with this effort, a strict policy will be applied in the area of loan portfolio classification, reserves (provisions) for possible loan losses, credit concentration in related firms, accrual of interest on nonperforming credits, valuation of fixed assets and compliance with minimum capital requirements. The work of bank supe-vision will be stepped up and the amount of public information on the financial condition of each institution will be increased. To this end, the Central Bank is interested in the technical assistance program that accompanies the World Bank loan that is requested. The emphasis of the supervision work will be on reviewing the quality of the loan portfolio and the oNerall financial condition of the intermediaries. To do this, new groups of inspectors will be established with specializations in specific areas (with emphasis on loan portfolio classification according to risk of default), and advanced instruction courses will be given on the characteristics and performance of firms and banking activity. These courses will be given by high-level academic professionals with proven working experience in these fields. The decisions that are being carried out cover the following matters: - 49 -ANNEX V Page 9 of 11 (a) Forms and Other Information Required by t.: Central Bank (i) the information contained in several forms that financial institutions now remit to the Central Bank is being replaced and rationalized as part of an information, control and inspection project planned for gradual implementation; and (ii) the data that have been received on main debtors will be used to implement a centralized debtors data base (Central de (b) Minimum CaRital Requirements. Minimum capital requirements have already been increased to reflect the effects of inflation. Financial institutions must gradually adjust their capital base so that by December 1989 they are in full compliance with .his new requirement. It is the policy of the Government to continue to adjust minimum capital requirements taking into account the effects of inflation. (c) Loan Portfolio Classification. Reserves for Loan Losses. and Interest Accruals. It is the decision of the Government to improve its system of loan portfolio classification according to risk of default, covering both the current and the past-due portfolio. It is also its decision to require financial institu,ions to maintain enough reserves to cover potential loal losses as reflected by the loan portfolio classification system. Similarly, financial institutions should not reflect as income the interest rate (in real terms) accrued on loans either that have been past due over 90 days or that have a high risk of default associated with them. To advance in the implementation of these policies, the Central Bank has recently issued regulations providing for a moze precise system of loan portfolio classification, and more restrictive policies on loan loss reserves and interest accruals. (d) Valuation of Fixed Assets. In this respect the Central Bank will increase its efforts to ensure that financial institutions reflect in their asscts the real market value of fixed assets and other real estate, as provided by the current regulations. (e) Information Disclosure. To increase transparency and confidence in the financial market, the Central Bank will formally inform all financial institutions that it will expand the publication of their financial statements by including information on their statements of income and expenses in its bulletin entitled "Estado de las Entidades Financieras." This information will be published at least on a semiannual basis, and will start with the June 1989 issue. The Central Bank is also in the process of redesigning its balance sheet to increase information to the public on its own financial statements, especially with regard to the different rediscount lines. - 50 - - 50 -ANNEX V Page 10 of 11 Reform of Public Banks It is essential to adopt measures useful in rationalizing the operation of public banks. Over the medium term, the Government expects that official national banks will enhance their capacity to serve the financing needs of agriculture, industry, housing and foreign trade, thereby getting back to their specialties and adapting their operations through basic modifications for this purpose. The objectives of this sectoral reform are to return these establishments to the specialties they had when they were started because these specialties have been undermined by the financial reforms of the latter years of the 1970s. These institutions would be given the resources appropriate to their specific purpose in terms of time, amounts and rates. Efforts will be made to bring about effective application of operating independence for each financial institution and to encourage national official banks to play their role as second-tier institutions which has not been adequately developed to this time. The role and area of operations for each of the official national banks were made public on July 20, 1987, by the Minister of Finance. In this respect, progress continues to be made in the efforts to recapitalize BANADE, revise its bylaws, and increase its second-tier operations. Rehabilitation and Liquidation of Problem Banks To bring about more efficient management of financial institutions having solvency problems and to make liquidation procedures more flexible and expeditious, the Central Bank is now preparing a draft law to establish an autonomous entity which shall: (i) administer and implement the restructuring or liquidation of insolvent financial institutions, and (ii) guarantee or insure small-sized deposits. This entity would be financed by fees from participating institutions, complemented, if required, by advances from the Central Bank. The entity would be entitled to perform a wide gamut of activities to rehabilitate or liquidate banks with a view to minimizing costs. Rehabilitation activities would include lending, purchase of assets, and recapitalization. In the latter case, existing shareholders would lose their invested capital and control of the institution. Until establishment of this entity, the Central Bank will implement and maintain in effect adequate procedures and measures for the restructuring or liquidation of insolvent financial institutions. These procedures and measures will be consistent with the draft law now under preparation. In drafting the law, consideration will be given to Argentina's experience as well as those of other countries that have gone through similar processes. At the same time, the work of privatizing administration and selling the loan portfolios of failed financial institutions has been started with the purpose of accelerating their liquidation and minimizing costs. Awards will be made under the public competitive bidding system. The first such award has been made to a private bank. Similarly, the -ANNEX V Page 11 of 11 mechanism for selling branches of failed institutions has been streamlined and 50 branches of recently failed institutions were sold last December. In consideration of the reforms that have already been adopted for the financial sector and those that are expected to be adopted in the near future, as described here, the Government of the Argentine Republic would appreciate it if you were to give favorable consideration to this request for a Banking Sector Loan. We hope to continue an exchange of ideas with the World Bank in this area and to discuss in the near future the progress made in implementing the financial reforms proposed. Sincerely yours, Jose Luis Machinea Juan Vital Sourrouille President, Central Bank of the Minister of Economy of the Argentine Republic Argentine Republic ARGENTINA - BANKING SECTOR LOAN POLICY MATRIx OBJECTIVES ISSUES ACTIONS ALREADY TAXEN ACTIONS TO BE TAKEN TIMING 1. Increasing a) Low level of deposit a) Complete elimination of confidence and mobilization controls on savings and deposit time deposit interest mobilisation rates (October 1987) b) Need to force banks to show b) Enactment of stringent b) Enactment of a new regulation b) Loan effectiveness their real financial regulations on: establishing a revised syste of condition in their loan las provisions to cover more financial statements, thus (1) loan portfolio adequately the risk of default forcing problem banks to classification associated with each loan restructure or exit the according to risk of market default (2) interest accruals on problem loans (including past due loans) c) Slow and costly solution of c) Deposit insurance c) Establismbent of an autonomous c) Draft law sent to the both the overdimension and coverage for all small Deposit Insurance Corporation for bank for comnts by the widespread solvency deposits the rehabilitation of problem banks May 11, 1968 end problem affecting the that are financiaily viable or the suittod to Congress banking system liquidation of non-viable by seco tranche institutions release d) Inability of the banking d) Technical assistance to strengthen d) Technical asaistance superintendency to take the banking superintendency's to start as of loan timely actions to stop capabilities on both credit risk effectiveness unsound financial prac- AcAloSva and assessment of the tices or, when necessary, overall financial condition of to force insolvent insti- banking institutions tutiions to exit the market at an early stage of insolvency a) Lack of public disclosure a) The Central Bank has e) The Central Bank will formaily ) Second tranche on the finsncial condition already instructed all comeunicane to all financial of bnki g institutions banking institutions to institutions that it will publish keep at their premises their respective finncial information on their statements, including balance sheets assets and liabilities, and detailed statements of income, loans to related parties, semisnnually in its monthly min shareholders, bulletin, such publication to members of the Board of comnnce with the June 1989 issue Directors, and external auditors a e) Te CetralBan vil forall OBJECTIVES SSUES ACTIOS ALREADY TWEN ACTIONS TO AE TAKEN TIMING f) Year by domestic agents to f) Monetary and fiscal policies f) Loan effectiveness hold domestic deposits consistent with lover rates of and second tranche because of the risk of high inflation. Maintenance of a release and variable rates of realistic exchange rate inflation and abrupt devaluations of the domestic currency 2. Improving a) Reduced banking system's a) In September 1986. credit discretionary lending reserve requiremeuts allocation (RRs) on Lncremental free deposits were lowered from 7.51 to 31 (or less depending on deposit maturity). Similarly, forced investments (FIs) on incremental free deposits were lowered from 522 to zero. In October 1987, these lover RRs were expanded to all incremental deposits b) Large Central Bank b) As a result of the b) Rationalization o! Central Bank intervention in credit October 1987 reform that rediscounts, including the following allocation eliminated regulated masures: deposits, 501 of CBA rediscounts that (1) The Central Bank will cancel/ b) (1) Loan effective- previously had an consolidate an amount of redis- ness and second interest rate based on counts equal to at least 151 of tranche release the regulated deposit the rediscounts outstanding as rate now have an interest of December 31, 1987, by apply- rate based on free market ing to these rediscounts an deposits. (The estimated equivalent amount of forced average interest rate to investments. Rediscounts to be charged by CBA to institutions now under Liquida- financial institutions in tion and those extended to cur- the 1988 rediscount rently operating institutions to program is 9.12 per year support specific restructuring in real terms) plans are excluded from this consolidation process (2) The net flow of rediscounts (new b) (2) Loan effective- rediscounts less recoveries) for ness and second 1988 has to be negative. (The tranche release Central Bank will provide the Bank with the rediscount program for 1988 before loan effective- ness). Rediscounts to support a institutions facing liquidity problems or specific restructur- Ing plans as well as those asso- ciated with external lines of U credit are excluded from this calculation MgISSUIS ACTIONS ALREADY TAKEN ACTIONS TO BE TAKEN TMIG (3) All Central Bank rediscounts to b) (3) Loan effective- be extended during calendar year ass 1988 (with the same exceptions mentioned in b)(2) above) will be presented to Congress, together with the nacion's budget 3. Reducing the a) Bigh pressure on interest a) New taxes and higher a) Reduction in the consolidated public a) Second tranch& cost of credit rates posed by domestic public utility rates sector deficit from the 1987 level. release financing requirements of (October 1987) (The October 1987 fiscal package is large public sector expected to reduce the consolidated deficits public sector deficit from an estimated 7 of GDP in 1987 to an estimated 41 of GDP in 1988) b) Deteriorated financial b) Starting November 1987, b) Action plans for the eight banking b) The Central Bank condition of several public provincial banks incur- institutions that had the largest shall request the banks ring new overdrafts in overdrafts xn their Central Bank action plans by their Central bank accounts during calendar year 1987 Nay 31. 1988. and accounts will automati- shall submit them to cally Im: excluded from the Bank by the clearinghouse. August 31, 1988. Elimination of AIMADE's Satisfactory progress access to short-term in the Implementation deposits as a way to of such plans by further its second-tier second tranche operations release c) Large Central Sank losses c) Substantial reduction in associated with the the staffing and fixed administration of failed assets of failed financial institutions financial institutions. Sale of loan portfolios to private intermediaries through public tenders * a p - 55 -ANNEX VII Page 1 of 6 pages AILGZNTIUA -BANK=IN CR MAN TZCHNI__L ASISTANCE COMP01MIT 1. The Technical Assistance Component has been specifically designed to strengthen the bank-supervising capacity of the Central Bank of Argentina (CBA). It consists of three building blocks: (i) support from consultants on specific issues, (ii) training, and (iii) purchase of computer equipment. I. Suyport from Consultints 2. The areas to be covered by consultants are: (i) on-site bank examination, including organization, procedures and reporting; and (ii) CBA organizational aspects, including both static and dynamic features, such as interaction among different departments within CBA and design of an integrated management information system (HIS) with easy access by the highest authorities at the Central Bank. A. On-Site Bank Examination 3. One of the most striking characteristics of current on-site bank examinations is the emphasis placed on controlling comp'tance with CBA reserve requirements and forced investment regulations. Though serious attention to these monetary issues may be justified in the context of the current Argentinian macroeconomic situation, overlooking the risks associated with the different assets held by banking institutions- -in particular the risks of the loan portfolio--and their overall financial condition, constitutes a serious problem. Other deficiencies of the current on-site bank examination process derive from: (i) the sparsity of the visits to the institutions, (ii) the lack of standardized reports, (iii) the lack of adequate training programs, and (iv) the lack of data and word processing equipment. 4. The consultants in charge of this area should: (i) revise current on-site examination practices to (a) redirect their emphasis towards integral financial analysis, and risk and loan portfolio evaluation, and (b) include auditing of computerized systems, (ii) design a standard on- site bank examination report, and (iii) support CBA in the preparation of a bank examination manual, providing guidelines and reviewing the final version. 5. The change in examination practices would: (i) allow for technically sound bank examinations and consequently better knowledge ot banks' true financial condition; (ii) provide the banking superintendency with an appropriate tool for controlling whether the bank under examination has been complying with CBA regulations; (iii) shorten the time devoted to each bank examination, improving examiners' efficiency, and allowing for increased frequency in the visits; and (iv) enable due auditing of banks' computerized systems. The standardization of examination reports would both make examiners' efforts more effective, and ease the superintendency's decision-making process. - 56 - Page 2 of 6 pages B. CBA Organizational Aspects 6. Argentinian laws have assigned the responsibility for banking supervision to CBA. However, CBA's organizational structure is apparently inadequate for fulfilling this function satisfactorily. In particular, (i) there are severe coordination and interaction problems among the different departments carrying on supervision tasks due to an unclear delimitation of responsibilities; and (ii) there is no top-level executive with exclusive dedication to this area. Coordination problems are especially notorious among the departments in charge of "control," "bank examination," and "regulations," to the extent that, occasionally, "control" has become aware of new regulations only days or weeks after their issuance. A different aspect relating to the dynamic functioning of CBA relates to the difficulties in the flow of information across different areas. Moreover, careful examination of the information received by different CBA departments may allow for the rationalization of the bank reporting system, with considerable reduction itt control and processing times. 7. On these bases, consulting support in the organizational area should be targeted to: (i) improve CBA's organizational structure to (a) allow for increased promptness and efficiency in dealing with banking institutions; and (b) enhance coordination among the different areas involved in this task; and (ii) rationalize the information system, including the design of an MIS of easy access by the higher authorities. II. Training 8. Strengthening CBA's supervisory ability will require special training efforts geared to both bank examiners and financial analysts. With regard to bank examiners, they should be trained in integral financial analysis, risk and loan portfolio evaluation techniques, and computerized systems auditing. The basic targets to be achieved by examiners completing the training program are to: (i) understand the importance of appropriate bank examination objectives, activities and reports; (ii) be able to perform technically adequate bank examinations: (iii) be able to produce precise, and technically sound reports; (iv) have a thorough knowledge and understanding of financial concepts and analysis, so that they are able to adequately analyze banks' financial condition; (v) understand the operational structure of a banking institution and how internal controls and audit procedures protect that structure; (vi) understand the significance of loan portfolio quality, and loan policies and management; (vii) be able to analyze the quality of a loan portfolio and the adequacy of the corresponding provisions; and (viii) be able to evaluate the quality of a bank's loan management systems. 9. Financial analysts in the "control" department use an approach that excessively emphasizes accounting aspects and past performance, with full reliance on the information received from the institutions being supervised. Less than satisfactory attention appears to be paid to unveiling the true financial condition of these institutions, and the assessment of the likely evolution of their liquidity, solvency and profitability. Adequately designed training in integral financial alysis, and, 'or the sake of completeness, risk and loan portfolio evaluation techniques, should eliminate these deficiencies. - 57 - - 57 -ANNEX VII Page 3 of 6 pages 10. Section V of this annex contains a tentative set of courses and its contents. The "integral financial analysis course" would be the same for both examiners and financial analysts. Full program completion (including systems auditing) is estimated to take about 120 hours. Actual duration will depend upon final contents. Because of the practical impossibility and inconvenience of having only one course dictated for all the 100 examiners and about 100 analysts, it is recommended that trainees be divided into groups of 25 participants each. The overall training program would therefore consist of (i) four complete sets of courses for the examiners; and (ii) four partial sets of courses (integral financial analysis, and risk and loan portfolio evaluation techniques), for the analysts. This overall program should be implemented during two consecutive years. III. Word and Data Processing Equipment 11. Strengthening banking supervision will require broadening and reinforcing the technical capacity of the corresponding CBA departments in terms of data processing equipment. Complementarily, word processing facilities are also necessary to shorten administrative processing time of the reports. 12. CBA has a central computer that is seemingly sufficient to satisfy the demands of all its departments, including the superintendency. However, the superintendency is located outside the main complex, and has no access to the main computer. CBA authorities are already working on solving this problem. A second problem faced by the superintendency is the lack of an autonomous processing capacity in the form of personal computers. Design of the co.iputer network should facilitate interaction among different departments related to bank supervision tasks, and should allow for (i) access to the central computer in the main CBA building; and (ii) autonomous processing capacity. Availability of word processing equipment in the department in charge of bank examinations would solve current bottleneck problems at the typing stage of the reports, which currently hinder their delivery on time. 13. In its current program of purchases CBA has included only 3 personal computers for the superintendency, while authorities of this department believe that 15 is a more adequate number. As stated by these authorities, personal computers are needed as follows: - 58 - Page 4 of 6 pages Area Quantity Applications DeoutZ General NanaLer 1 Access to the Financial Institutions Information System (FIS) Control Degartment Manager 1 Access to FIIS Technical Team 1 Access to FIIS; collection of data from computerized control system; operation & updating of FIIS & computerized control system Chiefs of Financial 4 Access to FIIS Analysts groups Administration Unit 1 Word processing; support tasks Verification Unit 2 Processing information on closures & rehabilitation of checking accounts Authorization Department Authorization Unit 1 Records on financial institutions' shareholders Expansion & Services Unit 1 Record of branches Bank Examination Delartment 3 Access to FIIS: word processing 14. The request for 15 personal computers seems reasonable given the type of activities and the workload in each of the areas and should be supported. IV. Estimation of Costs 15. Consultants' time devoted to the areas of on-site bank examination and CBA organizational structure is estimated as eight weeks per task. With estimated fees of about US$800 per day, a per diem of US$150, and travel expenses of US$3,000 per trip (with two trips per consulting job), the total budget for consultants comes up to approximately US$120,000. 16. Training costs are difficult to assess at this stage since decisions need to be made as to (i) who is going to be in charge of the courses, i.e., local or foreign instructors; (ii) final outlines; and (iii) location. As designed, the training program would require nearly 850 instructor/hours per year, or 1,700 hours in total. Assuming hourly fees of US$100, the total budget for training fees would be US$170,000. Additionally, training courses should be under the joint supervision of the -59 - A Page 5 of 6 pages Bank and an external advisor--a specialist in supervision of international reputation- -who would visit Argentina for two weeks each year to discuss programs, and focus on the courses with the appointed instructors, and to give four talks on matters related to the course. Assuming daily fees of US-800, a per diem of US$150, and total travelling costs of US$6,000 (US$3,000 per trip), the total budget for the external advisor would be approximately US$33,000. The resulting total trainina budget would be US$203,000. 17. Finally, Dersonal comouter prices will 6epend upon what the Argentinian experts decide should be the make, type, etc. Assuming an average price of US$8,000 per personal computer, the total budget for purchase of such equipment amounts to US$120,000. 18. Estimated consultants' fees, training fees, and computer purchases should not exceed an equivalent of US$500,000. V. Training Program: Tentative Evaluation Techniaues A. Risk and Loan Portfolio Evaluation Techniaues - Introduction - Sample selection systems - Statistical sampling - Internal control evaluation - Working papers - Audit environment - Bank examination planning and objectives - Risk and Loan Portfolio Analysis - Global credit risk evaluation - Introduction to credit - Types and terms of loans - Functions of the Credit Department - Credit file documentation - Loan policies - Loan administration - Problems in lending - Loan clasLification techniques - Provisions for potential loan losses - Problem loan restructuring - Renegotiated and workout loans - Bankruptcy - Examination Report - Objective - Contents - Facts - Analysis - Examiner's comments - Conclusions - 60 - 60 - ANNEX VII Page 6 of 6 pages B. Integral Financial Analysis - Accounting regulations - Analysis of balance sheet and profit and loss statements - Ratio analysis - Cash flow analysis - The CAMEL system - Uniform bank performance report C. Computerised Systems Evaluation and Auditing - Data processing systems - Analysis of internal controls - Programs application tests - Auditing through micro-computers and main-frames - Application controls - Data test techniques - Conclusions