Colombia - Financial Markets Development Project

Document of The World Bank Report No. T-7135-CO TECHNICAL ANNEX COLOMBIA FINANCIAL MARKETS DEVELOPMENT PROJECT May 28, 1997  CURRENCY EQUIVALENTS (Exchange Rate Effective February 1997) Currency Unit = Pesos ($) US$1.00 = $1,075 $ 1.00 = US$0.001 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AND ACRONYMS BANCOLDEX - Export-Import Bank of Colombia BR - Banco de la Republica (Central Bank) CAS - Country Assistance Strategy CONPES - National Council for Economic and Social Policy DANCOOP - National Department of Cooperatives DPPC - Promotion of Competition Vicepresidency DNP - Departamento Nacional de Planeaci6n FINDETER - Financial Corporation for Territorial Development GDP - Gross Domestic Product GOC - Government of Colombia ICETEX - Institute for Financing of Higher Education ICB - International Competitive Bidding ICR - Implementation Completion Report IFI - Institute for Industrial Development ISS - Instituto de Seguros Sociales (Social Security Institute) MHCP - Ministry of Finance and Public Credit PCD - Public Credit Directorate, Ministry of Finance PCU - Project Coordination Unit SES - Superintendency of Cooperatives (to be created) SB - Superintendencia Bancaria (Banking Superintendency) SIC - Superintendency of Industry and Commerce SOE - Statement of Expenditures SV - Superintendency of Securities TA - Technical Assistance TES - Titulos de Tesoreria (Treasury Securities) UIIF - Unidad de Informaci6n e Inteligencia Financiera (Financial Intelligence and Information Unit) VT - Viceministerio Tecnico (Technical Viceministry of Finance) Vice President S. J. Burki Director P. Isenman Division Chief K. Challa Task Manager A. Jaime  COLOMBIA FINANCIAL MARKETS DEVELOPMENT PROJECT TECHNICAL ANNEX I. Background 1. Since the late eighties, Colombia has embarked upon a program of economic reforms aimed at improving resource allocation by liberalizing domestic markets and opening the economy to competition and opportunities in the international markets. To complement the reforms in the trade, industrial and agricultural sectors, the Government has also undertaken an extensive reshaping of the financial sector. 2. Most of the earlier initiatives in the financial sector focused on the financial intermediation system, which has traditionally been the major source of financing and where the most urgent issues were concentrated due to the banking crisis of the mid eighties and the subsequent nationalization of many financial institutions. These initiatives included the liberalization of interest rates, phasing out of credit subsidies and forced investments, reduction of segmentation in the financial system, reduction in the role of public financial institutions, an increase in the autonomy of the Central Bank and improvements in banking supervision. As a result of these sustained efforts, the banking sector recovered from the crisis of the eighties and has since consolidated its strength and stability of its operation under a much improved supervision regime. 3. Despite these achievements in the financial intermediation sector, capital markets in Colombia have remained small and rudimentary as companies have traditionally preferred to use the financial intermediation sector. Though Colombia has three stock exchanges - in Bogota, Medellin and Cali - there is a very limited supply of securities due to several policy and market inefficiencies. The shallowness of capital markets development in Colombia has deprived domestic industry of efficient financial instruments and has also contributed to higher interest rate spreads in the banking sector because of limited competition from the capital markets. 4. The Government of Colombia appreciates the importance of well functioning capital markets, and in 1995 appointed a high level commission to make recommendations on measures to develop capital markets. The recommendations of this Commission', which were based on analytical work carried out by capital markets specialists with the assistance of the World Bank, have been a major input in guiding Government policy for capital markets development. This project is designed to support the implementation of these initiatives. The final report of the Mision de Estudios del Mercado de Capitales was presented in July 1996. The work of this Commission was supported by a PHRD project preparation grant.  2 II. Financial Markets in Colombia 5. The Colombian financial system comprises of a large number of institutions, with the primary actors being - 32 commercial banks that represent 51.2% of the assets of the financial system, 25 Development Finance Corporations (21 private and 4 public) providing credit for productive enterprises representing 13% of the assets of the financial system, 75 Commercial Finance Companies for trade and consumer credit and leasing with 10.6% of the assets of the financial system, 9 Savings and Loans Corporations which are specialized mortgage lending institutions and represent 22.1% of the assets of the financial system. In addition, there are also credit cooperatives, deposit warehouses, fiduciary companies and investment, mutual and pension funds systems. Since 1994, pension funds have grown and represent a much larger percentage of the financial system. 6. Traditionally, financial intermediation has been the primary form of financing in the Colombian markets. Substantive policy reform and strengthened banking supervision after the banking crisis of the mid 1980s helped the banking sector regain its strength and stability. A World Bank study undertaken in the early nineties2 identified the main outstanding issue in this sector to be ones of efficiency and competitiveness with continued high financial margins and large variances in interest rates. The main sources of these problems were identified to be a combination of high quasi-fiscal burden of reserve requirements, mandated investments and a low level of competition in the markets. Since this study was undertaken, Government has taken several steps to reduce significantly the reserve requirements and the pattern of mandated investments. It has also taken steps to reduce the level of public sector intervention in the banking sector by privatizing banks and other financial institutions and by taking the decision to restructure public sector financial institutions, such as the Banco de Comercio Exterior de Colombia (BANCOLDEX) , Financiera de Desarrollo Territorial (FINDETER) and the Instituto de Fomento Industrial (IFI), into second tier banks providing rediscount facilities to first tier private sector institutions. The restructuring of the latter two is being supported through World Bank projects3. In addition, the Government has also undertaken steps to improve the regulatory framework, including competition policy, and supervision capacity within the banking sector. These are discussed further below. Financial Markets4 7. Financial markets in Colombia in contrast, remain small, highly concentrated and illiquid - characteristics not dissimilar to other emerging economies. The capital market in Colombia has languished since the sixties, even though Colombia had the benefit of relatively low and stable inflation rates compared to other countries in Latin America. 2Colombia: Financial Sector Reform, Green cover report, World Bank, 1992. 3 The restructuring of FINDETER is being supported through Loan 3336-CO (Municipal Development Project) and is being undertaken jointly with the IDB. The restructuring of IFI is being supported through Loan 3449-CO (IFI Restructuring and Divestiture Project). 4 Comprehensive analysis of the financial sector and the financial markets are available in the two reports mentioned in footnotes 1 and 2. These reports are available in the project files.  3 Since the early nineties, many financial market indicators have shown an upturn, except for a decline in 1995. * Size of the Market: Capital markets in Colombia have been historically small. Over 1986-1993, average market capitalization on the Colombian markets was only 7% of GDP, comparable to Argentina, Indonesia and Nigeria, but well below the new industrialized countries like Hong Kong, Malaysia, Singapore and Chile with similar ratios greater than 100%. Since the early nineties, however, the markets have shown a substantial increase due to an increase in prices and number of listed companies. In 1996, the stock market capitalization had recovered to grow to US$ 15.35 billion or nearly 21% of GDP. The number of listed companies, which had languished during the eighties and the early nineties, also began to increase in 1993 and reached 440 in 1996. Nevertheless, the annual increase in the number of listed companies of 5.6% per annum over 1989-94 was very low compared to other emerging economies such as Indonesia and Turkey (about 35%) 5. * Concentration: Concentration indices for the Colombian stock market, measured as the share of the ten largest stock in market capitalization, have been among the highest in the world. During 1986-1993, the ten largest stock represented 74% of the market capitalization, while the value of the same index in the US and Japan was between 14-19%. A high degree of concentration, however, is typical of most small and emerging markets. Lately, there are encouraging signs that in Colombia, as well, market concentration numbers have begun to decline. In 1994, the value of this index was 61.2%. However, this level is still high compared to other emerging markets in the region, all of which share similar characteristic - Argentina (47.5%), Chile (39.9%), Mexico (36.5%). The market transaction concentration index as measured by the transactions of the 10 principal companies to total transactions however remained between 65% and 80% in each of the three Colombian stock markets (Misi6n report). * Liquidity: Transactions as a percentage of the GDP, have increased significantly in the last five years, with stock transactions rising by 47%. Nevertheless, at 5.19% of GDP for total securities transactions and 2.1% of the GDP for equity transactions, the Colombian capital market remains highly illiquid. In contrast, equity transactions as a percentage of the GDP are close to 45% in Japan, Malaysia and Singapore (Misi6n report). Another indicator of market liquidity is the turnover ratio or total value traded divided by average market capitalization for the year. In Colombia, this was a low 7%, comparing poorly to other countries in the region like Peru (39%), Mexico (33%), Jamaica (21%), Chile (15%), and Venezuela (9.8%) 6. (IFC) Factors Constraining Financial Markets in Colombia 5 Source: Report of Misi6n de Estudios del Mercado de Capitales 6 Source: IFC - Emerging Markets Database  4 8. The key feature constraining the growth of financial markets in Colombia has been a paucity of supply of securities, particularly from companies in the real sector. Demand for securities, on the other hand has been robust and rising exponentially, as the Government privatized large parts of the pension and the severance payments systems in the early nineties unleashing a large potential demand for securities. 9. The Supply of Securities: Constraining Factors Some of the factors constraining the supply of securities have been macroeconomic. A decline in savings and high interest rates in the seventies and the eighties led to a general decline in investment expenditures and reduced the need for the companies to go to the financial markets. In addition, the former trade and market restriction policies provided considerable protection to domestic companies, again reducing their need for investments to modernize or expand. 10. Other factors, however, relate specifically to policy and market inefficiencies that have led companies to favor financing through commercial banks and other financial intermediation agencies over the capital markets. A large number of public sector institutions had offered directed credit at rates substantially lower than those available in the capital markets. This bias was compounded by a tax policy regime that provided a more favorable tax treatment to debt over equity. Regulatory provisions such as very high norms about minimum quorums required for corporate decisions have reduced the incentive of companies to make public offerings of shares as they have feared deadlock in decision making. Another factor constraining underwriting activities and liquidity in the secondary market has been the underdevelopment of market infrastructure, such as adequate intermediation services. This is attributable, inter alia, to weak capitalization of intermediaries, lack of regulatory framework for own account operations and market making activities and, in the past, fixed bands for commissions on transactions. Nor have there been adequate market services such as custody, clearing and settlement systems, rating of securities, inter-connection and cross listing across the exchanges, all of which translate into increased transaction costs. 11. The practice of mandated high reserve requirements and forced placement of government securities has also hindered the development of a market for public securities. In other countries, treasury bonds and bonds issued by other government agencies such as municipal bonds have been an important instrument for increasing the size, term and liquidity of domestic capital markets and establishing a yield curve for reference in other transactions. As these are relatively secure investments, their introduction and well functioning securities markets is likely to attract new players initially into the market for public securities and progressively into private securities. 12. Another set of reasons that has constrained the growth of capital markets has been the lack of a full regulatory framework to meet the needs of a changing financial market and the introduction of new and specialized instruments. In 1991, the Government established a Superintendency of Securities (SV) which has rapidly moved to develop its institutional capacity and to promote capital markets development. Nevertheless, its institutional capacity and the regulatory framework for the securities markets is still under development. Recently, securitization, venture capital funds, new instruments to finance  5 housing leasing schemes such as have been introduced in Chile, are some examples that have been specifically cited where the absence of a regulatory framework has been constraining market development. 13. Actions Taken By The Government To Promote Financial Markets. The overall policy thrust of the Government harbors well for the growth and development of the capital markets in Colombia. Recent Government initiatives in opening up the economy to competition, privatizing the financial intermediation sector, reducing restrictions on foreign participation in the financial market and the establishment of privately managed severance payments and pension funds are all factors that will contribute to the long term development of the financial markets in Colombia. In addition, the Government's policy and increasing momentum of private investments in large infrastructure projects will also provide a positive impetus to the growth in the size and deconcentration of the markets. 14. The Government has also undertaken a policy direction in the financial sector to significantly reduce the level of government intervention and state participation by virtually eliminating mandated investments, reducing reserve requirements to minimal levels and by reducing the total participation of the public sector in the financial sector from 50% of all assets in early 90s to less than 22% by 1995. Even within the remaining public sector financial intermediaries, the Government is restructuring agencies such as BANCOLDEX, IFI and FINDETER into rediscounting second tier banks that would participate in the markets only through first tier private sector institutions. 15. In addition, the Government has already undertaken several measures to address specific issues that have constrained capital markets development. These include reforms in the tax code to eliminate double taxation of dividends, elimination of property taxation of stock holdings, elimination of tax deductibility of inflation component of interest payments, and other biases against participation in the capital markets, simplification of norms and rules regarding participation in the financial markets through subsidiary companies, provision of tax exemptions to certain funds investing in securities, removal of floors and ceilings on commission charged by brokers, reform of the commercial code to introduce preferential shares without voting requirements, reduction of voting quorum for certain types of decision making and upgrading of information disclosure requirements. Some of the specific actions taken by the Government are detailed in Box 1.  Box 1: Recent Measures Taken by the Govemment for Financial Markets DeveloDment Policy Area Effects on Financial Market Effects on the Stock Markets Tax Policy Gradual elimination of the deductibility of the inflationary component of Gradual leveling of the income tax applicable to publicly traded interest payments. companies and the elimination of double taxation of dividends. Elimination of property tax for stock ownership. The income obtained from capital gains is not imposed with an income tax or a windfall gain tax. Provision of income tax exemption and other complementary exemptions to investment funds, severance payment funds, pension funds and securities funds. (Decree 1321 of 1989 and Law 49 of 1990). Financial legislation Law 45 of 1990 sought to promote the transition from a scheme of Authorization for financial intermediaries to undertake activities specialized banks to one of banks with subsidiaries with the objective of different from banking tuough their subsidiaries, including improving the efficiency of the system. It also fixed the minimum intermediation of securities, thus increasing the types of entities that can capital requirements for the formation of different types of financial participate in the broker-dealer business. Also, expansion of the scope O entities, facilitated the transformation across different types of of activities for brokerage finns. (Law 45 of 1990). intermediaries, eliminated restrictions on foreign investment in banks and opened the door for foreign investment in acquiring up to 100% of stock capital of national financial entities. Prudential Regulation Establishment of prudential nonus for capital adequacy based on risk- The Financial Reform included certain monetary sanctions and civil weighted assets. Required entities to get their portfolio classified every actions against the use of privileged information. From 1991, six months according to five categories. Imposition of limits on regulations were introduced for the participation of rating agencies in individual credit exposure and establishment of new nonns for valuing the financial market. investments with market pricing (marked to market). Introduction of new Based on the opportunities opened by the new legislation, many The introduction of new agents in the market, in particular the creation agents financial intermediaries undertook investments in related financial of severance payment funds, pension funds and foreign investment funds businesses that provide complementary financial services, such as has contributed to strengthening the demand for securities in the capital fiduciary (trst) societies, pension and severance payment funds, and market. brokerage firms. Creation of new Introduction of preferential shares (without voting rights) to address the  instriments concerns of major shareholders about dilution of corporate control Creation of a regulatory framework for securitization of assets. Design of a structure for the operation of a second-tier market. Privatization Privatization of financial intermediaries to reduce public participation in A large part of the privatizations were undertaken through auctions and the financial sector from 50% of the assets of the sector at the beginning realized USS 660 million leading to an increase in the number of stock of the nineties to 22% by 1995. transactions. More privatizations and the new policy of private participation in infrastructure projects will contribute to the continued growth in the size, liquidity and deconcentration of the stock markets. Reform of the With regard to information disclosure requirements, the existing biases Commercial Code against publicly listed companies were elininated. Quorum requirements for decision making were revised to require only a simple majority of shareholders Regarding distribution of profits, only 51% majority needed if more than 50% of the profits are to be distributed. For the decision to distribute less than 50% of the profits, a higher majority of 78% of votes is required. (Law 222 of 'I 995). Source: Final Report of the Commission for the Development of Capital Markets, 1996.  8 16. With regard to the development of the market for public securities, Law 31 of 1992 mandates that as of 1999, the Central Bank will fully substitute the bonds issued for less than one year with treasury bonds issued by the Government - Tiuulos de Tesoreria (TES). This would create a single sovereign instrument, reducing the segmentation in the market for public securities and eliminating the inefficient competition between these two sovereign instruments. The development of a market in public securities is also being aided by the elimination in the mandated placements of such bonds with official agencies. The recent decentralization initiative that has transferred responsibility for infrastructure and social sectors to departments and municipalities also represents an opportunity for deepening of capital markets through bonds issued by these entities. Some sub-sovereign entities such as the city of Bogota and the Department of Guajira have already begun the process of issuing bonds on their own account, on both the international and (primarily) on the domestic market. 17. The Demand for Securities- Pension Reform Though the supply of securities has lagged in the Colombian markets, demand for securities has increased substantially in the past decade with the approval of foreign investment funds, the repatriation of capital by Colombian nationals and the liberalization of the insurance sector. The demand for securities received another significant boost with the creation of a system of privately managed severance payment funds (Cesantiafondos) and the pension reform of 1993. In 1992, a system of privately managed severance funds was established and in 1993, Congress passed a law that has established the framework for privately managed, compulsory defined-contribution pension funds. 18. The main thrust of the pension reform of 1993 is a change from the pay-as-you-go system to a filly funded one and the introduction of competitive pressures with the co- existence of private and public sector pension funds actively managing the savings of their members. Privately managed pension funds were created in parallel with the existing public sector agency Social Security Institute (Instituto de Seguro Social (1SS)) with individuals having a choice of which institution is to manage their pension fund account. For all affiliates of the old pension system, their former pension management entity ("caja") is obliged by law to transfer the equivalent of its accrued pension liabilities to their affiliates, earned during their past years of service, to the new pension fund chosen by them. Subsequent pension contributions bv individuals go directly into their newly chosen pension funds. 19. As these reforms deepen, it is estimated that the total resources of the institutional investors such as pension funds, severance payments funds, insurance companies and mutual funds, will increase from 3.7% of GDP in 1994 to between 9-12% of GDP by the year 2000 (as estimated by the Commission on Capital Markets). The amounts they invest in the capital markets are also expected to multiply three to four times in the same time period, significantly increasing the demand for securities - particularly those with longer maturities. Such a positive effect from private pension funds on the equity market was also experienced in Chile, where stock market capitalization has reached over 100% of GDP, up from 24% a decade ago. In addition, pension fund reform has allowed Chile to  9 be the only country in Latin America to have today a significant long term corporate bond market. 20. Competition Policy. It is widely recognized that the heritage of tariff protection, licensing, foreign investment controls, and other government policies coupled with the relative small size of the domestic market led to high levels of industry concentration in Colombia. The lack of effective domestic and import competition has traditionally enabled Colombian firms to engage in oligopolistic behavior. Some firms have been able to charge high prices and earn high profits while simultaneously being high cost and inefficient producers. Potential efficiencies and economies of scale have not been adequately exploited. In addition to high levels of industry concentration, the Colombian economy is also characterized by high levels of ownership concentration and conglomeration among financial and industrial enterprises. 21. Although competition policy in Colombia has existed dejure since 1959 with the passage of Law 155, that has not been the case in practice, as until very recently antitrust regulation was an almost completely nonexistent function. Law 155 of 1959 determined that the Superintendency of Industry and Commerce (SIC) was to be in charge of enforcing antitrust, price controls, intellectual property rights and quality control legislation and regulations. While the purpose of the law was to promote competition, antitrust legislation was never applied nor tested. This is attributed to the extent of government regulation of industry, lack of political will, and inadequacy of the regulatory and institutional structure aimed at maintaining and encouraging competition. Thus, there is no precedent on how should antitrust cases be analyzed, prosecuted and litigated. There are no standards of proof nor clear articulated defenses. 22. The opening of the economy and the initiation of an overall deregulatory process (apertura) in the 1990s, provided the impetus to starting correcting this vacuum. As a result of it, the Government issued Decree 2153 (with the status of Decree/Law), representing a turnaround in policy direction. The Decree seeks to safeguard and promote competition with the primary objectives of improving economic efficiency and consumer welfare. Decree 2153 is the legal document underpinning the new antitrust framework of Colombia. It provides SIC with a new legal mandate, a new organization and new functions"1, and also provides some guidance on what competition policy should be. The Decree gives the mandate to SIC about all aspects of antitrust enforcement, including carrying on investigations, arranging cease and desist agreements concerning particular practices, blocking mergers, prosecuting parties on competition violations, and imposing sanctions and fines. These powers are sufficient to have deterrent and punitive impacts. 23. The Decree also establishes the SIC as a "technical agency" within the Colombian public service system, and thus autonomous from an administrative, financial and budgetary point of view. This is of great importance in avoiding political interference in the operation of antitrust enforcement; it is also useful for SIC in being able to attract high 7 As part of this restructuring, the Delegatura para la Promocion de la Competencia (DPPC) has been created to be in charge of implementing competition policies.  10 quality staff as the agency can now have a salary scale above the general civil service pay levels. Remaining Agenda for Financial Markets Development 24. Though much progress has been made, and is reflected in the improvements in the indicators of market growth and performance in recent years, considerable challenges remain before Colombia can aspire to truly modem and efficient financial markets. In particular, the remaining agenda includes: * Further reform in the legal and regulatory framework to reduce impediments to the supply ofpublic and private securities The unfinished agenda includes continued changes in the Commercial Code to reduce the disincentives for companies to go public, changes in the valuation system in the tax code to remove biases against long term securities, harmonization of the different types of securities offered in the market, upgrading and clarification of information disclosure requirements for companies and market intermediaries, improvements in interconnection and cross listing across stock exchanges within and outside the country, as well as improvements in the accounting and auditing standards. Bonds issued by sub-sovereign entities also present an opportunity for the development of a new segment of the domestic capital markets. The development of a domestic market segment for this purpose still requires agreement on accounting standards for these sub- sovereign entities and the rationalization of the tax code to take these investments properly into account. * Development of market infrastructurefor public andprivate securities to reduce transaction costs in the placement and trading of securities in the markets. These include actions to promote the emergence of specialized market makers, actions to promote an increase in the number and technical capacity of brokerage services, as well as improvements in the clearing, settlement and custody systems. The broadening and deepening of the markets for public sector securities also requires the creation of an infrastructure to stimulate both the primary and the secondary markets through the creation of market makers and underwriters ("primary dealers") who can assume own positions as well as promote a secondary market through the provision of daily quotations. * Introduction of new, state of the art instruments to meet new business needs such as those already being used in other developed and developing economies - e.g.securitization, venture capital funds, the use of derivatives, etc. In addition, the Government has also expressed an interest in developing financial instruments in the private markets for the introduction of new instruments to mobilize private participation in housing finance and educational finance. Much work needs to be done to develop the legal and regulatory framework governing the introduction of these instruments, the  11 dissemination and development of technical knowledge, development of prudential norms within financial institutions that want to participate in these as well as the development of supervision and regulatory capacity. * Further promotion of institutional investors in the market With private sector management of pension and severance payment funds, institutional investors will increasingly play a much larger role in the financial markets. Changes are needed in the regulatory framework governing different institutional investors to enable them to adjust their portfolios to a dynamic and growing market, to invest in long term securities and the new instruments being introduced in the markets and to develop their capacity to manage the portfolio risks of these instruments. * Consolidation ofpension sector reforms Another major agenda in maximizing the participation of the institutional investors is the full implementation of the changes introduced by the pension reform of 1994. While this process of transferring the pension liabilities from the Government to the private pension funds is well underway for the central government, many sub-national entities have been slower to undertake this task. In large part, this has been due to the complex technical knowledge and human resources needed to reconstruct the employment history of each employee, calculate the pension liability and issue bonds to the pension funds, as well as ensuring that the decentralized entity has been able to put in place other financial arrangements to back these obligations. To ensure the credibility of the innovative pension reform, it is important that this process be undertaken as quickly as possible. * InWroving regulation and supervision of markets to generate consumer confidence and to develop depth. This is discussed in greater detail in the section below. m. Regulation and Supervision of the Financial Sector Institutional Reform 25. The new Constitution of 1991 initiated a major reorganization process of the institutional framework for the regulation and supervision of financial markets. It established the creation of the Superintendencia de Valores (SV), and gave the Government the mandate to further reorganize the regulatory and supervisory framework through the submission to Congress of Leyes Marco (Frarnework Laws) for the Financial Sector. In this context, Law 35 and several complementary decrees with power of law have been enacted by the Government, overhauling and modernizing the institutional structure of the financial system.  12 26. Among the most fundamental reforms included in this restructuring of the institutional framework carried out by the authorities are: (i) making the Central Bank independent from Executive Branch control, and enacting a new Organic Charter for the entity; (ii) separating the responsibilities for promotion and regulation of financial markets from those of supervision and control of the markets, thus allowing a more effective undertaking of each of them; (iii) creation of the Technical Viceministry of Finance, an entity which was set up to have a broad vision of financial sector issues as well as the responsibility to generate government policies across the overall financial sector, including all areas where resources from the public are at stake, such as banking, insurance, securities markets and pension funds; (iv) overhauling the objectives, responsibilities and functions of the supervisory bodies related to financial markets. Moreover, the reform process included -- in particular for the two weakest of these agencies (the former Comision Nacional de Valores, now transformed into SV, and the SIC), upgrading of their institutional status, provision of more adequate physical resources, and the means to be able to attract quality staff through the realignment of salary scales. 27. Before this reform process, there had been overlaps ofjurisdictions and responsibilities across the agencies which lead to significant unnecessary costs both for issuers as well as market intermediaries. The overlaps implied duplication of efforts by supervisory agencies and increased costs of public offerings due to regulatory delay and inconsistent information disclosure requirements among supervisory agencies. The Government's decision to consolidate the number of regulatory institutions involved in overseeing securities markets, including the transfer of Superintendencia de Sociedades' responsibilities about overseeing issuing companies to SV, reflects the Government's commitment to enhanced supervision and greater facilitation of securities issuance. Institutional Responsibilities and Capacities 28. Subsequent to this institutional reform process, the policy, regulatory and supervisory responsibilities for financial markets in Colombia are allocated among the following major agencies: 29. Central Bank of Colombia (Banco de la Republica) is responsible for setting monetary, credit and foreign exchange policies and is an independent entity with no direct control from other branches of the Government. Prior to the reform process, it was under the authority of the executive branch. 30. Technical Vice Ministry of Finance. Created by Law 35 in 1993, this Vice Ministry is responsible for setting and implementing macroeconomic and regulatory policy on all banking, insurance and securities activities as well as on any activity involving management or investment of resources from the public. The creation of this Vice Ministry was a big improvement in pulling together the financial sector policy making functions under one entity and to separate the formulation of policy for the promotion and regulation of the financial markets from the supervision and enforcement functions, thus allowing greater focus on both areas and less conflict among them.  13 31. Th7e Superintendency of Banks (Superintendencia Bancaria (SB)) oversees all credit institutions, insurance and leasing companies, deposit warehouses, fiduciary companies and pension and severance payment funds. Substantial efforts have been put in place to strengthen the institutional capacity of SB after the banking crisis of the late eighties. In particular, SB has made considerable progress in developing expertise in prudential regulations related to portfolio classification, asset and liability management, valuation of investments with market determined prices ("mark to market"), etc. Nevertheless, SB needs continuing inputs to upgrade its institutional capacity and train its staff, especially with the increasing globalization and complexity of financial institutions and transactions. SB has decided to overhaul its organizational structure - from its present functional organization to a more client based one of multidisciplinary teams focusing, inter alia, on specific groups of entities that they supervise. As financial intermediation has become more complex and international, with banks undertaking a number of transactions through intermediaries and other members of conglomerates, SB has realized that multi-disciplinary teams focusing on specific economic groups would provide more intensive and effective supervision. Such a reorganization and change in the focus of the supervision philosophy will need to be accompanied by significant staff training. 32. Staff training is also particularly urgent and important in two areas - supervision of pension funds and the development of anti-trust regulation within the financial sector. Recently, SB has also taken over the regulation and supervision of the newly established private pension and severance payments funds systems, creating a new Delegatura (equivalent to a Vice Presidency) for this function. Staff capacity in this relatively new area, which is new both for Colombia and much of the rest of the world, is less developed and requires considerable training inputs. Another area in which the institutional capacity of SB needs to be particularly enhanced, is in the implementation of competition and anti- trust regulation in the banking sector. With the restructuring of the Superintendency of Industry and Commerce (SIC) in 1992, (see below) the responsibility for the implementation of competition policy for the banking sector was assigned to SB. However, this responsibility has not been well integrated into the operations of the agency and is not being effectively discharged by SB. If the Government's objectives of an efficient financial system are to be realized, significant efforts are needed in this area. 33. Superintendency of Securities (Superintendencia de Valores (SV)) is responsible for the supervision and inspection of stock exchanges, custody companies (depositories), clearing houses, brokers and dealers, mutual funds and some types of voluntary pension plans. It also has responsibility for authorizing public issues of securities and for maintaining the National Registry of Securities, as well as promoting the development of securities markets. Established by the 1991 Constitution, SV is a relatively new entity in a growing and diversifying market. Although predisposition of SV's top management and commitment from the Government is excellent to make SV a strong institution responsive to the needs of a modern and efficient securities market, reality still differs significantly from that desired objective. This is to be expected, since  14 SV and its staff are so new. Most of SV's staff are not only new to the institution, but relatively inexperienced in securities markets operation and supervision as well. 34. SV has considerable institution strengthening needs, especially in staff training and learning from the regulatory and supervision practices in other countries with more developed financial markets. SV also needs to develop processes and systems to put in place more pro-active supervision with market monitoring and early warning systems, and strengthen in-house capacity for financial analysis and inspection of supervised entities. Staff training is also required so that SV be able not just to follow up, but anticipate the technical developments taking place in the securities markets of both Colombia and abroad. 35. Departamento Administrativo Nacional de Cooperativas (DANCOOP) In addition to the major superintendencies outlined above, DANCOOP ( as an "Administrative Department") is responsible for the supervision and regulation of some 2,070 financial cooperatives, 2,300 employee funds, 400 mutual associations and some 5,000 other cooperative entities. The financial cooperatives sector has more than 3 million members that account for some 9.5% of the population of the country and the assets of this segment of the financial markets have risen considerably in recent years to account for US$ 2.5 billion. Nevertheless, there has been considerable concern within the Government that the quality of regulation being undertaken for this segment of the financial sector has been very weak. The mission of DANCOOP is clearly complex - the number of entities overseen is large and the range of its responsibilities very wide - judicial examination, registration, policy formulation as well as the promotion and strengthening of the cooperatives sector. 36. To bring in greater professionalism and expertise in sector regulation and to separate the promotion and regulatory functions, the Government has proposed a substantive overhaul of the regulatory framework of the cooperatives sector. A draft law has been prepared which puts forward a three pronged approach to sector regulation: * The transfer of responsibility for the supervision of the largest financial cooperatives to the Banking Superintendency which already has considerable expertise in supervision of financial intermediaries. The rationale for this transfer is that these cooperatives are of a size and complexity similar to the traditional intermediaries supervised by SB. * Liquidation of the current organization and staffing of DANCOOP and the creation of a new entity called the Superintendencia de Economia Solidaria as the regulator of all other institutions in the cooperatives sector. * The transfer of the responsibility for the development and promotion of the cooperatives sector to a third entity, such as a mixed public-private corporation. 37. The proposed law is currently in Parliament for discussion and is expected to pass in the second half of 1997. While Government policy on the regulation of this sector is clearly evolving, it is also clear that the creation of an effective system of regulation and  15 supervision will require considerable and sustained institutional development and strengthening activities. In particular, significant efforts will be needed to develop professional regulatory capacities within the newly constituted Superintendency of Economia Solidaria. 38. Sistema de Inteligencia Financiera. A significant issue in the financial sector in Colombia is a concern about the use of the domestic financial system for laundering funds from illegal activities. Thus far, there has been no single and organized way for the Government to monitor and control money laundering activities. However, the Government has now put forward a strategy to create a comprehensive financial intelligence system to monitor transactions and detect suspicious activities. 39. Conceptualized as a three tier system, the basic information for this financial intelligence system would be gathered by financial institutions and other "first-tier" entities, which have the direct contact with the markets and the economic agents participating in them. These first-tier institutions will have specially trained staff to monitor transactions and flag those that give some indications of being part of possible money laundering activities. Such information will be routinely transmitted to the second tier entities which will be comprised of regulatory agencies such as SB, SV and other institutions. These entities, which have broad knowledge of the respective sector, will gather and refine the information received from the first-tier, including cross-institution linkages and consolidation. The top tier of the system will correspond to the Unidad de Informaci6n e Inteligencia Financiera (UhF) , which will be the focal point of the system of financial intelligence. 40. The UIIF will be a small and highly technical unit with the following functions: * To design and oversee the implementation of the financial intelligence system in its multiple components. * To provide guidance to the first- and second-tier entities in their involvment in the system. * To promote the legal and regulatory developments needed to efficiently monitor money, and in general asset, laundering. * To lead the investigations that would arise as a result of the possible money laundering operations detected at the first- and second-tier levels, and be the channel to turn over the relevant information to the judiciary authorities for criminal investigation and prosecution, if warrranted. 41. A draft law providing a comprehensive legal framework to such a system will be presented to Congress in mid-1997, and is expected to be approved before end- 1997. This is an important Government initiative towards the objective of systematically fighting corruption.  16 42. Superintendency of Industry and Commerce (SIC) Overhauled in 1992, the SIC had traditionally been responsible for protecting intellectual property rights, enforcing price controls, and quality control regulations. As a result of this restructuring, the Delegaturapara la Promocion de la Competencia (DPPC) was created to be in charge of implementing competition policy and to oversee the Chambers of Commerce, including the operation of the commercial registries. While the DPPC is still in its early stages, the initial steps taken by the SIC to organize the unit are very positive. The DPPC is being staffed in a lean manner, with high level professional staff, and it is taking an appropriately cautious attitude to its new powers and is conscious of its limitations. 43. Given that the DPPC is a very new entity, it presents both manpower and infrastructure deficiencies in order to start properly developing its mission of implementing competition policy. Since antitrust and industrial organization analysis are almost unknown technical fields in Colombia, hiring professionals with high quality academic backgrounds does not suffice for DPPC to acquire the necessary technical skills. Moreover, much of the acquisition of specialized knowledge in competition commissions around the world takes the form of in-house or on-the-job training. Agencies have over the years developed a way of doing "case work", and a set of implicit and explicit procedures. This knowledge of how to initiate, manage and carry a case to its conclusions, including negotiating with the defending parties, is not learnt in academia, but rather acquired mostly in an on-the-job basis. The DPPC, however, has no "institutional history" on which to base on-the-job training for new staff. Obviously, DPPC will develop such knowledge over the years. In the meantime, the knowledge has to be acquired from outside sources and transferred to the new staff. IV. THE PROJECT Project Objectives 44. The main objective of the project is to support the Government's efforts to foster more effective financial intermediation of resources, as well as more efficient operation of markets, as a key ingredient for sustained economic growth. 45. Specific project objectives are to: (i) develop the financial markets into a more efficient channel for mobilizing domestic savings (including long-term savings generated by social security funds) and financing investment; (ii) improve the institutional capacities for financial sector policy formulation and strengthen the regulatory and supervisory framework in order to, inter alia, minimize the risk of loss of confidence in the financial markets; (iii) contribute to increase the supply of securities, one of the main constraints to the growth of the financial markets, by inter alia facilitating the introduction of new financial instruments; (iv) consolidate the implementation of the social security reform; (v) contribute to deter corrupt or fraudulent practices such as money laundering; and (vi) contribute to more efficient operation of financial and non-financial markets by promoting competition and deterring anti-competitive practices in those markets.  17 Project Components 46. The following table provides the main components of the project and the principal areas to be addressed within these components. A detailed description of the objectives, activities to be undertaken under each sub-component, outputs/impact, timing and responsibilities is provided in Table 2 of Annex III. Table 1: Proiect components [ Cost (US$) L Developing the financial markets into a more efficient intermediation channel A. Improving the Functioning of the Market This sub-component is designed to 575,000 improve regulations and market infrastructure services to increase the efficiency of the functioning of the securities market. In particular, it will address issues of upgrading in the pricing, trading, custody, clearing, settlement and payments systems, promotion of inter-connection and cross listing across domestic and international exchanges, harmonization of different types of securities, and promotion of new types of trading instruments, such as short sales and repos. B. Developing the Marketfor Public Securities This sub-component will be aimed at 487,000 developing the primary and secondary markets for public securities through review and reform of regulatory and tax constraints that have thus far impeded the deepening of this market and the emergence of market makers and primary dealers for this market. It will also review and refine the financial management systems used by the Treasury for its borrowing operations, develop a methodology for controlling risks in this market, develop regulations and standards for market operations of sub-national entities offering public securities, improve depository functions, and support the development of information systems to monitor the market for public securities. The sub-component will also provide training and dissemination activities for government officials, regulatory agencies and other key market participants. C. Promoting Greater Participation of Institutional Investors in the Financial 175,000 Markets The primary focus of this sub-component will be to review and irvise outdated regulations governing portfolio management of institutional investors and to develop technical capacities to assess and properly manage the risks inherent in instruments such as mutual funds, life insurance, and severance payment funds IL Strengthening Regulation and Supervision Capacity in the Financial Sector A. Harmonization and Refinement of the Regulatory Framework This sub-component 440,000 will support the analysis and review of the overall regulatory framework of the financial sector, with a view to improving its efficiency, reducing regulatory arbitrage, harmonizing its different components and enforcement mechanisms, developing auto- regulation mechanisms, and an evaluation of the desirability of establishing a specialized judiciary instance to deal with cases of financial sector nature. B. Strengthening Institutional Capacityfor Supervision in the Financial Markets 2,075,000 Provision of international exposure, practical experience and training to staff of the different supervising entities - in particular the Superintendencies of Securities and Banking - to increase their knowledge of state of the art financial instruments and supervisory approaches and techniques, and to support a more modern institutional model of supervision at Superbancaria. This sub-component will also strengthen the  18 policy formulation capacity in the Technical Vice Ministry of Finance through technical assistance and staff training to update their skills and knowledge in best practice in financial sector policy and regulation. C. Creation of a New Regulatory Frameworkfor the Cooperatives Sector. Following 1,865,000 on the new legal framework currently under discussion, this component will support the possible liquidation of D XNCOOP, and support the establishment, staffing and institutional strengthening of a new Superintendency to regulate cooperatives (Superintendencia de Economia Solidaria). This sub-component will also support the establishment of a "Delegatura" for cooperatives in Superbancaria, in order to ensure appropriate supervision of the large financial cooperatives.. HL Increasing the supply of securities and the availability of other financial instmments A. Increasing Supply of Securities This sub-component will focus on necessary 715,000 changes in the legal and regulatory framework, including possible changes to the Commercial Code and its regulations, that continue to impede firms' interest to raise financing in the capital markets. It will also undertake promotion, training and dissemination activities for government officials, regulatory agencies, market intermediaries and potential issuers of securities to promote the use of the capital markets. B. Introducing and Promoting New Instruments - Inter Alia Securiftization, 1,891,000 Derivatives, Venture Capital Funds, Housing Finance and Education Finance This sub-component will provide technical assistance for review of legal and regulatory changes and dissemination activities for the introduction and promotion of new financial instruments such as the securitization of assets, derivative products, and venture capital funds to promote nascent small and medium companies. It will also provide assistance in studying the feasibility of introducing new instruments such as leasing finance for housing and private finaneing for student loan p.ograms for higher education. IV. Consolidating the Implementation of the New Social Security System A. Implementing the Transfer of Pension Liabilitiesfrom the Decentralized Public 3,370,000 Sector Entities (e.g. Municipaltties) to the New System. This sub-component will support the process of transfering past affiliates of Departmental and Municipal public pension schemes to the new pension funds. It will assist in the process of compiling the past contribution records, determining the actuarial value of those liabilities, and calculating and issuing the pension bonds that will result from those liabilities. It will also assist these decentralized public entities in devising mechanisms to funds these liabilities. B. Institutional Strengthening of the Delegatura of Pension and Severance Payments 218,000 Funds This sub-component will strengthen the institutional supervisory capacities of this relatively new entity which is in charge of overseeing the recently created pension funds as well as related institutions. C. Institutional Strengthening of the Institute of Social Security This sub-component 250,000 will assist the ISS in devising a strategy for upgrading its information systems to improve financial management, collection records and clienv services data including verification of eligibility for pension and health benefits under the new pension system.  19 D. Continue Implementation and Regulation of Law 100 on Social Security Reform 533,000 This component will help compile all norms and explanatory texts to the Reform Law, and provide support to decentralized entities to aid compliance with the new laws and regulations. It will also monitor the experience in the implementation of the new s;-stem and prcvide legal and financial expertise for continued finetuwing of the regulations based on the development over time of the system. V. Development of a system for Control of Corrupt and Fraudulent Practices A. Establishment of the System of Fnancial Intelligence and Preparatory Activities 850,000 for Subsequent Implementation. This sub-component will support the development of mechanisms to control money laundering, and specifically the initial creation of a financial intelligence system. This system will have at its core an umbrella unit which will guide the collection, monitoring and analysis of relevant information at the other layers of the system (e.g. supervisory institutions in ths middle layer and financial intermediaries in the bottom layer). This financial intelligence system will be developed through a structured sequence of building blocks. The major challenges are to build the necessary information and communication systems, to develop the capacities in all institutions involved, and to train the staff in the three layers. B. Impkmentation of the System of Financial Intelligence in Three Priority Sectors 500,000 This subcomponent will allow the system to be implemented in three priority sectors (banking, securities markets and corporate ownership), after approval of the necessary legal framework. C. Expansion of the System of Financial Inteligence to Additional Sectors of the 1,330,000 Economy This subcomponent will allow the system to have expanded coverage in other sectors of the economy, possibly such as cambios (foreign exchange brokers), customs, income tax, financial cooperatives, real estate, etc. 1,880,000 VL Development of Competition and Anti-Trust Policy Capacity This component will support the development of policy guidelines and procedural norms for anti-trust enforcement, not just in the financial sector but economy wide. It will also support the development of institutional capacity and specialized know-how on competition policy and enforcement practices VILL Project Management and Administration The project will support the administrative costs of the project management unit 816,000 including a project coordinator, an assistant, an accountant, secretarial support and a limited amount of office equipment, as well as the cost of an external administration/contracting agent. Physical Contingencies (5%/6) 898,000 Price Contingencies (3% per year, 4 years) 1,132,000 Total Project Cost 20,000,000  20 Project Costs Total project costs are expected to be US$ 20 mnillion and are broken down by expenditure categories as follows: Table 2: Project Costs by Expenditure Categories (US$ million) With Project Components Before contingencies contingencies Consulting services 13.29 14.79 Training 2.79 3.11 Equipment 1.89 2.10 TOTAL PROJECT COST 20.00 Financing Plan Table 3.1: Proiect FinancinE Plan (US$ million) Local Foreign Total Government 5.0 0.0 5.0 IBRD 3.2 11.8 15.0 Total 8.2 11.8 20.0 Table 3.2: Allocation of Loan Proceeds (USS million) Expenditure Category Amount Financing Percentage Consultants services 9.9 100% net of taxes Training 2.1 100% net of taxes  21 Goods 1.5 100% net of taxes of foreign expenditures and ex-factory, and 85% of other locally procured goods Unallocated 1.5 TOTAL 15.0 V. Project Administration and Implementation Project Execution 47. The Borrower would be the Government of Colombia, with the Ministry of Finance and Public Credit as the implementing agency. The project would be managed at two levels: a Steering Committee would be in charge of overall orientation, and a Project Coordination Unit (PCU) established in the Technical Vice-Ministry of the Ministry of Finance and Public Credit would be in charge of project administration. The Steering Committee would be comprised of representatives from the Ministry of Finance, the National Planning Department, the Superintendency of Banks, the Superintendency of Securities, and the Superintendency of Industry and Commerce. This committee would be headed by the Technical Vice-Minister of Finance, who would be the project's National Director. A project coordinator from the Technical Viceministry of Finance would be in charge of the executing unit and would be assisted by consultants hired to do specific tasks as required. The PCU would be headed by a project coordinator and composed of a project assistant, an accountant and secretarial personnel. The PCU would coordinate the project activities with the different beneficiary agencies of the Government and the municipalities. 48. The Coordination Unit would have primary responsibility for the preparation of terms of reference, identification of consultants and preparation of short lists, publication of notices and evaluation of proposals. Draft operational guidelines for the technical assistance program, setting out procedures and responsibilities, are included in Annex I. 49. Consistent with other similar projects in Colombia, the Government and the Bank have agreed to contract an external administration agent to provide support services to undertake procurement and manage payments, under a management arrangement satisfactory to the Bank (see Annex II). Its management fee of US$0.6 million would be financed from the proceeds of the loan. The external administration agent would disburse directly to consultants and would maintain supporting documentation on file for review by Bank supervision missions. 50. The proposed project would be completed in four years. The completion date is August 31, 2001, and the Closing Date is February 28, 2002. The National Director will  22 be responsible for project execution as planned, within time and budget, and with ensuring compliance with all Loan Agreement covenants. Bank requirements for accounting, administration and procurement procedures will be the responsibility of the Project Coordination Unit, with assistance from a contracting agent (see below). Procurement 51. Procurement will be carried out in accordance with the Bank's Guidelines for Procurement under IBRD Loans and IDA Credits (January 1995, revised August 1996). The bulk of the procurement of goods consists of computer equipment and software for an estimated US$1.6 million equivalent which will be procured through International Competitive Bidding (ICB) and, to a limited extent, National Competitive Bidding (NCB). Miscellaneous computer equipment and software and office and photocopying equipment required for project implementation and administration, will be acquired by National Shopping by price comparisons of at least three quotations, in packages valued at less than US$50,000, up to an aggregate of US$500,000 over the life of the project. 52. Consulting services will be contracted in accordance with the Guidelines for Selection and Employment of Consultants by World Bank Borrowers (January 1997). To the extent possible, the Borrower would employ consulting firms in preference to individual consultants for the provision of consulting services to the Project. Training activities (e.g. attendance to courses, seminars and workshops) would be procured based on the quality of the programs offered (see Table 3 of Annex III). 53. Standard contracts, based on the Bank-issued Standard Form of Contracts, and procurement documentation, based on Bank Standard Bidding Documents, modified as necessary for the purposes of the project, were agreed with the Government during Negotiations. Agreement was also reached on formats for the technical specifications in the case of goods, and terms of reference (including objectives, activities, results, performance indicators, and estimated breakdown of costs) and the use of the Bank's standard Letter of Invitation for consulting services. Bank Prior Review 54. Prior review by the Bank will be exercised for (see Table 4): * All goods procured through ICB and NCB * Consultant contracts over US$100,000 equivalent (in the case of consulting firms) and over US$50,000 (in the case of individual consultants and training activities); however, in all cases the Bank would exercise review of terms of reference for individual consultants or firms. 55. All contracts would be subject to post-review sampling during supervision missions. These arrangements imply that the substantive aspects of approximately 90 percent of the total value of all Bank-financed contracts will be reviewed ex-ante by the Bank.  23 Disbursements - - - ------------- 56. The Government, Consulting < 50 (indiv.) Selection according None (TORs through the Services <100 (firms) to Consultant only) executing Guidelines agency, will >50 (indiv.) | All periodically >100 (firms) " submit l l _|_| withdrawal Goods < 50 National Shopping None applications. >50 ICB All The contracting |_l_l_ l agent will make Training fees, < 50 Other None payments Workshops >50 All directly to and Seminars consultants and suppliers. Expenditures for individual contracts of goods or services, for which prior review by the Bank is not required, will be disbursed against Statement of Expenditures (SOEs) if the Bank so requests. Detailed supporting documentation for all expenditures will be kept by the PCU. Full documentation for all contracts requiring Bank's prior review will be submitted by the borrower to the Bank. Disbursements, representing mainly expenditures under short term technical assistance, will be made over a 4-year period, which is the average disbursement profile for technical assistance projects in the Latin America and Caribbean Region. Since the implementation of some activities has already started, retroactive financing not to exceed US$1.2 million (i.e., 8% of the loan amount) would be applied to finance eligible expenditures made after April 30,1997 but no more than a year before loan signing. 57. Accounting and Auditing Arrangements The PCU within the Ministry of Finance and Public Credit will be responsible for fulfilling the accounting, reporting and audit requirements. The PCU will be responsible for ensuring compliance of all accounting and auditing requirements and will maintain records and accounts to reflect, in accordance with sound accounting practices, the operations, resources and expenditures for each project activity. It will also be responsible for coordinating with the contracting agent for obtaining all necessary financial information from the procurement performed by it. The accounts will be consolidated annually to prepare financial statements for the project as a whole and project financial statements will be prepared in accordance with Bank guidelines and models. Supporting documentation will be maintained and made available to Bank missions and independent auditors as renuir-ed. For expenditures incurred on the basis of Statement of Expenditures, all records will be retained by the PCU until at least one year after the Bank has received the audit report for the fiscal years in which the last withdrawal from the Loan Account was made. Project records and accounts, including the SOEs, will be audited annually in accordance with appropriate  24 auditing standards consistently applied by auditors acceptable to the Bank, with terms of reference for the auditors approved by the Bank. The Bank's Financial Accounting, Reporting and Auditing Handbook (FARAH) published in January 1995 and other Bank guidelines will be used by the auditors in accordance with the Bank's auditing guidelines. Audit reports will be furnished to the Bank within four months after close of the Government's fiscal year. Project Monitoring and Evaluation 58. Within the Government, monitoring and evaluation would be undertaken by the Project Steering Committee, and would be done continually with activities grouped in six- month cycles. Bank supervision would also be carried out on a continuous basis, with supervision missions every six months. Twice a year, specific Action Plans would be prepared, describing in detail the activities, inputs, outputs, timing, personnel responsible for their execution, how the performance of the various activities will be measured and by whom, and other information necessary for the execution of the project. 59. The Project Coordinator, in consultation with the contracting agent, would prepare a Semi-Annual Progress Report to be formally presented by the National Director to the Steering Committee. This report would provide financial and procurement information on project execution, as well as status of performance indicators to date (input, output, outcome and impact) as compared to the last Semi-Annual Action Plan. The Steering Committee would review and approve the progress report, including the proposed new Action Plans. These Plans would be agreed with the Bank during the semi-annual supervision missions. Agreement on the model of the Semi-Annual Action Plans and Progress Reports was reached before Board presentation. Submission of the first Semi- Annual Action Plan would be a condition of loan efectiveness. 60. A Mid-Term review will be carried out jointly by the Bank and the Ministry of Finance during the mission scheduled for the first semester of 1999, to measure project progress and impact and agree on activities for the remainder of the project. The review would provide a formal opportunity for the Bank to assess covenant compliance by the Borrower with regard to the Project, an opportunity which the Bank nevertheless will have at all other times as well pursuant to the General Conditions incorporated in the Loan Agreement for this Project. This review would also serve as an opportunity to assess the need for any potential follow-up activity related to the Project. 61. An Implementation Completion Report (ICR) would be submitted to the Bank after project completion and no later than six months after the Loan Closing Date. Included in this ICR would be an assessment of the execution of the project, costs and benefits derived, the performance of the Borrower, the World Bank and other agencies involved in their respective obligations and accomplishments, and lessons learned.  25 Benefits 62. Developing the financial markets would increase the overall efficiency of financial intermediation between savings and investment. Specifically, the Project is expected to expand the size, depth, liquidity and intermediation efficiency of the financial markets. This would not only permit the companies going to the securities markets benefit from the expansion of the base of savings mobilized for investment, but it would also put competitive pressure on the lending spreads charged by the financial intermediary sector. The introduction of new financial instruments would also allow for expansion of the available capital for investment and allow for more efficient instruments to meet specific needs of companies at a lower cost of capital. 63. Strengthening and improving the regulatory and supervisory framework of the financial markets would provide better risk management, reduce the regulatory costs to the economic agents (issuers, market intermediaries, investors and financial institutions), contribute to the avoidance of market crises and build greater public confidence in the system that mobilizes savings. Implementing pension reforms would help in capitalizing workers' resources, facilitate the development of a long-term capital market, and increase the welfare of an important segment of the population, i.e. future retirees. Furthermore, solid financial markets would also enable the important privatization reform of infrastructure activities to take place successfully; the development of infrastructure by the private sector in many cases entails long-gestation bulky investments which would not be appropriately financed without long-term resources mobilized through the domestic market. Finally, active promotion of competition would help prevent welfare losses from non-competitive market arrangements, while active control of money laundering activities would deter corrupt practices that distort the efficiency of financial intermediation and resource allocation. Risks 64. There are three potential risks to the Project - institutional capacity for implementation, maintenance of a sector-wide vision of achivement of objectives and the political commitment to reforms. The project design has addressed these risks by placing project management with a specialized unit within the Technical Viceministry of Finance, an agency that is well experienced in handling multi-agency technical assistance projects. The Project also provides for the engagement of experienced procurement/contracting agents for added capacity. The implementation risk in this project is considered low. Potentially more important is the concern that it would be possible for key actors in the Government to lose the broad vision of sectoral reform. The Government has already appointed a Standing Commission consisting of the heads of the three stock exchanges, heads of the supervising agencies and representatives of the Ministry of Finance to follow up on the broad sectoral policy issues reviewed by the Comision de Mercado de Capitales. The views of this commission will be fully integrated in the work of the Steering Committee of the Project and the implementation Actions Plans to ensure focus on the achievement of development objectives. Finally, there is some risk of political commitment for needed legislation for some sub-components, specifically the restructuring  26 of the cooperatives sector and the control of corrupt practices such as money laundering activities. However, past experience with other legislative modernization initiatives in Colombia has shown that as long as these initiatives are presented to Congress with solid technical justification, approval is more likely to be expeditious. The Project also provides for the necessary activities that need to be carried out in order to solidly prepare those legislative initiatives.  27 Annex I COLOMBIA FINANCIAL MARKETS DEVELOPMENT PROJECT DRAFT OPERATIONAL GUIDELINES FOR PROJECT IMPLEMENTATION Preparation of Terms of Reference The participating entities (i.e., Ministry of Finance, SV, SB, etc.) produce final TORs (based on draft TORs already prepared in conjunction with the semi-annual Action Plans), with assistance of the Bank when requested. Final TORs are submitted to the Project Coordinator of the Executing Unit for approval and to the Bank for no-objection prior to issuing to consultants. 2. Creation of Short List for Recruitment of a Firm The participating entities prepare an initial list for review/approval by the Executing Unit. The short list is subsequently submitted to the Bank for no-objection. 3. Selection of Individual Consultants The participating entities make an initial selection, send the curriculum vitae (with a briefjustification of the fee) to the Executing Unit for review/approval and to the Bank for no-objection. 4. Draft Letter of Invitation, including Evaluation Criteria, and Contract The participating entities draft the documents (based on an agreed model) for review/approval by the Executing Unit. If approved, the Unit forwards them to the Bank for no-objection. 5. Evaluation of Proposals The participating entities evaluate proposals and select the winning firm. Before notifying the firms, the selection committees will send the evaluation report and winning proposal to the Executing Unit for approval and to the Bank for no-objection. 6. Negotiation of Contract  28 The negotiation of the contract is handled by the participating entities based on guidelines issued by the Executing Unit. Prior to signature, the negotiated contract will be sent to the Executing Unit coordinator for approval and to the Bank for no-objection. 7. Supervision of Consultants Supervision is the direct responsibility of the participating entities. Program reports on technical assistance progress will be included in the semi-annual reporting prepared by the Executing Unit for the Steering Committee. 8. Disbursements Payments to consultants and suppliers will be made directly by the contracting agent. Based on the information on actual payments made to consultants and suppliers by the contracting agent, the Ministry of Finance, through the Executing Unit, will prepare and submit withdrawal applications. These application for withdrawal requests submitted by the Borrower to the Bank will be for a minimum of US$250,000. The Borrower will submit to the Bank Statement of Expenditures for contracts below US$100,000 equivalent for consultant firms, and below US$50,000 equivalent for goods, training and individual consultants. The Borrower will maintain the supporting documentation which will be readily available for review by Bank supervision mission and the Auditors. Disbursements for all other contracts will be fully documented. 9. Audit An annual audit of the Project accounts will be undertaken at the end of each fiscal year by independent external auditors and submitted to the Bank.  29 Annex II COLOMBIA FINANCIAL MARKETS DEVELOPMENT PROJECT LOAN ADMINISTRATION AGREEMENT BETWEEN THE GOVERNMENT OF COLOMBIA AND CONTRACTING AGENT 1. The Ministry of Finance will be the Executing Agency on behalf of the Government for the Financial Markets Development Project (Loan) to be extended by the World Bank. AGENT will be in charge of the project administration as agreed between Ministry of Finance and AGENT in a letter of agreement. 2. For recruiting and managing consultants to be financed by the proceeds of the Loan, the division of responsibilities between Ministry of Finance and AGENT will be as follows: Ministry of Finance: * Repayment of principal amount, interest and other loan related charges * Granting approval to the Loan Administration Agreement