Colombia - Programmatic Financial Sector Adjustment Operation Project

Document of THE WORLD BANK FOR OFFICIAL USE ONLY Report No. 25472-CO INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US $150 MILLION FOR A PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT OPERATION TO THE REPUBLIC OF COLOMBIA April 3, 2003 Finance, Private Sector and Infrastructure Department Country Department for Colombia and Mexico Latin America and the Caribbean Regional Office 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  CURENCY AND EXCHANGE ,EAfSm (As of March 31, 2003) Currency Unit = Colombian Peso US$1.00 = C$ 2,958.75 IFISCAL YEAR January 1 - December 31 AiBBREVIIAlTrONS AND Acaommis AMLJCTF Anti-money laundering / Countering of terrorist financing BANCAFE Banco Cafetero (Bank serving the Coffee Grower's Region) BANCOLDEX Banco de Comercio Exterior de Colombia (State Export Bank) BECH Bancos Especializados en Credito Hipotecario (Mortgage Banks) BR Banco de la Repuiblica (Central Bank of Colomnbia) CAMEL Capital/Assets/Management/Earnings/Liquidity CAV Corporaci6n de Ahorro y Vivienda (Savings & Loan Banks) CISA Central de Inversiones, S.A. (Goverrnent Asset Management Agency) CONPES Consejo Nacional de Politica Econ6mica y Social (Economic Policy Courci;, DANE Departamento Administrativo Nacional de Estadistica (Statistics Agency) DGCP Direcci6n General de Cr6dito Publico (Public Debt Office of MoF) DIAN Direcci6n de Impuestos y Aduanas Nacional (Tax and Customs Agency) DTF Dep6sitos a Termino Fijo (Interest rate on time deposits) DTN Direcci6n del Tesoro Nacional (National Treasury in Ministry of Finance' EMBI Emerging Markets Bond Index FEN Financiera Energetica Nacional (Government Energy Sector Bank) FINAGRO Fondo para Financiarniento del Sector Agropecuario (Agro Sector Bank) FINDETER Financiera de Desarrollo Territorial (Municipal Financing Bank) FIs Financial Institutions (supervised by the Banking Superintendency) FOGAFIN Fondo de Garantias de Instituciones Financieras (Deposit Insurance Agency) FRECH Fondo de Reserva para la Estabilizaci6n de la Cartera lipotecaria FSAP Financial Sector Assessment Program LAIS International Association of Insurance Supervisors IFI Instituto de Fomento Industrial (Industrial Development Bank) M2 Currency in circulation, demand deposits and time deposits MBS Mortgage Backed Securities MoF Ministry of Finance PDR Problem Debt Restructuring RP/REPO Repurchase Market / Repurchase Operation SARC Sisterna de Administraci6n Riesgos de Cr6dito (Credit Risk Mgmt. System) SB Superintendencia Bancaria (Superintendency of Banks) SEARS Sisterna Especial de Andlisis de Riesgos de Seguro (Insurance Risk Mgxnt. Sys.) SEN Sistema Electr6nico de Negociaci6n (Electronic TSrading System - Gov't DebZ) SV Superintendencia de Valores (Securities Superintendency) TES Treasury Bills/Notes ULAF Unidad de Inteligencia y Analisis Financiero (AML Analysis Unit) UPAC Unidad de Poder Adquisitivo Constante (Mortgage Price Index) UVR Unidad de Valor Real (Index based on real value of mortgages) VAR Value at Risk VIS Vivienda de Inter6s Social (Social Priority Housing) Vice President: David de Ferranti Count Director: Isabel Guerrero Sector Director: Danny Leipziger Sector Manager: Fernando Montes-Negree Task Manager: John Pollner  FOR OFFICIAL USE ONLY REPUBLIC OF COLOMBIA PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN TABLE OF CONTENTS Loan and Program Summary PART I. Recent Economic Developments and Prospects ........................................... I A. Recent Economic Developments ...........................................I B. Economic Prospects and Financing Requirements ............................................ a . 3 PART II. Financial Sector Context and the Reform Program . ........................................... 5 A. Overview ............................................5 B. The Banking System ............................................7 The Govemment Reform Agenda for the Banking System .................................................... 10 C. Housing Finance .............................................................. 21 The Govemment Reform Agenda in the Housing Finance Sector .......... .............................. 23 D. The Insurance Sector and Non Bank Financial Services ......................................................... 26 The Govemment Reform Agenda in the Insurance Sector and Non Banks .. ..................... 28 E. The Capital Markets .............................................................. 32 The Govemment Reform Agenda in the Capital Markets ..... .............................................. 32 F. The Govemment Debt and Money Markets .............................................................. 35 The Govemment Reform Agenda in the Govemment Debt and Money Markets .................. 36 PART III. THE PROPOSED LOAN: A PROGRAMMATIC APPROACH ........... ....................... 38 A. Loan Description: Objective and Rationale for Bank Involvement ................. ..................... 38 B. Program Conditionality .............................................................. 42 C. Disbursement and Auditing .............................................................. 48 D. Environmental Aspects. .......... .................................................... 49 E. Social and Poverty Impacts ............................................................... 49 F. Benefits and Risks. .............................................................. 50 Annex 1: Policy Matrix. ............. ... 52 Annex 2: Letter of Sectoral Development Policy .............................. .... ; 56 Annex 3: Banking Regulation and Supervision in Colombia ......................................................... 72 Annex 4: Evaluation of the Insurance Sector with respect to IAIS Core Principles .......76 Annex 5: The Government Securities Market and its Link to the Domestic Capital Market .......... 83 Annex 6: Detail of Actual and Potential Proposals Comprising the Ongoing Policy Dialogue ...... 86 Annex 7: Timetable of Key Processing Events .......................................... ......................... 90 Annex 8: Colombia - Fund Relations Note ................................................................... 91 Annex 9: Colombia - Status of World Bank Operations ...................................................... ...... 94 Annex 10: Colombia - Statement of IFC's Committed and Disbursed Portfolio .................... ........ 95 Annex 11: Colombia at a Glance ................................................................... 96 Bank staff who worked on the FSALincluded Fermando Montes-Negret (Sector Manager, LCSFF), John D Pollner (Task Manager and Lead Financial Sector Specialist, LCSFF), Loic Chiquier (Lead Financial Officer, OPD), Joaquin Gutierrez (Lead Financial Sector Specialist, OPD), Patnck Conroy (Program Director and Peer Reviewer, FSEGP), Manuel Peraita (Consultant/Insurance), Thomas Glaessner (Lead Economist, OPD), Jeppe Furbo Ladekarl (Sr Financial Specialist, OPD), Claire Grose (Sr Financial Specialist, OPD), Augusto de la Torre (Senior Regional Financial Sector Advisor and Peer Reviewer, LCRCE), Helena Issa (Program Assistant, LCSFF) This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.   REPUBLIC OF COLOMBIA PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN PROGRAM AND LOAN SUMMARY Borrower: The Republic of Colombia Implementing Agency: Ministry of Finance Objective: The objective of the loan is to complete the clean up of the banking system as a result of the 1999-2001 crisis and to strengthen the government's capacity to manage and mitigate weaknesses in the financial system. The project also aims to strengthen and diversify the participation of the housing mortgage market including improved access to finance for the micro sector, as well strengthening non bank financial services and securities institutions in the financial system. Description: Banking Sector. A key aspect of the proposed program is the design of a multi pronged effort to first dispose of the financial system's residual loan assets (or collateral) remaining from the interventions during the earlier crisis, by developing more agile and modern financial instruments and fiduciary arrangements to package and sell loan assets. As part of this effort, the remaining intervened banks are expected to be divested and one of the largest second tier problem banks will be wound down. Prudential regulations and supervision would be strengthened to incorporate corporate governance rules and development of a graduated sanctions regime to ensure corrective actions. Housing Finance and Non Banks: As part of mortgage market reform, the program will address the micro credit sector and promote further credit access through the development of credit instruments targeted to the micro housing sector. The securitization industry will be further developed to support bank asset sales, to provide more liquidity to the mortgage industry, and to help develop the capital markets. A reform of the capital requirements and risk management regulations applicable to insurance companies, trusts, and pension funds, will be implemented to ensure the solvency of these institutions. Capital Markets and Government Securities. A reform of the entire securities legislation will be conducted as part of the program's second phase, to promote a more agile development of the local capital market. This will involve reforming corporate governance and disclosure standards as well as fit-and-proper criteria for securities industry participants. A streamlining and adjusting of the benchmarks and exposure risks of the government  debt market will take place as well as enabling the creation of a reference yield curve for the public and private bond markets. IPoverty Aspects: The program's objective as linked to social protection, is to strengthen and improve the financial sector's solvency and profitability to serve as a catalyst for private sector led growth. The implementation of reforms in bank resolution mechanisms and reforms of the deposit insurance scheme will protect the weakest depositors with the least economic assets, and assure prompt and full repayment of their funds in the event of bank failures. The regulatory reforms under the financial system law generate strong incentives and financial mechanisms to channel private banking credit to the micro and rural credit housing markets. The loan proceeds will help mitigate the impact from the govemment's tight fiscal policy, helping to maintain social expenditures. BleneffIs: The reformed legal framework would significantly upgrade and facilitate the regulation, corporate governance, and risk management of the financial system. It would increase the autonomy of the supervisory body and upgrade the mechanisms available for prompt corrective action, and resolution of intervened or insolvent banks to minimize potential drains on the public budget. The rationalization and consolidation of the state owned banking sector will also reduce fiscal exposure. The new framework will open up the financial market, under tight prudential rules, to allow diversification and improvement of products in the housing finance and mortgage market sector, including funding instruments for the micro credit sector, as well as in the capital markets, thus diversifying financial risks into other sub-sectors with capacity to raise financing and liquidity. Risks: The main risks to the reform program pertain to the possibility of adverse economic shocks which might be exogenously or regionally generated and which would set back the growth prospects for Colombia and thus compromise the long term health of the financial system which is just coming out of a tough period following the 1999 crisis. A low or negative growth scenario for the next two years would not only threaten overall welfare, but could also reverse the gains in banking system health and generate the need for new contingency plans to rescue vulnerable institutions. Another risk pertains to the fiscal risk of over exposure, particularly to the internal capital market as well as the risk that international financial market access will remain difficult for a prolonged period. Finally, a key risk is the potential for the internal conflict to deteriorate, causing additional fiscal stress and slowing down or braking progress on the financial sector reform.  Loan Amount: US $150 million, for the first programmatic loan, to be disbursed upon meeting Board approval conditions. Terms: LIBOR-based US Dollar Fixed Spread Loan with a final maturity in 2014 with a bullet repayment. Commitment Charge: 0.85% percent on undisbursed loan balances (first 4 years). During FY-2003, the annually approved 0.50% waiver of the charge, was in effect. Front-end Fee: 1 percent of the loan amount payable out of loan proceeds. Schedule of Disbursements: First loan to be disbursed upon Board Approval following effectiveness. Conditionality met prior to Board presentation. Project Identification No.: PE-P078869-LEN-BB   INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT ON A PROPOSED PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF COLOMBIA 1. This program document proposes a one-tranche Financial Sector Adjustment Loan as part of a two phase Programmatic Financial Sector Operation to the Republic of Colombia. The first loan would amount to US$150 million to support the reform of the financial system through a reform framework for banking legislation, strengthening of bank and securities supervision, resolution of banks using market mechanisms, closure, sale or merger of government owned financial institutions, as well as a legislative and institutional strengthening program to reform the securities market, non-bank financial services, and the government debt and money markets. The program would be implemented by the Ministry of Finance with support from the Superintendency of Banks, the Deposit Insurance Agency (FOGAFIN), the Superintendency of Securities, the Public Debt Office, the Central Bank and the National Treasury. The first Loan would be LIBOR-based, US Dollar denominated Fixed Spread Loan, with a grace period of eleven years and a final maturity of eleven years with a bullet repayment of principal. PART I. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS A. Recent Economic Developments 2. Colombia's vulnerability to external shocks has risen in recent months as a result of several factors: increased violence domestically and uncertainty as regards the future path of the internal conflict; the sharp deterioration in sovereign debt spreads; the recent worsening of market sentiment towards Latin America; problems in Venezuela, the second largest market for Colombia's non-traditional exports; and an uncertain outlook for the US economy, Colombia's main trading partner. That said, Colombia is relatively well-equipped to deal with moderate external shocks, given its floating exchange rate, falling inflation, adequate international reserves (US$ 10. 8 billion), as well as the implementation of new additional fiscal adjustments and reforms. 3. Colombia's sovereign spreads and currency had, until recently, been relatively unaffected by regional events, partly the result of the pre-financing by the government of more than three quarters of its external market financing needs for 2002. Pre-financing was undertaken in 2001 in order to avoid accessing the markets in the run-up to the presidential election. Colombian bond spreads fell throughout 2001 and in early 2002, but increased somewhat in April after Colombia's sovereign rating was downgraded by Fitch and its outlook changed to negative by Moody's, both citing growing public debt and an uncertain outlook for reforms and fiscal results. Despite this, in June 2002 the government obtained fresh funds in the international bond market for US$195 million issued at a 10.5% coupon interest rate, and an additional US$500 million in December 2002 at a 10.75% rate. 4. Colombia's macroeconomic performance is expected to continue improving in the next two to three years, but it will take longer before the country is able to achieve its full economic potential. Following a mild recovery of economic activity in 2002, GDP growth is expected to accelerate to about 2.5 percent in 2003 mainly due to a recovery of the export sector and slightly  - 2 - better prospects for aggregate private investment. Growth is expected to rise in 2004 to levels around 3 percent, accelerating to 3.5 percent by 2006. 5. External Envfironment. Exports will be aided by a projected recovery of international trade growth and prices of some of Colombia's key export products. A shift in trade pattems is also expected, as the share of trade with neighboring countries will likely shrink dramatically due to the weak economic prospects of some regional partners, especially Venezuela where recent policies may imply an almost total cut-off of Colombia's exports to that country thus having potentially serious adverse balance of payment effects. The prospective economic recovery in the U.S. and Europe suggests that Colombian exporters will shift their attention to these regions, with the impact of economic recovery in those markets further amplified by a possible weakening of the US dollar relative to other major currencies, particularly the Euro. Colombia's exchange rate is projected to depreciate mildly in real terms over the next three years, as continued low domestic inflation and a flexible exchange rate policy facilitate a smooth adjustment of the tradable sector. In this connection, inflation is expected to continue on a downward path and stabilize at levels close to 4 percent by 2005 (from 6 percent in 2002). 6. IFinaneWia and Monetary Developments. The Colombian peso depreciated by nearly 20 percent in nominal terms in the third quarter of the year, at the same time that Colombia's EMBI spread nearly doubled to 1100 basis points. The fall in Colombian bond prices was precipitated by negative alerts posted by the rating agencies as fiscal slippages became evident amid effects of intensified regional contagion. Increased risk perception also reduced the liquidity of the domestic public debt particularly at the long end, with the yield on ten year government notes rising by 5 percentage points to 17.5 percent. The stress in financial markets eased notably in October following indications of increased financing from the international financial institutions as well as a more general tightening of the risk premia in emerging markets in the region. By the second half of November, the bond spread had narrowed to below 700 bps. Emerging Markets Bond Index - Colombia vs. Latin Sproads 140 - 0 Lai MI _ oobaEB 1200 -__,X,. 600 L | Jun42 Jul-02 A e a i ^ AuMS.p02 Oct-02 No*0~1 3 oLatin EMBI c3Colombia EMBI|  - 3 - 7. A systemic banking collapse had been averted in 1999, through the officialization of affected banks and a consolidation process that drastically reduced the number of players in the market; however, the fiscal liability arising from rescuing borrowers, depositors, and bankers was large, and is so far estimated at about 4 percent of GDP (including non cash contingent liabilities of the Government and additional resources raised via the financial transactions tax). A final accounting of costs will also depend on how much of the losses from non-performing loans of public sector banks are recovered via the ongoing disposition of the foreclosed assets. 8. There are still significant weaknesses in the housing finance sector where the non- performing loan portfolios continue to loom large (especially in the state controlled entities) and risks associated with asset-liability mismatches have not yet been fully addressed. Reforms are also needed to improve the operation of public debt management, address critical governance and regulatory issues related to entities participating in the capital and debt markets, consolidation of state controlled second-tier banking entities, and regulation for bank resolution, bad-asset disposition and the insurance sector. Therefore, building on the financial sector reforms put in place during 1999-01, a second round of financial sector reforms will need to be implemented, while minimizing any further fiscal costs or interruptions in the flow of bank lending to the private sector. 9. Banking as well as insurance and pension reforms also go hand in hand with a strategy to create a deeper, more liquid capital market. Much activity is underway: the three stock exchanges have already been integrated and merged; a proposed draft capital market framework law that would reduce obstacles for private securities issuance is currently in preparation; a new private mortgage securitization firm is now operating; market-making has been institutionalized for government bonds; and, an almost complete range of Treasury bill maturities are now available. 10. Finally, a healthy and stable development of the domestic financial sector requires strengthening the legal and regulatory framework applicable to financial institutions, including the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) regime. The Ministry of Finance and Banking Superintendency have strengthened the AML/CTF system over the last two years, including the establishment of a monitoring unit to detect money laundering and white collar crime. B. Economic Prospects and Financing Requirements 11. While the current policy framework is expected to provide for a solid-adjustment of the external sector, the key risk to the country's macroeconomic stability remains the large fiscal deficit and the high burden of public debt. Assuming a full implementation of the macroeconomic reform package, the overall public sector deficit is projected to fall from about 4 percent of GDP in 2002, to between 2.5 - 3.0 percent in 2003, and between 2.0 - 2.5 percent in 2004 and 2005. However, due to the lag in the fiscal adjustment process as well as the relatively conservative economic growth prospects projected for the country, on a net basis total public debt is still projected to continue rising (although at diminishing rates) before stabilizing at levels close to 50 percent of GDP by 2006. Achieving these goals for the overall public sector and thus macroeconomic stability on a sustainable basis will require strong and deep adjustment at the level of the central government, especially on the expenditure side, for which the authorities have agreed on a strategy in coordination with the IMF. In January 2003, an IMF Stand By Arrangement (SBA) was approved for a two year period. The SBA also includes structural  -4 - banking sector benchmarks for privatizing Bancafe and eventually divesting Granahorrar, two State banks. 12. The Colombian economy has since 1998, been growing at an average rate of close to zero cumulatively during the last four years. The current account deficit in 2002 is estimated at $2.2 billion, and is projected at $2.4 billion for 2003 and $2.3 billion for 2004. For 2003 and 2004, the presently identified financing requirement in the capital account, is estimated at $2.0 billion and $1.7 billion for both years, respectively (see table below), excluding the changes in international reserves across both years. Colombia: External IFienciang RIequiremenimts ($US mniDlons) 2002 2003 2004 2005 (est) (pro.j0) (projo) (proj.) Current Account Balance (2,259) (2,413) (2,349) (2,201) Capital Account Financing, net: i. Foreign Direct Investment 2,333 2,391 2,475 2,561 Iii. Loans:I o/w Official/Multilateral 442 1,655 2,309 1,396 o/w Private (448) (1,090) (1,729) (1,107) iii. Other Capital (31) (96) (99) (74) Int. Reserves increase] (37) (446) (607) (576) Source: World Bank Country Assistance Strategy, Annex B6 13. While the current account deficit is not expected to grow, financing from the capital account, particularly from private lenders, is expected to reflect negative flows on the order between -$1.0 billion to -$1.5 billion, for the foreseeable future. Therefore, balance of payments financing requirements will rely primarily on multilateral and official financing to meet the gap which, including other factors, will require on average, $2 billion annually in the next two years.  - 5 - PART II. FINANCIAL SECTOR CONTEXT AND THE REFORM PROGRAM A. Overview 14. At the start of the 1998 banking crisis, the government, recognizing the seriousness of the issues facing some segments of the financial sector, the Government introduced in November 1998, through an Emergency Executive Decree, a series of relief measures designed to help the most vulnerable groups affected by the crisis - mainly low income mortgage borrowers and depositors in the cooperative system. In May 1999, taking into account the increasingly acute portfolio problems of financial intermediaries, the Government announced a special recapitalization program to be administered by the deposit insurance agency (FOGAFIN). The support was in the form of medium-term loans to the banks' shareholders to be used exclusively to recapitalize the banks. These lines of credit were funded with bonds issued by FOGAFIN which were then applied by the shareholders to the banks' balance sheets as an investment asset along with the equivalent corresponding entry in the capital account for paid-in-capital. 15. The objectives of the program supported by the earlier loan were to minimize systemic risk in the Colombian financial system and to promote the longer-term capacity and efficiency of the system in restoring economic growth. The objectives addressed both the immediate risks associated with financial system stress as well as the challenges faced by the system in the medium to long-term. The principal components supported by that operation were a macro- economic program that enabled the stabilization and significant reductions in real interest rates, combined with financial sector reforms to ensure a timely and effective implementation of prudential rules and supervision of financial institutions, including preventive measures, case-by- case resolution actions, consolidation of different types of financial intermediation under one institution, and a restructuring of public banks. The operation was viewed by the Government as an important complement to the Economic Emergency Measures adopted in 1998. 16. The government's strategy with respect to the state-owned banks was meant to isolate them from the rest of the financial system in order to restructure or sell them under controlled conditions while avoiding an additional factor of potential contagion to the already weak private banks. Public banks were formally "officialized," meaning that the management oversight and ownership stake were taken over directly by FOGAFIN with a view to clean up the balance sheets, recapitalize the banks, and sell them or liquidate them. The Caja Agraria, a rural finance bank, was closed and a new Banco Agrario created out of a Leasing Company (Colvalores) which was part of the Banco de Desarrollo Empresarial; following a reform in the statutory mandate of the institution. Although the remaining banks could have been easily sold in one or two years if economic and market conditions were favorable, the potential further deterioration of the loan portfolio under less favorable conditions and the operating costs of keeping troubled banks open, created some risks. Moreover, for banks that had been experiencing severe management difficulties and weak control systems (often the case for public banks), it was particularly difficult to redress ingrained management habits and instill a new governance culture.  - 6 - Box 1: Lessons from the 1999/2080 FSAL Loan and the First Financial Sector Reforms The context in which the pnor FY00 FSAL reforms took place, reflected a situation of crisis prevention, avoidance of contagion across the banking sector, and assuring the stability of the financial system. In this light, the measures taken were thoughtful and essentially contained three key strategic tools: (i) intervening, managing and/or providing liquidity and capital support to weak financial institutions, (ii) raising the capital and solvency requirements to force all institutions to build up stronger balance sheets to handle impending risks, and (iii) implementing early corrective actions as defined by the Banking Superintendency to reverse adverse trends in individual institutions before they reached insolvency. Taken together, the measures were comprehensive and holistic in their approach. However, the existing financial "technology" as well as the limitations in the bank resolution policy framework, later revealed some shortfalls which had not been anticipated, in particular: (a) For those intervened banks or officialized public banks taken over by FOGAFIN, the asset sale and liquidation process was lengthy, in part due to legally specified time periods endorsed judicially under the Commercial Code which is not governed by the Banking Law. Since this phase of the unwinding of banks constituted the last phase in a process preceded by attempts to sell a bank or a part of its loan portfolio, the issue of final liquidation of collateral and potential judicial delays had not been addressed. This therefore, resulted in the State holding on to such assets for longer periods than anticipated, following the end of the crisis period. (b) As part of the banking resolution process, the reform permitted the option of transferring viable assets of intervened banks, matched by deposits, to other banks willing to purchase or take over such obligations. The procedure required the concurrence of the ceding bank's depositors and was not fully clear regarding the hierarchy of the bank's creditors, which made it more difficult to transfer deposits with matching assets without taking into account other bank liabilities or obligations. In retrospect, the concurrence of the ceding bank's depositors and other parties while meant to protect legal rights, was not all that practical and made the process of balance sheet transfers more difficult and drawn out. Nevertheless, the procedures were successfully implemented though their frequency and speed might have increased substantially without the legal obstacles. (c) Even with the successful purchase of assets by healthy banks, along with the assumption of matching deposit liabilities, acquiring banks needed to carefully evaluate the loan portfolios they were purchasing to verify their stated quality. While FOGAFIN did in some instances provide credit enhancement guarantees or outright bonds in order to share the risks of these transferred portfolios, this meant that the State began assuming more contingent liabilities. The existence of securitization mechanisms (which were not fully developed until later when housing finance and capital market norms began to be defined for that purpose) could have avoided the assumption of risk sharing obligations by the State. This is because under securitization procedures, the portfolio assets would be held by a trust at a multiple of the face value of the secuntized bonds issued by the trust, thus they would have provided a more optimal 'market based' comfort mechanism for the acquiring banks. However, under near crisis conditions, the development of innovative financial instruments was not of immediate priority and the banking law was not explicit enough to allow optimal use of these instruments along with asset/liability carve-out mechanisms. While many of the above procedures were indeed envisioned under the 1999/2000 reform, the specification of their implementation mechanisms and the institutional/market infrastructure were not yet sufficiently developed to provide the government with the additional instrumentalities for handling troubled banks. However, despite these initial limitations, the government, through FOGAFIN's management of insolvent institutions and its asset management agency (CISA), was able to achieve substantial progress in the gradual sale and reduction of the assets of those banks. The further development and implementation of the new procedures should provide the government added flexibility in the resolution and divestment of the remaining officialized banks such as Bancafe, Granharrorar, as well as IF, the second tier industrial development bank.  -7 - B. The Banking System Background 17. Total assets of the Colombian financial system amount to Col$ 159 trillion or approximately US$ 55 billion. The structure and composition of the Colombian financial system is shown below. Table 1: Colombia - Structure of the Financial Sector Financial Intermediary Assets (As of December 31, 2002, in Col$ billions) Banks and Corporate Ordinary Finance Pension Insurance Trust Deposit Financing Finance Leasing Funds Industry Co's. Total Institutions Co's. Companies Companies Local 47,623 6,694 1,072 2,121 11,724 4,230 22,404 95,868 Foreign 14,256 604 81 9,176 3,044 10,780 37,941 State 14,989 1,730 487 106 957 10,475 28,744 Total 76,868 8,424 2,163 2,308 20,900 8,231 43,659 162,553 as % of GDP 39% 4% 1% 1% 10% 4% 22% 82% Source Superintendency of Banks Note: Total asset figures may be overestimated as financial institutons may hold as assets reflectng the liabilities of other institutions 18. During the 1998-2001 crisis, the financial system underwent some consolidation as credit institutions, particularly mortgage banks were closed, as well as other commercial banks and finance companies. To-date, the financial system has 18 fewer commercial banks (including the ex savings & loans) than it had towards the end of 1998 at the onset of the crisis. Restructuring of the Banking System 19. After the banking restructuring process during 1999-2001, fewer risks remain with respect to government support of private banks. However, though the experience has been generally favorable, if adverse economic conditions persist and additional banks are not to repay the capitalization credit lines to FOGAFIN, then the State would need to effectively take on the share ownership which was meant to be financed temporarily by FOGAFIN's credit line. 20. For the state-owned banks, the process has been somewhat arduous: more than three years after initial intervention, the final resolution status of some of these is still being worked on, and as the time draws out, the more costly option of outright liquidation looms larger. While the government has successfully been able to gradually reduce and sell off the balance sheets and physical infrastructure of these banks, its investment in this process may need to continue for some time to achieve its end target of privatization or extinction. 21. Table 2 shows the support of FOGAFIN's capitalization program to restore technical solvency of state-owned banks following the intervention and officialization of these banks.  - 8 - Table 2. Capitalization Support Provided to State-Owned Banks, 1998-2001 Bank Amount (Col$ billions) BCHJ' 1,546 Banestado 1,240 Bancafe 2 1,660 Granahorrar 689 IFI 700 Banco Agrano 150 FES 45 Total 6.030 as % of GDP 3 6% 1. Includes CISA managed assets of BCH. 2. Includes CISA managed assets of Bancafe. Source: FOGAFIN Outcomes and Next Steps 22. Thus, it should be pointed out that the government's rapid response and policy approach has been instrumental in averting a systemic financial collapse given the macroeconomic, regional, and global environment. The prompt introduction of a new legal framework for banking capital adequacy, portfolio concentration, and consolidated supervision of financial groups was critical for early diagnosis of the problems. At the onset of the crisis, the establishment of progressively stringent prompt corrective actions for banks facing possible insolvency prevented what might have been fiscal outlays in multiples of what was actually disbursed. The fast implementation of bank capitalization schemes coupled with incentives for risk sharing by owners and more modern procedures for the prompt exit or merger of weak banks in the system was crucial to avoid the proliferation of "zombie" institutions that would have only postponed more serious problems, raising the overall cost of the crisis. Therefore, the government's record in tackling this precarious situation was commendable. However, final resolution and stability of the sector is not assured, and certain risks remain. Some of the key gaps requiring attention so as to permit the orderly conclusion of the processes initiated, include: 23. Improvements and increased flexibility in banking resolution measures used to restructure or dispose of weak banks using market agents and instruments. While the prior reforms of the banking law alluded to such mechanisms, the good bank/bad bank approach facilitated by securitizations of portfolios held in trust, was not used given the lack of a firm legal framework requiring such procedures for the resolution of banks. To avoid the languishing of financial institutions under the State's umbrella, if privatizations do not materialize, increased incentives such as auctioned loan portfolio securitizations should be applied, to allow a more prompt carving out of good assets with matching deposits from intervened institutions. 24. Reducing and Extinguishing Potential Fiscal Liabilities: To improve the prompt privatization or liquidation of financial institutions considered insolvent, and to wind down weak institutions that have no earnings prospects while compensating depositors, the government has considered additional options for the liquidation or asset sale procedures using a multibank portfolio approach managed competitively. Time-bound performance measures and compensation fees should be applied, with rotation of liquidators to provide incentives for achieving maximum returns in stipulated time periods. Time-bound limits for the disposition (sale or liquidation) of intervened banks could be set, particularly for banks where investments have already been made in recapitalization and improvement of their financial condition. An a priori assessment of market demand is also crucial.  -9- 25. Strengthening the Early Corrective Action Regime: While banking prudential regulations are strict and include additional provisions for market risks in conformance with Basle standards, completion of these best practices will include the implementation of a matrix of prompt corrective actions associated with a schedule of sanctions and penalties, based on non compliance with regulations. Future work is also expected to incorporate the quantification, weighting and incorporation of deficient corporate management and sub-optimal risk management practices as key triggers for invoking corrective measures and penalties. To support the long term implementation of these practices, the Superintendency needs to be provided with resources to strengthen its supervision procedures, provide staff training, upgrade its knowledge of risk management analysis and modernize its systems for evaluating and monitoring banking risk. 26. Addressing the Non-bank Financial Institutions: To ensure the prudential management of non-credit institutions, other priorities include the reform of solvency standards and consolidation of the insurance and non bank sector regulatory framework. Priority will be given to upgrading insurance industry regulations, including the proposed adoption of actuarially sound solvency margins particularly to ensure more adequate technical reserve provisioning for both health insurance and general insurance risk exposures. The upgrading of regulations and guidelines for the trust industry is also required, particularly with the advent of new products to be managed, such as asset securitizations and managed funds for third parties. Prudential Regulation and Supervision - Background and Diagnosis of Issues 27. Since the beginning of the past decade Colombia exhibited a relatively complete and advanced prudential regulatory framework. The initial financial crisis reforms were anchored by several crucial laws that provided the basis for empowering the Superintendency to manage the crisis, regulate debt and bank restructuring, require and enforce remedial actions, and revise previous prudential regulations. For prudential regulation, the most important pieces of legislation were Law 510/1999 (which updated the Organic Statute of the Financial System and gave the Superintendency additional powers to improve prudential regulations and effect enforcement) and Law 550/1999 (which set the path for the restructuring of problem loans). 28. Future Development of the Regulatory Framework: The most important regulatory priorities, in the near term, would be directly related to the latest Financial Sector Reform, and evolve around some of the provisions of Law 795/2003. Regulatory priorities of the SB include, inter-alia: (a) strengthening the definitions of bank insiders, so that comprehensive supervision of financial conglomerates can take place, including real sector related parties; and, (b) establishing a consistent, homogeneous and transparent, framework of criteria to administer remedial actions. 29. Under Decree 1775/2002, the Government also revamped the internal organizational structure of the Superintendency, advancing changes that will enable supporting the approach that is to preside over the development of the supervisory agency during its next strategic, cycle. By this decree, supervisory resources were concentrated into five delegated Intendencies ('Delegaturas') of the Superintendent, merging together onsite examiners and offsite analysts, and nominating new Directorates to provide for essential support functions such as Supervision, Regulation, Technical Analysis, Legal, and IT and data processing.  - 10- The Governmient IReform Agenda folr the 3anking System The First Operation under the Program 30. Given the above issues, and the need to assure a full and sustained recovery of the financial system, the Government has embarked on a second round of reforms of the law governing the financial system. Key objectives of this reform are to provide additional tools to ensure a non- traumatic and market oriented restructuring of the financial sector as well as additional regulatory and supervisory tools to effect prompt corrective actions and avoid deterioration and contagion from mismanaged financial institutions. The Government reform program thus contains the following key policy actions: Corporate Governance, Rules of Conduct and Client Protection 31. Governance. The new financial system law incorporates a number of rigorous norms to ensure proper governance of financial institutions. Proper corporate governance in a sense, is the first line of defense to protect the viability of banks and generates a culture of self regulation by requiring transparency and accountability by the management and Boards of institutions. The reforms of the law, set out norms to ensure Board independence and strengthen the code of conduct including risk management and ethical responsibilities of managers and directors. A key provision in the reform which puts additional force into these norms, is the strengthening of a regime and schedule of sanctions which extends its applicability beyond bank managers to cover administrative officers of various degrees of responsibility, Board Directors, legal staff, bank auditors, as well as other officials designated with a particular fiduciary role such as officers in charge of monitoring money laundering activity. 32. Strengthening Sanctions. Another aspect relates to the available sanctioning tools of the Superintendency of Banks (SB), both for corporate governance norms as well as standard prudential norms, pertains to the establishment of time bound periods for institutions to comply with SB directives issued previously, with particular focus on loss provisioning requirements, wherein, lack of compliance within specified periods, automatically leads to additional sanctions or fines for persistence of a given unprudent practice. This aspect of the new law strengthens the resolve of the regulatory framework to ensure that institutions no longer count on time delays or other legal procedures to avoid meeting their outstanding obligations without penalty. 33. Conflicts of Interest. The new law, in addition, sets stricter controls on banking operations to avoid conflict of interest situations. Specifically, under the new framework, Boards of Directors of financial institutions are required to vote by unanimous decision in order to approve any lending or deposit taking activities with any of its shareholders or their relatives (or administrators of the institution) which happen to exceed five percent of the institution's share of ownership. The measure forces transparency as well as accountability by Boards of Directors, to ensure that banking operations are not put at risk via the concentration of transactions in key shareholders or stakeholders of the institution, and who might otherwise unduly influence the polices of the institution to meet their specific investor interests rather than those of the majority of shareholders. 34. Client/Consumer Protection. The reformed legislation also sets out regulatory requirements for financial institutions to comply with information transparency norms to adequately disclose their products, pricing norms, terms and inherent investment risks and  - 11 - protections applicable to clients. The new law, in addition, establishes the internal public liaison function of the 'client advocate' to be implemented within each financial institution and which will serve as a first recourse instance to internally resolve and address any complaints emanating from clients of said institutions, before such issues are escalated to the SB for handling or for undertaking any required regulatory action. Enforcement Powers 35. As part of the revised legal framework, a number of areas of modification relate to the SB's autonomy as well as special powers to ensure prompt reversal of risky actions engaged by financial institutions or their parent economic groups. In this context, an innovative approach to supervision of consolidated groups is promoted by authorizing the SB to inspect companies within those economic groups not traditionally subject to SB's supervision. This will permit more leeway for the SB to uncover related party operations or double counting of capital or assets within financial groups and/or larger economic groups which go beyond the financial system. In addition, the new law also establishes a sanctions regime for implementation in the event of conflict of interest breaches which involve bank operations with subsidiaries or related institutions. 36. Another key aspect for optimizing the enforcement operations of the SB, pertains to its degree of autonomy in carrying out the necessary actions in a timely manner when dealing with problem institutions. For this purpose, the new financial system law grants the SB autonomy to enforce regulatory norms under its mandate including the promulgation of directives and application of sanctions to non complying entities. The new law also paves the way for future development regulations which would allow the SB to take possession or intervene a bank when necessary, without prior approval from the Finance Ministry. 37. The rationale for this change is not only to provide the SB with the operational autonomy that it requires, but also to avoid delays in the execution of prompt corrective actions which would otherwise potentially contribute to the further deterioration of financial institutions before appropriate steps could be taken. In addition to decision making autonomy, the new law also authorizes the SB to have additional budget autonomy in terms of its internal resource allocation where this pertains to resources raised through regulatory fees and not through any central government budget transfers. This will provide the SB with the needed flexibility to manage its internal resources according to technical and logistical requirements. To support this, the new law paves the way to provide future presidential authorization to establish a special career regime for the SB, in order to train and retain qualified and adequately compensated personnel. 38. Consistent with the above, the reform program also includes the preparation and approval of the SB's institutional development and strategic plan. The plan includes the upgrading of supervisory policies to be reflected in updated manuals and procedures, as well as the planned implementation of risk rating methodologies to monitor subject banks and assess potential vulnerabilities. The plan also includes increased SB capacity to train, recruit as well as adequately compensate and retain qualified supervisory personnel under a budgetarily sustainable career development program. Regulatory Infrastructure, Financial Stability, and Tracking of Sensitive Funds 39. Regulatory Costs. The monitoring of not only potential credit risks but new market risks too, and the move towards the latest Basle reforms, has resulted in a heavy information reporting  - 12- requirement for financial entities. In this regard, the Government has confirmed its initiation of an exercise to assess opportunities to reduce the regulatory costs and rationalize reporting requirements of supervised entities, where necessary, and avoiding duplicate requests from separate units within the SB or other financial and/or regulatory authorities. In addition, the reduction of reporting requirements following the end of the 1998-2000 crisis was not fully recognized by all entities, hence a review of all current requirements and proposals for rationalization will be conducted. For the first loan under the programmatic operation, the Government has started conducting the regulatory reporting rationalization exercise. Once the issues have been diagnosed and identified, the Govemment will, under the second loan in the programmatic operation, implement the reporting and cost rationalization measures. 40. Payments System Risks. The new legal framework also clarifies and confirms the authority of the Central Bank as it relates to large payment systems transactions. This is important given that, while the previous banking law alluded to the Central Bank's role in oversight of the payments system, it did not fully confirm the CB's regulatory authority in this area which was left undefined between the CB and the SB. The new law thus confirms the CB's authority in particular as it relates to large transactions and thus allows the CB to set or modify the rules of operation of the payment system in this area, as needed for efficiency or enhanced security. At the same time, given the proliferation of smaller payment system transactions such as those executed via debit cards and credit cards, the new law gives the SB powers to supervise such operations. The legal framework thus clarifies and maintains the CB as the overseer and authority in terms of the large non-retail payment transactions which constitute the bulk of fund movements in the financial system, while the SB retains authority over other payment system operations associated with specific lines of business or retail products. 41. Anti Money Laundering/Countering Terrorism Financing. Given Colombia's particular social and business environment affected by both the guerrilla insurgency, the associated drug trade, and the potential for large sums of laundered illicit funds, the financial reform, through SB's issuance of new procedural regulations, strengthens the special anti-money laundering information intelligence unit which is ascribed to the Finance Ministry. Colombia's anti-money laundering framework and countering of terrorist financing is already well established given the framework law No. 526 of 1999 which established a special financial intelligence unit for this purpose as well as the earlier banking law of 1999 which set out the obligations of financial institutions in reporting suspicious transactions. Since then, a number of regulations and decrees issued by the Banking Superintendency as well as the Revenue and Customs Department (DIAN) and the Superintendency of Notaries, have reinforced the institutional and private financial business accountabilities in reporting illicit transactions which are channeled for analysis to the financial intelligence Unit (UIAF). 42. The UIAF, besides entering into inter-institutional agreements with other State entities including police, crime detection, auditing, cadastral and tax institutions, has also set up a complex multi-feed information database system (the centralized information query system or the SCCI) which matches financial information with particular geographic, business, residential, legal, and other attributes, to detect most likely transactions which originate from illicit sources and which fall into the AMIJCTF oversight framework. To further strengthen the UIAF's oversight and detection mandate, the new financial system reform law requires that all financial sector institutions submit (electronically) all information related to cash transactions equal to or above US$5,000 equivalent directly to the ULAF for processing and screening. The UIAF, following its procedures would identify any transactions subject to suspicion based on other  - 13 - attributes including reasonableness of source and size of income in the given area and sector, and forward any likely candidates to the Attorney General's office for follow up and legal or police action. To further augment the detection capabilities of illicit funds, the new law also gives the SB authorization to monitor the destination and composition of offshore investment monies of domestic financial institutions. 43. Financial Stability and Contingency Planning. Finally, in order to ensure that the recent effects of the 1998-2000 crisis and their resolution contain the seeds for sustainable financial sector health and stability, the govemment intends to carry out a sensitivity and diagnostic review of the condition of the financial system. The commitment to conduct such a review and its core parameters are defined as part of the first loan under the programmatic operation, and the execution and finalization of it will be implemented by the second operation. Essentially, the review will evaluate the risks posed by remaining weak or vulnerable banks and financial institutions and assess their potential performance under scenarios of low or no growth in the economy, including their capacity to service loans, and where applicable, their capacity to repay FOGAFIN loans which were extended to them as part of an institutional capitalization scheme during the crisis. Mechanisms for the Resolution of Problem Banks linked to the Operations of the Deposit Insurance Fund 44. During the 1998-2000 crisis years, the earlier changes to the banking law had enabled FOGAFIN, the deposit insurance and bank restructuring agency to move away from outright intervention and subsequent immediate liquidation of failed banks towards a less traumatic method which preserved asset value, and whereby viable bank assets were matched against deposits and packaged as "partial balance sheets" for sale or transfer to another acquiring bank with a healthy solvency condition. In theory this approach was more progressive and avoided running up fiscal liabilities on account of payments to depositors which could not be funded with underlying assets (until after full liquidation). In practice, however, the transfer to other banks, of viable remaining assets along with depositor funds, was made more difficult during recessionary periods where demand was lacking and the value of such assets was uncertain. In addition, bank shareholders and managers resisted the break up of their bank into parts, and instead preferred to undertake supervised rehabilitation plans. 45. Restructuring Powers. Under the new financial system law's reforms, many of these aspects are improved to allow implementation of a more effective and workable bank resolution procedure. The new law defines more precisely the SB's powers and authority in this regard, so that once a bank is deemed unviable from a solvency perspective, and following the possession of said bank by the SB, the asset/liability carve out procedure becomes automatic rather than optional. The idea is to minimize moral hazard and essentially undo a banking operation which is clearly insolvent yet can be absorbed in part by other institutions. In this regard, given that the subject bank no longer has sufficient regulatory capital to be licensed for operation, the SB may automatically proceed to determine the most optimal asset/liability carve out procedure without the consent of the shareholders or managers. 46. Securitization Instruments. However, the more innovative aspect covered under the new law, is the active use of asset securitizations to enable a more effective transfer of portfolios with associated liabilities (e.g.: deposits) to acquiring institutions. With the establishment of an asset securitization company in Colombia as well as the start of the mainstreaming of the  - 14 - securitization industry, this mechanism provides an efficient means of transferring underlying loan portfolios to other banks, without the uncertainties of asset valuation or loan recovery prospects inherent in the earlier approved procedures. The securitization method permitted as part of the resolution tool kit under the new law, is set up by transferring the viable loans of the subject bank, into a trust which subsequently issues securities (e.g: bonds or notes) whose yields are based on the projected cash flows of the underlying portfolio. The securitized bond is normally over collateralized, that is, a portfolio of underlying loans of significantly higher nominal value than the bond's face value, is used as the underlying asset pool to back the bond(s). In this way, the non repayment of part of the underlying portfolio would not necessarily affect the bond's performance, at least within its more 'senior' tranches.' 47. Fiduciary Trust Vehicles. Under the new law, a key provision in making the resolution mechanism more effective, is the use of fiduciary trust vehicles to house the underlying portfolio and to issue the securitized bond. The advantage of this approach, particularly for those bond holders within the senior tranche, is that loan portfolio valuation becomes less of an immediate requirement and therefore assets can be transferred more expeditiously via this instrument. To complement the transfer of assets to acquiring banks under this instrumentality, the new law also permits FOGAFIN to utilize its own bonds, guarantees, or if needed, deposit insurance funds2. Purchasing banks, from a regulatory perspective, need to have a slightly larger asset base for every similar value batch of new deposits they acquire in order to have an adequate solvency margin. Thus, a transfer of deposits (which avoids fiscal pay-outs of deposit insurance funds) and which are matched by securitized assets, may not always be viable if the Government wished to maximize the amount of deposits transferred to other banks. Therefore, the new law provides additional flexibility for FOGAFIN to "add" assets to the partial balance sheets of those acquiring banks, so that they might have enough viable assets, including the securitized ones, to assume the mass of deposits desired. The "added" assets, thus, can take the form of additional bonds issued by FOGAFIN and backed by deposit insurance resources, or FOGAFIN contingent guarantees to cover any unexpected defaults on the securitized portfolio, or outright cash assignments in lieu of deposit insurance payments. 1 The securitized bond can be broken up into subordinated/jurnor, mezzanine and senior tranches. Each tranche receives a successively higher repayment priority so that the senior tranches are 'preferred credits' in that they have first guarantee of payment proceeds, while each successive tranche is guaranteed payment only based on the residual cash amounts received after paying the higher tranches. Thus, the most subordinated tranche has the lowest credit rating for investment purposes. 2Provided that the amount utilized is equal to or less than any amount which would have been required as a direct cash pay out to depositors, if no asset/liability transfers had taken place.  - 15 - Securitization Structure Used as Bank Resolution/Asset Transfer Mechanism Loan Portfolio of Intervened Bank (Average portfolio rati = BB) Securitized Asset - Bond Issued AA tranche Depositor funds for transfer with BB tranche matching CC tranche assets Fogafin Bond Matching assets and liabilities transferred to acquiring bank(s) 48. Phased Asset Carve Outs. Finally, an additional modality authorized under the new law, applies primarily to institutions that wish to voluntarily close down due to unfavorable future business prospects. Under this modality of "progressive dismounting" the SB and FOGAFIN are authorized to oversee a gradual carve-out, reduction and sale of assets of a financial institution in order to decrease its operating balance sheet progressively until a minimum of core assets remain which can be liquidated outright. This modality, which also avoids immediate liquidation of all assets and State pay-outs to depositors, and does not necessitate the quick transfer of asset/liability packages to other banks, nevertheless provides regulatory flexibility for banks which voluntarily decide to close down, permitting an orderly exit from the market. 49. Asset Management Modalities. To increase the administrative flexibility in managing any residual assets which may not be subject to securitization under the above scheme, and which would require liquidation and/or foreclosure of underlying assets, the new law also authorizes banks and fiduciary companies to offer services for the administration of assets and trustee services, respectively, in order to undertake portfolio management for institutions undergoing liquidation. This measure allows further 'privatization' of asset liquidation exercises previously conducted primarily by CISA, the government's asset management/liquidation company, for the officialized banks; and the measure also provides private banks and trust companies with adequate legal tools and instrumentalities to conduct such work as separate lines of business which can remain as off balance sheet activities given their fee based nature and objective as a specialized financial service. At the same time, the new law provides CISA itself with additional flexibility to conduct its asset management functions. CISA, while State owned, operates under  - 16 - the private contractual regime, and the new law now permits it to utilize securitization procedures in order to enhance its asset sale/liquidation options which would help to accelerate such processes. With this legal change, CISA is thus authorized to engage in enhanced asset management procedures and permitted to take on trustee functions. Thus, entities undergoing liquidation may have their assets administered by CISA under both trust arrangements as well as standard asset management contracts. 50. Deposit Insurance Policies. The work of FOGAFIN itself, while receiving more attention under its bank restructuring operations, is principally one of managing insurance funds for depositors. During the 1998-2000 period, the Government transferred resources to FOGAFIN to capitalize its insurance fund more adequately given the expected bank failures at that time and the need to have deposit insurance and bridge funds during the restructuring or liquidation processes of banks. Following that period, however, the actual indemnities paid to depositors under the insurance scheme were reviewed with a view towards ensuring fairness both in terms of coverage as well as in terms of deposit insurance premiums charged to deposit taking institutions in the financial system. Under the new legal reforms these issues are addressed and modified as follows: While previously, deposit insurance payments contained a co-insurance element whereby depositors paid a percentage of their coverage out of their own pocket (akin to a rolling deductible), the new law excludes this provision and provides FOGAFIN the flexibility to set the co-insurance deductible at a level starting from zero. In this manner, the smallest depositors need no longer pay a co-insurance deductible which would otherwise mean that they immediately lose that portion of their deposits if a bank fails. Instead, FOGAFIN, within the limits of coverage established, would pay small depositors 100% of their deposits as long as they were equal to, or below the coverage limit. The law also formalizes an adjusted premium approach charged to banks, and authorizes implementation of a 'rebate' program whereby the risk based premium is adjusted on an ex post basis by refunding to those banks in good standing a portion of their premiums paid at the start of the year, or charging additional premiums if they are not in good standing. Restructuring and Resolution of the State Owned Banks 51. As discussed earlier, one of the large programs which involved government intervention and support concerned the State owned banks, many of which were officialized and put under direct oversight by FOGAFIN while they were restructured or wound down. In the process, most of the officialized banks were gradually wound down with portfolios or liquidated assets being sold off. The key remaining banks at the moment are Bancaf6 and Granahorrar which have yet to be fully resolved, sold or disposed of. In addition, the State still has the second tier lending banks although these have not had major portfolio and solvency problems with the exception of IFI (Instituto de Fomento Industrial). The Government has been considering a strategy to consolidate some of the second tier banks so as to reduce the State banking institutions. 52. First Tier Banks. In terms of the remaining two first tier banks3 listed above, under the reform program the government has formally committed to privatizing Bancafe, with the sale process having already been initiated along with the hiring of an investment firm to manage it. While the privatization process for Bancafe is now well underway, the situation for Granahorrar 3 Not including the Banco Agrario which was created from the merger of other institutions and which, as a matter of government policy will remain as the only first tier bank of the State, to serve the needs of the rural sector.  - 17 - whose portfolio is less attractive is somewhat different. The Government's intention is to also eventually sell Granahorrar so as to capitalize on the remaining assets and avoid materialization of a fiscal liability. However, market demand for the bank has still not been identified and the Government is considering options for structuring a deal which would be well received by the financial industry. In this regard, the Government is developing a number of policy options to achieve a viable restructuring and sale strategy for Granahorrar, including the securitization of a portion of its assets as well as the issuance of bonds to fill any balance sheet gaps. The Government will evaluate these options in the context of potential market demand in order to arrive at a realistic determination of the optimal sale or disposal strategy for the bank. The legal and financial instruments authorized under the new law will also provide the government the needed flexibility to exhaust all possible avenues for providing the most secure package to potential investors. 53. Second Tier Banks. In the second tier banking sector, the Government has reinitiated its intent to rationalize that sector and improve the financial condition of its banks. Under the reform, IFI, the most problematic bank, has been put under a private contractual regime and is formally only permitted to engage in second tier lending operations. Following that, as part of the reform, the Government, through IFI's shareholders assembly, authorized the transfer IFI assets and liabilities as well as some of its operational infrastructure, into Bancoldex, the export bank, with any remaining untransferred assets to be liquidated. In effect this decision downsizes and merges these banks although Bancoldex is maintained as the legal entity and EFI is formally dissolved. To complement these measures and avoid future loss making operations of State banks, the new law also requires that State banks such as Banagrario and IF1 set lending rates to fully cover financial and operational costs and credit risks, with no subsidies allowed in lending. The only exception which the law provides is if a given State bank can obtain separate budget resources transferred to it from the Government to engage in an explicit subsidized lending scheme, something which would require authorization at the highest Ministerial levels. Prudential Regulation and Supervision -Phase I 54. Actions planned by the Government will focus on finalizing a complete inventory of the decrees required to develop the provisions of the new Financial System Law. The inventory will also include the external circulars that the Superintendency will need to implement the provisions of the new law (795/2003). In addition, the SB intends to ensure that as part of its 2003-2006 Strategic Planning cycle, it adopts a Supervisory Development Program to continue strengthening its capacity. 55. Assessment of Credit Risk Parameters: As part of the ongoing efforts of the Superintendency to implement a circular on integrated credit risk management processes, the SB has committed to develop terms of reference for an independent expert to review the overall consistency for approval of credit risk methodologies. 56. The Government intends to carry out two quantitative studies to provide input for further actions to follow strengthening the efficiency and stability of the financial system. The first study addressed earlier, will consist of a prospective stocktaking of the degree of progress achieved in restoring the health of the banking system. The second study intends to establish the effect of current regulations - economic, tax, prudential, reporting -- on financial intermediation, both in terms of regulatory and business costs. This study will also aim at identifying actions to mitigate such costs.  - 18 - 57. As part of the first operation supported by the Bank, there will be an agreement regarding the commitment and overall scope for such studies. As part of the programmatic approach followed by the Government, it is expected that the recommendations and conclusions emanating from these studies will be considered in taking measures to continue consolidating the health of banks and mitigating the effect of regulatory costs, including the adoption of additional actions to address any relevant findings by the time of the second programmatic financial sector operation. Actions for Institutional Development of the Superintendency 58. Supervisory Development Program: The Superintendency has committed to developing a new Strategic Plan for the 2003-2006 cycle of operations of the SB, including among others, detailed components of a Supervisory Development Program to address the challenges and issues identified by the SB, in order to: a) Design and formalize a revised risk based4 operational Supervisory Strategy, to streamline, and integrate into current Supervisory Processes -- for licensing and authorizations, onsite and offsite supervision, and remedial, enforcement, and resolution actions-- whose steps would be charted, identifying major decision points, to ensure a consistent supervisory response; b) Compile and update currently dispersed out-of-date Supervisory Manuals of Procedures, combining both solvency and risk based approaches, including computerized planning, and working programs and papers, in order to support supervisory assessments of financial institutions as per a new Risk Rating Matrix Methodology; and c) Review, simplify, and make cost efficient, current Supervisory Products --such as examination reports, surveillance analysis notes, and CAMEL indicators -- ensuring a set of homogeneous executive oriented reports warehoused in accessible network computerized systems. 59. Related Investment Projects: The above plan will include any incremental investment projects that would facilitate implementing the Supervisory Development Program of the Superintendency during its planning 2003-2006 cycle, indicating the level of funds to carry out the necessary programmed actions, including consideration of major training sessions. 60. Supervisory Staff Training and Compensation: To resolve the current restriction impinging on the depth and caliber of supervisory staff, the Ministry of Finance has agreed to evaluate, and present alternatives to ensure that the Superintendency can effectively mitigate its deteriorating staff turnover ratio, as well as train and compensate its staff closer to market and institutional standards. 4 To focus on risk accumulation at systemic and individual bank levels; centering on assessing both quantitative and qualitative aspects of risk, including the primary quality of assets and earnings, the availability of genuine residual capital, and adherence to sound standards of business and financial practices; and, looking prospectively at resilience to risks under stress, rather than to static measures of compliance with regulatory capital and risk limits.  - 19 - The Second Operation under the Program - The Banking System 61. The proposed program for the second operation is described below. Under the second loan, the main areas covered anticipate: (a) full implementation of the required regulations emanating from the financial system reform law (including those for supervision of conglomerates, conflicts of interest, governance rules, and enforcement of sanctions), (b) actions to improve banking system efficiency by rationalizing tax and regulatory constraints and fine tuning the payments system, (c) measures to ensure systemic integrity through prompt application of corrective actions, (d) examination of contingency measures to assure safe operation of the banking system under adverse economic states, and (e) actions to improve the efficiency of the regulatory process and implement an institutional development plan for the Superintendency. While the main thrust of the program is further described below, the final policy agreements and specifics of implementation will be defined during the formal preparation of the second phase. 62. A key aspect under the second phase pertains to integrating regulations relating to the SB's enforcement actions including the span of remedial actions as well as subsequent schedules of pecuniary sanctions applied in a graduated manner based on the seriousness or persistence of given infractions. This section of the report addresses banking sector issues whose major reforms will have occurred under the first phase -- the subsequent sections address other various key subsectors including insurance, non-banks, securities, housing finance and the government debt market, where a major set of reforms will take place under the second loan of the programmatic operation. Financial Efficiency and Systemic Integrity. 63. The second phase will also allow the government to review and address structural tax and regulatory rigidities in the financial system which could in the long term affect the competitiveness and the soundness of the financial system. While economic and credit conditions will remain a key priority in the oversight of the financial sector, the payments system and instruments used for generating temporary liquidity in the interbank market (e.g.: repos) will also be enhanced to prevent any transaction related default risks. 64. During the first phase of the programmatic operation, the Government has committed itself to conduct a vulnerability review of the financial system. Under the second phase, said study will have been completed and a contingency plan defined to handle any possible downturns, systemic effects, or institutional failures caused by lower than anticipated economic growth and other factors potentially affecting banking health. Institutional Strengthening and Regulatory Process Efficiency 65. In order to ensure that the reform's progress and implementation of the new regulatory framework is sustained over the medium and long term, and as per the provisions for enhancing the SB's institutional autonomy under the reformed financial system law, under the second phase, the government will seek to implement a Strategic Plan for the institutional development of the SB over the 2003-06 period. Part of the institutional plan, besides the sustainable career development and compensation plan, and the approval of investments for the SB's development program , will include the establishment of ongoing internal risk ratings of financial institutions  -20 - so as to allow a more strategic approach to undertaking supervisory activities and focusing on vulnerabilities in the sector. Prudential Regulation and Supervision 66. Reduction of Regulatory Costs: The Superintendency intends to diagnose and identify measures to rationalize its requests for prudential information, with a view to alleviate the regulatory costs associated with the current system of reporting requirements. 67. Internal Corporate Governance Standards: The Superintendency will implement, as well, regulations governing the codes of conduct and duties of bank boards and management, including a more detailed set of standards for bank board procedures, their functioning and their operating committees. 68. Conflicts of Interest: The Superintendency intends to establish, as well, regulations to implement articles of the Financial System Reform Law covering measures to mitigate conflicts of interest under major decisions and transactions where significant shareholders of an institution, directors or senior management, are parties. Actions for Development of the Superintendency 69. By the time of the second programmatic operation, the Superintendency intends to have advanced substantially in specifying objectives and targets for a Supervisory Development Program, including selected benchmark indicators in the areas of intemal governance standards communicated to the industry, market risk management and collateral valuation standards, as well as full disclosure of its sanctions regime and associated fines, improved and documented supervision procedures and examination strategies, and implementation of the supervision of consolidated groups including offshore entities.  - 21 - C. Housing Finance Background 70. The housing finance crisis was caused by massive unemployment, excessive levels of UPAC-denominated loan rates, unsafe underwriting standards, falling housing values which created negative equity and wealth losses, and a spreading culture of non-payment fueled by court rulings adverse to lenders. Non-performing loans represent 24% of mortgage loans, although that level when expressed in nominal pesos stopped deteriorating in 2002 (at 2 trillion pesos, plus 0.7 trillion of foreclosed assets). 71. The CAVs or savings and housing loan banks (now known as BECHs) suffered particularly strong financial shocks on account of four factors: (a) the economic downturn including rapidly rising unemployment and variable interest rates put many housing loan borrowers in default with their banks, thus significantly increasing the CAVs level of non performing loans; (b) the higher interest rates which caused a mismatch on asset and liability yields on CAVs' balance sheets; (c) the recession also depressed real estate prices which had been used as collateral/guarantees to back home loans - with lower real estate values, collateral guarantees were eroded and thus the CAVs had to forcibly provision more income against losses, and repossess real estate assets, while at the same time those borrowers were denied further access to credit or refinancing; and (d) during the same period, the Constitutional Court ruled that the variable mortgage rate index used by the CAVs (the UPAC), based on average interest rates levels, was invalid since an inflation based index should have been consistently used over the years, and therefore this ruling prompted the government to refund on an ex post basis many of the interest charges to borrowers which would have been lower if a non-interest rate index had been used. In response to these challenges, the Government embarked on a series of specific measures to address the immediate problems in the financial sector, as well as the structural reforms needed to enhance the efficiency, competitiveness and risk profile of the banking sector. 72. The housing finance law No. 546 was approved in December 1999 in order to keep the housing financial industry alive but rebuild solid foundations. The main blocks of reforms were: (a) Savings & Loans institutions ("CAVs") were converted into fully regulated banks, subject to diversification, and tighter loan-loss provision rules (some institutions being restructured by Fogafin or closed). (b) The Government through FOGAFIN, purchased CISA in 2000 as an asset management company to dispose of the bad loans including mortgage ones, from restructured banks, primarily Bancafe and BCH. Despite a slow start, CISA has paralleled the efforts of the private banks in active debt recovery and loss mitigation". (c) Fogafin has been operating a credit enhancement program for mortgage securities refinancing social housing loans ("VIS"). Until 2001, it has also provided some 10 By September 2002, CISA purchased $925 million of assets (peso 1.6 trillion from Bancafe), and disposed of $370 million. About 44% of the assets were mortgage loans. CISA plans to sell $185 million of assets in 2003 and complete its sales by 2005.  -22 - subordinated credit lines to shareholders of banks to help these meet tighter solvency goals. It also sold its own portfolio through a competitive bidding process. 73. Most banks have learned to pursue active mortgage debt recovery and mitigate their losses. The coverage ratio of mortgage loan-loss provisioning has steadily increased up to 39% as a result of tighter prudential regulations set by the SB. Many of these loans correspond to households that stopped repaying for various reasons more than a year or two ago. Most have already been restructured but loss provisions need to increase as the classification worsens. 74. The quality of the portfolio and the revival of sound loan production depends on the evolution of housing prices and of a stable macro and judiciary environment. The housing sector started to revive in 2002 after three years of distress. There is a reported 20% increase in new construction as households have resumed investing in housing, even if carefully. Demand was boosted by new tax benefits offered in 2002, for new mortgage borrowers. 75. Most mortgage lenders are now liquid but remain vulnerable to credit and market risks. The ex-CAV banks are still struggling to diversify their production into more profitable sectors. Most struggle to meet stricter regulatory solvency ratios and have had to leverage using the re- capitalization lines provided by Fogafin to the shareholders. Fogafin stopped extending these credit lines after 2001 and is now actively monitoring inherent risks and bank repayment capacities, including if needed, collateral strengthening actions. 76. Banks have not yet entered into contracts using the FRECH fund created as a transition policy instrument to hedge their market risks resulting from the UVR portfolio conversion, because of the high (and inadequate) level of the triggers under that swap contract, compared to the actual low real market rates. The FRECH fund was created by law as a transition measure to partially hedge the increased market risk exposure of banks whose mortgage portfolios were converted in 2000 into the UVR index. This sizeable fund - now of 350 billion pesos - was partly financed by taxes imposed earlier on transactions within the financial system, and is administered by the central bank. Its swap design has been conservatively priced to preserve the fund in a range of risky environments, and to protect lenders against significant spikes in real market rates. 77. Under current circumstances, any contracting institution would have to pay expensive contributory fees (adverse to its profitability), with further unpredictable yearly flows. Despite extensions and minor adjustments, banks have not found the mechanism attractive enough to contract, as short-term real rates have remained low. Banks have remained exposed to large market risks although the eligible portfolio for this mechanism, is amortizing through time, and shareholders instead borrowed re-capitalization credits from the state through Fogafin to meet SB's capital adequacy requirements for credit and market risks. Therefore alternative hedge instruments and their design are being considered to modify the FRECH mechanism. 78. In a major advance towards the access to long-term funds for mortgage lenders, securitization is again operational. It is a useful instrument to manage liquidity and market risks, and to leverage scarce capital. A sizeable amount of high-quality mortgage loans was successfully securitized in 2002 at favorable conditions " through the new securitization company that was capitalized by the majority of the ex-CAVs. But this initial phase remained II About Peso 1 trillion through two securitization programs, the latest was placed under the following conditions: interest rate at UVR +5.4%, terms between 5 and 15 years, with moderate structuring and trustee fees.  -23 - largely driven by large tax advantages, as the offering banks later purchased and held a large part of these mortgage backed securities (MBS) to capture the tax exemption on MBS interest. Their exposure to market risk was then only partly reduced, as about 30% of the senior rated MIBS bonds were acquired at issuance by a diversified group of other investors (mutual funds, insurance companies, pension funds). The sustainability of securitization should be developed on its own merits with sunset rules after 2004 to phase out disputable, regressive and fiscally costly tax subsidies. Nevertheless, the tax exemption has helped the housing finance sector to raise new funds increasing the availability of mortgage finance to new borrowers. The exemption does not apply to the securitization of other non mortgage loans, as utilized for more generalized banking resolution procedures. The Government Reform Program in the Housing Finance Sector The First Operation under the Program Housing Finance and Mortgage Market Reforms under the New Financial System Reform Law 79. Under the first operation, the financial system reform law and the reform of the civil procedures code include several fundamental elements that will enhance the development of the housing finance sector in Colombia. These include the following: * Reducing the complexity, length and costs of the mortgage foreclosure process. * Facilitating the leasing of foreclosed assets by mortgage lenders as a remedy to cases of delinquent mortgage loans. * Granting CISA abilities in the financial management of assets, in order to strengthen its credit pledge enforcement capacity and contract external servicing companies. After having set up automated systems and organizational capacity, CISA should be able to dispose of assets even more rapidly. * Facilitating procedures for bank privatization and/or close ending resolutions. * Extending micro-finance to housing with permitted additional administration fees, and open access for lenders to the credit guarantee program of the Fondo Nacional de Garantias (National Guarantee Fund). By giving banks special provisions to extend micro housing loans as well as permitting banks to fund credit lines for finance companies for the same purpose, this will permit a broader outreach to potential homeowners who traditionally have not had direct local access to housing credit institutions. Inflation /Interest Rate Hedging Mechanisms 80. Other reforms undertaken as part of the program under the first operation, include an actuarial study to review the guarantee enhancement program operated by Fogafin since 2002 for mortgage securities which finance social housing loans ("VIS"). Fogafin has been charging 81 basis points for its support of securitized loans that would meet eligibility criteria, and 32 basis points for its insurance/credit enhancement program to support mortgage bonds issued by banks. This program was originally envisaged as lasting two years, as an incentive to spark the growth  -24 - and trust in mortgage securities, by extending a state guarantee that would reduce funding costs of VIS loans (capped by law at UVR + 11%). The premium will be updated and differentiated according to the net risk exposure, and so that no type of security structure is favored in a non- economical way. Should the program be extended, sunset clauses will be clearly announced and/or the program will be transferred to a regulated professional insurance institution. 81. Another constructive use of FRECH, implemented under the first operation and which is not a hedge mechanism but simply deploying the liquidity accumulated and available in the FRECH fund, consists of it acting as a liquidity backstop facility for the newly developed mortgage securities markets by permitting the swapping of eligible mortgage securities with repo-able government securities. This use of FRECH has been approved and the Central Bank will promulgate its methodology to determine the corresponding pricing haircuts. It will also adjust the general valuation rules for debt securities, to the specifics of mortgage securities, which are infrequently traded through secondary markets, as well as valuation methods for and embedded callable options. 82. Simultaneously, while the FRECH hedging mechanisms is being modified, Fogafin has developed operational guidelines for a new UVR-swap program operated through by it on behalf of the Government. The guidelines have just been disclosed through the recent Decree 66 of January 15, 2003. The swap is directly contracted between Fogafin and eligible borrowers through the partner credit institutions. It is applied against the UVR level and a fixed 6% peso interest base, and pertains to the next 40,000 eligible housing loans for a limited credit amount until mid-2004. The program is designed to regain trust by the population of UVR mortgage loans, using a hedge against any catastrophic inflation risk. The program represents a long-term bet on inflation. Should inflation fall below 6%, reassured households would stop contracting, but if inflation exceeds 6%, pressure may materialize to enlarge the program beyond its current size and format. In this context, the government will take care to avoid resulting in fiscal liabilities which could be detrimental to the overall national housing policy. Fogafin will also establish prudential financial reserves institutionally, and has developed its own hedging strategy against inflation risk to support this mechanism and to avoid any undue accumulation of contingent risks. The Second Operation under the Program - Housing Finance 83. The proposed program for the second operation is described below. The second phase of the program will include progress in the implementation of: (a) harmonized rules for capital adequacy between banks and securitization companies, particularly with regard to securitized asset instruments, (b) reform of the swap inflation hedging mechanisms, (c) regulatory measures to increase the competitiveness of the mortgage industry, (d) developing alternatives for inflation indexed mortgage loans, (e) improving the micro finance infrastructure to increase credit access, and (f) creation of a national housing information center. While the main features of the program are described further below, the final policy agreements and specifics of implementation will be defined during the formal preparation of the second phase. 84. Regulatory Improvements. Harmonized rules for capital adequacy and loss provisioning between banks and securitization companies are expected to be implemented, with respect to their net exposure to risks generated from holding or guaranteeing different tranches of mortgage securities, so as to avoid regulatory arbitrage detrimental to the soundness of the financial sector.  - 25 - 85. Industry Efficiency. Additional measures will also be explored to make the mortgage lending industry more competitive and efficient. Competitive mortgage lending would be accelerated by some newly-licensed credit institutions, acting either as commercial banks or as non-depository specialized mortgage finance companies. The permitted use of external providers of specific and unbundled mortgage finance services (origination, appraisal, servicing, etc.) would increase the efficiency of mortgage lending by leveraging their respective comparative advantages on operation costs and risks. 86. Market Benchmark Indices. Alternatives will be considered regarding the lack of liquidity attached to the imposed UVR-indexation of mortgage securities. Since there is no liquid UVR benchmark, the affordability of housing finance is affected by a liquidity premium. 87. The Tax Regime. The taxation of housing finance along with exemptions will be assessed from various perspectives (fiscal authorities, borrowing households, lending institutions, investors of mortgage securities). The slow recovery of the housing finance industry may not tolerate too unfavorable and unexpected changes in the tax regime, but some rules need to be reformed for the system to be more consistent and efficient. 88. Real Estate Valuation and Micro Finance. Additional infrastructure is needed for the development of micro-finance as applied to housing investment. Links with formal VIS social housing subsidies are needed, as well as housing savings products, risk analysis tools, eligible distribution channels, institutional strengthening, market-oriented pricing and refinancing products. A national housing information center is needed to provide updated, reliable, and accessible information on the evolution of housing markets and actual market prices. 89. Market Instruments and Infrastructure. The FRECH fund will be reformed into a more effective hedging mechanism through the concerted efforts of a working group. Parametric changes would be justified, or alternative hedge structures will replace the swap design, particularly through interest rate options or extended credit enhancements to non-VIS mortgage securities.  -26 - D. The Rnsurance Sector and Non B3ank Financial Services Background 90. The key regulations that kicked off the liberalization of the insurance activity were Laws No. 45/90 and No. 9/91. The Superintendency of Banks is the authority responsible for the supervision of all the financial institutions including insurers and other non-banks, but excluding securities market players and small mutual cooperatives. The Delegatura de Seguros is the Department within the SB that specializes in the control of the insurance industry. While the SB is responsible for supervision, Law 35/93 established that a Technical Vice-Ministry of the Ministry of Finance (Hacienda) would be the Regulatory Body. 91. Insurance companies must specialize in either the Life or the General Insurance sector. Presently there are 28 companies licensed for General Insurance and 23 for Life. Most of the Life Insurers are sister companies in the same group as that of a Non Life Insurer. 92. Insurers are required to regularly submit to the SB financial returns and other types of schedules. The most recent regulation that defines the information that must be regularly forwarded by insurers to the SB was issued in December 2002 within the External Circular No. 052. The last relevant Law that regulates the Financial System Law 795/2003 which applies new reforms to the entire financial system. Corporate Risk Management - The SEARS Approach 93. The SB, through External Circular No. 052 of Dec. 2002, established the requirement for adopting formal procedures in the analysis and measurement of all risks that affect the development of activities of any insurance company. Each insurer is requested to produce its own SEARS method (Sistema Especial de Analisis de Riesgos de Seguros) which must be approved by the SB. A time schedule for the implementation of SEARS has also been issued. Reinsurance 94. Reinsurance plays a key role in the proper development of insurance activity. However in some cases reinsurance is used for non desirable purposes such as "fronting" for example, where the insurer does not retain any risk, passing most or all of it to the reinsurer and operating as a mere intermediary. 95. According to the Colombian regulations, foreign reinsurers do not need to have a domestic company to operate in the Colombian market, but they must register at the SB which monitors that market using: (a) A specialized reinsurance surveillance scheme; (b) Support to specialized inspection activities regarding the reinsurance programs of each insurer; and (c) Impact on the solvency margin of ceding companies, in the case of excessive use of reinsurance. 96. The SB is seeking ways to eliminate financial reinsurance and to reduce "fronting" operations, limiting them only to those cases where it might be technically required. 97. The existing regulations also affect reinsurance brokers which are required to be domiciled locally and are subject to a sanctions regime against malpractice. The register of reinsurers is granted only to those that count with a satisfactory evaluation of an international specialized rating agency.  -27 - The Trust Industry 98. The Trust agency industry ("Fiduciarias") in Colombia has grown into a significant player in the domestic financial markets. At the present, thirty one actively operating Trust companies exist and are subject to the Financial System Law which governs banks and other financial institutions. Trust companies are authorized to invest funds as trustees for third parties, to enter into contracts for the administration of assets (both real and financial), to administer collateral guarantees to assure financial obligations of third parties, and to administer or oversee any assets underlying the execution of any such collateral guarantees. They are also authorized to act as agents for the registration and transfer of securities as well as custodians of assets held under judicial procedures. Trust companies can also provide fee based financial advisory services. A high growth area in the Trust business has been the management of mutual funds as well as pension and retirement funds. Mutual funds managed under trust arrangements account for over 11% of all funds held under trust in the industry. 99. The fast evolution of the trust business and its fiduciary role in managing a large stock of investment assets, has prompted the authorities to examine closely the risk management requirements and responsibilities of the industry and to start developing appropriate regulatory norms commensurate with the current development of the market. At the same time, industry participants understanding their growing role in the financial markets in Colombia and the potential for increasingly diversified business lines, have begun proposing regulatory changes to provide the trust industry more flexibility to offer products in line with what they perceive as growing market demand. In this context, the reform program for the trust industry addresses both prudential risk management requirements and the need to avoid regulatory constraints for market development. The Private Pension Sector 100. The private contribution defined pension system was established in 1993 following the approval of Law No. 100. Prior to that, the State run defined benefit social security system was the only pension provider for obligatory retirement funding. Private pension management firms (AFPs) are currently a significant player in Colombia's capital markets. Currently there are seven AFPs operating in the industry which manage obligatory pensions for workers in both the private and public sectors. 101. Pension assets managed by the AFPs currently amount to Col$15.7 trillion or US$ 5.4 billion equivalent. During the last five years, pension funds managed by the AFPs yielded an average rate of return of 20.7% per year, equivalent to a real rate of 9.9%. The current number of affiliates to the private pension system is 4.7 million individuals. Of these, a little under 50 percent are active contributors. Inactive affiliates are those who, due to unemployment or other factors, have not contributed within the last six months. 102. In terms of investment instruments in the portfolio, the primary categories constitute government securities which represent 49 percent of AFP portfolios, while financial institution securities represent 21 percent and corporations outside of the financial system, 20 percent. In currency terms, the portfolio includes 57 percent of investments in local nominal currency, 15 percent in inflation adjusted instruments, 22 percent in dollars and 4 percent in euros. The SB regulates a minimum rate of return required on AFP portfolios, and which is specified as a maximum downward deviation compared to a rate of return yielded by: (a) a  -28 - benchmark/reference portfolio of lower risk securities, and (b) the average AFP industry return; with each of these two factors having a 50 percent weight in the calculation. The reference portfolio is referred to as the "synthetic portfolio" and is constructed by the SB. 103. The public defined benefit pension system still remains open to new affiliates, but recent reforms have helped reduce benefits in order to lower the projected actuarial deficit. Under the public system there exists the main social security system (1[SS) as well as other specialized funds for government and congressional workers as well as specific sectoral (teachers military) pension funds. In addition, territorial and municipal funds are being consolidated into a common funding mechanism (FONPET) to better manage their combined actuarial deficit. The specialized sectoral/professional public pension funds are partially funded with close to Col$ 3 trillion in reserves although, the same is not the case with the social security and govemment workers' funds whose reserves fall very short of future obligations. Affiliates in the main public funds (ISS, Govemment, Congressional) amount to almost 4,600,000, about the same number as in the private system. The Government Reforzm lPirogram for the linsuraince Sector and Non IBanks 104. Before reaching the second stage of implementation of the SEARS approach and the introduction of a multi-factor model to establish risk based capital requirements, the govemment, in line with prudent practices will implement the following changes to the present regulatory regime, as discussed below. The First Operation under the Program The Insurance Sector 105. Technical Solvency Standards. The implementation of a full Risk Based regulation that has been initiated, will still take a relatively long time before it becomes fully operative. Meanwhile, the Insurance Sector needs to be improved in terms of the capital requirements for insurers and reinsurers, the updating of the minimum solvency levels that they must meet, the basis for the establishment of the technical provisions that should be reflecting the liabilities arising from their insurance activity, and the type of assets that can be allocated for the coverage of these provisions. 106. Capital Requirements. Under the first loan, the financial system reform Law (No. 795/2003) modifies articles 80 and 82 of the "Estatuto Orgdnico del Sistema Financiero (Financial Sector Framework Law)". The new Article 80 establishes that the minimum capital for an Insurance Company (except those operating export credit insurance and Reinsurers) has been set at 5.5 billion Pesos, and for a Reinsurer at 22 billion Pesos. These amounts will be automatically updated with the CPI. Article 82 defines the concepts of Technical Net Worth, Adequate Net Worth and the Guarantee Fund, and establishes that the required Net Worth to operate in each Line of business ("ramo") will be fixed by the Govemment and that these amounts should be added to the capital requirement of Article 80. 107. The Government, therefore, using its capacity and increased regulatory flexibility provided in Article 82, will proceed towards a prompt revision of the minimum capital (net worth), requirements for insurers and reinsurers. In doing so, the Government will allow consideration of both the local environment and the need to align these amounts with intemational standards for the different lines of business (property, life, accident). This revision affects not only to the minimum initial capital but also the solvency requirements for each line of business.  - 29 - 108. Technical Reserves. Law 795 has also modified Article 186 of the framework law, empowering the Government to establish the technical provisions that must be set by insurers. These provisions must be equal to at least: (a) the Unearned Premium Provision (still called Unexpired Risk Provision), (b) the Mathematical Provision, (c) the Pending Claims Provision and (d) the Claim Stabilization Provision. In a first phase, the Government will analyze which improvements can be introduced to the present regulation. 109. Enforcement Regime. In order to guarantee a proper fulfillment by insurers of the solvency and reserving requirements in the first stages of this reform, the SB will count on a schedule of sanctions for breaches of minimum solvency requirements or the adequate level of technical reserves. The SB's insurance supervision will also be extended local offices or agents of foreign insurance and reinsurance operations. 110. Investment Norns. Finally, in the area of investments of insurer's technical reserves, the Government is considering a policy proposal to establish a more flexible regime for the investment in assets permitted to fund the technical reserves so as to allow insurers to better match the maturity of their liabilities with corresponding investment assets. In that regard allowance might be made for the introduction of a certain proportion of real estate and loans as qualifying assets, although this should will be done with strict adherence to all the prudent principles that investment of these funds are subject to. The Trust Industry 111. For the first operation under the program, the Government has implemented an initial set of reforms within the financial system reform law, in order to address business transparency and operational flexibility needs for the trust industry. A key concern of the authorities has been the diverse pricing practices of trust companies with respect to funds managed under either trust or asset administration contracts. Prior to the reform, the pricing of investment management services could have been based on either fixed commissions, asset based fees, return/yield based fees, or other modalities. In order to promote transparency and comparability for clients, the new financial system reform law requires that trust company fees for managed investment assets, be expressed as a percentage of the managed assets, and that fees be discounted from the fund. In this manner, pricing norms are normalized and comparability of products and transparency is assured for clients. 112. In terms of prudential risk management practices, the new financial system reform law replaces the previous limits on investment instruments regulated for the trust industry, with a requirement that trust companies establish their own internal investment risk management systems for reporting to the SB. Consistent with banking system practices being adopted in line with Basle H guidelines, the risk management models of trust companies for asset management functions, are also to be developed internally by the supervised institutions. These risk management systems, once developed by each firm, will be subject to review and no objection byf the SB. The new law therefore, avoids the prior practice of attempting to regulate investment norms for a multi-function and diverse industry, and instead migrates to a modernized framework based on the SB's evaluation of internal corporate systems.  - 30 - The Second Operation under the Program - The I[nsurance Sector and the Non Banks 113. The program for the second operation is described below. The second operation would include actions and reforms to: (a) phase in new risk based solvency and capital adequacy norms, (b) establish norms for the calculation of technical reserves and mathematical provisions, (c) regulate the insurance supplied pension annuity market, (d) establish a more adequate framework regulating the use of catastrophe risk reserves and for the accounting for financial reinsurance contracts, (e) remove tax obstacles and product restrictions for trust companies, (f) modify pension sector regulations to permit increased investment flexibility and protect pensioner funds, and (g) implement value-at-risk regulatory methodologies for trust and pension companies. While the main thrust of the program is described below, the final policy agreements and specifics of implementation will be defined during the formal preparation of the second phase. The Insurance Industry 114. Once a conclusion has been reached by the SB regarding the technical provisions to be established by insurers to better reflect their liabilities arising from their insurance activity, under the second loan, regulations will be issued updating the rules for the calculation of solvency margins, the uneamed premium provision, technical reserves, mathematical provisions in the life insurance industry, technical discount rates, and pricing of products pertaining to the pensions/retirement annuity market. 115. A modification of the regulations regarding the accumulation and use of catastrophe reserves will be considered in order to allow their utilization for major events, with reserve replenishments achieved according to a graduated schedule. The accounting norms for reinsurance contracts will also be reviewed with a view to adjusting these to recognize financial (or finite) reinsurance treaties as contracts without having full risk transfer characteristics, regardless of their commercial names. 116. The introduction of the changes mentioned above will significantly reinforce the solvency of the insurance industry in Colombia and will allow a more gradual and phased implementation of the new risk based solvency regulations. The introduction of the SEARS approach will be rolled out in a manner consistent with the local progress of the industry and supervisors' actuarial and risk management capacities. The Trust Industry 117. Under the second operation, certain regulations applied to the trust industry are expected to be examined. For example, the financial transactions tax may be applied more frequently to trust companies given their multiple routine transactions required during the transfer of funds. In addition, since trust companies currently have a sales tax applied on their commissions and fees, the reform will review this practice to make it consistent with practices in other parts of the financial industry. 118. An additional area that will be considered, is the level of capital requirements for trust companies. Current requirements are somewhat arbitrary given that trust companies effectively have no need for a solvency margin. In addition, the minimum requirement on the size of client funds to be invested for business by trust companies, will be reviewed. To support the development of internal risk management systems, regulatory circulars will be issued by the SB specifying value-at-risk (VAR) and duration gap methodologies to be applied by the trust industry to measure market risks.  - 31 - The Pension Fund Industry 119. Under the second operation, prudential norms for the pnvate pension fund industry will be upgraded and disseminated in line with those in the trust industry, so that AFPs follow appropriate VAR methodologies for assessing investment portfolio risks, and take measures to fully monitor their asset and liability duration gaps. Using these VAR methodologies as well as with calculations regarding the relative liquidity and secondary trading of securities, the benchmark/reference "synthetic" portfolio used by the SB to compute the minimum allowable rate of return of pension funds, will be reviewed to better reflect actual market investment opportunities in line with the tradability and liquidity of securities, which the existing synthetic portfolio does not take into account, and which diminishes its usefulness as a reference investment strategy. In order to diversify risk and protect the value of pension assets, the government will consider regulations permitting an increase in AFPs investment limit in foreign securities (currently AFPs invest under 10% of their portfolio in these).  - 32 - lE. The Capfital Markets Background 120. A comprehensive strategy for capital markets and financial intermediaries needs be developed. At present, there exists an excessive fragmentation in Colombia's financial markets. Capitalization of the stock market amounts to only 13 percent of GDP, one of the lowest for the more developed economies of the region. The integration of the three stock exchanges in Colombia will help to increase market liquidity. The new securities law, now under preparation will also help reduce obstacles into the issuance of securities by companies and provide incentives for capital market activity, such as providing the legal basis for developing securitized transactions, one of which has been recently implemented. To facilitate securitization, a standardized mortgage instrument needs to be created. The recent launching of a securitization firm now provides the legal and institutional mechanism to jump-start the securitized asset market, which should help promote longer-term securities backed by credit or other asset portfolios. 121. Accelerating the development to deepen the markets for securities, long-term debt and securitized assets and derivatives, and promoting an ordered development of the large institutional players in such markets -- including insurance companies, mutual funds, and pension funds -- constitutes an important alternative mechanism to facilitate the absorption of risks by market participants. The development of the market for corporate stocks and securities will lessen the reliance on banking intermediation, thereby reducing debt leverage and allowing macroeconomic and financial shocks to be directly absorbed by investors rather than debtors or financial intermediaries. 122. The government has continued to progressively and successfully develop the basis for a capital market, particularly through its government securities market. The institutionalization of market-making agents in the financial sector and the regular schedule of auctions implemented by the government has succeeded in creating a liquid and deep capital market in government paper. More recently, the government implemented short-term issues of bills and notes and longer-term bonds, so as to complete the maturities available on the government debt yield curve while providing a full range of risk-free benchmarks to support private market securities pricing. The addition of issues of short-term maturities (60 days to 180 days) will also help set the zero risk benchmark of the yield curve for short-term corporate paper. At the subsovereign level, the Bogota District govemment recently began to issue municipal bonds on the fixed-income market, backed solely by the credit of the municipality-district. The Government Refofrm PFrogram - The Capital Markets The First Operation under the Program 123. Asset Valuation Standards. As part of the first operation and prior to the approval of the new securities law, the govemment has taken steps to set strengthen the institutional and normative framework for the oversight and operation of the capital markets. Specifically, the govemment has instituted a common methodology for the valuation of assets in the securities market to ensure the mark-to-market norms are established and applied consistently across the banking, securities and other non banks sectors (e.g.: institutional investors). For this purpose, a working committee among the SV, the SB and the Central Bank has been established, and an asset valuation methodology has been developed and disseminated to the industry. Valuation  -33 - standards have been established for government (Treasury) securities, external debt securities, other public agency securities as well as private fixed income instruments. 124. Cross Sectoral Consolidated Supervision. Given the increased inter-linkages between banking and securities institutions including cross ownership ties, the government has considered it of utmost priority to ensure that the supervision of such related entities is conducted at the consolidated level. For this purpose, under the first operation, a four year inter-institutional agreement between the SB and the SV has been entered into in order to conduct joint supervisions of financial groups which include banking and securities enterprises. The supervision teams of both authorities, will thus jointly examine operations which fall under both their mandates, including mutual funds managed by trusts, bank trading desks, and affiliated financial services. 125. Capital Requirements and Conf icts of Interest. The operation of a sound capital market also relies on the strength and financial resilience of the key intermediaries in that market. For that purpose, under the first operation, the government will issue regulations governing the proprietary market positions as well as capital at risk and provisions against conflicts of interest, as applied to the securities brokerage and dealer industries. This will put in place a framework holding dealers and brokers accountable for the management of client funds and to ensure their fiduciary responsibilities in separating their strategies when managing own funds versus third party investments, including the requisite procedural fire walls to avoid illicit leveraging of client funds. 126. Institutional Strengthening. In order to carry out the above functions effectively, the Superintendency of Securities (SV) has carried out a reorganization by decree. This will create a new structure including a separate mutual funds division to oversee the multitude of funds modalities in Colombia and begin to develop a regulatory and supervisory framework consistent across the industry. Another division for intermediaries and markets will be created to primarily focus on the regulation of entrants into the securities market, as well as the regulation of those institutions needing to exit the market due to non compliance with prudential norms, solvency risk, or other factors. Finally, a separate supervision division will be created to focus exclusively on surveillance of the market and enforcement of regulations. In the above structure, the SV therefore, will be strategically placed to focus its attention in the key risk areas pertaining to the operation of the market. The Second Operation under the Program - The Capital Markets 127. Under the second operation, described below, reforms for the capital markets would include: (a) a new Securities Law, (b) provisions and regulations established for corporate governance, securities issuance, sanctions regimes, professional/technical entry requirements and qualifications, regulation of investment banks, and securities trading infrastructure, (c) unification of regulation and treatment of fund managers in the mutual funds industry, (d) dematerialization and electronic custody of securities, and (e) modernization of the SV including implementation of market monitoring instruments. 128. While the main thrust of the program is further described below, the final policy agreements and specifics of implementation will be defined during the formal preparation of the second phase. Under the second loan, the Government intends to have finalized the new securities law and regulatory/institutional framework. The new securities law will address key issues which will reform the operation and behavior of market participants while promoting  - 34 - additional issuance of securities through less onerous regulatory procedures. A number of key reforms under the law are considered: 129. The law will provide guidance and regulatory powers to the SV to establish industry entry criteria with respect to standards and qualifications of professionals in the securities industry including those working for securities firms, mutual fund managers, bank securities desk operators and other participants in the capital markets. The qualification and fit-and-proper aspect will be critical to ensure that industry entrants and players are fully trained and knowledgeable of market risks as well as govemance and conflict of interest norms. Norms on corporate govemance of public companies will be substantially reformed to increase transparency and accountability including definition of responsibilities of corporate Boards, management, legal counsel, auditors, and other de facto controlling interests in companies. In line with the supervision of the banking system's approach, the new securities law and associated regulations, will implement a sanctions and penalties regime within a graduated schedule of regulatory actions based on the magnitude of regulatory breaches by market participants. 130. Mutual Funds. A key aspect of the new securities framework will be the unification and consolidation of the mutual funds industry. The industry is segmented into various subsectors and the Banking Superintendency is responsible for supervision mutual funds managed by Trust companies even if such funds have similar or same characteristics of those managed by securities firms. In addition, the current regulation varies according to the type of fund (equities, fixed income, money market, venture, etc.) and thus supervision of the industry becomes inconsistent and cumbersome. As part of its market development mandate, the new law will also define licensing and regulatory requirements for the investment bank industry which is still very embryonic in Colombia. Investment banks can be important intermediaries and market makers in the securities market, and the new law will improve the definition of these agents so as to reduce regulatory ambiguity and encourage entrants into this market segment under transparent rules. 131. Market Infrastructure. Subsequent to the implementation of the law, the SV will also set and implement standards and operational procedures to modernize trading and electronic negotiation systems so as to increase the transparency and integrity of the price formation process as supported by the previously implemented asset valuation methodologies. The regulations under the new law will also implement the dematerialization of securities and the implementation of electronic custody registers so as to allow the more efficient purchase, sale, and ownership change in traded securities to be effected on an electronic book entry basis.  - 35 - F. The Government Debt and Money Markets Background 132. Over the last decade many substantive improvements have been made in the structure and processes of the local debt markets. The modernization of local debt markets and monetary policies as well as the primary issuance process, accelerated in 1997 and 1998. Over this period the authorities introduced the primary dealing arrangements, and the two tier on-line dealing system (SEN) for government securities was set up. The Central Bank (Banco de la Republica or BR) has also gone from being a very active issuer of its own paper to using indirect monetary instruments in implementation of monetary policy. Under the new model only the Ministry of Finance issues sovereign debt via fungible standardized issues. By 2002 the most liquid benchmark on the yield curve was represented by the 10 year 2012 maturity and the overall average modified duration of the treasury debt (TES B) was almost 2.5 years at past mid 2002. 133. At the outset of the modernization process, actions were also taken to improve liquidity in the money markets via actions to permit borrowing and lending of securities, the partial relaxation on taking short positions in the repurchase agreement market, and the subsequent complete liberalization via introduction of a new type of repo contract ("simultanea")'2. Finally, over this same period important actions were taken with respect to the investment regulations applicable to forms of investment funds and pension and severance payment funds. 134. The debt market, however, despite implementation of these important steps, has experienced some set-backs in its development and exhibited a number of vulnerabilities. This was most recently illustrated by the mini-crisis in the TES market during August and September, 2002. The vulnerability witnessed in Colombia's debt markets in 2002, which eventually required the discontinuation of auctions of government bonds from mid August until the end of November 2002, highlighted the importance of implementing a mutually reinforcing set of reforms to reduce the reoccurrence of such scenarios. The 2002 vulnerability in the Colombian local debt markets was caused by a number of factors including: * the transfer of interest rate risk to the private markets via issuance of government securities of long maturity and duration; * the structure of the tax system which harmed liquidity, and contributed to rapid growth in the use of funds; * structural factors in the debt market (e.g., public sector domination within the investor base) that limited liquidity and increased interest rate volatility; * extensive fragmentation and segmentation in areas such as: the money markets, due to, e.g., differences in regulatory treatment of REPO contracts; in information transparency, lack of proper aggregation of information within and between trading platforms and in consolidation of information collected by different supervisory agencies. These problems hindered effective supervision, hurt the integrity of asset prices used in valuation, and harmed liquidity; * an inadequate valuation and accounting framework that allowed losses to be hidden, and compromised the value of disclosures as a self-disciplining device; 12 In the Colombian market two types of repo's co-exist: a "repo" (which is a loan against collateral, with the collateral blocked at the level of the CSD) and a "simultanea" (which is a sale / buy back arrangement). When discussing repo markets in this document both instruments are covered unless explicitly stated.  - 36 - o lack of an adequate risk management culture - in particular the capacity to measure and control market risks - by certain banking and non-banking entities; and o gaps in regulations and supervision that hindered proper coordination, and slowed responses to the problems. The Government Reform Plrogram - The Government ]Debt and Money Markets 135. A credible reform package to address the vulnerabilities noted, involves three carefully sequenced areas for action: (i) debt market development, (ii) the money market, and (iii) a package of actions to improve risk measurement and management by various market participants. In the case of the first loan under the programmatic operation, emphasis will be on improving valuation and capital regulation while the second loan will focus on fundamental short to medium term actions aimed at addressing the vulnerabilities of the debt market and its participants. The First Loan under the Programmaic Operation 136. Under the first loan of the programmatic operation, core actions will be taken in the following areas: o measures aimed at increasing liquidity of Treasury securities; o upgrading capital regulations for non-banks; and o strengthening the valuation framework. 137. Liquidity of Tes B (Treasury) securities: The Tes B market has in general suffered from a lack of liquidity during periods of high volatility. While primary dealers have been required to "make the market", the obligations have been relatively light and not enforced. The Ministry of Finance has devised and issued a new set of Primary Dealer regulations which have strengthened obligations and the enforcement mechanisms (Resoluci6n No. 001, 2003). Additionally, the Central Bank has changed its investment policy to allow it to purchase outright Tes B securities open for issue (so called on-the-run issues). This move is also expected to increase the liquidity and the associated liquidity premia for the on-the-run Tes Bs. 138. Capital regulations for non-banks: The authorities (in particular the Securities Superintendency or SV) are rapidly moving to strengthen the capital regulations and requirements for independent broker-dealers ("comisionistas") to limit the amount of leverage allowed by these entities, and to create incentives for better risk measurement and management. An important part of this effort is to harmonize capital regulation where possible, between entities regulated by the Banking Superintendency (SB) and the SV. However, such changes to capital regulations cannot prudently be introduced without consultations with the financial sector and with affected independent brokers in particular. The SV therefore, will issue a new set of capital regulations for broker/dealers with the aim of implementing the new capital regulatory framework after a brief consultation period. The authorities are also preparing an explicit transition plan for the phasing in of this new capital standard, which must be completed by December 2003. 139. Valuation framework: The lack of a solid valuation framework was identified as one of the most important factors adding to the vulnerability of the local debt markets, and the authorities have already progressed in this important area. The valuation methodology has been defined, and guidelines have been promulgated for valuation of all TES B instruments. Such securities by  - 37 - far account for a dominant share of all outstanding securities in the financial system. The guidelines have been successfully implemented, and the integrity of the prices and methodology utilized, is monitored by the authorities in a collaborative process designed to ensure rapid consultation with regard to any anomalies in asset prices. The authorities are also establishing a high level valuation committee for this purpose. The committee will undertake such tasks as: periodically validate or review the methodologies used to determine prices, establish margins and reference rates; propose new methodologies that improve the accuracy of the valuation methodology; and recommend means by which the public and investors should be informed about the valuation methodology. The Second Operation under the Program - The Government Debt and Money Markets 140. The Second Phase. Under the second operation, a number of reforms, described below, are anticipated. These include: (a) establishment of valuation guidelines for all securities, (b) setting out an issuance strategy as vetted by an established high level debt management committee, (c) implementing a new collateral system for central bank operations and taking measures to strengthen the efficiency of the repo market, (d) regulations to clarify the accounting treatment of forced investments in public securities taken by public agencies, and (e) establishing risk management VAR guidelines for institutional investors managing securities and fixed income funds. While the main thrust of the program is further described below, the final policy agreements and specifics of implementation will be defined during the formal preparation of the second phase. Under the second loan of the programmatic operation, core actions will be taken in the following areas: * debt market development with special emphasis in the near term, on the definition of an operational debt issuance strategy; * strengthening of the money market with special emphasis on the development of local repurchase agreements and treasury bill markets; and * a package of actions to improve risk measurement and management by various market participants. 141. An essential building block to support risk measurement and management, is development of the money market. Instruments such as T-bills or CDs are the natural instruments to be held in the portfolios of money market mutual funds. The lack of money market development has been due in part, to the debt issuance strategy that has not focused adequately on development of the short term T-Bill market. In the near term, immediate priority will also be given to the development of the repurchase markets. In the medium term a new approach to the short-term T-bill market is warranted. There will be consideration to establish a revolving T-bill program of significant size in maturities on the short end of the yield curve. The next steps in promulgating an overall valuation methodology will include design of a valuation methodology for a broader cohort of securities. The authorities plan next to introduce valuation methods to be applied to other forms of public debt. There is also a need to introduce a package of measures relating to the capital regime, risk management guidelines and reporting practices while continuing to strengthen and broaden the valuation framework. The SV started with the issuance of new capital regulations for independent broker dealers that corrects problems with the definition of capital and also imposes risk related capital requirements. This coupled with other changes in the regulatory framework, will also lead to improvements in the solvency of primary dealers and management of funds.  - 38 - PART 1111l. THE PROIPOSElID LOAN: A PIROGRAMMATHIC APPROACH A. Loan Descrniption Objective and Raftionle for 1Bank lInvolvemnent 142. Loan Objective. The objective of the loan is to complete the clean up of the banking system as a result of the 1999-2001 crisis and to strengthen the government's capacity to manage and mitigate weaknesses in the financial system. At the same time the objective is to prevent crisis contagion effects from neighboring countries or other exogenous events, by utilizing strong regulatory incentives for prudential management, market risk-sharing mechanisms and optimal supervisory powers to expeditiously contain any emerging risks in the financial system. The project also aims to strengthen and diversify the participation of the housing mortgage market as well as of non bank financial services and securities institutions in the financial system in order to implant a framework which provides more liquidity in the markets and diversifies the sources of finance for investors and actors in the real economy. At an institutional level, the objective will be to strengthen the capabilities and financial/supervisory institutions while strengthening the legislation to incorporate areas of corporate accountability, governance and risk management as key elements in the regulatory strategy. 143. A key aspect of the proposed program is the design of a two pronged effort to first dispose of the financial system's remaining loan assets (or collateral) remaining from the interventions during the earlier crisis by developing more agile and modern financial instruments and fiduciary arrangements to package assets according to credit rankings while making collateral liquidation procedures much more agile and effective. As part of this effort, the remaining intervened banks are expected to be divested and the largest second tier problem bank will be wound down. A second aspect is the development of a liquid securities market by, inter alia, modifying the framework for the mortgage sector to permit more standardization and allow securitization of loans as well as to reform the entire securities legislation to promote a more agile development of the local capital market while streamlining and adjusting the benchmarks and exposure risks of the government debt market as a key pillar to support the private fixed income securities market. 144. At the same time, the operation addresses the micro credit sector and promotes further credit access by pernitting financial institutions to provide credit or leases to small financial entities so they can better fund their financial services to the micro sector. Finally, given the unique environment in Colombia, the above reforms are supported by specialized measures to detect money laundering activity associated with the drug trade or terrorist activity. 145. IP2ro gram Amount and Sequencing. The program will consist of two operations, each of one loan. The first loan will be in the amount of US$150 million and the second one for US$150 million. All prior actions for the first operation have been undertaken at this time. Disbursement of the first loan will take place immediately following approval and compliance with standard effectiveness conditions of the Bank. Approval and disbursement of the second loan is expected to take place approximately a year hence, following completion of tangible implementation indicators and enforcement actions associated with the first loan as well as with conditions including approval of the pertinent legislative frameworks required under the second operation.  - 39 - Rationale for Bank Involvement and Strategy 146. Relation to Country Assistance Strategy. The operation constitutes a main pillar in the Bank's Country Assistance Strategy (CAS) as delineated in the CAS document discussed on January 16, 2003 (Report No. 25129-CO dated December 24, 2002). The assistance strategy which relies on the government completing a number of structural changes supporting its economic growth, poverty reduction, and fiscal strategy, includes consolidating and extending the reforms of the financial sector to set the base for funding private sector led growth with sufficient regulatory and market incentives while assuring the solvency and proper governance framework of financial institutions. 147. Since current economic conditions preclude strong incentives for private bank lending, and thus financial access is very restricted, the financial sector strategy as envisioned in the CAS as part of the macroeconomic growth package of policies, includes strengthening the capital base of the banking system by removing unproductive financial assets through mergers, acquisitions, asset transfers and/or liquidations while aiming to modernize the funding instruments and institutions in the country's financial market so as to improve the liquidity of the savings base through the regulation and standardization of financial contracts under a diversified set of instruments (bank lending, micro lending, housing finance, securitization, fixed income and equities, insurance and trust services, and streamlining the government debt market). Since one of the main pillars of the CAS is to increase the role of the private sector in promoting growth, the development of the private financial industry while reducing the role of the State in the financial sector, constitutes a key part of the policy and institutional package with which to engender economic reactivation and facilitate the financing of new investment in Colombia. 148. Timing and Level of Financial Support. From a balance of payments and budgetary perspective, Colombia clearly requires external financing to meet its obligations given the net expected outflows of private lending during 2003 and 2004 ($1.1 billion and $1.7 billion respectively). At this juncture, Colombia's access to financing from the international private capital markets is quickly declining, and due to the fiscal situation, there are few reassignable funds to fill any gaps and meet debt servicing obligations. In 2003 total debt service as a share of exports of goods and services, is estimated at 49% versus 42% for 2002, and debt outstanding as a percentage of GDP was estimated at 55% in 2002 and projected at 56% for 2003 with the latter increase expected to be temporary, to be reversed. In addition, the 1999 banking crisis which required intervention by the State, generated direct fiscal costs amounting at the time to about 4% of GDP, as well as contingent liabilities which continue to be outstanding (approximately US$ 2 billion) due to intervened financial institutions which are still being resolved. The proposed program aims as well to implement modernized banking resolution tools which generate market sharing risk mechanisms such as sale and transfer of asset portfolios to the private sector, with the objective of reducing and eventually extinguishing those outstanding government liabilities. 149. Under the program period, GDP growth is projected to be 2.5% in 2003 and between 3.0% to 3.5% in 2004. The same time, the government's budget deficit is estimated between 2.5% - 3.0% of GDP in 2003 and is projected at between 2.0% - 2.5% of GDP for 2004. However, an eventual war in Iraq and/or a further escalation of violence in Colombia might make these projections on the high side. The budget balance would thus aim to remain at -2.5% or below from 2004 onwards under the IMF program, from an estimated -4.0% in 2002 and a target of under 3.0% in 2003. Monetary policy is expected to be modestly tight in order to maintain  -40 - inflation low between 4% and 8%, and to avoid any sharp changes in currency value which will remain on a very gradual depreciating path. The proposed loan would, through the more efficient mechanisms and legal provisions for the disposal, sale and/or liquidation of intervened bank assets and liabilities, aim to stem any further fiscal losses or potential liabilities of the State due to unresolved financial institutions, thus protecting social expenditures which target the poor and eventually attracting additional external financing and investment. 150. Medium Term Objec