Colombia - The Colombian investment banking system and related financial sector issues

"rLEi COPY4 Report No. 4274-CO Colombia The Colombian Investment Banking System and Related Financial Sector Issues August 1, 1983 Projects Department Latin America and the Caribbean Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS 1/ Currency Unit = Colombian Peso (Col$) US$1.0 = Col$70.11 Col$1.0 = US$.0143 Col$1.0 million = US$14,164 LIST OF ABBREVIATIONS BR Banco de la Republica (The Central Bank) Caja Caja de Credito Agrario, Industrial y Minero (The Official Agrarian Bank) CAT Certificado de Abono Tributario (Tax Rebate Certificate For Non-traditional Reports) CAUFs Companias de Autofinanciamiento ('Auto-financing' Companies) CAVIs Companias de Ahorro y Vivienda (Savings and Loan Associations) CDTs Certificados de Deposito al Termino (Certificates of Deposit) CFs Corporaciones Financieras (Investment Banks) CFCs Companias de Financiamiento Comercial (Trade Finance Companies) FFI Fondo Financiero Industrial (Industrial Financing Fund) FIP Fondo de Inversiones Privadas (Private Investment Fund) WFI Instituto de Fomento Industrial (Official Industrial Development Bank) INCOMEX Instituto Colombiano de Comercio Exterior (Colombian Foreign Trade Institute) PROEXPO Fondo de Promocion de Exportaciones (Export Promotion Fund) 'Superintendencia Bancaria' (Superintendency of Banks) 'Superintendencia de Sociedades' (Superintendency of Companies) I/ December 31. 1982  FOR OFFICIAL USF ONLY COLOMBIA THE COLOMBIAN INVESTMENT BANKING SYSTEM AND RELATED FINANCIAL SECTOR ISSUES TABLE OF CONTENTS Page No. PREFACE AND ACKNOWLEDGEMENTS SUMMARY AND RECOMMENDATIONS ........................... i-x I. PAST TRENDS AND POLICIES IN THE COLOMBIAN FINANCIAL SECTOR .................. 1 Institutional Structure ........................1 Developments Through the 1960s .1 The Creation of the UPAC System (1972)............ 2 The Financial and Tax Reforms of 1974/75. .. 3 Creation of New Financial Intermediaries For Trade and Consumer Financing. 4 CFs and CDTs ........................................... 4 Equity Investments by CFs .............................. 5 The 1977-79 Stabilization Measures. 5 Recent Developments .......... .......................... 6 The Formation of Financial and Industrial Groups 7 Conclusion .......... .. . 7 II. ISSUES FACING THE CORPORACIONS FINANCIERAS. 8 Nature of the Main Issues. 8 The Share of Medium and Long Term Credits in the CFs' Portfolios .10 Dynamism of Growth of CFs .12 Equity Investments by the CFs .14 The Overall Profitability of CFs' Operations .......... 18 III. INTEREST RATE AND OTHER FINANCIAL SECTOR POLICIES 21 Background .21 Deposit Interest Rates ................................ 22 Interest Rate Spreads and Lending Rates .22 The Level of Credit Subsidies .25 General Financial Sector Liberalization .26 This report is based on the findings of a World Bank mission comprising Messrs. K. Challa (mission chief), M. Hinds (both of LCP), J. Silva Lopes, F. Veneroso and J. Villarzu (consultants). The mission visited Colombia during July/August 1982. IFC (CCMD) collaborated by supporting part of the consultant assistance. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TABLE OF CONTENTS (Continued) Page No. IV. INSTITUTIONAL ASPECTS OF THE FINANCIAL SYSTEM ... ...... 29 Recent Developments ................................... 29 Evolution of Financial/Industrial Groups and Concentration of Financial Sector Assets ............. 29 Multi-banking vs. Specialized Banking ............... 31 Recommendations for Institutional Restructuring ...... 33 Specific Institutional Proposals for CFs .............. 35 V. RESOURCES FOR MEDIUM AND LONG TERM LENDING BY THE CORPORACIONES FINANCIERAS ............................ 38 A. Introduction ........ ............................. 38 B. Creating Conditions for Term Transformation and Deposit Resources ........ .................. 38 a. Floating Interest Rate Loans as a Solution to Avoid Interest Rate Risks .... ........... 38 b. The Liquidity Problem in Terms Transformation. 40 c. Summary of the Features of the Proposed Term Transformation Mechanism .... ............... 41 d. Capitalization of Interest Payments .... ...... 42 e. Tax Treatment of Floating Interest Rate Loans. 43 f. Transparency of Effective Lending Rates ...... 44 g. Advantages of the Proposed Modifications ..... 44 C. Improving Conditions for Issue of Longer Term Savings Instruments ............................ 45 D. Access to Official Financing Funds .... ........... 4i7 E. Role of the Instituto de Fomento Industrial (IFI). 49 F. Increasing Foreign Currency Resources for Productive Sector Financing ..... ............... 49 VI. RISK CAPITAL INVESTMENTS ............................. 51 Increasing Use of Hybrid Instruments ................. 51 Fiscal Measures to Improve Incentives for Risk Capital Investments ................................ 52 Stock Market Development ............................. 53  TABLE OF CONTENTS (Continued) Page No. STATISTICAL APPENDIX Table I: Effective Interest Rates - Principal Financial Assets ....................................... 57 Table II: Colombia: Central Government Cash Deficit Adjusted For Cuenta Especial de Cambio (C.E.C.) and its Effect on The Money Base .... ......... 58 Table III: Estimated Outstanding Credit to Manufacturing by Source Percentual Composition .... ............ 59 Table IV: Percentual Composition of Deposits in Colombia - 1970-81 ....... ................. 60 Table V: Colombia: Nominal and Real Interest Rates on 3-Month Certificates of Deposit (CDs) .... ..... 61 Table VI: Legal Reserve Requirements and Forced Investments Imposed on the Colombian Financial System ..... 62 ANNEXES 1. Colombia: Alternative Long-Term Interest Rate Regimes ...... 63 2. Illustrative Example of a System of Floating Interest Rate Medium and Long Term Loans with Partial Capitalization of Interest ............................... 73 3. Hybrid Risk Capital Investments ............................ 80   PREFACE AND ACKNOWLEDGEMENTS This report is based on the findings of a World Bank financial sector mission which visited Colombia in July 1982 at the Government's invitation. The single most important focus of the study was to review the performance of the Corporaciones Financieras (investment banks) system and suggest ways to improve it in the future. It was recognized, however, that broadei institutional, capital markets and financial sector policy questions directly or indirectly related to the above would also have to be addressed as part of the mission's work. In view of the nature of the problems addressed and the inter-relationships among different issues, several relatively detailed recommendations concerning the implementation of the required changes are included in the report, in addition to the recommendations on sector policy directions. In many instances, qualitative analysis and judgments regarding the relative weights to be placed on different factors played a complementary role to quantitative analysis in arriving at the recommendations. Many officials of the Colombian Government, Banco de la Republica, Superintendencia Bancaria, Comission Nacional de Valores and other public agencies, representatives of the Colombian banking and industrial sectors including in particular the Asociacion Bancaria, Asociacion Nacional de Instituciones Financieras, Asociacion Nacional de Industriales, as well as the IFC and IMF, have provided valuable help and advice during the course of this work, particularly in arriving at judgments regarding the balance of factors. The report is organized as follows. Chapter I traces the evolution of the institutional structure of the Colombian financial system and financial sector policies over the last two decades. The specific issues that face the Corporaciones Financieras today, which follow to a large extent from the above evolution, are identified and analyzed in Chapter II. Chapter III examines in more detail the impact of interest rate and other financial sector policies and recommends directions for future policy evolution. The last three chapters analyze and provide recommendations in three specific areas concerning the future development of the Corporaciones Financieras, namely, the institutional structure of the financial system (Chapter IV), resources for medium and long-term lending (Chapter V) and risk capital investments (Chapter VI). Several actions relevant to the issues discussed in this report which were taken subsequent to the visit of the financial sector mission which have not been incorporated herein. These are summarized here briefly with the relevant paragraphs in the main report indicated in parentheses:  - ii - (a) Through Junta Monetaria Resolutions 1 and 27 of Jauary 1983 and March 1983 respectively, marginal reserve requirements on demand and sight deposits (with maturities of up to 30 days), which had been in effect since 1977, were removed unconditionally. This de-links the liberation of such reserve requirements from the use of Official Financing Fund resources (paras. 4.13 and 5.22 of the report). (b) Through Junta Monetaria Resolution 10 of February, 1983, the effective spreads to the participating intermediaries under operations of the Official Financing Funds were improved slightly to provide somewhat better incentives for the intermediaries to participate in them (para. 5.22). (c) Through Junta Monetaria actions, including Resolution 72 of December 1982, the conditions for the use of the last resort facility ('cupo extraordinario') by the Corporaciones Financieras (CFs) were improved and supplemented by a new facility to provide for a more adequate protection in case of liquidity problems (e.g., as a result of term transformation) and to make treatment of CFs more comparable to that of commercial banks (para. 5410). (d) Through Junta Monetaria Resolutions 16, 41, 56, 72 and 75 of 1983 (all issued between February and July 1983), a sepcial 'Enterprise Capitalization Fund' has been established in Banco de la Republica (BR) to facilitate the purchase of minority-shareholdings by Colombian investors, particularly in widely-held Colombian companies (although closely-held Colombian companies and foreign or mixed ownership companies are also eligible for support within certain limits). The Capitalization Fund would stimulate such purchases of shares by making available loans via CFs to investors to finance the purchases and/or by providing financing to CFs to support their 'under-writing' operations (para. 6.09). (e) Legislation to exempt or alleviate the effect of double-taxation of dividends and increase incentives for capitalization in widely-held companies (Law 9 of 1983) was proposed by the Government and approved by the Congress in the second quarter of 1983 (paras. 607 to 6.09). (f) Authorization for the creation or operation of the Companias de Auto Financiamiento (CAUFs) has been withdrawn, except for a limited transient period over which the operations of existing CAUFs would have to be phased out (para. 4.10). (g) Through Decree 1914 of July 1983, the Government also clarified the regulations governing the public issue of bonds by Colombian companies and strengthened the oversight and regulatory functions of the National Securities Commission in this respect (para. 5.19). (h) The high level National Commission for Financial System Reform submitted to the President of the Republic its summary report and main conclusions. The commission's report endorses measures to:  - iii - (i) regulate more closely the activities of 'financial groups' and interlocking ownership of financial institutions; (ii) define more clearly and enforce strictly the rights, responsibilities and obligations of the different categories of financial institutions; (iii) reinforce the specialization of functions among the different categories of financial institutions through appropriate institutional regulations; (iv) enforce stricter controls over portfolio concentration, minimum capitalization and lending to other financial institutions; (v) regulate more closely the activities of the majority shareholders and directors of financial institutions; and (vi) strengthen faculties of the Superintendency of Banks and improve coordination of its control activities with those of the National Securities Commission and other concerned agencies (paras. 4.10 to 4.14). (j) A special Sub-Commission chaired by the Vice-Minister of Finance with participation of senior representatives of BR, Junta Monetaria and Superintendency of Banks has been created to study further the special issues related to the operations of CFs and needed reforms.   SUMMARY AND RECOMMENDATIONS Background i. The Colombian financial sector enjoyed a prolonged period of stability and was characterized by a relatively simple institutional system comprising mainly commercial banks and investment banks (Corporaciones Financieras -- CFs) until the late 1960s. A series of developments in the subsequent period led to numerous changes in the institutional structure of the system as well as financial instruments. Most importanit among these are: (a) periodic movements towards financial sector liberalization as a means to increase the volume of resources intermediated by the institutionalized (formal) system; (b) development of a flourishing extra-bank (informal) market as a response to strong financial sector repression which prevailed over a major part of the decade and prevented the institutionalized financial system from meeting fully the demand for intermediation; some of the informal market was later regulated under the name of Companias de Financiamiento Comercial (CFCs); (c) the creation of new categories of financial intermediaries (Corporaciones de Ahorro y Vivienda (CAVIS) and CFCs) and of new instrur ts such as Certificates of Deposits (CDTs) and indexed instruments (1UPAC) to mobilize resources to fill specific evolving needs in the economy; (d) domestic and international economic developments, including the coffee and illegal exports boom during 1975-80 and the subsequent worldwide recession; and (e) perceived conflicts between stabilization and financial sector liberalization policies in the face of high inflation rates during the 1970s and early 1980s. ii. The complexity of these developments has put strains on the traditional framework of financial institutions. By the end of the 1970s, several inconsistencies were visible in the institutional framework and in the body of financial regulations. The liberalizing measures introduced over parts of the last decade have not succeeded in reducing the fragmentation of the financial markets, but instead, have tended to increase it. They led to a complex system in which the institutionalized free market coexists with a compartamentalized system of subsidized credit and a large and growing informal market. The structure of market incentives in recent years made it more profitable even for intermediaries traditionally oriented towards term financing to move increasingly towards short term operations. A de facto multibanking system has resulted from the formation of groups of entities working in the different specialized markets and linked by common ownership, and linkages between financial and non-financial groups have become widespread, in the absence of adequate regulation of such groups. iii. The sources of the above can be traced in part to the conflicting, or at least competing, objectives which the Government tried to pursue with its financial policies. Among the competing objectives were: (a) to supply subsidized credit to priority sectors; (b) to increase the intermediation of resources through the institutional financial system; and (c) to use regulation of the financial sector as an instrument to control inflation. The relative weight given to these aims differed at various periods during the seventies.  Interest Rate Policies and Prospects for Financial Sector Liberalization iv. Observed real lending interest rates have been high over the last 1-2 years in Colombia due to: (a) the high real international interest rates; (b) varying expectations of savers regarding future exchange rate of the peso; (c) the growing cash deficits and/or credit needs of the Govern- ment, the high marginal reserve requirements used in part to finance them and neutralize their inflationary impact; (d) the use of forced investments to finance subsidized credits; and (e) the imperfect competition in financial sector arising from the existing oligopolistic market structure and the protection afforded by the regulatory framework through restricted access to external credit and absence of free entry for new financial intermediaries. v. The high real interest rates coexist with relatively large credit subsidies. The latter have several undesirable effects on resource alloca- tion. They tend to discriminate against labor intensive techniques, discourage efficient use of capital and create incentives for industrial firms to become exceesively leveraged. Moreover, based on field interviews with industries and financial institutions, there is reason to believe that the subsidies are contributing to a worsening of ownership concentration in the Colombian industrial sector, because the larger industrial groups in Colombia tend to have close linkages with the major financial institutions and are typically able to obtain privileged access to the subsidized credits. Finally, under the current system of fixed interest rates for subsidized credits, the amount of subsidy automatically increases whenever the market nominal interest rates increase, as may result from rising infla- tion rates. The forced investment requirements in effect operate as a wedge between free market and subsidized rates, causing increasing segmentation between the two segments as inflation rates rise. vi. In general, the continued process of financial sector liberalization appears to offer the best prospect of helping to solve the problems identified. A relatively free financial system would be a prerequisite for financial intermediaries (including the CFs) to be able to perform the desired role in promoting industrial investment and development. Any attempts to bring the current interest rates down by administrative means, without addressing the underlying causes, are likely to be frustrated by large and destabilizing shifts of funds from the controlled segments to less restricted segments of the sector offering better yields, from formal to informal markets, and from domestic financial instruments to domestic real (tangible) assets or foreign (real or financial) assets. The liberalization strategy would, however, have to be chosen cautiously and should reflect a gradual approach. Among the early measures should be a significant but gradual reduction in the credit subsidies and forced investments, and steps to promote freer entry of institutions and more effective competition in the formal financial system. At a later stage, a gradual reduction of the legal reserves requirements and/or interest rate ceilings on current and savings accounts, could also be considered to help increase price competition and resource mobilization in the financial system. However, the beneficial  - iii - effects of such liberalization would be achieved only if the Government succeeds in bringing its budget deficits and inflationary pressures under control. The Corporaciones Financieras (CFs) System vii. The system of CFs was created in Colombia as the investment banking component within a specialized banking model, to provide term credit and risk capital to the productive sector and to help in the process of Colombian capital markets development. While these objectives have been partially realized, several concerns have emerged in recent years regarding the performance of the CFs system. Among the important concerns are: (a) the tendency of the private CFs to operate increasingly in the short term market; (b) relatively less dynamic resource mobilization by the CFs in comparison with other types of Cinancial institutions; and (c) the observed limited impact of the CFs in stimulating risk capital investments in the productive sector. These concerns have led to a dilution of the identity of the CFs as genuine investment banks. viii. The lack of a proper identity for CFs is reflected by the fact that there are in Colombia at least three types of CFs with diverse objectives. These are: (a) private CFs which have attempted to fulfill their original objectives of providing term financing and risk capital to productive enterprises; (b) private CFs which were established mainly to take advantage of certain regulatory and other benefits and which focus almost entirely on short term operations; and (c) special purpose official CFs created by the Government to fulfill specific sectoral functions. ix. The causes for the above situation can be traced to the macro-economic climate, the regulatory and incentives framework, official intervention, the evolving structure of the financial/industrial groups and the early stage of development of the Colombian capital markets. These have contributed to the relatively low profitability and high risk of medium- and long-term financing (including equity investments) in comparison with shorter term lending operations and have weakened the competitive position of the CFs vis-a-vis other types of financial institutions. x. Specific factors that currently impair the working of the CFs system as originally conceived include: - the strong liquidity preference among domestic savers, stemming from the uncertainties regarding future inflation rates, frequent changes in the relative yields of savings instruments and the lack of suitable longer term savings instruments; - the lack of adequate mechanisms to facilitate using short term deposit resources for medium- and long-term lending, particularly in the presence, in effect, of an "inverted" yield curve caused by availablity of highly subsidized medium- and long-term loans through the official system;  - iv - - competitive disadvantages faced by the CFs vis-a-vis other types of financial institutions with respect to the type of deposit accounts permitted, size of branch network, etc.; - a relatively high degree of concentration of financial power characterized over the last decade by the emergence of "de facto" financial/industrial groups, some of which control directly or indirectly institutions covering the whole spectrum of financial activities as well as a wide range of industrial firms; - the absence of a comprehensive regulatory framework to control activities of 'groups' to define clearly the mutual responsibilities and obligations of the constituents (and owners) of a group and to protect the interests of minority shareholders; and a tax system that favors heavy debt financing by industrial firms in preference to adequate capitalization and acts against a satisfactory development of the stock market and wide distribution of share ownership. xi. To address the above problems and issues, a series of actions is recommended to improve the CFs system, investment financing mechanisms and the related policy framework. Some of these actions can be taken immediately, but some will require further study and elaboration before they can be implemented. IMMEDIATE MEASURES A. Interest Rate Policies xii. Any new administrative controls of interest rates should be avoided. Likewise regulatory policies and official interventions which lead to frequent variations in the relative yields of alternative savings instruments should be resisted. Avoiding arbitrary changes in the yields of savings instruments would help reduce the uncertainties facing the savers, the consequent large liquidity preference among them, and potentially large destabilizing flows of resources among instruments and among institutions (para. 3.15 of the main report). xiii. The existing forced investment requirements applicable to resources of financial institutions should be reduced gradually but substantially in order to reduce the segmentation between the free and subsidized credit markets (paras. 3.14 and 3.16). B. Facilitating Floating Interest Rates and a Term Transformation Mechanism. xiv. A floating interest rate scheme which links the CFs' lending rates to an index representing the average cost of raising deposit resources should  - v - be introduced to facilitate term lending to the productive sectors. The floating rate feature would allow the use of the short term deposit resources by the CFs to make medium- and long-term loans. The satisfactory working of such a system would critically depend on a stable and liberal interest rate policy applicable to CDTs and competing market instruments (paras. 5.03 to 5.11). xv. The term transformation scheme should preferably also provide the option to borrowing enterprises to capitalize automatically part of the interest payments due on the loans. This would help alleviate the cash flow problems of borrowing enterprises in the initial years of investment under conditions of high nominal interest rates (paras. 5.12 to 5.14). xvi. Several specific actions should be taken to facilitate the implementation of the term transformation scheme along the above lines: (a) BR should calculate and publish periodically (say once a month) a suitable index of the average cost of new CDT (Certificates of Deposit) resources e.g., the average effective interest rate on 3-6 month CDTs issued by Colombian financial institutions over the most >ecent period; the index would be based on information gathered by BR on the borrowing costs of financial institutions, with suitable cross-checks to ensure its accuracy and reliability; the availability of similar supplementary indices should be facilitated through requirement of publication by banks and CFs of their effective CDT (and lending) interest rates (para. 5.07). (b) Reasonable access, subject to appropriate restrictions, should be allowed for the CFs to BR's 'cupo extraordinario' and/or other supplemental schemes (e.g., those involving a short term sell and buy-back of term loans) to help address liquidity problems that might arise from term transformation in case of a demonstrated drop in CDT deposit resources (para. 5.09). (c) In order to correct the artificially low ceiling on final interest rates applicable to arrearages, which also acts as a de facto ceiling on the lending rates themselves, the 'tasa de interes en operaciones crediticias ordinarias', which is to be determined by the Superintendencia Bancaria under the 'Codigo de Comercio' for fixing maximum interest rates on loan arrearages, should be revised at least once a year, and more frequently if conditions so demand, to set it equal to a representative market rate, say, the average CDT interest rate in the month immediately preceding such revision (para. 5.05). (d) Information on the lending rates of financial institutions, which is required to be published periodically under a current Junta Monetaria Resolution (and is published through the Asociacion Bancaria under current practice), should be required to state clearly the effective lending interest rates which take account of all loan charges, advance payments and commissions, in order to allow greater transparency in lending rates and help improve competition in the financial markets (para. 5.17).  - vi - C. Access to Official Financing Funds and Levels of Subsidies xvii. (a) BR's rediscounting funds ('Official Financing Funds') should also replace their current fixed interest rates system by a floating rate system along the lines described in item B (using the same base index). This would imply that any interest rate subsidies provided under the credits would stay essentially at a constant level over the period of the loan. The floating rate system would avoid arbitrary increases in the margin of subsidization when inflation and nominal interest rates rise. The level of subsidies should be substantially lowered from their current levels, using a gradual approach to allow the necessary time for adjustment (para. 5.22). (b) The proportion of the loans refinanced by the Official Financial Funds should be reduced significantly over time and the financial intermediary required to contribute a larger share from deposit resources mobilized from savers in financing term loans. The spreads to the intermediaries should be modified in order to allow them to cover their full operating costs, costs of deposit resources raised on their own and default risks, and to provide a reasonable incentive in the form of a fair profit (paras. 5.22 and 5.23). (c) Domestic currency loans financed by IBRD and other official international organizations should, as far as possible, also be based on the floating interest rate system described above (para. 5.23). (d) The 5-year maximum limit on terms of lending under the FFI scheme should be eliminated because it creates a bias against investment whose cash flows imply a need for longer term financing. (e) The CFs should be assured of at least an equal access to the resources of the Official Financing Funds by securing the special privileges enjoyed by commercial banks in the rediscounting operations (paras. 4.13 and 5.22). D. Institutional Development xviii.(a) The CFs should in the near term be encouraged to reestablish their identity as specialized institutions devoted to term financing and equity investments in productive enterprises. In view of the higher risks involved in long-term lending and equity investments, the maximum limit on the debt to equity ratio for CFs should be reduced from its current level of 15:1 to about 10:1. To ensure soundness of portfolios and adequate diversification, total loans and equity investments outstanding to the constituents of a single group of affiliated financial and industrial enterprises (defined comprehensively to include all enterprises with significant  - vii - ownership linkages), their owners and managers should be limited to, say, 50% of the CFs' own networth; separate maximum limits on the total equity investment by a CF in a single firm are also in order, say a maximum of 40% of the firms' networth or 10% of the CFs' own networth, whichever is higher. Similar restrictions on portfolio concentration and strict public disclosure requirements should also apply to other kinds of financial institutions such as commercial banks and CFCs (paras. 4.09 and 4.11). (b) In general, free entry should be allowed for financial intermediaries, and Government authorization granted to new CFs as long as certain well specified criteria, including the minimum capital requirement, are met. In the case of CFs, the minimum capital requirement should be reduced from the currently high level of Col$ 1.0 billion to, say, Col$ 500 million, but this requirement should apply to existing as well as ntewly created CFs. The CFs should also be required to maintain a substantial proportion (60%-70%) of their portfolios in medium- and long-term loans or equity investments. Existing CFs should be given a transition period (of say 2-3 years) to comply with the new requirements. Smaller, marginally competitive CFs,which were originally created when the minimum capital requirement was extremely low (Col$ 50-100 million), but are still operating, should be allowed, during the transition period, to merge as necessary to comply with the new minimum capital requirement (para. 4.11). (c) In order to ensure sufficient financial incentive for CFs in tne light of the institutional requirements proposed above, the CFs should be provided incentives in the form of a waiver of the 10% forced investment requirements on CDTs and allowing a larger percentage and/or a higher spread on BR's rediscounting funds (para. 4.13). The Government may also wish to examine whether it would be desirable to provide privileged access by CFs to those Official Financing Funds which require particular technical capacity and skills in evaluation and supervision of investment projects (e.g., FIP and medium- and long-term financing operations of PROEXPO) (para. 5.22). E. Risk Capital Investments by CFs xix. In addition to their normal equity holdings, CFs should be encouraged to make use of quasi-equity instruments such as subordinated convertible debentures, preferred shares and equity instruments with an obligation to repurchase. These would provide CFs with a wider range of instruments falling somewhere between pure debt and pure equity, and would enable them to match the instruments better with the borrowing firms' cash flow characteristics and needs. At the same time they would provide greater marketability and a better assurance of a fair return on the CFs' risk capital investments. More work is needed, however, to analyze the legal, tax and other aspects of these instruments and decide on their specific application in the Colombian system (paras. 6.01 to 6.06). Steps to stimulate stock under-writing activities of CFs should also be considered (para. 6.09).  - viii - F. Access to Borrowings from Foreign Commercial Sources xx. Limitations on external borrowings by CFs and industries in connection with expansions in productive capacity could be relaxed, e.g. through removal of the maximum term limitations for such borrowings, which no longer appear appropriate, and allowing some external borrowings for financing local investment costs. The increased access should help promote investment financing and could also put a downward pressure on bank spreads and lending rates through increased competition. Such relaxation should, however, be compatible with other macro-economic developments (such as import liberalization) and total external debt capacity (paras. 5.27 and 5.28). LONGER TERM MEASURES A. Institutional Structure and Regulation xxi. (a) More comprehensive regulations covering the activities of finan- cial/industrial groups should be developed and implemented. Such regulations should specify permissible ownership, funds flow and other linkages among different types of financial institutions and between financial and industrial groups, the rights as well as obligations of the owners and constituents of a group (ensuring an appropriate balance between such rights and obligations), and requirements to provide consolidated financial statements for groups of related enterprises (paras. 4.04 and 4.10). (b) The supervisory functions of the Superintendencia Bancaria and the legal information requirements from financial institutions should be strengthened by: (i) placing under the authority of Super- intendencia Bancaria all financial intermediaries raising resources from the public; and (ii) improving the quality and timeliness of the information available from the financial institutions to the Superintendencia Bancaria and the public at large (para. 4.10;). (c) Any borrowings from the public by majority owned financial subsi- diaries of large industrial firms or groups should be secured by the assets of the parent company, be within prudent limits commen- surate with such security, and preferably be in the name of the parent company (para. 4.10). (d) In the long term, once adequate regulation of financial groups has been achieved and the required expertise for investment financing internalized within the banking system, the authorities could consider whether a move towards a 'multi-banking' system might be justified. Such a move, if chosen for the longer term, would still have to build on the expertise developed in the specialized institutions in the near term. In view of the potential ologopolistic effects, such a move should be undertaken cautiously, and only after confirming that competitive financial markets can be ensured (para. 4.08).  - ix - B. Longer Term Instruments for Resource Mobilization xxii. (a) CFs should be encouraged to raise longer term resources in the domestic markets. This should be facilitated through issuance of medium and long-term floating rate notes and bonds whose interest rate would be linked with the average CDT rate prevailing in the market to be published periodically by BR (paras. 5.20 and 5.21). (b) To avoid possible destabilizing flows affecting the Corporaciones de Ahorro y Vivienda (Savings and Loan Associations - CAVI), they should also be permitted to issue CDT-based bonds as well as long term UPAC indexed bonds with a gradually liberalized ceiling on the monetary correction to ensure equilibrium between UPAC rates and market interest rates, taking into account the Government policy of providing suitable financing to stimulate housing construction. C. Capital markets development xxiii.(a) Fiscal and legislative measures should be taken to strengthen the operation of the securities markets and thus achieve greater attractiveness for equities and other long-term savings instru- ments. Needed reforms include measures to improve protection of the rights of minority shareholders and removal of existing fiscal biases against investments in risk capital e.g., those stemming from the double taxation of dividends, full interest rate deduction on debt financing for purposes of tax computation, and the much larger withholding taxes on dividend income (up to 40%) compared to interest income (only 5%). Both the difficulty of equitably enforcing taxes on interest and dividend income and their potentially negative effect on personal savings suggest that these taxes should be reduced if not eliminated. Consideration should also be given to introducing a full inflation accounting system in the accounts and tax systems of corporations and financial institutions. These reforms are best undertaken in the context of a wider ranging reform of the tax system and administration (paras. 6.07 to 6.09). (b) Efforts should be made to strengthen the secondary market for the CDTs, including through the creation and administration of a special facility to help secondary market liquidity (but without any associated price guarantee). It would also be desirable for the Government to consider homogenizing the characteristics of the several short term official papers being issued under different names and with different characteristics ('titulos de participacion', 'certificados de cambio', etc.). This would facilitate a secondary market of the required depth and breadth for these instruments, and could provide an excellent index of short term interest rates which can be used as the reference for future floating rate instruments (para. 5.07).  -x - D. Further financial sector liberalization xxiv. Further liberalization of the financial sector should be considered for the longer run through a gradual reduction of the reserves requirements as inflation is brought under control. This should be accompanied by a gradual removal or relaxation of the ceilings on checking and savings accounts interest rates. In order to achieve the desired longer-term benefits of such liberalization, these measures would have to be accompanied by other measures related to macro-economic management such as a substantial reduction or elimination of fiscal deficits and improvement of public sector savings. The possible liberalization measures should therefore be considered carefully to ensure full compatibility with macro-economic conditions and monetary management (paras. 3.16 to 3.18).  I. PAST TRENDS AND POLICIES IN THE COLOMBIAN FINANCIAL SECTOR Institutional Structure 1.01 Colombia has a relatively well-developed and diversified financial sector comprising the Central Bank (Banco de la Republica - BR), about 25 each of commercial banks and corporaciones financieras (CFs--investment banks), a central mortgage bank (Banco Central Hipotecario--BCH), 10 savings and loan associations (Corporaciones de Ahorro y Vivienda--CAVIs), nearly 40 trade finance companies (Companias de Financiamiento Comercial--CFCs), more than 70 insurance companies, several mutual funds and two stock exchanges (at Bogota and Medellin). The commercial banks have the largest branch network, with more than 1,800 offices distributed throughout Colombia, followed by the CAVIs (400 branch offices in total), BCH (75 offices) and CFs (over 100 branch offices). Commercial banks represent the dominant segment, accounting for more than one-third of the total outstanding credit of the institu- tionalized financial system in recent years. As described below, to a sig- nificant extent this institutional structure represents the result of an evolution of the system over the last few decades in response to the changing financial sector policies, regulations, the macro-economic situation, and related stabilization measures. 1.02 Direct lending by banks is supplemented by rediscounting funds of BR funded in part out of the legal reserves of the banking system. For industry, the most important of these are the Industrial Financing Fund (FFI), which rediscounts loans made by commercial banks and financieras to small- and medium-size industrial firms (those with total assets of up to Col$60 million), the Private Investment Fund (FIP), which mainly finances firms larger than those covered by the FFI, and PROEXPO, which provides credit to non-traditional export activites (typically industry), using mostly funds from a 5% import tax. Developments Through the 1960s 1.03 The Colombian financial sector enjoyed a prolonged period of stability up until the late 1960s. However, by that time the financial system was a relatively repressed one, characterized by depressed financial savings due to low ceilings on interest rates, high reserves requirements, and substantial credit rationing. The regulations obliged private inter- mediaries to pay negative real interest rates on savings deposits, in part to reduce competitive pressures on official banks and government borrowings. By the end of the 1960s, an increasingly flurishing informal (extra-banking) market developed to circumvent the regulations of the formal institu- tionalized financial system. 1.04 The main institutional innovation during the 1950s and 1960s was the creation of the Corporaciones Financieras(CFs), through Decrees 336 of 1957 and 2369 of 1960. The stated objective of the CFs was "to promote the creation, reorganization, and transformation of firms (in the manufacturing, mining, and agricultural sectors), to participate in their capital or facili- tate the participation of others, and to provide them credit". The only other major financial intermediaries operating were the Caja Agraria (Caja de Credito Agrario Industrial y Minero), an official credit institution created in 1931 primarily to provide credit to small scale farmers (later broadened  - 2 - to include provision of credit to small industry and small scale mining), and the Central Mortgage Bank (BCH), an official bank created in 1932 to fulfill the full range of moirtgage banking functions. By the end of the 1960s there were 23 commercial banks, 9 CFs, and 2 specialized official credit institu- tions (Caja Agraria and BCH). The financial system remained relatively simple until the late 1960s and the functions of the different categories of credit institutions were delineated clearly. Apart from the specialized functions assigned to the two official banks, commercial banks were raising resources through checking and savings accounts and lending mainly through short-term operations as conceived originally under Law 45 of 1923 (although in the early 1960s the banks began to participate in term lending operations through the rediscounting funds of BR), while the CFs focussed their efforts primarily on provision of medium and longer term credit to the productive sectors and to a limited extent participation in the share capital of productive enterprises. 1.05 The prolonged period of stabilization ended in the late 1960s and early 1970s, when a major liberalization of the financial sector was under- taken. The liberalization was made possible in part by the establishment of a crawling peg exchange rate system in 1967 which reduced the risks of capital flight in anticipation of major devaluations. In 1969 interest rate ceilings on term deposits with banks, BCH certificates and publicly-held government debt were increased. To further increase the intermediation of resources through the institutionalized financial system, and to enable the system to compete with the secondary market yields of the Certificados de Ahorro Tributarios (CATs - negotiable tax rebate certificates created in 1967 to stimulate non-traditional exports), commercial banks were allowed, starting in 1971, to issue CDTs at interest rates substantially higher than those on savings accounts (see Table I of the Statistical Appendix). T'hese measures facilitated an increase in the total assets of the institutionalized financial system from about 15% of GDP in 1967 to 17% during 1970-72. The Creation of the UPAC System (1972) 1.06 The creation of the savings and loans institutions (CAVIs) in 1972 represented a major innovation in the Colombian financial market, not only because it represented a further specialization within the institutional system, but also because they were allowed to index both their credits and liabilities to the public through the use of a "constant purchasing power unit" (UPAC) linked to the consumer price index. Interest rates (both lending and borrowing rates) were subject to ceilings, but were expressed as margins additional to the monetary adjustment of the UPACs. Thus, the UPAC system represented a further liberalization of the financial system, but for the specific purpose of stimulating the housing and construction sector, which was an important vehicle to spur economic development under the Pastrana administration's "Four Strategies." 1.07 The effective interest rate on UPAC savings accounts in 1973 was 26.2% compared to 13.6% and 8.8% in commercial banks' CDTs and savings accounts respectively. This yield differential in favor of a quasi-liquid instrument made for a steep growth of CAVIs. Their share of total deposits with the financial system went up from nothing in 1972 to 12.1% in 1973 and 16.7% in 1974. The housing industry boomed as a result, reflected as a. sharp increase in housing starts. However, the UPAC investments posed a danger to the rest of the financial system, which by 1973/74 began to experience a significant disintermediation.  - 3 - The Financial and Tax Reforms of 1974/75 1.08 The solution to the above problem was provided by the comprehen- sive reform of the financial system which was undertaken by the Lopez Michelsen administration upon taking office in August 1974. The general philosophy of the reform was to liberalize the financial sector in order to permit higher financial savings, improve efficiency in credit allocation and therefore a higher productivity. The reform had the following major ele- ments: - Interest rates on deposits with financial intermediaries still remained under control, but the ceilings were raised substantially. Interest rates on savings accounts were raised to 12% on minimum quarterly balances (up from 8% previously) and those on CDTs were doubled in nominal terms from 12% to 24% to make them approximately equal to those offered by UPAC instru- ments (Table I). - Interest rates on loans by financial intermediaries were freed, eliminating the previous 14% limit. - The Government intervention on the allocation of resources was reduced through the reduction of reserve requirements and forced investments and the abandonment of policies attempting to fix the amount and destiny of loans other than rediscounts. 1.09 The above liberalizing measures were, however, accompanied by imposition of a ceiling on the monetary correction allowed under UPAC instru- ments, in order to put them on an approximately equal footing with CDTs. Moreover, the 1974 financial reform was accompanied by a tax reform enacted in the same year to strengthen the fiscal base and make taxation more pro- gressive, which had a somewhat unintended effect of neutralizing some of the benefits offered by the financial sector liberalization. Specifically, the tax law changes reduced the attractiveness of financial savings, since interest income from savings accounts and certain other instruments such as CATs became subject to taxation (after deducting a minimum tax fee allow- ance). Also, realized capital gains were made subject to the same tax rate as ordinary income except for a deduction of 8% allowed as compensation for inflation (which averaged about 16% per year during 1970-74 and 25% during 1974-81). UPAC's monetary correction was also made taxable except for a 8% deduction. 1.10 The net effect of the financial and tax reforms was an increase in the ratio of deposits mobilized by the institutional financial system to GDP from an average of 19.7% in 1970-74, to 24.6% in 1975-79. However, this was not adequate to fill the intermediation needs of the economy and the informal (extra-bank) market remained strong. During the mid and late-1970s, it is estimated that as much as one-quarter to one-third of total industrial credit was being channeled through the extra-bank market, which comprised operations of unregistered entities as well as complex innovations such as sales of portfolios and trust accounts developed by the formal banking institutions to circumvent the regulations.  - 4 - Creation of New Financial Intermediaries For Trade and Consumer Financing 1.11 In an effort to bring into the institutionalized system part of the resources which were being siphoned off by the informal market, the Government created, through Decrees 1773 of 1973 and 971 of 1974, a new formal category of financial institutions, simply called "financial inter- mediaries," which were subject to less supervision and regulation by the authorities than commercial banks, CFs an CAVIs, although some amount of control was exercised through the Superintendencia de Sociedades. The types of credit operations and deposits which could be undertaken by the new "financial intermediaries" were defined only in vague terms, giving the new institutions a large amount of flexibility in managing their operations. The bulk of the resources of the new intermediaries were raised through 3-6 month papers and their credit was oriented mainly to trade and consumer financing. The minimum capital and other requirements for establishing the new type of intermediaries were less demanding than for other categories of financial institutions. The response from the market was overwhelming: 16 such new "financial intermediaries" were created between 1974-76 and an additional 18 were created during 1977-78, to take adavantage of the looser regulations and escape the more restrictive regime applicable to other intermediaries. These new "financial intermediaries," which were renamed in 1979 as 'Companias de Financiamiento Comercial' (CFCs), remained the most rapidly growing segment of the organized financial system through the end of 1981. Their share of the total liabilities of financial intermediaries in Colombia increased from about 2% in 1975 to 3.9% by the end of 1977 and 4.9% by year-end 1980. CFs and CDTs 1.12 In 1975 (through Decree 399/75), the operations of CFs were broadened to permit them to issue CDTs of 90, 180 and 270 days to mobilize short-term resources, and to finance the working capital needs of productive enterprises through short-term lending operations using the CDT resources. This measure had a profound impact on the operations of the CFs. Previously, CFs had been heavily dependent on BR and BR-administered external lines of development credit to finance their credit operations. Decree 399 had the positive impact of liberating the CFs from excessive dependence on BR's and other rediscounting lines of credit of their resources. However, at the same time, it also freed the CFs from the need to lend on medium or long term. In fact, the prevailing market conditions were such that short-term lending operations using CDT resources were much more profitable than longer-term operations, partly as a result of the inverted yield curve which effectively prevailed in Colombia since firms had access to subsidized longer-term credit. This created strong incentives for the CFs to move increasingly towards shorter-term lending operations in preference to medium and long-term credit operations or equity investments. By 1978, resources utilized by the private CFs through CDTs as a percentage of the total resources of CFs accounted for more than one-third of their total resources. 1.13 The above liberalization measures together with the prevailing market incentives and higher leverage ratios permitted for CFs compared to commercial banks resulted in the creation of a large number of new CFs in the ensuing years. As many as 12 new CFs were established between 1974 and 1978 most of which had the primary objective of operating in the short-term markets. The existing CFs also tended to shift their emphasis in the same  direction, but those CFs which attempted to maintain their initial objectives were less aggressive in mobilizing short-term resources. The largest single CF with a short-term orientation mobilized more resources through CDTs than all the six major traditional ones in every single year during the 1976-81 period. I/ Equity Investments by CFs 1.14 Responding to increasing concerns that CFs have not been able to stimulate significantly the capitalization of productive enterprises (those operating in the industrial, agricultural or mining activities), which was one of the originally stated objectives of the CFs system, the Monetary Board imposed, through its Resolution 65 of 1977, requirements for CFs to hold at least 10% of their total assets in the form of equity investments. The concerns were well jLstified, although the real reasons for the lack of interest in equity invstments were the absence of adequate market incentives and lack of a developed secondary market for venture capital type investments (see Sections II and VI for a detailed discussion). The period for complying with the above requirement was later extended until mid-1979, and the Resolu- tion itself was amended subsequently to require minimum equity investments in the portfolio of any CF equal to 80% of its networth instead of 10% of total assets. The latter change was made to take into account the diverse leverage ratios of the CFs and that for reasons of financial prudence the CFs should limit their risk capital investments to an amount somewhat less than the value of their own equity. The CFs have generally complied with the minimums specified. The above requirements had an effect of increasing equity invest- ments of CFs from about Col$ 800 million in 1976 to more than Col$ 3,000 million by year-end 1978. In the case of several industrial companies in whose share capital they participated, the CFs have played a significant developmental role, although this observation should be tempered with the qualifications expressed in Section It (para. 2.13). 2/ The 1977-79 Stabilization Measures 1.15 In 1977 a series of stabilization measures were implemented to counter the strong inflationary pressures brought about by the sharp rise in foreign exchange earnings due to the coffee bonanza and the substantial illegal exports as well as the shortage of basic food supplies. The measures effectively reversed most of the financial market liberalization undertaken during 1974/75. Since the increased foreign exchange flows were viewed as a temporary phenomenon and conspicuous consumption of non-essential imports was considered undesirable, the Government was unwilling to liberalize imports significantly. Instead, strict monetary controls were imposed in the form of 100% marginal reserve requirements on increases in checking accounts, term deposits and foreign currency deposits above their January 1977 levels and some increases in the average reserve requirements on checking accounts 1/ Significantly, CFs which retained a longer-term orientation tended to be mainly those that were forced to do so under contracts signed for World Bank lines of credit which specify maximum limits on short term lending by the par- ticipating CFs. 2/ Through an earlier measure in mid-1979, the Government created a National Securities Commission with the objective of stimulating and regulating the securities markets.  - 6 - and foreign currency obligations. Concurrently, in an attempt to avoid a slowdown of investment in key sectors, renewed emphasis was placed on trhe system of selective credit allocation through BR's industrial financing funds, the forced investment regime was restored through requirements for the acquisition of agroindustrial and IFI bonds, and more restrictive ceilings were reimposed on interest rates which therefore could not rise with inflation. Additional restrictive measures included the institution of forced investment requirements (initially of 15% and later 25%) on CDs inssued by the CFs, the issue by BR of 90-day "certificates of exchange" denominated in dollars for the purpose of "mopping up" the liquidity originating from the external sector, and, starting in September 1979, open market operations through the issue of 'certificates of participation' i(akin to treasury bills in the U.S.) offering effective yields of up to 37% p.a. (for maturities ranging from 15 to 90 days) which exceeded the yield allowed for the institutionalized financial system. A withholding tax of 5%, which was instituted through Law 20 of 1979 for income on interest earnings, had a further dampening effect on resource mobilization by banks and CFs. The immediate effect of these measures was a virtual stagnation of financing savings channeled through the formal financial system in 1977. This "counter-reform" of the financial sector was maintained through the years 1978 and 1979, while the extra bank (informal) market continued to grow. 1.16 In order to ensure more effecte vigilance of at least part of the extra bank market, the Government took measures in August 1979 (through Decree 1970) to make the "financial intermediaries" referred to above (which were earlier on the fringe of the institutionalized banking system) a formal part of the institutionalized system with clearly specified rules and objec- tives and direct supervision of these entities by the Superintendencia Bancaria. Renamed as "Companias de Financiamiento Comercial" (CFCs--trade finance companies), they were made subject to higher minimum capital requirements of Col$ 100 million (up from Col$ 10 million earlier). The CFCs were allowed to issue CDTs and other term deposit instruments and authorized to use those resources for making short and medium-term loans (of up to three years in maturity) for financing durable consumer goods, services and other aspects of trade. The term deposits mobilized by CFCs were made subject to forced investment requirements comparable to those of CDTs issued by commercial banks and CFs. Also, CFCs have been precluded from rediscounting loans with BR's Official Financing Funds and contracting external loans. Recent Developments 1.17 Starting in 1980, restrictions on the financial sector have been eased. In January 1980, the Monetary Board put in effect a series of major reforms to remove or relax a wide range of regulations affecting banks and CFs. Most importantly, it removed ceilings on interest rates on CDTs and on loans made with funds raised through CDTs. The Monetary Board also abo:Lished the 100% marginal reserve requirements on current accounts and foreign currency deposits as of January 1980 and substituted this by a gradual increase of the regular (average) reserve requirements from 45% to 50%. Regular reserve requirements for CDTs of banks and CFs were reduced from 25% to 15%, and later to 10%. Yields provided on the forced investments were increased. Finally, the Monetary Board lifted the 3-5 year mandatory ceil- ings on the terms for external financing contracted directly by the private sector for equipment purchases and delegated to the External Trade Council (Consejo Directivo de Comercio Exterior) and INCOMEX, the authority to approve terms for each external financing operation compatible with the  - 7 - investaent's gestation period and cash flow projections. In September 1980, and again during 1982, interest rate ceilings on savings accounts and UPAC inst.-uments were liberated slightly and reserve requirements further lowered (see Section III). 1l18 The expansion of reserve money continued into the 1980s, even after the end of the above boom, as the Government started to use the "Cuenta Especial de Cambio" to finance its increasing cash deficit (estimated at about 2% of GDP for 1981 (see Table II of the Statistical Appendix). To counteract this, the Government continued to maintain relatively high marginal reserves requirements, although substantially lower than the 100% marginal requirement used during the coffee boom. At the same time, in order to provide subsidies in the form of low cost credits to some sectors and activities which were considered to be of high priority (e.g. agriculture, small-scale industry, long-term industrial investments) the Government retained substantial forced investment requirements on financial intermediaries. The Formation of Financial and Industrial Groups 1.19 seen from the above discussion, the Colombian financial system, which consis-ed primarily of commercial banks and two official credit institutions in the 1950s was gradually widened to include CFs, CAVIs and CFCs. This growth of specialized institutions was accompanied by a trend tow;ards formation of financial conglomerates (groups), which was to a significant extent a natural consequence of the specialization itself. Most of the important CFs and CAVIs and to a lesser extent, CFCs, were created by commercial banks or their shareholders as a way to expand services to their customers. 1.20 What distinguished the 1970s from earlier times was the emergence of a trend of groups to grow through acquisition rather than through creation of new enterprises, the key role played by financial institutions in the process, and the formation of large conglomerates that include industrial as well as financial companies. Since access to funds from public deposits provides powerful opportunities for takeover in a market characterized by low share values (see Section II), control of financial institutions themselves became an attractive proposition to large groups. Not infrequently, the incentive to control a financial institution arose from the possibility of channeling its credit to the new shareholders to finance other acquisitions, in a dangerous process that led two Colombian groups into receivership in 1982. Conclusion 1.21 The institutional structure and the relative growth rates of different instruments and institutional categories can for the most part be explained as rational responses of the system to changing government policies and macro-economic prospects. For example, the variations in the strength of the extra-bank market, the rapid growth rate of CDTs in the mid-1970s and changes in the relative growth rates of CFCs, CAVIs, CFs and commercial banks, etc. over the last decade can all be explained by the changes in the regulatory policies and official intervention. However, once certain patterns (e.g., formation of groups or means to circumvent normal regulatory practice) set in, they have tended to perpetuate themselves unless deliberate official action is taken to reverse them.  - 8 - II. ISSUES FACING THE CORPORACIONES FINANCIERAS Nature of the Main Issues 2.01 As explained in Section I, the system of Corporaciones Financieras (CFs) was created in Colombia starting in the 1960s, as the investment banking component of a specialized banking system. The specific objective of CFs was to support the creation and expansion of the productive capacity in the industrial, mining, tourism and related sectors through the provision of the medium- and long-term credits and risk capital. A related objective was to help promote the Colombian capital markets through the development of suitable instruments and channels for term credit and equity investments. Although the CFs have had significant success in achieving some of these objectives (see para. 1.14), recent trends have become causes of concern: (a) The CFs have been driven by the prevailing market conditions and incentives to operate increasingly in the short-term lending market. At the end of March 1982, 74% of the total CFs' lending portfolio was short term and only 8% in medium- or long-term loans. (b) Total credit granted by the CFs to the manufacturing sector has not kept pace with the growth in manufacturing value added over the last decade (see para. 2.12). In terms of total assets, the CFs as a group have grown less rapidly over the last decade than other types of financial institutions such as CFCs and CAVIs (See Statistical Appendix Table III). The share of CFs' deposits in the total deposits market stood at a modest 5% as of December 1981. (c) As a group, the CFs have had only a limited impact in stimuliating the creation or expansion of productive enterprises through risk capital investments. 2.02 The above average trends mask the substantial heterogeneity among the CFs, which can be classified into three distinct groups according to the term composition of their loan portfolio: (i) Private CFs which have attempted to fulfill their original objectives of providing term financing and risk capital to productive enterprises. As seen from the table below, these CFs have a lower than average proportion of short-term credit in their portfolios (47% in March 1982, as compared to an overall average of 74%). (ii) Private CFs which have little commitment to the stated objectives of the CFs system, per se. Many of them were created to take advantage of certain regulatory benefits and the relatively easy entry of new CFs to financial intermediation at a time when authorization of new commercial banks was virtually suspended (since early 1970s -- see para. 4.01). As the following table shows, their portfolios are almost entirely short term oriented (94% as of March 1982).  - 9 - (iii) Special purpose official CFs created by the Government to fulfill specific sectoral functions (six of them, the largest one being the Instituto de Fomento Industrial -- IFI), which lie in between the former two groups, with 65% of their average portfolio being short term. TM( COMPOSITION OF THE CFs' LOAN PORTFOLIOS, BY GROUP 1/ (As of April 30, 1982) ed:-Tcn.hTer Crit Total Cr2ait Share of Mc:-~T r-- dit re orE t Short-term Share of 1!.cium- % of _e`umn- Long-term Z of Long- Credlit in 7 of Total SF.ort- Term Credit in Terr. Crcdit Credit in Term Credit