Colombia - Programmatic Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 27355 SIMPLIFIED IMPLEMENTATION COMPLETION REPORT (Loan No. 7167-CO) ON A LOAN IN THE AMOUNT OF US$ 150 MILLION TO THE REPUBLIC OF COLOMBIA FOR A FIRST PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN December 22, 2003 Colombia and Mexico Country Management Unit Finance, Private Sector and Infrastructure Department Latin American and the Caribbean Region 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.   TABLE OF CONTENTS 1. Program Data .....................................................1 2. Principal Performance Ratings .....................................................1 3. Program Description ..................................................... 4. Achievement of Objectives and Outputs .....................................................5 5. Major Factors Affecting Implementation and Outcome ..................... ................................9 6. Bank and Borrower Performance .....................................................9 7. Findings and Implications for Subsequent Operation(s) in Series .................................................... 10 8. Additional Information - Evaluation by Borrower .................................................... 10 Annexes .................................................... 14 Annex 1. Key Performance Indicators / Log Frame Matrix .14 Annex 2. Matrix of Policy Actions .16 ACRONYMS BECH Bancos Especializados en Cr6dito Hipotecario (Mortgage Banks) CAMEL Capital/Assets/Management/Earnings/Liquidity (a supervisory rating tool) CAV Corporaci6n de Ahorro y Vivienda (Savings & Loan institution) DTF Dep6sitos de Terminos Fijo (Time Deposits) FOGAFIN Fondo de Garantias de Instituciones Financieras (Deposit Insurance Agency) FRECH Fund for Reserves and Stabilization of the Mortgage Portfolio MTR Mid term Review P-FSAL Programmatic Financial Sector Adjustment Loan SARC Sistema de Administraci6n de Riesgos de Credito (Credit Risk Mgmt. System) SB Superintendency of Banking SEARS Sistema Especial de Analisis de Riesgos de Seguro (Insurance Risk Mgmt. System) SV Superintendencia de Valores (Superintendency of Securities) UVR Unidad de Valor Real (Inflation Index) Vice President: David de Ferranti Country Director: Isabel Guerrero Sector Director: Danny Leipziger Task Manager: John Pollner   Simplified Implementation Completion Report For Programmatic Adjustment Operations Operation ID: P078869 Operation Name: P-FSAL I Team Leader: John Pollner TL Unit: LCSFF Report Date: December 15, 2003 1. Program Data Name: Programmatic Financial Sector Adj Loan L/C Number: 7167-CO Country/Department: Finance, Private Sector & Infrastructure Region: LAC Sector/suabsector: Banking, Capital Markets, Housing, Insurance, Contr. Savings Theme: Regulation, Competition, Financial Architecture, Bank Restruc. KEY DATES Original Revised/Actual PCD/PR: 03/06/03 Effective: 06/04/03 Appraisal: 3/27/03 MTR: Not applicable A pproval: 4/24/03 Closing: 06/30/03 Borrower/Implementing Agency: | Republic of Colombia / Ministry of Finance Other Partners: Banking Superintendency, Deposit Insurance Agency, Securities |Superintendency STAFF Current At Appraisal Vice President: David de Ferranti David de Ferranti Country Director: Isabel Guerrero Isabel Guerrero Sector Manager: Fernando Montes-Negret Fernando Montes-Negret Team Leader at ICR: John Pollner John Pollner ICR Primary Author: Manuel Lasaga 2. Principal Performance Ratings (HS=Highly Satisfactory. S=Satisfactory. U=Unsatisfactory. HL=Highly Likely. LLikely. UN=Unlikely. HUN=Highly Unlikely. HU=Highly Unsatisfactory, H=High. SU=Substantial. M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: SU Bank Performance: HS Borrower Performance: HS QAG (if available) ICR Quality at Entry: S Operation at Risk at Any Time: No  -2 - 3. Program Description 3.a. Overall Program I. The Financial Sector Program which is supported by two Programmatic Loans (this ICR covering the first) encompasses comprehensive sector reforms that were embarked upon by the Government to overcome the difficulties resulting from the 1998-99 banking crisis and achieve sound growth of the financial system. A programmatic approach was adopted because of the need for flexibility in terms of loan timing and conditionality in view of the complexity and the sequencing of the reform efforts. This first Operation (Programmatic Financial Sector Adjustment Loan I, P-FSAL I) focused on legislative and regulatory reforms oriented mainly towards the banking system, with the expectation that the implementation of these reforms in the financial system would provide a sound basis for the Second Operation which would have a larger focus on non-bank financial institutions and capital markets. Because of the reform sequencing under the two Operations, it was necessary to allow for flexible timing between the two phases to ensure that all necessary reforms had been fully applied in the first operation within realistic time margins, so as to allow the second operation to build on these adequately. At the same time, the government's financial sector strategy was a comprehensive medium-term program that had been defined for the duration of the current administration, which took office in August 2002. Bank support was thus appropriately envisioned as a series of Operations, which would also permit adjustments, as the new administration unfolded its reform agenda for the banking system and the subsequent capital market and non bank sectoral reforms. The objectives of the overall Program were: (i) to strengthen the government's capacity to manage and mitigate weaknesses in the financial system through an improved legal and regulatory framework and the implementation of modernized risk management approaches to cushion future losses; (ii) to complete the clean up of the banking system as a result of the 1998-2001 crisis and provide mechanisms to dispose of assets which might represent contingent liabilities of the State, and (iii) to strengthen and diversify the participation of the housing mortgage market as well as of non- bank financial & insurance services. as well as the securities market framework and related institutions in the financial system. 2. The achievement of the first objective was to focus on the reinforcement of existing financial legislation to incorporate better standards of corporate accountability, governance and risk management as key elements in the regulatory framework. A new financial system law would enable the supervisory agencies to establish more effective rules and regulations that would strengthen the basis for banking practices promoting sound growth as well as modernized risk management tools for financial system participants. 3. In support of the second objective the Government was to implement measures to dispose of the financial system's loan assets remaining from earlier bank interventions, while making collateral liquidation procedures and future bank resolution processes more agile and effective. In addition, the remaining intervened banks were expected to be divested and the largest public second tier problem bank to be wound down. 4. The third objective was to be supported by several initiatives including the development of market risk hedging mechanisms for the mortgage sector and micro finance instruments, a liquid securitization market for primary residential mortgages, the raising of capital adequacy standards in the insurance sector, the deepening of the government securities market including the development of unbiased securities valuation methodologies and more effective government debt management policies, and the reform of the securities legislation to promote a more agile development of the local capital market.  - 3 - The principal componenits of the program include: 1. Bank Regulation and Resolution * Implementation of the Reformed Financial System Law to strengthen and ensure sustainability and prudential treatment of credit, market, governance and operating risks in the financial system; * Implementation of the refonned Financial system Law for improving the effectiveness of banking resolution procedures to reduce excessive fiscal outlays in the process; * Privatization and winding down of State banks; II. Housing Finance * Strengthening the housing finance sector and expansion of the mortgage market while mitigating market and financial risks in that sector. This includes development of instruments to hedge interest rate and inflation risks, expansion of micro housing credit instruments, and further developing the mortgage securitization market. III. Non-bank financial institutions * Strengthening the regulatory framework and financial soundness of the insurance, trust and pension industries. IV. Capital Markets * Modernizing the legislative framework for the securities market and instituting improved market surveillance procedures and higher professional standards for market participants. V. The Government Debt and Money Markets * Upgrading the policy and operational framework for the government securities market and developing that market as a zero risk benchmark for fixed income securities. Economic Context 5. At the time of the Program's preparation, Colombia's vulnerability to external shocks had intensified as a result of increased domestic violence and uncertainty regarding the future path of the internal conflict; a worsening of market sentiment towards Latin America; problems in Venezuela, the second largest market for Colombia's non-traditional exports; and an uncertain outlook for the US economy, Colombia's main trading partner. These problems were exacerbated by a sharp deterioration in sovereign debt spreads. which posed greater hurdles for the management of the country's external debt. On the other hand, Colombia was relatively well-equipped to deal with moderate external shocks, given its floating exchange rate, falling inflation, adequate international reserves, as well its commitment to the implementation of fiscal adjustments. On the fiscal side, the nationwide referendum called for by the Administration to seek support for its program, did not garner the critical mass of voters to make it binding (despite the fact that over 90% of those who did vote, supported the proposed government initiatives) - this generated some uncertainty regarding the ability of the government to fully implement its intended fiscal and macroeconomic stabilization program. 6. Colombia's macroeconomic performance was expected to continue to improve during the period under the Program; although it was anticipated to take longer for the economy to achieve its full growth potential. During the period 1983-1997, and prior to the economic recession which started in 1998, GDP growth had averaged 4.1 percent per annum, compared to the projected growth rate of 3.0 percent during the implementation of the Program covering 2003-06. 7. The principal risk to the country's macroeconomic stability, and thus to the sustainability of the financial sector reforms, remained the large fiscal deficits and the high burden of public sector debt. Excluding the one-time effects of the privatizations, the public sector deficit had risen from 0.3 percent of GDP in 1993 to 4.3 percent in 2001 (see Economic Indicators Table 1 in the Annex). Assuming full implementation of the macroeconomic reform package, it was expected that the overall public sector deficit would fall from about 4.0  - 4 - percent of GDP in 2002, to between 2.5 - 3.0 percent in 2003, and then to between 2.0 - 2.5 percent during 2004-2005. 8. External Environment. The outlook for the external sector at the time of Program preparation was less favorable than during the previous economic expansion period. While the current account deficit was not expected to grow, financing from the capital account, particularly from private lenders, was expected to reflect negative flows on the order between -US$ 1.0 billion to -US$1.5 billion, for the foreseeable future. Therefore, balance of payments financing requirements would have to rely primarily on multilateral and official financing to meet the gap which, including other sources of capital inflows, would require on average, US$2 billion annually during the Program period 2003-2004. Status of the Financial System 9. As a result of the economic downturn during 1998-1999, the financial system had entered a period of substantial stress. The adverse effects were significantly accentuated by turbulence in the global financial markets which affected most emerging economies in 1998. At the same time, domestic interest rates jumped in 1998 to very high levels, which intensified credit woes in the financial system (see Table I in the Annex). One of the factors behind the increase in domestic interest rates was the Government's reduced access to external financing, which led to greater reliance on domestic financial markets, thus putting upward pressures on interest rates. 10. Two particularly vulnerable components of the financial system at that time were the CAVs (Housing Finance Banks) and the cooperatives. The CAVs specialized in residential mortgage lending and had built up a notable pricing imbalance between their deposit liabilities which paid a nominal peso rate of interest and their mortgage loans which were indexed to the inflation rate. The dramatic rise in peso interest rates (DTF rates) resulted in excessively high real, or inflation adjusted, interest rates, thus creating an unsustainable unfavorable gap between the mortgage bank's interest income and expenses. 11. As a result of the financial sector crisis, total assets of the commercial and housing banks dropped 25 percent in real terms during 1999-2002. In dollar terms, the banking system shrunk by 40 percent during that period. Huge losses during 1998-2000, induced by problem loans, resulted in an average return on equity (ROE) of -24 percent. By 2002, system earnings had recovered to an acceptable ROE of 9.6 percent (see Table 2 in the Annex). However, within these figures, the commercial banks showed much improved results while segments of the CAVs (renamed BECHs following the crisis) still had serious vulnerabilities from over exposure to the mortgage sector. 12. The Bank's successful FSAL during 1999-2000 had helped set the stage for closer collaboration with the Government on the preparation of the current Program. The measures supported by that FSAL focused on three key areas: (i) intervention, liquidity and capital support for weak institutions; (ii) strengthening of capital and solvency standards; and (iii) implementation of early corrective actions by the Banking Superintendency and Fogafin to avert an eventual failure of an institution. While these measures were comprehensive, they faced institutional and legal constraints that were addressed in the design of this Program. 3.b. The Current Operation (P-FSAL I) 13. The P-FSAL I dealt with the adoption of major banking reforms and regulations; while the second P- FSAL II is expected to focus on the implementation of institutional reforms and the preparation of a revised securities law and a framework for the non-bank sector. This Operation was thus designed to set the stage for a sound and sustainable banking sector and some initiation of reforms in the non-bank sectors, to be expanded further under the subsequent loan. The actions contemplated under the P-FSAL I comprise a critical mass of reforms and institutional upgrading that are expected to correct remaining weaknesses in the banking system and to support the successful outcome of the entire Program.  - 5 - 14. The banking legislative component in P-FSAL I was anchored in the passage of Law 795 of the financial system and the development of appropriate rules and regulations to enhance asset quality, earnings performance, and liquidity of financial intermediaries, while introducing new methodologies for measuring and managing credit risks, interest rate risks, and other mark-et risks. The bank reso]ution measures were aimed at structuring a standard operational procedure for the swift resolution of intervened banks by carving out and securitizing the "good" assets with corresponding deposit liabilities of the affected institution under a scheme that sought to minimize the government's deposit insurance liabilities. 15. The housing finance initiatives focused on legal reforms to streamline banking foreclosure proceedings, increasing access to housing micro-financing, providing an inflation hedging mechanism for mortgage borrowers; and enhancing the liquidity of mortgage-backed securities. 16. The other components of the operation focused selectively on other key areas of the financial system. With respect to non-bank financial institutions, P-FSAL I called for a strengthening of basic capital standards for the insurance industry. The capital markets and the govemnment debt components shared similar initiatives: the consolidation of methodologies for securities valuation adopted by both the Superintendency of Banks (SB) and the Superintendency of Securities (SV), as part of an ongoing convergence strategy regarding the regulatory standards applied by both agencies; and the establishment of a formal arrangement for coordination of examination activities undertaken by both supervisors. In addition, the government debt market component called for the development of a pricing methodology for the valuation of government securities based on a standard yield curve that would in turn be applied to the valuation of other non-government fixed-income securities. 4. Achievement of Objectives anid Outputs 17. The outcome of the first operation, P-FSAL I, is considered highly satisfactory in terms of its contribution to the overall objectives of the Program. Many of the achievements of this operation dealt with the establishment of a framework - through legislative and regulatory reforms, that will serve as the basis for the continuation of the Program through its implementation as part of the second operation. The principal achievements are outlined in Table 1 below. Table 1: Achievements of the First Operation: P-FSAL I Outputs Objectives I. Bank Regulation and Resolution Law 795 to reform financial sector, approved in January The passage of Law 795 and associated regulations, will 2003, introduced the legal changes to prevent future strengthen the government's capacity to manage and problems in the sector. In terms of supervisory mitigate weaknesses in the financial system. This will be implementation. the Integrated Credit Risk Management evident in improved financial performance by banks based System (SARC) adopts international best practices. Bank on strong reserving and capital adequacy. The reforms will rating methodology based on an expanded CAMEL allows also address some of the pending issues of bank resolution regulators and deposit insurance agency to charge fees associated with the 1999-2001 crisis. based on risk rating of institution. Market valuation and related interest rate risk regulations have been jointly issued New bank rating methodology will make possible the early by SB and SV. detection and correction of adverse financial trends via prompt application of sanctions by regulators. Based on Law 795 and External Circular 046, financial Detection of illicit financial activity will support the intermediaries are obligated to report information on cash government's efforts to ensure safe and sound growth of the transactions to the Ministry of Finance's anti-money financial system. laundering unit. The new Law establishes compulsory procedures for asset More efficient resolution of bank failures will minimize  -6- and liability transfers and carve-outs from failing banking fiscal liabilities associated with intervened financial institutions using securitization and trust vehicles to ease institutions, and thus strengthen the government's ability to transfer of asset ownership. mitigate weaknesses in the financial system. Privatization of state banks is now focused on the sale of BANCAFE, a large financial institution, which has been Privatization of state banks will support the clean up of the formally put up for sale and capitalization by the private banking system as a result of the 1999-2001 crisis and sector. As well, IFI, the industrial development bank has reduce contingent fiscal liabilities. been wound down and merged with BANCOLDEX the export development bank. II. Housing Finance Law 794 has streamlined the judicial proceedings for a New judicial procedures will generate greater commercial foreclosure. It is estimated that the new regulations could bank interest in the absorption of assets of failed financial reduce the time to foreclosure from 5 to 3 years. institutions, and thus strengthen the government's capacity to effectively manage failures in the financial system. Through Law 795 and Decree 710 procedures established to This initiative will help diversify the participation of banks increase access by low income segments of the population in the housing market as well as in the housing lease to housing micro-credit and housing leasing. market. Implementation of these initiatives is at an early stage with the recent issuance of regulations for this purpose. Special swap programs implemented for :(i) borrowers to The inflation and interest rate hedges should sustain the hedge against the inflation risk of their indexed residential sound growth of the housing finance market in periods of mortgages; and (ii) financial institutions to hedge their above normal inflation or rapid changes in interest rates. interest rate liability risk as well as enhance the liquidity of their holdings of mortgage-backed securities by allowing them to swap those securities for government securities through the FRECH fund at the Central Bank. Ill. Non-Bank Financial Institutions New regulations governing minimum capital and solvency By buttressing the solvency of the insurance industry, this requirements for the insurance industry were authorized measure will strengthen the participation of this sector in under Law 795 for each product branch of the industry, and the financial system and provide a cushion against will be in force by mid 2004. A value-at-risk methodology unexpected financial/business shocks. has been developed for non-bank institutions to report portfolio returns taking into account expected market risks. A sophisticated risk management methodology (SEARS) is being developed with input from insurers to address and recognize actuarial, financial and operational risks. IV. Capital Markets Both SB and SV have issued compatible market valuation Consistent valuation methodology applied to all financial criteria to be applied by financial intermediaries and intermediaries will strengthen the government's capacity to investment funds in the valuation of securities in their mitigate asset mis-pricing weakness in the financial system portfolios. and will facilitate the expansion of the securities sector. Both SB and SV have signed a Memorandum of Joint supervision will contribute to the safety and soundness Understanding to carry out joint supervision and of the financial system by avoiding potentially disruptive surveillance of financial intermediaries. Harmonization of regulatory arbitrage as well as to provide a level playing  - 7 - regulations for the mutual funds industry. covering both field for similar financial products offered by intermediaries sectors. is well advanced. supervised by different agencies. V. Government Debt and Money Markets An effective securities pricing mechanism, by generating a Government's debt management unit implemented a more realistic valuation of financial intermediary program to construct a yield curve up to 10 years to serve as investments, will strengthen the government's capacity to a basis a zero risk benchmark and for valuation of private manage weakness in the financial system by making sector securities. A program of government debt secuirities financial asset valuation transparent and providing a more issuance for the short end of the yield curve, has begun. liquid market for public securities at various maturities. 18. The measures aimed at improving banking regulations are expected to result in greater efficiency and competitiveness in financial intermediation. Most regulations pertaining to the provisions of Law 795 are issued. The introduction of the SARC methodology which reflects some of the most advanced Basel II recommended models for bank quantification and reporting of credit risks, elevates risk management to a new level seen primarily in the more highly developed countries. Financial intermediaries, under these rules, are developing internal quantitative and actuarial models to project losses and provisioning requirements in their portfolios based on both probabilistic and credit history data. The methodologies use highly sophisticated statistical tools which incorporate expert knowledge on risk attributes - these are being introduced by regulation, and are expected to be fully implemented by end 2004 once the SB has evaluated the methodologies presented by the banks in the system. In terms of financial asset valuations, new norms for the valuation of securities developed under a common methodology by the SB, SV and the Central Bank, adopt international best practices. Both of these regulatory innovations will result in improved transparency in asset classification and pricing in the financial system. The SB has started implementing Basel norms regarding interest rate risk and other market risks. Once fully implemented, these regulations will contribute a more solid solvency position of financial intermediaries and a better ability to foresee and deal with asset price changes and requisite loss provisioning. The SB has developed methods for evaluating financial intermediaries that will enable regulators to better track their risk profiles. Nevertheless, the successful outcome of the bank regulation initiatives now hinges on the SB's ability to enforce the new norms in the banking sector in a timely manner. In this context, supervisors need to be brought fully up to speed regarding the review process for methodologies presented by banks, and efficient oversight methods to detect weaknesses once they are implemented. For this, the Superintendency of Banks (SB) will require additional resources for staff training, hiring of personnel, and acquisition of needed equipment and software. 19. The introduction of a new bank resolution scheme, backed by Law 795, to facilitate the expedient resolution of intervened financial intermediaries should minimize the fiscal cost of any future interventions. The process whereby the deposit insurance agency, FOGAFIN, carves out the good assets to be placed in a trust under a securitized instrument that in turn backs the corresponding deposit liabilities of the intervened bank, has been applied successfully in other countries and facilitates the prompt transfer of assets to new institutional buyers. In the meantime, the State bank. BANCAFE has been formally offered for privatization and IFI, the non-solvent industrial development bank has been wound down, with its remaining viable assets merged into BANCOLDEX, the export financing development bank. 20. Selective initiatives in the housing finance sector have improved the infrastructure for lending. The measures adopted under the P-FSAL I were aimed at channeling more financing to the lower income bracket of the population, to protect existing borrowers from unexpected increases in inflation; and to contribute to greater liquidity of the mortgage-backed securities market and availability of micro housing credit and micro housing leasing through the banking system. Despite the positive characteristics of these initiatives, the lingering memories of the 1998-1999 financial system crisis have discouraged banks from extending residential mortgages, though the measures under the operation provide numerous incentives and market hedges to expand in that sector. With the securitization market now developing, the SB has also progressed in developing a capital adequacy regulation for asset risks inherent in mortgage securitization instruments.  - 8 - 21. Demand for the inflation hedge by borrowers has been below the targeted level, in part because consumers find the mechanism complex, and also because inflation has been relatively low and stable during the past two years. On a related initiative, the Central Bank program for banks to swap the rates on their mortgages from a UVR (inflation) to a DTF (interest rate on deposits) based index has also met with minimal demand.' Once again, the design of the FRECH swap mechanism may have limited its appeal2, although the relatively low inflation rates and peso interest rates have discouraged banks from incurring the costs associated with this hedging instrument. Should nominal interest rates become more volatile in the future, the availability of these hedging schemes will serve to minimize systemic risk. More importantly in the short-run, as regulators begin to adopt a more strict adherence to interest rate risk guidelines, financial institutions are more likely to seek these swap mechanisms as well as directly adjusting their asset/liability gap in order to avoid encumbering their own capital to provision for such risks. In the meantime, the Central Bank is developing an alternative option instrument to purchase interest rate protection. The Central Bank's fund used for swapping mortgage securities into government securities for use in collateral under repo transactions, is now operational. 22. Government efforts under the P-FSAL I to strengthen the regulatory framework and financial soundness of the insurance, trust and pension industries have so far established a new regulatory framework demanding stricter solvency and capital standards. Additional substantive measures for implementing the new standards and developing appropriate risk measurement models, are conditioned on the second operation with respect to the implementation of new proposed methodologies for risk management (SEARS for insurance sector) that address insurance companies' calculation of technical and mathematical reserves against a broad menu of risk factors, as well as identifying values-at-risk in the investment portfolios of insurance companies, pension funds, and trusts, an area that has progressed substantially in terms of defining the underlying methodologies and transparent disclosure of market risks of institutional investors that manage collective investment schemes. 23. The capital market measures emphasized joint actions between the Superintendency of Banks and the Superintendency of Securities. Each regulatory agency issued comparable rules regarding the valuation of public sector fixed income securities and certain private sector securities. Bank participation in this process was instrumental in getting the Securities Valuation Committee, comprised of the MoF, SB, and SV. and which had unsuccessfully attempted to reach an accord on a common valuation methodology since 1995, to agree on a common set of rules and methodologies. later incorporated into regulation. At the same time, the signing of a Memorandum of Understanding between the two regulatory agencies to carry out joint supervision and surveillance, should help to preserve a level playing field within the financial system and avoid regulatory arbitrage. To-date, much progress has been achieved in developing regulations for harmonizing the prudential rules for the operation of mutual funds and similar collective investment schemes. Submission to Congress of a new Securities Market Law would strengthen the regulatory and institutional framework for the issuance of new securities in the market, and has been identified as a feature of the second operation. 24. In an effort to bolster the liquidity of the government securities market and to provide an accurate methodology for the valuation of a range of other securities, the government, as part of the P-FSAL I, developed a framework to construct a zero coupon yield curve, including the authorization for the Treasury to issue short term T-bills, which will then be applied to the development of a matrix of fixed-income security prices. The more rigorous valuation process will result in greater transparency and eventual investor demand for long-term securities, which will likely improve the supply of instruments for longer term financing. Most housing loans are indexed to inflation using the so-called UVR index. On the other hand, driven by depositor preferences, banks usually pay a nominal peso interest rate on their deposits (DTF rate). The short duration of these deposits imply that the banks' liabilities are being re-priced at a high frequency, and are thus vulnerable to a jump in nominal interest rates that could create an unfavorable interest rate gap between their deposits and loans. 2To protect against upswings in interest rates, participants in the FRECH swap needed to continuously contribute funds reflecting the difference between the current low interest rates and the trigger rate beyond which participants were protected. However, in a low rate environment, banks were suffering cash outflows and would only benefit once rates rose above the trigger. A protracted period of low rates was making the mechanisms less desirable and unpopular.  - 9 - 25. In view of the wide scope and complexity of the new reforms adopted in the P-FSAL I and considering the remaining weaknesses in the financial system, it is essential that the government undertake a stocktaking review of the financial sector as specified in the matrix of conditionality for the second operation. This review should include appropriate stress tests of the banks' loans portfolios, and the vulnerability of housing finance banks to interest rate changes as well as asset/liability risk mismatches. Progress is already underway and a first draft has been prepared jointly by the authorities and the Bank. The conclusions of the study may result in some adjustments in the design of the Second Operation. 5. Major Factors Affecting Implementation and Outcome 26. The vulnerability of the economy to external shocks, as explained in the earlier section, had initially dampened activity in the financial sector leaving some segments of the system more fragile than others. The regulators' decision to implement the new rules in a gradual manner (such as the verification of the new risk management models to be presented by both banks and insurance companies, as well as some components of market risk provisioning), were influenced by concerns about possible negative repercussions on the balance sheets of financial institutions, and the need to avoid inadvertent technical insolvencies on account of purely normative rather than performance criteria. Nevertheless, regulators should consider fully implementing these rules as soon as technical capacity is evidenced both within the private sector and the SB, so as to avoid obscuring fundamental solvency issues which would have been less apparent under the older normative framework. 27. The presentation of new legislation, which depends on Congressional approval, is to some extent beyond the control of the Government. In this case the modernization of the legislative framework for the securities market involves the passage of a revised securities law. Recent government setbacks at the polls as well as in assuring passage of an ambitious set of fiscal reforms, could affect the timely approval of such legislation, which is a condition for the second operation of the Program. 28. A key factor in the successful outcome of the first operation was the Government's strong commitment to the reform process in the financial sector. With respect to macroeconomic policies, the government has held firm in terms of its commitment to lowering inflation. More stable inflation during the past two years has contributed to lower inflation-adjusted interest rates. The strong commitment of the Implementing Agency, MoF and the high degree of cooperation of the SB, was also conducive to the Program's satisfactory and timely results. 6. Bank and Borrower Performance Bank 29. In the identification phase of the Program the Bank showed sound judgment in selecting the targets drawing on the previous experience with the earlier FSAL as well as comparative reforms undertaken in other parts of the region. The Bank was instrumental in getting the regulatory agencies to work out an agreement regarding the methodologies for the valuation of securities and providing technical assistance in the process. While the design of the P-FSAL I was complex, it was compatible with the Borrower's capacity. In general the Program and the corresponding first operation were well designed and consistent with the Bank's country strategy and its contribution to macroeconomic stability. Borrower 30. The commitment of the Government to support the Programmatic framework was instrumental in the smooth process of design and implementation of the P-FSAL I. Senior staff at the Implementing Agency, the MoF, as well as the staff of key regulatory/supervisory agencies such as SB, SV, and Fogafin, were closely involved in the design of the Program and had also participated in the earlier FSAL. The three agencies maintained a very positive policy dialogue with the Bank during program design. The quality of the technical  - 1( - output produced by the Implementing Agency as well as the SB, the Central Bank, Fogafin, and the SV, was excellent. 7. Findings and Implications for Subsequent Operation(s) in Series * By emphasizing legislative and regulatory changes in the first Operation of a Programmatic series, there are some benefits of scope in the design of conditionality across various sub-sectors; followed by greater attention to implementation and second generation reforms in subsequent operations. The P- FSAL I was heavily weighted towards legislative and regulatory reforms. This approach also appears to be more adaptable to a relatively new government which can, at the outset, push forward an ambitious legislative agenda. * It is easier to design sophisticated methodologies for risk management that reflect current international best practices, than to apply and enforce them. In the case of the P-FSAL I, regulators were keen to begin enforcement of the new market rate risk norms but had to provide detailed guidance and await the building up of internal capacity and competency in the supervised financial entities, before the process could be implemented in a successful manner. Likewise, the internal capacity requirements on the part of the SB, to implement such changes, need to be incremented to ensure a timely conclusion. * The design of new regulatory tools and the development of more complex rules, as part of a financial sector reform program, should be dependent on the commitment from the Government to provide the resources to upgrade supervisory skills as well as on a realistic timetable for bringing regulators up to speed in the implementation of new policies and procedures. The development of the SARC system as well as the expanded CAMEL rating of financial institutions will require additional training of examiners as well as time to fully implement. Budgetary support and expert training to match the new responsibilities, should be adequately provided to ensure success. * A solid macroeconomic policy framework is an essential condition for the successful implementation of a financial sector reform program. The Government's success in bringing down inflation and resuming growth during the past two years has helped to stabilize the financial system. * While the successful outcome of the P-FSAL I will improve the likelihood of a successful second operation, the completion of a comprehensive stocktaking study of the financial sector with emphasis on potential risks should provide an initial perspective on the impact of recent financial sector reforms and any future risks, particularly on those aspects related to capital adequacy and loss provisioning for achieving adequate solvency. These latter effects will become more transparent following the stocktaking analysis. The recommendations from such a study should be used as input in the final design of the Second Operation. 8. Additional Information - Government Evaluation of the First Phase INFORME DE EVALUACION Primera Operaci6n: Cr6dito Programatico de Ajuste para el Sector Financiero, P-FSAL I Ministerio de Hacienda y Credito Publico - Direcci6n General de Regulaci6n Financiera Con el prop6sito de continuar promoviendo el fortalecimiento del sistema financiero y el desarrollo del mercado de capitales, el Gobierno Nacional solicit6 al Banco Mundial la estructuraci6n y el acompahamiento para el desarrollo de un nuevo cr6dito programatico de ajuste para el sector financiero, FSAL I Programatico Las acciones mas importantes que el presente Gobierno ha puesto en marcha, en el marco de los compromisos de 6ste cr6dito, estan relacionados con las areas de fortalecimiento de la regulaci6n, supervisi6n y  - 11 - esquemas de resolucion de entidades, creaci6n de mecanismos para la financiaci6n de programas de vivienda y apoyo al desarrollo del mercado de valores y de deuda publica. Como consecuencia, a partir del ano 2002, el sector financiero ha presentado una recuperacion significativa frente a la dificil situaci6n presentada a finales de la decada del 90 y, hoy por hoy, las distintas entidades que conforman el sector financiero presentan menores niveles de cartera vencida, menor exposici6n patrimonial y mejores indicadores de rentabilidad. Ademas, la recuperaci6n del sector financiero ha contribuido a Ia reactivaci6n de los diversos sectores de la economia por cuanto el sector financiero es canalizador de recursos hacia el sector productivo y eje del sistema de pagos. En efecto, los indicadores disponibles muestran que este ano el crecimiento del PIB sera mayor al de la meta establecida para el ano 2003 (2.0%); al primer semestre de este aho el crecimiento del PIB fue de 3.1% y sectores como el de la construcci6n, servicios financieros, industria manufacturera, comercio y transporte deben seguir impulsando este crecimiento. DESARROLLOS Un aspecto importante que se ha venido desarrollando para seguir en la direcci6n de fortalecer el sistema financiero y adecuar nuevos instrumentos es la reglamentaci6n de la Ley de Reforma Financiera (Ley 795 de 2003); la misma incluye dentro de sus articulados muchos de los compromisos adquiridos por el Gobierno Nacional en la Matriz de condicionalidades del FSAL I Programatico. Instrumentos y operaciones previsto en la Ley 795 de 2003, tales como el leasing habitacional, cuyo fin es impulsar la construcci6n y financiaci6n de vivienda; fondeo para el microcr6dito, para financiaci6n de microempresas; y, operaciones de microcredito inmobiliario, han permitido incentivar el desarrollo de determinados nichos de mercado. Igualmente, el establecimiento de nuevas medidas de salvamento y resoluci6n de entidades; normas de protecci6n a los clientes y usuarios del sistema financiero; incorporaci6n de parametros que otorgan mayor responsabilidad al supervisor bancario y establecimiento de un regimen sancionatorio objetivo y coherente; y ajuste al regimen de algunas entidades financieras publicas con el prop6sito de definir su funci6n dentro del sistema financiero, ha permitido modernizar algunos aspectos de la legislaci6n, corregir las debilidades evidenciadas en el proceso de reacomodamiento del sector financiero y flexibilizar rigideces de la normatividad actual. Por otro lado, y en desarrollo de la Ley de Ajuste a la Legislaci6n Financiera, se han emitidos normas claras y prudentes en el desarrollo de la actividad de intermediaci6n que permitan una adecuada supervisi6n asi como, normas que armonizan la legislaci6n colombiana con los parametros internacionales en materia de solvencia, capitales minimos y regimen de inversiones, particularmente del sector asegurador. En el tema de vivienda y su financiaci6n, y teniendo en consideraci6n que este sector es un pilar generador de empleo y de inversi6n, se han disenado nuevos mecanismos para contrarrestar los factores que afectan la demanda de credito y el riesgo en que incurren las entidades crediticias. Lo anterior, en el marco de la Ley 546 de 1999 que introdujo ajustes que significaron una profunda modificaci6n a la estructura de financiacion de vivienda e implicaron el reordenamiento del negocio y de su regulaci6n. De esta forma, las medidas adoptadas en el marco de esta Ley, han permitido definir claramente las caracteristicas de los cr6ditos hipotecarios y los nuevos mecanismos creados por el gobierno estan teniendo  - 12 - buenos resultados. Ademas, si el entorno macro y las tasas de cambio e inflaci6n siguen bajo control se generara mayor confianza en el sistema, lo que a su vez fortalecera la reactivacion que se viene presentando. Uno de los esquemas creados con la finalidad de implementar un mecanismo que le permita a los usuarios de vivienda asegurar los flujos futuros de sus creditos hipotecarios y al sector financiero acelerar el proceso de desembolsos de cr6ditos para financiaci6n de vivienda dentro de un marco de seguridad y riesgo manejable es la cobertura contra la inflaci6n que, a agosto de 2003, ya habia sido solicitado por 6.024 deudores de creditos por valor de $148.000 millones. Igualmente, se ha continuado revisando el esquema de operacion del Fondo de Reserva para la Estabilizaci6n de la Cartera Hipotecaria - FRECH, mecanismo creado para cubrir el riesgo de los establecimientos de credito hipotecario del diferencial entre la tasa de inter6s y la inflaci6n. Principalmente, se han adelantado estudios para determinar la viabilidad del mecanismo a las necesidades de los agentes involucrados. Ante todo se busca garantizar la estabilidad del sector financiero hipotecario dada la volatilidad existente en sus fuentes de fondeo. Como se observa, la estrategia del Gobierno para el sector de la construcci6n y la financiaci6n de vivienda ha sido integral, sin dejar de lado el impulso decidido a la vivienda de interes social y a la adquisici6n de la misma, dada la importancia de este tipo de vivienda dentro de segmentos de la poblacion colombiana. Por otro lado, y en desarrollo del programa de Renovaci6n de la Administraci6n PCublica, a traves del cual se adelanta la creaci6n y consolidaci6n de un Estado gerencial, que presupone una gesti6n austera en el manejo de los recursos publicos y al servicio del ciudadano, se ha venido adelantando la racionalizaci6n de entidades estatales, incluidas las del sector financiero. El espiritu de esta politica es enajenar las participaciones accionarias que se tengan en diferentes entes econ6micos publicos y privados, conservando exclusivamente aquellas entidades necesarias para que el Estado cumpla con su funci6n social. En cumplimiento de esta politica de racionalizaci6n de la banca publica el Gobierno tom6 la decision de mantener como unica entidad financiera publica de primer piso al Banco Agrario de Colombia S.A. y procedio a liquidar la Caja de Credito Agrario, Industrial y Minero, castigar los activos improductivos y transferir los activos productivos y los pasivos con el publico del BCH a Granahorrar, transferir los activos productivos y pasivos con el publico de BanEstado a Bancaf6. Respecto de Bancafe, actualmente se esta buscando vincular como operador estrategico a un inversionista(s) calificado(s) para tener a su cargo la operaci6n del banco y con el apoyo de FOGAFIN y la Corporaci6n Financiera Internacional (IFC) se apoyara el proceso de vinculaci6n de capital privado en el Banco. El sector fiduciario y la banca de segundo piso tambien ha sido objeto de intervenci6n con el prop6sito de reducir la participaci6n del Estado en este sector. En el primer caso, la ultima acci6n adelantada tiene que ver con la fusi6n por absorci6n de Fiduagraria S.A. con Fiduifi S.A.. y, en el segundo caso, con el desmonte del IFI mediante la cesion de activos y pasivos a BANCOLDEX y la recuperaci6n de activos residuales mediante la venta a un tercero. Otro aspecto que se debe mencionar en el cual el Gobierno Nacional esta comprometido, dado el fen6meno de la globalizaci6n de los mercados que exige que la regulaci6n de los mismos se ajuste a las practicas y tendencias internacionales y que la competencia y las nuevas tecnologias en informatica y comunicaciones han permitido un vertiginoso desarrollo de los mercados de valores alrededor del mundo, es la necesidad de ajustar el esquema regulatorio a las nuevas formas de negocios y a los nuevos riesgos involucrados.  - 13 - Bajo esta premisa, se ha retomado el analisis de proyectos de regulacion y del anteproyecto de ley para regular las actividades de manejo, aprovechamiento e inversi6n de recursos del publico que se efectuen mediante valores, con el fin de proveer al pa[s de un marco legal coherente, actualizado, moderno y flexible, que organice las distintas autoridades, instituciones y agentes del mercado de valores de manera armonica; proteja los derechos de los inversionistas; promueva el desarrollo, eficiencia y funcionamiento; y preserve la confianza del publico. Hay que mencionar, ademas, el esfuerzo que el Gobierno Nacional esta haciendo para fortalecer la supervisi6n del mercado de valores. CONCLUSIONES Son muchas las tareas por desarrollar para continuar con los esfuerzos hasta ahora realizados y lograr afianzar el sector financiero asi como el fortalecimiento de la regulaci6n, supervisi6n, creaci6n de mecanismos para la financiaci6n de programas de vivienda y apoyo al desarrollo del mercado de valores y de deuda publica. Por ello, el Gobierno Nacional, para la segunda fase del FSAL Programatico, ha previsto continuar y complementar las reformas iniciadas, dentro de las cuales se pueden destacar: * Continuar con la reglamentaci6n e implementacion de la Ley 795 de 2003 mediante la emisi6n de Decretos y Circulares. * Adoptar por parte de la SB un Plan Estrat6gico que incluya procesos de supervisi6n y politicas, manuales y procedimientos, metodologias de valoracion de riesgos, entre otros. * Adoptar medidas que incrementen la competitividad, eficiencia y transparencia del mercado hipotecario. * Presentar propuestas de reforma al Mercado de Valores, ya sea a traves de Decretos o Leyes. Sin embargo, es importante mencionar que los avances son satisfactorios y las condiciones econ6micas y sociales estan dadas para continuar con las reformas que se requieran en la direcci6n de dotar al mercado intermediado y no intermediado de estabilidad y claridad en las reglas que los regulan, en beneficio de todos los participantes, en particular, usuarios del cr6dito, inversionistas, instituciones, ahorradores, depositantes y demas actores.  - 14 - ANNEXES ANNEX 1. KEY PERFORMANCE INDICATORS / LOG FRAME MATRIX Table 1.1 Colombia: Selected Economic Indicators 1995 1996 1997 1998 1999 2000 2001 2002 GDP growth (%) 5.2 2.1 3.4 0.6 -4.2 2.9 1.4 1.7 Inflation (%): Average 20.9 20.8 18.5 18.7 10.9 9.2 7.9 6.5 year-end 19.5 21.6 17.7 16.7 9.2 8.8 7.6 7.0 Interest Rates: DTF 32.34 31.14 24.13 32.58 21.33 12.15 12.44 8.94 Lending rate 42.77 41.99 34.22 42.21 30.41 26.37 20.72 16.33 Exchanqe Rate (Pesos / US$) Average 912.8 1036.5 1141.1 1427.0 1758.6 2087.4 2299.8 2508.0 (% chg) 13.6 10.1 25.1 23.2 18.7 10.2 9.1 year-end 987.6 1005.3 1293.6 1542.1 1873.8 2229.2 2291.2 2864.8 (% chg) 1.8 28.7 19.2 21.5 19.0 2.8 25.0 Public Sector Deficit (% of GDP) with privatizations -0.06 -0.86 0.45 -3.14 -3.74 -3.76 -4.24 -3.59 excl. privatization -0.31 -1.7 -2.81 -3.67 -4.08 -4.19 -4.34 -3.59 Balance of Pavments (millions of US$): Current Account (4,528) (4,642) (5,751) (4,858) 671 626 (1,251) (1,639) Financial Account: FDI (net) 712 2,784 4,753 2,033 1,392 1,973 2,493 1,171 Loans (net) 1,565 2,595 1,517 97 (1,075) (1,354) (4) (1,347) Other (net) 2,282 1,304 318 1,184 (873) (634) (99) 1,472 Net Financial Acct. 4,560 6,683 6,587 3,314 (555) (15) 2,390 1,295 Errors & Omissions (30) (321) (559) 154 (430) 259 78 482 Overall Balance 2 1,721 277 (1,390) (315) 870 1,217 138 o/w: chg. in reserves 2 1,721 277 (1,390) (315) 870 1,217 138 Crrnt Acct (% of GDP) -4.9 -4.8 -5.4 -4.9 0.8 0.7 -1.5 -2.0 Sources: Central Bank, Finance Ministry, and the National Statistical Institute  - 15 - Table 1.2 Colombia: Commercial Banks (excl. Cooperatives) Selected Indicators 1996 1997 1998 1999 2000 2001 2002 I Real Growth Rates Loans 7.1 3.0 -9.9 -16.3 -7.9 -4.2 Deposits 4.5 1.3 -1.6 -6.7 -1.3 -0.7 Assets 6.9 1.8 -8.6 -10.0 -4.0 -0.5 11 Asset Quality Past-Due Loans / Loans 6.8 7.3 8.7 13.9 11.8 10.9 10.0 Past-Due Loans / Capital 31.7 33.5 44.7 82.0 61.4 55.8 50.0 Loss Allowance / Past-Due Loans 30.7 30.2 28.8 33.2 47.7 61.0 78.2 Loans Rated C,D,E / Loans 14.3 16.2 14.4 Loans Rated C,D,E / Capital 74.3 83.0 72.6 By Type of Loan: Commercial Past-Due/Com. Loans 5.4 6.3 7.5 11.4 9.2 6.7 5.3 Commercial Past-Due / Capital 13.5 15.8 20.5 36.3 27.2 19.9 16.0 Consumer Past-Due/Con. Loans 13.8 12.5 13.8 19.8 14.0 9.7 7.1 Consumer Past-Due / Capital 13.6 10.4 12.9 18.9 10.1 7.4 5.3 Mortgage Past-Due/Mrtg. Loans 4.0 5.9 7.8 15.0 16.0 20.7 23.5 Mortgage Past-Due / Capital 4.7 7.4 11.3 26.8 24.1 28.5 28.5 Structure of the Loan Portfolio (%): Commercial 53.5 54.6 53.5 53.6 57.1 58.4 60.8 Consumer 25.1 27.2 28.2 30.3 29.0 26.8 24.3 Mortgage 21.3 18.2 18.3 16.1 13.9 14.8 14.9 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 IlIl Liquidity Cash & Due From / Deposits 15.3 13.4 12.9 10.9 9.4 9.1 10.0 Savings + Time Dep. / Deposits 68.8 73.6 60.3 61.3 64.9 65.7 83.8 Loans/Deposits 114.5 117.4 119.3 109.3 98.0 91.5 88.2 Foreign Liabilities / Liabilities 7.2 8.3 9.1 7.4 6.0 5.1 5.0 Deposits / Liabilities 66.6 65.3 64.0 67.5 70.4 72.1 71.8 IV. Capital Net Worth /Assets 14.1 14.4 13.0 11.1 11.7 11.4 11.2 V. Earnings ROA 1.63 1.19 -2.48 -3.53 -2.37 0.13 1.07 ROE 11.50 8.32 -19.10 -31.88 -20.24 1.11 9.57 VI. Management Efficiency (excl depr&amortization) 61.3 61.3 70.5 80.5 80.0 74.1 71.0 Personnel / Total Admin. Expenses 55.28 55.60 50.96 45.73 42.45 43.06 43.50 Interest Income/Assets 20.30 17.05 19.12 15.44 10.73 9.96 8.36 Interest Expense/Assets 15.60 12.61 15.57 12.99 7.47 7.11 5.15 Effective Spread 4.70 4.44 3.55 2.45 3.26 2.85 3.21 Net Interest Margin 7.06 6.37 5.26 3.80 4.41 3.72 4.02 VIl Size Total Assets (avg,billions) 51,342 65,003 78,496 79,545 78,202 81,051 85,779 Total Assets (US$s, billions) 49.5 57.0 55.0 45.3 37.5 35.2 34.2 Memorandum: Inflation 20.2 18.5 18.7 10.9 9.2 8.0 6.3 Consumer Price Index (1995=1.0) 1.20 1.42 1.69 1.87 2.05 2.21 2.35 Exchange Rate (end of period) 1005.3 1293.6 1507.5 1873.8 2229.2 2291.2 2864.8 Exchange Rate (Period average) 1036.7 1141.0 1426.1 1756.2 2087.9 2299.6 2508.0 Source: Supertindency of Banks  Anniiex 2. Matrix of Policy Actionls Policv Matrix and Ac hun s' Comnpleted FIRSTPROGRAMMATIC I-. I \i I.t li' rOR STATUS OF P-FSAL I AT TIME OF SECOND PROGRAMMATIC Fl'. I.\ i ll KEY EXPECTED RESULTS AT THE END OF THE ADJUSTMENT LOAN -- PRIOR ACTIONS TAKEN ICR SECTOR ADJUSTMENT LOAN - FUTURE PROGRAM AACTIONS MACROECONOMIC POLICY ENVIRONMENT Policy Objective: Maintenance of a soundmacroeconomicpolicyframework. Responsible Government Agency: MHCP The BoiTower through MoF has maintained a sound In January 2003, an IMF Stand By The Borrower through MoF. has maintained a Reduction of fiscal deficit and reliance on long term macroeconomic program maintained with appropriate Arrangement (SBA) was approved for a two sound macroeconomic program maintained with debt financing, to increase stability. fiscal, monetary, inflation, reserves and exchange year period. Moderate reduction in the fiscal appropriate fiscal, monetary, inflation and policies. deficit achieved, but additional efforts needed. exchange policies. L. BANK REGULATION AND RESOLUTION IMPLEMENT'IA TION OF THE REFORMED FINANCIAL SYSTEM IA W TO ENSU fRE S USTAINABILITY OF THE FINANCIAL SYSTEM Policy Objective: Upgrading the Banking Regulatory, Supervisory, and Institutional Framework Responsible Goveinment Agencies: MHCP, SB The Borrower has enacted Law 795-2003 to regulate, Law 795 approved in January 2003. Specific The Borrower through: (a) MoF has issued Banking stability and supporting financial and inter alia: (a) the independence of decision making by measures as follows: (a) Article 13, and Decrees for implementing the financial reform balance sheet strength indicators become evident. Fis' of boards of directors: (b) the enhancement of the Circular 007; (b) Articles 12 and 13; (c) law and (b) SB has issued circulars and Transparent and accountable identification and existing code of conduct for managers and directors at Articles 12 and 45: (d) Articles 81 and 82; (e) regulatory amendments to adapt existing removal of conflicts of interest and related party risks Fls; (e) the integration of sanctions rules applicable to Articles 6 and 26; and (f) Articles 32, 33, and regulations to the supervision of financial is achieved. Evidence of their reduction within the administrative officers, board directors and auditors at 45. Some 30 decrees and regulations have conglomerates and related parties. financial system. is established via the SB's record of FIs; (d) the powers of SB to conduct supervision of been issued by SB and MOF to proceed with application of the new corporate governance consolidated financial groups including authority for the implementation of the new rules regulations for the financial sector. SB to inspect companies in those financial groups not established by Law 795 including the directly under its supervision: (e) the prevention of procedures for consolidated supervision. New Application of the enhanced banking supervision conflicts of interest related to the operations of Fls; (f) credit risk management system (SARC) based powers is evidenced. permitting the early correction the enhancement of SB's mechanisms to intervene Fls on External Circular 011, 2002 in process of The Borrower though the SB has demonstrated: of adverse financial trends via the prompt application and apply sanctions. implementation. (a) the application and enforcement of the Law of sanctions and fines towards mismanaged and non 795-2003 via actions such as specifying and complying financial institutions. Graduated and integrating in a sequenced manner, prompt intensifying process of sanctions provides evidence of The Borrower, (a) through SB, has issued Circular Extensive regulations set forth concerning the corrective actions to be applied, and developing institutional correction or dissolution of entities Externa No. 046, dated October 29, 2002, which reporting of financial transactions as specified procedural handbooks specifying enforcement of posing insolvency risk, thus reducing potential costs strengthens existing regulations that prevent money in External Circular 25 as per Law 795. remedial actions under a graduated regime of to the State. Improved prudential practices increase laundering in the Borrower's financial sector, and (b) sanctions, and (b) the effectiveness and the confidence and stability of the financial system, through the enactment of Law 795-2003, regulates Fls' improvement of supervision via progress on and permit managed risk taking, allowing channeling obligations to directly report information on financial benchmarks established under it's Strategic Plan, of increased credit into the economy- cash transactions to MoF's anti money laundering unit. including the improvement of risk assessments made for financial institutions, the conducting of Detection of illicit financial activities and cash flows consolidated financial group examinations, and becomes more successful as regulatory. market the investmentof resources for SB's institutional ; I..I; I ;1 : ,o .'. -.I . ' , , p -.oved.  - 17 - Policy Matrix anzd Actionis Comiipleted FIRST PROGRAMMA TIC I i'. Il 'I II 1 rOR STATUS OFP-FSAL IATTIME OF SECOND PROGRAMMA TIC l-iVtVl Wi A 1. KEY EXPECTED RESULTSA7TTHE END OF 7'IIE ADJUSTMENT LOAN -- PRIOR ACTIONS TAKEN ICR SECTOR ADJtUSTMENT LOAN - i I 1 1. I PROGRAM ACTIONS strengthening. IMPLEMENTA TION OF THE REFORMED FINANCIAL SYSTEM LA W FOR IMPROVING EFFECTIVENESS OF BANKING RESOLUTION PROCEDURES Policy Objective: Upgrading the Bank Resolution and Deposit Insurance Operational Framework. Responsible Government Agencies: MHCP, FOGAFIN The Borrower, through the enactment of Law 795- As per Law 795 the specified areas were The Borrower through MoF has undertaken a Reduction of fiscal liabilities and State interests in 2003, has regulated (a) the compulsory procedures for covered as follows: (a) Articles 11, 12, 28, and financial sector stability review to assess future intervened financial institutions is achieved via the asset and liability transfers and carve-outs from failing 29; (b) Article 28 f. g, h, and 1: and (c) Article banking system health using projections of: (a) sale of their assets and matching liabilities through banking institutions; (b) FOGAFIN's issuance of 28. the risks of weak banking institutions under low the new securitization/trust mechanisms. Evidence guarantees backed with deposit insurance funds, and (c) growth scenarios: (b) the banking sector's actual exists of failed banks' viable assets/balance sheets FOGAFIN's powers for swapping bonds issued by the In addition to the carve-out procedures, Article cash flows: (c) the goveinment debt securities successfully transferred to private sector institutional securitizaton trust, with FOGAFIN bonds. 7, 29, 30, and 31 and SB Decree 1335 address held by commercial banks and its possible risks buyers. Increased banking strength and liquidity of the winding down of a financial institution, to said banks: and (d) contingency plans to the remaining solid banks, permit the provision of The Borrower through MoF has issued a commitment resolve any potential negative effects within said credit to an increased number of productive letter to the Bank dated March 28. 2003, to tndertake a Commitment letter to the Bank confirmed, and sector, enterprises with cash flow prospects. stocktaking review of the Borrower's financial sector. study currently underway. including, itter alia, a review of: (a) the risks affecting weak banking institutions under low economic growth scenarios; (b) the banking sector's cash flow generation; (c) the Borrower's public debt securities held by commercial banks and the possible risks affecting said banks as holders of said debt securities; and (d) contingency plans to address any potential risks caused by internal and/or external factors affecting the financial sector. The Borrower: (a) through IFI's shareholders assembly Transfer of IFI assets to BANCOLDEX The Borrower through FOGAFIN, has Evidence, if liquidation of banks is required, that all of January 27, 2003, has approved the transfer of IFI's completed as per shareholder assembly. undertaken progressive actions in the small depositors covered under the insurance selected assets and liabilities to BANCOLDEX; and (b) divestment/dismantling of insolvent State banks, threshold limit are fully paid out with 100% of their through CONPES Document Number 3214 dated Privatization process of BANCAFE has and measures for selling off assets of said banks balances protected. Premiums charged to financial January 9, 2003, has requested FOGAFIN to proceeded with public bid requests issued to the private sector. institutions by the State for deposit insurance, are commence the privatization process of BANCAFE. and including: (i) sale of 51 % of the bank to a applied based on the risk categorization of banks (c) through FOGAFIN has selected an investment firm strategic investor; (ii) sale of the remaining established by the SB. that will carry out said privatization. 49% of shares to the public: and (iii) strategic investor to buy unsold shares. The divestment, merger and liquidation of the remaining insolvent State-owned banks has been completed. and fiscal contingent liabilities in this respect have been reduced substantially or fully eliminated.  - 18 - Po ,1i. I .MaIr,i.1 .,,,.. It iion, X C,11p *I/tod 1 FIRST PROGRAMMATI( I'1: t , I II1 e rOR | i 7I 7 OFP-FSAL IAT TIME OF ei '0tt PROGRAMMA TIC FINANCIAL KEY EXPECTED RESULTSATTIIE END OF THE ADJUSTMENTLOAN-- PR'-R v1 I. \ I'AKEN [CR '1 1'It R 1111I 'iti/i LOAN-FUTURE PROGRAM ACTIONS II. HOUSING FINANCE STRENGTHENING THE HOUSING FINANCE SECTOR AND EXPANSION OF THE MORTGAGE MARKET Policy Objective: Upgrading the Regulatory/Operational Framework of the Mortgage Market and Improving Access to Credit Responsible Government Agencies: MHCP. FOGAFIN The Borrower has: (a) enacted Law 794-2003 to, inter Law 794 enacted in JanLary 2003 including The Borrower though MoF, and with technical New judicial procedures show evidence of fast and alia, streamline banking foreclosure related judicial the relevant Articles: 124, 300, 315, 424, and support from FOGAFIN and SB. has taken efficient sale of loan collateral assets, allowing proceedings. and therefore execute collateral in a timely 501; (b) Decree 710 issued stating procedures measures to increase the competitiveness, increased private market participation in the manner; (b) through MoF has issued Decree No. 710 for micro-credit from commercial banks soundness, efficiency and transparency of the absorption of assets of failed financial institutions, dated March 20. 2003, establishing procedures for through finance companies; (c) Decrees 775, mortgage industry, and to improve the and prompt payment of creditors. finance companies to obtain financing from commercial 777, and 779 and Extemal Circular 22 of 2003 institutional set-up to support housing micro banks so as to increase housing micro credit lending; provide the basis for housing lease finance. finance. Increased access to housing credit evidenced by (c) enacted Law 795-2003 to regulate (i) the increase of underserved segments of the population. The access to segments of the population with limited or no The streamline of banking foreclosure production of mortgage loans has expanded and access to financial services with respect to housing procedures is expected to significantly reduce lending margins reduced. The micro housing finance micro credit, and (ii) the participation of banks in the delays in executing a foreclosure. market applied to housing has expanded. housing lease market. Mortgage bonds and mortgage backed securities The Borrower through MoF has taken measures develop with sufficient liquidity as a sustainable The Borrower, through: (a) FOGAFIN has issued (a) Law 795, Article 96 and Decree 66 to ensure that secondary mortgage market funding tool without undue regulatory arbitrage operational guidelines for a new swap program to establish the guidelines for the FOGAFIN regulations and practices are adjusted, including and/or tax privileges. protect mortgage borrowers against the risks of swap. FOGAFIN has issued External Circular improved securitization methodologies to inflation; and (b) the Central Bank has adopted and 001 for 2003 providing detailed guidelines for harmonize risk-based capital adequacy norms and A package of public policy tools to augment the published on its web site, procedures for swapping of financial intermediaries. In addition. oversight functions between banks and housing finance market (e.g.: interest rate hedge, mortgage backed securities through the FRECH fund, informational literature has been developed for securitization companies. inflation swap. mortgage security guarantees. in order to acquire more liquid treasury securities. consumers explaining the swap protection rationalization of tax exemptions) improves the program; (b) the Central Bank has also operation, risk management and ongoing sustainable adopted and published procedures whereby development of the primary and secondary mortgage financial intermediaries can utilize mortgage markets. backed securities in REPO operations. I III. NON-BANK FINANCIAL INSTITUTIONS (INSURANCE, PENSIONS, TRUSTS) STRENGTHENING REGULA TORY FRAMEWORK AND FINANCIAL SOUNDNESS OF THE INSURANCE, TRUSTS, AND PENSION INDUSTRIES Policy Objective: Upgrading the Regulatory Frameworkfor Risk Management and CapitalAdequacy of the Non Bank Financial Service Institutions. Responsible Govemment Agencies: MHCP, SB The Borrower has enacted Law 795-2003 to regulate: Law 795 adopted the approptiate language as The Borrower through SB has demonstrated (a) The solvency of the insurance industry is confirmed (a) MoFs powers to establish solvency margins and follows: (a) Articles 17 and 43: (b) Articles 5 significant progress in the implementation of new with respect to international standards, and the  - 19 - Policy Matrix and Ac ti. ,'l i Comizpleted FIRSTPROGRAMMATIC I '. 1V' i ii. vf r OR STATUS OF P-1 s AL [AT TIME OF SECOND PROGRAMMATIC FINANCIAL KEY EXPECTED RESULTS AT TIIE END OF THE ADJUSTMENT LOAN -- /" kit; t I I-\ S TAKEN ICR SECTOR ADJUSTMENT LOAN - FUTURE PROGRAM ACTIONS technical reserve of the insurance industry. (b) the and 16 and Decree number 1222: and (c) insurance regulations addressing solvency margin viability and actuarial soundness of the industry is minimum capital requirements for insurers and re- Article 16. New capital standards are expected standards and methodologies to upgrade the established for the risk ttnderwriting business. insurers; and (c) MoF's powers to establish minimum to be enforced as of January 2004. calculation of technical and mathematical Corporations and households increasingly rely on capital requirements for the different business lines of reserves, and (b) set forth regulatory insurance coverage for personal and property risks. insurance. methodologies for identifying Values-at-Risk in the pensions, trust and insurance industries' Insurance companies which only collect premiums investment portfolios. and commissions but have no solid actuarial solvency or risk management culture, either adapt to the new norms or capitalize adequately. or are consolidated and removed from the market by the regulatory authorities. Pension, trust and insurance companies are adequately hedged and capitalized, and have improved corporate policies to ensure their provision against financial market risks, thus guaranteeing improved protection of client assets, reduction of liabilities for the State. and expansion of the client industry base. IV. CAPITAL MARKETS MODERNIZING T-HE LEGISLATIVE FRAMEWORK FOR THE SECURITIES MARKET Policy Objective: Upgrading the Regulatory Framework for the Governance, Transparency, Operations and Liquidity of the Securities Market Responsible Government Agencies: MHCP, SV (a) The Borrower, through SB, has issued Circular Both SB and SV, as agreed in (a) and (b) have The Borrower through SV, has implemented a Increased issuances of securities on the capital Number 033. dated August 2, 2002 to update and adjust issued regulations governing valuation of new Securities regulatory and institutional markets and purchases of securities by investors are market valuation regulations; (b) the Borrower, through securities, including the classification of framework covering, inter alia: evident in the expansion of the capital market. SV, has issued Resolution Number 0550, dated August holdings and the treatment of gains and losses. (a) Corporate governance norms including role of supported by improved rules of disclosure, corporate 2, 2002 to regulate a common securities and financial The Borrower has also developed a the Board, management, auditors, and other governance, professional qualification of industry asset valuation methodology to unify market pricing methodology to establish a yield curve used as industry officials: participants. and improved securities industry trading norms: and (c) SB and SV have signed a memorandum a basis for valuation of other non-liquid (b) Securities issuance norms and disclosure infrastructure. of understanding dated November 13, 2002, to, inter securities. The Colombian Stock Exchange requirements including rationalized procedures alia. carry out a joint supervision and surveillance of publishes a daily price vector. which is to be for issuance: and The mutual funds industry and its enhanced risk Fls and securities brokers and dealers, in accordance used by financial intermediaries in the (c) Qualification of standards for industry management practices has developed, with increased with the procedures set forth therein. valuation of their investment portfolios. professionals and entrants. participation by consumers and investors, based on the iniplementation of consistent regulatory, valuation Both SB and SV, as mentioned in (c) at left, The Borrower through the coordination between and pricing norms across the sub-sector. have signed a memorandum of understanding SV and SB, has harmonized the regulatory and for mutual collaboration. The procedures for supervisory framework for the mutual and joint supervision are being worked out. investment funds industry -- trust institutions, specialized investment funds and mutual fupnds under different supervisory auithorities are placed within a consistent framework.  - 20 - Policy Matrix and Actionis Comtipleted FIRSTPROGRAMMATIC rI.Vt i VC;il( 7W TOR STATUS OF P-FSAL I ATTIME OF %: ''\f ,t PR; . F I I//( { i 11/l KEY EXPECTED RESULTSATT7IE END OF THE ADJUSTMENTLOAN--Jl'l't; Al 1l'\ 1 IA/-\ ICR SECTOR 1/t, %I ll/' I IL.OAN- FjTURE PROGRAM A CTIONS The Borrower through SV has implemented valuation guidelines for a range of public securities and private fixed income instruments. V. THE GOVERNMENT DEBT AND MONEY MARKETS UPGRADING THE POLICY AND OPERA TIONA FRAMEWVORK FOR THE GOVERNMENT SECURITIES MARKET Policy Objective: Implementation of a Public Debt Issuance Strategy to Improve the Functioning of the Fixed Income Market Responsible Government Agencies: DGCP, SV, BR (a) The Central Bank's board has issued the procedures (a) as per Law 795, Article 16, and External The Borrower through MoF. has developed an A regular issuance program for government securities for said institution's purchase of on-the run securities Circular issued by the Central Bank regarding issuance strategy for government debt developed is implemented spanning across the yield curve (traded securities reflecting the series most recently the purchase of on-the-run securities: (b) through a coordinated effort comprising technical spectrum, thus engendering the increased issuance of issued); (b) the Borrower, through MoF has issued resolution regulating primary dealers was teams from the MoF regulatory units, the DGCP, private sector fixed income securities which use the Resolution Number 001, dated January 2, 2003, to issued; and (c) Resolutions 964 and 1047 were and the Central Bank. government market as a benchmark. The size and regulate, inter alia, primary dealer operations; and (c) issued to regulate the valuation of domestic depth of the capital market is improved. thus the Borrower, through SV, has issued Resolutions treasury securities based on the methodology increasing alternative funding sources for businesses Number 0964 and 1047 dated December 13, 2002 and used in estimating a yield curve that is to apply and corporations. December 30, 2002, respectively, to regulate the in the case of non-liquid segments of the valuation of domestic treasury securities, market.