Mexico - Financial Sector Technical Assistance Project (supplemental loan)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6629-ME MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SUPPLEMENTAL LOAN IN THE AMOUNT EQUIVALENT TO US$13.8 MILLION TO NACIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT MAY 25, 1995 This document has a restricted distribution and may be used by recipients only in the 3erformance of their official duties. Its contents may not otherwise be disclosed without World BanL- authorization.  Currency Equivalents (As of May 25, 1995) Currency Unit = Mexican New Peso (MexN$) US$ 1.0 = MexN$ 5.885 Abbreviations and Acronyms CAS Country Assistance Strategy CNB Comisi6n Nacional Bancaria (National Banking Commiss on) CNBV Comisi6n Nacional Bancaria y de Valores (National Banking and Securities Commission) CNSF Comisi6n Nacional de Seguros y Fianzas (National Insurance and Bonding Commission) CNV Comisi6n Nacional de Valores (National Securities Comn ission) CONSAR Comisi6n Nacional del Sistema de Ahorro para el Retiro (National Commission of the Retirement Savings System) FAMV Fondo de Apoyo al Mercado de Valores (Securities Mark, t Support Fund) FOBAPROA Fondo Bancario de Protecci6n al Ahorro (Bank Fund for Savings Protection) FTAL Financial Sector Technical Assistance Loan FSRL Financial Sector Restructuring Loan FY World Bank Fiscal Year (July 1 - June 30) GOM Government of Mexico ICB International Competitive Bidding IEIU Investment, Energy, and Industry Unit of SHCP LCB Local Competitive Bidding NAFIN Nacional Financiera, S.N.C. PCR Project Completion Report PAR Performance Audit Report PROCAPTE Programa de Capitalizaci6n Temporal (Temporary Capitalization Program) SAR Sistema de Ahorro para el Retiro (Retirement Savings S stem) SECOFI Secretarfa de Comercio y Fomento Industrial (Ministry of Commerce and Industrial Development) SHCP Secretaria de Hacienda y Credito Publico (Ministry of F nance and Public Credit) UDI Unidad de Inversi6n (Investment Unit)  FOR OFFICIAL USE ONLY MEXICO FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT SUPPLEMENTAL LOAN Loan and Project Summary Borrower: Nacional Financiera, S.N.C. (NAFIN) Guarantor: United Mexican States Implementing Ministry of Finance and Public Credit (SHCP) Agency: Beneficiary: SHCP and two commissions under SHCP - National Banking and Securities Commission (CNBV), and National Retirement Savings System Commission (CONSAR); Poverty: Not Applicable. Amount: US$13.8 million equivalent. This Supplemental Loan will increase IBRD assistance to the Financial Sector Technical Assistance Project to US$37.4 million equivalent. Terms: With the same repayment terms as the original loan (3838-ME) Commitment Fee: 0.75 % on undisbursed loan balances, beginning 60 days after signing, less any waiver. On-lending Terms: Not Applicable. Financing Plan: See Schedule A. Original MOP: Report No. P-6451-ME Net Present Value: Not Applicable. Staff Appraisal Not Applicable. Report: Project Number MX-PA-41811 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.  l  MEXICO FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT SUPPLEMENTAL LOAN TABLE OF CONTENTS Page No. Background: Financial Technical Assistance Loan ..... .................. 1 Rationale for the Supplemental Loan ............................... 3 Description of the Proposed Supplemental Loan ......................... 3 Implementation of the Supplemental Loan ............................ 7 Recommendation ............. 8 Schedule A ....... ..... 9 Schedule B . .................................... ...... 10 Schedule C ..................................... ....... 11 Schedule D . .................................... ...... 12 Annex I ...................................... ...... 15 Project Modifications and Description .... 15 A. National Banking and Securities Commission .... 15 B. National Retirement Savings Commission .... 19 Project Administration and Implementation .... 20 Attachment I: Project Implementation Plan .................... ...... 22   MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SUPPLEMENTAL LOAN TO THE UNITED MEXICAN STATES FOR A FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT' 1. I submit for your approval the following memorandum and recommendation on a proposed supplemental loan to Nacional Financiera, S. N.C. (NAFIN), with the guarantee of the United Mexican States for the equivalent of US$13 8 million. It will supplement the Financial Sector Technical Assistance Loan (Loan 3838- ME) to NAFIN increasing the Bank Loan from US$23.6 million to US$37.4 million equivalent. The proposed Supplemental Loan would be made on the same repayment terms and conditions as Loan 3838-ME. 2. The two primary objectives of the original project were to: (i) improve the safety and soundness of the Mexican financial system through enhanced prudential regulation and supervision; and (ii) support the development of the pension system. The negative reaction of financial markets immediately after the December 1994 devaluation of the Peso hit an already weak banking system and exacerbated the financial distress faced by Mexican banks. This required the Government of Mexico (GOM) to develop a Financial Sector Restructuring Program (FSRP) in close consultation with the Bank (see para 6). Successful implementation of the FSRP will require an expansion of the assistance provided under the Financial Technical Assistance Loan (FTAL) to supervisorv agencies and Ministry of Finance and Public Credit (SHCP). Simultaneously, assistance is urgently needed in new areas such as diagnostic studies of banks and preparation of bank restructuring plans. The financial crisis has also highlighted the need to undertake reforms to both increase and improve the allocation of domestic savings. Thus, the GOM has established pension and contractual savings reform as a key component of its National Development Plan. In this context, it has become necessary to redefine the types of assistance to be provided under the original National Commission of the Retirement Saving System (CONSAR) subcomponent of LN 3838-ME (see para. 15). The proposed supplemental loan is the most appropriate vehicle to assist the GOM in these two priority areas of reform. Background: Financial Technical Assistance Loan 3. Project Objectives and Description. The US$23.6 million FTAL was approved by the Board on January 24, 1995 and signed on March 9, 1995. Its three interrelated objectives are: (a) to improve the safety and soundness of the financial system through improved prudential regulation and supervision via greater incentives for self-regulation by market participants; (b) to support the  -2- development of the pension system; and (c) to strengthen public investment evaluation and budgeting. The Project's two primary components consist of: (a) a program of assistance to modernize financial sector regulation and improve supervision that provides support to the National Banking and Securities Commission (CNBV) which was created via the merger of the National Banking Commission and National Securities Commission that became effective May 1, 1995, National Insurance and Bonding Commission (CNSF) and the CONSAR; and (b) assistance to strengthen the public investment and budgeting procedures and processes of SHCP. The project activities include: hiring external consultants to assist in the development of specific policies and regulations; commissioning of related studies, financing participation in seminars, advanced training programs, and other human resource development activities; secondment of special long-term consultants to strengthen specific activities of the Commissions; and procurement of the necessary software, hardware, and equipment. 4. Implementation Experience: The project is being executed by SHCP. The implementation of the supervision and regulation component is being undertaken by each Commission (CNBV, CNSF, and CONSAR). Separate institutional development plans (IDPs) were established by the Commissions that served as the basis for development of the technical assistance program. Thus far, particular emphasis has been placed on providing urgently needed assistance to: (i) establish appropriate principles and procedures for resolving troubled banks; (ii) upgrade on-site inspection through secondment of a foreign examiner to the CNBV for 6 months; and (iii) review or assist in preparation of regulations in such areas as troubled debt restructuring guidelines, risk asset classification guidelines, new regulatory accounting standards, and proposed capital adequacy standards. The public investment and budgeting component will be implemented by the Unidad de Inversion within SHCP. Thus far, the GOM has placed less emphasis on implementation of this component given the emergency situation within the Mexican financial system. Overall project implementation is going very well and is faster than originally foreseen in the case of the supervision and regulation component. SHCP and the related Commissions are very committed to the project and are in compliance with all major covenants. 5. The FTAL is not yet effective. The GOM has been using its own resources, but will ask for reimbursement upon effectiveness given the retroactive financing available under the original FTAL. Although the original FTAL could have been made effective shortly, it has been agreed that it be made effective at the same time as the new supplemental loan (para 25, Agreements Reached).  -3- Rationale for the Supplemental Loan 6. Changing Country Economic Background. Facing rapid depletion of its foreign reserves, Mexico was compelled on December 20, 1994 to abandon its longstanding defense of the peso exchange rate. The subsequent negative reaction of international financial markets placed further strain on Mexico's already weak banking system. In response to the crisis, the Government requested an accelerated and expanded Bank program of financial support and technical assistance to restructure the financial system. In February 1995, the Bank began preparation of the Financial Sector Restructuring Loan (FSRL) to support the Government's financial sector restructuring program to restore the solvency and soundness of the financial system. The Government's program is described in the Memorandum of the President for the FSRL (Report No. FSRL P-6616/ME). The program is designed to: (i) restore the solvency and soundness of Mexico's banking system, restructure banks, and improve confidence in the financial system; (ii) reform the accounting standards and prudential regulations for banks, and strengthen supervision to prevent future recurrence of systemic problems; (iii) improve discipline in the provision of liquidity by the Banco de Mexico (Central Bank); and (iv) initiate reforms in accounting practices and regulation of financial groups and the deposit protection system. 7. Due to the events in the Mexican financial sector described above, the activities supported under the FTAL as approved in January 1995 now require significant acceleration, expansion, and modification. The proposed FSRP will require expanded technical assistance to support rapid government efforts. The Supplemental Loan will also support the Government's objective to increase growth rate and the efficiency of allocation of domestic savings through pension and contractual savings reform. Hence, the component of the project implemented through CONSAR is being restructured and slightly enlarged to help lay the foundation for a deeper reform of Mexico's three pillar pension system. 8. The proposed supplemental loan is fully consistent with the Bank's Country Assistance Strategy and the FSRL (Report No. FSRL P-6616/ME) that will be presented concurrently with this operation. This supplemental loan addresses two of the most important priorities of the CAS--restoring the safety and soundness of the banking system and helping to increase the growth rate and improve the efficiency of allocation of domestic savings. In addition, the FTAL will serve as an umbrella project to coordinate assistance provided by various bi-lateral donors (e.g. supervisory agencies in other countries) in financial sector reform. Description of the proposed Supplemental Loan 9. Project Objectives. The proposed supplemental loan will pursue the first two objectives of the FTAL as originally approved: (i) to improve the safety and  -4- soundness of the financial system through improved prudential regulation and supervision, and via greater incentives for self-regulation by market participants; and (ii) to support the development of the pension system. Technical assistance to support policy actions under the FSRL fall under the first objective and will involve assistance to CNBV (para. 12). Assistance involving the development of Mexico's pension system will be re-designed, but will still be provided to CONSAR (para. 15). Finally, improvements in the public investment and budgeting system and related support to the IEIU remain as project objectives. 10. Project Description. The supplemental loan would support expansion of existing as well as new activities under the Financial Sector Regulation and Supervision component of the existing FTAL. The modifications to the original Project are fully described in Annex I. Cost estimates are provided in Schedule A inclusive of new incremental financing required as well as funds released through the restructuring of the components of Ln 3838-ME as originally appraised. The Project Implementation Plan (Attachment I of Annex I) provides information on the activities, expected output, forms of assistance, timing, and how the technical assistance program assists the GOM to implement studies, policies, or other actions under the FSRP. 11. The total estimated cost of additional activities under the modified FTAL would be US$17.7 million, including US$13.8 million in Bank financing. Coordinated assistance will be provided through the Secretarfa del Hacienda y Cr6dito Piiblico (SHCP - Ministry of Finance and Public Credit) over a 3 year period to the Comisi6n Nacional Bancaria y de Valores (CNBV - National Banking and Securities Commission) and the Comisi6n Nacional del Sistema de Ahorro para el Retiro (CONSAR or National Commission of the Retirement Savings System). The vast majority of this supplemental financing will support assistance to CNBV to support important reforms under the FSRP. Supplemental financing provided to CONSAR relative to originally programmed amounts will be small, because this component has been redesigned to reallocate financing previously provided for goods and services. 12. National Banking and Securities Commission. Additional assistance to CNBV would be provided for related activities agreed under the FSRL: * Diagnostic Studies of Troubled Banks. The revised FTAL would support the hiring of auditors to assist CNBV in conducting rapid, in-depth assessments of bank capitalization, provisioning requirements and in some cases assessing the viability of specific financial institutions. * Advisors for Restructuring of Troubled Banks. Assistance through specialized consultants to select investment banks and legal advisors to prepare and execute bank restructuring plans.  -5- 13. In addition, the supplemental loan would help CNBV to implement the FSRP through assistance to: (i) accelerate the planned upgrading of the inspection process for banks and non-bank affiliates within financial groups!'; (ii) examine possible means to reduce the fiscal costs of the UDI (inflation-indexed units of account) scheme and to improve inspection of the restructured assets placed in UDI trusts; and (iii) improve the quality of financial information (already being undertaken under the original FTAL) with additional measures including upgrading appraisal standards and qualification criteria for new appraisers. 14. Finally the loan will help CNBV carry out several critical stuidies of the legal and regulatory framework. These will include: (i) a study of remaining impediments to securitization of bank and non-bank originated assets; (ii) a study of the legal framework for secured transactions; (iii) examination of options to streamline procedures for recognition of out-of-court corporate debt workouts and arbitration awards; and (iv) a study and formulation of a plan to remove legal and regulatory impediments (inclusive of tax) to voluntary corporate debt restructuring. 15. National Retirement Savings System Commission. Assistance to CONSAR would be restructured to lay the foundation for a more fundamental reform of the contractual savings system. New actions would include support to: (i) establish the regulatory framework for the private investment management of SAR accounts; (ii) develop a consistent regulatory framework for voluntary occupational plans offered by private sector and parastatal enterprises; (iii) develop CONSAR's capacity to supervise and inspect the Retirement Saving System (SAR) accounts; (iv) provide assistance to design a public communications program in support of pension and contractual savings reform; and (v) develop a program of human resource development and training in such areas as actuarial techniques, finance, and supervision of pension funds. Finally, assistance to conduct a joint study with the CNSF to develop a plan for development of Mexico's annuity markets will still be undertaken as programmed under the original FTAL. 16. Project Costs and Financing. Additional costs of the activities supported by the supplemental loan of US$17.7 million are fully described in Schedule A. The Bank would provide US$ 13.8 million, approximately 75% of the total financing, and the GOM the remaining US$ 3.9 million. Procurement arrangements and the revised disbursement schedule are shown in Schedule B. A timetable of key project processing events and the status of Bank Group operations in Mexico are given in Schedules C and D, respectively. The project 1/ Financial groups are defined here to only include groups that have a commercial bank affiliate.  -6- completion date would remain December 31, 1997 as under the original FTAL, and the closing date would remain June 30, 1998. 17. Lessons from Previous Bank Involvement. The design of this project draws on lessons learned from the experience of the Bank in the delivery of technical assistance around the world and in Mexico. Bank experience highlights the need for (i) a high level of Government commitment essential for successful implementation; (ii) well-defined Project objectives which accurately assess the country's needs and absorptive capacity; and (iii) regular monitoring of Project performance indicators and rigorous supervision offering substantive, issue- oriented support. Based on these experiences, the modified Project contains a limited number of components critical to reforms of the financial sector. 18. Project Sustainability. Following the economic turbulence which began in late 1994, the Government has indicated a willingness to undertake an accelerated and deepened program of reforms and restructuring in the financial sector. With the Government's strong support, this technical assistance project would facilitate the implementation of the FSRP and provide a solid basis for the future operations of the regulatory and supervisory institutions involved. 19. Environmental Aspects. Category C. The project would have no adverse environmental impact. 20. Program Objectives Categories. The project supports private sector development by promoting efficient allocation of domestic savings. The project would also help strengthen Government agencies responsible for regulation and supervision of the financial system. 21. Project Benefits. The supplemental loan would support the implementation of the FSRL, enhancing the sustainability and quality of financial sector restructuring and reform. The modified Project would support the benefits pursued under the FSRL, including: increased confidence in the financial system through support of bank restructuring; early recognition of future problems through enhanced disclosure requirements and greater transparency of regulatory and accounting standards; and improvements in prudential regulation and supervision and in the legal framework for financial transactions lea(ling to a more efficient, sound, and stable financial system. In addition the supplemental loan would have the benefit of increasing and making more efficient the allocation of domestic savings through the redesign of the work programmed with the CONSAR on pension reform. 22. Project Risks. Although the GOM has given every indicatiolm that the Project will continue to receive strong support, several risk factors remain at this time: (i) the possibility that the recommended reformns to improve commercial  -7- bank and financial conglomerate supervision may be slowed due to political considerations; (ii) the possibility that mandatory SAR contributions remain below the level required for economic viability of the system despite the reforms undertaken through the project; and (iii) non-implementation of proposals derived from studies or inadequate follow-through in implementation of the program by counterpart agencies. 23. The ad hoc Financial Sector Working Group led by the CNBV and consisting of representatives of SHCP, CNSF, CONSAR, and the Central Bank established by the Government to oversee implementation of the FSRP, would facilitate and coordinate project activities. This Working Group would also serve to mitigate the risks noted above related to implementation and follow -through of the expanded technical assistance program. Due to the large number of complex and sensitive issues involved in implementation of the revised Project, additional resources for Project supervision would be provided. These additional supervision resources would serve to mitigate the risks identified above. In addition, the close link between the technical assistance to be provided under the revised FTAL and the FSRP will further offset the risks noted above. Implementation of the Supplemental Loan 24. Institutional Arrangements. The arrangements for administration and implementation of the revised FTAL remain essentially as under the original Loan approved by the Board in January 1995. Arrangements for procurement and disbursement, and maintenance and auditing of accounts remain unchanged from the original project. The main modification proposed under the revised project is due to the May 1, 1995 merger of the National Banking Commission (CNB) and the National Securities Commission (CNV) to create the new National Banking and Securities Commission (CNBV). All responsibilities under the original FTAL assigned to the former two agencies have now been assumed by the CNBV and loan and guarantee agreements would be amended accordingly. There are no other changes in the actions agreed under the original FTAL. 25. Agreements Reached. Legal documents reflecting the changes in the project description in paras 9-15, and the disbursement profile (Schedule Bi have been agreed with NAFIN and SHCP. It was also agreed that documentation required for effectiveness of the original FTAL (LN3838-ME) and for effectiveness of this supplemental loan will be provided to the Bank at the same time.  -8- Recommendation 26. I am satisfied that the proposed Supplemental Loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve it. Richard H. Frank President ad interim Attachments May 25, 1995 Washington, D.C.  - 9 - MEXICO FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Schedule A SUPPLEMENTAL LOAN Summary of Appraisal and Revised Cost Estimates and Financing Plan US$ (000) Equivalent 1. Estimated Costs Original Estimate (January 1995) Revised Estimate (May 1 995) PROJECT SUB-COMPONENTS Foreign Local Total Forein Local Total I _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Cost Cost Cost Cost l 3 NAT '-.. '.'.'- .: - ,.....'..'''' "'' "'''""' I. Combined CNB and CNV Program at Appraisal 12,1001 7,3401 19,4401 12 1001 7,340 19.440 Expanded CNBV Program under Supplemental Loan: 1. Acceleration of Inspection Process 2 200 600 2.800 2. Diagnostic Studies of Troubled Banks 12 000 4,000 16.000 3. Select Advisors for the Restructuring of Troubled 150 50 200 -Banks 4. Improve the Quality of Financial Information 125 25 150 5. Analysis of UDI Scheme and Inspection of UDI Trusts 350 100 450 6. Facilitate Corporate and Other Debt Restructuring 100 25 125 7. Study Impediments to Securitization of Assets 500 150 650 8. Secured Transactions 350 100 450 Subtotal: New CNBV Activities 15 775 5.050 20,825 Less: Allocation of Releasod Funds _CNB & CNV) 2 620 995 3,615 -Total Revised FTAL (CNBV) a] 25 255. 11395 36 650 Additional funds required b] .......... ... ......... .. . 13 1551 4,055 17,210l l. . .. N L ........ . .". > C .5U