Argentina - Small and Medium-Scale Industry Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Repot No 13865-AR PROJECT COMPLETION REPORT ARGENTINA SMALL AND MEDIUM-SCALE INDUSTRY CREDIT PROJECT (LOAN 2793-AR) January 11, 1995 Public Sector Modernization/Private Sector Development Division Country Department I Latin America and the Caribbean Regionial 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.  CURRENCY EOUIVALENTS Currency unit - Peso Exchange Rate (end of period):* 1985 US$1 = 0.00008005 1986 US$1 = 0.0001257 1987 US$1 = 0.000375 1988 US$1 = 0.001337 1989 US$1 = 0.1795 1990 US$1 = 0.5585 1991 US$1 = 1.0 1992 US$1 = 1.0 1993 US$1 = 1.0 * Note: In mid-1985, the peso was changed to the Austral (eliminating three digits); and in January 1992, the Austral was changed to the peso (eliminating another three digits). ABBREVIATIONS AND ACRONYMS BANADE National Development Bank BCRA Central Bank of Argentina BHN National Housing Bank BNA Banco de la Naci6n Argentina (National Savings Bank) FOPYME Fund for Small & Medium-Scale Enterprises IFC International Finance Corporation INTI National Institute of Industrial Technology PB Participating Bank PCR Project Completion Report RTAC Regional Technical Assistance Center SIGEP Comptroller of State Companies SMSE Small and Medium-Scale Enterprise SSME Sub-Secretariat for Small and Medium-Scale Enterprises TA Technical Assistance UNDP United Nations Development Program  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Otfice of Director-General Operations Evaluation January 11, 1995 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Argentina Small and Medium-Scale Industry Credit (Loan 2793-AR) Attached is the Project Completion Report on Argentina - Small and Medium-Scale Industry Credit (Loan 2793-AR) prepared by the Latin America and Caribbean Regional Office. No contribution was received from the Borrower. The main objectives of the Small and Medium-Scale Industry (SMI) Credit Project were to encourage the modernization, expansion and productivity enhancement of Argentina's SMI sector. The project involved a loan amount of US$125 million to finance a line of credit, which was channelled through a second-tier fund within the national development bank, Banco Nacional de Desarrollo (BANADE); and a technical assistance component aimed at strengthening institutional support for SMIs. The project was implemented during a particularly difficult period (1988-91) in Argentina marked by hyper-inflation and severe financial hardship. The macroeconomic conditions, combined with weaknesses in project design and financial problems in BANADE, undermined the achievement of project objectives. Demand for the line of credit was weak and there was a lack of interest in the technical assistance component. However, the project did contribute to developing project appraisal capabilities in a number of banks. BANADE's mounting financial problems, which were the result of poor management, lack of operational autonomy and the impact of worsening macroeconomic conditions, eventually triggered its liquidation and the cancellation of US$64.2 million of the IBRD loan. The disbursed loan funds financed 338 subloans, over 70 percent of which were channelled through BANADE. There is no record of subloan arrears or subloan performance. The Bank's performance in project preparation and design was poor. Macroeconomic risks were not carefully identified, the pre-existing weak financial condition of BANADE was never fully analyzed, and the loan pricing formula was faulty. However, supervision missions were effective in handling BANADE's unfolding crisis and, following two attempted activations of loan suspension procedures, were instrumental in eventually convincing the Government to liquidate the bank. The project outcome is rated as unsatisfactory. Institutional development is rated as modest and sustainability as unlikely. The PCR is of very good quality. It provides a very candid assessment of the project's design weaknesses and implementation shortcomings. An audit is not planned. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents nmay not otherwise be disclosed without World Bank authorization. l   FOR OFFICIAL USE ONLY ARGENTINA SMALL AND NlEDIUM-SCALE INDUSTRY CREDIT PROJECT TABLE OF CONTENTS PREFACE ............................................ EVALUATION SUMMARY ................................. PART I. PROJECT REVIEW FROM THE BANK'S PERSPECTIVE ...1... A. Project Identity ................................ 1 B. Background .................................. 1 The Industrial Sector ............................ 2 The Financial Sector ............................ 2 C. Project Objectives and Description .................... 4 D. Project Design and Organization ..................... 5 Creation of a second-tier mechanism within a main retailer bank opened the possibility of conflict of interests ... ...... 5 Oversight of BANADE's problems undermined the loan ... .... 6 The use of debt/equity ratios to monitor BANADE's financial performance was not effective .................. 6 Loan pricing and interest rate policy discouraged usage of the loan .................................. 7 Loan limits and the subloan approval process further hindered PB's participation ....... . . . . . . . . . . . . . . . . . . . 8 E. Project Implementation ....... . . . . . . . . . . . . . . . . . . . . 9 Hyper-inflation undermined the loan's objectives ..... . . . . . . 9 BANADE's financial crisis triggers loan cancellation ... ..... 9 Other problems triggered by the financial crisis ..... . . . . . . . 13 Response by PBs and SMSEs to the loan was mixed ..... . . . . 13 Reformulation of Technical Assistance ..... . . . . . . . . . . . . 14 F. Project Results ........ . . . . . . . . . . . . . . . . . . . . . . . . 14 Provided medium and long-term financing for SMSEs .... . . . . 15 Helped to develop expertise in project financing among commercial banks ......................... . 16 G. Project Sustainability ....... . . . . . . . . . . . . . . . . . . . . . 16 H. Bank Performance ....... . . . . . . . . . . . . . . . . . . . . . . . 17 I. Borrower/Executing Agency Performance ..... . . . . . . . . . . 18 J. Project Relationship ....... . . . . . . . . . . . . . . . . . . . . . . 19 K. Project Documentation and Data ...... . . . . . . . . . . . . . . . 19 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not othervise be disclosed without World Bank authorization.  Table of Contents (Cont'd) Page PART III: STATISTICAL INFORMATION ....... ............... 21 3.1 Related Bank Loans .21 3.2 Project Timetable .............................. 21 3.3 Loan Disbursements .22 3.4 Project Estimated (Appraisal) Cost .22 3.5 Project Estimated (Appraisal) Financing .22 3.6 Project Financing Planned and Actual .23 3.7 Project Results .23 3.8 Status of Covenants .24 3.9 Use of Bank Resources .28 3.10 M issions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 ANNEXES ANNEX I: SUMMARY OF TERMS AND CONDITIONS OF THE LOAN .. 30 ANNEX II: BANADE'S FINANCIAL CRISIS ........ . . . . . . . . . . . . 35 Background ........................ ...... ..... .. . 35 Origins of the Crisis .............. ... .. ... ... .. ... .. . 36 BANADE: Summary of Key Financial Problems ...... . . . . . . . . . . 36 Response to the Crisis ............. .. ... .. ... .. .. ... . . 40 ANNEX III: LOAN STATISTICS ............ .. .. .. .. .. ... .. . 45  - j - PROJECT COMPLETION REPORT ARGENTINA SMALL AND MEDIUM-SCALE INDUSTRY CREDIT PROJECT (LOAN 2793-AR) PREFACE This is the Project Completion Report (PCR) for the Small and Medium-Scale Industry Credit Project in Argentina, for which Loan 2793-AR in the amount of US$125 million equivalent was approved on April 14, 1987. The project was implemented during a particularly difficult period marked by very high inflation and severe financial hardship for Argentina. The final disbursement was made in November 1991. At the request of the Borrower, the loan was cancelled in July 1993, about one year ahead of the original planed loan closing date. A total of US$64.2 million was cancelled over the life of the loan. The PCR was prepared by the Public Sector Modernization/Private Sector Development Division, Country Department I, of the Latin America and Caribbean Regional Office (Preface, Evaluation Summary, Parts I and III). Submission of Part II by the Borrower is still pending. In preparation of this PCR, a mission visited Argentina in July 1993 and discussed the effectiveness of the operation with Governmental officials, with representatives of the Executing Agency, and with representatives of the participating financial intermediaries and industrial enterprises that received financing from this loan. The report is based, inter alia, on these discussions, the Staff Appraisal Report, the Loan and Guarantee Agreements, supervision reports, correspondence between the Bank and the Borrower, and internal Bank memoranda.   - ii - PROJECT COMPLETION REPORT ARGENTINA SMALL AND MEDIULM-SCALE INDUSTRY CREDIT PROJECT (LOAN 2793-AR) EVALUATION SUMMARY 1. Project Objectives. The project objectives were to encourage modernization, to strengthen productivity, and increase productive activity by small and medium scale enterprises (SMSEs), with particular emphasis on employment generation and on greater economic diversification outside the major urban areas. These objectives were to be achieved by providing a line of medium- to long-term credit to overcome constraints on investment financing faced by SMSEs, complemented by a technical assistance program for SMSEs. A unit, called the Fund for Medium and Small Scale Enterprises (FOPYME) was established within the National Development Bank (Banco Nacional de Desarrollo, BANADE), to operate as a second-tier financial intermediary to lend to commercial banks and BANADE's own first-tier units, for onlending to private sector enterprises. FOPYME was eventually to become the principal public sector institution for financing of SMSEs. 2. The credit line was structured to finance: (a) fixed assets and related permanent working capital needs of SMSEs, including machinery and equipment (and their installation costs); building construction, handling and storage facilities; civil works; quality and pollution control equipment; replacement of obsolete machinery and equipment; investments for improvement of product, quality and design; and acquisition of new technologies; (b) free standing working capital needs; and (c) technical and managerial assistance needs of SMSEs. 3. The thrust of the technical assistance (TA) component was to: (i) strengthen BANADE's capabilities to provide assistance to SMSEs and participating banks; (ii) strengthen the National Institute of Industrial Technology's (INTI) capabilities to assist SMSEs; and (iii) support the creation of a system of Regional Technical Assistance Centers (RTACs) for SMSEs by the Commerce Ministry's SMSE Division (SSME). These funds were to be applied towards training, preparation of studies and purchase of equipment. 4. Design and Implementation Experience. The project addressed one of the weak links in the development of industrial enterprises in Argentina: the scarcity of medium- and long-term finance for investments by SMSEs. As a result of a long history of inflation, lending by Argentina's banking system was constrained almost exclusively to  - 111 - short-term financing. This project, therefore, provided the only medium- and long-term credit facility available to SMSEs at that time. 5. The most important design features that affected the outcome of the project were the following: * Creation of the second-tier mechanism within a major retail bank opened the possibility of connict of interests. One of the principal design elements of the project was the establishment of FOPYME as a permanent specialized wholesale banking unit within BANADE to lend to both private banks and BANADE's own first-tier units, for onlending to SMSEs. It was expected that FOPYME would become the development finance vehicle to manage similar future loans from bilateral and multilateral agencies. The establishment of the second-tier unit within one of the main retailers of the credit line posed serious conflict of interests and created the perception of likely bias. Some participating banks (PBs) felt that BANADE's approval authority gave it an unfair advantage in processing its own loans. * Oversight of BANADE's problems during appraisal undermined the loan. Weaknesses in loan preparation were noted in the appraisal's evaluation of BANADE. Prior to appraisal, BANADE's financial problems were widely known throughout the banking industry, although their magnitude was difficult to measure due to poor accounting and auditing standards and procedures. BANADE's financial problems stemmed from inappropriate management decisions and policies that were frequently influenced by political considerations. This should have raised concerns within the World Bank over BANADE's viability, or possibly have led to the consideration of a restructuring of that institution prior to making the loan. * The use of debt/equity ratios to monitor BANADE's financial performance was not effective. The project used a maximum debt/equity ratio covenant to monitor BANADE's performance. Without credible information on the value of BANADE's assets, such ratio gave a misleading picture of the bank's actual financial situation. Moreover, the certification of covenant compliance was given by the Office of Comptroller of State Companies (SIGEP), which was not inclined, at that time, to sound alarms about the fact that BANADE's net worth was probably negative. * Loan pricing and interest rate policy discouraged usage of the loan. The rate charged on subloans was expressed in terms of a fixed real, or  - iv - inflation adjusted, rate that was to be applied to an indexed amount of principal, and which included a spread of 3.75 percentage points for the PBs. This spread, which seems to have been determined arbitrarily, was much lower than the historically high spreads charged by Argentine banks. Participating banks were required to co-finance 10% of each subloan with their own funds. They had to source these funds in the money market where they paid substantially higher rates in nominal terms. This requirement discouraged banks from participating because, in addition to a sizeable negative interest rate spread on their 10% component of the loan, the spread earned on the remaining portion of the loan was not commensurate with what banks would normally charge to cover credit risk and the cost of servicing the loan. In fact, most PBs interviewed for this report concluded that this facility generated a loss in terms of interest rate margins, although these were partly compensated by other aspects of the overall relationship with their customers. Eventually, of the 40 commercial bank candidates identified at the time of appraisal, only 13 banks participated. * The Bank remedies did not allow the Bank to stop new commitments in response to worsening macroeconomic conditions. According to the Loan Agreement, the Bank could suspend disbursements whenever "an extraordinary situation shall have arisen which shall make it improbable that BANADE will be able to perform its obligations under the Project Agreement." Although the macroeconomic crisis was such a situation, it was too cumbersome for the Bank to exercise its rights with this clause during the initial stages of the crisis, when its impact on BANADE was still unclear. At this stage, the Bank was also unable to suspend disbursements based on BANADE's failure to comply with the debt/equity covenant, because SIGEP' s audit reports indicated that BANADE was still in compliance. The Bank was able to protect the Borrower's interests initially through a slow down of subloan approvals, and later, through an agreement with the Borrower and BANADE to link subloan approvals to BANADE's successful reorganization. It would have been useful to have in the Loan Agreement a review clause that would have allowed the Bank officially to suspend new commitments when the crisis started, while giving the Bank time to initiate suspension procedures. 6. The following issues in implementation of the loan were identified: * Hyper-inflation undermined loan objectives. At the time of appraisal, Argentina was undergoing an economic revival that had begun in August 1985, with the announcement of the Plan Austral. However, soon after Board approval of the loan, inflation began to accelerate as a result of an  v overly accommodative monetary policy and inability to maintain the fiscal situation under control. During the hyper-inflationary spiral in 1989, commercial banks experienced an acute liquidity crisis, as depositors rushed to withdraw their funds from account whose value were being eroded through inflation. Hyper-inflation increased FOPYME's credit risk exposure to the participating banks, including BANADE. Also, high inflation and uncertainty discouraged SMSEs from embarking on new investments. In such a volatile environment, loan demand was bound to be unpredictable, credit risk difficult to measure, and loan pricing unprofitable. * BANADE's financial crisis triggered loan cancellation. One of the critical variances between planned and actual implementation was the financial crisis which engulfed BANADE, an already weak bank. Persistent efforts by supervision missions to induce BANADE's management to address the institution's problems proved unsuccessful. The Bank's negative assessment of BANADE's restructuring plans helped to convince the Government to intervene and eventually liquidate that institution. The process of loan cancellation was a long and complicated one due to the many vested interests in preserving BANADE and the Bank loan. * The TA componenit was reformulated several times. The loan's appraisal had noted the absence of an active and coordinated TA program for SMSEs. Despite a detailed description of the TA needs for this project, including the identification of the executing agencies (BANADE, SSME and INTI), the implementation process was stymied by the broader macroeconomic and financial crises, BANADE's own problems, Government reorganizations that resulted in new views on TA needs or lack thereof, and inadequate follow up regarding additional resources that were needed to assure continuation of the programs. The TA programs were not given priority during loan implementation. The weak performance was attributable to a lack of interest on the part of the implementing agencies as well as to changes in the scope of the TA programs which were not adequately evaluated in terms of linkages to the overall loan objectives, and in terms of additional resource requirements. 7. Project Results. Despite its many weaknesses and premature cancellation, this loan made some progress towards achieving its objectives. Specifically, this loan channeled US$60.4 million to support investments in expansion of existing plants or in the creation of new ones by SMSEs which would otherwise have had to rely on more limited internally generated funds, or on very expensive and volatile short-term credits. Subloans concentrated in the following subsectors: food and beverages, 27% of the total;  - vi - chemical products, 19%; and machinery and equipment, 17%. These loans helped to develop expertise in medium and long-term financing in the banking system. To qualify for participation, a commercial bank had to establish a specialized medium- and long- term SMSE financing unit within its organization. By enhancing project appraisal capabilities in a number of banks, this project may ultimately have been helpful in strengthening the institutional basis for the recent expansion of medium- and long-term financing in Argentina. 8. Project Sustainability. The sustainability of an operation of this type depends on the establishment of a viable and effective delivery mechanism to allocate funds in an efficient manner according to project objectives. In the event, BANADE's problems aborted the operation, which in turn thwarted FOPYME's prospects for becoming an effective wholesale development banking entity. 9. Lessons Learned. Several lessons can be extracted from the experience of this project including the following: * The experience of this project suggests that Bank loans for credit operations should not be provided in a situation of macroeconomic instability. Loan appraisals should assess macroeconomic programs more closely and spell out the types of developments that would jeopardize the objectives of the loan. Loan Agreements should provide adequate remedies for suspension of new commitments or disbursements if such conditions arise. * The experience of this loan also suggests that credit lines should not be provided if the banking regulatory and supervisory framework is inadequate. The poor quality of bank supervision and regulation in Argentina rendered the available financial information highly unreliable, making it difficult for the Bank to evaluate the financial situation of BANADE and for FOPYME to evaluate and monitor the financial situation of the PBs, particularly as inflation accelerated. * Second-tier lending facilities should not be administered by a public bank that also acts as first-tier lender. In any event, public sector banks should limit their role to that of a wholesaler. Also, greater coordination of public and private sector participation should be encouraged, possibly by incorporating private sector representation on the Board of Directors of the public second-tier agency. * Greater emphasis should be placed on loan information requirements. For example, the Bank might consider requiring periodic reports by PBs with the following information: (i) payment arrears on sub-loans by  - vii - number of days in arrears; (ii) any refinancing of loan payments; and (iii) summary performance indicators of each investment enterprise. This information would be useful in assessing the impact of the loan. In addition, whenever the government assumes the exchange rate risk from conversion of local currency into dollars, a quarterly report should be submitted showing realized gains/losses, as well as translation gains/losses. * Credit line operations should establish exposure limits to a single PB to avoid concentration of risks, particularly if public banks are allowed to participate. * The pricing and termns of the sub-loans should be market determined. The currency denomination should be left as an option to the PB and the final borrower. In the case of local currency denomination, the interest rate charged on the loan should incorporate a margin to cover potential exchange rate losses and should be based on the interest rate structure in the country. PBs should be allowed to negotiate with their clients the size of the spreads charged on the subloans. In other words, pricing mechanism should rely as much as possible on market signals.  PROJECT COMPLETION REPORT ARGENTINA SMALL AND MEDIUM-SCALE INDUSTRY (SMI) CREDIT PROJECT (LOAN 2793-AR) PART I. PROJECT REVIEW FROM THE BANK'S PERSPECTIVE A. Project Identity Project Name: Small- and Medium-Scale Industry Credit Project Loan Number: 2793-AR RVP Unit: LAICO Country: Argentina Sector: Finance and Industry B. Background 1.1 Once among the world's most prosperous economies, Argentina has experienced low economic growth since the 1940s. By the mid-1970s, the country's long-term growth declined noticeably, and in the last half of the 1980s, the country suffered from its longest period of stagnation in the century. Savings and investment rates fell precipitously from the mid-1970s until 1989. This economic performance was traceable to chronic public sector deficits and endemic inflation. After the return to constitutional democracy in 1983, public demands to control inflation were translated into four successive stabilization programs. All failed to eradicate inflation, and each ended in a more virulent inflation than the one preceding it. The main reason for these failures was the inability of the stabilization programs to redress rapidly and permanently the structural deficit of the public sector. 1.2 By the time of project preparation, the democratic Government, after several unsuccessful attempts to stabilize the economy, had introduced a new program called the Plan Austral (in June 1985), which included the creation of a new currency known as the Austral as well as measures to freeze prices and the exchange rate. Shortly after the announcement of the stabilization plan, the Government requested a Bank loan to support the development of small and medium industries. Like its predecessors, however, this program was short-lived. At the time of loan effectiveness, in April 1988, monthly inflation was fast approaching the 20% mark. In mid-1988, the Government introduced the Primavera stabilization plan, which again used the nominal exchange rate as the anchor for inflation without sufficient fiscal restraint. The plan collapsed in early 1989 in the middle of a hyper-inflationary spiral which lasted several months--July inflation alone was 200%. The inflationary crisis drove the economy into recession: commercial banks experienced an acute liquidity crisis and the problem of bankruptcies intensified. In response to the crisis, the Menem administration, which took office in July 1989,  - 2 - undertook two stabilization plans in 1989 and 1990. Neither succeeded, principally because of the intractability of the fiscal deficit. Stabilization came with a new fiscal package introduced in February 1991, which was able to close the fiscal gap, and with the Law of Convertibility, introduced in April 1991, which guaranteed the convertibility of the peso into dollars at a one to one rate and effectively proscribed money creation other than to buy net foreign reserves. 1.3 The Industrial Sector. Argentina's import-substituting strategy of industrial development started showing its weaknesses during the 1960's. The military government that took office in 1976, introduced some trade liberalization measures, but many non- tariff barriers remained that provided tailor-made protection to powerful domestic groups such as the auto industry and the petrochemical and steel companies, owned by the military. Unionized labor benefitted from high wages, guaranteed employment, and rigid rules governing hiring and dismissals. The strong protection granted to intermediate industries and high labor costs, coupled with the overvaluation of the currency and growing inflation, resulted in decreased competitiveness of industrial producers, both in local and export markets. As a result of this strategy, during 1970-82, the industrial sector grew at a dismally low annual rate of 0.13%. The trade liberalization program was reversed when the 1982 debt crisis emerged. The civilian government extended significantly import tariffs and licenses, as well as export subsidies and subsidized credit for some industries, while increasing export taxes for others. 1.4 Industrial policies discriminated against small and medium-scale enterprises (SMSEs) which had less access to subsidized credits and inputs, so that most SMSEs with plans for modernization or expansion were unable to carry them out. Many of them ceased to produce, while others reduced their operations or moved into the informal economy. Between 1974 and 1984, the number of SMSEs productive facilities declined by 13% to about 32,000 units with more than five employees each; physical production fell 15%; and employment decreased 34%. A survey of industrial firms carried out in 1984, showed that only 30% of the SMSEs made new investments during 1977-83. Another survey conducted by BANADE in mid-1986, complemented by the findings of several Bank missions, showed that SMSEs had obsolete equipment, but were willing to invest in modernization. However, scarcity of appropriate credit was viewed as a binding constraint for investment. 1.5 At the time or preparation of this loan, the Government had heightened its interest in the development of SMSEs. The Sub-secretariat for Small and Medium-scale Enterprises (SSME) was established within the Secretariat of lndustry and Trade to promote SMSEs in the industrial sector. This loan was envisioned as an instrument to support the Government's newly developed interest in SMSEs. 1.6 The Financial Sector. At the time of loan appraisal, Argentina's financial system consisted of the Central Bank (BCRA), four specialized national banks: the country's  - 3 - largest commercial bank (Banco de la Nacion Argentina-BNA); BANADE, the industrial development bank; the national housing bank (BHN); and 189 banks, of which 31 (including 24 provincial banks) were public and 158 were private (of which 31 were foreign and 127 were nationally owned). The balance of the system included 68 finance companies and 45 savings and loan associations and credit unions. The public banks, excluding BCRA, had about 57% of total deposits and were responsible for about 66% of the total volume of loans. Private banks controlled about 41% of total deposits and provided about 32% of the credit. The equity base of the financial system, excluding BCRA, was relatively small, equivalent to US$3.7 billion by year-end 1985. 1.7 The growth of public banks had discouraged financial development in different ways. First, several of these banks hindered private sector banking development by lending at subsidized terms. Second, a large proportion of public banks' credit had been channeled to notoriously inefficient public enterprises. Third, despite the weak financial position of public banks caused by mismanagement, strong political pressures, specially from the Provincial governments which relied heavily on financing from public sector banks, made it virtually impossible for the BCRA to deny funding as a last resort. Finally, public sector banks had set an undesirable example of not being subject to review and being partially freed from regulatory restrictions. 1.8 The private banking system was oversized given its large number of branches (about 5,000) and institutions, its relatively low resource base, and its small portfolio size. Between 1950 and 1985, bank employment tripled while real deposits did not exhibit any sustained growth. Thus, deposits per employee declined by about 66%. Inordinate physical expansion, including excessive branching per bank, was encouraged by subsidized central bank credit and controlled interest rates on deposits, which coupled with inflation, provided opportunities for banks to benefit from the inflation tax. Furthermore, bank investors had been attracted to the banking business by the 100% deposit guarantee regime, which provided another opportunity of profiteering from the Government. These conditions encouraged excessive risk taking. 1.9 Since the 1960's, Argentina's financial sector performance had been undermined by macroeconomic and financial sector policies. The financial system's core structural problem was the peculiar BCRA intermediation arrangement that had evolved to channel subsidies and to fund the public sector deficits. In effect, BCRA borrowed funds through the "forced-investment" mechanism from the private commercial banks, and passed these on through "rediscounts" to public sector financial institutions--mainly to BHN, BANADE, and to the provincial banks, which in turn subsidized credit to public and private enterprises. The BCRA was called upon to provide credit to the public banks because the macroeconomic instability had made it impossible for them to raise sufficient funds to finance their activities. This problem was compounded by the inefficiency of the public banks' operations. In the early 1980's this problem was further aggravated because BCRA began to use the same mechanism to provide credit to the Treasury. An  - 4 - oversized banking system, weak capital adequacy rules and lack of prudential regulation and supervision, were strong incentives to corruption and contributed to the declining health of financial institutions. The Bank did not use this loan as a vehicle to address any of the problems affecting the financial sector; these problems were expected to be addressed by a US$400 million Banking Sector Loan under preparation at that time. C. Project Objectives and Description 1.10 A Bank report on strategies toward industrial and export development, dated September 1985, identified the need to assist SMSEs as a major component for an industrial development strategy in Argentina. The appraisal mission was carried out in October 1986. Negotiations were held in Washington from February 24 to March 6, 1987. The loan was approved by the Bank's Board on April 14, 1987 and was signed on December 21, 1987. The loan became effective on April 8, 1988. Subsequently, the loan was cancelled at the request of the Borrower in July 1, 1993. 1.11 The project objectives were to encourage modernization, strengthen productivity, and expand output by SMSEs, with particular emphasis on employment generation and on greater diversification outside of the major urban areas. The project objectives addressed one of the weak links in the development of industrial enterprises in Argentina: the scarcity of medium- and long-term lending to SMSEs. Due to a long history of inflation, financial system lending in Argentina was limited almost exclusively to short- term financing. This project aimed to reactivate commercial banks interest in medium and long-term project financing 1.12 The project was structured as follows: a credit line component of US$123.1 million to finance: (i) fixed assets and related permanent working capital needs of SMSEs (including machinery and equipment and their installation costs; building construction, handling and storage facilities; civil works; quality and pollution control equipment; replacement of obsolete machinery and equipment; investments for improvement of product, quality and design; and acquisition of new technologies); (ii) free standing working capital needs; and (iii) technical services for SMSEs and for the establishment and operations of trading companies related to SMSE activities. A technical assistance component of US$1.9 million to strengthen the organizations providing technical assistance to SMSEs. Specifically, the TA component would: (i) strengthen BANADE's capabilities to provide assistance to SMSEs and to participating banks in the areas of project evaluation and sub-sectoral analysis; (ii) help INTI (the National Institute of Industrial Technology) to implement three types of technical training programs for SMSEs to: build management skills, develop in-plant managerial assistance, and address deficiencies in INTI's own training programs; and (iii) support the creation of a network of Regional Technical Assistance Centers (RTACs) within the Sub-Secretariat for Small and Medium-Scale Enterprises under the Ministry of Industry and Trade.  - 5 - 1.13 A unit called the Fund for Medium and Small Scale Enterprises (FOPYME) was established within BANADE to operate as a second-tier financial intermediary responsible for administering the project. FOPYME was eventually to become the principal public sector institution for financing of SMSEs through BANADE and private commercial banks as direct lenders. FOPYME was also responsible for coordination of a TA program for SMSE development. One of the conditions of loan effectiveness was that BANADE's Board approve FOPYME's Statement of Policies and Operating Regulations as well as the Statement of Policies and Procedures for subproject appraisal and supervision. 1. 14 BANADE was selected to manage the second-tier mechanism because it was the main source of credit for industrial projects in the country. BANADE had been created as an autonomous Government-owned industrial development bank in December 1970, out of the reorganized "Banco Industrial." In addition to its primary development objectives, BANADE also provided commercial banking services, and had become practically the only domestic institution providing long-term lending for industry. Only those PBs that were pre-qualified by FOPYME/BANADE (estimated at 40 plus BANADE itself), in consultation with BCRA--based on creditworthiness analysis made by FOPYME/BANADE--would be able to participate. 1.15 The cost of the investment projects financed under the loan was estimated at appraisal at US$250 million, of which 53% represented foreign exchange costs. The Bank loan of US$125 million was expected to cover 50% of the project costs, with the SMSEs contributing about 25 %, and the remaining portion to be financed with BANADE/FOPYME, BCRA, PB's funds. A summary of the Loan's terms and conditions is provided as an Annex. D. Project Design and Organization 1.16 The most important design features that affected the outcome of the project were the following: Creation of a second-tier mechanism within a main retailer bank opened the possibility of conflict of interests. 1.17 One of the principal design elements of the project was the creation of FOPYME as a specialized wholesale banking unit within BANADE. It was expected that FOPYME would become the development finance vehicle to manage similar future bilateral and multilateral agency lending facilities. It was felt that, if properly managed, FOPYME could perform the credit analysis of financial institutions, supervise financing operations, and provide technical assistance to financial intermediaries and SMSEs, either directly or in conjunction with other local technical institutes. Through an entity such as FOPYME, the external financing agencies would then be able to achieve a more  - 6 - acceptable level of risk diversification, since FOPYME would spread the risks to as many banks as possible. Previously, external agencies that dealt directly with local banks had limited themselves to dealing with a few so-called "top-tier" institutions. 1.18 The Subsidiary Agreement gave loan approval authority to BANADE, which some PBs felt gave BANADE an unfair advantage in processing its own loans. To the extent that BANADE approved its own loans faster than loans from other PBs, SMSEs would be encouraged to seek a loan from BANADE. This perception may have been a deterrent to more active participation by PBs. Also, under the Loan Agreement, PBs were free to make sub-loans up to US$500,000 as long as they followed proper procedures (which were to be supervised by the Bank). However, under the Subsidiary Agreements, free-limit loans above US$300,000 had to be approved by BANADE's Board of Directors, which should not have been necessary. The creation of FOPYME within BANADE created the perception of likely bias and generated distrust from the other participating banks. Oversight of BANADE's problems undermined the loan 1.19 Prior to appraisal, BANADE's financial problems were widely known within the Argentine banking industry, although the magnitude was difficult to measure due to poor accounting and auditing standards and procedures. BANADE's financial problems were associated with inadequate management decisions and policies that were frequently influenced by political considerations. While the appraisal noted BANADE's weak financial situation and performance, it pointed to improvements since 1983. The appraisal did not include detailed information on BANADE's loan portfolio showing the extent of arrears by age or the type of classification assigned to risk assets. The appraisal concluded that BANADE's overall portfolio exposure/quality was relatively acceptable (although it recognized problems associated with the 50 largest corporate borrowers) and that its provisioning policies and level of provisions as of June 30, 1986 were satisfactory. Although one of the conditions of loan effectiveness was that BANADE revise its policy on loan loss provisions, the Bank did not require that loan loss provisions actually be adjusted to conform with the new policy. The lack of adequate credit policies and procedures should have raised concern over BANADE's viability, or possibly have led to the consideration of a restructuring of the institution prior to making the loan. The use of debt/equity ratios to monitor BANADE's financial performance was not effective. 1.20 The financial conditionality applied to BANADE consisted only of a maximum debt to equity ratio. This ratio was highly misleading due to Argentina's accounting practices: assets were not classified by risk, there were no provision standards, and incomes and expenditures we accounted on accrual basis. As a result, it was impossible  - 7 - to quantify BANADE's equity realistically. In addition, the certification of covenant compliance was given by the Office of Comptroller of State Companies (SIGEP); only when the Bank pressed for a special audit did SIGEP produce a qualified report. In principle, the financial conditionality applied to BANADE as a wholesaler bank should have focused more on portfolio quality, such as percent of arrears; on earnings, such as rate of return on assets; on liquidity, such as current assets to current liabilities; and on policies and procedures, such as requiring an update of certain policies and procedures and manuals. Although the debt/equity ratio was inadequate to monitor BANADE's financial performance, failure to comply with this covenant was one of the arguments ultimately used by the Bank to recommend loan cancellation. Loan pricing and interest rate policy discouraged usage of the loan 1.21 According to the Loan Agreement, the rate charged on sub-loans was expressed in terms of a fixed real, or inflation adjusted, rate that was to be applied to an indexed amount of principal, and which included a spread of 3.75 percentage points for the PB. This spread seems to have been determined arbitrarily, and was much lower than average spreads in Argentina. This in turn discouraged bank participation. The spread a bank earns on a loan should compensate for credit risk, administrative costs associated with loan servicing, and the opportunity cost of funds which reflects the degree of liquidity in the financial system. Clearly, the liquidity factor alone would have implied a much higher spread on the sub-loans. In this type of operations, PBs should be allowed to negotiate the spreads directly with the borrower, and the real rate applied to the indexed portion of the loan should also be market determined. 1.22 BANADE was responsible for reviewing interest rates applicable to the subsidiary loans and subloans at least twice a year, and for revising them according to the following criteria: a) that rates should be higher than the prevailing average rate on deposits; or b) that rates charged should cover BANADE's and PB's cost of funds. Both conditions were vague with respect to reference rates. The requirement that rates on subloans were to exceed rates on deposits proved difficult to apply due to the high inflationary environment in Argentina. Since most deposits were short-term, their yields were expressed in terms of a nominal rate. Yet the interest rates specified for the subloans were expressed in terms of a real rate on top of indexation. These two types of rates were not comparable. The reference to the cost of funds rate was not practical in view of the lack of available information on banks' cost of funds, and of PB's reluctance to provide BANADE, a perceived competitor, with sensitive information regarding their cost of funds. 1.23 The subsidiary loans and subloans were denominated in Australes, instead of dollars, because it was felt that the primary source of income for most of the industrial enterprises that would participate in this project was the domestic market. SMSEs that had borrowed dollars in the past had incurred substantial losses as a result of maxi-  - 8 - devaluations. However, not all banks shared this view, which suggests that perhaps more commercial banks should have been consulted during the initial stage of loan design. 1.24 Since the subloans were denominated in Australes, an indexation formula was devised to adjust the principal amount of the loan by inflation. According to the Loan Agreement, this adjustment was to be based on a special price index which combined the consumer and wholesale price indices. This mechanism proved inadequate in dealing with very high inflation rates. Since the price index was published with a delay of about 30 days, the actual adjustment to the loan's principal value was based on the previous month's inflation. During periods of accelerating inflation, this formula benefitted the borrower, but during periods of declining inflation it resulted in an increasing value of the loan in real terms. As shown in Table 6, depending on when the loan was initially contracted, the adjustments produced dramatic differences in the outstanding balances. For example, a US$100 loan disbursed in June 1989, would show an outstanding amount of US$777 by March 1991; whereas the same loan disbursed in December 1990 would show an outstanding amount of US$81 by March 1991. Distortions were also created by drastic changes in the real exchange rate. The adjustment lag resulted in significant prepayments when the inflation rate dropped, since borrowers rushed to prepay in order to avoid the adjustment for the very high inflation in the previous month. One SMSE claimed that it had prepaid a US$250,000 line of credit with US$70,000. This opportunity could have arisen right after a maxi-devaluation, but before the local inflation rate reflected the impact of the devaluation, and thus before the loan's value had been adjusted by the price index. Loan limits and the subloan approval process further hindered PB's participation 1.25 Loan limits for each subproject may have resulted in a funding gap which discouraged the financing of viable projects. The Bank's participation in the financing of each investment project was limited to 50% for the project, within which two sub- limits were established: first, a limit of 40% was to apply to the first US$62.5 million of loan disbursements; and second, a 60% limit on the remaining portion of the loan. The Subsidiary Agreement required PBs to participate with another 10% of the subloan amount, even though this condition was not contained in the Loan Agreement. The subloans were in turn limited to 80% and 60% of the subproject costs respectively for existing and for new SMSE's. In the case of an existing SMSE that would have qualified for a subloan during the latter phase of the loan, the Bank's 60% plus the PB's 10% would have left a gap of as much as 30% of the subloan amount. The loan's financing structure should have been simplified to only one or two types of operations, with a complete accounting of each institution's participation within the total amount of each subloan spelled-out in the Loan Agreement.  -9 E. Project Implementation Hyper-inflation undermined the loan's objectives 1.26 At the time of project appraisal, Argentina was undergoing an economic revival that had begun in August 1985, with the announcement of the Plan Austral. Monthly inflation had been kept at single digit rates, and the economy was in a full blown expansion. Soon after Board approval of the loan, inflation began to accelerate as a result of an overly accommodative monetary policy. During the first half of 1989, commercial banks experienced an acute liquidity crisis as depositors rushed to withdraw their funds from indexed deposits whose value was being eroded through hyper-inflation. By providing emergency liquidity support to commercial banks, the Central Bank prevented a collapse of the financial system and thus safeguarded FOPYME's credit risk exposure to the PBs and BANADE. Private sector borrowers were not as fortunate, and the incidence of bankruptcies was widespread. 1.27 Operating a medium and long-term lending facility is exceedingly difficult in such an adverse economic environment. Typically, financial operations take on a very short time horizon, seven to 30 days, during periods of high inflation. Businesses focus on cash flow management, such as collections, and defer any investment plans until market conditions stabilize. Any assessment of this project needs to recognize the highly unusual macro-economic circumstances, which, when combined with the preexisting problems of BANADE and the lack of experience with medium and long-term lending in Argentina, complicated practically every aspect of this operation. 1.28 While it was difficult to predict at the time of Board approval that the Plan Austral would collapse and thus trigger a hyper-inflationary spiral, when loan effectiveness was declared inflation had already accelerated substantially. Although macro-economic performance was not a condition of effectiveness, the fact that inflation was getting out of hand should have been interpreted as a warning signal for potential credit risk problems and possibly have led to a stay in loan effectiveness. While economic conditions improved dramatically following the successful implementation of the Convertibility Law in 1991, by then it was too late to have prevented the loan's cancellation. If this loan had been made later in 1991 or in 1992, after the Convertibility Law, perhaps the implementation and results would have been different. BANADE's financial crisis triggers loan cancellation 1.29 The economic crisis that unfolded during the initial implementation of the loan worsened BANADE's financial problems, and subsequently led to the loan's early cancellation. (A description of BANADE's financial problems is contained in Annex II). 1.30 Shortly before the loan was declared effective in April 1988, a Bank report had  - 10 - raised serious concerns about the weakness of BANADE's portfolio. The report showed that loans to the 50 largest private borrowers in arrears represented 68% of total loan exposure. In addition, the Government had not complied with its guarantees attached to a sizeable portion of the affected portfolio. The report also pointed out that the loan portfolio was highly skewed towards heavy intermediate-goods industries, such as pulp and paper, petrochemicals and chemicals. The lack of an integral and coherent loan portfolio administration and supervision policy impeded the performance of basic due diligence of asset protection. In view of the deficiencies pointed out by the report, loan effectiveness should have been postponed, or perhaps new understanding should have been reached that would have further limited the ability of BANADE to act as a first-tier lender under the project. 1.31 Immediately after loan effectiveness the Bank began to discuss the need for a restructuring of BANADE to avert further deterioration in its portfolio. Based on the Bank's analysis, BANADE had technically lost its capital, although reliance on BCRA credit had deferred a liquidity crisis. Nevertheless, since the official audit reports from SIGEP did not show the extent of BANADE's equity problem, the Bank was limited in terms of legal remedies to address this problem. Financial statements were found to be misleading specially since loans with substantial payments arrears were still being accounted for as performing assets. A recommendation was made at that time to withhold any new Bank financing to BANADE until a satisfactory restructuring was achieved. As a result of heavy losses incurred during the first half of 1988, BANADE had failed to meet the loan's required debt to equity ratio. At this point, the Bank began to stress the urgency of a thorough restructuring of that institution, while raising the possibility of a freeze on new commitments under the loan. The restructuring options being considered included a major downsizing of BANADE into a wholesale banking operation, with the Government assuming a large portion of the non-performing loan portfolio. Opposition to any major cut in BANADE's 3,100 employee base was strong. 1.32 In October 1988 a Bank supervision mission for the Second Industrial Credit Project (Loan 2063-AR), administered by BANADE, found that only 48% of BANADE's its portfolio could be classified as normal and that BANADE had a serious cash-flow problem. This situation was further aggravated by the Ministry of Finance's decision not to meet its obligations regarding guarantees on loans extended by BANADE to several public and private enterprises which had defaulted. The mission also found that BANADE's long term debt to equity ratio was above the agreed limit under Loan 2063- AR and above one of the three debt/equity covenants under Loan 2793-AR. The mission recommended a prompt restructuring followed by recapitalization of BANADE. Although BANADE's management was lukewarm about the need for restructuring, the Government agreed to present by December 1988 a restructuring plan for BANADE as a condition of effectiveness of the Banking Sector Loan (approved in early 1988), which was eventually cancelled without ever becoming effective.  - 11 - 1.33 A Bank mission visited Argentina in December 1988 to review the restructuring plans of BANADE and another state banks and to carry out a limited supervision of Loan 2793-AR. The mission provided detailed advice for a restructuring to make BANADE a financially sound institution, without recourse to BCRA funding. To achieve this objective the Bank recommended: (i) strengthening the management of the loan portfolio;(ii) refraining from funding in the short-term money market; (iii) downsizing of staff and branch network; (iv) strengthening of lending policies and procedures; and (v) improving management and auditing procedures. 1.34 With the onslaught of hyper-inflation and the resulting financial system crisis during the second quarter of 1989, the Bank began seriously to question the financial viability of BANADE. In June 1989, following the recommendations of the May 1989 supervision mission, the Bank required the re-evaluation of participating banks and the updating of sub-loans already presented for Bank approval to reflect current inflationary conditions. The Bank also requested that BANADE provide audited mid-year financial statements. The decision to suspend disbursements was deferred out of concern over the potentially negative impact of such a freeze on BANADE's frail financial condition. 1.35 After President Menem assumed office in July 1989, a new administration was appointed to BANADE. The new management supported the plan to restructure BANADE as a wholesale bank with limited retail operations. A September 1989 supervision mission visited BANADE to assess the feasibility of continuing loan commitments. The mission made field visits to review a number of subprojects previously presented for Bank approval, which had been re-evaluated, and found them viable. However, the Bank did not approve further disbursements, awaiting the results of the mid-year audit review. 1.36 In October/ November 1989, a Bank mission carried out a review of Argentina's financial sector including public banks. The mission confirmed the seriousness of BANADE's solvency problems, and concluded that a recovery was not feasible. The mission found that BANADE's net worth was probably negative, its management very weak and its restructuring plans inconsistent. With respect to the restructuring plan that had been submitted by the new management, the Bank's analysis cast doubt on BANADE's ability to embark on new lines of activities such as fee-based services. In view of its somber assessment, the Bank concluded that there were only three realistic options for managing Loan 2793-AR: (i) to continue lending through FOPYME, but stop BANADE's first-tier lending; (ii) to transfer FOPYME to BCRA; or (iii) to cancel the loan. In December 1989, the Bank advised BANADE that continuous non-compliance with the financial covenants could lead to suspension. In view of the seriousness of the situation, the Bank initiated internal processing for suspension of disbursements. 1.37 In March 1990, the Government intervened BANADE. An understanding was reached with BANADE's new authorities to defer a decision on suspension of the loan  - 12 - pending BANADE's presentation, no later than June 30 of that year, of audited financial statements confirming compliance with the financial covenants for 1989, and that it was implementing a viable restructuring plan. In May 1990, the Government ordered BANADE's restructuring into a second-tier bank. The bank's interventor hired Price Waterhouse to assess the restructuring plan and to help during the transition period. Important restructuring steps were taken which included the closure of all branches, adoption of voluntary retirement plan and cessation of all commercial banking activities. 1.38 After BANADE submitted the requested audited statements in July 1990, a delegation of its top managers visited the Bank to seek endorsement of its restructuring plan and approval of a number of subprojects that BANADE had processed but which had been frozen since the Bank had stopped approving subprojects in May 1989. The Bank agreed to approve the pending subprojects subject to several safeguards. The Bank made clear, however, that full normalization of the credit line would be subject to proof that BANADE was still a going concern, and that it complied with the Bank's requirements concerning risk management. 1.39 A Bank mission that visited BANADE in March 1991 to review its restructuring plans concluded that more work was needed to substantiate the viability of the bank, and to quantify its capital requirements. It was agreed that BANADE would not submit subprojects for Bank approval or authorization for the time being. The Bank sent a letter to the Government indicating that given the uncertain outcome of the feasibility study for BANADE's reorganization, and the costs to the Government of maintaining the credit line unutilized for a year or more, the authorities should consider cancelling the loan. Soon after, the Bank informed the Borrower that if it failed to request cancellation of the loan, the Bank would consider suspension. The Bank reactivated suspension procedures which were stopped when the Government requested cancellation of US$39.5 million of uncommitted funds. The cancellation was made effective as of November 1, 1991. 1.40 Cancellation of the remaining funds proved a long and arduous process. Following the Government's decision to close BANADE in May 1992, and to transfer BANADE's industrial promotion functions to BNA, the Bank formally requested the committed funds be disbursed or cancelled as soon as possible. In July, at Government's request, the Bank cancelled--retroactive to April 1992--US$17.4 million of undisbursed funds; another US$4.2 million were cancelled in November. By then all uncommitted funds had been cancelled except the balance of US$3.8 million in the Special Account, for which BANADE had legal commitments with sub-borrowers who were paying commitment fees. Between June 1992 and July 1993, the Bank made numerous attempts to get the Government to return the remaining funds in the Special Account and to close the loan. The authorities were advised of the consequences foreseen in Article VI of the General Conditions of not reimbursing these funds. The loan was finally closed in July 1993, following the reimbursement of the remaining funds in the Special Account.  - 13 - Other problems triggered by the rinancial crisis 1.41 During the hyper-inflationary period loan subborrowers encountered serious liquidity problems that were exacerbated by the subloan's indexation formula. Subborrowers demanded dollarization since the adjustment applied to their loan in Australes greatly exceeded the rate of devaluation. A number of subborrowers went to court to demand conversions by suing the PBs, which in turn sued FOPYME and BANADE. However, this issue was not resolved until 1991, when the passage of the Convertibility Law in effect made the option to convert a moot point. At BCRA's proposal, the Subsidiary Agreement was amended in December 1991 to allow conversion of Austral denominated subloans into dollar subloans. Under this new scheme, SMSE's would have the option of either maintaining their loan in Australes (pesos) or converting it into dollars. Response by PBs and SMSEs to the loan was mixed 1.42 PBs interviewed for this report, did not regard the Bank's loan as a profitable operation. In addition to a sizeable negative interest rate spread on the 10% component of the loan, the spread earned on the remaining portion of the loan was not commensurate with what banks would normally charge to cover credit risk and the cost of servicing the loan. However, most of those interviewed concluded that the loss in terms of interest rate margins were compensated by other aspects of the overall relationship with their customers. The problems of credit risk and of an inflexible loan pricing formula were exacerbated by the very high inflationary environment. Eventually, the 10% rule was relaxed allowing PBs to designate their participation as working capital financing which had a shorter repayment period; eventually they were allowed to lend the 10% for a term of less than a year. 1.43 Most of the sub-loans were made to well-established clients of the PBs. Typically, PBs offered this loan as a last resort, and only if the customer requested it. The lack of experience in medium- and long-term financing, coupled with the unattractive terms on this facility, and the high degree of volatility in the economy, contributed to the unenthusiastic reception and promotion of this facility by PBs. In fact, of the 40 commercial bank candidates identified at the time of appraisal, only 13 banks participated. 1.44 Initially, demand for the loan by SMSEs was strong due to the relatively favorable terms with respect to the maturity of the sub-loans. Later on, demand slackened as high inflation discouraged SMSEs from embarking on new investments. PBs became also more cautious in approving loans because in such a volatile environment project evaluations became unpredictable, credit risk difficult to measure, and loan pricing unprofitable. Nevertheless, some demand for loan funds continued even during the height of the hyper-inflation period.  - 14 - Reformulation of Technical Assistance 1.45 Despite a detailed description of the TA needs for this project in the appraisal report, the implementation process was stymied by BANADE's own problems, Government reorganizations of the implementing agencies that resulted in new views on TA needs or lack thereof, and inadequate follow up regarding additional resources that were needed to assure continuation of the programs. 1.46 Of the initially envisaged three TA programs, only the development of the network of RTACs was finally carried out with loan funds under the supervision of the UNDP. INTI did not participate in the project as originally expected, and thus the training seminars were excluded from the final program. Part of the reason for INTI's exodus from the project was that its participation had originally been spearheaded by an official which subsequently left the organization, and his replacement could not come to terms with the Bank. The program to strengthen BANADE's capabilities to assist SMSEs was only partially implemented due to BANADE's financial problems. With its own funds, BANADE created a computer program to do financial evaluations which was made available to the PBs. BANADE's plans to carry out sectoral studies and to update a 1985 study on shadow prices--used in calculating the economic return on investments--did not go ahead. 1.47 The RTACs project consisted of training seminars and development of data bases which would be offered to SMSEs through regional centers. Part of the funds financed the purchase of computers to link each regional center with a central information center. The RTACs program experienced some setbacks when the Government changed the coordinator and staff of the SSME in charge of this program. The Bank temporarily delayed approval of new expenditures for the RTACs project due to unconvincing reformulations of the TA program by the new SSME coordinator. Although the program was eventually completed, its sustainability is doubtful. While the equipment was purchased and the network installed in several RTACs, the SSME did not assign the necessary staff to the centers or allocated additional funds for their maintenance. Eventually, the network was utilized for electronic mail between government agencies in the different facilities. The data base developed to assist SMSEs in obtaining strategic information on market opportunities contains valuable information on government agencies, regulations, contacts, as well as financing availability at commercial banks. However, without adequate maintenance, this information will soon become stale and of limited use to SMSEs. F. Proiect Results 1.48 Despite its many weaknesses and premature cancellation, this loan made some progress towards achieving its objectives in terms of providing credit to SMSEs and developing skills for medium and long- term financing among participating banks.  - 15 - Provided medium and long-term financing for SMSEs 1.49 At a time when medium- and long-term financing was scarce, this loan channeled US$60.4 million (49% of the original credit line component) to support investments in expansion of existing plants or in creation of new ones. These funds were applied to SMSEs which would otherwise have had to rely on limited internally generated funds, or on very expensive and volatile short-term credits. As shown in Table 1, total financing was more or less evenly distributed between small and medium sized enterprises.' About 71% of the loans were made to small scale enterprises accounting for 54% of the total amount disbursed. As expected, the average loan size for medium scale enterprises was slightly more than twice as large as for small scale companies. About two-thirds of the sub-loans were to the central region of the country, which includes the provinces of Buenos Aires and Cordoba, where most of the industrial sector is situated, followed by the northwestern region with 18%. 1.50 This loan helped to finance investments by industrial enterprises with concentration in the following sub-sectors: food and beverages, 27% of the total; chemical products, 19%; and machinery and equipment, 17%. These three industries accounted for 63 % of total disbursements. The remaining portion of the loan was spread out over nine other industrial sub-sectors. 1.51 While the weak link in the project's structuring proved to be BANADE's financial problems, FOPYME, as a self-contained financing unit within BANADE, was able to shield, the execution of the project from the financial difficulties of the host institution. In principle, FOPYME could have continued to operate as an independent second-tier financing agency, or have been transferred to another public sector bank. However, this transfer was not a realistic option given the weak financial situation of public sector banks in Argentina. 1.52 This loan provided PBs with the opportunity to channel medium and long-term credit to their clients at a time when these types of funds were scarce. About 28% of the funds were disbursed through PBs, which is moderately above the minimum of 25 % as per the loan Agreement (See Table 1). PBs role was more important in financing mid-sized enterprises--with about 38% of total financing to that sub-sector--while BANADE was more active in lending to small companies--with 79% of the total. The size distribution between BANADE and the PBs may be due to BANADE's extensive network of branches in small towns and rural areas, which was not the case for PBs. 1. The information on loan disbursements contained in this section is based on information as of 12/31/91. This was the most recent information available from FOPYME at the time of this report. The reported amount of $58.5 million represented 97% of total disbursements.  - 16 - 1.53 The PBs emphasis on mid-sized enterprises could also be explained by their different approach in qualifying applicants. The customer profile of the corporate banking department of commercial banks is typically dominated by mid- and large sized companies. They prefer to deal with a mid-sized companies that have an established track record of performance, for which financial information is more readily available, and which also have greater amplitude for loan collateral. In addition, loans to mid-sized companies are more attractive than to small-scale enterprises because of lower administrative costs relative to the size of the loan. In this regard, a policy of freely determined spreads could have resulted in greater lending to small scale enterprises by the commercial banking sector. 1.54 While no information was available on the quality of the sub-loan portfolio, at the time of the PCR mission, FOPYME reported that no Participating Loans to PBs were in arrears. This would imply that FOPYME performed adequately in its evaluation of PBs, and that financial intermediaries were able to cope in Argentina's highly unstable economic environment. No information was available on the level of arrears on subloans made by BANADE as a first-tier bank. Helped to develop expertise in project financing among commercial banks. 1.55 This loan also helped to develop expertise in medium and long-term project financing in the banking system. To qualify for participation, a commercial bank had to establish a credit evaluation unit within its organization. Commercial banks had to build up their new units including the development of policies and procedures, the training of staff, and the promotion of these new products and services throughout their organization. Some of the PBs seized on their initial investments in these units to further expand their activities through participation in other bilateral and multilateral facilities, such as the Spanish and Italian bilateral programs and the IFC's lines of credit. However, banks begun to consider financing as a viable activity only after the inflationary spiral had been eradicated, and the private sector was willing to consider a longer term investment horizon. G. Project Sustainabilitv 1.56 The sustainability of any financing operation hinges on the design of a viable and effective delivery mechanism to allocate funds in an efficient manner according to project objectives. In the event, BANADE's problems, exacerbated by the effects of hyper- inflation, aborted the operation, which in tum thwarted FOPYME's prospects for becoming an effective wholesale development banking entity (See discussion of BANADE's financial problems in Annex II). There is no information as to the sustainability of industrial operations financed by project subloans.  - 17 - H. Bank Performance 1.57 In the interest of launching this operation expeditiously, the Bank's staff may have overlooked, during preparation and appraisal, some pertinent questions regarding the country's macroeconomic conditions and the implementing agency's performance capabilities. However, when the economic conditions deteriorated, Bank staff worked diligently to protect the Bank's and the Borrower's interests and in pursuing remedial actions to work out the problems confronting BANADE. 1.58 During the time of appraisal, Argentina was experiencing the benefits of the Austral Plan in terms of strong growth and low inflation. The Bank's staff may have been led by good intentions in seizing on an opportunity to support that economic program. However, given Argentina's chronic inflationary problems, the appraisal was overly optimistic about the prospects of a stabilization plan that was just being implemented. With respect to the choice of implementing agency, a number of warning signals were already evident at the time of appraisal such as BANADE's loan portfolio problems, that should have alerted Bank staff to rethink the loan design. Furthermore, the mixed experiences from two previous Bank loans which used BANADE as project administrator should have put in question BANADE's role as implementing agency. Unfortunately, PCRs of the other operations came too late to provide lessons for the design of this loan. 1.59 Loan supervision flagged BANADE's problems almost immediately after loan effectiveness. Successive Bank missions (including missions not directly involved in the supervision of this loan) provided advice to BANADE's management and Government officials on remedial actions to address BANADE's problems. The Bank considered suspension when the economic crisis jeopardized the objectives of the loan. The Bank could suspend disbursements whenever "an extraordinary situation shall have arisen which shall make it improbable that BANADE will be able to perform its obligations under the Project Agreement." Although the macroeconomic crisis was such a situation, it was too cumbersome for the Bank to exercise its rights with this clause during the initial stages of the crisis, when its impact on BANADE was still unclear. At this stage, the Bank was also unable to suspend disbursements based on BANADE's failure to comply with the debt/equity covenant, because SIGEP's audit reports indicated that BANADE was still in compliance. The Bank was able to protect the Borrower's interests initially through a slow down of subloan approvals, and later, through an agreement with the Borrower and BANADE to link subloan approvals to BANADE's successful reorganization. When it became evident that BANADE's restrLcturing efforts were inadequate, the Bank was instrumental in convincing the Government of the need to cancel the loan and to close BANADE, a bank responsible for a large share of Argentina's foreign debt.  - 18 - I. Borrower/Executing Agency Performance 1.60 On the macro-economic front, the Government was unable to maintain a suitable environment for medium- and long-term financing. Eventually, macro-economic performance improved dramatically with the passage of the Convertibility Law and other reforms by the Menem Administration, but it was too late to save the loan. 1.61 BANADE's downfall can be attributed to the inadequate response to its financial problems which became critical as a result of the hyper-inflation. The Borrower's representatives were not always willing to recognize BANADE's problems and take actions to address them. BANADE's management was also unwilling to accept the Bank's assessment of the financial and managerial problems affecting the institution. Only when the Government interventor took over the bank's management, serious measures to solve the problems were adopted. However, attempts at restructuring BANADE were ultimately unsuccessful due to the difficulty of changing that bank's entrenched culture. Eventually, it became evident to the Bank and the Borrower that BANADE had to be closed. However, as discussed in the previous section on implementation, the cancellation of the loan was a complicated process due to the many vested interests in preserving the Bank loan which at the time was the only source of funds for BANADE. 1.62 One of the positive features of this loan was the development of FOPYME as a wholesale development finance unit. Its staff implemented a methodology to qualify PBs despite the lack of prudential banking regulations. Regular reports on financial conditions of these banks produced by FOPYME demonstrated good monitoring performance. A selective review of subloan files showed that documentation procedures were adequate. Some of the PBs expressed positive comments regarding their relationship with FOPYME. A number of PBs complained of inordinate delays in getting BANADE's approval, although part of this problem may have been caused not by FOPYME, but by the Bank's decision to slow down its own approvals during the hyper- inflationary crisis in 1989. The Bank's decision was supposedly communicated to all PBs, so that they could in turn advise their customers and possibly have considered other alternative sources of financing. When the hyper-inflation caused major distortions in the indexing of the subloans, FOPYME pressed for the option to dollarize the subloans, and eventually succeeded in getting Bank approval. 1.63 Despite the good progress made by FOPYME in gaining acceptance as an effective development finance unit, BANADE's crisis inevitably compromised its ability to function adequately. FOPYME's staff had peaked at 15 persons during 1989, before significant staff reductions were made as part of BANADE's restructuring efforts. The cutback in human resources hindered FOPYME's ability to perform normal loan supervision activities. For example, in 1989 the unit developed a questionnaire to supervise loan performance for BANADE and the PBs; however, subsequent staff  - 19 - reductions prevented further work on this initiative. 1.64 Prior to loan cancellation, the Bank staff had considered transferring FOPYME to another entity such as BNA. However, BNA had similar problems as BANADE in that it was also a first-tier bank. At that time, the Bank's agricultural loan was having problems with conflict of interest arising from BNA's dual role as project administrator of the agricultural loan and direct lender. 1.65 The performance of the TA implementing agencies--SSME and INTI--was weak; lack of institutional continuity caused the project's TA component to fail in meeting its objectives. J. Project Relationship 1.66 Relationships between the Borrower and the Bank and between the Executing Agency and the Bank were mixed. Relations between the Bank and BANADE were affected by the Bank's insistence on measures to address the financial problems of that institution. The Bank was in the difficult position of having to pressure the Government to take action to resolve BANADE's problems. Tensions between the Bank and the Borrower may have been caused in part by Government officials who consistently denied the seriousness of BANADE's financial problems. On the other hand, FOPYME staff worked closely with the Bank. K. Project Documentation and Data 1.67 The project appraisal report contained extensive information that proved useful in identifying the Borrower's needs and in structuring the loan. The description of FOPYME's mission statement was appropriate and facilitated the development of this unit. However, the appraisal was somewhat inaccurate in its analysis and conclusions regarding BANADE. In effect, the report assigned a satisfactory rating to that institution despite serious loan portfolio problems. 1.68 The Loan Agreement provide for suspension of disbursements if BANADE failed to comply with the financial covenants or whenever an extraordinary situation shall have arisen which would make it improbable that BANADE would be able to pursue its obligations under the Project Agreement. As explained before, it was cumbersome for the Bank to use the suspension clauses to suspend disbursements during initial stages of the hyper-inflation crisis, when the effects of the crisis on BANADE were still unclear. It would have been useful if the Loan Agreement had a review clause that would have allowed the Bank to stop new commitments when the crisis started, while giving the Bank time to initiate suspension procedures if the situation worsened.  - 20 - 1.69 The auditing arrangements of this loan were not fully satisfactory. As mentioned before, SIGEP the Government auditing agency, was not inclined to sound the alarm about the fact that BANADE's net worth was probably negative. Only when the Bank pressed for a special audit of BANADE's compliance with the financial covenants, did SIGEP produced a qualified report. 1.70 Basic data and statistics on the results of this loan were deficient. Financial data on BANADE was not complete, i.e. external assets and liabilities were not available, summary statistics of loan portfolio performance by aging were also not available. Statistics on investment projects regarding projected employment compared with actual results, sales growth, and rates of return calculations were not available. It was thus not possible to assess the economic impact of this loan. The lack of basic data on the loan, especially statistics, was due in large part to BANADE's institutional problems which resulted in staff cutbacks. However, the Bank could have been more persistent in requesting summary statistics on a regular basis as a means of monitoring sub-loan results and performance.  - 21 - PART III: STATISTICAL INFORMATION 3.1 Related Bank Loans Loan Title Purpose Year of Status Comments Approval Industrial Credit Credit Line 12/76 Closed PPAR 10/91 Project I I Second Industrial Credit Line 04/81 Closed PPAR 10/91 Credit Project 3.2 Proiect Timetable Item Date Planned Date Actual Identification 09/85 Preparation 03/86 Preparation 06/86 Appraisal Mission 10/86 Loan Negotiations 02/87 Board Approval 04/14/87 Loan Signature 12/21/87 Loan Effectiveness 03/22/88 04/08/88 Loan Closing 06/30/94 06/01/93 Loan Completion 01/30/94 06/01/93  - 22 - 3.3 Loan Disbursements Cumulative Estimated and Actual Disbursements (US$ million) FY88 FY89 FY90 FY91 FY92 FY93 FY94 Appraisal Estimate 3.7 25.0 53.7 82.5 103.7 117.5 125.0 Actual 8.0 19.8 37.5 61.1 63.9 63.9 60.8 Actual as % of Estimate 216.0 79.2 69.8 74.1 61.6 54.4 48.6 Date of First Disbursement 05/88 Date of Last Disbursement 11/91 3.4 Project Estimated (Appraisal) Cost (US$ Million) Estimated Local Foreign Total Costs Investment/Credit 114.9 130.0 244.9 TA 3.5 1.6 5.1 Total 118.4 131.6 250.0 3.5 Project Estimated (Appraisal) Financing (US$ Million) Estimated Local Foreign Total Financing Bank 125.0 125.0 BANADE/BCRA/FOPYME 49.3 3.3 52.6 Government/INTI 0.6 0.2 0.8 PBs 9.3 - 9.3 SMIs 59.2 3.1 62.3 Total 118.4 131.6 250.0  - 23 - 3.6 Project Financine Planned and Actual (US$ Million) Source of Financing Planned Allocation Actual Allocation Bank 125.0 60.8 BANADE/BCRA/FOPYME 49.3 )37.4 GOV/INTI 0.6 PBs 9.3 N.A. 3.7 Project Results (US$'s) Lender No. of Loans Amount" Average Subloan Amount BANADE 205 70,232,516 342,598 Other Banks - Cooperatives 20 1,259,700 62,985 - Public Banks 42 6,368,651 151,635 - Private Banks 71 20,342,936 286,520 290,54 Total 338 98,203,803 290,544 1/ Includes: Bank proceeds plus BANADE/BCRA/FOPYME funds, plus PB's funds.  - 24 - 3.8 Status of Covenants Section Description Status of Compliance Loan Agreement 2.02 (b) The Borrower to open and maintain Complied with. a Special Account in dollars in the Central Bank. 2.03 The Closing Date to be June 30, Loan closed June 1, 1993. 1994. 3.01 (c) The Borrower to transfer to INTI, as Part B 2 (i) was not carried grant, the amounts allocated from out. time to time to carry out Part B 2 (i) of the Project. 3.02 (a) The Borrower to transfer loan Amended 1/16/88 to make proceeds to Banco Central under the the terms the same as those same terms and conditions applicable applicable to BANADE. to the Loan. Banco Central to relend loan Complied with. proceeds to BANADE under the following conditions: * loans made and repayable in Australes. * interest applicable on outstanding principal adjusted for inflation on the basis of the Combined Index. * interest rate initially of 7% p.a. on funds to be used by BANADE for purposes of Parts A (1) (ii) and 2 and B (1) of the Project. * interest rate initially of 4% p.a. for purposes of Part A (1) (i) and (3) of the Project.  - 25 - 4.01 (a) Maintenance of separate records and Complied with concerning accounts of SSME and INTI in respect of SSME but not INTI. Part B (2) of the Project 4.01 (b) Furnish to the Bank by April 30 audit Complied with audit of reports on the accounts referred to in 4.01 the Special Account (last (a) including the Special Account. audit for period ending 31/1992). Not complied with audit of SSME. 4.01 (c) Audits of SOEs to be included in annual Not complied with respect audits referred to in 4.01 (b). to SSME. 6.03 Effectiveness Date is: March 22, 1998. Effectiveness declared 04/08/88. Schedule 1 Bank resources to finance 60% of 60% was taken as a expenditures for each subproject up to maximum with many aggregate amount of US$62.5 million and subprojects below 60% 40% of expenditures of each subproject Bank financing. financed thereafter. Working capital subloans not to exceed the Complied with. accumulated amount of US$30.775 million. The Borrower to present evidence that it has Not complied with. entered into a contractual agreement with INTI, and that INTI's Board of Directors has approved plans for its center for research of methods and techniques for SMESs and its Management Advisory Program. Schedule 2 Project consists of two parts: Partially complied with. Only Part A and Part B Part A financing of: (2) (ii) were implemented. * fixed assets and related permanent working capital of SMSEs. * permanent incremental working capital of SMSEs. * technical assistance to SMSEs.  - 26 - Part B financing of: (1) strengthening BANADE's capabilities to provide TA to SMSEs. (2) (i) strengthening INTI's capabilities to assist SMSEs. (2) (ii) strengthen SSME's capabilities to provide technical assistance to SMSEs. Schedule 4 Authorized allocation of US$8.0 million to be Complied with. deposited in the Special Account. Project Agreement 2.01 (a) BANADE to carry out Part A of the Project Complied with respect through FOPYME and Part B (1) through to Part A only. FOPYME and other departments or units. 2.05 (a) BANADE to enter into Participation Complied with. Agreements with Participating banks. 2.8 BANADE to review at least every June 30 Partially complied and December 31 the appropriateness of with. Reviews failed interest rates on Participating Loans and sub- to expose increasing loans; exchange views with the Bank on the problems with pricing results; and revise such interest rates as mechanism. required. 3.01 BANADE to carry out its operations and Not complied with. conduct its affairs in accordance with sound administrative and financial practices. 4. 01 (a) BANADE to maintain procedures and Partially complied separate records and accounts to monitor with. Procedures and progress of Part A and B (1) of the Project. record keeping deteriorated with BANADE's crisis. 4. 01 (b) BANADE to furnish to the Bank by April 30 Partially complied audit reports of its records accounts and with. Last audit of financial statements. financial statements submitted was for year ending 12/1991.  - 27 - 4.01 (c) Audits of SOEs to be included in annual Complied with. Last audits referred to in 4.01 (b). audit of SOEs submitted was for year ending 12/1992. 4.02 (a) BANADE to maintain the following ratios Not complied with. from December 1987 and thereafter: * Consolidated long-term unsecured debt to capital: 8 to 1. * Consolidated unsecured debt to capital: 12 to 1. * Consolidated long-term debt to capital: 20 to 1. Schedule 1 Subloans to be made in Australes and Pricing mechanism principal repayments thereunder to be amended in 12/23/1991 to adjusted for inflation on the basis of the allow for dollar lending. variations of the Combined Index. Schedule 2 Maximum term on subloans: Complied with. * Financing of fixed assets: 10 years with up to 3 years grace. * Working capital: 3 years with up to 6 months grace. * TA subloans: 5 years with up to 1 year grace. Schedule 3 Interests on subloans to be applied to a Pricing mechanism principal amount adjusted for inflation on amended in 12/23/1991. the basis of the Combined Index. An interest rate of 8% p.a. on the adjusted amount for subloans to finance fixed assets and TA, and of 12% p.a. for subloans to finance working capital. Schedule 4 Interest rate spreads between Participating Complied with. Loans and the corresponding subloans to be 3.75 percentage points. Schedule 5 Participating banks to pay BANADE a Complied with. commitment charge not exceeding 1 % p.a. on the principal amount of each Participating Loan not withdrawn.  - 28 - Schedule 6 Subloan limits: Complied with. * Up to 80% of cost of subproject for existing SMSE. * Up to 60% of cost of subproject for new SMSE. * Up to US$2.0 million in respect to investment subloans. * Up to US$1.0 million in respect of working capital subloans. * Up to US$0.2 million in respect of TA subloans. Subloans to an industrial enterprise not to exceed US$2.0 million. The permanent working capital component not to exceed 50% of a subloan. Schedule 9 Free limit subloan: US$500,000 cumulative Complied with. of all subloans to a subborrower. Schedule 10 Last date for presentation of subloan Extended to 12/31/1991. applications: December 31, 1990. 3.9 Use of Bank Resources Staff Inputs Stage of Project Cycle Period (FY) Staff Weeks Through Appraisal 86-87 49.7 Appraisal through Board Approval 87 37.2 Supervision 87-92 61.0 PCR 93-94 6.4 Total 86-94 154.3  - 29 - 3.10 Missions Month/ Number Number Staff Dates of Overall Activity Year of of Weeks Report Project Persons Weeks Status Rating Identification 03/86 4 2 1/2 10 04/86 Pre-appraisal 06/86 4 2 1/2 10 08/86 Appraisal 09/86 4 3 1/2 14 03/87 - Supervision 12/88 1 1 1 01/89 2 Supervision 05/89 1 2 2 06/89 2 Supervision 09/89 3 2 6 10/89 2 Supervision 03/91 2 1 2 04/91 3  - 30 - ANNEX I: SUMMARY OF TERMS AND CONDITIONS OF THE LOAN Loan Amount: US$125 million equivalent. Borrower Republic of Argentina. Term and Rate: Repayable over 15 years with 3 years grace, at the Bank's standard variable rate. Effectiveness: Upon satisfaction of the following conditions: * Signing of Subsidiary Loan Agreement. * that BANADE's Board has established FOPYME. * that FOPYME has approved sub-project appraisal guidelines. * that BANADE has signed Participation Agreement with at least four PBs. * that BANADE has revised policy on loan loss provisions. Allocation: Category 1: US$123.1 million to finance up to 60% of expenditures for each sub-project financed under sub-loans up to US$62.5 million; and 40% of expenditures thereafter, thus the Bank would on average finance 50% of the project costs. Funds to be applied towards the purchase of fixed assets, of permanent incremental working capital (up to a grand total of U$30.775 million), and the financing of technical assistance for SMSEs. Category 2: US$1.9 million to finance technical assistance to: (i) strengthen BANADE's capabilities to provide assistance to SMSEs and to PBs and to carry out sub-sectoral analysis; (ii) help INTI to implement technical training programs for SMSEs and address deficiencies in INTI's own training programs; and (iii) support the creation of a network of Regional Technical Assistance Centers within the Sub- Secretariat for Small and Medium-Scale Enterprises. Special Account: To be opened in the BCRA in dollars, with an authorized amount of US$8.0 million to be replenished based on proper documents in evidence of expenses associated with subloans.  - 31 - Subsidiary Loan: Description: A loan from the Borrower, through BCRA, to BANADE, as project administrator, denominated in Australes [pesos]. Loan to be governed by a Subsidiary Loan Agreement. Term: Same as the Bank loan. Interest Rate: To be applied to the principal amount adjusted for inflation on the basis of the Combined Index (the percentage rate of variations of the combined wholesale and consumer prices as calculated by BCRA). An interest rate of 7% per annum on the adjusted amount for funds used by BANADE to finance permanent working capital requirements as well as the technical assistance component dealing with the strengthening of BANADE's capabilities; and an interest rate of 4% per annum for funds used by BANADE to finance fixed assets and technical assistance directly to SMSEs. These rates to be reviewed semiannually. Participating Loan: Description: A loan made by BANADE to a PB, financed out of the proceeds of the Bank loan, governed by a Participating Agreement between BANADE and the PB. The PB to act as subloan originator and servicing agent, and to assume full commercial risk of the underlying subloan. PBs were to relend at least 25 % of the total Loan amount; BANADE was to relend the remaining portion as a first-tier bank. Conditions: Same as those applicable to the corresponding subloan as explained below. Interest spread: BANADE to charge an interest rate to the PB equal to the rate applicable to the subloan less a spread of 3.75 percentage points to be earned by the PB. The appropriateness of this rate is to be reviewed twice per year. Fee: A commitment charge of 1 % per annum on the un- withdrawn amount of the Participating Loan.  - 32 - Subloan: Description: A loan from a PB to an SMSE denominated in Australes [as of 11/91: Australes, pesos or dollars]. Term: Maximum terms on subloans: _ Financing of fixed assets: 10 years, with up to 3 years grace. - Working Capital sub-loans: 3 years, with up to 6 months grace. Technical Assistance sub-loans: 5 years, with up to 1 year grace. Interest: To be applied to a principal amount adjusted for inflation on the basis of the Combined Index (the percentage rate of variations of the combined wholesale and consumer prices as calculated by BCRA). An interest rate of 8% per annum to be charged on the adjusted amount for subloans to finance fixed assets and technical assistance, and of 12% per annum for subloans to finance working capital. The appropriateness of this rate is to be reviewed twice per year. Fee: A commitment fee of 1 % per annum on the un-withdrawn amount of the subloan. Loan Limits: In terms of type of borrower: U Up to 80% of cost of subproject for existing SMSE. U Up to 60% of cost of subproject for new SMSE. In terms of purpose of the loan: US$2.0 million in respect of an investment subloan. US$1.0 million in respect of a working capital subloan. US$0.2 million in respect of a technical assistance subloan. In terms of accumulated lending to one borrower: Accumulated amount of all subloans to one borrower not to exceed US$2.0 million. In the case of an investment subloan, the working capital component was not to exceed 50% of the sub-loan amount.  - 33 - Free Limits: A loan approval limit for a PB of US$0.5 million cumulative of all subloans to one borrower. Any subloans beyond this limit require prior Bank authorization. Co-Participation: [No conditions were specified in the Agreement, although they were incorporated in the Participation Agreement]. Supervision: BANADE was to maintain procedures, records and accounts to monitor and record progress on each investment project. Documentation: For a free limit subloan the information to be provided by the PB to BANADE, which in turn would submit it to the Bank for final approval, included a summary description of the expenditures proposed to be finance out of the proceeds of the subloan and the terms and conditions of the subloan. For a subloan above the free limit, the information included: (i) a description of the borrower and appraisal of the project; and (ii) proposed terms and conditions of the subloan. Eligibility: To qualify for a subloan an investment enterprise had to be considered a SMSE with primary business activity in the industrial sector. Definitions: Small scale enterprises: fixed assets not exceeding the equivalent of US$350,000, excluding land and buildings; Medium scale enterprises: fixed assets greater than US$350,000, but not exceeding US$3.0 million excluding land and buildings. Conditionalitv: BANADE' s Financials: According to the Project Agreement, BANADE was to maintain the following ratios from December 1987 and thereafter: Consolidated long-term unsecured debt to capital: 8 to 1. Consolidated unsecured debt to capital of 12 to 1. Consolidated long-term debt to capital of 20 to 1.  - 34 - Interest Rates: BANADE was to review interest rates applicable to the Subsidiary Loan and Subloans at least twice a year and revise rates as required by the following criteria: _ Interest rates must: (i) be higher than prevailing average interest rates on deposits--if such deposit rate is, in the opinion of the Bank, conducive to resource mobilization; or (ii) cover BANADE's and PB's cost of funds as measured in a form satisfactory to the Bank.  - 35 - ANNEX II: BANADE'S FINANCIAL CRISIS 1. This section describes the evolution of BANADE's financial performance with special emphasis on the latter period, when the institution experienced a severe financial crisis which eventually led to its liquidation and consequent cancellation of the Bank's loan. Background 2. Banco Nacional de Desarrollo (BANADE) was founded in 1944 as Banco Industrial, to serve as an autonomous Government-owned industrial development bank. The name was subsequently changed to Banco Industrial de la Republica and then to BANADE in 1970. BANADE had been chronically troubled since its establishment, partly because macroeconomic instability made it difficult to secure finance and made its assets excessively risky, but also because management had never succeeded in streamlining and modernizing its operations. In addition, successive governments had used the institution to channel subsidized credit and to rescue failing industrial enterprises. During the mid-1980's it had come to rely on BCRA rediscounts for its funding due to insufficient funding (mostly comprised of external credits) and to a rapidly deteriorating asset portfolio. 3. BANADE's role in resource mobilization had been focused on capturing specific lines of credit mostly from multilateral and bilateral lending agencies, such as the Bank and the Interamerican Development Bank. In this regard, it was the only domestic institution providing medium and long-term financing to the industrial sector. BANADE's local deposit base was negligible representing less than 5% of total financial liabilities. 4. At the time of appraisal, BANADE operated through its headquarters and 33 provincial offices, with about 3,600 employees. Operating in a shrinking financial market during the 1980's, BANADE had managed to somewhat maintain its asset size and the level of its operations. Reflecting the events of the Argentine economy, BANADE's financial structure experienced significant deterioration during the 1980s. Nevertheless, the Bank's appraisal report evaluated BANADE's overall portfolio exposure/quality as relatively acceptable--although it pointed out that the 50 largest borrowers accounted for about 60% of the loan portfolio and these had been principally responsible for BANADE's high loan arrears ratio of 16% of total loans--and concluded that BANADE's loan loss provisions policies and the level of provisions were relatively satisfactory.  - 36 - Origins of the Crisis 5. Indications of BANADE's growing crisis appeared in the financial statements for the first half of 1988. A loss was reported for the first half of that year of US$87.7 million. The real situation was much more serious because the financial reports had been prepared on an accruals basis of accounting, and thus did not adequately represent the actual cash gains and losses of the institution. More importantly, the initial losses reported during the first half of 1988 were only the first signals of a severe portfolio imbalance that had accumulated over many years of inadequate policies. Loan approvals to high risk borrowers had in many instances been instigated directly by the Board of Directors against the recommendations of the bank's staff. BANADE's situation became more precarious during the hyper-inflation period in 1989. 6. BANADE's problems resulted from the low quality of the loan portfolio which resulted in a lack liquidity that was eventually exacerbated by a high degree of economic instability. The key problem areas are outlined below. BANADE: Summar of Key Financial Problems 7. Asset Quality: A large proportion of BANADE's loans were to money losing industrial enterprises that did not have the financial strength to repay their loans. BANADE's loan classification and loan loss provisions policies and procedures were inadequate, obscuring the full extent of the portfolio problems. Liquidity: Large maturity gap caused by increasing reliance on short- term funding. Historically BANADE had been overly dependent on external sources of funding. When availability from these sources diminished, BANADE had to access volatile short-term funds. Also, substantial loan arrears made its assets illiquid. Interest rate risk was intensified by the high inflationary environment and the mismatch between short-term nominal rates on liabilities and indexed real rates on assets. Exchange rate risk was above acceptable levels due to reliance on foreign currency liabilities to finance local currency assets.  - 37 - Management: High degree of institutional inflexibility. Low staff turnover with limited management training and development. Information systems were not up to standards of other banks, although some progress was being made at the time of loan appraisal. Political factors had dictated Board decisions on institutional policies. Earnings: Earnings began to deteriorate in 1988; however, inadequate recognition of asset quality problems had led to overstating of operating income in prior years. Capital: At the time of the financial crisis, BANADE's capital was insufficient to absorb the losses. Its precarious financial condition prevented access to additional capital, although some creative financial transactions were attempted in order to buttress its equity position. 8. Asset Quality. BANADE's poor overall portfolio quality was the principal cause of its financial crisis. Inadequate policies and procedures on loan classification, loan loss provisioning, and loan recovery precluded effective management action to remedy the loan quality problems. One of the principal shortcomings of the credit review process was that only loans to firms in liquidation or under legal procedures were classified as non-performing, while loans in arrears continued to accrue interest, even if the fundamentals of the borrower pointed to an inability to return to normal debt servicing capacity. In April, 1988, BCRA Circular Al 171 established minimum criteria for loan loss provisions. Banks were required to begin provisioning for loans past due 24 months on the basis of 1/12th the value of the loan per month until 100% reserves were achieved. At that time, BANADE decided not to follow these criteria but to rely on their own internal assessment of the quality of each individual loan, even though they could be more than 24 months overdue. 9. According to a previous Bank analysis (October 1988), portfolio quality was affected by: (i) portfolio concentration; (ii) inadequate portfolio recovery planning; and (iii) inadequate portfolio management and control. BANADE's credit to its 50 largest debtors, of which 52 % were in arrears, represented nearly 75 % of its portfolio. Credit relationships between BANADE and its largest debtors were marked by political favoritism which held up the normal process of loan rescheduling and recovery. Those credit problems that originated during previous bank administrations were blamed on the past, but little interest was shown in normalizing or resolving the problem up until BANADE was intervened by the Government. 10. Another major complication arose from the refusal by the Ministry of Finance to comply with its guarantees for loans BANADE had made to private as well as public  - 38 - sector enterprises. After the introduction of the Plan Austral in June 1985, the newly appointed Minister of Finance announced that the Government would no longer cover any claims under previously issued guarantees to BANADE. This meant that whenever a borrower did not meet its debt obligations and the underlying guarantees were uncollectible, BANADE had to resort to BCRA rediscounts, to the extent possible, in order to continue normal servicing of its own liabilities. 11. According to the above mentioned Bank study of BANADE, due to the Government's refusal to comply with its guarantees, non-performing loans could easily have exceeded 50% of the loan portfolio. Yet the financial statements showed that reserves to loans were a minimal 7.77% in 1988 (see ANNEX Table 3). Prudent banking practices would have dictated a minimum reserve ratio of 30% of loans. Clearly, the bank was grossly understating its potential losses from loans. 12. Liquidity. Previous analyses of BANADE's financials refer to chronic cash flow problems arising from asset illiquidity. This problem had its roots in the management of the bank's assets and liabilities resulting in a huge maturity gap. To the extent that loans were reported on an accruals basis, even though they were substantially in arrears, or had been restructured, the validity of the bank's financial statements were highly misleading. The ballooning of loan arrears, combined with the refusal by the Ministry of Finance to make good on the guarantees, resulted in minimal cash flow from assets. On the other hand, the rigid liability base of the bank, mostly foreign loans with very limited domestic deposit capability, greatly reduced BANADE's flexibility. Thus, the only realistic option was to resort to BCRA's rediscount facility to remedy the lack of liquidity. Eventually, accumulated arrears with BCRA contributed to BANADE's financial problems. 13. BANADE's focus on providing medium- and long-term financing resulted in a high level of interest rate risk which commercial banks had traditionally avoided by managing their balance sheets on a purely short-term basis. While a major portion of its liabilities were in the form of medium-term financing from multilateral and bilateral lending agencies, the acute liquidity problems described above led to increasing reliance on short-term funds whose costs were subject to dramatic swings. Another complication arose from the method used in pricing assets and liabilities. For instance, some instruments were indexed, with the principal amount adjusted by inflation, or the variation in the exchange rate, while others were priced at a nominal interest rate which reflected both the inflation and the real interest rate factors. The absence of a clear policy on the management of interest rate risk resulted in significant losses to the bank. 14. Foreign exchange risk contributed to BANADE's losses. However, at the time of this PCR, no information was available on BANADE's net foreign exchange position. BANADE officials have commented that the foreign exchange position had varied from year to year. Thus, the net effect on profitability must have similarly fluctuated.  - 39 - BANADE did maintain a non-interest bearing claim on BCRA of approximately US$579 million in 1988 as a result of foreign exchange guarantee contracts dating back to the early 1980's, and for which BANADE had assumed the liability to the external creditor. 15. Management. BANADE's organization chart followed a classic development bank scheme. In 1989, total staff exceeded 3,000, with little turnover. Salaries were lower than those offered by the private sector, yet the bank offered attractive fringe benefits. Internal procedures were defined extensively in a huge Operations Manual which had not been updated for a long time. BANADE's Board of Directors was ultimately responsible for the management of the bank, although Senior Management had the responsibility for implementing day-to-day decisions, and advising the Board on critical issues affecting the bank. Most analyses of BANADE performed by various supervision missions pointed to organizational rigidities, and to a lack of experience in meeting the changing demands of the marketplace. In effect, BANADE's management was ill-equipped for dealing with the financial weakening of its loan portfolio. This was due in part to an unresponsive organizational structure and to outdated procedures in credit classification and administration. 16. More importantly, BANADE's demise was triggered by Senior Management's failure to anticipate critical problems; and perhaps more critically, by a lack of fiduciary responsibility exhibited by a politically appointed Board of Directors. While a final assessment of BANADE's downfall may never be completed, this report recognizes that the bank counted with many well trained and loyal staff, including mid-level management, that performed their responsibilities in an exemplary manner, and that their well prepared recommendations may have often been ignored by higher level management. 17. Earnings. Historically, BANADE's reported earnings had presented a distorted view of the bank's financial situation. Interest income was accrued on a sizeable portion of the loan portfolio that was in fact non-performing. Insufficient provisioning for loan losses combined with the over-accruing of interest income projected a much more favorable outcome in terms of earnings. Inadequate treatment of "de facto" non- performing loans grossly overstated net interest margins, and under-stated non-interest expenses as a proportion of adjusted income. While the first annual losses were reported in 1990, the bank actually incurred a loss in the previous year that was hidden by the extraordinary gains from a number of debt swaps arranged by BANADE by which clients in arrears repaid their loans with rescheduled external debt papers of the Republic of Argentina (traded at the time at about 6% of their face value). The swaps resulted in an accounting gain, but not an economic gain for the bank. Overall, it is difficult to separate the bank's earnings performance from the underlying problem of asset quality. 18. Capital. According to the reported financial statements, BANADE's debt to equity ratio were in compliance with the Loan Agreement's covenant until 1991. This  - 40 - was an overstatement of BANADE's capital position. Clearly, if the bank had properly recognized the loan quality problems by provisioning a reasonable amount against non- performing loans, the consequent losses would have de-capitalized the institution. Response to the Crisis 19. The hyper-inflationary period during 1989 further debilitated BANADE's finances. Despite efforts to restructure, it was too late to achieve a turn around of the significantly weakened institution. While the financial statements showed a modest profit in 1989, these were due to a one time swap transaction engineered to prevent further hemorrhaging. BANADE's staff had devised a debt swap operation that produced an accounting gain. The swap transactions involved a number of large borrowers that were in substantial arrears, and for which the bank had already significantly reserved for losses. The basic operation consisted of the borrower exchanging Republic of Argentina rescheduled external debt, which it obtained in the secondary market at a very deep discount, plus a certain amount in cash, for its own obligation to BANADE. BANADE treated the transaction as a swap of equal nominal values, with the difference that the new asset it received from the borrower had the guarantee of the Republic of Argentina. To the extent that the original loan had been partially written down, the swap produced a double gain: the higher nominal value of the Republic of Argentina debt paper presented by the borrower plus cash, and the recovery of the loan amount which had already been written down. However, the gains produced by the swap operation were actually accounting gains derived from the assumption that both types of loans would have eventually been paid off. Normally, these swaps should have been recorded at the corresponding market values of the debt instruments--as commercial bank creditors have typically done in reserving against Argentina's external debt. In that case the gains realized from the swaps, if any, would have been much lower. 20. Once the financial media revealed BANADE's problems, a number of borrowers saw this as an opportunity to stop making payments on their loans. They based their actions on the expectation that if BANADE had to be intervened and eventually liquidated, the process of resolving all pending debts would drag on for years. Thus, any borrower in arrears would be at an advantage in negotiating a final settlement during the liquidation phase. 21. The first definitive step towards resolving BANADE's crisis was taken in March 1990, when the Government issued Decree 435 calling for an end to BCRA's rediscount facility for BANADE and named the Ministry of the Economy as the Interventor of the bank. Subsequently, in May of that year, Decree 866 outlined additional steps that would be taken as a result of the intervention. These included the following: * The closure of all branches. * Sale of BANADE's portfolio.  - 41 - * Reorganization of the bank into a wholesale operation. * However, BANADE was still permitted to lend to medium scale industrial enterprises until January 1994. * Government debts to BANADE would be settled with Government Consolidation Bonds. * BANADE was to produce an action plan to implement the reorganization within 60 days. 22. BANADE's attempts at a restructuring were not successful. As a result, the Government issued a new Decree (No. 1504) in August 1992, which called for the merger of BANADE into BNA. BNA was named administrator of BANADE and assigned 180 days to determine the appropriate allocation of BANADE's assets and liabilities in consultation with the Ministry of the Economy. 23. Finally, in May 1993, the Government decreed the dissolution and subsequent liquidation of BANADE and its remaining assets and liabilities.  - 42 - ANNEX II ANNEX TABLE 1 BANADE: STATEMENT OF CONDITION (Thousand of US$'s) 1988 1989 1990 1991 Cash and due from Banks 131,016 34,358 56,385 42,605 Investments in Other Co.'s 68,380 46,806 80,146 95,790 Less: Reserves for Losses 43,773 29,714 57,271 59,532 Government Securities 9,794 16,814 10,729 7,521 Total Net Investments 34,401 33,906 33,604 43,779 Loans: Commercial & Industrial 2,223,519 1,837,470 1,965,045 2,050,946 Plus: Inflation Adj. + Cu 1,358,222 331,274 990,976 938,737 Less: Loan Reserves 401,935 88,071 442,096 774,343 Other Loans 1,532,225 869,134 838,537 833,478 Plus: Inflation Adj. + Cu 211,729 157,054 421,099 525,952 Less: Loan Reserves 12,031 2,146 6,639 29,163 Total Net Loans 4,911,729 3,104,716 3,766,922 3,545,607 Fixed Assets 29,323 14,792 42,321 36,238 Other Assets 14,087 5,924 21,249 38,569 TOTAL ASSETS 5,120,556 3,193,697 3,920,480 3,706,798 Deposits 180,411 24,549 86,789 141,495 Plus: Inflation Adj. + Curr 24,184 16,715 15,091 5,858 Other Financial Liabilities Due to Financial Institution 0 1,741,912 1,938,820 2,025,511 Other 3,772,249 522,710 665,612 591,332 Plus: Inflation Adj. + Curr 788,936 433,859 643,397 697,699 Total Other Financial Liabilities 4,561,185 2,698,481 3,247,829 3,314,543 Other Liabilities 30,774 9,522 125,864 85,259 Stockholders Equity 323,881 444,430 444,908 159,644 TOTAL LIABILITIES 5,120,435 3,193,697 3,920,480 3,706,798 Memo: 516,413 496,031 497,866 Net Position BCRA 812,213  - 43 - ANNEX II ANNEX TABLE 2 BANADE: STATEMENT OF INCOME (Thousands of US$'s) 1988 1989 1990 1991 Interest Income 2,824,244 1,426,153 2,473,818 828,136 Interest Expense 1,929,323 922,494 635,422 269,517 Net Interest Income 894,921 503,659 1,838,396 558,619 Less: Loan Loss Provisions 602,177 251,480 667,659 701,773 Net Interest Income After P 292,745 252,179 1,170,736 (143,155) Non-Interest Income: Commissions 20,556 18,941 50,761 25,803 Other 1,028 590 3,774 1,829 Total Non-Interest Income 21,584 19,531 54,535 27,633 Non-Interest Expenses: Personnel 36,336 14,361 34,096 26,613 Commissions 3,265 872 411 2,161 Other Expenses 24,002 9,560 54,939 16,941 Total Non-Interest Expenses 63,603 24,793 89,446 45,715 Inflation Adjustments (260,459) (291,008) (1,264,228) (111,309) Extraordinary Gains (+)/Losses 29,565 322,066 (78,389) 2,175 NET INCOME 19,831 277,975 (206,792) (270,371)  - 44 - ANNEX II ANNEX TABLE 3 BANADE: SELECTED RATIOS 1988 1989 1990 1991 Return on Assets (%) 0.39 8.70 -5.27 -7.29 Return on Equity (%) 6.12 62.55 -46.48 -169.36 Net Interest Margin (%) 16.17 15.30 42.14 12.43 Non-Interest Exp's/Adj. Income 6.94 4.74 4.73 7.80 Personnel to Tot. Non-Int. Exp 57.13 57.92 38.12 58.22 Reserve to Loans (%) 7.77 2.82 10.64 18.48 Provision to Loans (%) 15.18 8.78 20.70 20.58 Gov. Sec's to Assets (%) 0.19 0.53 0.27 0.20 Deposit/Tot. Financial Liabilities 4.29 1.51 3.04 4.26 Capital to Assets (%) 6.33 13.92 11.35 4.31 * NOTE: Adjusted Income is non-interest income plus net interest before provision.  ANNEX IH: LOAN STATISTICS TABLE 1: LOAN STATISTICS BY BORROWER AND LENDER (US$'s) SMALL SCALE ENTERPRISES MEDIUM SCALE ENTERPRISES TOTAL SMSE LOANS No. of Average No. of Average No. of Average Loans Amount Loan Loans Amount Loan Loans Amount Loan Amount Amount Amount BANADE 158 42,009,612 265,884 47 28,222,904 600,487 205 70,232,516 342,598 Other Banks Cooperatives 18 1,136,702 63,150 2 122,998 61,499 20 1,259,700 62,985 Public Banks 26 2,750,726 105,797 16 3,617,925 226,120 42 6,368,651 151,635 Private Banks 39 7,045,401 180,651 32 13,297,535 415,548 71 20,342,936 286,520 Total Other Banks 83 10,932,829 131,721 50 17,038,458 340,769 133 27,971,287 210,310 TOTAL 241 52,942,441 219,678 97 45,261,362 466,612 338 98,203,803 290,544 PERCENT STRUCTURE BANADE 65.6 79.3 48.5 62.4 60.7 71.5 Other Banks: Cooperatives 7.5 2.1 2.1 0.3 5.9 1.3 Public Banks 10.8 5.2 16.5 8.0 12.4 6.5 Private Banks 16.2 13.3 33.0 29.4 21.0 20.7 Total Other Banks 34.4 20.7 51.5 37.6 39.3 28.5 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 Source: FOPYME's records.  - 46 - TABLE 2: SELECTED LOAN STATISTICS No. Average of % of Amount Total Loan Loans Total Amount Central Region 228 67.5 62,457,208 63.6 273,935 Noa Region 43 12.7 17,762,819 18.1 413,089 Cuyo Region 36 10.7 12,833,585 13.1 356,488 Nea Region 18 5.3 2,817,062 2.9 156,503 Patagonia 13 3.8 2,333,129 2.4 179,471 TOTAL 338 1100.0 98,203,803 100.0 290,544 Source: FOPYME's Records. TABLE 3: SELECTED LOAN STATISTICS No. Average of % of Amount Total Loan Loans Total Amount Fishing 3 0.9 1,100,000 1.1 366,667 Mining 9 2.7 4,366,299 4.4 485,144 Food & Beverages 89 26.3 26,122,130 26.6 293,507 Textiles & Leather Pro 26 7.7 8,104,552 8.3 311,714 Wood & Furniture 12 3.6 1,516,771 1.5 126,398 Paper & Products 19 5.6 4,584,616 4.7 241,296 Mineral Products 55 16.3 18,406,160 18.7 334,657 Basic Metals 14 4.1 5,559,420 5.7 397,101 Machinery & Equipment 9 2.7 3,017,063 3.1 335,229 Electricity, Gas & Steel 61 18.0 16,538,164 16.8 271,117 Construction 12 3.6 5,665,340 5.8 472,112 Other 20 5.9 2,880,744 2.9 144,037 9 2.7 342,544 0.3 38,060 TOTAL 338 100.0 98,203,803 100.0 290,544 Source: FOPYME's Records.