Colombia - Programmatic Financial Sector Adjustment Loan Project

PROJECT INFORMATION DOCUMENT I 6o0570 Country Name: Republic of Colombia Project Name: Programmatic Financial Sector Adjustment Loan Region: Latin America and the Caribbean Sector: Financial Sector Project ID: P078869 Borrower: Ministry of Finance, Colombia Executing Agency: Ministry of Finance Contact: Mr. Juan Ricardo Ortega Vice Ministro Tecnico Ministerio de Hacienda y Credito Publico Carrera 7a, 6-45, Piso 3 Bogota, Colombia Phone: 57-1-350-1238 Date this PID Prepared: March 21, 2003 Project Board Date: April 24, 2003 1. Country and Sector Background. 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. 2. 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.  - 2 - 3. 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 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. 4. Program Context. 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. 5. 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. 6. 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. 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. 7. Project Objectives. 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,  - 3 - market risk-sharing mechanisms and optimal supervisory powers to expeditiously contain any emerging risks in the financial system. 8. 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 implement 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. 9. A second medium term objective 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. At the same time, the operation addresses the micro credit sector and promotes further credit access to small financial entities and individuals. 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. 10. Project Components. 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 modem 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. 11. 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. 12. 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.  - 4 - 13. Benefits. 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. 14. 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. 15. Institutional and Implementation Arrangements. The project's policy reforms will be implemented through the Ministry of Finance and the other supporting agencies listed below in order to cover the banking, housing finance, insurance, securities and debt market sectors. Disbursement arrangements will follow the simplified procedures for SALs/SECALs. For the purposes of the Programmatic FSAL's disbursements and audits, the Government will open a specific deposit account, prior to furnishing the Bank with the first request for withdrawal from the loan account, and thereafter maintain in the Central Bank a dollar denominated account on terms and conditions satisfactory to the Bank. 16. The Bank will monitor and assess ex-post (through supervision missions with the government's concurrence) the use of the deposit account based on the Comptroller General's Audit Report, if this shall have been carried out. The Government undertakes that the proceeds of the loan will be used to finance only eligible expenditures based on an existing negative list for the loan. The Bank will thus reserve the right to request an audit of the deposit account conducted in accordance with appropriate auditing principles consistently applied, by independent auditors acceptable to the Bank 17. Executing Agencies. The principal executing agency is the Ministry of Finance. Other supporting agencies are the Superintendency of Banks, the Deposit Insurance Agency (FOGAFIN), the Superintendency of Securities and the Office of Public Debt. 18. Project Sustainability. 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. In addition, a risk would involve the potential for the internal conflict to deteriorate, causing additional fiscal stress  - 5 - and slowing down or braking progress on the financial sector reform. Overall, reforms however, are expected to be implemented and sustained given their grounding in legislative changes and specific institutional mandates. Rigorous and full implementation will require monitoring, however, to ensure adequate enforcement. 19. Poverty Category and Environmental Aspects. The program contains important elements of social protection for certain segments of the population. To begin with, the financial system law's reforms which affect the protection of depositors are aimed at providing full coverage of deposit losses for the smallest depositors in the event of bank failures. While the lowest income segments of the population may not always own bank deposits, other features in the law (see further below) would aim to increase the bankability of previously underserved segments of the population. With respect to deposit insurance reforms, previously all depositors needed to pay a coinsurance or deductible portion of their deposits when receiving compensation for funds lost through bank failures. The government, recognizing that the smallest depositors have little ability to monitor or correct bank risk taking, has authorized through the law, full coverage and reimbursement to those small depositors whose deposits fall within the specified insurance limit provided by the State. Thus, for the smallest depositors, they may receive full protection and compensation by the State. 20. Another social intervention via the financial system, is the new financial system law's allowance for commercial banks to fund credit lines for finance companies for the purpose of extending micro finance to the housing sector. The new law also permits banks to engage in micro housing credit operations. In addition, given the difficulty to finance housing without owning real or other collateral, the new law introduces the concept of housing leases to be offered by banks, and which would provide housing options to lower income families without the need for a down payment. The leases would have an option to purchase once the holder could accumulate funds to convert the contract into a mortgage. These policies are specifically aimed at providing increased access to credit to the underserved or non-bankable sectors of the population. In addition, reforms aimed at increasing the efficiency of banking operations , mitigating future risks of bank failure, and developing alternative financing sources in the capital markets, would indirectly benefit the poor avoiding the sudden withdrawal of weak financial institutions from given sectors or regions which inevitably leads to steep drops in community and business investments. Similarly, the enhancement of anti money laundering systems would help reduce contamination of the banking system with illicit funds which become volatile and do not serve as a reliable savings base for investment in community development, particularly in rural areas. 21. The project has no direct impact on the environment. For the purposes of Operational Directive 4.01, it has an environmental category of C, which does not require an environmental assessment. In terms of environmental considerations, there exists a process of collateral valuation used by the government and the private industry to value loan portfolios of banks in the process of being dissolved or sold in whole or in part to other institutions. Such valuation also applies to the sale of assets under foreclosure procedures, and takes into account as part of the prudential review of asset quality, existing environmental liabilities (e.g.: real property in flood zones, industrial property  - 6 - requiring environmental clean up) as part of the market valuation process for determining net value of such properties. While the process is based on market discounting to account for such liabilities, the Bank has communicated to the government the benefits of developing means for systematizing the environmental review process under such transactions to allow for identification of environmental issues as well as to ensure precision in the valuation of assets based on both real and financial factors. 22. Program Objective Category. Economic Management. 23. Contact Point: World Bank: John Pollner, Task Manager/Lead Financial Sector Specialist Finance Sector, Latin America and the Caribbean Region Phone: 202-473-0079 Fax: 202-522-2106