Mexico - Financial Sector Adjustment Loan

Dooume of The World Bank FOn omcL USE ONLY Repot No. 12077 PERFORMANCE AUDIT REPORT MERICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) JUNE 24, 1993 MICROGRAPHICS Report No: 12077 Type: PPAR Operations Evaluation Department 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. CURRENICY EOIVALENTS 1989 US$ 1 =Mex$ 2,461.5 1990 US$ 1 =Mex$ 2,812.6 1991 US$ 1 =Mex$ 1,018.4 ABBREVIAIOS ANAGSA - Agro Aseguradora Mexicana (Mexican Agro Insurer) BANRURAL - Banco Rural (Rural Bank) BANPECO - Banco Nacional dePequeflo Comercio (NationalBank for Retail Trade) CNB - National Bank Commission ESW - Economic Sectoral Work FONATUR - Fondo Nacional de Fomento al Turismo (National Fund for Tourism Promotion) FSAL Financial Sector Adjustment Loan GDP - Gross Domestic Product IFC - International Finance Corporation IMP - International Monetary Fund NAFIN - Nacional Financiera, S.N.C. OED - Operations Evaluation Department PACTO - Economic Solidarity Pact PAR - Performance Audit Report PCR - Project Completion Report PECE - Stabilization and Growth Pact PERL - Public Enterprise Reform Loan SAR - Staff Appraisal Report VAT - Value Added Tax FISCAL YEAR January 1- December 31 FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 24, 1993 MEMIORANDUM TO THE EXCUTIVE DIRECTORS AND TIM PRESIDENT SUBJECT: Performance Audit Report on Mexico Financial Sector Adfustment Loan (Loan 38IM ) AttPched is the Performance Audit Report on Mexico - Financial Sector Adjustment Loan (Loan 3085-ME) prepared by the Operations Evaluation Department. It confirms the ratings of the Project Completion Report which provided a good assessment of this successful project. The project outcome is again rated as satisfactory, its sustainability as likely and the insdtutional impact as substantial. The most important lesson of the audit is the possibility to introduce financial sector reform in the presence of high inflation when strong macroeconomic policies are introduced to reduce the fiscal deficit and therefore inflation. Attachment This documnt has a restricted distribution and may be used by recipients only in the perfounanco of their ficia; d, 4s. Is contes atoy not otherwise be disclosed without World Bonk authorization. FOR OFFICIAL USE ONLY PERFORMANCE AUDIT REPORT MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) TABLE OF CONTENTS PAGEN. PREFACE ...... ............................................... i BASIC DATA SHEET............................................ .iii EVALUATION SUMMARY .......................................... v I. INRODUCTION ..................................... 1 II. THE PROGRAM: OBJECTIVES AND DESIGN ................... 1 WI. IMPLEMENTATION .................... 2 IV. EVALUAIN AND SUSTAINABLITY ....................... 5 V. LESSONS QF EXPERIENCE ............................... 7 () Successful Financial Reform in Inflationary Environment .......... 7 (ii) Need to Focus FSAL Type Projects ....................... 7 (iii) Importance of Solid ESW Prior to the Project-Bank/Country Relations . 7 (iv) Action Plans vs. Pre-Defined Concrete Measures .............. 7 VI. CONCLUSIONS ...................................... 7 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. PERFORMANCE AUDIT REPORT MEXICO FINANCIAL SECTrOR ADJUSTMENT LOAN (LOAN 3085-ME) PREFACE 1. This is the Performance Audit Report (PAR) on the Financial Sector Adjustment Loan (FSAL) to Mexico (Loan 3085-ME) amounting to US$ 500.00 million equivalent with a cancellation of US$ 12.86 million. This final disbursement of the loan was March 24, 1993 and the closing date will be June 30, 1993. 2. The PAR was prepared -y the Operations Evaluation Department (OED) and the Project Completion Report was prepared by t.- Latin America and Caribbean Regional Office. The PAR is based on the PCR, the President's Report, the loan documents, staff files and Staff Appraisal Report (SAR). 3. The PCR provides a very good assessment of the project experience and discusses the performance of the Bank and Borrower executing agencies. It also provides a clear and forward-looking discussion of the actions needed to further develop the renarkable gains achieved under the project. The main points raised in the PAR are: (i) the possibility of having successful financial sector adjustment operations in an inflationary environment when at the same time strong macroeconomic policies are adopted; (ii) the need to focus FSAL projects on aspects directly linked to the program, avoiding branching out in more remote areas such as state and local finances; (iii) the importance of solid ESW before embarking on programs containing aspects that have not already been well analyzed by the Bank. 4. Comments received from the Region are reflected in the PAR. No comments were, however, received from the Borrower. - Iii - PERFORMANCE AUDIT REPORT MEXIQ FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) BASIC DATA SHEET LOAN PQSITION (Amounts in US$ Million) As of March 31. 1993 Lan Original Disbursed Cancelled fpald OutAing 3085-ME 500.00 485.79 12.86 - 485.79 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS I2.2 19.9 1M0 Appraisal Estimate 235 500 500 Actual 235 485 485.5 Actual as % of Estimate 100 97 97 Date of Final Disbursement: March 24, 1993 PROGRAM DATES Orikinal Actua Appraisal Mission 10-11/89 10-11/89 Negotiations 10-11/89 4/24-29/89 Board Approval - 6/13/89 Loan Signature - 6/16/89 Effectiveness 9/19/89 6/27/89 Loan Closing 6/30/91 6/30/93 Loan Completion 12/31/90 12/31/93 - iv - STAFEINPITS (staffweeks) EM12 EM 1291 E12 ITAL Preappraisal 4.0 4.0 Appraisal 111.6 111.6 Negotiations 108.0 1.0 109.0 Supervisions 4.0 64.8 1.5 12.7 83.0 Other 3.8 3.8 TOTAL 231,5 65.8 1.5 12.7 311.4 MISSION DATA No. of No. of Staff Mor.thlYear WQkm Persons Appraisal 10-11/88 2 - - Supervision 1 06/89 1 4 4 Supervision II 09/89 1 2 2 Supervision M 12/89 1 7 7 Completion 11/91 1 3 3 SUPERVISION RATINGS (Form 590) Evaluation Develorment Legal Management Availability Int Oveall Obiecives Covenants Performance FAU& 1989 1 1 1 1 1 1990 1 1 1 1 1 1991 1 1 1 1 1 1992 1 1 1 1 1 -v. PERORM AUDIR MXICQ FINANCIAL O ADIMELOWAN (LOAN 308-ME) EALUAT SUMMARY Introduction tax administration, while at the same time im- proving the finances of the Federal District and 1. The Financial Sector Ad,'stment Loan revamping state and local finances. (PSAL) was part of a Bank program to support the Mexican Government's effort to stabilize the 4. Thefinancialreformsincludedliberaliza- economy and revamp economic growth. The tion of the banking system, strengthening pru- FSAL was presented to the Board in 1989, dential regulations and supervision, redefining parallel with an Industrial Sector Policy Reform the roles of development banks and trust funds Loan and a Public Enterprise Reform Loan. and r3ducing lnterest subsidy and transfers to The three loans constituted a comprehensive those institutions. At the same time IFC had package including macroeconomic policies and taken the lead role with respect to the reforms in key sector adjustments. the supervision of brokerage houses. 2. Following the 1982 financial crisis and Evaluation the subsequent nationalization of commercial banks, the financial sector in Mexico until 1988, 5. The program was very successful in the when the Government introduced the Solidarity areas of macroeconomic stability and fiscal Pact, remained rather restricted with the devel- reforms at the Federal and Federal District opment banks and trust funds, responsible for levels, in the liberalization of the banking sys- directed credit, competing with commercial tem, in overhauling the supervision and financial banks which in turn were also forced to lend regulations of banks and brokers and reducing their funds to favored sectors at below market the subsidies to the development banks and trust interest rates. As a result, intermediation funds while improving the transparency of their through banks declined while institutional bro- funding. kers and the intercompany market channeled a growing share of the financial market. 6. As the PCR acknowledges, the program was less successful in the area of state and local The Programfinances reforms and this essentially because of design problems, i.e., this part of the program 3. The purpose of the FSAL was to support was not really at the center of the FSAL and price liberalization, and fiscal and financial furthermore, the preparatory work in this area sector policies which formed the basis of the had not been sufficient. The program was also Government adjustment effort to redress the less successful in redefining the roles of the economic situation of the country. In particular development banks and trust funds, especially it included, on the fiscal side, corporate and those dealing with the agricultural sector. Issues income tax reforms and measures to strengthen of overlapping activities among them and appro- - VI - priate interest rates charged to borrowers are tion of the issues, weak conditionality and very still outstanding and will have to be pursued little progress achieved under the project in this jointly by the Bank and the Government. The area. broader issue here Is whether directed credit at subsidized interest rates provided by relatively CHO lmw=ce of Solid ESW Prior to the cumbersome institutions such as development EW1ect-BmktCun= Reations banks and trust funds, is the most efficient way to reach the target groups, in particular, small 10. The PCR acknowledges that the Finan- enterprises and low income farmers which are cial Sector Adjustment LAn caught the Bank very much at the center of the Government almost by surprise in tem of adequate body of concern to have a more equitable distribution of studies on the sector in previous years. As a the gains from the adjustment effort launched in result, a large amount of the thinking process 1988. had to take place at the time of the project preparation. The reason for this impreparedness 7. With respect to the sustainability of the is that the Mexican Government had been reluc- project, the assessment is positive and stems on tant to allow the Bank to come *near* the sector one side from the rapid progress already realized as part of Its ESW, essentially because of a in the areas of fiscal reforms and commercial certain uneasiness in discussing the experience banks reforms which are there to stay, and on with the nationalized banking system after the the other side, from the continued commitment 1983 reform. of the Mexican Government to pursue the adjust- ment effort. (1v) Action Plans vs. Pre-Defined Cocrete Lessons of Experence 11. The K'R illustrates the risk involved in (1) Successful Financial Reforms in Inflation- basing the project on a series of action plans to ary Environment be caried out rather than on specific well-de- fined measures. The action plan was In some 8. The single most important positive cases, as with the development banks and trust lesson from this project, well evidenced in the funds reforms, the result of the Bank's limited PCR, is that it is possible to introduce financial knowledge in this area, in turn the result of the sector reforms in the presence of high inflation already mentioned lack of up-to-da first hand pgvided that at the same time strong macroeco- knowledge of the sector before the project. In nomic policies are adopted to redress the fiscal general, however, action plans, while a channel deficit, thereby succeeding in rapidly reducing for policy dialogue with the Government in inflation. In the case of Mexico the financial critical areas, saw little follow-up on implemen- sector reform success was also due to other tation after the second tranche was released. important measures in the areas of price liberal- .ization, trade reforms, and strengthening of the Cnlions prudential regulatory and supervisory framework for the banking system. 12. As indicated in the Introduction, the FSAL took place just before and just after a (ii) Need to Focus FSAL Type Projects number of major strucwral adjustment opera- tions carried out by the Bank but also by the 9. Branching out by the FSAL into areas IMF. These included Industrial Sector Policy, remotely linked to the financial sector such as Public Enterprise Reform and Sectoral Adjust- state and local finances leads to a loss of focus ment Loans. It fell therefore on very fertile with the consequent insufficient conceptualiza- ground in terms of ownership by the Mexican - vil - Government who had decided, after the rocky attributable to the general adjustment atmosphere sailing during the best part of the 1980s, to dominatngthecoutryatthetimeofItsprepa- drastically change and imp-3ve the country's ration and Implementation. Its longm-tem, economic situation. The fact that the PSAL was sustainabillty Is very much dependent on the a success, notwithstanding some flaws well continuation of that atmosphere. captured in the PCR, was to a large extent PERFORMANCE AUD1I REEO MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) I. INTROUCTON 1. From 1982, when a major financial crisis occurred following five years of misuse of oil revenues, to 1988, when the Economic Solidarity Pact was introduced following the 1987 second major financial crisis, the financial sector had experienced a very turbulent and restricted sailing. In 1982, commercial banks, many of which were insolvent, were nationalized with their numbor being reduced from 80 to 20. At the same time brokerage firms, privately owned, saw their role expanding and, together with the eight development banks and 21 government financial trust funds providing subsidized credit, they gradually reduced by the end of the period the role of commercial banks. 2. The Solidarity Pact included measures to revamp the role of the private sector in the economy. As part of such effort, the need for a well functioning financial sector was reognized and the Bank, as part of its support to the Government, launched three sectoral adjustment operations, one of which was a Financial Sector Adjustment Loan (FSAL). The other two were an Industrial Sewtor Policy Loan and a Public Enterprise Reform Loan. These three loans were linked to the Interest Support Loan of 1989.Y 3. The Financial Sector Adjustment Loan was a successful project and the Project Completion Report's (PCR) evaluation of it is quite clear and convincing. While problems still exist in the areas of development banks and trust funds, the projects most interesting feature is the demonstration that financial sector reforms can be successfully introduced in an inflationary environment in the presence of strong macroeconomic reforms as was the case in Mexico. II. THE PROGRAM: OBJECTIVES AND PESIGN 4. The objctives of the reforms included in the FSAL were to (i) increase competition in the system which would gradually reduce unusually high intermediation costs; (ii) modernize the financial system, improving the quality of services and expanding the array of financial services available; (iii) deepen the financial system, increasing the volume of resources available to finance the productive sectors of the economy; (iv) regulate the financial markets and overhaul the cumbersome regulatory framework while strengthening bank supervision; and (v) redefine the roles of development banks and trust funds while reducing interest subsidies and transfers of resources to those institutions. IFC took the lead on the reforms in the supervision of brokerage houses. 5. These being the "core" objectives of the FSAL, other areas included in the project were the achievement of a macroeconomic program consistent with the objectives of stabilization and growth, a reform of the tax system, in particular corporate and income taxes, and improvement in tax administration, strengthening of public investment planning and improvement in state and local finances. See PAR, Mexico - Interest Support Loan (Loan 3159-ME). .2- 6. The PCR rightly states that the program was well designed as it was part of a comprehensive structural adjustment effort both at the macroeconomic level and at the sectoral level, i.e., public enterprises and industrializatio'. Furtheraore, the FSAL provided an important basis for the renegotiation of foreign debt and the re-privatization of the banking system. 7. From the PCR itself, however, one can evince the feeling that the program suffered some overloading, for evample, in the area of state finances where inadequate conceptualization and therefore conditionalities were present. This should not come as a surprise if one considers that issues of state finances are not really part of the core in any FSAL operation. Avoiding overambitious design is one of the primary lessons of experience for the formulation of Bank projects. Already, in this project, the inclusion of corpo, 2e and income taxation reforms-cum strengthening of tav administration could be considered a "border" area with respect to the FSAL's core, and even more so the improving of the finances of the Federal District. But state finances was clearly an "out of border" objective. 8. Another design issue raised in the PCR is the limited time available for the preparation of certain components of the program. This was due essentially to the fact that the very modest involvement of the Bank in financial sector issues over the previous years had prevented the develonment of adequate ESW work in the subject, unlike with the more general macroeconomic issues. As th ?CR states, some of the relevant economic and sector work had to be carried out during project implementation. As a result, the design of the loan conditionality was affected in terms of its specificity and, for instance, the second *ranche conditionality was more based on formulation of action plans at the time than on pre-defined actions. III. IMPLEMENTATION 9. Most of the reforms envisaged by the FSAL were successfully implemented. The FSAL supported the Governments macroeconomic program which formed the basis of the PACTO. In particular, reduction of the fiscal deficit and inflation, reduced interest rates, price deregulation, flexible exchange rate policy and resumed private investment were the conditions implied by the FSAL and they were largely met. 10. The progress between 1988 and 1991 as shown by key economic indicators is quite impressive. Table I from the PCR illustrates it eloquently. 21 The reluctance during the 80s of the Government to discuss the experience with the nationalized banking system was mainly responsible for the light presence of the Bank's ESW in the sector. -3- [Ale.J: KEY ECONOMIC INDICATORS 1988 1989 1990 1991 GDP Growth Rate 1.1 3.2 4.4 3.6 Debt Service/XGNFS 346.8 291.0 251.7 269.0 Private Invest./GDP 14.1 14.4 15.8 17.0 Pri-ate Savings/GDP 18.2 16.6 17.1 15.6 Current Account/GDP -1.4 -2.9 -2.9 -4.7 Fiscal Primary Balance/GDP 7.9 8.3 7.8 5.5 Inflation (annual average) 114.2 20.0 26.7 22.7 Real interest ratel' 23.6 19.1 1.3 0.7 Source: Banco de Mexico INEGI and World Bank estimates. 1' 2nd semester one month treasury bill rate deflated by CIP. e: estimated The only shadow in the macroeconomic picture is the worsening of the current account deficit prompted mostly by an import boom and compensated by huge capital inflowsy 11. At a more detailed level, the corporate and income tax reforms included in the FSAL were successfully implemented with major loopholes being eliminated, taxable income being indexed for inflation, and top marginal rates for both corporate and income taxes being reduced. Also, the VAT rates were reduced and harmonized. In parallel, the FSAL supported the Government effort to improve tax administration through a technical assistance component. As a result, computerization of accounts, reorganization of auditing procedures and introduction of a new management style based on accountability of results and monetary incentives to inspectors were implemented. In assessing the results of the tax reforms the PCR rig ly notes that the success was to be measured more in terms of the improved efficiency of the tax system than in terms of immediate increase in tax revenues. 12. As to state and local finances reforms, as Indicated earlier, the FSAL was more successful with respect to the Federal District, which saw a dramatic increase in revenues, than to the states and local finances in general for which, as the PCR recognizes, the Action Plans agreed upon with the Government have not yet been implemented. 13. With respect to the core of the FSAL, i.e., the financial sector, at the time of appraisal in 1988 the main issues were: (i) extremely limited and highly directed banking credit to the private sector; (ii) inefficient financial intermediation and inadequate price competition due to deposit and lending rates controls; (iii) unclear role for development banks and trust funds and inadequate control of subsidies ' See PAR - Interest Support Loan for discussion of this aspect. -4- and transfers; and (iv) inadequate supervision and prudential regulation of banks and brokers. 14. Before Board presentation of the FSAL the Government had proceeded to eliminate controls on commercial banks, eliminate the 10 percent reserve requirements, and do away with preferential credit imposition on commercial banks, this type of credit being provided exclusively by development banks and trust funds. 15. At the same time, as the PCR indicates, far reaching reforms were being Introduced which were not linked to FSAL conditionality but supported the financial sector liberalization effort. These reforms aimed at reducing market segmentation, increase competition among financial institutions, simplify regulation of insurance premiums and policies, and, most important, in May 1990 the constitution was amended to allow full private ownership of commercial banks. The impact of these reforms was dramatic. Commercial banks assets increased by an annual average of 24 percent in real terms over the 1988-1991 pt iod and lending to private sector rose from 25 percent of total assets in 1986 to almost 60 percent in 1991. 16. While the success of the FSAL with respect to the commercial banking system has been remarkable, development banks and trust funds, as indicated earlier, have shown less progress and the PCR provide a very thorough discussion of this problem area. In 1988 development banks and trust funds were facing three sets of problems. First, their respective roles were not clearly defined with consequent significant overlapping in their activities. Second, subsidies to final borrowers were not carefully targeted. Third, tranmfers to some of these institutions, in particular BANRURAL (Agricultural Development Bank) and ANAGSA (National Agricultural Insurance Company) were substantial and encouraged wasteful practices. In 1988, the assets of the eight development banks were close to those of the commercial bacs and more than 80 percent of their assets represented lending to the public sector. Lending by the development banks to the private sector was 20 percent of total private sector lending of the entire banking system. The development banks, together with 21 trust funds, provided lending at subsidized terms for a large range of economic activities. The development banks received funds, not included in the Government budget, under the form of forced lending by commercial banks and direct Government lending below the marginal cost of funds. 17. As part of the FSAL, at the end of 1989 the Government prepared a program of Structural Change and Financial Modernization of Development Banks and Trust Funds. The main objectives of the program were to: (i) restructure the major rural sector institutions by December 1991; (ii) ensure that the development banking system would be complementary rather than competitive with commercial banks; (iii) charge the development banks and trust funds the full opportunity costs of funds raised by the Federal Government for on-lending to these institutions; and (iv) establish the treasury bill rate as the floor for future lending rates of development banks. A major part of the program was limiting Government subsidies and transfer to development banks and trust funds. 18. As the bulk of the transfers were in the agricultural sector, this was the central intervention area of the FSAL. The figures show that between 1986 and 1992 total transfers to the rural financial system by the Government declined from 0.57 to 0.14 percent of GDP. Reduction of interest rate subsidies were also part of the program and data show that progress was achieved in this area. The goal of completing the restructuring of the rural financial institutions by 1991 was not achieved and, notwithstanding improvement in lending and recovery procedures, loan recovery efforts have been disappointing. -5- 19. More generaAly, the PCR concludes that while major reforms have taken place in the development banks and trust funds, there still is significant scope for improvement. The number of trust funds and development banks remain excessive and overlap in their activities continues. Some institutions, such as NAFIN (Nacional Financiera) still compete with rather than complement the activities of the commercial banks. Finally, the development banks and trust funds continue to channel significant financial subsidies mainly by lending at preferential rates. 20. Finally, the improvement in prudential regulatory framework and bank and brokers supervision was an important component of the FSAL. An Action Plan covering this aspect was part of the second tranche release of the FSAL. In particular, it addressed the following areas: (i) a system to classify the loan portfolios according to default risks; (ii) stringent provision for loan losses; (iii) detailed public disclosure of each bank's financial state; and (iv) a better system to supervise both banks and brokers. Towards this goal the Bank produced a report on banking supervision and regulation system which formed the basis for the Government action plan. The objective of the FSAL in this area were achieved, and significant improvements have taken place. As the PCR indicates, these improvements played an important role in increasing the public's confidence in Mexican banks and securities, facilitating the expansion in banks' resource mobilization and their successful privatization. The reforms also contributed to the boom in the stock market which saw its index rising by 266 percent in real terms and by 405 percent in dollar terms from end-1988 to end-1991. IV. EVALUATION AND SUSTAINABILITY 21. The PCR captures accurately the achievements under the program and, more importantly, dwells on the remaining agenda thus providing the right forward-looking perspective. On the whole, the program was very successful in the area of macroeconomic stability and fiscal reform at the Federal Government level, in the liberalization of the banking system, in overhauling the supervision and financial regulations of bankers and brokers, in reducing subsidies to development banks and trust funds and improving transparency of their funding and in improving the finances of the Federal District. The PCR rightly indicates that central to the success of the reforms was the Government commitment to a major overhaul of the macroeconomic framework with the private sector destined to take the lead role in resumed growth of the economy. In this respect the FSAL was a window of opportunity for introduction at a subsequent stage of privatization of the commervial banking system which played an important role in restoring confidence by both domestic and foreign private investors. 22. As already mentioned when discussing the design of the program, the less than satisfactory progress in the area of state finances reflected, in the words of the PCR "the fact that the complex issue of state finances was not the focus of the program. The conditionality attached to this goal was "reduce non-matching grants to the state". The condition could not be directly quantified as the necessary data was not available." (para. 11). 23. The other area in which progress was also less than satisfactory was the redefinition of the role of development banks and trust funds. The PCR admits that in this case the Bank was in part at fault as it did not, at the time of project preparation, identify a well defined set of specific actions and furthermore, the Bank and the Government could not agree on the appropriate role of some of these Institutions. The latter aspect should not come as a surprise since for decades development banks and trust funds had been the Government instrument to support specific sectors and the interest groups behind them. -6- 24. The above leads into the remaining agenda. In general terms, competition in the banking system needs to be further developed. Barriers to entry of new banks resulting from high initial capital requirements and restriction to foreign competition need to be reduced. At present Mexico does not allow foreign banks to establish branches as subsidiaries and total foreign participation in Mexican banks is limited to 30 percent with individual entities holding limited to five percent. 25. More specifically, with respect to development banks and trust funds there still is significant functional overlap among them, directed credit is still priced below market and the agricultural sector institutions continue to benefit from large Government transfers. Furthermore, It is not certain that there is a role for some of the existing development banks in particular NAFIN and BANPECO, and trust funds (FINA, PIDEX, FONATUR, FICAR). 26. With respect to supervision, the National Bank Commission (CNB) should have more power to become the real supervisor of the banking system. CNB should be able to require external auditors to assess the validity of the portfolio classification and its staff requirements and composition should be adjusted to the new and expanded role. Another important measure would be to provide summaries of the consolidated financial statements of parties within a financial group in CNB's monthly bulletins. 27. With respect to securities markets regulation and supervision, while legislation and regulations are quite advanced in Mexico there is still scope for improvement especially to tighten capital requirements or reduce the leverage capability of Casas de Bolsa and to reduce potential conflict of interest between Casas de Bolsa an! Mutual Funds due to their close relationship and too flexible investment policies. The National Stock Exchange Commission is well aware of these problems and is studying new regulations to correct them. 28. While progress in tax administration has been remarkable, some improvements are needed in the areas of stabilization of the legal system, revision of the efficiency of the current tax payment schemes which were designed for high inflation periods, and strengthening of that part of the computerization system required by the inspection function which has been relatively less developed than the collection system. 29. Finally, the little progress made in the areas of state and municipal finances suggests that, based on the positive experience at the Federal and Federal District levels, a concentrated effort in this area should generate good results. 30. There are no doubts as to the sustainability of the project. The Government commitment to continue on the way of further changes along the lines indicated above is quite strong. The privatization of the commercial banking system is the backbone for the sustainabiity of the financial sector reform and the response of the private domestic and foreign sector is its best indicator. As to the progress required in the area of development banks and trust funds, the PCR realistically indicates the difficulties ahead. It recognizes the concern of the Government, in a country where there is still widespread poverty, to have as large as possible segments of the population to share in the benefits of the economic reform. It raises, however, the issue whether directed, subsidized credit to small enterprises and low income farmers is the most efficient way to achieve this goal, especially when managed by large and cumbersome development banks. The sustainability of the initial progress under the project in terms of reduced government transfers to these special institutions still faces problems of appropriate interest rate structure and targeting of intended beneficiaries. -7- V. LESSONS OF EXPERIENCE (i) Successful Financial Reforms in Inflationary Environment 31. The single most important positive lesson from this project, well evidenced in the PCR, is that it is possible to introduce financial sector reforms in the presence of high inflation provided that strong macroeconomic policies are adopted to redress the fiscal deficit, thereby succeeding in rapidly reducing inflation. In the case of Mexico the financial sector reform success was also due to other important measures in the areas of price liberalization, trade reforms, and strengthening of the prudential regulatory and supervisory framework for the banking system. (ii) Need to Focus FSAL TMe Projects 32. Branching out by the FSAL into areas remotely linked to the financial sector such as state and local finances leads to a loss of focus with the consequent insufficient conceptualization of the issues, weak conditionality and very little progress achieved under the project in this area. (iii) Importqnce of Solid ESW Prior to the Project-Bank/Country Relations 33. The PCR acknowledges that the Financial Sector Adjustment Loan caught the Bank almost by surprise in terms of an adequate body of studies on the sector in previous years. As a result, a large amount of the thinking process had to take place at the time of project preparation. The reason for this impreparedness is that the Mexican Government had been reluctant to allow the Bank to come "near" the sector as part of its ESW, essentially because of a certain uneasLess in discussing the experience with the nationalized banking system after the 1983 reform. (iv) Action Plans vs. Pre-Defined Concrete Measures 34. The PCR illustrates the risk involved in basing the project on a series of action plans to be carried out rather than on specific well-defined measures. The action plan was in some cases, as with the development banks and trust funds reforms, the result of the Bank limited knowledge in this area, in turn the result of the already mentioned lack of up-to-date first knowledge of the sector before the project. In other cases, however, while a good channel of policy dialogue with the Government on critical areas, saw little follow-up on implementation after the second tranche released. VI. CONCLUSIONS 35. As indicated in the Introduction, the FSAL took place just before and just after a number of major structural adjustment operations carried out by the Bank but also by the IMF. These included Industrial Sector Policy, Public Enterprise Reform and Sectoral Adjustment Loans. It fell therefore on very fertile ground in terms of ownership by the Mexican Government who had decided, after the rocky sailing during the best part of the 1980s, to drastically change and improve the country's economic situation. The fact that the FSAL was a success, notwithstanding some flaw well captured in the PCR, was to a large extent attributable to the general adjustment atmosphere dominating the country at the time of its preparation and implementation. Its longer-term sustainability is very much dependent on the continuation of that atmosphere.