Argentina - Bank Reform Loan

Report No. PIC2442 Project Name Argentina-Bank Reform Loan Region Latin America and the Caribbean Sector Private Commercial Banking Sector Project ID ARPA40904 Borrower The Argentine Republic Implementing Agencies Name: Central Bank of the Argentine Republic; address: Reconquista 266 - 1003 Buenos Aires, Argentina; contact: Mr. Pablo Guidotti; telephone number: (541) 348-3726; fax number: (541) 394-8703 Name: Ministry of Economy; address: HipAlito Yrigoyen 0 - Piso 10 - Oficina 1020; contact: Mr. Daniel Falcon; telephone number: (541) 349-8753; fax number: (541) 349-8800 Date PID Prepared July 10, 1995 Appraisal Date April 1995 Projected Board Date July , 1995 Country Background I. Economic Context. With the adoption of the Convertibility Plan in April 1991, Argentina moved quickly from extreme hyperinflation to low inflation, which dropped to an annual rate of 3.9 percent in 1994, and rapid GDP growth, which averaged 7.7 percent during the last four years. As a result of the economic recovery, poverty levels have declined significantly, although economic restructuring with a rigid labor market has resulted in increased unemployment, about 12 percent of the labor force by late 1994. II. To deal with problems caused by an initially overvalued exchange rate, the Government launched a number of microeconomic reforms, particularly in labor legislation, with the aim of reducing labor costs and increasing productivity. Exports, which were affected by declining international prices in 1992-93, rose by 20 percent in 1994, with manufactured goods exports exhibiting particular buoyancy, growing at an average of 27 percent in 1993-94. Better international prices for grains and improved economic conditions in Brazil contributed to export growth. In 1994, imports grew at the fast pace of 27 percent. Imports of capital goods led the expansion, indicative of the acceleration in investment and the restructuring of the economy. Financing trade and current account deficits was not difficult, given Argentina's improved access to international financial markets during 1993 and 1994. During the first two months of 1995, exports rose by 35 percent, while imports remained approximately at the previous year's level. III. With the increased accumulation of international reserves, and the reduction in bank reserve requirements earlier in 1993, monetary  aggregates expanded at a fast pace. Bank credit also grew at a rapid rate, reflecting the sub-par, but rapidly improving, monetization of the economy. Interest rates on peso deposits declined from percent in December 1992 to 9 percent by early December 1994, just before the Mexico crisis began. Interest rate spreads, although also declining, remained high, indicative of the continued segmentation and shallowness of the financial system. Towards the end of 1994, approximately half of Argentina's financial assets were dollar-denominated, and interest rates and spreads on dollars were much lower than those for peso-denominated assets. The general rise in dollar interest rates that started in early 1994 produced a deceleration in reserve accumulation and credit expansion in the first three quarters of 1994. IV. The Mexico Crisis. Argentina was particularly vulnerable to the events in Mexico due to its relatively heavy reliance on foreign capital inflows (financing in 1994 an estimated current account deficit of 3.6 percent of GDP), the inflexibility of its exchange rate regime, and the need for a strong financial system under the Convertibility Plan. Compared to Mexico, however, Argentina enjoyed several advantages: (a) its current account deficit was less than half that of Mexico; (b) it had stable political and economic leadership; (c) its level of international reserves remained high; (d) public debt maturities were not concentrated in the short-term spectrum of the market; and (e) many of its structural reforms--privatization, governmental reform, domestic market liberalization, and foreign investment--were deeper. Nevertheless, Argentina could not escape the effects of Mexico. Its stock and bond markets suffered precipitous losses, and, given its exchange rate system, the Central Bank lost more than US$5 billion of its reserves between December 1994 and end March 1995. V. The Government reacted forcefully to the crisis. During February and March 1995, it took measures to reestablish a fiscal surplus by cutting expenditures on, inter alia, export subsidies, public sector wages, and social security expenditures, while raising Value-Added Tax (VAT) rates and other taxes and eliminating many tax exemptions. These measures are expected to yield some US$6.3 billion, about 2 percent of GDP, during the remainder of 1995. Swift action by Congress in approving unpalatable emergency measures added to their credibility. The Government expects to maintain strong macroeconomic management under an IMF Extended Fund Facility (EFF) program, which was extended to June 3, 1996, with an increased amount of US$2.4 billion. VI. As the Government announced these measures in mid-March 1995, it also assembled an international financial package of approximately US$11 billion in support of the Convertibility Plan. About US$5.4 billion would come from the IMF, the Inter-American Development Bank (IDB), and the World Bank; with an additional US$800 million from the Eximbank of Japan; over US$2 billion from two large bond issues; and US$2.4 billion is expected from projected asset sales. As a result, by early April 1995 financial markets showed signs of stabilization and recovery, and appear to have become firmer. Not only did the authorities react firmly to the crisis on the eve of presidential elections by suspending insolvent banks, but they have also received strong political support in Congress, where financial reform legislation was approved swiftly and the mechanism for crisis resolution was rapidly put into place. -2 -  VII. The Mexico crisis brought to light important lessons for Argentina. It highlighted the extent of the economy's reliance on volatile capital flows; revealed the need for a strong financial system, given the Central Bank's limited lender of last resort capabilities; reemphasized the need to sustain the credibility of the economic program; and clearly illustrated the difficulties of a fixed exchange system in times of generalized crisis. The Government's forceful and rapid reaction to the crisis has reduced concerns about future domestic policies, but the external environment remains uncertain. Although the initially strong negative reaction of financial markets to the Mexican crisis has been partially abated, a clear reluctance to renew significant flows of capital towards emerging markets remains, particularly flows to Latin America. Moreover, there continues to be a general lack of market discrimination between countries in the region. Even under an optimistic scenario, in which the principal countries affected by the crisis adopt appropriate economic policy measures to reestablish credibility in the eyes of international investors, access to international financial markets may only be slowly reestablished, and capital inflows are likely to remain well below those observed in previous years for quite some time. Financial Sector Background VIII. Structure of the Banking System. Argentina's financial sector consists chiefly of commercial banks. This is a result of Argentina's Law of Financial Entities (LFE) which allows banks to extend a full scope of financial services. Of a total of 203 financial institutions existing in December 1994, 168 were commercial banks which accounted for 98 percent of total financial sector assets. The remaining 35 banks were finance companies or savings institutions that do not offer checking account services. As of April 15, 1995 the number of commercial banks had shrunk to 140, owing to 15 mergers, principally among the cooperative and regional retail banks. The banking system as of that date included three federal public banks (Banco de la NaciAn Argentina (BNA), Banco Hipotecario Nacional (BHN), and Banco de InversiAn y Comercio Exterior (BICE), 29 provincial/municipal banks (three of which have been privatized); 57 national private banks (including the formerly federal Caja Nacional de Ahorro y Seguros, privatized in 1992), 31 foreign private banks, and 20 cooperative banks. Overall, private banks (including cooperatives) accounted for about 55 percent of total assets, and 59 percent of total deposits as of February 1995. The 10 largest private banks, each with assets over US$1 billion, accounted for between 28 and 30 percent, respectively, of total assets, loans and deposits. IX. Resource Mobilization and Interest Rates. Until 1990, financial deepening in Argentina decreased as a result of declining confidence in the domestic currency and other financial assets. Successive episodes of hyperinflation and outright asset confiscations in the early 1980s and later in 1990 discouraged investors and depositors from holding domestic financial assets. Since 1990, the Government has sought to increase mobilization of financial resources and thereby contain the cost of capital to meet the anticipated expansion of demand. Macroeconomic stabilization and growth policies were very successful in increasing resource mobilization, at least until the end of 1994. With -3 -  greater interest rate stability and higher growth, currency and bank deposits increased from an average of 5 percent of GDP in 1990 to 19 percent in 1994. The policies were further successful in increasing corporate equity and bond issues. Corporations, including commercial banks, raised an impressive US$9.9 billion in equity issues and registered US$6.5 billion in bond issues during 1990-1993. Finally, increased resource mobilization reduced lending rates, from 52 percent at the onset of the Convertibility Plan in April 1991 to 23 percent in November 1994. X. Partly generated by memories of past confiscations of deposits, the disruption of Mexico's economy triggered a banking crisis. Loss of confidence led depositors to withdraw a total of about US$8 billion from the banking system, thereby causing a major liquidity crisis. As a result, interest rates increased to levels unprecedented since the onset of the Convertibility Plan, and in March 1995, the banking system was on the brink of a fatal run on deposits. The Central Bank (BCRA), converted into a currency board in 1991, was rigorously constrained in its ability to provide liquidity. Sector Adjustment Program XI. Provision of Liquidity. Faced with the banking crisis, the Government struggled to provide liquidity. This effort included: (i) an initial "club" of five private banks in early January 1995 each contributing about US$50 million to purchase illiquid wholesale bank portfolios; and (ii) a transfer of 2 percent or about US$870 million of the banks' reserves at the Central Bank into a special account with the Banco de la NaciAn Argentina (BNA). BNA, acting as agent for and on instructions from the Central Bank, lent the funds to wholesale and provincial banks at 16 percent p.a. against collateral of bank assets and in some cases personal guarantees of the owners. These funds were quickly exhausted. In February 1995, the Trust Fund for Privatization was established to handle the workout of provincial banks. XII. The Central Bank's capacity to act as a lender of last resort is constrained by the Convertibility Law which requires it to limit its monetary liabilities below its international reserves. As of April 1994, BCRA provided US$1.8 billion in extraordinary liquidity assistance to all banks. (see 1/) Banks met further liquidity needs through lower reserves requirements (about US$1.7 billion) and by exercising their right to borrow a part of their required reserves (about US$1.3 billion), currently set at 32 percent. The Central Bank's charter was amended to allow it to extend the maturity of its liquidity rediscounts, thereby enabling it to lend for terms beyond 60 days and above the previous ceiling of the net worth of a bank. However, under the restriction of the Convertibility Law, BCRA has little capacity at present to provide further liquidity. With available liquidity in the system virtually exhausted, the government established a Bank Capitalization Trust Fund (BCTF) to handle the recapitalization/restructuring of distressed banks. XIII. Deposit Insurance. To help restore confidence, the Government created a limited deposit insurance scheme, effective April 17, 1995. Deposits with maturities of less than 90 days are insured up to -4 -  US$10,000. A further US$10,000 insurance is provided for deposits exceeding 90 days maturity (total insurance on these deposits is US$20,000 minus any claims on deposits below a 90-day maturity). These insured amounts include the first right of claim that deposits of up to US$5,000 have on the reserves of a failing bank. For term deposits, the new insurance applied to new deposits after April 18, 1995. The insurer, a privately financed Deposit Insurance Fund, would cover nearly 100,000 holders of fixed-term accounts, plus a large majority of savings and current accounts, totalling about US$10 billion, or a quarter of deposits. The fund will be financed by contributions from the banks. The fund is likely to reverse the decline in small deposits, but is less likely to encourage the return of institutional deposits. XIV. Bank Regulation. The Government has steadily improved bank regulation and supervision. Prudential regulations of the BCRA cover: (i) capital adequacy and minimum capital requirements; (b) reserve requirements; (c) loan classification and loan-loss provisioning; (d) operations with affiliated companies; (e) consolidation; (f) internal and external auditing; and (g) diversification of credit risk. Minimum capital requirements for commercial banks are subject to risk ratings based on normal CAMEL criteria. Minimum capital requirements were set at 11.5 percent of risk-weighted assets (adjusted by the CAMEL-based risk rating) as of January 1995. These include a minimum of about 8 percent of risk-weighted assets in tier one (equity) capital. Portfolio classification has been changed from a classification system based primarily on guarantees to one reflecting a borrower's financial situation and repayment capacity. Provisioning requirements are determined both by portfolio quality and by the guarantee arrangements. As of December 1994 the sub-normal portfolios in public and private banks were 33 percent and 10.3 percent, respectively. XV. Supervision. Together with the improvement in prudential regulation, enforcement capacity is being strengthened steadily. The Superintendency of Financial Entities (SEF)'s capabilities have been improved during the 1990s under support from the Bank's Public Sector Reform Technical Assistance Loan (Ln. 3362-AR)) and Financial Sector Adjustment Loan (Ln. 3558-AR)), and through technical assistance and training from the Federal Reserve Bank of New York (NYFed) and the US Office of the Comptroller and the Currency (OCC). SEF now has a staff of around 500. The staffing of the Supervision Division was increased as of July 1994 from 160 to approximately 300, organized into six on- site inspection groups specializing in different types of financial institutions The managers of these inspection groups were hired through an executive search from international accounting firms and are being paid competitive salaries. One hundred and ten newly trained bank examiners who were hired out of 2,000 applicants in 1994 replaced 100 retiring examiners. Present policies provide for full on-site inspections every year for the larger and more risky banks and every eighteen months for other banks, monthly off-site inspection reports for all banks, and daily supervision of distressed banks. XVI. Distressed Bank Resolution Procedures. Policies to resolve distressed banks include: (i) early identification of problems, (ii) a set of remedies related closely to the severity of the problem and the degree of cooperation of existing managers/owners, and (iii) - 5-  minimization of court-ordered liquidation which is a time-consuming and costly process. Broadly the process can be divided into two stages. In the first stage, SEF holds the primary responsibility for identifying problems from its routine oversight procedures and resolving them through administrative remedies. In the second stage, in which the problems are more acute, BCRA resolves them through liquidity support; suspension of the operations of a bank; recapitalization, merger, or acquisition; or liquidation of the institution. XVII. Consolidation of the Banking System. It is generally acknowledged that Argentina has an excessive number of banks, with widely different sizes and cost structures. Consolidation of the banking system started before December 1994 and has accelerated considerably since then. The profile of the sector is likely to change. First, the ongoing strain on provincial finances and the poor financial situation of provincial banks will trigger further privatization or closures of these banks. Most wholesale banks with a single branch and limited retail depositor base are likely targets for takeovers. The cooperative banks have several weaknesses: highly regional and poorly diversified portfolios, strong affiliation with specific clientele which weakens their portfolio, high costs, and inadequate capacity to raise capital. These cooperative banks are therefore merging/disappearing quickly and are already down to 20 by end April 1995 from 39 in August 1994. The smaller private banks also lack economies of scale and loyalty of depositors, and face higher cost of attracting deposits. They would be forced to either merge or be acquired. XVIII. If the authorities continue to implement the prudential norms forcefully, the number of Argentine banks in the coming five years may be halved from about 160 at the beginning of 1995. The surviving banks may comprise 30 foreign banks, 5 to 10 cooperative banks, 5 to 10 provincial/federal banks, 5 wholesale banks, a dozen or more first-tier private banks with national branch networks and about 20 second-tier banks with smaller national, or multi-provincial presence. Such consolidation will still leave Argentina with proportionately many more banks than in Mexico, Chile or Brazil, and thus is not likely to reduce competition substantially. The two largest public banks would have control of one third of the market share, and two or more foreign banks would operate with a significant retail franchise. The retrenchment would force the banks to cut costs, rationalize their branch networks and introduce better technology. However, at present only about six of the banks are publicly listed, and progress in terms of greater public shareholding, reduction of family controls and professionalization of top management will take longer. The Proposed Loan XIX. Loan Objectives. The purpose of the loan is to provide balance of payments support to the Argentine Republic in the aftermath of the regional crisis that has abruptly curtailed the country's access to foreign capital. The foreign exchange is needed to help reduce the severity of inevitable import compression now underway in Argentina. The country's dependence on official flows has increased dramatically in 1995, and these sources will account for the bulk of capital inflows. - 6 -  XX. At the same time, the loan will support the Government's ambitious program of bank reform. That program has the following principal objectives: (a) to hasten the process of consolidation of a fragmented private banking sector; (b) to improve the financial structure of a distressed banking sector by encouraging acquisitions, mergers, and restructurings; and (c) to contribute to the restoration of confidence in the banking system. XXI. Loan Description. A fast-disbursing fixed-rate US dollars single currency loan of US$500 million is proposed. The loan would have a repayment period of up to 15 years; and each semester's disbursements would have a maturity of 12 years from the rate fixing date, including 3 years' grace. The loan would disburse in three tranches in accordance with conditions covering macroeconomic and financial sector policies. The Borrower is the Argentine Republic and the implementing agencies are the Ministry of Economy and Public Works and Services and the Central Bank of Argentina. Counterpart funds would be made available to the Bank Capitalization Trust Fund (BCTF). All three tranches would be disbursed in accordance with policy conditions; however, the second and third tranches would also require the achievement of a specified level of US$167 million of eligible Trust Fund recapitalization transactions in accordance with principles agreed between the Government of Argentina and the Bank. XXII. Counterpart funds will be used by the BCTF for recapitalization and debt refinancing of liabilities in order to render a bank receiving BCTF assistance fully able to meet all prudential capital requirements. Financing will be provided in accordance with principles agreed with the Bank for three possible kinds of transactions: (a) acquisitions by qualified banks of weaker or distressed banks or acquisitions of parts of insolvent banks which have undergone BCRA suspension and procedures of article 35 bis of the LFE; (b) mergers among qualified banks where at least the dominant merger partner is rated "3" on the CAMEL rating or its functional equivalent and has the managerial capacity and capital adequacy to undertake the transaction; or (c) a restructuring of a bank, deemed by the SEF to have fully adequate tier one capital, willing to both match any BCTF subordinated loans dollar-for-dollar with new ownership capital, and follow an institutional development plan to improve its management and operations. XXIII. Financing. Potential demand for financing of acquisitions/mergers is difficult to predict. At the peak of the crisis, some 80 private financial institutions (banks, finance companies, and savings and loan associations) with assets valued at US$14 billion were recipients of extraordinary liquidity assistance, and many of these are still candidates for recapitalization, acquisition or merger. The banking sector's potential demand for funds is estimated to be in the range of US$2.0 to 2.5 billion. This includes about US$1.6 - 7 -  billion of refinancing of Central Bank advances as well as US$350 to 870 million to meet identified or potential capital or provisioning shortfalls. For only those banks currently being assisted by the BCRA, total potential demand for financing is more likely to be in the US$1.8 to 2.1 billion range, using conservative estimates. Some of this demand--the tier one equity requirements--could be met by the acquiring banks themselves. Trust Fund resources are authorized to total US$2.5 billion, reflecting the proceeds of domestic and foreign bond that will be in place by July 1995 (the "Argentina bonds" placed among domestic and foreign investors), and the proceeds of the proposed Bank loan of US$500 million. Thus, the Bank would provide a maximum 20 percent of Trust Fund resources. XXIV. Implementation. Loan supervision will follow the principles of the Bank's new supervision strategy, with appropriate use of resources in the field. Loan supervision will take the form of monitoring Argentina's new system of supervision and distress resolution for the private banking system. In addition to an ex-post review of Trust Fund transaction, for purposes of tranche release, annual audit reviews of the Trust Fund's operations are required. Close contact will be maintained with the Federal Reserve Bank of New York, which is providing technical assistance to the Superintendency of Banks in the areas of supervision and prudential regulation. The Bank and the government will retain the option to either redesign or augment the existing Technical Assistance Loan for Capital Markets Development (Loan 3710-AR), should the need for additional technical assistance become necessary. Loan supervision will include review of the policies and operations of the Central Bank as they affect the use of the proceeds of the loan. Detailed reporting requirements have been established to enable the Bank to supervise this project effectively. 1/ Private banks received US$1,165 million of this amount. This is in addition to the BNA safety net lending of US$468 million, which was financed by the more liquid private banks themselves. Contact Point: Public Information Center The World Bank 1818 H Street N.W. Washington D.C. 20433 Telephone No.: (202)458-5454 Fax No.: (202)522-1500 Note: This is information on an evolving Project. Certain components may not necessarily be included in the final project. - 8 -