Peru - Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL, USE ONLY Report No. 16826 IMPLEMENTATION COMPLETION REPORT PERU FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN NO. 3489-PE) June 30, 1997 Public Sector Modernization, Private Sector Development and Energy Division Country Department mI Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (As of March 31, 1996) Currency Unit = Nuevo Sol (S/.) US$1.00= S/. 2 54 GOVERNMENT'S FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ADR = American Depository Receipt AFP = Asociaci6n de Fondos de Pensiones (Private Pension Fund) BCR = Banco Central de Reserva del Pern (Central Reserve Bank of Peru) BN = Banco de la Naci6n BNF = Banco Nacional de Fomento (National Development Bank) COFIDE = Corporacion Financiera de Desarrollo (Development Finance Corporation) COPRI = Comision de Privatizaci6n (Privatization Comission) FSAL = Financial Sector Adjustment Loan FSD = Fondo de Seguro de Dep6sitos (Deposit Insurance Fund) GRADE = Grupo de Analisis Para el Desarrollo IDB = Inter-American Development Bank IMF = International Monetary Fund ONP = Oficina de Normalizaci6n Previsional (Office of Insurance Regulation) SAL = Structural Adjustment Loan SBS = Superintendencia de Bancos y Seguros (Superinitendency of Banks and Insurance) SNP = Sistemiia Nacional de Pensiones (National Pension System) SPP = Sistema Privado de Pensiones (Private Pensioni System) TPRL = Trade Policy Reform Loan UCR = Unidad Central de Riesgos (Central Risk Unit) Vice President: Shahid Javed Burki Director: Paul Isemnan Division Chief: Krishna Challa Task Manager: Geoffrey Shepherd  FOR OFFICIAL USE ONLY Table of Contents Page Preface ..............................................................i Evaluation summary ............................................................. ii Part I: Project Implementation Assessment .............................................................. 1 A. Background ..............................................................1 B. Statement and Evaluation of Objectives .............................................................. 2 Objectives ..............................................................2 Evaluation of Objectives ............................................................. 3 C. Achievement of Objectives ..............................................................8 Macroeconomic Objectives ..............................................................8 External Financing Program .................... ......................................... 9 Reducing State Participation in the Financial Sector ............................................ 10 Improving the Banking Regulatory System ........................................................... 14 Reinforcing Capital Markets ............................................................. 16 The Impact of Program Objectives on Financial Sector Performance ................ 18 D. Major Factors Affecting the Project ................................................ ............. 20 Factors not subject to Government control ............................................................ 20 Factors subject to Government control ............................................................. 20 Factors subject to implementing agency control .................................................... 21 E. Project Sustainability ............................................................. 21 F. Bank Performance ............................................................. 22 G. Borrower Performance ............................................................. 22 H. Assessment of Outcome ............................................................. 23 L Future Operations ............................................................. 23 J. Key Lessons Learned ............................................................. 24 Part II Statistical Annexes ............................................................. 26 Table 1: Summary of Assessments ............................................................. 27 Table 2: Related Bank Loans/Credits ............................................................. 29 Table 3: Project Timetable ............................................................. 30 Table 4: Loan Disbursement: Cumulative Estimated and Actual ............................ 30 Table 5: Key Indicators for Project Implementation: not applicable ....................... 30 Table 6: Key Indicators for Project Operation: not applicable ................................. 30 Table 7: Studies Included in the Project ............................................................. 31 Table 8A: Project Costs ............................................................. 35 Table 8B: Project Financing ............................................................. 35 Table 9: Economic Costs and benefits: not applicable ............................................... 35 Table 10: Status of Legal Covenants ............................................................. 36 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Table 11: Compliance with Operational Manual Statements . . 37 Table 12: Bank Resources: Staff Inputs ................................................. ............ 37 Table 13: Bank Resources: Missions ............................................................. 38 Appendixes. A. Board Paper: Release of the Second Tranche (Waiver of Two Conditions) ....... 39 B. Borrower contribution to the ICR ............................................................. 51 C. Map ............................................................. 65  i IMPLEMENTATION COMPLETION REPORT PERU FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN NO. 3489-PE) PREFACE This is the Implementation Completion Report (ICR) for the Financial Sector Adjustment Loan in Peru. A loan in the amount of US$400 million equivalent was approved on 17 June, 1992 and made effective on 18 March, 1993. The loan was closed on 30 September, 1996, compared with the original closing date of September 30, 1994. The first tranche, released on effectiveness, was filly disbursed on the same day; the loan was fully disbursed with the release of the second tranche on 28 December, 1995, compared with the original date at the end of 1993. The ICR was prepared by Geoffxey Shepherd, Public Sector Modernization and Private Sector Development Division, Country Department Im, Latin America and the Caribbean Region, and Manuel Lasaga, Consultant, and reviewed by Krishna Challa, Chief of the same Division, and Robert Crown, Project Adviser in the same Department. The borrower provided comments that are included as an appendix to the ICR. Preparation of this ICR effectively began during the Bank's second- tranche release mission (November 1995). The memo to the Board on the release of the second tranche (reproduced as Appendix A to this report) provides a comprehensive assessment of the FSAL, reflecting discussions with the Government. The Borrower commented on the draft ICR.  ii IMPLEMENTATION COMPLETION REPORT PERU FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN NO. 3489-PE) EVALUATION SUMMARY Introduction 1. In 1986 the Peruvian Government suspended servicing on debt to the Bank and by 1990 severe mismanagement had led to the collapse of the Peruvian economy. The Financial Sector Adjustment Loan (FSAL) addressed the severe financial repression that had played its part in this collapse. This repression was the result of substantial state ownership of commercial and development banks, widespread interference in financial market mechanisms (interest and exchange-rate distortions, credit rationing, and excessive regulation), and poor banking supervision. As a result financial intermediation was severely damaged and macroeconomic stability undermined. 2. Equally as important to the FSAL were non-financial-sector objectives. The FSAL was part of a package of three adjustment loans disbursed in 1993 as part of the workout of Peru's arrears to the Bank. One of the Bank's first programs under the policy of Additional Support for Workout Programs in Countries with Protracted Arrears, this workout culminated the successful completion of a 1990-92 reform program which involved stabilization, structural adjustment, and implementation of an external financing plan (which also cleared arrears with the rDB and IMF). The second tranche of the FSAL was disbursed in December 1995 with two waivers. 3. This Report only covers the sectoral aspects of the FSAL, the other aspects having been covered by the Project Completion Report for the other two adjustment loans. Project Objectives 4. The FSAL sought a comprehensive financial reform by: reducing state participation in banking (by eliminating the development banks, curtailing activities of Banco de la Nacion, and privatizing state-owned commercial banks); improving the regulation of banks (by re-casting banking regulations and strengthening the banking superintendency); and reinforcing capital markets (by strengthening regulations and introducing a private pensions systems). 5. Generally, the financial-sector objectives were well conceived and deemed to have been substantially achieved: extreme financial repression requires radical reform, and Peru's reform were among the deepest and most rapid in the region. The loan was also successful in supporting macroeconomic stabilization and the external financing program.  iii 6. The main commentary on financial-sector objectives and their implementation comes in respect of the curtailing of Banco de la Nacion's (BN) activities. Because of opposition within the Government (in alliance with BN management), the loan conditions had to be stated in general (rather than specific, quantifiable) terms; they had to be watered down; and eventually a waiver was necessary. Perhaps with the benefit of hindsight, a slower approach, requiring more gradual implementation and greater flexibility, might have been better. In any case, the loan achieved a substantial restructuring of BN which eliminated the threat it had posed to macroeconomic stability and greatly reduced its levels of activity and use of state resources. 7. The second waiver was in respect of the incomplete liquidation of the assets of the development banks: the liquidation process could have been better designed, but in any case the assets had little market value and the slowness of this process was of little importance compared to the project's success in closing down the development banks. in addition, the loan contributed to: the complete privatization of Peru's commercial banks; considerable improvements in banking regulation; an effectively re-born banking superintendency (which has, however, room for continuing to improve its techniques of ensuring the quality of banks' assets); better securities legislation (though capitai markets remain narrow); and the initiation of a private pensions scheme (which may suffer, initially, from insufficient investment opportunities). 8. The forces of competition engendered by the package of FSAL-supported financial reforms have since 1991 helped foster substantial improvements in the depth of financial intermediation and the health of the banking system. The reforms helped Peru to escape most of the effects of the financial crisis in Mexico and the financial pressures in Argentina. Implementation Experience and Results 9. Peru's radical and successful financial reform was the result above all of the Government's extraordinary commitment to financial-sector and macroeconomic reform. A number of effective implementing agencies (the Ministry of Economy & Finance, the privatization commission, and the banking superintendency) made important contributions. The only important problem arose as a result of the conflict within the Government over BN. The Report considers the sustainability of the reforms to be likely, but the Government should continue to seek improvements in the supervision of financial intermediaries. The Report also finds that the Bank was effective in preparing and supervising the project. Summary of Findings, Future Operations, and Key Lessons Learned 10. Overall, the Report rates the outcome of the FSAL as highly satisfactory. The Bank has had a follow-up operation in the form of a Pension Reform Adjustment Loan and is preparing an urban property rights project which could provide better collateral conditions. 11. The experience of the FSAL underlines the importance of borrower commitment and of completing reforms prior to Board presentation. Moreover, macroeconomic stability and economic growth were essential to the success of the reforms. The Report also suggests that for certain reforms, either second-order reforms (like the liquidation of development bank assets) or those requiring restructuring of complex entities (such as BN), greater flexibility in the conditionality would be useful.   IMPLEMENTATION COMPLETION REPORT PERU FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN NO. 3489-PE) PART I: PROJECT IMPLEMENTATION ASSESSMENT A. BACKGROUND I. After a period of growing economic mismanagement (including suspension of debt servicing to the Bank from 1986), Peru's economy had reached a state of collapse in 1990, when a new Administration came to power and began a rapid and far-reaching process of stabilization and structural reforms. The economic program for 1991-92 was intended to consolidate the macroeconomic stabilization measures taken in mid-1990 and early 1991, and to deepen the process of structural reforms then initiated. 2. Financial repression during the previous decade had undermined the solvency of the banking sector, and as a consequence, the state had assumed a predominant role in the intermediation between savings and investment. Inefficiencies in financial intermediation were pervasive. Control over interest rates distorted savings and investment allocation. Foreign exchange controls engendered mistrust of the financial system, and thus led to capital flight. Arbitrary credit allocation regulations exacerbated the loan portfolio problems of commercial banks by requiring that they lend to questionable business ventures. High reserve requirements added to the problem of exceedingly high costs of funds, while abetting the public sector's inflated deficits. Market segmentation of financial intermediation activities contributed to higher costs of operation and to greater risks by not allowing banks to diversify across business lines. These problems were further compounded by the predominant role played by the state, first through highly inefficient development banks which relied on Central Bank credits to fund their operations, and second through Banco de la Naci6n, a state-owned bank which enjoyed a monopoly over all public sector funds, including the exclusive rights to the management of tax collections. 3. The initial steps towards financial sector reform involved the liberalization of interest rates and of the currency market, introduction of money market operations by the Central Bank, and the promulgation of a new banking law. These initiatives, combined with dramatic stabilization measures, triggered a period of turbulence and restructuring within the financial system in 1992. In that year, several financial institutions were intervened and subsequently liquidated, and the loan portfolio of commercial banks deteriorated sharply. 4. The Financial Sector Adjustment Loan (FSAL) was, with a Structural Adjustment Loan (SAL) and a Trade Policy Reform Loan (TPRL), part of a package of loans that was disbursed in 1993, and formed part of the workout of Peru's clearance of arrears. One of the Bank's first programs under the policy of Additional Support for Workout Programs in Countries with  2 Protracted Arrears, the Peruvian workout occurred as a result of a successful completion of several earlier steps: a 1991-92 stabilization program agreed with the IMF (which led to a debt workout similar to and contemporaneous with the Bank's), an external financing plan for 1991-92, which rescheduled Paris Club debts and concluded a debt workout with the IDB; and as mentioned above, a 1991-92 program of structural adjustment, trade policy reform, and financial sector reform. This Report only covers the sectoral aspects of the FSAL, the other aspects having been covered by the Project Completion Report for the TPRL and the SAL'. B. STATEMENT AND EVALUATION OBJECTIVES Objectives 5. The objective of the FSAL, SAL, and TPRL was to support Peru's medium-term program of macroeconomic stabilization and structural reforms and a comprehensive external financing package. The FSAL proceeded to support reforms in the financial sector which were essential for the sustainability of the economic recovery. The program of financial sector reform was organized into three main areas: (i) reducing state participation in the financial sector; (ii) establishing an efficient and credible regulatory system; and (iii) reinforcing and expanding the capital markets. The fulfillment of these objectives was expected to result in greater efficiency, competition, and depth of the financial sector, with the private sector assuming the dominant intermediary role. 6. The loan aimed to achieve these objectives through aggressive actions in the following areas: REDUCING STATE PARTICIPATION IN THE FINANCIAL SECTOR: * substantial curtailment of the activities of four development banks (Banco Agrario, Banco Minero, Banco Industrial, and Banco de la Vivienda); * substantial reductions in the functions and size of the Banco de la Naci6n; * privatization of publicly-owned commercial banks. IMPROVING THE BANKING REGULATORY SYSTEM: * restructuring the Superintendency of Banking and Insurance (SBS); * enhancing banking supervision through more effective guidelines and their enforcement. 'See Project Completion Report: Peru - Trade Policy Reform Loan (Loan 343 7-PE) and Structural Adjustment Loan (Loan 3452-PE), Report No. 14157, March 29, 1995. See also Performance Audit Report - Peru - Trade Policy Reform Loan; Structural Adjustment Loan, June 30, 1995, SecM95-966.  3 REINFORCING AND EXPANDING THE CAPITAL MARKETS: * strengthening the regulatory institutions in the securities market; * expansion of the capital markets, partly through a private pension system. Evaluation of Objectives 7. The design of the program objectives was consistent with the Bank's Country Assistance Strategy, and with the other two concurrent Bank operations. Without financial sector reforms, the stabilization program would not have been sustainable. By 1990, state-owned banks had undermined control over monetary policy. They had created a sizable drain on the government's financial resources and impeded development of the private sector. On the other hand, the then dysfunctional and struggling private banking sector was not in a position to support the growth of investment by private sector enterprises. Market-based reforms were thus necessary to promote private sector-led financial deepening of the economy. 8. Based on the Letter of Development Policy, which formed the basis for the government's compliance with the program as specified in the FSAL, 12 macroeconomic policy conditions of formed part of the general macroeconomic framework supported by the three loans. With respect to the financial sector measures, 27 loan signing conditions were established, followed by 28 for second tranche release. In contrast, both the SAL and the TPRL were structured as a single tranche operation, with total disbursement upon effectiveness. The decision to structure the FSAL as a two-tranche operation allowed the Bank to include certain critical objectives that required more time for their achievement. Experience with sectoral lending has demonstrated that reform of the financial sector is a much slower process than the implementation of macroeconomic stabilization objectives. At the same time, financial sector reforms can be de-stabilizing for intermediaries, and because of their central role in the allocation of resources between savings and investment, this could have potentially disruptive consequences for the economy as a whole. 9. In the design of objectives, perhaps more attention might have been placed on the fiscal consequences of all the financial sector reforms, specially those dealing with the closure of state participation in the banking system, and the development of the private pension system. Clearly, the exit of the government from the banking business gave rise to substantial savings from chronic losses by development banks, and from inefficient utilization of resources by Banco de la Naci6n, and in the case of pensions, from mounting imbalances between contributions and net pay-outs; nevertheless, there were substantial up-front costs associated with the government's disengagement, in terms of the accumulated losses from the state-owned banks, and of the transfer of pensioners from public to private sector pension programs, that may have contributed to excessive increases in public sector debt. Even though the net benefits would have in the long- term been very beneficial, more planning might have been helpful in determining the short- to medium-term cash-flow consequences of these actions for the government's then severely constrained cash budget. 10. The objective of reducing state participation in the financial sector was critical for the success of the reform program in preparing the groundwork for greater private sector participation. With respect to the development banks, the initial thinking had been to merge  4 them into a new development bank to be called Banco Nacional de Fomento (BNF). After consultation with the Bank, the government decided instead to close the development banks' operations and to transfer any viable operational units to COFIDE, an existing development bank, and then to focus on restructuring COFIDE by shedding all its first-tier activities, and thus to transform it into an Apex type development finance intermediary, which would on-lend external lines of credit from multilateral and bilateral agencies through local banks. 11. One of the effects of the liquidation of the development banks, in particular Banco Agrario, was a reduction in credit availability to the rural sector. But the adverse impact was limited. According to GRADE (Grupo de Analisis Para el Desarrollo) estimates, about 10 percent of small producers received credit from the banking system, 40 percent relied on family support or cost cutting measures, and 50 percent depended on money lenders. These figures indicate that despite its commitment to small producers, Banco Agrario was not succeeding in reaching its target market. At the same time, commercial banks have not been active in lending to the agricultural sector, except for very few well-known clients who would typically have no problem in obtaining unsecured lines of credit. 12. Lack of financing to the rural sector can also be traced to the high risk and low level of productivity associated with small scale producers, security problems in remote areas of the country and a lack of progress in land titling and registration. Thus, the financial problems of the rural sector went beyond the availability of development bank lending. The Bank's adjustment lending supported a longer-term solution of lending by commercial banks on the basis of security provided by land titles. The FSAL also supported a government program to allocate about US$100 million in financial support for small farmers in remote areas. Notwithstanding the merits of this compensatory measure, perhaps the Bank might have considered a technical assistance component to perform an in-depth analysis of the problems of credit availability to the rural sector and to design new financing vehicles. 13. Perhaps one of the most challenging objectives of the loan was the substantial reduction in the functions and size of the Banco de la Naci6n (BN). Like the four development banks, BM was also a threat to macroeconomic stability, but a lesser one. At the same time, BN was in effect a fiscal problem: it made substantial losses as a result of the poor quality of its portfolio, the failure to service that portfolio, and the high co of its operations, These losses were masked by the high fees charged on government transactions. Any attempt to reduce BN's role was complicated by the fact that it had important responsibilities as financial agent for the government, even though these functions could well have been performed by commercial banks (but perhaps not prior to 1990 when the banking system had experienced severe problems). The Banks thus faced an unusual challenge in attempting to reduce the size of BN, yet not being able to prove that BN was "losing money." 14. The then-Minister of Finance was set on shutting BN down and hoped to use the FSAL to help achieve this. But the Vice-Ministry of Finance, which was represented through key personnel on BN's Board and was responsible for using BN as the government's financial agent, was intent on continuing BN's activities with a minimum of substantial changes. Thus, the political consensus was lacking, within the Government, to make the closure of BN a formal objective. The FSAL's approach therefore to focus on the monopoly position of BN and the need to foster greater competition within the financial system. In this regard, the FSAL's objective was well placed, but it was not fully met. It might have been met through a more flexible approach,  5 without compromising the critical aspects of the program. In fact, by the time of second tranche release, the objective had already been watered down from its specification at the time of loan signing, and the new version still eventually required a waiver. 15. The problems with the design of the Banco de la Naci6n reform objectives can be attributed to: (i) an underestimation of BN's ability to resist any efforts to downsize its operations, (ii) unrealistic expectations that the application of drastic measures could work in the case of a large and complex ongoing organization; (iii) the pitfalls of applying imprecise and evolving conditionality when consensus has not been achieved. The sense of urgency regarding Peru's clearance of arrears at the time that the FSAL was being structured, may also have contributed to staff decisions to accept an incompletely specified condition with the hope that any disagreements would have been resolved by second tranche. 16. The technical diagnostic analysis of BN, performed by Bank staff and consultants during loan appraisal, was highly satisfactory. In fact, an extensive consultant's report prepared for the Bank made the following critical recommendations: "BN is a bank with one principal client, the Government, who is also the owner. This client is both a recipient of credit and the main source of funding, through tax collection and public enterprise deposits... Today it is an institution with a heterogeneous range of activities lacking any true corporate culture [and operationally inefficient].. .We recommend that the formal liquidation of BN takes place once the activities of the bank have been reduced to a minimum.. .Furthermore, leaving liquidation to the end of the 14 month [downsizing] process allows political flexibility, and the Government may consider the option of maintaining BN as a much reduced institution and the only state owned bank ... [However] the winding up of BN will create a range of legislative, political, operative, labor and financial problems."2 17. From an economic perspective, the diagnosis appropriately concluded that it was in the best interest of the financial system to disengage BN from all of its banking activities. Because of its extensive size, BN was interfering with the development of private banking activities. However, there were strong interests in favor of its continuation. While the Finance Minister strongly supported drastic actions to terminate BN's banking monopoly, BN's management and the Vice Ministry of Finance strongly opposed this line of action. In effect, Bank staff was caught in the cross-fire. 18. As stated in the Letter of Development Policy, the BN objective was to: (i) Remove the BN monopoly over government and public enterprise deposits; and (ii) Develop a plan, satisfactory to the Bank, to transfer all BN operations (including assets and liabilities), mostly to commercial banks, and to reduce staff and close branches. 2 From Executive Summary of "Peru: Banco de la Naci6n" prepared by DFC corporation, March 1992.  6 After Board approval, but prior to Loan signing, the Bank agreed to the Government's request for a change to these objectives. This in effect called for the issuance of a decree to abolish the monopoly of BN, and another decree to establish a high level commission which would then prepare an action plan for the total and final restructuring of BN. At the same time, the second tranche condition was modified, calling for full implementation of the restructuring plan during the life of the project. In retrospect, acceptance by the Bank of this revised condition may have further compounded the problem with the design of the BN objective. The Loan Committee's recommendation that Bank projects should not rush into measures that affect the financial markets was critically applicable in the case of BN. The Bank should perhaps have been more wary of expecting full implementation of BNs complex restructuring and downsizing plan in time for second tranche release, in view of the strong political opposition as evidenced by the need to modify the original program conditions. 19. The fluid and imprecise nature of the BN objective was not only attributed to political opposition, it was also caused by the complex nature of the financial enterprise. Usually, macroeconomic policy objectives can be attained through drastic actions, such as full liberalization of a currency market, freeing up of interest rates, sharp reductions in the public sector budget deficit, and across-the-board narrowing of trade tariffs. However, micro-economic objectives dealing with the restructuring of complex enterprises may require more extensive organizational analysis, and a gradual implementation of restructuring plans. The decision to close down the development banks, specially after their loss of funding from the Central Bank had made them technically insolvent, received widespread support within the government. On the other hand, the objective of restructuring a complex organization such as BN, which was considered a major player in the financial market, should have been designed with a flexible timetable for its implementation. 20. The design of the privatization objective was facilitated by the government's 3trong commitment to reorienting the economy from heavy state intervention to reliance on market forces. From the start, a single committee was appointed to coordinate the sale of the state-owned banks. At appraisal, several key issues, including the handling of non-performing loans and the use of debt-equity conversions as partial payment for the banks were given special attention. Bank staff identified several risk factors which called for careful planning of the privatization process: (i) the ability to attract investors; (ii) insufficient public acceptance of the process; and (iii) lack of liquidity in the economy. Despite the extensive design work for this objective, the government had apparently announced its own decision to start with the sale of Banco Popular del Peru. Because of the poor financial condition of this bank, the decision by the government to start with the bank in effect heightened the risk that there would be insufficient investor interest, and as Bank staff noted at that time, such a negative response could in turn have compromised the subsequent sale of other banks. 21. The reinforcement of the banking regulatory system was an important objective. This objective focused on two areas: (i) the restructuring of the principal regulator, the Superintendency of Banks and Insurance (SBS); and (ii) reinforcement of supervision through more effective guidelines. At the time of appraisal, SBS had too many administrative positions, but was chronically understaffed in terms of analysts and field examiners. The staff was also in need of additional training in new evaluation techniques such as the CAMEL rating system. In addition, the decision to establish a deposit insurance scheme appropriately addressed the need to reinstate the confidence of small depositors in the banking system.  7 22. The objectives dealing with reinforcement and expansion of the capital markets were aimed at improving market efficiency through continued support of market-determined interest rates and the expansion of the capital markets. Within the capital markets, the FSAL emphasized the development of the pension system. One of the components of the program also dealt with the implementation of a Securities and Exchange Law that had been passed in 1991. Several aspects of that legislation needed to be strengthened, for instance, improving the quality of financial and other information requirements, and reducing the discretionary powers of the securities regulators. In terms of sequencing of reforms, it made sense to have the FSAL focus more attention on the other aspects of the program such as reducing state participation in the financial sector, and in strengthening banking supervision, than in building up investment banking activities. In order to operate efficiently, capital markets must first be supported by a well functioning banking system with an active money market, and only after a stable macroeconomic environment has been firmly established. 23. The design of the pension system objective might have underestimated the technical complications of issuing recognition bonds for all transferees. As is typical of social security administrations in emerging markets, Peru had a dearth of information with respect to registrants and their lifetime contributions. Before the so-called recognition bonds could be issued, the government had to devise a system to calculate the current value of an individual's lifetime contribution. Since there were no reliable records on cumulative contributions by individuals, a standardized formula was devised, based on the last two years of reported income. After determining the amount of contribution to be recognized, the social security agency (Oficina de Normalizaci6n Previsional--ONP) was supposed to issue the recognition bonds, in the form of contingent liabilities, which then committed the government to that liability at the time of the beneficiary's retirement or death. Once again, a more flexible approach might have been considered, rather than having to issue all the recognition bonds, the objective could have been framed in the context of having issued bonds within a pre-specified time period from the date when the requests were made, but allowing for an extra delay during the initial period when ONP was bound to be flooded with requests. As the actual results demonstrated, the transfers have, however, been processed efficiently. 24. While it was not possible to solve all the problems of the capital markets in one program, perhaps some mention should have been made in the appraisal concerning the need to ensure that with the growth in the supply of long-term investment funds by AFPs, generated by a large influx of clients, a counter balancing growth of investment opportunities would need to be forthcoming, such as new public offerings of debt and equity. Otherwise, the AFPs would find themselves too liquid, but short on investment income. 25. Complementarity with parallel IDB Financial Sector Loan. Concurrent with the Bank loan, the Inter-American Development Bank (IDB) arranged a financial sector adjustment loan, which was approved by their Board on March 18, 1992. The structure of the FSAL and the IDB loan were very similar, with the exception that the latter contained three tranches. There was a commonality of interest with respect to the objectives of privatizing the government-owned banks, restructuring BN, and reinforcing banking regulations and supervision. However, the IDB loan did not include a capital markets component. The IDB loan was fully disbursed on March 31, 1994, without the need for waivers.  8 26. The objectives of the IDB were very similar to those of the FSAL, except that they called mostly for the implementation of action plans. The privatization objective consisted of implementing an action plan and finalizing the sale of Banco Popular, Hipotecario, and Continental. The development banks objective called for the implementation of the corresponding phase of an action plan on the restructuring of the banks and to evaluate several options for their merger. With respect to the BN objective, the IDB program involved making satisfactory progress on a restructuring plan. In this regard, the approach was more flexible. Even though the IDB program was more flexible in scope, its inability to reach agreement with the government on certain aspects of the program led to its reliance on Bank enforcement of these conditions, and this allowed the IDB to move ahead with disbursements. C. ACHIEVEMENT OF OBJECTIVES3 27. The program supported by the FSAL has had a very favorable impact on the performance of the financial sector. The underlying macroeconomic framework has continued to support the sustainability of these reforms. In fact, the Mexican crisis in December 1994, and subsequent concerns regarding systemic risk of the Argentinean banking system, had only minor spill-over effects on Peru's financial sector, and mostly through temporary short-term capital outflows. This positive response is a reflection of the strength and the high degree of market confidence in the Peruvian financial system. The equally strong successes of the three adjustment loans in achieving the macroeconomic and external financing objectives contributed to the FSAL's own substantial achievement of objectives. Overall, the government has been solidly committed to this program. Macroeconomic Objectives 28. Fiscal and monetary discipline together with structural reforms, greater public order, and targeted programs to alleviate the condition of the poor had remarkable results from 1990 to 1996: the economy improved noticeably (See Table 1), terrorism was nearly defeated, and the percentage of families below the poverty line decreased by 10 percent. There was a steady decline in inflation and unbroken fiscal discipline, and Peru moved from virtual international isolation to become one of the most attractive emerging markets in the region. Higher confidence resulted in a large inflow of capital, which boosted aggregate demand and economic growth. Productivity increased steadily and so did per capita income and consumption levels, specially in remote regions. 3This section draws on information contained in Release of the Second Tranche (Waiver of Two Conditions), December 15, 1995 (reproduced as Appendix A of this Report), and the President's Report for the Pension Reform Adjustment Loan, November 25, 1996. ,,  9 Table 1: Impact of the Macroeconomic Reform Program 1986-90 1991416 Indicatos Avg 1993 1994 1995 1996 Avg 1991-96 1986- ODP (real growth) -1.2% 6.4% 13.1% 7.0% 2.8% 5.0% Poverty Head Count1' Inflation Rate (year avg) 823.B% 48.6% 23.7% 11.1% 11.6% 65.0% Deposit Interest Rates (year avg.) 21 836.6% 44.1% 22.3% 16.0% 15.4% 47.2% Tax Collection (% ofGDP) 9.1% 9.3% 10.5% 11.5% 12.4% 10.4% NFPS* Overall Balance (% of GDP) -7.8% -2.6% 3.6% -2.6% -0.3% -1.1% Extemal Sector: Current Accournt Balance (% of GDP) -4.4% -5.2% -5.1% -7.2% -5.8% -5.1% DFI ** and short-term Private Capital (% of GDP) -0.7% 2.1% 6.4% 4.4% 5.4% 3.5% international Liquidity (mths of imports) 3.7 6.4 10.4 8.8 7.0 7.4 External Debt Ratio (debt to exports) 490 460 399 402 375 437 *: NFPS - non-financial public sector *: DFI - direct foreign investment 1/ The information available shows a decline from 55 pecent to 49 peracent between 1991 and 1994. 2/ Information for 1986 and 1987 is not available; average shown for the period 1988-90. 29. The rate of inflation fell steadily since 1990 as a result of stringent fiscal and monetary measures. The elimination of credit from the Central Bank to the development banks drastically reduced the rate of monetary expansion and inflation thus plummeted from **** percent in 1990, to *** percent in 1996. Monetary expansion during this period has resulted primarily from purchases of foreign exchange. However, the Central Bank has applied open market operations to absorb any excess increase in the money supply resulting from its accumulation of foreign currency assets. 30. Fiscal policy has been tight, maintaining public sector spending in line with tax collection, and financing the deficit entirely through external credits. Even though public sector spending was drastically reduced at the beginning of the stabilization program, most of the savings were brought about through the elimination of credit subsidies, the reduction of state participation in the financial system, and cuts in the deficit of state-owned enterprises, in other words, a reduction in government transfer payments, and not cutbacks in essential public services, which would have had negative social consequences. External Financing Program 31. The government has taken decisive steps towards reintegrating Peru in the international financial market. Peru cleared its arrears with the IDB in 1991, and with the IMF and the World Bank in 1993, rescheduled its obligations with the Paris Club in 1991, 1993 and 1996, and in 1997 closed a debt and debt service reduction agreement with its commercial bank creditors affecting about US$7.9 billion of medium-term obligations. 32. While Peru's formal reintegration into the international capital market has taken several years, firm steps to reform the economy had an immediate impact on international capital flows,  10 and Peru thus moved from being a net exporter of capital to a net recipient of significant capital inflows, both long- and short-term. Short-term capital inflows (including errors and omissions) during 1991-95 were over US$5.7 billion, while medium- to long-term flows amounted to US$6.7 billion. The high level of capital inflows boosted aggregate demand, and thus the economic recovery. 33. Short-term capital, whether in the form of risk capital from overseas investors, or in the form of repatriation of offshore deposits by local residents, has in large part been drawn by attractive interest rates on local currency and dollar denominated deposits, as well as by working capital needs of expanding businesses. Medium- to long-term inflows have been dominated by foreign investors acquiring Peruvian companies through the privatization process. Both of these components were substantially greater than anticipated at the time of loan appraisal, and indicate the exceptional success of the program in achieving its objectives. 34. Notwithstanding the strong multiplier effects on income and employment from capital inflows, there are still some concerns about: (i) their sustainability; (ii) the economy's vulnerability to short-term inflows; and (iii) the persistently high financing requirements as measured by the current account deficit. A large part of the inflows has gone into investments to increase output, and to improve productivity, including the introduction of new technologies by foreign investors. These capital inflows have made a positive contribution to sustainable economic growth. However, with almost half of all capital inflows consisting of short-term funds, Peru is vulnerable to a sudden outflow of capital, which could trigger a crisis as in the case of the Mexican financial crisis in December 1994. The risk is greater the greater the proportion of short-term capital used to finance medium- to long-term investments, which are not easily liquidated in order to pay off investors. As a hedge against this threat, the Central Bank established a very high reserve requirement rate on dollar deposits in the banking system of 50 percent. Unfortunately, this reserve requirement applies only to deposits, and not to loans; thus banks have learned their way around these limitations by booking their customers' deposits in offshore banks and then borrowing against those deposits without incurring the reserve requirement obligations. In the medium-term, Peiu still faces the challenge of narrowing its current account deficit to a level commensurate with a manageable level of medium- to long-term capital inflows. Reducing State Participation in the Financial Sector 35. Progress towards the objective of reducing state participation in the financial sector is considered substantial. 36. Development Banks. Cessation of the operations of the development banks was the crucial objective. Through their dependency on Central Bank lines of credit to fund their lending activities, the development banks had interfered with the implementation of monetary policy, and had contributed to a miss-allocation of resources. Once their lifeline support from the Central Bank was cut off in 1990, they became technically insolvent, and if allowed to operate in those conditions would have been a serious drain on public sector resources. The achievement of this objective is thus considered substantial. 37. The assignment of development lending responsibilities to COFIDE was accomplished according to the program objectives. The Bank and the Government agreed that COFIDE would be Peru's only second-tier development bank. Most of its business is to capture wholesale funds  14 from multilateral agencies and then to on-lend those resources through the private banks.4 As specified in the agreement, following the sale to the government of its outstanding first-tier portfolio in early 1995, COFIDE terminated its first-tier operations. 38. Just as the closure of the development banks complied fully with program objectives, the other part of the objective, to complete the transfer of financial assets and liabilities of the banks to private financial intermediaries was only partially effective, and thus required the issuance of a waiver for second tranche release. The liquidation process was very slow; and is, at the time of this report, not yet completed. A Liquidating Comrnission responsible for the transfer of financial assets achieved little in three years of operation. For instance, at the end of 1996, only 21 percent of the loan portfolio had been recovered either through government cancellation of the debts, actual collections, sale of collateral, or netting with other liabilities. If the cancellation of debts is excluded, which mostly affected loans to small farmers by Banco Agrario, then the percentage of recoveries from 1992 to 1995 would have been a very modest 11 percent of total loans. The sale of fixed assets was also very disappointing. 39. The government adopted a new approach in mid-1 995, when it transferred all the assets to government ownership, under the responsibility of an Administrating Commission in the Ministry of Economy and Finance. This Commission established that the assets of the development banks had a marginal market value. Nevertheless, progress on their liquidation continued to be slow. A waiver for this condition was deemed appropriate in view of the relatively low value at stake in terms of the liquidation, and more importantly, after considering that the critical objective of eliminating the lending activities of the development banks had been accomplished. 40. Perhaps the Bank was somewhat optimistic from the beginning in accepting that the full liquidation of the development banks could be achieved before the loan's closing date. It is not unusual for the liquidation of a commercial bank to take three or more years to complete, unless the interventor can find another bank willing to purchase the whole operation. In the case of the four development banks, the very poor quality of their assets should have called for a much longer liquidation period, or a more aggressive approach to writing off assets. In the end, the government has had to recognize a substantial loss. The trade off in this case was to take a bigger loss up front, and thus avoid the cost of a drawn out collection process. Another option would have been for the government to have hired collection agencies, or other firms specialized in loan workouts and recoveries, and compensated them on the basis of a percentage of recoveries. 41. Banco de la Nacion. Achievement of the Banco de la Naci6n (BN) objective is considered partial. In fact, this was one of two waivers required for second tranche release. Based on the Letter of Financial Sector Development Policy, and as subsequently revised prior to loan signing5, the goal was to develop a plan, satisfactory to the Bank, to restructure and substantially downsize BN. One interpretation of this condition, which was also supported by diagnostic work during the appraisal, was that the plan would detail the action steps necessary for the eventual dismantling of BN. At least that is how one of the key government officials 4 Typically the multilateral lending agencies require a guarantee of the Republic, and thus the funds need to be channeled through a government-owned intermediary. From an operational perspective, the local development bank also contributes to economies of scale in administering very large credit facilities to many intermediaries, which would otherwise impose a huge administrative burden on the multilateral lender. 5See Board document, Peru: Final Review of the Bank's Workout Program, R92-226, December 10, 1992.  12 negotiating the FSAL had intended it. Unfortunately there were lengthy delays in developing the Action Plan; and, after it had been agreed to by the Bank, its implementation proceeded at an even slower pace. The plan underwent further revisions, which in effect lessened the conditionality, and even with these modifications, the Bank had to eventually acknowledge that the objective of curtailing BN as a financial intermediary could not be achieved. Strong political opposition to the downsizing of BN frustrated the Bank's persistent efforts at reaching the initial objectives. 42. Despite the serious problems encountered in carrying out this objective, the action steps that were eventually taken did eliminate the macroeconomic threat posed by BN through its impact on the money supply, and through inefficient allocation of public sector resources. Government operational transfers to BN were reduced significantly. In addition, the following steps were accomplished: * Cessation of BN's new commercial banking activities, and the provision of those services only when specifically requested by the state. - Transfer of the government's main accounts to the Central Bank. - The transfer of a major portion of BN's tax collection services, and the beginning of the transfer of its salary-payment services, to commercial banks, except in remote areas. * Design and implementation of a reorganizational plan, although not on the scale of the Bank's expectations. * Initial steps to have the Treasury of the Republic assume the functions of the government's financial agent. * Implementation of a financing plan to recognize BN's portfolio losses. 43. BN remains an intact institution with an extensive branch network. Based on November 1996 financial statements, BN's total assets arnounted to US$3.6 billion, placing it as the second largest bank in the country after Banco de Credito with US$4.9 billion. BN also reported a network of 341 branches, and 2,652 employees, compared to the Banco de Credito figures of 204 branches, and 4,076 employees. When compared to the figures for 1991, BN shows a big improvement, since employment then was 7,000 and the bank had 445 branches. In terms of its balance sheet for November 1996, about 60 percent of BN's total liabilities were in the form of deposits, while almost two-thirds of assets were in cash and cash equivalent deposits. In other words, BN continues to operate as the fiscal agent of the government managing the accounts of public entities and collecting taxes, although at a much more reduced scale than before the FSAL. 44. BN's first reorganization plan was issued in October 1993. The fact that this was a plan approved by BN's Board of Directors implied that it was part of their fiduciary responsibility to have assured that it was implemented diligently and expediently. However, the actual experience, in terms of long delays and partial compliance with some of the goals, would indicate that this plan had not been adequately conceived nor fully supported by BN's management. Some of the crucial elements of the plan's thirteen action steps were actually open-ended. For example, the  13 government was given the option of naming BN as its fiscal agent whenever the situation should require it; the administration of the Treasury's sub-accounts was left to BN; the transfer of tax collection activities to commercial banks was to proceed in a progressive fashion, and not according to a strict timetable; BN was allowed to continue to perform payment services to public employees if commercial banks were not interested in providing these services, although it did not specify what were considered to be realistic incentives to the commercial banks. 45. Progress on the following specific plan objectives was below expectations: * BN still retains a significant share of tax collections (all smaller tax payers), government deposit accounts (sub-accounts), and payment of civil servants. * While an administrative restructuring was implemented, it did not go as far in reducing the size of BN as the Government and the Bank had originally intended (though this intention was never formally quantified). * BN still engages in a number of activities as fiscal agent for the government that would go beyond its fiduciary role. 46. On the other hand, Bank staff prudently safeguarded the fiscal accounts from BNs growing appetite for government support, which at that time represented 2.0 percent of GDP. The pension liabilities of BN were transferred to ONP. This eliminated the need for a government transfer to BN equivalent to 1.0 percent of GDP, and as a consequence, a new condition was introduced that limited government transfers to BN to 0.8 percent of tax revenues, which in effect represented a net 0.2 percent of GDP reduction in the government's operational transfer. More importantly, the transfer of BN's pension liabilities implied a future savings to BN, arising from expected future increases in pension benefits, that could significantly exceed the 1.0 percent of GDP figure estimated at the time of the transfer. This new budget constraint thus helped reduce the fiscal burden arising from BN's inefficient financial management operations. 47. In view of the difficulties encountered with this component, even prior to loan signing, staff supervision took up the challenge early on to find a workable solution. Unfortunately, opposition to the restructuring plan was unyielding. In fact, relations between the Bank and parts of the government were at times strained due to the workout difficulties concerning BN, which detracted from the highly satisfactory progress made on the crucial components of the financial sector reform program. 48. Privatization of government owned banks. With the dissolution of Peru-Invest and Banco Popular (after its auction drew no bidders), and Banco Hipotecario in 1992, and the privatization of Banco de Comercio (June 1992), Banco Popular's Bolivian branch (November 1993), Interbanc (July 1994), and Banco Continental (April 1995), the process of privatizing all publicly-owned banks was completed and thus achievement of this objective is considered substantial. 49. The success in selling the banks can be attributed to: (i) extensive diagnostic work at loan appraisal which identified appropriate strategies; (ii) specification of a clear and tangible objective; (iii) a favorable macroeconomic environment; and (iv) the quality of the implementing agency, in this case COPRI. Except for Banco Popular, which had serious solvency problems, the state-  14 owned banks, once restructured and re-capitalized, offered good investment opportunities. In particular, the involvement of foreign investors in the banks' acquisitions, such as Banco Bilbao Vizcaya's purchase of Banco Continental, contributed to the opening of the financial sector to international competition, and to the entry of global players who brought with them new technologies. The successful privatization may also have encouraged other foreign investor groups to acquire Peruvian banks. Except for Banco de Comercio, which is still experiencing earnings problems, Interbanc and Banco Continental have posted significant improvements in their profitability during 1994-96. Improving the Banking Regulatory System 50. In view of the very successful regulatory reforms program, the achievement of these objectives is considered substantial. The 1991 banking law rationalized banking activity by authorizing universal-type banking and by applying uniform legal standards to public, private, and foreign-owned banks. This law was subsequently revised with passage of new banking legislation in 1993 which strengthened banking regulations, as well as standards of safety and soundness. In another banking law revision in December 1996, additional powers were given to the Superintendency of Banks. 51. The 1993 legislation introduced significant improvements over the previous banking code. The principal changes included: (i) increase in regulatory capital requirements from 6.7 percent of risk adjusted assets to 8.0 percent; (ii) tightening of credit limits, specially with respect to insiders, affiliates, and related parties; (iii) a unification of minimum reserve requirements; (iv) increased powers for the Superintendency of Banks and Insurance (SBS), mainly additional powers to place a financial institution under surveillance as well as to intervene a troubled institution, and greater flexibility in the ability of SBS to identify relationships within economic groups; and (v) authorization for two new types of financial institutions: consumer credit companies and investment companies. 52. The present banking legislation incorporates internationally accepted principles of prudential regulation. The rules on capital adequacy, credit concentration and exposure limits, loan classifications and corresponding provisioning, valuation of collateral, and enforcement powers are consistent with basic standards on safety and soundness. 53. Since the passage of the 1993 banking legislation, SBS has issued numerous regulations to strengthen the implementation of the law. The topics addressed by these regulations include: (i) capital adequacy; (ii) loan portfolio management; (iii) bank liabilities; and (iv) the establishment of new banking activities. With respect to the loan portfolio, new loan classification and provisioning standards, introduced in April 1995, expanded the classification criteria for commercial loans and defined new rules for the classification of the consumer loan portfolio. Another SBS circular defined new criteria for the treatment of refinanced loans which should help reduce the use of loan refinancing to conceal problem loans. 54. Banking Supervision. The adequacy of banking legislation and prudential regulations rests on the efficacy of its supervision by the respective regulators: SBS, the Central Bank (BCRP), and the Deposit Insurance Fund (FSD). SBS is the primary regulator in Peru. The Central Bank is consulted regarding SBS decisions on surveillance or intervention of problem banks. In addition, the Central Bank defines the reserve requirement policies, supervises foreign  15 currency transactions and monitors payment system risks. The Central Bank is responsible for the management of the insurance fund (FSD). It relies on SBS for supervision of financial institutions covered by deposit insurance. The present institutional framework for banking supervision is far superior to the ineffective regulatory environment that existed prior to 1992. In fact, prior to the 1991 banking law, there was no on-site supervision of financial intermediaries. 55. Since the initiation of systematic bank examinations, the principal focus of on-site inspections has been the quality of the loan and investments portfolio. SBS has been implementing a regular annual supervision program for all commercial banks. As part of the reorganization plan, SBS established a Central Risk Unit (UCR) to monitor the loan portfolio on a system-wide level. This unit developed an excellent data base that is compiled from all the financial reports submitted by the banks to SBS on a monthly basis. SBS has also developed examiners' manuals for risk assets and for financial analysis of banking institutions. The manual for financial analysis of banks describes the basic methodology based on the CAMEL system of rating. The financial analysis manual should be expanded to include other areas such as Asset / Liability Management, treatment of financial groups, and off-balance sheet items. 56. The examination reports have so far focused on the commercial loan portfolio. This emphasis on commercial loans is explained by the sizable carryover of bad loans from the pre- 1991 period, as well as their weight within the total loan portfolio of the banks. However, the inter-relationship within financial groups needs to be addressed directly, i.e. prudential regulations should be applied to financial groups on a consolidated basis. 57. The Deposit Insurance Fund (FSD) was established in 1991. Deposits are insured up to S/. 9,000 per person per bank with the amount adjusted annually by the wholesale price index. The Fund is financed by the banks which are assessed a fee of 0.75 percent of covered deposits. If the FSD has insufficient funds to pay off depositors, then it is authorized to borrow from the Ministry of Finance (Treasury). The objective of the FSD is to provide an explicit guarantee for small depositors. 58. Notwithstanding the notable improvement in regulation and supervision of the banking system, perhaps greater attention now needs to be focused on how financial intermediaries manage liquidity risk. Unless the Central Bank fund is given additional powers to use the Deposit Insurance Fund on a pre-emptive basis to support weakening institutions, the absence of a lender of last resort puts greater responsibility on SBS to prevent such problems from spreading. For this reason, the identification and implementation of effective procedures for managing and monitoring liquidity risk should be given a high priority. The need to improve liquidity management is not limited to Peru, it also applies to other countries in the region. An analysis of the banking crises in Chile (1982), Mexico (1995), and Venezuela (1994), points to a lack of adequate liquidity management procedures as one of the instrumental factors behind the collapse -- in a technical sense, of each of the systems. Certainly macroeconomic instability was the critical shock which led to the unraveling of the financial sector, but inappropriate liquidity management, such as excessive foreign currency exposure and mismatching of assets and liabilities, compounded the problems. 59. Banking regulations have so far paid little attention to the need to define effective asset I liability management tools and their application by financial intermediaries. Interest rate and maturity risk are barely considered in the analysis of financial institutions. Whether a simple gap  16 model, or a more sophisticated duration-based analysis, financial intermediaries need to implement comprehensive tools to manage these potential risks. At the same time, greater analysis of currency risk, both direct and indirect exposure, is highly recommended. 60. The issue of liquidity management is also related to the Central Bank's policies regarding reserve requirements. Perhaps a lowering of reserve requirement rates can be validated by enforcing more rigorous asset/liability management standards. At the same time, the current policy of applying the high reserve requirement rate to dollar denominated deposits, but not to dollar borrowings has created a highly distortionary funding practice. In order to avoid high reserve requirements, financial intermediaries channel their depositors' funds to offshore banks which then turn around and lend those deposits back to the Peruvian banks, and thus avoid the reserve requirements. Consequently, short-term borrowing in foreign currency classified under "other" by commercial banks has risen from 4.6 percent of total assets in 1993 to 11 percent in 1995. Reinforcing the Capital Markets 61. Achievement of the capital markets objectives is considered substantial. 62. Enhancing securities laws. The 1991 Capital Markets Law strengthened the Securities' Commission, giving it financial autonomy and stronger supervisory and regulatory authority over the stock exchange and all market intermediaries. The Commission has since, satisfactorily to the Bank, issued a series of implementing regulations dealing with specific issues such as mutual funds, disclosure, credit-rating agencies, and commodity exchanges. The Commission has become an effective regulator of an active and growing securities market. Achievement of this objective is thus considered substantial. 63. The capital markets reforms of 1992 helped start or increase the use of new financial institutions and instruments, such as mutual funds, ADRs, and corporate bonds, and contributed to improved regulatory oversight, as well as trading and information systems. Additional reforms enacted in October 1996 included the following: (i) operation of investment funds; (ii) securitization of credit; (iii) streamlined mutual fund regulations; (iv) improved regulations for money market instruments; (v) strengthened capital requirements; (vi) self-regulation of the stock market; (vii) more effective exchange clearing mechanisms; and (viii) greater disclosure. 64. Notwithstanding these improvements, Peru's capital market is small and there is still a need to expand the range of financial instruments available, specially for institutional investors such as AFPs. First, the stock market is almost entirely devoted to trading in shares issued prior to 1990, and few have increased their share offerings. Second, medium-to-large companies have begun to issue debt in the securities market, while new ventures or small firms must still rely on short-term financing from commercial banks. 65. Promoting pension reform and development of private sector pension funds. The pension fund reforms supported by the FSAL have been pivotal in increasing the demand for capital markets instruments, and in reducing the fiscal burden of the public sector, by moving from a pay-as-you-go defined benefits system to one of defined contribution. The achievement of this objective is considered substantial. The private pension system (SPP) was instituted in 1992 with the authorization of the private pension funds (AFPs). The new regime permitted Peruvians to  17 open individual retirement accounts in AFPs, receiving partial credit for previous contributions to the National Pension System (SNP) through a "Recognition Bond." 66. The Recognition Bond is issued to every individual who switches from the SNP to the SPP, and it recognizes the individual's cumulative contributions from the time first employed to the date when the switch is declared. The face value of the bond is then automatically adjusted by inflation every year until the individual reaches retirement or passes away. Upon retirement, the individual receives the full amount of the adjusted face value, which is then deployed in the purchase of a fixed annuity to cover the retirement period. 67. Legislation passed in July 1995, eliminated differences in contribution rates and retirement ages between the SNP and the SPP. These measures brought about a significant increase in transfers from the SNP to the SPP. Further reforms were enacted in 1996, thus making it more attractive for members of the Cedula Viva government pension system to switch to the SPP. 68. Peru's pension system is currently in a transition stage where a fully funded defined contribution regime covering about 1.4 million employees coexists with (i) a defined benefits pay- as-you-go regime covering about 1.0 million active and about 0.3 million retired employees; and (ii) a privileged defined benefit regime which covers about 50,000 active and 250,000 retired civil servants. Since the SPP system is still relatively new, about four years old, it may still take some time for most individuals to transfer from the SNP to SPP system. Given the lack of a proven track record by the AFPs so far, individuals may feel uncertain about the AFPs' investment capabilities, which in turn would affect the value of their pension benefits, whereas those who belong to the SNP system are, in principle, guaranteed a defined benefit. 69. While the government, under Bank advice, has been encouraging individuals to opt for the SPP system, and thus reduce the fiscal burden that membership in SNP entails, perhaps greater consideration needs to be given to the protection of the individuals' interests. In presenting the option to switch, the government needs to provide greater explanation of the benefits and risks -- and the probabilities of eventual pay-outs-- associated with both systems. For example, not just providing each interested individual a statement of what the value of their recognition bond would be if they chose to switch, but comparing that amount with the benefits they would receive under the SNP system. At the same time, greater emphasis should be placed on identifying the risks of investing in the SPP system, particularly since there are no guarantees on what amount of pension benefits an individual would receive. Those benefits will depend on the actual performance of the AFP's investment portfolio. Also, individuals should have the right to switch from one AFP to another at any time, subject to a nominal load factor. 70. The stronger than expected growth of the private pension system has revealed some potential weaknesses in the capital markets. The AFPs have become exceedingly large suppliers of medium-to-long-term funds in the capital market, but there are only a limited range of investment opportunities. The issuance of debt and equity is still restricted to a select group of corporations. In fact, the AFP's own investment guidelines are relatively strict as to the quality of issuer in which they can invest, as they should be. In view of the relatively low level of equity market capitalization in Peru, 21 percent of GDP in 1995, and the small number of listed equities, 246 in the Lima Stock Exchange, AFPs are challenged to find investment grade securities while providing an acceptable degree of diversification. In December 1995, about 46 percent of the AFP's portfolio was invested in Central Bank Notes and in time deposits at commercial banks, and  18 only 12 percent in equities of non-financial corporations. From a portfolio theory perspective, it would make sense for Peruvian AFPs to invest more of their portfolio overseas; however, this could create problems for the currency markets, since the funds would then become large purchasers of dollars. 71. Further progress in the development of new instruments, and in drawing more issuers to the market should be encouraged. On the other hand, the AFPs have already made a positive contribution to the development of the leasing market in Peru. In December 1995, about 9 percent of AFP assets were invested in bonds issued by leasing companies, and this share is expected to increase. The much longer Chilean experience with pension funds reveals that the AFPs in that country were also constrained in the beginning by limited investment opportunities. Nevertheless, capital market reforms in Chile eventually led to an increase in new issues, and more importantly, the surge in funds availability from the AFPs led to a sizeable increase in price to earnings ratios from 4.9 in 1986 to 17.1 in 1995, which thus encouraged firms to seek greater equity participation in their business. A similar trend is likely for Peru. The Impact of Program Objectives on Financial Sector Performance 72. The financial sector of Peru has made substantial progress since 1991, due in large part, to the quality of economic reforms and to the opening up of the financial sector to competition. The improved performance and stability of the banks is also attributed to the capable and disciplined approach of banking regulators, who were given broad powers under the 1993 banking law, and more recently, under the revised 1996 banking legislation. The reforms to the securities law and the pension system have also laid the groundwork for sustainable development of the capital markets. 73. Commercial Banking: Asset quality. As an economy in transition, Peru faces macroeconomic risks that could have an adverse impact on the health of the financial system. One of the leading indicators of financial system weakness is the quality of the loan portfolio, which in turn reflects the ability of borrowers to meet debt service obligations. The quality of the loan portfolio has continued to improve, although the level of arrears still remains relatively high. Past- due loan payments as percent of total gross loans has declined from 13.9 percent in March 1993 to 4.8 percent in December 1995 (though this figure rose again in 1996). This improvement is explained in large part by the strong growth in new lending during this period, combined with the overall improvement in the macroeconomic environment. 74. The principal risks to the banking system in terms of a worsening of asset quality are: (i) a recession and/or maxi-devaluation; and (ii) excessive risk taking arising from the very strong growth of lending that has occurred during the past three years (and the associated insufficiency of priovisions for loan losses). 75. Dollarization. With about 65 percent of total liabilities in foreign currency, the banking system is highly dollarized. The fact that the reserve requirement rate on dollar deposits is very high (45 percent) reflects the concern of the monetary authorities over the degree of dollarization of the monetary system. However, as mentioned earlier a uniform but lower reserve requirement rate on all foreign currency liabilities would be desirable.  19 76. Interest rates and margins. With the liberalization of interest rates in 1991, financial markets have offered a positive real return to savings. On the deposit side of the ledger, interest rates on both domestic and foreign-currency-denominated instruments offered by commercial banks have been converging. However, on the asset side there are significant differences in the rates charged by banks. This variance in rates could arise from the methodology used in reporting interest rate information. Further analysis of this issue would be desirable. 77. Asset / Liability management. As mentioned earlier, commercial banks need to manage their liquidity position as well as their interest rate and foreign exchange gaps on a regular basis. Asset / Liability Management policies should include quantitative limits on volatile deposits, loan to assets, interest rate gap, and foreign exchange exposure. Greater SBS monitoring of Asset/Liability Management policies and procedures would be desirable. 78. Increasing Competition. With the initiation of reforms in 1991, banks have been restructuring in order to succeed in the new competitive environment. The banking law of 1993 opened new areas of business such as leasing, insurance, and stock brokerage. The large banks have already entered these businesses through new divisions or through subsidiaries. By expanding into new lines of business, commercial banks have enhanced their profitability. The influx of foreign commercial banks has contributed to increased competition. Currently foreign investors control about 23 percent of total banking system assets, and this share is likely to increase. Foreign banks represent a healthy challenge to the dominant position held by the largest banks. Foreign-owned banks are expected to use price competition -- lower interest rates and commissions, to acquire market share mostly from the large banks. 79. Pension Funds. Peru's public pension systems (SNP and Cedula Viva) are bankrupt on an actuarial basis. They demand payments from the State that cannot be met now, and which are projected to increase exponentially during the next 20 years. On the other hand, the private pension fund (AFPs) portfolio has grown fast to over US$1 billion in September 1996, but there is little product diversity and intermediation costs are high. The pension fund regulatory regime does not encourage an efficient intermediation of funds, since it penalizes deviations from market averages. At the same time, it does not discourage taking high risk and actually contributes to systemic risk by inducing an over-concentration in a limited group of assets. These problems have been addressed by the Bank's Pension Reform Adjustment Loan. 80. Equity Market. The equity markets have shown an impressive growth in terms of market capitalization. During 1991-1995, market capitalization increased by a factor often times, form US$1,118 million in 1991, to US$11,795 million in 1995, making it one of the fastest growing emerging country equity markets. This bodes well for sustained growth supported by further expansion of the pension funds.  20 D. MAJOR FACTORS AFFECTING THE PROJECT 81. The high success of the FSAL is attributed to a solid working relationship between the Bank and the government. In general, a strong government commitment contributed to the very positive outcome, despite some unfavorable external developments. Nevertheless, the effectiveness of the objective dealing with the reduction of the state in the financial system was tempered by some difficulties associated with the implementation of the Banco de la Naci6n reorganization plan. Minor procedural issues regarding the liquidation of development bank assets also challenged Bank staff resources during the implementation period. Because of these obstacles, the loan closing date had to be extended twice, from the original estimate of September 1994, to September 1996. Factors not subject to government control 82. During the period of implementation of reforms, the program was challenged by two external factors: (i) the political crisis in 1992, marked by the suspension of constitutional guarantees, to which the international community responded by temporarily curtailing their support of the external financing program; and (ii) the Mexican currency and banking crisis in December 1994, which led to a significant outflow of capital from Latin America. Fortunately, in each case, the potential threats did not materialize with sufficient force to undermine the momentum of the program. In part this can be explained by the strength of government commitment to the program. At the same time, the international financial community perceived that the Peruvian economy did not exhibit the same external disequilibrium and associated mismatch between sources and uses of capital that characterized the Mexican experience. Factors subject to government control 83. The program supported by the FSAL was one of the deepest and most rapid financial- sector reform programs in the region. At the time the reforms were initiated in 1991, the economy was dominated by the state, with an extremely weak administrative machinery, while the private sector had been severely weakened through de-capitalization. The financial sector was highly fragmented and vulnerable to a systemic crisis. Thus one of the critical factors to the success of this program was the government's extraordinary commitment to the reforms, which contributed to a strong credibility factor early on in the process, and to the better-than-expected outcome from the macroeconomic adjustment. Borrower ownership was instrumental in achieving these results. In fact, as with the associated TPRL and SAL, many of the reforms had already been implemented at the time of loan signing. The FSAL objectives were thus aimed at supporting the continuity of previous government actions. 84. While not detracting from the excellent macroeconomic and financial sector performance, some weakness was encountered in terms of government commitment to Banco de la Naci6n restructuring and misconceptions regarding the procedures for effectively liquidating the development banks. Apparently the political price of privatizing BN's activities was much higher than the economic benefits in terms of lowering the fiscal burden, and reducing the state's role in the financial sector. Another constraint was the government's own lack of effective treasury operations, and at a time when austerity was being implemented in the form of cash-flow management of the fiscal accounts, BN was used to help the government solve its fiscal problems.  21 It had thus assumed the role of an essential financial agent for the government during the stabilization process. 85. The liquidation of the development banks was a procedural issue, whereas the principal objective to cease the development banks' highly inefficient operations had been complied with. The difficulties in collecting and restructuring existing loans, and in liquidating other assets may have been caused by having assigned this task to an unprepared bureaucracy caught in a maze of conflicting regulations, as well as to the Ministry of Economy & Finance's own underestimate of the complexity of such an operation. Perhaps a more productive approach would have been to assign this task to an outside collection agency or to an experienced financial broker who could have been compensated based on a percentage of recoveries (solutions the Bank had urged on the Government in 1992). Factors subject to implementing agency control 86. As with the government in general, the implementing agency was highly committed to the success of the program. As usually happens with complex programs such as the FSAL, some lack of coordination with other government agencies was noted from time to time. Nevertheless, the difficulties encountered with BN pointed to some weakness in terms of consensus building. A more constructive approach by the implementing agency from the beginning might have eased tensions in the subsequent implementation phase. E. PROJECT SUSTAINABILITY 87. Program sustainability based on the objectives of reducing state participation in the financial system; improving the banking regulatory system; and reinforcing and expanding the capital markets is considered likely. Strong government commitment to the program has been one of the critical factors to its success and continuity. The impressive accomplishments in terms of macroeconomic stability -- low inflation, sustainable growth, and improving international liquidity -- bode well for the sustainability of the program. One of the critical factors for the stability of the financial system is macroeconomic stability. Low inflation and sustainable growth contribute to increased savings and to greater appetite for longer term investments, which result from reduced uncertainty. As financial markets expand in terms of instruments and time horizon, investment activity is bound to accelerate. In this regard, the success of the program supported by the FSAL suggests that if government commitment to maintaining a stable macroeconomic environment continues, the sustainability of financial sector reforms is likely. Nevertheless, this assessment is based exclusively on an evaluation of the current government's plan of action; but the continuation of these policies with a new government cannot be assured. At the same time, it is possible to speculate whether a change in government would produce a reversal in economic policies. This evaluation can only refer to the likelihood that the current government will continue to support economic reforms, but even this commitment could be compromised if changes in the political profile of Congress were to favor a shift from market-based reforms to greater government intervention. 88. Because of its critical role in the allocation of savings and investment, the sustainability of financial sector reforms is also pivotal to the maintenance of a stable macroeconomic  22 environment. The vulnerability of financial intermediation to shifts in market expectations and to unexpected shocks, raises the stakes for the development of adequate market mechanisms and for effective regulatory supervision. In this regard, some potential weaknesses could still compromise the integrity of financial sector intermediation. The lack of systematic attention to liquidity management by financial intermediaries could put the banks in a compromising position in the event of a surge in market risk. With respect to the capital markets, greater attention needs to be paid to the trading of short-term money market instruments in the stock exchange. Financial disclosure requirements also need to be strengthened, including control over the use of inside information and the implementation of homogeneous accounting standards. The sustainability of the pension funds also hinges on achieving greater diversification of investment portfolios. At the same time, regulators need to ensure that individual investors are adequately informed of the potential risks in the SNP and the SPP systems. F. BANK PERFORMANCE 89. Bank performance in the FSAL was highly satisfactory. Project identification, preparation, and appraisal exceeded expectations in terms of organization, speed, and analytical quality. Supervision also exceeded expectations, in particular the extensive documentation that was prepared for tranche release, including a detailed analysis of compliance. Generally, there was a close working relationship between the Bank and the government. However, the problem with the design of the BN reform partly detracted from this otherwise excellent relationship. 90. The quality and quantity of staff analysis and its effectiveness in communicating with the government contributed to the very positive outcome of this program. The FSAL, like other sectoral adjustment programs, was a highly complex operation for which the Bank had to rely on a series of assumptions as to the likely outcomes, and the appropriate sequence of reforms. The highly satisfactory rating recognizes that Bank staff had to piece together this operation under highly volatile conditions. The obstacles encountered with BN were flagged early on, and continuous efforts were made to develop a solution. Perhaps a more productive outcome would have been to focus exclusively on the fiscal aspects of BN's operations, such as placing gradually declining limit on central government transfers to BN, which would then have avoided the head- on confrontation over an institutional reorganization issue. In the final analysis, it would have been more efficient to transfer all of BN's activities to the commercial banks and the Treasury; however, BN was a large and powerful entity. G. BORROWER PERFORMANCE 91. Borrower performance during the FSAL is considered satisfactory. From the start, the government was highly committed to this program. Ownership of the program was clearly in the hands of the government. During preparation and appraisal the government provided extensive cooperation. This commitment was also evident in the strong support given to Bank missions throughout the period of the loan. 92. Despite a high degree of commitment to the program, the government was not able to resolve a political standoff between two key government officials over the design and  23 implementation of the BN objectives. While the government was able to eventually markedly reduce BN's involvement in financial sector activities, its inability to resolve the problems in an expeditious manner led to the postponement of the closing date. Delays in the liquidation of development banks was due to a lack of experience, and thus to the government's optimistic assessment early on in the program of its capability to manage the liquidation process. Nevertheless, the government subsequently took forceful action by giving the Ministry of Finance greater powers to dispose of the assets and achieve closure. H. ASSESSMENT OF OUTCOME 93. On the basis of the review of this program, including the review of legal documents, supervision reports, and the findings of the final supervision mission, the FSAL is rated as highly satisfactory. The program achieved its major objectives. One of the distinguishing characteristics of this operation was the efficiency of the outcome. Most of the reforms were implemented prior to loan effectiveness. The very high quality of the outcome was evident in the fact that large capital outflows from Latin America triggered by the Mexican crisis, and consequent concerns over the weakening of the Argentinean financial sector, were hardly noticed in Peru, where the financial sector continued to post strong gains. Compliance with specific loan covenants was satisfactory. Sustainability of the objectives is considered likely. L. FUTURE OPERATIONS 94. Further improvements in some areas of structural and policy reforms could benefit from the support of future Bank operations. Financial intermediation can be made more efficient through new credit enhancement mechanisms -- strengthening the use of collateral, institutionalizing the transferability of property rights such as in a mortgage, and introduction of new mechanisms for securitization; banking regulations and supervision should place greater emphasis on liquidity management as well as expand the nascent credit information industry to include information on consumer loans; leasing activity could assume a more prominent role in dealing with small- to medium-sized companies that usually have difficulties in accessing adequate financing; the pension system needs to undergo further reforms; and additional studies are needed on the questions of rural credit availability and the access by small- to medium-sized companies to the capital markets. 95. The Bank is already taking action with regards to some of these issues. Specifically, a new Pension Reform Adjustment Loan was approved by the Board in February 1997. An urban property rights project is currently being designed. Other improvements may occur as financial markets mature. It is also possible that another financial sector operation, possibly a capital markets adjustment loan, could address some of the above mentioned issues.  24 J. KEY LESSONS LEARNED 96. The high degree of success of this operation can be attributed to the following factors: * Borrower commitment is critical to the success of a program. The Peruvian government was highly committed to the reforms, as demonstrated by the fact that most of the policy reforms were undertaken prior to loan signing. Design and implementation of a reform program is more effective when the relevant legislation supporting the reforms has been enacted. For this reason, passage of legislation as an objective should be avoided, unless it can be made part of Board presentation conditions. In the case of Peru, a comprehensive banking legislation had been approved prior to, and as a condition of, the loan. Thus, the loan focused on implementation of the new law and its refinements in subsequent revisions. With privatization, the government had already approved the law to privatize government enterprises. A stable macroeconomic environment is a necessary condition for sustainable reforms of the financial sector. Typically, the lower the trend rate of inflation, the longer the duration of financial instruments. Stable prices tend to reduce uncertainty and thus the willingness of investors to trade off liquidity for return. Sustainable economic growth makes it easier for financial intermediaries to manage credit risk, since the growing level of economic activity bodes well for the cash flow position of their borrowers. And a steady currency reduces the volatility of capital flows and thus enhances the capabilities of the financial sector to safely manage their global liquidity position. The excellent track record of Peru's macroeconomic policy management during the period of this loan was instrumental in the buoyant recovery of the financial sector. 97. Some weakness was noted in the following areas: Vague conditions phrased in imprecise language can compromise loan objectives. If lack of clarity is due to lack of consensus on a course of action, as was the case with conditions for Banco de la Nacion, then the Bank should address the problem directly. Designing an objective with the rationale that partial achievement is better than no action could backfire by compromising the Bank's relationship with the government and by taking away from the other accomplishments of the program. Measures to expand the capital markets should be sensitive to potential demand / supply imbalances. Perhaps some mention should have been made in the appraisal concerning the need to ensure that, with the growth in the supply of long-term investment funds by AFPs generated by a large influx of clients, a counter balancing growth of investment opportunities would need to be forthcoming, such as new public offerings of debt and equity. Otherwise, the AFPs would find themselves too liquid and short on investment income.  25 * To the extent possible, an attempt should be made to quantify the fiscal effects of any reforms, in order to assess short-term costs relative to the government's limited resources, and to use that information in establishing implementation priorities. In the case of the development banks, one option would have been to write off the bulk of the portfolio, and then to have hired a collection agency for recoveries. However, the write-off amount could have been much greater than what the government could spare in terms of its budgetary resources. 98. Loan design should consider the following issues: * Key objectives, such as policy reforms and market liberalization, should be placed in proper perspective when considering other less essential issues, such as procedural tasks or follow-up actions to the basic policy reforms, in determining specific loan conditionality and its contribution to the achievement of the loan's objectives. For example, the goal of closing down inefficient development banks should attain a much higher order of priority than the timing of their liquidation. Because of this, it might be useful to consider a dual set of conditionality: one consisting of key policy and project actions for which full compliance would be expected prior to loan disbursement, and the other consisting of less critical mostly procedural actions for which a given percentage of compliance would be considered satisfactory for the release of funds. * The specification of loan conditionality should be sensitive to the degree of complexity of the tasks. Some macroeconomic reforms such as liberalization of interest rates and currency markets can be accomplished relatively quickly and with decisive actions. Others, such as organizational restructuring of complex public enterprises, like Banco de la Nacion, require greater flexibility in their agenda.   26 PART II: STATISTICAL TABLES   27 Table 1: Summary of Assessments A. Achievement of objectives Substantial Partial Negligible Not apDlicable Macro policies _ O D D Sector policies [ O LI Financial objectives ] O O V Institutional development El El [] Physical objectives OEl El Poverty reduction [ [ o_ Gender issues Ol O El V Other social objectives O O O / Environmental objectives LEl [1 0 Public sector management V LIEl 0 Private sector development VI El Other (specify) Ol LO L (Continued)  28 B. Project sustainability Likelv Unlikely Uncertain (I) (/) (/) / O O Highly C. Bank performance satisfactory Satisfactory Deficient (/) (/) (/) Identification _/ O O Preparation Assistance V/ O a Appraisal O O/ Supervision $/ Oii Highly D. Borrower Performance satisfactorv Satisfactory Deficient (/) (/) (/) Preparation O V [ Implementation O V D Covenant compliance U O V Highly . Highly E. Assessment of outcome satisfactory Satisfactory Unsatisfactory unsatisfactory V/ D/ D/ D/  29 Table 2: Related Bank Loans/Credits Loan/credit title Purpose Date of approval Status Preceding operations* 1. Trade Policy To support the 02/04/92 Fully disbursed. Reform Loan Government's (3437-PE) medium term program of trade policy reform. 2. Structural To support the 03/26/92 Fully disbursed. Adjustment Loan Government's (3452-PE) medium term program of macroeconomic stabilization and broad-based structural reforms Following operations 1. Pension Reform To support measures 02/11/1997. Fully disbursed Adjustment Loan I deepening the reform mto the of the pension system (Memorandum and imroigeh President # P-703 1- and improving the PE of November 25, efficiency of its 1996.) capital markets. * The Trade Policy Reform and Structural Reform Loans were the first and second in a series of three quick disbursing loans, the Financial Sector Reform being the third. The loans were designed to support Peru in its macroeconomic and structural reform efforts in the context of clearance of arrears to the Bank at end-1992.  30 Table 3: Project Timetable Steps in Project Cycle Date Planned Date Actual/ Latest Estimate Preparation August 1991 August 19-21, 1991 Appraisal March 1991 March 18-31, 1991 |_Negotiations May 1992 Mary 5-8, 1992 Letter of Development Policy May 1992 May 13, 1992 Board Presentation June 1992 June 17, 1992 Signing December 1992 December 22, 1992 Effectiveness February 15, 1993 March 18, 1993 First Tranche Release December 1992 March 18, 1993 Second Tranche Release December 1993 December 28, 1995 Project Completion December 1995 December 28, 1995 Loan Closing September 30, September 30, 1996 1994 Table 4: Loan Disbursements: Cumulative Estimated and Actual (US$ million equivalent) FY93 FY96 Appraisal Estimate 300 100 Actual 300 100 Actual as % of Estimate 100 % 100 % Date of Final Disbursement December 28, 1995 Table 5: Key Indicators for Project Implementation: not applicable Table 6: Key Indicators for Project Operation: not applicable  31 Table 7: Studies Included in Project Purpose as Defined Study at Appraisal/Redefined Status Impact of Study 1. Arrau, Patricio & Prepared for LAI CO Completed January 31, Acevedo, Peru: Banking Division of World Bank. 1994. Sector Study. l 2. Daniel A. Artana, La Prepared for the IDB and Completed, September, Banca de Fomento en el UNDP. 1991 Peru. 3. Canales-Kriljenko, Draft prepared for LAICO Completed December, Jorge Ivan, Social division of World Bank. 1991 Security in Peru: Current Situation and Reform. 4. Canales-Kriljenko, First draft prepared for Jorge Ivan, Privatization LAICO division of World of Mandatory Insurance Bank. in Peru. 5. DFC, Peru: Banco de Completed March la Nacion, [Development 1992. Finance Corporation, Madrid, Jose Luis Mombru, Managing Partner] 6. DFC, Peru: Banco de Completed March la Nacion: Executive 1992. Summary, [Development Finance Corporation, Madrid, Jose Luis Mombru, Managing Partner] _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7. DFC, Peru: Banco de Completed March Fomento Nacional, 1992. [Development Finance Corporation, Madrid, Jose Luis Mombru, Managing Partner]  32 Purpose as Defined Study at Appraisal/Redefined Status Impact of Study 8. DFC, Peru: Banco de Completed March Fomento Nacional: 1992. Executive Summary, [Development Finance Corporation, Madrid, Jose Luis Mombru, Managing Partner] 9. Iglesias P., Augusto, Completed August Comentarios al Sistema 1993. de A.F.P. en Peru. 10. Knaudt, Susana, Completed July 1991. Peru: Instituto Peruano de Seguridad Social (IPSS): Policy Issues. 11. Knaudt, Susana, Completed July 1991. Peru: Capital Markets Development. 12. La Banca de Fomento, nd. 13. Lasaga, Manuel, Completed February Perspectives on the 1996. Financial Sector of Peru: FSAL Supervision Report. 14. Lavados, Hugo, and Completed December Monica Caceres, El 1991. Mercado Asegurador Peruano: Regulacion y Supervision de la Industria Aseguradora. 15. Lavados, Hugo, and Completed December Monica Caceres, The 1991 Peruvian Insurance Market: Regulation and Supervision of the Insurance Industry.  33 Purpose as Defined Study at Appraisal/Redefined Status Impact of Study 16. Macroconsult S.A., Completed May 1991. El Sistema Financiero Peruano. 17. Meyer, Klaus E., Prepared for LAICO Completed September Development Banking division of the World Bank. 1993. in Peru. 18. Mitra, Saumya, et al., Completed September Financial Sector 1994. Reforms in a Stabilizing Economy -- the Case of Peru. Prepared for LAICO Completed July 1993. 19. Moreno-Herrero, division of the World Bank. Blanca, Peru. New Banking Legal Framework. Monetary and Financial Policy Implications. 20. Morris Guerinoni, Confidential Final Report, Completed August 21, Felipe, La Banca de prepared for the LAlCO 1991. Fomento en el Peru: Division of the World Bank. Diagnostico y Soluciones. 21. Morris Guerinoni, Confidential Final Report, Completed August 21, Felipe, Development prepared for the LAlCO 1991. Banking in Peru: Division of the World Bank. Diagnosis and Solutions, Final Report, prepared for Completed March 14, 22l Morris, Felipe, the LAlCO Division of the 1992. l 22. Morris, Felipe, World Bank. Review of Financial Sector Policies in Peru and Remaining Issues. Confidential Final Report, Completed March 18, 23. Morris, Felipe, and Prepared for LAICO 1992. lFernando Polar, The Division of the World Bank Financial Condition of the Peruvian Commercial Banking System, , .  34 Purpose as Defined Study at Appraisal/Redefined Status Impact of Study 24. Morris, Felipe, and Prepared for LAlCO Completed December Fernando Polar, Division of the World Bank 1993. Financial Condition of the Banking System Post Financial Sector Reform. 25_ Paul F., Luis Hernan Confidential, Prepared for Completed August 9, 25. Paul F., Luis Hernan, LAlCO Division of the 1992. Analisis del Mercado de World Bank Valores en Peru, Reservado, Preparado para The World Bank, 9 de AGosto de 1992 26. Thomberry, Guillermo, Report on the Process of Banco Popular Privatization, Draf, n.d. 27. World Bank, Peru: Privatizacion del Sector Bancario  35 Table 8A: Project Costs l________ Appraisal Estimate (US$M Actual (US$M) 1. First 300 300 Tranche 2. Second 100 100 Tranche TOTAL 400 400 Table 8B: Project Financing Source Appraisal Estimate (US$M) Actual (US$M) IBRD 400 400 TOTAL 400 400 Table 9: Economic Costs and benefits: not applicable  Table 10: Status of Legal Covenants AgreetSetion Type'Typ Description of Covenat Origin Revised Status Co _mmes __ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Ddte Dade _ _ _ _ _ _ _ __Da Loan Sci c The Borrower slall have ageed with the Bank on an action plan for the 12.22.92 Done 4..01 cessation of opetion ofthe public developmnt banks, except with (a) respect to first4ier agiculturl loaS and grants to small-scale famers in remote areas, and shall have inplenented it 4.01 (b) c The Bonower shall have completed the transfer offiancial ass and 12.22.92 12.28.95 Done liabilities ofthe development banks to private financial insitutions and __________ shallI have conpleted the financig of their portfolio losssam______ __________ 4.01 (c) c The Borrower shall have agreed with the Bank on an action plan for 12.22.92 Done second-tier lending and for Corporacion Financiers de Desarrollo and sal _______ have implenenated it 4.02 c The Borrower shall have agreed with the Bank on an action plan to renove 12.22.92 12.28.93 Done fSnctions of Banco de la Nacion as indicated in the Letter of Fiancial Sedor Development Policy, to restructure Banco de [a Nacion and to reognize its loses, and shall have irnplemented it 4.03 (a) c The Borrower sa have completed the sale of Banco Popular, its branches 12.22.92 July 1994 Done and Invest-Perm, and Banco de Conmercio. 4.03 (b) c The Borrower shall have completed the sale of either lnterbanc or Banco 12.22.92 Done __________ ________ Continental. 4.03 (c) c The Borrower shall have adopted a plan satisfactory to the Bank for: (i) the 12.22.92 Done w sale ofthe bank refeed to in pangraph (b) above that was not sold, (ii) the sale of aU the subsidiasies of Banco Continental; and (iii) divestiture of its slareholdg in other banks. 4.03 (d) c The Borrwer shall have issued the inviation for proposas (incling 12.22.92 Done tenns of reference) for the valuation of the bank referred to in paragraph (c) ______ _____ ______ _____ (i) shove._ _ _ _ _ _ _ _ _ _ 4.04 (a) c The Borrower shall have agreed with the Bank on a deposit insurance 12.22.92 Done _______________ __________ schme and shall have established it 4.04 (b) e Th Suprinteanncy of Banking and Insurance ("Superintendencia de 12.22.92 Done Bancos y Seguros') shall have issued prudential regulations for off-site evaluation nd on-e inspection, including the right for it to intervene in __________ cases of insolvency. _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ _ _ _ 4.04 (c) c The Borrower shall have conmpleted the restucturing of the 12.22.92 Done Superintendency of Banking and Insurance ("Superintesdencia de Bancos y Segurns"). 4.05 (a) c The Borrower shall have issued regulations for the Viplaemntation of 12.22.92 Done Decree 755 C(Ley de Mercado de Valores, El Peruano, Novenber 13, _ 1991). 4.05 (b) c A suprntendcy of private pension funds shll have been established and 12.22.92 Done shall be operational and the state social security ageWy ("latituto Peruano de Seguridad Social") shal have issued appropride recognition bonds to all fonmer member who switched to private pension fSnds 6 C- Caplied with  37 Table 11: Compliance with Operational Manual Statements (There was no case of non compliance with Operational Manual Statements) Table 12: Bank Resources: Staff Inputs Stage of Planned Actual Project Cycle . Weeks US$ Weeks US$ Preparation to Appraisal N/A 88.4 225.8 Trust Funds* N/A 127.2 231.0 Appraisal-Board N/A 15.8 38.5 Trust Funds* N/A N/A N/A Negotiations through Board Approval N/A 9.4 22.7 Trust Funds* N/A 5.0 8.8 Supervision N/A 92.6 319.1 Trust Funds* N/A 38 114.5 Completion .6 2.2 TOTAL 377.0 962.6 *TF025410, TF025380, TF021155, TF025680, TF020535  38 Table 13: Bank Resources: Missions Peafomnnce Raing Number Specialized Implemenatio Develop-mt Stw of MonUi/ of Days in Staff Skills n Objectives Project Cycle Year Pesons Field Rqeeseted Statul Through Appraisa M91 3 11 Economist 10/91 3 5 Banking Spec Fin. Specialist Economist Appraisal tuwg 21/91 5 13 Economis Board A oval 2/92 10 Eoonmist 3/92 6 13 Supeision 10/92 4 9 Economist I 1 11/92 1 7 BankingSpec I I 1/93 2 7 Fin Specialist na. na. 4/93 4 11 Economist 1 1 6/93 1 3 Bankinglaw I I 8/93 3 15 BankingSpec I 1 11/93 1 2 Economist na. na. 4/94 2 8 Economis 2 1 6/94 1 4 Banking Spec nI. nU. 10/94 2 Economist a a 6/95 2 Economist a s 10/93 2 Economist a s 2/15/96 1 Economist 5 s  39 .kPPEXDI:; A International Bank for Reconstruction and Development FOR OFFICIAL USE ONLY R95-230 FROM: Vice President and Secretary December 15, 1995 FINANCIAL SECIOR ADJUSTMNT LOAN (IDn 3489-PEQ Release of the Second Tranche (Waiher of Two Conditions) Atached is a President's Memorandum entitled "Peru - Financial Sector Adjustment Loan (Loan 3489-PE) - Release of the Second Tranche (Waiver of Two Conditions)", dated December 15, 1995. In the absence of objections (to be communicated to the Vice President and Secretary or Deputy Secretary by the close of business on December 27, 1995), the recommendation contained in paragraph 34 of the memorandum will be deemed approved and so recorded in the subsequent meeting of the Executive Directors. Questions on this document may be refefred to Mr. Geoffrey Shepherd (ext. 31912). Distribution Executive Directors and Alternates Office of the President Senior Management, Bank, IFC and MIGA | This document has a retricted distribution and may be used by recipients only in the perfoaned ao their oficial duties, Its contents mAY not otherwise be disclosed without World ank authorldton.  4C FROM: The President December 15, 1995 FINANCIAL SECrOR ADJUSTMNT LOAN (Loan 3489-PE) Release of the Second Tranche (Waiver of Two Conditions) 1. The Board of Executive Directors approved a Financial Sector Adjustment Loan (FSAL) to Peru on June 17, 1992 in the amount of US$400 million equivalent for disbursement in two tranches. The loan was declared effective on March 18, 1993, when the first tranche of US$300 million was disbursed. The Loan supports the Govermment of Peru's program of financial sector reform. This memorandum summarizes recent economic developments and progress made in meeting the conditions established for the release of the second and final tranche of US$100 million equivalent. Based on the progress made in implementing the program supported by the loan; this memorandum recommends that the second tranche be released (para. 34) and duly notifies the Executive Directors of this recoThmendation. I. LOAN OBJECrIVES AND FEATURES 2. Country objectives of the loan. The FSAL was, with a Structural Adjustment Loan (SAL) and a Trade Policy Reform Loan (TPRL), part of a package of loans that was disbursed in 1993, immediately following Peru's clearance of arrears. One of the Bank's first programs under the policy of Additional Support for brkout Programs in Countries with Protracted Arrears, the Peruvian workout occurred after successful completion of several earlier steps: a 1991-92 stabilization program agreed with the IMF, which led to a debt workout similar to and contemporaneous with the Bank's; an external financing plan for 1991-92, which rescheduled Paris Club debts and concluded a debt workout with the IDB; and a 1991-92 program of structural adjustment, trade policy reform, and financial sector reform. I The SAL and TPRL were disbursed in their entirety in March 1993, following successful completion of the agreed reform program.2 Only the first tranche of the FSAL was released as the program of financial sector reform had not been completed.3 3. In the context of an Extended Fund Facility with the IMF, and within the framework of Bank adjustment lending, Peru has continued a policy of macroeconomic discipline, ensuring economic stability, fiscal balance, and freedom in foreign exchange markets, prices, and private sector wages. 1. The Bank has since approved rwo further adjustment loans. The third tranche, for USS100 million, of a Privatization Adjustment Loan approved in 1993 is outstanding. A US$50 million second tranche of an Electricity Privatization Adjustment Loan approved in 1994 was recently disbursed and a third tranche, for US$50 million, is outstanding. The Bank is now preparing, at the request of the Governnent, a second Structural Adjustment Loan and a DDSR in the context of a planned normalization of Peru's relations with foreign commercial banks in 1996. 2. See Performance 4udit Report - Peru: Dtde Policy Refonn Loan; Structural Adjustment Loan, June 30, 1995, SecM95-966. 3. IDB prepared a parallel Financial Sector Adjustment Loan. The two loans covered some conmmon areas, but also divided up tasks in other areas. Thus the IDB's loan privatized other banks and provided technical assistance for the stock exchange commission, the Superintendency of Banks, and the Central Bank.  4. Sectoral objectives of the loan. The first tranche of the FSAL recognized financial sector reforms that had occurred prior to loan signature, from mid-1990 through 1991 (see para. 16 below). The second tranche underwrote further reformns, to be undertaken in 1992 and 1993, that would: advance the process of liquidating the development banks; substantially reduce the role of the state bank, Banco de la Naci6n (BN); privatize publicly-owned commercial banks; reform the banking law and improve banking supervision; and develop capital markets and private pensions funds. 5. Second tmnche release. The originally anticipated date for this was the end of 1993 and the closing date September 30, 1994. Tvw 12-month extensions of the closing date have been granted, bringing it to September 30, 1996. 6. The Government has made substantial progress in all areas of the FSAL. Second- tranche conditions have now been completed, in form and substance acceptable to the Bank, in all components except on actions under two components, restructuring Banco de la Naci6n (see paras. 25-29) and transferring remaining assets of the development banks to private hands (see para. 24). The Banco de la Nacion component has nonetheless been fulfilled to a large extent, and enough to ensure that financial sector reforms can be maintained. A process of selling the development bank assets is well on its way to completion and the waiver is requested on narrow, technical grounds. II. RECENT ECONOMIC DEVELOPMENTS The Economy 7. Peru's economic policies and prospects have been reviewed in the 1994 Country Economic Memorandum (Peru at the Crossroads: Building a Modern State, Report No. 11943- PE). The latest country assistance strategy for Peru was in 1994 (Report No. 12997 PE). Updating information was also provided in the context of the October 24-25 Consultative Group meeting (Economic Achievements and the Challenges of Social Development, October 11, 1995, CG 95-63). 8. After a period of growing economic mismanagement, Peru's economy had reached a state of collapse by 1990, when a new Administration came to power and begun a rapid and far- reaching process of stabilization and structural reforms. Since loan approval in 1992, the Government has sustained its program aimed at reducing inflation and creating the conditions for sustained growth and long-term economic viability. The result of these reforms has been to move the economy toward a market-based system, reducing the role of the State but strengthening its effectiveness in providing public goods. Firm financial discipline and commitment to economic reform have brought important economic improvements to all income groups and have begun to create a foundation for sustained growth and poverty reduction. By making more productive use of existing resources, a newly buoyant private sector has been the principal engine of growth. GDP in 1994 increased by nearly 13 percent and in August 1995, was up by 5.7 percent over the previous twelve months. The estimated share of the poor in the total population fell from 55 percent in 1991 to 50 percent in 1994. Gross domestic savings during 1994 grew by the equivalent of 2.5 percent of GDP to 16 percent of GDP, an increase broadly in line with that of investment which reached 21.5 percent of GDP. 9. Tight fiscal and monetary policies have been key to stabilization. Inflation was reduced from 7,650 percent in 1990 and 139 percent in 1991 to 15.4 percent in 1994 and 7.8 percent for the year ending September 1995. Central government revenues increased from 7.8 percent of GDP in 1989 to 13 percent in 1994, but tax collection is still low by developing country  4.- standards (11 percent in 1994). In the wake of even faster growth of social and capital expenditures, some fiscal pressures have emerged since mid-1994, as central government spending increased from 15.4 percent of GDP in 1993 to 16.9 percent in 1994. Even so, the primary fiscal balance moved from a deficit of 2 percent of GDP in 1990 to a surplus of 0.3 percent in 1993 and 1994, and the consolidated public sector deficit dropped from 3 percent of GDP in 1993 to 2.6 percent in 1994 (all figures exclude revenues from privatization). Privatization proceeds rose from 0.5 percent of GDP in 1993 to 4.5 percent in 1994. Monetary policy has observed stabilization targets. Open market operations have been conducted through the purchase and sale of foreign exchange. 10. External Economy. Broad trade liberalization eliminated most non-tariff barriers and sharply reduced the number, level, and dispersion of tariffs. Over the most recent 12-month period, exports rose by 30 percent, assisted by strong intemational prices for minerals. But imports rose-even more on the strength of demand for rehabilitation and expansion of productive capacity and rising consumption. The current account deficit rose from US$1.7 billion in 1993 to US$2.2 billion in 1994. But this deficit was more than compensated for by capital inflows - US$2.4 billion and US$5.4 billion, respectively, over the same period - which to a large extent reflected privatization proceeds. International reserves of the Central Bank rose by nearly US$3 billion to US$5.7 billion during 1994 (equivalent to 11.4 months of 1994 imports) and further to US$6.2 billion by September 1995. 11. External Debt. Peru has a heavy debt overhang from its payments moratoria during the 1980s. Total external debt outstanding at end-1994 was US$28.3 billion, equal to 621 percent of merchandise exports and 54 percent of GDP. Public debt service in 1994 was US$1.8 billion, or 32 percent of 1994 exports. Debt owed to commercial banks is estimated at US$10 billion including past due interest. Following arrears clearance with the international financial institutions and debt rescheduling with bilateral donors during 1991-93, the Government has reached agreement in principle on a debt and debt service reduction package with the commercial Bank steering committee, and is advancing toward a Brady deal.' 12. Privatization and complementary legal/regulatory and institutional reforms are proceeding at a brisk pace, dramatically reorienting the economy from heavy state intervention to reliance on market forces. 48 state enterprises were privatized in 1994-95 in the energy, telecommunications, banking, mining, and manufacturing sectors, providing $4.1 billion to the national exchequer and mobilizing investment commitments of nearly US$2.5 billion. The bulk of privatization revenues were used to increase international reserves and to finance social programs. 13. The IMF is supporting Peru through a SDR1.1 billion Extended Fund Facility (EFF) covering 1993-96. The IMF has just completed the 1995 Article IV consultation and the mid-term review of the third-year program under the EFF, and the Government has observed all performance criteria under this program through the end of September. Nevertheless, private sector growth and investment have been stronger than projected, resulting in a larger-than- programmed current-account deficit of about 7.5 percent of GDP for 1995. About two-thirds of this deficit have been financed by private sector floLws, including increased short-tern borrowing by commercial banks. Data deficiencies at this time make it difficult to determnine the maturity structure of private capital inflows, although the Central Bank is making progress to improve the data. The Government is conscious of the risks posed by these trends. There is likely to be a 4. See PERU - Briefing Note on the Agreement in Principle on a Commercial Debt and Debt Service reduction Operation, November 14, 1995, SecM95-1163  1,3 need to curtail the growth in public expenditure while maintaining strict surveillance of the banking system. 14. The Bank will continue to work with the IMF in monitoring the nacroeconomic program. The Govermment has reiterated its commitment to maintaining macroeconomic stability and continuing the reform program, while seeking continued support from the intemational community in attaining its reform objectives. Maintenance of a macroeconomic franmewrk consistent with the financial sector reform program is a condition for second tranche release, and the Government is deemed to have complied with this. The Finacial Sector 15. The sector in 1990. By 1990, financial intermediation had been severely repressed by interference in the price mechanism and credit allocation, taxes and subsidies, and extrme economic instability. The segmenta.tion (i.eiegislated specialization) of financial institutions led to rigidities. A handful of public banks - development banks, publicly-owned conmmercial banks and BN, the goverunment's financial agent - dominated banking activity, undermining competition and leaving the banking system with a very weak portfolio. Bank supervision was weak. The money market was inoperative due to the dominant role of the Central Bank in providing liquidity to the system. The capital market was largely dormant as a result of instability, inadequate regulation and supervision, and a lack of institutional investors. 16. Reforms in 1990-91. Stabilization policies introduced in 1990, the concurrent elimination of controls on interest rates, credit allocation, and foreign exchange, the elimination of subsidies, and the more gradual reduction in taxes were vital pre-conditions to the recovery of financial intermediation. A new law in 1991 permitted universal banking, removed discrimination against foreign banks, and laid the basis for stricter bank supervision. In 1990-91, the four first- tier development banks ceased activity and entered in a process of liquidation. In 1991, BN started a process of restructuring, losing the monopoly it had enjoyed as banker to state-owned enterprises. In 1991, a new capital mnarkets law was introduced to reinforce supervision, while the state monopoly for pensions was eliminated. The first tranche of the FSAL recognized all these reforms. 17. Reformsfrom 1992. A deposit insurance scheme was introduced in 1992 to strengthen public confidence in financial intermediation. Several measures were taken to permit stricter supervision (and a clamp-down on parallel banks). The banking law was augmented in 1993, and a series of implementing regulations and a program of restructuring and training further strengthened the supervisory hand of the Superintendency of Banks and Insurance. The remaining development bank, COFIDE, was strictly limited to functioning as a second-tier institution. Between 1993 and 1995, all publicly-owned conmmercial banks were liquidated or privatized. The process of restructuring BN continued, through its downsizing and the transfer of its functions to other goverrnent agencies or to private banks (but also because a rapid privatization process removed many major clients). Regulations issued under the 1991 capital markets law enabled a beginning to the process of diversifying financing instruments. Private pension funds started operating in 1993 - with a new law in 1995 improving the incentives for workers to shift from public pension schemes - and the Government is now paying into the private funds the accumulated rights of retirees. Finally, in 1994-95, the Government began in earnest the process of rationalizing the balance'sheets and getting rid of the non-performing assets of the public banks. - The second tranche of the FSAL underwrote most of these reforms (see section III).  44 18. Evolution of thefinancal sector. As a result of stabilization, a strong economic recovery, and financial-sector reforms, there has been a substantial recovery in financial intermediation. The average liquidity (M) of the financial sector grew from 5.2 percent of GDP edin 1990 to 13.9 percent in 1994 and projected to be 15.3 percent in 1995. Competition among banks is growing, for two principal reasons. First, there has been a dramatic reduction of the role of public banks. From October 1990 to October 1995 their share in all banking deposits fell from 54 to 11 percent and in banking credits from 75 to five percent. Second, following the inroduction of universal banking, new foreign banks have recently begun to enter Peru (through the processes of privatization, partnerships, green-field investments, and representative offices). A movement has also now begun towards acquisition of smaller banks and domestic-foreign partnerships of medium banks. That competition is increasing is evident in a falling level of expenses (reflecting, among other things, large staff cuts in mnany banks in recent years). Nonetheless, Peruvian banking is still characterized by high spreads and high lending rates. Sol- denominated interest rates and spreads have been gradually falling since 1993, but dollar- denominated rates and spreads have been stable since 1994. (About two-thirds of banking deposits are in dollars, and one reason that the spread remains high is that there is a 45 percent unremunerared cash reserve requirement on foreign currency deposits.) 19. There has been a significant improvement in the quality of the banks' risk assets, reflected in a falling share of bad loans and a higher level of provisioning. But for some of the banks, there is still progress to be made in completely overcoming the problem of a poor portfolio inherited from early times and in avoiding all the pitfalls of lending in new areas in a rapidly growing market (in consumer lending, for instance). 20. Notwithstanding recent reforms, the capital market is still small, with few stocks and few players. Economic recovery has led to a dramatic increase in the level of trading, and consequently in market capitalization, but not in new issues. There are now six private pension funds, with around a mnillion members (not all of them active) and assets around US$500 million. The private funds have grown more slowly than expected, partly because of the weak incentives that many workers faced to transfer from the public system. The new law of 1995 addressed this problem. 21. Prospects for the financial sector. The level of financial intermediation is still low in Peru and has considerable room for further recovery. In particular, credit to agriculture is still insufficient, and the banks are likely to be slow to move into rural areas. (The Bank and the IDB are currently undertaking some sector work to analyze the constraints to rural credit.) Peru's banking market is small, and activity remains highly concentrated. Competition will need to increase - partly through the further entry of new banks, especially foreign - to put further pressure on interest rates. Any normalization of Peru's relations with foreign commercial banks is likely to put more competitive pressure on Peruvian banks by facilitating loans from abroad. The Superintendency of Banks must also continue aggressively to put pressure on the banks to improve their financial position, particularly as they move into new areas such as housing and consumer credit. The IDB has completed one program of technical assistance to the Superintendency and is likely to approve another, concentrating on training.. The Bank will also investigate ways in which mechanisms to maintain confidence in the banking system can be supported.  45 m. PROGRESS AGAINST TRANCHE RELEASE CRITERIA 22. Under paragraph 4 of Schedule 1 of the Loan Agreement, conditions for the -r second tranche release require that the Bank be satisfied with the progress achieved by the Borrower in carrying out the program and shall also be satisfied that the actions related to the release of the second tranche, described in Schedule 4 of the Agreement, have been taken. 23. The overall progress that the Borrower has achieved in carrying out the program is highly satisfactory. There are 13 specific actions under five components for the release of the second tranche. These specific actions and the progress made under each of them are as fbllows. 24. Development Banks (Mining, Agriculture, Industry, Housing) '(a) The Borrower shall have agreed with the Bank on an acton plan for the cessation f operantions o? the public development baiks,; acept with respect to first-tier agricultural loans and grants to small-scale farmers in remote areas, and shall have implemented it." Complied. An action plan was agreed on and fully implemented in 1992, when the development banks ceased to operate. They will cease to exist as legal entities once the present liquidation process has been completed. Thus development-bank lending to agriculture has ceased. "(b) The Borrower shall have completed the transfer offinancial assets and liabiliiies of the development banks to private financal institutions and shall have completed the financng of their portfolio losses. Not fully complied, although the main actions required to complete this measure have been taken. The process of financing the portfolio losses of the development banks was completed with a Treasury bond issue in 1994, and the Government then became the only creditor and debtor of the development banks. A Liquidating Commission responsible for the transfer of financial assets achieved little in three years of operation, the result in part of perverse incentives that Commission employees faced to keep the Conmission in business. The Government adopted a new approach in mid-1995 when it transferred all the assets (as well as those of several other public banks being restructured, liquidated, or privatized) to govermment ownership, under the responsibility of an Administrating Commission in the Ministry of Economy and Finance. Following the transfer, it was established (notwithstanding earlier valuations) that those assets which have not been provisioned, now with a book value of only US$71 million, have an absolutely minimal market value, either because they are too small to collect effectively or because collateral security is worth very little. Thus, liquidation will now be a "tidying up" process, rather than one of recouping resources to any significant degree. A sale by public offer of all remaining assets estimated to have sufficient value to attract bids has been announced and the bidding process was completed on December 7, 1995. The proceeds from the public sale, once completed, are expected to amount to about US$8 million. While the sale has not yet been completed - grounds for a technical waiver - - we are satisfied that there is little risk that this process will not be concluded expeditiously. After this, remaining assets will be written off and given over to collection agencies and arrangements to formally dissolve the banks will take place as early as possible in 1996. "(c) The Borrower shall have agreed with the Bank on an action plan for second-tier lending and for Corporacion Financiera'de Desarrollo and shall have implemented it." Complied. An action plan was agreed on and fully implemented. The Bank and the Governnent agreed that Corporacion Financierm de Desarrollo (COFIDE) would be Peru's only second-tier development bank. Most of its business is to wholesale funds from multilateral agencies to private  46 banks. Following the sale to the Government of its outstanding first-tier portfolio in early 1995, COFIDE terninated its first-tier operations. 25. Banco de la Naci6n eTh Borrower shall have agreed with the Bank on an action plan to remove functions of Banco de la Nacidn as indicated in the Letter of Financial Sector Development Policy, to restructure Banco de la Nacidn and to recognize its losses, and shall have implemented it. ' The Letter of Financial Sector Development Pblicy had defined the scope of the action plan as follows.' 'A plan, satisfactory to the Bank, for (a) the trnsfer of BN operations (including assets and liabilites) to the Central Bank and to commercial banks, (b) the transfer of the tax collection fumction, (c) the transfer of the role'of external agent of the government, (d) the recognition of portfolio losses, (e) staff reductions and branch closures will be established." 26. Partially complied. The action plan subsequently agreed with the Bank, in October 1993, required the following actions with respect to BN. (a) a limitation on activties: cessation of new commercial bank activities and provision of services as the state's financial agent only at the state's request; (b) transfer of government accounts: the transfer of the governnent's main accounts and sub- accounts to the Central Bank; (c) transfer of tax-collection and payment servces: the transfer of all BN's tax-collection services and the beginning of the transfer of its salary-payment services to conmunercial banks, except in areas of the country from which the banks are absent or have no interest in providing these services; (d) restructuring: the design and implementation of a restructuring plan (administrative restructuring, reduction of personnel, and transfer of pension obligations to the government); and (e) National Treasury System: the strengthening of the National Treasury System in line with the action plan (i.e. for the Treasury to more fully assume the functions of the government's financial agent), including the drafting of a law to regulate the new system. (f) portfolio losses: implementation of a financing plan to recognize its portfolio losses. 27. The present status of progress with respect to these actions is as follows. 5. The Letter had envisaged that this action plan would be agreed before disbursement of the first tranche, with not less than the agreed first year of implementation of the plan being carried out for the second tranche. This condition was modified in a supplemental letter (see Annex 4 of the Final Revew of the Bank's Vebrkou: Program, December 10, 1992, R92-226, a document which followed Board presentation and was a condition of loan signing). In essence, this letter undertook to provide an agreed action plan (consistent with the Letter of Financial Sector Development Policy) after first-tranche release, but to fully implement it before second-tranche release.  47 (a) Limitation on acniuines. BN had lost, before disbursement of the first tranche, its position as monopoly banker to the public sector. BN's actions were then clearly limited by new By-laws legislated in 1994. These by-laws allow BN principally to: collect taxes and - make payments for the government, but without exclusivity; manage the govermnent's sub- accounts (by delegation of the Treasury); and act as the state's financial and external agent, when requested to do so by the government. The By-laws allow it no role as a banker to the private sector, but allow it to provide correspondent services in areas where commercial banks do not operate. (b) Transfer of government accounrts. The government's main account was transferred to the Central Bank when these By-laws were introduced. However, the Central Bank declined to accept the sub-accounts on the grounds that a direct involvement in transactions with the private sector would be inappropriate. This is a reasonable position, given the inde2endence accorded to the Central Bank by law. BN's By-laws have substantially limited its ability to use the sub-icowunts to carry out inter-bank operations. (In addition, privatization and the migration of profitable state-owned enterprises to commercial banks paying interests on deposits have severely limited BN's business with these enterprises.) The Government intends to transfer the sub-accounts to the new National Treasury System, once it is functioning (see (e) below). (c) Transfer of tax-collecdon and payment services. Collection of taxes has now been transferred as far as possible out of BN. The commercial banks and the tax authority now collect over 80 percent of taxes. BN still collects the taxes of smaller tax payers (the majority of tax-payers), both because it has a more extensive branch network in Peru's provinces and because the commercial banks have been reluctant to take them over since they do not see small tax payers as a profitable business. Progress in transferring payment of public-servant salaries from BN to the banks has also been more limited as the banks have not wished to take on the business of lower-paid workers. However, most of Peru's public servants can now elect to be paid into private accounts. (d) Restructuring. * A major restructuring of BN was completed by 1994: employment fell from 7,000 in 1991 to 2,800 by end-1994, together with the reduction by almost 100 in the number of branches (445 in 1991). A further, more modest reduction of activity occurred with the closure in 1995 of 26 more branches, and a further 11 branches will be closed as of the end of 1995. These closures are expected to leave BN with around 2,500 employees. The results have fallen short of the substantial restructuring originally agreed. Once the National Treasury System is implemented, the Government anticipates that treasury functions, such as salary payments, will be transferred out of BN. * The action plan also envisaged a transfer of BN's pensioners to the Treasury. The pension liability will be transferred to the Government by the end of 1995. Reform of the pension system ("cedula viva") that many public servants, including BN employees, enjoy will be a central theme of the proposed SAL 11 loan:' reforming, and improving the financing mechanism for, the pensions of BN employees will be one of the first problems to be addressed. * In 1994, when the main government account was removed from BN, its operating costs were financed by the receipt of two percent of taxes collected. The figure was reduced to 1.8 percent in October of this year. With the transfer of BN's pension obligations and the restructuring process it has gone through, this figure will be reduced, as of January 1,  1996, to 0.55 percent. This figure is a ceiling for transfers to BN, and the Government will periodically review the figure with a view to encouraging greater efficiency in BN's operations. (e) National Treasury System. Progress in designing and implementing a new National Treasury System has been slower than expected, because the Ministry of Economy and Finance had difficulties with various options proposed. The Ministry has now agreed on the broad outlines of an Integrated System of Financial Management which will integrate budget, expenditure, and audit processes and will eventually be used in all government agencies. This system is intended to accommodate the sub-accounts that BN still manages and to facilitate direct payments. The Ministry is now beginning detailed design, and the system is expected to be operational in 1997/98. IDB is providing technical assistance in this area. The Bank will provide complementary support, if required, through the proposed second Structural Adjustment Loan or a proposed technical assistance project for public sector modernization. - (f) Portfolio losses. The main step in restructuring BN's balance sheet and recognizing its portfolio losses occurred at the end of 1994, when BN's principal assets and liabilities - with the Central Bank - were consolidated. The Admrinistrating Commnission in the Ministry of Economy and Finance has recently taken possession of BN's outstanding private-sector portfolio and is in the process of disposing of it to financial institutions. BN still has some small liabilities with some state-owned enterprises; these will be assumed by the Ministry of Economy and Finance for those enterprises privatized and written off for those liquidated. 28. In sum, BN's role in the financial system has been substantially limited by changes that have occurred since 1991. It has lost its monopoly in many areas and, without the ability to carry out inter-bank operations, there is no longer a major risk of its operations causing macroeconomic instability. BN continues to represent a fiscal burden, due to the costs of maintaining a still-extensive network of branches (which mainly collect taxes and pay public servants) - although most of these branches are in areas not served by other banks. 29. The action plan has been completed with respect to the clear limitations that have been placed on BN's activities, the transfer of the main government account to the Central Bank, and the recognition of portfblio losses. Implementation of the plan can be considered to have fallen short of achieving the originally agreed substantial restructuring in two particular respects. First, the transfer of tax-collection and payment services to commercial banks and the consequent downsizing of BN did not substantially meet the agreed objective. The failure to downsize further partly reflects the inability or unwillingness of the commercial banks to take on much of BN's present tasks. Second, the government's sub-accounts still remain with BN. This is the result of the slower-than-hoped progress in the design and implementation of a National Treasury System. It is on this basis that a partial waiver of the BN component is requested. 30. Privatization '(a) The Borrower shall have completed the sale of Banco Popular, its branches and Invest-Peru, and Banco de Comercio. (b) The Borrower shall have completed the sale of either Interbanc or Banco Continental.  /e 0 (c) The Borrower shall have adopted a plan satisfactory to the Bank for: (i) the sale of the bank referred to in paragraph (b) above that was not sold; (ii) the sale of all the subsidiaries of Banco Continental; and (iii) divestiture of its shareholdings in other banks. (d) The Borrower shall have issued the invitation for proposals (including terms of reference) for the valuation of the bank referred to in paragraph (c) (i) above." Complied. With the dissolution of Peru-Invest, Banco Popular (after its auction drew no bidders), and Banco Hipotecario in 1992 and the privatization of Banco de Comercio (June 1992), Banco Popular's Bolivian branch (November 1993), Interbanc (July 1994), and Banco Continental (April 1995), the process of privatizing all publicly-owned commercial banks was completed and this component was more than fulfilled. 31. Banking Regulation "(a) The Borrower shall have agreed with the Bank on a deposit insurance scheme and shall have established it. (b) The Superintendency of Baning and Insurance ("Superintendencia de Bancos y Seguros") shall have issued prudential regulations for off-site evaluation and on-site inspection, including the right for it to intervene in cases of insolvency. (c) The Borrower shall have comnpleted the restructuring of the Superintendency of Banking and Insurance ("Superintendencia de Bancos y Seguros). " Complied. There has been substantial progress in banking supervision in Peru. With the help of technical assistance from IDB, the Superintendency of Banks and Insurance has completed a process of organizational restructuring, and personnel are being trained on a continuing basis. The Superintendency has continued to make progress in its task of assuring the soundness of banking institutions (see para. 19). It introduced a deposit insurance scheme satisfactory to the Bank in early 1994. The Superintendency has issued all regulations for a regular program of bank evaluation involving on- and off-site inspection. All banks are visited at least once a year. On-site inspections have focussed on a review of loan quality. Under a continuing effort to strengthen prudential regulations, the Superintendency recently issued new regulations requiring increased loan loss provisions for commercial loans and introduced new standards for classifying consumer loans based on length of arrears. 32. Some banks still show portfolio weaknesses, and the Superintendency will need to continue its vigilance of the banking system. Supervision of potential problem loans has been enhanced by the recently completed Central Risk Unit which maintains a computerized data base of the position of all borrowers with respect to all banks. The Bank will stand ready to help in this area in the future, if needed. 33. Capital Markets "(a) The Borrower shall have issued regulations for the implementation of Decree 755 ("Ley de Mercado de Wlores, El Peruano, November 13, 1991")." Complied. The 1991 Capital Markets Law strengthened the Securities' Conimission, giving it financial autonomy and stronger supervisory and regulatory authority over the stock exchange and all market intermediaries. The Comrnmission has since, satisfactorily to the Bank, issued a series of implementing regulations dealing with specific issues such as mutual funds, disclosure, credit-  53 rating agencies, and commodity exchanges. The Comniission has become an effective regulator of an active and growing securities market. '(b) A superintendency of private pension funds shall have been established and shall be operatonal, and the sute social security agency (Instituto Peruano de Seguridad Social) shall have issued appropriate recognition bonds to all former members who switched to private pension fivds. X Complied. The Superintendency to administer private pension funds has been fully operative since 1993. A recent law reduced taxes affecting these funds and, by equalizing the levels of contributions to public and private pensions funds, has removed an important advantage the public system continued to enjoy. In 1995 a system for issuing recognition bonds (a government liability representing its accrued obligations to a worker transferring to the private system) was set up under the auspices of a new public agency responsible for all publicly-administered pension schemes. Almost 600,000 workers have switGhed from the public to the private pension system and have a right to a bond. Since October of this year, the Government has been issuing these bonds as private pension funds request them on behalf of their members and has been paying the value of those bonds falling due into workers' accounts in the funds. m. RECOMMENDATIONS 34. Thanks to the depth of the reform program introduced from 1990, there has been an impressive recovery of the Peruvian economy. Deep financial sector reforms have played an important role in this process. There has been a strong implementation of reforms under the FSAL, and there is every expectation that these reforms will be sustained. In some cases, notably the extent of cessation of development-banking activity and bank privatization, the reforms have exceeded expectations. The Govermnent has been unable to complete all the reforms in one component, the restructuring of Banco de la Naci6n, but the essential objectives of this component have been met. Given this overall performance, I recommend that the Executive Directors approve a waiver of the remaining conditions for tranche release and, consequently, the release of the second tranche of the loan. Upon approval, the Bank will notify the Government of Peru that the second tranche of US$100 million equivalent is available. James D. Wolfensohn President  51 APPENDIX B IMPLEMENTATION COMPLETION REPORT PERU FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN NO. 3489-PE) This report evaluates Borrower and Bank performance throughout the evolution and implementation of the project, with an emphasis on relevant lessons for the future. Introduction Back in 1990 Peru was undergoing a severe economic crisis. The administration that was inaugurated in July that year devised a global strategy to restore internal and external equilibria including a stabilization program, structural reforms, a return to the international financial community, and a social safety net program. To foster stability and production, structural reforms focused on foreign trade, privatization, taxation, financial system deregulation, and more flexible labor regulations. The stable framework thus created has effectively encouraged foreign and domestic investment. From the outset, a foreign sector goal was to restore the flow of outside resources as a complement to domestic savings generated by the stabilization and structural reform efforts. Peru's negotiating strategy to achieve these goals was built around the gradual return to normal relations with all its creditors. It emphasized the need for payment relief and fresh funding to mitigate the social costs of the stabilization efforts and to finance the structural reforms. The strategy was to pay long overdue debt to restore Peru's relations with multilateral organizations. In September 1991, Peru paid its arrears to the IDB, and in March 1993 it paid its arrears to both the IMF and the World Bank. On March 18, 1997, arrears with the World Bank amounting to US$910 million were repaid using the freely available resources provided by three structural adjustment loans from that institution: the Trade Policy Reform Loan (TPRL) for US$400 million, the Financial Sector Adjustment Loan (FSAL) for US$400 million, of which a US$300 million tranche was initially disbursed, and the Structural Adjustment Loan (SAL) for US$300 million. At the same time, Peru paid its debt to the IMF and signed an Extended Facility Agreement for three years. The agreement confirmed the IMF's support for Peru's economic program.  52 The loans aimed fundamentally at supporting the economic reforms launched by the Government of Peru and its full return to the international financial community. The loan contracts signed on December 22, 1992 outlined the goals for the government's reforms including: * A reformed import tariff structure, tariffs surcharges for agricultural products, improved foreign trade and anti-dumping regulations and a customs reform. All these were part of the TPRL. * In the FSAL were included measures to restructure the development banks, the Banco de la Naci6n, and the Superintendency of Banks and Insurance (SBS). It also included provisions for the privatization of commercial banks partly owned by the State, or "associated banks" as they were known, and to create the appropriate conditions for the effective development of a capital market. * Reforms included in the SAL modified the tax code and administration, as well as fiscal, agricultural, labor, social, privatization, and social security policies. Of the US$900 million disbursed on March 18, 1997, US$867 million were used to settle the IBRD debt. The amount owed represented a reconciliation of figures between Peru's Public Debt Bureau (Direcci6n General de Credito Publico) and the IBRD. The remaining US$33 million were designated as freely disposable resources to be distributed according to the priorities set by the Cash Committee (Comite de Caja) of the Ministry of Economy and Finance. A second tranche of the Financial Adjustment Loan, for US$100 million, was disbursed by the IBRD directly to Peru's Treasury on December 28, 1995. Peru has also signed debt rescheduling agreements with the Paris Club and under Brady Plan terms. The debt rescheduling agreement reached with Paris Club creditors between July 17 and 20, 1996, gave it pre-cut off relief for 1996 through 1998 and, additionally, permitted the partial rollover of debt stock, thus effectively reducing debt service for the 1997-2007 period and matching Peru's mid-term capacity to honor its debt from this source of funding. Bilateral negotiations with Paris Club member countries have already concluded, as foreseen in the Minutes signed on July 20, 1996. Additionally, on 7 March, 1997, Peru signed an agreement to restructure its debt with foreign bank creditors. The Brady Plan will allow the restructuring and reduction of mid- and long-term debt by as much as 50 percent.  53 Such debt restructuring will allow Peru to effectively return to international financial markets and attract foreign investment capital. The Financial Sector Since 1990 Peru has undertaken a number of financial-system reforms to deregulate interest rates, update its financial regulations, and eliminate subsidized credit and State- owned development banks. The reforms -- and banking crises in other countries of the region -- prompted the Government to enact new and modern banking legislation and to more closely oversee commercial banks. Capital markets reform is still incipient and has mainly aimed at introducing flexibility and dynamism into the market, while making it more transparent. As a result, both portfolio investments and trading on the Lima Stock Exchange have increased dramatically in recent years. OBJECTIVES OF THE FINANCIAL REFORM Privatization Up to April 30, 1997, privatizations had enlarged Peruvian government coffers to the tune of US$7,065 million and created investment commitments for another US$7,719 million. Sales of State-owned stock in commercial banks has generated transactions worth about US$318 million. Program objectives in this area included the sale of Banco Popular, Banco de Comercio, Banco Continental, and Interbanc. A detailed account of the process follows. Banco Popular del Peru On December 1, 1992, SBS dissolved the Banco Popular del Peru through resolution 1332-92-SBS, and appointed a Liquidation Commission to liquidate its assets and business and wind up the bank. Banco de Comercio On June 5, 1992, in a Stock Exchange auction, the Mario Callirgos and Peruval S.A. brokerage firms paid US$5,365,552.20 for 1,877,138 shares of the Banco de Comercio.  54 Banco Popular del Peru - Bolivia On November 4, 1993, Financiera de Credito del Peru y Asociados paid US$6,150,000 for controlling stock of Banco Popular del Peru - Bolivia branch. Partners in the winning bid were Banco de Credito del Peru, Credibolsa Sociedad Agente de Bolsa S.A., Dionisio Romero, Raimundo Morales, and Benedicto Ciguenas. Interbanc A consortium made up of International Financial Holdings from Grand Cayman, and IFH del Perui S.A. paid US$51 million for 99.86 percent of State-owned stock in Interbanc. The sale package included Interbanc's affiliates Interfip (its financial branch), Internacional de Inmuebles, and Empresa de Servicios Internacionales (Interserv). Banco Continental Spain's Banco Bilbao Vizcaya, and Brescia Group companies Inversiones Breca, Inversiones San Borja, Urbanizadora Jardin and Minsur, bought 60 percent of Banco Continental for US$195.7 million in cash and US$60 million in foreign debt paper at nominal value. Also included in the package were Interbanc affiliates Financiera San Pedro, Contidata and Almaconti. Meanwhile, Surmeban was merged with Banco de la Naci6n (Decree Law 25740) and dissolved without liquidating the bank. Peruinvest was likewise dissolved in May 1992, as were Banco Central Hipotecario in August 1992 and Banco Popular in December 1992. Banco de la Naci6n Program goals concerning Banco de la Naci6n were to cancel the bank's monopoly handling of government and State-owned company deposits and to eliminate duplicate operations by transferring them to the Central Bank and commercial banks. Goals were also to suspend its tax collecting authority, transfer the bank's role as the government's foreign financial agent, reduce its portfolio and portfolio-related losses, and streamline personnel and operations. In line with program commitments, in December 1992 the government issued Decree Law 25907 to suppress the Banco de la Naci6n's monopoly on deposits by State-owned companies. Decree Law 25903 provided for the bank's restructuring and suppressed the privileges and monopolies enjoyed so far by Banco de la Naci6n in the functions it performed on behalf of the State. Later, in October 1993, the Government and the World Bank signed an Action Plan for restructuring the Banco de la Naci6n. Chief among the plan's objectives was to suspend all commercial banking at Banco de la Naci6n -including its participation in inter-bank  55 loans - and reduce its disproportionate role in the financial system which was at the root of many distortions in monetary -and exchange-rate-policy management. New Banco de la Naci6n By-laws were approved on January 20, 1994, by Supreme Decree 07-94-EF empowering the bank to perform the following main functions: * Act as cashier for government funds. * Collect taxes on behalf of the tax authority. Act as proxy for the Public Treasury in handling sub-account transactions. * Act as proxy for other banks or financial institutions to channel foreign and domestic resources to borrowers without incurring loan risks as a consequence. A Ministry Resolution dated February 3, 1994, (R.M. 018-93-EF/10) appointed a Special Commission reporting to the Ministry of Economy and Finance that would issue recommendations for streamlining the Banco de la Naci6n. As a consequence of the Commission's report, on 19 April, 1994, Emergency Decree 09- 94 launched the bank's reorganization. Its new organization was required to reflect the bank's by-laws, including a program of financial incentives for voluntary resignations. Between December 1993 and December 1995, the number of Banco de la Naci6n offices dropped from 435 to 384, and the number of personnel was cut from 4,775 to 2,745. Fees paid to the Banco de la Naci6n for its banking services as the government's treasurer were set at 0.55 percent of the total monthly tax collection accnring to the Central Government. Finally, Supreme Resolution 150-95-EF on December 1, 1995 transferred payroll administration for pensioners subject to Decree Law 20530 regulations to the Oficina de Normalizaci6n Previsional (ONP), Peru's agency for managing the transition to a private pension fund system. The transfer became effective on January 1, 1996. Development Banks Four first-tier development banks were dissolved as part of the program. COFIDE -- Peru's second-tier financial development corporation -- became the only development banking institution, thus effectively abrogating the negative economic consequences of the State's role in making direct loans to borrowers. When it acted as a first-tier banker, the State incurred significant financial losses. Additionally, resources were allocated arbitrarily, while political considerations exerted  56 undue influence in deciding the loans. Relaxed criteria in making the loans and high financial subsidies created perverse incentives to credit beneficiaries who used the loans to finance economically weak projects. Moreover, these policies prevented private banking institutions from financing industries like agriculture, which were substantially backed by the government's development banks. Although significant government funding was available for development loans, the beneficiary sectors failed to increase output or enhance productivity. Moreover, to finance the development banks, the Central Bank printed large amounts of money that fueled macro-economic instability in Peru during this period. Solving these problems required that the government no longer take a direct risk by lending public funds to private borrowers. To the extent that the State still had to play an interim role in channeling long-term foreign credit and in supporting small and very small companies, it found it most convenient to regroup its development loan functions under COFIDE. However, they were restricted to "second-tier" banking operations granting loans exclusively through private entities operating in the market. This further ensured that the State would not compete directly with institutions operating in the financial system and would leave this sector's development to private business. In the mid-term, the State's participation in COFIDE may be transferred gradually to private business, as the program reaches its objectives. A brief account of the reforms in development banks follows. Restructuring of development banking started with Legislative Decree 367 to re-organize the State's development banks. Later, Legislative Decree 754 dated November 12, 1991, merged the government's development banks into the National Development Bank (BNF). In May 1992, Decree Law 25478 dissolved the Agricultural, Industrial, Mining and Housing development banks and appointed the commissions charged with liquidating their respective assets and business. Later, the government decided to bring the four liquidations under a single commission. To create an appropriate framework for national development functions within a single institution, Decree Law 25694 of 28 August, 1992 modified COFIDE's by-laws to include financing for small business and farming, preferably in poor areas, through financial and other development institutions. It chartered COFIDE to channel local and international financial resources, as well as public moneys, donations and the like. However, COFIDE was forbidden to receive deposits from the public or make loans to borrowers other than financial intermediaries. This regulation also eliminated the National Development Bank. Likewise, the government chose to use the development banks' assets to serve the infrastructure needs of some of its agencies and therefore approved the necessary transfers of fixed assets formerly owned by development banks.  57 To settle the past-due loan portfolio carried by development banks, a number of schemes were devised to write-off non-performing loans, as well as special debt restructuring and settlement programs. Emergency Decree 032-95 of 5 May, 1995 created the Liquidation Managing Commission for the loan portfolios of the Agricultural, Industrial, Mining and Housing Banks of Peru. The Commission was empowered to identify the ways to consolidate, recover, manage, compensate and penalize the banks' portfolio of non-performing loans and to devise any other scheme that would be required to collect bad loans. Also, an Ad-Hoc State Attorney would represent the government in all administrative and legal matters connected with the liquidation of the Agricultural, Industrial, Mining and Housing Banks and coordinate the transfers of assets and real estate properties belonging to the liquidated institutions. Finally, Legislative Decree 848 established the Special Installment Regime for Tax Debt Settlement applicable to government institutions, which also covered financial debt incurred by liquidated development banks. Later, the Agricultural Companies Reform Act (Legislative Decree 877) established that these companies' debt could be settled under the same terms applied to pay overdue taxes. Up to 31 December 1996, the non-performing loan portfolio of the four development banks including their outstanding, past-due and legal action loans, amounted to US$981 million, of which US$266 million was recovered. Assets were worth US$23.5 million and sales and transfers reached US$76.7 million. COFIDE was redefined as a second-tier development bank and empowered to fund all sectors of the national economy. It would channel resources through institutions recognized as financial intermediaries or development institutions and subject to the regulatory scrutiny of the Superintendency of Banks and Insurance (SBS). Such institutions could be engaged in development activities in the countryside or with small firms generally. COFIDE's by-laws explicitly prevent the corporation from lending directly to non-financial institutions or receiving deposits from the public at large. COFIDE has also started an institutional restructuring program to adapt to its new functions. Basically, the program includes streamlining operations, re-engineering of lending processes and assessment of intermediaries using updated and transparent criteria, computer systems upgrading, and a redesigned mechanism for the transfer of its first-tier portfolio, among other measures. To this end, Supreme Decree 140-94-EF dated November 9, 1994, authorized the Ministry of Economy and Finance to buy COFIDE's direct loan portfolio as of January 1, 1994, except for the portion of loans with full bank guarantees. Selling its non-performing loans allowed COFIDE to become eligible for IDB's Multisectorial Credit Program inasmuch as it had made significant progress in putting its finances in order and strengthening its position as a second-tier development bank.  58 Superintendency of Banks and Insurance (SBS) Reform of the SBS -- Peru's Bank and Insurance Superintendency -- sought to standardize commercial bank regulations, continue the issue of banking prudential regulations enforce inspections, and redesign the organization. The SBS has issued a series of regulations conceming banking prudential regulation. It monitors banks short of capital to make them comply with the capitalization and increased-reserves programs required after they were inspected. During the project's execution, the SBS's Risk Rating Unit (UCR) was strengthened and provided with modern software and hardware to help the SBS perform its functions. Progress was made in reporting of accounts (accounting codes and presentation of financial statements), and in asset quality including provisions, portfolio rating, oversight of participation in high-risk loans, registration and internal auditing controls, guarantee evaluation, and limits on loans to related parties. In the insurance regulatory department, progress focused on preparing an accounting code, regulations about asset backing for general insurance - including life insurance - using "solvency margins" criteria, and arrangements for diversifying the use of the new techniques. In October 1993, Legislative Decree 770, the General Banking, Finance and Insurance Law, standardized the criteria applied to the banking and insurance industries for organizing companies and requesting authorizations for capital-, reserve- and dividend- related issues. It also included regulations about protection of savings, the Risk Rating Unit (UCR), legal reserves, guarantees, termination and liquidation of companies, as well as provisions on limitations and prohibitions applicable to existing financial instruments. More recently, in December 1996, Law 26702, the General Law for the Financial and Insurance Systems and Organic Law for the Superintendency of Banks and Insurance incorporated current industry developments such as new financial and other products and services, market globalization, innovative financing, securitization and bank automation, among others. Advances in SBS administration and personnel procedures, enhanced training and oversight, as well as the introduction of computer hardware and software, and the agency's new facilities should also be noted. In particular, computer systems have been improved, procedural handbooks for the new accounting plan drafted and a related training program prepared. From the outset, the SBS appointed a Special Overseeing Unit charged with modemizing and re-invigorating the system's specific watchdog functions. From 1993 to 1995,  59 analysts inspected procedures at financial institutions while risk inspectors carried out field inspections. Rationalization of top SBS management cut staffing by about 50 percent and redistributed personnel in a new organizational scheme that pays careful attention to personnel recruitment. Capitals Market Reforms in the capitals market sought to achieve the goals of Legislative Decree 755, effectively implement Legislative Decree 724, launch the Pension Funds Regulatory Agency, and issue recognition bonds for members of the private pension fund system. The reform was launched by Legislative Decree 755 of 1992 the Capital Markets Law, which authorized new financial institutions and instruments including mutual funds, ADRs, and corporate bonds, while improving oversight and intermediation and accountability information systems. Some of the main regulations designed to achieve the goals included in Legislative Decree 755 appear below. . Regulations for registration, temporary suspension, and withdrawal in the Stock Exchange. * Regulations for Initial Primary Offering of Stock. * Regulations for Stock Market Intermediation Agents. * Regulations for the Public Registry of Stock and Intermediaries. * Regulations for Penalties in the Stock Market. * Regulations for Financial Reporting. E Regulations for presenting Audited Financial Statements. * Regulations to create the Stock Market Unit. * General Provisions for Supplying Information on "Relevant Events" by listed corporations. * Regulations for Investing in Mutual Funds and Corporations to Manage this. * Regulations for the Administration of Stock Portfolios. I. Regulations for the Guarantee Funds at the Lima and Arequipa Stock Exchanges. II. Regulations for the registration of company equity issued by pension fund managers in the Public Registry of Securities and Intermediaries. III. Regulations related to the management of fixed revenue stock portfolios. IV. Regulations concerning "Important Reserved Information" applicable to stock issuers. Additionally, the government enacted the Commodities Exchange Law and Statutes, and the Risk Rating Agencies Law.  60 Changes were introduced to reflect the wider range of financial instruments in Peru's capital market, the enhanced regulatory environment, and the new instruments available to institutional investors, such as pension fund managers. Legislative Decrees 861 and 862 of October 1996 introduced capital market regulations aimed at reaching the following goals: * creating a regulatory framework for investment funds * creating a solid foundation for securitization of financial assets that would otherwise remain illiquid (such as mortgage loans, accounts receivable, etc.) * streamlining mutual fund regulations * improving regulations for short term paper and convertible bonds * increasing capital requirements for financial intermediaries * introducing the notion of self-regulating stock markets * establishing independent agents charged with settlement and liquidation of financial transactions in stock markets, and * improving the transparency of markets Pension System Reform Peru's pension system reform started in December 1992 when Law 25897 authorized private pension funds (AFPs) to start operating as an alternative to the "redistributive" scheme of the National Pension System. Included in the law was the establishment of the Private Pension Fund Regulatory Agency (SAFP) whose by-laws were enacted in January 1993. At present, the agency is fully operational and plays a key role in ensuring the System's transparent, secure, and regular development. Initially eight AFPs were organized to serve a market whose size and growth potential were overestimated. AFP stockholders were therefore pushed to take cost cutting measures that eventually led to three mergers. As a result, five AFPs survived, namely Horizonte, Integra, Nueva Vida, Profuturo, and Uni6n. Workers enrolled in the new private pension (SPP) can open individual accounts at the AFPs and get partial credit for their previous payments to the national system through so- called "recognition bonds," government-backed securities issued on behalf of individual workers for a maximum pre-established amount pegged to the inflation index until their redemption. Recognition bonds are seen as seed savings by workers who choose to move from the government's to the private pension system. After the Pension Regulatory Office (ONP) started operating in June 1994, it was authorized to issue recognition bonds for up to S/.1.6 billion through December 1996. In July 1995, Law 26504 equalized worker contributions to both systems, and regulated minimum pensions, exemptions from General Sales Tax for services provided by AFPs, retirement age, and modified investment ceilings. Transfers from the national to the  61 private system stepped up after July 1995 and, by raising retirement age, reduced contingent pension liabilities in the national system. Legislative Decree 817 substantially mitigated the impact of the state-employee pension system ("Cedula Viva") on government expenditures by authorizing civil servants to move freely to the private system, while allowing the ONP to audit all benefits claims under the "Cedula Viva" system and deciding on their validity. It also set the rules for an accounting system that determines and recognizes contingent pension liabilities by requiring the ONP to periodically review the book value of the national and Cedula Viva pension systems and of recognition bonds. A trust fund was set up to back the corresponding liabilities. To further improve the mid- and long-term outlook of government finances through smaller and restricted benefits granted by the national pension system while strengthening the private system, Legislative Decree 874 (enacted in November 1996) promoted enrollment of young workers in the private system by introducing more flexible eligibility rules to apply for recognition bonds. In January 1997, Supreme Decree 144-96-EF created a single framework for asset and liability management. It regulates the Consolidated Pension Reserve Fund created through the transfer of one billion dollars of government deposits previously held by the Central Bank and/or the Banco de la Naci6n to this Fund as a guarantee of recognition bond liabilities. Finally, the government enacted a Single Unified Text for the Private Pension Funds System Law through Supreme Decree 054-97-EF. In 1997 the government of Peru will introduce a series of complementary reforms to increase the efficiency of fund intermediation, improve the transparency of financial information on the government's pension plans, and improve the mid-term fiscal outlook. Bank Performance Throughout the reform of the financial sector discussed here, the Bank performed according to the highest standards of coordination and provided viable recommendations to overcome the difficulties that emerged along the way. Borrower Performance Operational problems emerged during the initial implementation stages of the Financial Sector Adjustment Program. In particular, some institutions were not informed that they were included in the reforms supported by a Sector Adjustment Loan, nor were they informed of the scope of the reforms to be implemented in their respective sectors. To this should be added the problems resulting from the large number of institutions involved in the Program. Coordination was smooth with some (such as COPRI, COFIDE, SBS, CONASEV), while the nature of the functions and the goals set by their respective  62 administrations made for a more complex relationship with others such as Banco de la Naci6n and the Liquidation Commissions. Specifically at the Banco de la Naci6n, grave initial obstacles hampered good coordination with management to implement a smooth reorganization. A critical barrier to the rapid implementation of reforms was the resistance of the bank's management to organizational streamlining, including closing offices and moving out of the financial system. Later, when the bank's by-laws and the restructuring plan drafted by a special commission (established by a Ministry of Finance resolution) were approved at the beginning of 1994, the process finally took off. To honor government commitments in the Loan Agreement, the Banco de la Naci6n had to undergo successive restructuring stages to fit the goals set by the various government agencies involved. Eventually this led to the issue of a waiver to enable the disbursement of the second tranche of the loan. The Government also performed effectively in dismantling first-tier State banks. However, it did face obstacles in transferring their financial assets. These difficulties stemmed principally from a low-quality loan portfolio that hampered the sale to the private sector that had been originally envisaged. Since May 1995 the government has implemented a Portfolio Management Commission to collect bad debts, entrust their collection to third parties, or transfer them. Progress in reaching the Commission's goals has reflected the low demand for such assets. Moreover, guarantees can only be partially enforced, given their low coverage rate and slow court proceedings. Overall, and despite the many difficulties arising in the above mentioned components, the program has been implemented consistently and with continuity, in conformity with government policy goals and reforms in line with the loan's primordial objectives. Nor does the State hold a juridical status as a player in the financial system any longer. Rather, it has assumed its new role as a watchdog and regulator through the Bank Superintendency (SBS) and the Central Bank. During the implementation stage of the program, Peru's financial system recorded spectacular growth as reflected by the recovery of the main monetary indicators. A higher degree of monetization was partly due to increased demand for foreign capital and, since 1994, to higher intermediation in domestic currency. Yield, efficiency, portfolio quality and equity solvency indicators have improved dramatically ever since. Higher financial intermediation also added to the equity restructuring of Peru's banking industry, as reflected by fresh capital contributions by shareholders of various local banks. Others sought resources in foreign capital markets or placed subordinated bonds in the local market. Over the next three years, bank equity is expected to grow by US$250 to US$300 million annually.  63 Interest rates have dropped gradually. Thanks to increased resource intermediation in domestic and foreign currency and smaller operating costs, companies now face reduced financial costs. Increased competition in the local financial industry should also result from new entrants and the revamping of existing institutions. Lower inflation, recovered output, and the growth potential of Peru's relatively small financial system continue to attract domestic and foreign investors. Clearly, foreign investment flows to Peru's financial system are responding to the sector's potential for development and the country's stable economic environment. In this new climate, banking and financial institutions have ventured into new businesses, in particular retail banking, mortgage loans, financing for small and mid-sized companies, and a whole array of investment banking and futures transactions. Both tranches of the loan were duly audited and reported by the Auditing Firm Rodolfo Retamozo and Associates. Lessons Learned Reforms made possible by the loan contributed to macro-economic stability and to the enhanced solvency of the financial system. The program included a reduced participation of government in financial intermediation, as well as stronger monetary policy and banking supervision. Crucial new regulations aimed at opening the financial system and the economy at large. As a result, foreign capital was attracted to invest in banking institutions, thus increasing competition and the supply of financial resources at ever lower costs to the benefit of final consumers. It is of the utmost importance to step up participation in the reforms by all involved agents. This will permit a unified rational strategy to reach the stated goals and speed up the reforms. The government's commitment in this respect is essential and should logically result in an optimum design and implementation of reform. Also to be underscored is the need for all sector loans to be flexible enough so that quick changes may be introduced as the economic program gets implemented, without need for major modifications in the programs' general objectives. Relations between the Borrower and the Bank during Loan Implementation Coordination between the Bank and the Ministry of Economy and Finance was open and continuous.  64 A postponement of the loan's closing date was requested to allow the completion of financial sector reforms, in particular those concerning Banco de la Naci6n and the development banks.  IBRD 26572R ob- i8- O ? i4 72- ECUADOR J COLOMBIA 2. 2- / ./-R Ca s' UMB11 I, ~UI0S /0 <NiN>* #> rr/E-l) IX ~ l\ - 2 E 3J<