Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7337 CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT OF EUR 482.3 MILLION (EQUIVALENT TO US$505.6 MILLION) TO THE REPUBLIC OF COLOMBIA FORA FINANCIAL SECTOR ADJUSTMENT PROGRAM October 20, 1999 This document has a restricted distribution and may be used by recipients only in the peiformance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective end-September 1999) Currency Unit = Pesos ($) US$1.00 = $2008 EUR 1.00 = US$1.04725 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AFP - Private Pension Fund Administrator BANCOLDEX - Colombia's EX-IM Bank BCH - Banco Central Hipotecario (state-owned mortgage bank) BR - Banco de la Republica (Central Bank) CAF - Andean Development Corporation CAS - Country Assistance Strategy CAV - Savings and Loan Corporation CF - Financial Corporation CFC - Finance and Leasing Company DTF - Index of interest rates on term deposits EEF - Extended Fund Facility FDIC - Federal Deposit Insurance Corporation FEN - Agency channeling credits and guarantees to power sector FOGACOOP - Deposit insurance and resolution agency for Cooperatives FOGAFIN - Bank Deposit Insurance and Resolution Agency for Financial Institutions FINAGRO - Second-Tier Rediscount Agency for Agricultural Loans FOREC - Coffee Region Reconstruction Fund (CRRF) FSAL - Financial Sector Adjustment Loan IDB - Inter-American Development Bank IMF - International Monetary Fund NFPS - Non-Financial Public Sector SAL - Structural Adjustment Loan SB - Superintendencia Bancaria (Banking Superintendency) SECAL - Sector Adjustment Loan VAT - Value Added Tax Vice President: David de Ferranti Country Director: Andres Solimano Sector Director: Danny Leipziger Sector Leader/Task Team Leader: Krishna Challa FOR OFICIAL USE ONLY COLOMBIA FINANCIAL SECTOR ADJUSTMENT LOAN PROJECT Table of Contents Page Loan and Project Summary ......................................... . . . . 1. Recent Economic Developments and Prospects ..I A. Economic Context and Recent Developments .1 B. External Environment.2 C. Fiscal and Monetary Developments .2 D- Economic Prospects and Financing Requirements .4 . Financial Sector Context ..5 A. Sector structure and context .5 B. Recent sector evolution .......................................................................................6......................... .....6 C. Housing finance institutions ..8 D. State-owned and "officialized" banks ............................8...................8 E. The Cooperatives Sector .................................................................................................9 F. Institutional strengthening of Banking Superintendency and FOGAFIN . .......................................... 10 G. Other key segments of the financial sector .... ...........................................................10 Ill. The Proposed Financial Sector Reform Program ............................................. 12 A. Special one-time relief and recapitalization programs ...................................................................... 12 B. Structural Reforms in the Financial Sector ............................................. 14 IV. Bank Group Strategy ............................................. 20 V. The Proposed Loan and Conditionality .. ........................................... 21 A. Program Management and Loan Administration ............................................. 21 B. Disbursement and Auditing Arrangements ...................................1.................................................... 21 C. Financing Plan ............................................. 21 D. Benefits and Risks ............................................. 22 VI. Recommendation ............................................. 23 Annex 1: Matrix of Reform Actions ............................................. 25 Annex 2: Letter f Development Policy ............................................. 28 Annex 3: Colombia: Principles of Prompt Corrective Action and Resolution of Financial Institutions ............................................. 38 Annex 4: Roots of the current financial sector difficulties . .. ......................................... 41 Annex 5: Key Economic Indicators .......................................... . 45 Annex 6: Status of Bank Group Operations in Colombia .......................................... 48 Annex 7: Colombia At-a-Glance ........................................... 50 This loan was prepared by Krishna Challa (Sector Leader and Task Team Leader. LCC4C); Augusto de la Torre (Lead Specialist, LCSFP); David Yuravlivker (Lead Economist, LCC4C); Issarn Abousleiman (LOAEL); Baralides Alberdi (LCSFP); Jose Antonio Alepuz (LEGLA); Edgardo E. Barandiaran (LCSFP); Jose Augusto Carvaiho (LEGLA); Fernando De Mergelina (LCSFP); Walter Zunic (LCSFP); Connie Luff (Country Officer, LCC4C); and Zeinab Partow (Country Economist, LCC4C). The team also worked very closely with an IDB team led by Mr. Edgardo Demaestri in connection with a parallel loan. The tean gratefully acknowledges the support provided by Alain Ize (IMF) in connection with the Financial Sector Assessment and George Bouza and Virginia Barreto who were in charge of putting together various documents and administrative arrangements. 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 - COLOMBIA FINANCIAL SECTOR ADJUSTMENT LOAN PROJECT LOAN AND PROJECT SUMMARY Borrower: Government of Colombia Implementing Agency: Ministry of Finance and Public Credit; FOGAFIN; Superintendency of Banks Amount & Terms: Fixed Spread Loan for Euro 482.3 million (about US$506 million equivalent) with 17 years maturity, including 5 years of grace period, and an option for automatic rate fixing. Commitment Fee: 0.85 percent (including 0.1 percent risk premium) on undisbursed loan balances for the first 4 years, beginning 60 days after loan signing, 0.75 percent thereafter. Front End Fee: 1 percent of the loan amount payable upon effectiveness. Description: The FSAL would support a comprehensive program of financial sector reform being implemented by the Government of Colombia. The loan would be disbursed in two equal tranches. The main Program objectives are to support: (i) required changes in financial sector legislation and regulations to facilitate strengthening of bank supervision and deposit insurance, and to promote timely, fair and efficient resolution of banks facing financial solvency problems; (ii) to strengthen the institutional capacity of the Superintendency of Banks and the entity responsible for deposit insurance and bank resolution (FOGAFIN); (iii) restructuring, recapitalization, privatization and, if necessary, liquidation of state owned and "officialized" banks currently under public sector management; (iv) effective implementation of special measures to address the immediate impact on the financial system stemming from economic and other emergencies. The Inter-American Development Bank (IDB) and Corporacion Andina de Fomento (CAF) are expected to provide complementary financing to support the financial sector reform program. Risks and Safeguards: The strategy supported by the program is to minimize the chance of a debilitating systemic risk in the Colombian financial system through a macro-economic program that enables stabilization and significant reductions in real interest rates, combined with a timely and effective implementation of prudential rules and supervision, preventive measures, special recapitalization actions, and case-by- case resolution. The Government's financing plan also seeks to minimize the burden placed by the Program on the general budget - ii - revenues. An important risk affecting the transition of the financial system back to a healthy state is the Government's inability to contain the real interest rates in the economy to moderate levels which would directly impact on the capacity of borrowers to service their debt. The Government as well as the central bank are acutely aware of this, and are making their best efforts to address the issue through the implementation of a demanding fiscal program, comprehensive structural reforms, and instilling confidence in international and domestic investors through a credible stabilization plan and exchange rate management. A significant worsening of the external environment through renewed turbulence in international financial markets could disrupt the implementation of the fiscal adjustment program and the achievement of the stated macroeconomic goals. The proposed program, with its emphasis on structural reforns in the financial sector and efficient case-by-case resolution of credit institutions, helps minimize the risks of a fully blown systemic crisis through appropriate incentives and builds greater preparedness to tackle such an eventuality. A failure by the Government to put in place in a timely manner the improvements in the institutional capacity and resolution process, or significant problems discovered during the planned intensive banking supervision, could elevate the potential for systemic risk. The clearly laid out program of actions to be taken prior to the Board presentation and second tranche under the proposed loan are designed to minimize such a risk. REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO COLOMBIA FOR A FINANCIAL SECTOR ADJUSTMENT PROGRAM 1. I submit for your approval the following report and recommendation on a proposed loan to the Government of Colombia for EUR 482.3 million (about US$505.6 million equivalent) in support of a Financial Sector Adjustment Program. I. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS A. Economic Context and Recent Developments 2. After decades of consistently solid growth and prudent economic management, Colombia today is in the midst of its sharpest recession in over sixty years. That comes as a shock to a country whose GDP has grown every year for more than six decades. Notwithstanding a growth record averaging over 4 percent per year for the past forty years, the economy perfornance remained below its potential. Productivity in most sectors has been stagnant and inflation has remained in the range of 20-30 percent since the mid-1970s. 3. During the 1990s, growing fiscal and external imbalances became the main threat to macroeconomic stability. These imbalances have ballooned to worrisome levels by the mid-1990s: the current account deficit was in the range of 5-6 percent of GDP per year in 1995-98, while the Non-Financial Public Sector (NFPS) deficit has steadily increased from 1 percent to over 6 percent of GDP this year. Altogether, over the past several years, the Colombian economy has under-performed compared to most other Latin American countries in terms of GDP growth as well as in its fiscal and balance of payment accounts. Today, the country faces significantly negative growth for 1999 and an unemployment rate of close to 20 percent. 4. The Colombian economy's performance has deteriorated sharply in the last three years: (i) the fiscal accounts of the non-financial public sector, which were roughly balanced in the early 1 990s, are projected to show an estimated deficit of 6.2 percent of GDP in 1999 (Table 1); (ii) GDP fell by 6.7 percent in the first half of 1999 as compared to the previous year; and (iii) the current account of the balance of payments reached a deficit of 5.7 percent of GDP in 1998, although it is expected to fall to about 2.5 percent of GDP in 1999 due to a sharp decline in imports.' Economic decline has been accompanied by a rapid increase in unemployment, which in urban areas stood at 20 percent in September 1999. Restoring fiscal balance is needed if Colombia's efforts at These ratios use the revised GDP series - the result of a recent revision of the National Accounts -- which for 1999 are about 15 percent higher than previous figures. - 2 - poverty reduction and more rapid medium-term growth are to be realized. It is also crucial for the resolution of problems in the financial sector. 5. The weakening of the country's economic situation and the wish to enhance the credibility of its economic policies, have prompted the Pastrana Administration to formally request an Extended Fund Facility (EFF). The US$2.7 billion progran is centered on fiscal consolidation and structural reforms, including a plan to address the difficulties faced by the financial sector. Along with the reduction of the fiscal deficit, a cut in the external current account deficit to sustainable levels is also being sought. The program, which is expected to be approved by the IMF Board of Directors in the fourth quarter of 1999, would be the country's first IMF funding arrangement since the 1 970s. Implementation of the program requires strong fiscal discipline, and passage by the Colombian Congress of fiscal and tax reform packages and the second round of structural reform measures described below. B. External Environment 6. Colombia's external environment also deteriorated substantially throughout 1998 and into 1999. The country was hit by severe shocks: (i) a trade shock due to the drop in oil and coffee prices, estimated at 1.5 percent of GDP; and (ii) events in international credit markets stemming from the East Asia crisis of 1998 and its secondary effects in Latin America, which have increased the cost of borrowing and decreased the availability of external finance for both the public and private sectors. Moreover, with the virtual closing of international credit markets to developing economies and the skyrocketing cost of external credit, Colombian authorities have had to turn to the domestic market for additional financing, putting further pressure on domestic interest rates. Colombia's investment-grade rating was recently downgraded by three major credit rating companies. This is a negative development for the country, which for many years was one of the few in Latin America that enjoyed wide access to international credit markets and was able to draw on international funds to support the development of its economy. The downgrading could complicate external financing plans, and the Government is making efforts to ensure the availability of alternative sources of financing until it can return to international credit markets under satisfactory conditions. C. Fiscal and Monetary Developments 7. The Government has made reducing the fiscal deficit one of its key macroeconomic objectives. After taking office in August 1998, the Government took several revenue enhancing and expenditure reducing measures, including measures to fight tax evasion and smuggling, increasing gasoline surcharges, widening of the VAT base, improving tax collection, and cutting the operational costs of the Central Governnent. However, due to external trade shocks, sharply reduced revenues as a result of the economic downturn, the outlays needed to rebuild the areas affected by a devastating earthquake in early 1999, and the need to shore-up the ailing financial sector, this year's deficit is projected to exceed that of 1998 (see Table 1). - 3 - Table 1: Economic Indicators Projected 1995 1996 1997 1998 1999 Real GDP Growth 5.2 2.0 2.8 0.6 -4.5 Inflation 19.5 21.6 17.7 16.7 11.0 NFPS balance/GDP -1.0 -2.4 -3.7 -3.7 -6.2 Current Account Bal./GDP -5.0 -4.8 -5.4 -5.7 -2.1 Public External Debt/GDP 15.0 14.9 15.7 18.5 23.3 Total External Debt/GDP 27.0 29.0 31.1 34.9 41.3 Sources: Banco de la Republica, Ministry of Finance, DNP, IMF, and World Bank. 8. In order to achieve fiscal adjustment that is sustainable in the medium and long- term, the Government is complementing its stabilization measures with structural refonns in various areas of public finance. Within the context of the National Development Plan, in the first half of 1999 Congress approved legal amendments that would improve the fiscal situation in the medium term, including (i) reform of the resources and competencies of local governments (Law 60), and increasing the efficiency of expenditure in education; (ii) improving efficiency in public universities (Law 30); (iii) changes in royalties allocations to attract private investment; and (iv) reforms to the Budget Law, to reduce earmarking and improve the allocation of local expenditures. In addition, Congress passed the Financial System Reform Law, which among other things raises minimum capital requirements and strengthens the faculties of the Banking Superintendency and FOGAFIN. Further, proposals for additional structural reforms are being introduced in the July-December 1999 legislative session: (i) a law to rationalize public finances, and to curb their expansion: (ii) changes to continue the reform of social security, including elimination of several special regimes; (iii) measures to curtail the current expenditures of local governments; (iv) a constitutional amendment to save part of the transfers to local governments to finance local pension funds; and (v) a constitutional amendment that would freeze, in real terms, future transfers to local governments. The Government has also submitted, for congressional approval, an austere budget for year 2000. To consolidate and expand these reforms, the Government has fused them into a comprehensive stabilization program that would be supported by the IMF. 9. The Central Bank (Banco de la Republica - BR) shifted the exchange rate band on two occasions over the past year. In September 1998, an upward shift of the exchange rate band by 9 percent was announced. The ensuing depreciation of the peso resulted in a real devaluation of about 6 percent in 1998. Several fundamental changes in the past decade, however, including the opening of the economy in the early 1990s, the high current account deficit over the past 4 years, the decline in export commodity prices, and the tightening of external credit suggest that the real exchange rate continued to be overvalued. These factors, and the country's worsening economic and security conditions, eventually led to mounting pressures on the currency. In June 1999, faced with a choice between allowing this imbalance to increase or devaluing, BR opted for the latter, since higher interest rates would undermine the prospects of economic recovery. The mid-point of the band thus was raised (devalued) by 9 percent, its width increased from 14 percent to 20 percent, and its slope, or rate of devaluation, reduced to 10 percent from 13 percent, in accordance with the lower inflation targets. Pressure on the peso - 4 - continued, however, costing BR around US$400 million in September 1999, and pushing the currency beyond the new ceiling of the band. Thus, on September 25th, BR decided to abandon the exchange band regime, opting instead for a free float of the peso. Altogether, during the first nine months of 1999, the Colombian peso has undergone a 20 percent real devaluation. 10. Since the end of 1998, the Colombian authorities have taken concerted measures to bring down interest rates, whose reduction is seen as essential for any reactivation of the economy. The benchmark 90-day deposit rate has dropped from its peak of 37 percent in June 1998 to 18 percent in September 1999. Despite falling interest rates, however, lending has declined sharply. Banks are reluctant to lend under conditions of high credit risk, falling collateral prices and tightening liquidity conditions. Further reductions in real interest rates, and in spreads, can be achieved by continuing to pursue fiscal adjustment, and through the restructuring of the financial system as planned. Fiscal adjustment and enhanced confidence should ease the upward pressure on real interest rates, thereby contributing to a revival of economic growth in 2000-2002, while bringing down inflation to single digit levels. D. Economic Prospects and Financing Requirements 11. As the projections presented in Table 1 show, the rate of GDP growth is expected to be negative 4.5 percent in 1999, as the slowdown in economic activity has been longer and deeper than expected. Inflationary pressures have dramatically declined, with the inflation rate falling from its historical level of near 20 percent to a projected II percent for 1999. As regards the NFPS deficit, and as mentioned above, the projection is for a deficit of 6 percent of GDP this year. The bulk of the fiscal adjustment is planned for 2000, when the deficit would fall to 3.5 percent of GDP, in part as a result of an increase in revenues from the tax measures described above. On the expenditure side, larger interest payments would be offset by further cuts in Central Government investment and the wage bill. Starting in 2001, the fiscal adjustment would be achieved mainly through a reduction in operational expenditures as a result of structural reforms expected to be introduced this year. The objective of the Government is to end its 4-year term in 2002 with a fiscal deficit of about 1.5 percent of GDP. 12. The external accounts will be subject to competing pressures. On the one hand, they would improve as non-traditional exports respond to a more depreciated real exchange rate, and the cut in the fiscal deficit reduces domestic absorption. Also, a recovery in the trade balance could be further boosted by an upturn in the prices of oil and coffee. On the other hand, much of the improvement in the external balance is due to the decline in imports which would be reversed with any upturn in economic activity. The forecast is for a current account deficit of 3.5 percent of GDP for 2000 and 2001. With respect to sources of financing, As Colombia begins to return to international credit markets, it has sought the assistance of multilaterals to make up for the closure of international market financing earlier this year. -5 - II. FINANCIAL SECTOR CONTEXT A. Sector structure and context 13. The Colombian financial system has historically developed under a specialized banking model, with functions divided between: commercial banks, active in both retail and wholesale banking; financial corporations (corporacionesfinancieras--CFs) whose activities are largely based on corporate banking; finance and leasing companies (companias definanciamiento comercial --CFCs), savings and loan associations (corporaciones de ahorro y vivienda -CAVs); and a cooperatives sector. As of March 1999, the Colombian financial system had 106 financial institutions (excluding the cooperatives sector) with assets totaling about US$51 billion equivalent, or 50 percent of GDP. State-owned institutions accounted for about 20 percent of total assets2, and foreign institutions for around 17 percent of total assets, with the rest of the financial intermediation undertaken by domestic private institutions. The legal framework for financial intermediation was gradually allowed to evolve away from strictly specialized banking. Most importantly, over time commercial banks have been progressively allowed to take on virtually all other functions with the exception of investing in equities. Moreover, the creation of financial conglomerates (gruposfinancieros) with affiliates in each specialized function was allowed, moving the system progressively towards one- stop if not universal banking. After a rapid expansion in the number of institutions in the early 1 990s, Colombian banks experienced recently a process of major consolidation and the entry of foreign groups. During 1997 and 1998, there were over 40 mergers and acquisitions. By early 1999, the system included 33 commercial banks, 14 CFs, 6 CAVs, and 53 CFCs. The consolidation process is continuing, with the system gradually moving towards mergers into larger commercial banks. 14. Following a significant tunnoil in the mid-1980's that led to closing and restructuring of some major financial institutions, the sector benefited from positive rates of economic growth, considerable improvements in the prudential regulations, strengthened supervision and institutional improvements. A Banking Framework Law approved in 1993 laid the basis for longer term improvements, incorporating significant liberalization of the operations of the different types of financial institutions and clearer guidelines for affiliate relationships, decreasing credit subsidies and forced investment requirements, reducing financial system segmentation and regulatory arbitrage among institutions, and thereby increasing competition in the system. The Law confirmed the role of the deposit insurance and bank resolution agency (FOGAFIN), which was established earlier (through Law 117 of 1985) as an instrument to provide partial guarantees of deposits subject to a maximum coverage (currently about US$7,000 equivalent), and thereby promote greater confidence among depositors. To foster the development of a healthy banking system, FOGAFIN was also assigned certain functions 2 The main state-owned institutions were: Banco del Estado (a commercial bank), Caja Agrania (an agricultural credit institution devoted to meet the credit needs of farmers and to attain certain social and regional development objectives such as the provision of payment services), Banco Central Hipotecario ( a savings and loan), IFI (Instituto de Fomento Industrial-a finance corporation), and two institutions that were intervened in 1998 (a commercial bank, Uconal, and a savings and loans, Granahorrar). Banco Cafetero, owned by the National Coffee Fund, is considered a quasi- government institution. -6- related to facilitating restructuring of problem banks when needed, although these faculties were not used to any significant extent until 1998. Benefiting from these institutional improvements, as well as a reasonably good economic growth performance by Colombia, by the mid- 1 990s the financial system had largely recuperated its solvency and stability. B. Recent sector evolution 15. Since 1995, however, this has been offset by the steadily deteriorating fiscal situation and low economic growth over the last four years. Application of tight monetary policy, together with the adverse developments in international capital flows (e.g., those stemming from the Asia and Brazil crises), devaluation expectations and other domestic developments,3 led to high and very volatile interest rates. A pattern of boom- and-bust credit cycle experienced in the 1 990s, with periods of fiscally induced expenditure expansion followed by protracted periods of high real interest rates and slowdown in economic activity, stemming from counteracting austerity measures taken by the authorities, was at the root of these problems (see Annex 4 for a more detailed description of these underlying roots). Together with the not yet fully developed bank supervision capacity, inadequate or non-existent supervision of certain segments such as the cooperatives sector, and continued fragmentation among segmented institutions, this rekindled a progressive weakening of portfolios of credit institutions since 1995. Chart 1: Real Interest Rates in Colombia, 1997-99 30 _ _ _ _ _ _ . . 25 _ _ _ _ _ _ _ _ _ _ _ _ _ _ " K, 10 . 15 Jan-97 !vy-97 Sep-97 Jan-98 Mey-98 Sep-98 Jan-99 May-99 Sep-99 Deposit rate Lending rate 3 Real interest rates on deposits had risen from about 4 percent in the third quarter of 1997 to 18 percent in the last quarter of 1998. Annual real interest rates on loans increased from 14 percent to 26 percent. Although external shocks played a role, several domestic factors may have contributed to the increase in interest rates: (i) greater demand for credit by the public sector to finance the fiscal deficit; (ii) increased demand for credit by the private sector and financial institutions due to expectations of devaluation; (iii) an increase in the flow demand for funds due to distressed borrowing by both debtors and credit institutions; (iv) a decline in the supply of loanable funds due - 7 - 16. The Colombian financial system is currently undergoing a period of substantial stress. Owing to a sharp deterioration of loan portfolios and a large volume of non productive assets, the solvency and profitability of financial intermediaries worsened abruptly during 1998 and the first semester of 1999. At the same time, liquidity difficulties have been experienced by a number of institutions. The adverse effects were significantly accentuated by the round of turbulence and volatility in international capital flows which affected most emerging economies in 1998, progressive withdrawal of international commercial lending from Latin America. During the 12-month stretch from the second quarter of 1998 through early 1999, real interest rates on term deposits stayed consistently in the 12-18 percent range, and average real lending rates were 8-10 percent above those levels (see Chart 1). These high rates, together with unprecedented low and negative economic growth since late last year, have stretched the payment capacity of even the healthiest companies and individual borrowers. Reflecting the difficulties, reported arrears in the loan portfolio of the total banking system have grown from about 7 percent in September 1996 to more than 9 percent by September 1998, and are currently estimated at more than 13 percent (see Table 2). The impact on some parts of the system, such as the cooperatives, institutions engaged in housing and construction finance, and the smaller trade, financial and leasing institutions has been particularly severe. While officially reported arrears in commercial bank loans rose more moderately during that period (from about 6 percent in 1996 to 10.6 percent in August 1999), arrears facing housing finance institutions (CAVs) more than tripled. The cooperatives system and finance and leasing companies also experienced severe problems, with arrears now approaching alarming levels in the 15-20 percent range. Table 2: Financial Institutions current portfolio, arrears, and provisions Loans in arrears as a Provisions as % of total portfolio % of Arrears Portfolio 8131199 as % USS million eqv.* of total Sep-96 Sep-97 Sep-98 Aug-99 Aug-99 Total consolidated credit institutions 26230.3 100.00 7.0 7.3 9.1 13.4 29.0 Banks (without Caja Agraria) 15455.5 58.92 6.0 S.8 7.3 10.6 40.2 Corporaciones Financieras 2881.2 10.98 5.3 4.5 5.4 8.0 45.5 Savings and Loans-CAVs (without BCH) 4881.3 18.61 5.1 7.9 10.3 19.0 11.2 Trade Finance and Leasing Companies 932.1 3.55 142 12.2 13.8 19.9 25.7 State Banks Caja Agraria 394.0 1.50 16.2 6.3 BCH 1117.2 4.26 13.7 18.7 39.8 21.0 Mortgage loans transferrred to FOGAFIN and BR 569.0 2.17 4.7 24.9 Other Financial Institutions Financial Cooperatives (excl. Cooperative Banks) 31.8 8.5 6.4 10.9 15.0 29.0 Second-tier Institutions 4183.1 0.1 0.1 0.1 1.0 43.1 * US$1= 1,994 pesos 17. Institution specific information, where available, indicates that actual amounts of loan portfolio experiencing problems could be even higher if strict loan classification procedures are applied. Since June 1998, the Government has had to intervene and "officialize" (i.e., take ownership of) two medium size private credit institutions (a to a sustained decline in private savings in the 1990s; and (v) tighter monetary policy. - 8 - savings & loan institution and a cooperative) in addition to a number of smaller CFCs and financial cooperatives, spurring speculation about additional institutions that may find themselves in trouble. The total borrowings from credit institutions from the central bank (BR) have also been showing a clear upward trend. Scenario analysis applying stricter provisioning methodologies and more realistic assumptions on payment capacity of borrowers shows potential for further worsening of this trend, unless quick remedial actions are taken. However, the situation has not yet deteriorated to a point that characterizes a high risk of a systemic crisis. Timely corrective actions would be crucial to minimize such risk. C. Housing finance institutions 18. The housing finance sector has been particularly hard hit by the financial market volatilities and high real interest rates, given the large mismatch between the average maturities of their deposits (about 3 months) and loans (10-15 years). Their portfolio problems are further exacerbated by the specific indexing method used for most housing loans which provided for automatic capitalization of a substantial portion of the interest, typically covering all the inflation component as well as part of the real interest payment due. The root cause behind this was that the indexing method for housing finance instruments (called the UPAC) was gradually shifted by the authorities from its original direct linkage to the consumer price index to market interest rate indices. This was done in an effort to keep the UPAC-linked deposit rates competitive and enable CAVs to maintain their deposit base in tlle face of steeply rising real interest rates in the market. However, this practice masked the real cost of loan funds, with a tendency for the real balances of loans to actually grow, while the underlying market value of the housing assets falls due to high real interest rates and slow economic activity. As the value of collateral dipped below that of the loans, debtors were induced to cede the collateral to the bank rather than repaying the loan. This contributed to an increasing share of unproductive assets in banks' portfolios, thereby increasing the need for provisions and severely eroding their profitability. D. State-owned and "officialized" banks 19. Despite the declared policy of limiting state participation in economic activity and the downsizing of the 1 990s in public sector participation in the financial system that can be handled by the private sector, for historical reasons, the Colombian financial system has a still sizable state-owned sector, which accounts for nearly a fifth of the total deposits as well as total assets of the first-tier banks in the system. Of these, the most important first-tier banks directly owned by the state included the Caja Agraria, Banco del Estado and Banco Central Hipotecario (BCH). The Caja Agraria, the largest and most delicate case among these, had been operating over the last several decades as an agricultural credit institution devoted to meet the credit needs of farmers as well as certain social and regional development objectives. In recent years, the role played by the Caja in providing financial services in regions where there is significant guerilla and paramilitary activity became a critical symbol of the limited formal government presence. Of the other two, Banco del Estado, taken over in an earlier episode of intervention, operates as a state-owned commercial bank; it is involved in a specific problem related to a large legal claim by one of its prior clients, which had complicated most prior efforts to - 9 - privatize it. BCH is a commercial bank specialized in mortgage lending, which got into problems as a result of some bad and questionable business decisions (including the take- over of another problematic CAV), and the difficult market in housing finance. A fourth institution, Banco Cafetero, which is not owned by the state but by the National Coffee Fund (a specialized fund originally established to promote stabilization of coffee related revenues which derives its resources from private coffee growers), is also facing major portfolio problems originating from the economic fragility of the coffee sector, compounded by recent earthquake related losses in the coffee growing region. 20. A similar situation prevails in two banking institutions which experienced solvency problems and went through a special form of official intervention (in combination with government capitalization) called "officialization". These include: Granahorrar, a previously successful savings and loan association whose problems worsened because of certain special problems among its shareholders and the resulting poor business decisions; and Banco Uconal, which was originally a financial cooperative but was converted into a bank with a view to facilitate its resolution. Following a full write-down of the previous owners' claims, FOGAFIN became the formal owner of these two institutions during 1998/99. The privatization or other resolution of these institutions also needs to be pursued together with that of state-owned banks. The Government also owns a specialized development finance corporation, Instituto de Fomento Industrial (IFI), which in earlier times was used as a first-tier institution to promote certain strategic lines of industrial development, but in recent years has shifted its focus to second-tier banking activities operating through other banks for objectives such as small and medium enterprise (SME) development. Due to its special charter and hybrid/second-tier status, IFI will be treated separately under the reform program, together with other second-tier institutions. 21. Overall, the situation of public and intervened financial institutions as a group is far worse than the private banking segments. Most of them are deeply decapitalized or outright insolvent, with much higher loan delinquency ratios and lower liquidity levels. Each of these institutions is facing problems stemming from low efficiency, bureaucratic systems and political interference in credit decisions, and would need to be privatized, or if necessary, restructured, recapitalized, or liquidated to achieve a more competitive and healthy banking system. E. The Cooperatives Sector 22. A specific area that has already demanded immediate attention on the part of the Administration is the cooperatives sector. The cooperatives also experienced substantially more severe difficulties than private banks, due to the acute deterioration of consumer loans, deficiencies in their supervision and difficulties in loan collection. There are more than 3,000 cooperatives in Colombia, distributed among three main categories. More than two,thousand are small, "closed" cooperatives which are allowed by their statutes to lend only to members. There are also about a thousand "multi- sectoral" cooperatives which represent small groupings of people engaged in similar trades who organize themselves as a cooperative, but are not really functioning as a financial intermediary. As of mid-1998, there were 52 "financial cooperatives", which are typically larger in size, and accept deposits from members as well as non-members, - 10- competing with regular credit institutions. A major weakness was a lack of clarity regarding the prudential rules governing operations of the cooperatives, institutional responsibility for supervising them and mechanisms for deposit insurance resolution of solvency problems among cooperatives. One result of this weakness was that several financial cooperatives fell into financial solvency problems and had to be intervened; a number of the smaller "closed" cooperatives also faced serious problems and the integrity of their deposits was threatened. Given that the total membership of cooperatives is estimated at as high as 2 million small depositors (with average deposits typically in the range of US$200-400 equivalent), any major failures can lead to a potentially large social problem. Cognizant of this and the need to clarify and improve supervision of cooperatives system, the Government has initiated action to restructure the cooperatives system and put them on a more sustainable financial basis, clearer prudential rules and supervision system, in consultation with the Bank and IDB. Among other things, the Government has recently put in place legislation to create a specialized supervisory agency to oversee the operations of the smaller "closed" cooperatives, while maintaining the responsibility to supervise the "financial" cooperatives with the Superintendency of Banks. It also established a new, separate deposit insurance and resolution agency, FOGACOOP, to address the needs of cooperatives, fulfilling functions similar to those of FOGAFIN for banking institutions. F. Institutional strengthening of Banking Superintendency and FOGAFIN. 23. Despite the improvements achieved in the institutional capacity and quality of bank monitoring and supervision in recent years, there is still a need for substantial further strengthening, in light of the deteriorating financial condition of the system and acute problems faced in some segments such as housing finance and the cooperatives sector. Energetic action and high quality judgments by the Superintendency of Banks will be needed to enforce proper loan classification and adequate provisioning on financial intermediaries, given the erosion of portfolio quality that most institutions have witnessed over the last two years. The quality of information available to the Superintendency as well as technical capacity of its supervisors need to be enhanced in meeting the challenges of the new reality. Likewise, while FOGAFIN has formally operated satisfactorily as a deposit insurance and problem bank resolution entity, its capacity has not been tested since there have been very few bank failures in prior years. Given the vastly more formidable challenges which FOGAFIN will be facing in the area of bank resolution, and the various new responsibilities which have been added to it under recent emergency relief measures (see below), a rapid building of FOGAFIN's institutional capacity is of a high order of priority. In particular, it would be critical for FOGAFIN to develop its capacity to design and apply modern resolution techniques for problem banks that make a fuller use of market based instruments and facilitate quicker and more economically efficient resolution. These institution building measures will be key to overcoming the current fragilities of the banking system and enabling its healthy longer term development. G. Other key segments of the financial sector 24. An important area of improvement for the medium-term concerns the operation of several second-tier financial institutions (institutions which rediscount loans to first-tier - 11 - banks) which cater to the needs of specific productive or service sectors: BANCOLDEX (Colombia's EX-IM Bank) which caters financial services to exporters and importers; FINDETER, a specialized entity which rediscounts bank loans to municipalities to help finance urban development and decentralized public utilities; IFI, the Government's industrial development bank which also provides second-tier lending to micro- and small and medium size enterprises; FEN, an agency specializing in channeling credits and guarantees to the power sector; and FINAGRO, a second-tier agency to rediscount agriculture loans. Although each of these agencies has been fulfilling a useful function to bridge gaps in the financial system, some of them have outlived their original mandates. There are considerable efficiency gains that can be achieved through consolidating and rationalizing the operations of these second-tier credit agencies, and ensuring consistent procedures across them. The Government stated its intention to review options in this area, as part of its medium term strategy. As a first step towards this, the Government recently issued a decree officially consolidating a number of these second-tier entities, together with IFI discussed above, into one. 25. Colombia's capital markets are relatively underdeveloped, reflecting the effects of a prolonged period of inflation and interest rate volatility, country security concerns and information deficiencies. However, there are no major policy distortions impeding capital market development. Based on joint work carried out by a Bank sector mission and a capital markets commission during the last Administration, the Government has embarked on a program of long term institution and capacity building. The program contemplates strengthening regulation and supervision capacity of relevant supervisory bodies (including the Superintendencies of Securities and Banking), harmonizing regulations and enforcement across agencies, upgrading of pricing, trading, custody, settlement and payments systems, promotion of interconnection across exchanges, developing deeper primary and secondary markets for public securities and greater participation of institutional investors in securities markets, and developing appropriate norms and promoting the effective use of derivatives, securitization and other modem financial instruments (e.g., standardized mortgage securities) as well as credit rating companies, improvements in debt and risk management methods, and control of fraudulent and corrupt practices. The Bank is actively supporting this program through the ongoing Financial Markets Development Project. In the longer run, Colombia also needs to take explicit steps to strengthen its corporate governance through additional steps to protect shareholders' rights, equitable treatment of all shareholders (including minority shareholders), timely and accurate disclosure and transparency of company performance data, and on the basis of the latter, development of a more systematic monitoring of corporate financial health and vulnerability data. 26. Colombia undertook a major reform of its social security and pension system through a comprehensive law adopted in December 1993, to overcome the problems associated with its previous pay-as-you-go system which was becoming increasingly underfunded. The reform introduced a competitive system of private pension managers similar to that of the Chilean private pension funds management (AFPs) system, as an alternative to the public system. However, unlike the Chilean system, Colombia allowed its citizens the option of continuing in the existing scheme or moving to the new scheme, with no strong incentives to move to the new system and freedom to switch between them every three years. As part of the reform, Colombia scaled down the liberal benefits - 12 - and eligibility conditions under its public pensions systems, and increased the contribution rates to equal those under the private system. Overall, the Colombian AFPs system is quite modern, with regulations that allow foreign investment of assets from the beginning and a modem benchmarking system. Implementation of the reforms has, however, been slow as a result of the complex financial planning required by the provision to allow back-and-forth switching between public and private systems, multiplicity of public pension systems and problems in timely issuance of recognition bonds from the decentralized levels of government. With support from the IDB, the Government is taking actions to reduce the disparities among the multiple public pension systems and address the problems related to the implementation of reformns in decentralized entities. Capital markets improvements facilitated by the reforms in the financial sector should assist the AFPs by broadening the range of investment instruments available to them. III. THE PROPOSED FINANCIAL SECTOR REFORM PROGRAM 27. In addition to laying out a proposed new macro-economic framework for the coming years described in Section I (paras. 11-12), the Government has embarked on a series of specific measures to address the immediate problems identified in specific segments of the financial sector, as well as major structural reforms oriented to assuring efficiency, competitiveness and prudent risk i1ianagement in the banking sector and the longer term health of the financial system. The Government is seeking support from the Bank for this comprehensive reiform program through the proposed Loan. The IDB is expected to provide complementary support through a parallel loan. 28. The main objectives of the Program are: (i) to support required changes in financial sector legislation and regulations to facilitate strengthening of bank supervision and deposit insurance and promote timely, fair and efficient resolution of banks r.acing financial solvency problems; (ii) institutional strengthening of the bank supervision agency and FOGAFIN, the entity responsible for deposit insurance and bank resolution; (iii) restructuring recapitalization, privatization and, if necessary, liquidation of state owned and "officialized" banks currently under public sector management; (iv) help effective implementation of special, one-time measures to address the immediate impact on the financial system stemming from macro-economic, intemational market and related problems. A. Special one-time relief and recapitalization programs 29. (i) Economic emergency relief. Recognizing the seriousness of the issues facing some parts of the financial sector, the Government introduced, through an emergency executive decree dated November 25, 1998, a series of relief measures designed to help the most vulnerable groups affected by the crisis -- namely low income mortgage borrowers and depositors in the cooperatives system. In the case of housing loans, the relief measures included: refinancing at preferential interest rates (with up to 10 year terms) to homeowners who have maintained a good payment record but whose outstanding balance on indexed housing loans went up more than 20 percent in nominal terms over the course of the last year, for amounts not exceeding the 20 percent; - 13 - refinancing for housing borrowers who have arrears of three months or less, also on preferential but somewhat different terms; and mortgage payment relief for low income homeowners that lost their jobs. In the case of the cooperative institutions facing liquidation or other severe payment problems and not covered by FOGACOOP (the newly created deposit insurance entity for cooperatives), the decree provided for reimbursement of up to about US$350 equivalent of their deposits for the lowest income depositors (defined as those with incomes not exceeding twice the minimum salary); these amounts would be treated as credits to the respective cooperative institutions while their resolution is still in process. The decree also provided for an additional measure designed to strengthen institutional infrastructure to resolve problems associated with problem mortgage loans, through support to the establishment of specialized asset management and disposal/leasing companies, which can purchase real assets pledged and foreclosed (or accepted) under problem mortgage loans in lieu of the corresponding debt service, manage and dispose of such assets through quick and efficient sale. As an additional impetus for efficient resolution, FOGAFIN has been given faculties to provide financing to such asset management/leasing companies as well as for asset securitization companies whose formation had earlier been authorized. These relief and facilitating measures are being financed primarily through a temporary 0.2 percent financial transactions tax, effective through December 31, 1999, for most transactions except inter- bank market dealings. 30. The relief measures have been well thought through, and carefully circumscribed in terms of the total amounts of relief, target population and eligibility requirements. They are aimed at facilitating future structural reform in the financial system by addressing the problems of some of the most critically affected groups and reducing market distortions induced by distress borrowing by non-viable borrowers and institutions. Whether the relief provided to the most vulnerable groups is sufficient or not will depend, to a considerable extent, on the success of the Government in enhancing market confidence and bringing down the real interest rates in the economy, which in turn will be governed by the success of the macro-economic program and the adequacy of reforms of the financial system. The relief measures have since become subject to certain limitations and clarifications of the decree issued by the Constitutional Court of Colombia, but the main thrust of the measures has been kept intact. 31. (ii) Earthquake relief. Colombia has had to deal with yet another major emergency in early 1999, stemming from a major earthquake that hit the western coffee growing region of the country in January. The epicenter was near Armenia, a major city in the coffee growing region, but the quake also devastated the urban and rural infrastructure in many towns and villages across four Colombian provinces, thousands killed and wounded, and over 150,000 people rendered homeless. Roads, water systems and other public infrastructure services, as well as schools and hospitals incurred substantial damage. The Government has issued emergency decrees to guide the relief and reconstruction measures. The required resources for reconstruction, estimated to be of the order of US$1.0 billion, are being channeled and administered through a special Coffee Region Reconstruction Fund (FOREC). Among the emergency measures are direct lump-sum subsidies to affected families, and credit on preferential terms and limited credit risk underwriting offered to residents whose homes have been destroyed or need major repairs. The amount of subsidy varies depending on the income class of the - 14- affected families. The Government has designated FOGAFIN as the entity that would channel these subsidies, using resources to be provided by FOREC.4 32. (iii) Recapitalization plan from financial institutions. In May 1999, taking into account the increasingly acute portfolio problems and consequent erosion of capital that became evident by mid- 1999 in other segments of the system, the Government announced special support to facilitate recapitalization of institutions deemed to be viable but experiencing temporary capital inadequacy. The support is provided in the formn of medium tern loans from FOGAFIN to owners of those institutions that fully adjust their assets and capital to reflect the true economic value of their assets, following stringent standards that require writing off most non-productive assets (100 percent of non- performing portfolio, 50 percent of deferred assets and 20 percent of accounts receivable). The loans would be subject to strict collateral requirements, and would be available only to those institutions that decide to adopt this course by the end of 1999 and have submitted a satisfactory plan to restore financial viability in the medium term. This "general purpose" recapitalization plan provides for credit lines from FOGAFIN to eligible institutions not to exceed 80 percent of the funds needed to bring the capital of the institution to a fully adequate solvency ratio (10 percent), to be repaid in 3 through 7 years at market related interest rates (DTF plus 2-3 percent depending on maturity). The remaining 20 percent has to be provided by the shareholders. The financing loan has to be guaranteed with the shareholder's stake in the institution and additional collateral so that at least 133 percent of the loan in covered. These lines of credit are funded with bonds issued by FOGAFIN and consequently do not imply cash disbursements for the Government. FOGAFIN and the Superintendencia Bancaria will closely monitor and supervise the implementation of the agreed programs, as reflected explicit performance agreements (convenios de desempeho) signed by the respective recapitalized financial institutions. 33. The recapitalization program as designed has a number of attractive features. It is simple, transparent, universal, and open to any fit-and-proper investor, which will limit the risk of accusations of shady deals and favoritism. In addition, its emphasis on straight recapitalization instead of asset purchases will increase the effectiveness of the resources invested in it. FOGAFIN's practice of using comprehensive audits jointly conducted by international consultants and staff of the Superintendency of Banks as a condition for accessing its recapitalization funding is very appropriate. The plan would, however, need to be implemented taking care to avoid abuses and any perverse incentives, with close monitoring of the performance agreements with recipients. B. Structural Reforms in the Financial Sector 34. The Govermnent recognizes the critical importance of avoiding any further instability in the financial system and laying the basis for a healthy and efficient development of the financial system as an essential ingredient for sustainable growth. Accordingly, it is giving high priority to putting into effect measures to: (i) enhance competition and efficiency in the financial system, by putting in place appropriate 4 The Bank is supporting the reconstruction effort by redirecting the balances of ongoing projects and processing a proposed new loan to help earthquake recovery. - 15 - prudential rules, effective supervision and efficient failure resolution mechanisms; (ii) building the capacity of key supervisory and resolution institutions, including development of asset management and liquidation companies; (iii) reforning, privatizing or, if necessary, closing some state-owned banks and reforming the second-tier institutions; and (iv) reforming the cooperatives system. 35. In order to avoid a repetition of the problems witnessed in the financial sector, and to set the basis for a healthy development of the Colombian banking system in the future, the Government has also prepared and obtained Congressional approval of a major reform of the Framework Law (Estatuto Organico) of the Financial System through Law 510 of 1999. Reforms put in place under this amending law, which became effective in August 1999, include far reaching structural, regulatory and supervisory reforms for the sector. These include measures to: (i) liberalize the types of operations which different categories of financial institutions in Colombia can engage in, thereby increasing competition in the sector and virtually eliminating any remaining "regulatory arbitrage" among financial institutions; (ii) define the roles of the Superintendency of Banks and FOGAFIN, including their responsibility to assure timely detection, corrective action, and resolution of banks facing liquidity and/or solvency problems, and provide for stronger enforcement of consolidated financial reporting of financial groups and off-shore transactions; and (iii) authorize a wide range of modem bank resolution methods which FOGAFIN can use in order to achieve efficient and timely resolution of problems, akin to the authority exercised by the FDIC in the Unites States. The Reform Law also envisages welcome improvements in the disclosure requirements and regulations governing participants in the Colombian capital markets. Important improvements continue to be made in building the institutional capacity of the Superintendency of Banks through focused training programs. 36. Among the specific provisions of the new legislation are: (i) an increase in the minimum capital of financial institutions; (ii) the strengthening of procedures for the timely detection of troubled institutions and the introduction of automatic "prompt corrective actions" by the Superintendency; (iii) the introduction of time limits to different procedures undertaken by the Superintendency such as: the decision on whether to liquidate or close an institution (two months); the intervention without liquidation (one year); and the liquidation of an institution (four years); (iv) the tightening of clauses under which a financial institution may be intervened (including when severe accounting data inconsistencies are encountered, the capital adequacy ratio falls below 40 percent of its minimum required level, or recapitalization proposals are nor presented or approved within the established deadlines); and (v) new powers to FOGAFIN to expedite mergers and acquisitions, purchase assets from and make loans to financial institutions, and promote securitization. 37. The Government has also agreed with the Bank on a set of principles that will govern the detailed implementation of this legislation and regulations related to corrective and resolution actions in the financial sector. Among other things, these principles provide for: (i) clear criteria and conditions under which a ladder of increasingly strict corrective actions by the Superintendency would be triggered as severity of problems detected increases; as far as possible, automatic triggering of certain minimum actions would be provided for each type of condition, in order to assure - 16- equitable application of rules and avoid possibility of ad hoc regulatory forbearance while also preventing charges of prejudicial treatment; (ii) likewise, clear criteria when bank intervention (toma de posesion) would be triggered; (iii) ensuring that any assistance provided by FOGAFIN would be in the context of satisfactory restructuring plans, covering required changes in ownership, management and administration; all restructuring plans would honor agreed specific principles of burden-sharing between shareholders, creditors, depositors, and the deposit insurance agency, e.g., that existing shareholders bear their full share of losses incurred, and that the assets and their capital be written down as precondition to FOGAFIN financing; (iv) minimizing the conditions under which such intervention will lead to the Government taking over the ownership or operation of a bank, while allowing for exceptional treatment in cases where there is a significant risk of contagion or payments system disruption or where public interest is served by avoiding systemic risk; (v) keep any instances of "oficializacion" (a form of open bank assistance) to a minimum and reserved only for exceptional circumstances as described above; in all cases, oficializacion will involve a full write-down of existing shareholders' capital against identified losses or provisioning requirements - before providing any recapitalization assistance; and (vi) as a normn, application of market based resolution techniques for sale of assets and transfer of liabilities of problem banks with a view to minimize the economic cost of resolution and optimize these transactions wherever possible by integrating them with fulfillment of FOGAFIN's deposit insurance obligations. Annex 3 provides the English translation of the principles adopted by the authorities in order to ensure prompt corrective actions and optimal resolution. 38. As a complementary measure designed to increase liquidity in the system and reduce cost of interrnediation, BR has also taken strong actions to further decrease the legal reserve requirements of banks and credit institutions, and has maintained since January 1999 a low average reserve requirement levels of about 5.5 percent. This, together with the partial remuneration of such reserves, breaks a long tradition of high implicit taxation of the Colombian financial system, and should help bring down spreads between borrowing and lending rates. Under the current stage of development of BR's liquidity management capacity, and to avoid undermining the soundness of the payments system, it is not advisable to lower reserve requirements further. BR has also increased the amount of "repo" transactions and eased access to the last resort lending facility in order to provide liquid resources to those institutions that have suffered deposit withdrawals, subject to well specified criteria and strict limits. 39. An area that requires close attention is the institutional strengthening of the two main agencies involved in the oversight and resolution of banks -- the Superintendency of Banks and FOGAFIN. The Government agreed to put in place a comprehensive institutional strengthening plan for both agencies, including organizational improvements, analytical and technical training through assisted inspections, in-house workshops and study visits to other countries, and recruitment of additional staff as needed. The strengthening plan for the Superintendency of Banks includes specific measures to: (i) significantly strengthen on-site inspection, including where necessary advisory assistance from external on-site supervision experts, a greater focus on control processes of the financial institutions in areas such as the lending process, monitoring of compliance of borrowers with agreed covenants, and internal audit; (ii) further enhance off-site analysis capabilities, through ensuring timely availability of standard data and - 17- putting in place a new integrated risk management system that takes into account credit, market, environmental and management risks, and provides an improved early warning system; (iii) improve and standardize methodologies to apply rigorous loan classification and provisioning requirements - e.g., to determine appropriate loan classification, taking into account borrower's real ability to pay rather than collaterals offered or past record per se; (iv) standardize and reorganize itself to strengthen the practice of consolidated supervision of financial conglomerates (gruposfinancieros) and tracking off-shore operations; (v) adopt clear principles of preventive and prompt corrective actions, including a graduated set of corrective actions linked to certain automatic triggers as provided under the new law; and (vi) implement a comprehensive staff training and development program to increase and broaden their technical capacities. 40. The institutional strengthening plan for FOGAFIN includes specific measures to: (i) improve its organizational structure, with a clear strategy to identify areas in which it needs to hire external expertise and those in which internal staff capacity needs to be developed; (ii) protect its core functions of deposit insurance and bank resolution from becoming adversely affected by the administrative burden imposed by other functions such as those under the economic and earthquake emergency decrees; (iii) clearly delineate among the different types of activity that FOGAFIN engages in (e.g., between their normal and special or "emergency" functions, and between the different categories of institutions they serve), with safeguards to assure that the reserves managed for each type of activity are fully protected from activities in other spheres; (iv) improve the technical capacity of its staff to design and apply modern, market-based instruments, market based sales of assets or transfer of liabilities, mergers, disposition of repossessed real assets, creation of "bridge banks" or "good bank/bad bank" structures, and integrating execution of these with fulfilling its deposit insurance liabilities to achieve timely and least cost resolution of bank problems; and (v) implement a comprehensive program of staff training and development to help achieve these objectives. 41. The Government has also put into effect an action plan to achieve resolution and/or privatization of the main state-owned and "officialized" banks (Caja Agraria, Banco del Estado, Banco de Credito Hipotecario, and the erstwhile assets of Banco Uconal which have been formally consolidated into the new Banco del Estado), as well as Banco Cafetero which is owned by the National Coffee Fund. A considerable amount of groundwork has been prepared to support the Government's decisions in this area, including some with Bank/IDB support. Downsizing, comprehensive reform and/or privatization of these institutions present sensitive social and political problems, given the critical social and financial intermediation functions they had been fulfilling. 42. In the case of the Caja Agraria, which presents the most sensitive issues in this connection, the Government has already taken action to dissolve the institution and dismiss all its employees, through a special decree issued in June 1999 (Decree No. 1065). In its place, the Government created a substantially downsized new institution, Banco Agraria, by closing most branches of the Caja in locations where there are private financial institutions available, and closing or consolidating other branches where justified, after taking into account the payments and other basic service needs of these areas. In total, more than 200 (out of about 800) branches of the old Caja have been closed and further consolidation may occur in the future. The non-perforrning part of the - 18- Caja has been separated and will be liquidated according to agreed procedures. The new Banco Agraria will be a much leaner institution and will operate under clearly laid out banking principles, with a clear focus on serving smaller farmers, and separating out the channeling of any subsidies for social development purposes which would be funded directly from government budget resources. Banco Agraria will concentrate its activities in areas currently not served by other financial intermnediaries, and will be subject to strict limits on the size of the loans and the total amount of credit exposure it can assume. 43. In the case of the other five major state-owned and "officialized" banks,5 the Government strategy is to privatize them within the next eighteen months, or if this does not prove feasible, initiate liquidation of these institutions in a manner that does not result in any net additional fiscal cost to the Government and maximizes the value of assets recovery. In preparation for the privatization effort, the Government has issued decrees to consolidate these institutions into three "packages", which offer greater synergies and help overcome certain legal obstacles that have until now hindered the sale of the banks to prospective buyers. FOGAFIN will act as the Government's agent to undertake the privatization of these institutions and to manage them tightly during the transition. For the first package, comprising Granahorrar and Banco de Credito Hipotecario (BCH), FOGAFIN has already contracted an investment bank (Goldman Sachs) to prepare and execute the process to bring them to the point of sale by June 30, 2000. For the other two packages comprising Banco Cafetero, and the result of the Banco del Estado-Banco Uconal merger, FOGAFIN expects to hire qualified investment banks within the next six months and bring them to the point of sale by about the end of 2000. To minimize the fiscal and economic costs associated with continued operation of the state-owned banks during the transition period, individual transition plans have been formulated for each of the state-owned banks, which encompass strict limits imposed on them by the Superintendencia Bancaria and/or FOGAFIN on the use of deposits and loan recoveries for making fresh loans, as well as other restructuring actions to help improve their financial health and solvency ratios in preparation for privatization. Any continuing support to state-owned institutions (e.g., to pursue certain high priority social goals) would come entirely from the Government's budget or specially mobilized resources (e.g., those raised through the emergency provisions) in a transparent manner, without causing any further financial burden to FOGAFIN. The attachments to the Government's Development Policy Letter clearly lay out the background, privatization strategies and the transition plans for these institutions. 44. As a second phase of the reform of public financial institutions, the Governnent also intends to review the options for rationalizing and improving the efficiency of its main second-tier institutions, including IFI. Completion of this review will be a second tranche condition of the proposed loan. 45. With regard to the cooperatives, the Government's strategy is to first address the "stock" problems (institutions and portfolios already identified as having problems), and encourage all cooperatives to more clearly delineate their roles either as "closed" credit unions accepting deposits only from members, or as nearly full fledged credit institutions 5 Or possibly only four formal entities, taking into account the recent Government ordered formal fusion of Banco de Estado and Banco Uconal, which has, however, been questioned by the Constitutional Court and may have to be reversed. - 19 - open to taking deposits from the public. This transition process will be implemented over the next year or so. The Government has already initiated this restructuring process, and has taken steps to clearly separate the treatment of the smaller credit unions which do not accept deposits from the general public, from that of the "financial cooperatives" which have faculties to accept such deposits and therefore need to be supervised on par with other general or special purpose financial intermediaries. A separate supervisory and deposit insurance system has been created under Law 454 of 1998 to attend to the former group (credit unions). The Superintendency of Banks has already launched a comprehensive process of assessing the financial condition and solvency of all financial cooperatives, with a view to verify that the new institutions fully comply with applicable prudential and other regulations, and, in case of the contrary, take steps either to implement a viable plan to reach solvency, or to close them or achieve other resolution of these institutions. So far, based on a first-round review of the 52 financial cooperatives that were operating in 1998 has been completed. Of these, 20-22 are deemed to be capable of potentially qualifying for operation as financial cooperatives under the new rules. The others are likely to liquidate themselves voluntarily, become absorbed in other institutions, convert themselves into "closed" cooperatives (credit unions), or be liquidated under Superintendency orders (some are already under liquidation). On-site inspections and full reviews of all these institutions are to be completed by the Superintendency of Banks by the end of year 2000, and final disposition of these institutions achieved. The full program to accomplish this is detailed the relevant achievement to the Development Policy Letter. 46. The Bank team also sought understandings with the Governnent that future housing finance through the CAVs (savings and loan associations) and other financial institutions will be made in a way that make the full cost of such loans fully transparent, and under all circumstances avoid any automatic capitalization of interest beyond the portion accounted for by inflation This will enable future housing finance contracts to be made in the full knowledge of the real costs of the financing and its affordability in relation to the borrowers' income levels. Operationalization of measures to reform the housing finance system along these lines will be a condition for release of the second tranche of the proposed loan. Related to this, a recent Constitutional Court ruling questioned the validity of the shifts in the definition of the UPAC index that were put into effect in past years (since 1988 - see para. 18) and asked for retroactive reduction in loan balances to be provided to housing finance recipients. The ruling may accelerate the need for the Government to propose a new housing finance system that meets the criteria mentioned above. The need for retroactive correction of the existing system, however, impose additional fiscal demands, which would need to be accommodated within a satisfactory macroeconomic program. The Government has already started looking at options to meet these requirements, and is expected to propose a new housing finance law for that purpose. 47. As longer term measures, it would also be important for Colombia to: (i) help mobilization of longer term deposits instruments for the housing finance market, in order to avoid the excessive term transformation that characterizes almost all the housing finance institutions in Colombia; (ii) review existing civil and commercial code and propose modifications to address the problem of extremely cumbersome and time- consuming processes involved in repossession of collaterals and creditors under - 20 - Colombia's existing judicial processes; and (iii) promote standardization of mortgage instruments and operation of securitization companies, which can help provide liquidity and depth to housing finance markets. These measures will also be supported by the ongoing Financial Markets Development Loan and a proposed operation for judicial reform, as well as under a new housing finance law which the Administration proposes to pursue. IV. BANK GROUP STRATEGY 48. The last full Country Assistance Strategy (CAS) for Colombia was discussed by the Board on November 6, 1997. The accompanying report entitled "Colombia: Country Assistance Strategy - Progress Report" (Report No. 17107-CO dated October 20, 1999) provides a full review of the strategy and the progress achieved so far. 49. The CAS, following a participatory process that included open dialogue and effective consultations with Government leaders and civil society, identified the main objectives of poverty reduction, social development, and sustainable growth. These objectives were to be achieved by interventions in six strategic areas: (i) promoting peace and development; (ii) promoting rural development; (iii) developing human capital; (iv) attaining public sector responsiveness and efficiency; (v) improving infrastructure services; and, (vi) ensuring sustainable development. These key priorities have not changed and the basic objectives and the overall thrust of the existing CAS remain valid. However, changes in the international environment, the deterioration of the financial sector, greater emphasis on the peace process, a devastating earthquake, the Government's commitment to impose fiscal discipline and to implement structural reforms to be supported by a formal IMF program, and improved portfolio performance warranted a reassessment of our lending program, in particular of the type and arnount of lending. The progress report proposes moving to a high-case lending program that includes two adjustment operations, including the proposed FSAL. This movement is justified due to the need to cushion the adverse social impact of the unprecedented economic recession, financial instability and internal conflict on the poor, the Government's commitment to implement structural reforms to be supported by a fornal IMF program and the need to support the developmental aspects of the peace process. 50. The proposed FSAL would directly support a healthy and sustainable development of the Colombian financial system which will be critical to achieving the economic recovery, growth and financial services to vulnerable groups as called for under the Government's overall economic program. The operation is therefore an integral part of the updated country assistance strategy, and supports the CAS objective of achieving sustainable growth. 51. IFC's strategy and programs include active involvement in operations related to financial markets, private participation in infrastructure and selective manufacturing and service areas, all of which would benefit from reforms in the financial sector supported by the proposed loan. In particular, IFC's recent investment in a development finance company assisting small and medium enterprise development, a proposed investment which it is considering to create a secondary mortgage facility for housing finance, and advisory services to establishment of private equity funds will benefit from the financial - 21 - framework being supported by the proposed loan. The accompanying CAS Progress Report provides full details of IFC and MIGA operations in Colombia. V. THE PROPOSED LOAN AND CONDITIONALITY 52. A Bank Loan of EUR 482.3 million including the capitalized front end fee to the Republic of Colombia is proposed to support the Government's Program described in Section III. It would be disbursed in two equal tranches. The loan will be a Fixed Spread Loan, to be repaid in 17 years, including a five-year grace period. The policy matrix attached in Annex 1 indicates the main areas of reform action to be supported under the Loan and the corresponding conditionality. All special conditions for disbursement of the first tranche have already been met, including: passage of the required legislative reforms, agreeing on a plan and initiating measures for institutional strengthening of FOGAFIN and the Superintendency of Banks, preparation of satisfactory restructuring plans for the state-owned and officialized banks and initiating the process to bring them to the point of sale, and putting into effect measures to reform the cooperatives system. The second tranche would be released upon satisfactory implementation of the reforms, with an agreed calendar and specific milestones, which would lay the foundation for a medium term healthy development of the sector. Details of these conditions are spelled out in the Policy Matrix in Annex 1. It is anticipated that the second tranche would be released during 2001. The Program Objective Category is Economic Management. A. Program Management and Loan Administration 53. The Government of Colombia would be the Borrower of the proposed Loan. The Ministry of Finance and Public Credit will be the principal executing agency and will have the overall responsibility for coordinating and overseeing all aspects of the program. The Superintendency of Banks and FOGAFIN will also have key roles in executing the program and will work closely with the Ministry of Finance and Public Credit and Banco de la Republica in executing program components under their respective jurisdictions. The closing date of the Loan would be December 31, 2001. B. Disbursement and Auditing Arrangements 54. Disbursement arrangements will follow the simplified procedures for SALs/SECALs approved by the Board on February 1, 1996. The Borrower will open an account in Colombia's Central Bank (Banco de la Republica). Once the Bank formally notifies the borrower that a tranche is available for withdrawal, the borrower may submit a withdrawal application so that the proceeds of the tranche are deposited by the Bank in this account to be used in accordance with the Loan Agreement. Although a routine audit of the deposit account will not be required, the Bank reserves the right to conduct one. C. Financing Plan 55. The total cost of the above-described elements is estimated at over US$6 billion equivalent, not including earthquake related financing relief. This includes the cost of restructuring, dismantling and/or privatization of state-owned and officialized banks, the - 22 - associated worker severance payments and related obligations (US$4.3 billion); recapitalization of private banks and reserves for resolution of other financial institutions facing problems (US$1 billion); and payments for adversely affected home-owners and small depositors of cooperatives (excluding earthquake related cooperatives), establishment and initial deposit of FOGACOOP and assistance to asset management and disposition (US$800 million). About three-quarters of these costs will be funded through domestic resources mobilized through the temporary 0.2 percent financial transactions cost, accumulated reserves from deposit insurance premiums, capital contributions from shareholders and potential owvners, and expressly authorized general budget funds (e.g., to dismantle Caja Agraria and to establish FOGACOOP and cover the low income depositors of cooperatives). Contributions from multilateral development banks will help cover about US$1 billion equivalent of the remaining gap (about US$500 million equivalent from the Bank, US$300 million from IDB, US$200 million from CAF); resources under the expected EFF program from the IMF and other sources may have to be used to cover the rest. Under the proposed loan, the Bank has received assurances that additional resources equivalent to at least US$200 million will be transferred to FOGAFIN to help address emerging bank resolution needs. Overall, the financing plan seeks to minimize use of general budget revenues (other than funding expressly provided by multilaterals) for the purpose of implementing financial sector reforms, and thus minimize the fiscal impact on other sectors of the economy. In addition to its direct participation through the proposed $300 million parallel financial sector operation, the IDB has also provided two other fast disbursing loans to Colombia over the past 12 months: a US$350 million energy sector loan approved in December 1998, and a US$550 million fiscal adjustment loan approved in February 1999. The IMF has announced tentative plans for a EFF of up to US$2.7 billion. D. Benefits and Risks 56. The proposed loan would support the recovery and healthy long-term development of the financial system with the minimum cost to the economy, which is essential for the economic reactivation and achievement of the growth targets envisaged under the macroeconomic program. The strategy supported by the program is to minimize the chance of a systemic risk in the Colombian financial system through a macro-economic program that enables stabilization and significant reductions in real interest rates, combined with a timely and effective implementation of prudential rules and supervision, preventive measures, and case-by-case resolution actions. The Government's financing plan also seeks to minimize the burden placed by the program on the general budget revenues, by following the principle that the costs of the reform program should, as far as possible, be covered by revenues generated through the financial system itself, including taxes, deposit insurance premiums and capital contributions from participants/owners; external assistance from multilateral institutions is sought to help smooth out the impact of the one-time up-front costs. 57. An important risk affecting the transition of the financial system back to a healthy state is the govemrnent's inability to reduce interest rates in the economy which would directly impact on the capacity of borrowers to service their debt. The Government is acutely aware of this, and is making best efforts to address the issue through the implementation of a demanding fiscal program, comprehensive structural reforms, and - 23 - instilling confidence in international and domestic investors through a credible stabilization plan and exchange rate management. A slippage in the implementation of the Government's stated macroeconomic program, or a significant worsening of the external environment through continued turbulence in international financial markets could disrupt the achievement of the program goals. The downward movement of interest rates in recent months, and the likelihood that Colombia will shortly reach a funding agreement with the IMF for an Extended Fund Facility program, with specific monitorable indicators for the macroeconomic program are positive factors moderating this risk. 58. The proposed program, with its emphasis on structural reforms in the financial sector and efficient case-by-case resolution of credit institutions, helps minimize the risks of a fully blown systemic crisis through appropriate incentives and builds greater preparedness to tackle such an eventuality. A failure by the Government to put in place in a timely manner the improvements in the institutional capacity and resolution process, or significantly more acute problems discovered during the planned intensive banking supervision, could elevate the potential for systemic risk. The clearly laid out program of actions prior to the Board presentation and second tranche disbursement under the proposed loan, including in particular the capacity building measures and well thought out calendars of action under each reform area, are designed to minimize these risks. Recently, the Constitutional Court of Colombia has questioned some of the provisions of the housing finance system, and ordered certain changes to be put into effect, which may lead to additional financial sector and/or fiscal costs. However, the Government is taking swift remedial action to correct this and in fact accelerate putting into effect a workable housing finance scheme as required under the second tranche conditions. VI. RECOMMENDATION 59. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve it. James D. Wolfensohn President By Sven Sandstrom Washington, D.C. October 20, 1999 Attachments Annex 1: Matrix of Reform Actions Area of Reform; Current Status & Key Issues Acion compeleted prior to Board Presentation Second Tranche Conditions 1. Ensuring a satisfactory macro-economic framework. The Govemment has prepared a medium term macro-economic plan Agreement on a satisfactory macro-economic framework and key Maintenance of a satisfactory macro- consistent with the goals of achieving stabilization, substantial reduction targets; this agreement has been reflected in the Govemment's economic framework, consistent with in the fiscal deficit over the next three years to achieve near balance, and Development Policy Letter. the Program described in the significant reductions in inflation and real interest rates. Bank and IMF Development Policy Letter. teams have reviewed the program, and find it realistic and worthy of support. The IMF is expected to support the program through financing under the Extended Fund Facility (EFF). A Letter of Intent is expected to be finalized shortly between the Government and the IMF for this purpose. An IDB Fiscal Adjustment Loan is supporting the implementation of parts of the program. Bank/lMF/IDB teams are following further macroeconomic developments on a continuous basis. II. Strengthening the legal, regulatory, and institutional framework of the financial system and problem bank resolution Existing legal and regulatory framework has served reasonably well in A. Passage of an amended Financial Institutions Framework Law A. (i) Adoption and application by the the past, but needs to be reformed and strengthened to take account of (Estatuto Organico), and putting in place satisfactory principles of Banking Superintendency of emerging problems and set the basis for healthy long term development prevention and prompt correction in the oversight of financial regulations and internal procedures of the banking system. Among other things, the new legislative intermediaries, and resolution in the case of institutions facing (e.g., those related to prompt corrective framework was needed to strengthen faculties for supervisory and problems. The new legislative framework and principles will actions, loan classification and resolution agencies to put into effect strong prudential, capital adequacy enable inter alia: (i) appropriate capital adequacy and prudential provisioning rules) required to and related rules, take strong preventative measures to anticipate and rules, including rules on related party lending and portfolio implement the provisions of the avoid problems, and implement modern methods of bank failure concentration and application of prudential rules on a consolidated Framework Law and related principles; resolution when solvency problems arise. Bank/IDB preparatory work in basis for all affiliates of a financial group; (ii) establishment of a (ii) adoption and application by connection with the FSAL and a Joint Bank-IMF Financial Sector system of progressively stringent prompt corrective actions for FOGAFIN of bank resolution Assessment, which has been completed for Colombia in October 1999, banks facing increasing degrees of solvency problems; (iii) use of techniques that fully comply with the have provided additional suggestions for institutional and policy market-based modem bank resolution devices such as mergers, agreed principles to assure efficient strengthening. sales of assets and/or liabilities, "good bank/bad bank" solutions, and fair resolution; and (iii) rules put and if appropriate, liquidation, in a way that facilitates equitable into effect to ensure that the full cost in and economically efficient resolution and integrates the deposit real terms of future housing finance insurance instrument more effectively into the financial resolution loans is transparent, and that indexing process; (iv) all FOGAFIN financing provided to credit mechanisms are designed to ensure the institutions (including any recapitalization assistance) to be sustainable payment capacity of explicitly conditioned on satisfactory application of agreed borrowers. restructuring, burden-sharing and resolution principles; (v) clear separation of the functions and strict delineation of financial accounts related to FOGAFIN's various insurance, resolution and institution development activities. Area of Reform, Current Status & Key Issues Action completed prior to Board Presentation Second Tranche Conditions B. Adoption and initiation of a satisfactory institutional B. Satisfactory implementation of the strengthening plan to correct existing weaknesses in the Banking institutional strengthening plan of the Superintendency, covering: improvements in technical capacity, Banking Superintendency, consistent assessment of major risk areas and the banks' capacity to manage with the calendar and milestones them, strengthening supervision of financial groups on a included in the plan. consolidated basis, strengthening information systems to facilitate timely diagnosis and monitoring, on-site and off-site inspections, including inspections assisted by external experts as part of on- the-job training, execution of a ladder of prompt corrective actions depending on the degree of solvency problems encountered, and comprehensive on-house and external training programs. C. Preparation and initiation of a satisfactory institutional C. Satisfactory implementation of development plan for FOGAFIN, covering improvement of its FOGAFIN's institutional strengthening technical capacity to diagnose, analyze options and undertake plan, consistent with the calendar and resolution of banks facing difficulties, and required training to milestones included in the plan. ifulfill effectively the various functions of FOGAFIN. 111. Restructuring and Resolution of State-owned and "Officialized" Banks The Bank (and IDB) has been in discussion with the Government on the A. The Government has taken formal action to dissolve Caja A Formal action to bring to point of need to restructure, privatize and/or achieve resolution of the three state- Agraria and release all its employees, replacing it with a much sale (for privatization) or initiate owned first tier banks (Caja Agraria, Banco Central Hipotecario, Banco smaller and streamlined new institution to provide agricultural liquidation of the other five banks del Estado ) and development of appropriate options thereof. Likewise, credit in underprivileged areas; the new institution, Banco currently under official control. the Government and FOGAFIN are studying options for the privatization Agrario, will operate on sound commercial banking principles, or other resolution of the two largest credit institutions which have been with any remaining subsidies directly funded under the intervened and are currently controlled by FOGAFIN - Granahorrar (a Government's budget. savings and loan association) and Banco Uconal (a cooperative bank). Resolution options for Banco Cafetero, a private bank indirectly controlled by the public sector through the National Coffee Fund whose B. The Government has undertaken to hire, or undertake to hire B. Satisfactory implementation of the assets have been adversely affected by the recent earthquake in the by June 2000, investment banks to pursue privatization of the respective transition plans for each of coffee zone are also being analyzed. The Government is also seeking to other five state-owned and "officialized" banks. The current plan these banks. rationalize and improve operation of its second-tier financial institutions. calls for bringing all five institutions to the point of sale by end of year 2000; if the privatization attempt fails for any of these, alternative resolution of the institution will be achieved within 12 months thereafter. Transition plans have been developed for each of these institutions to limit their activities and minimize any consequent fiscal burden prior to their privatization or resolution. C. Completion of a study on options to rationalize and increase the efficiency of state-owned second-tier institutions. Area a/Reform, Current Status & Key Issues Action completed prior to Board Presentation Second Tranche Conditions IV. Reform of the Cooperatives System The Government has taken steps to define more clearly the distinctions A. (i) Adoption by the Banking Superintendency of satisfactory A. Continued satisfactory among the three categories of cooperatives - "financial", savings (akin to principles, strategy and action plan for licensing and supervision implementation of the action plans and credit unions) and multi-sectoral--, and to establish applicable prudential of cooperatives consistent with the overall structure and vision of the agreed resolution process for rules and supervisory responsibilities for each category. A new the Colombian financial system; (ii) Adoption by the Banking financial cooperatives, which specialized supervisory agency and a deposit insurance and resolution Superintendency and initiation of an action plan for inspection, contemplates final decision on their agency were created to look after the latter two types of cooperatives review, and if necessary, resolution of all existing financial status and, if necessary, resolution (also called "closed" cooperatives) which tend to be very small entities cooperatives. actions on existing financial serving large numbers of low-income depositors. The Banking cooperatives. Superintendency will oversee the financial cooperatives which have faculties similar to banks and other formal credit institutions. Rules and incentives have been put in place to encourage the reclassification of "financial" cooperatives into formal credit institutions or else as "closed" credit unions. Several financial cooperatives facing difficulties have been intervened and/or slated for liquidation. V. Recent Special Programs being Implemented by FOGAFIN In November, 1998, the Government took a number of emergency A. Steps taken to ensure that FOGAFIN's institutional capacity A. Continued compliance of the measures to provide carefully circumscribed relief to the most vulnerable does not become unduly stretched as a result of the added condition. borrowers and associated financial institutions, to help them tide over the functions related to the implementation of these special programs, crisis. Relief is to be mainly in the form of guarantees of the first to the detriment of its primary functions of deposit insurance and US$350 equivalent for low income depositors of troubled cooperatives mainstream bank resolution. This is incorporated as part of which had no formal deposit insurance scheme (treated as advances to FOGAFIN's institutional strengthening plan. the respective cooperatives), and refinancing at preferential rates of increases in real loan balances of low income homeowners (for loan 13. Clear separation of the funding for FOGAFIN's special B. Continued compliance of the balances of up to 5,000 UPACs) who borrowed under the indexed home programs from those for its mainstream resolution and deposit condition. Government to make mortgage system. This limited targeted relief program should help insurance functions. available resources equivalent to facilitate sustainable solutions and limit social problems among the most US$200 million to FOGAFIN as vulncrable groups. FOGAFIN has also been given authority to provide additional reserves to support its bank credits to assist the formation and/or operation of asset management and resolution activities. securitization companies as additional instruments to encourage market- based resolution in mortgage lending operations. The Government C. Rules governing FOGAFIN's special relief programs promulgated a temporary (through end-1999) financial transactions tax consistent with the Program's objectives and satisfactory to the C. Satisfactory rules governing these of 2 per 1000 to finance the costs of this relief and restructuring program. Bank. rules maintained. FOGAFIN is also implementing a recapitalization plan to assist private financial institutions which are facing temporary difficulties in meeting solvency criteria, but are considered viable in the medium-term; the recapitalization credits are subject to strict limits governing the amounts of such credits and the burden assumed by their shareholders. - 28 - Annex 2: Letter f Development Policy September 22,1999 To: Mr. David de Ferranti Mr. Enriqlue Iglesias Regional Vice President President Latin America and the Caribbean Regional Office Inter-American Development Bank The World iBank Washington, D.C. 20577 Washington, D.C. 20433 Dear Messrs. De Ferranti and Iglesias: I am writing this Letter of Development Policy in order to provide the background and context for the proposed Financial Sector Adjustment Loans to support the broad range of financial sector reforms which we are undertaking. As you know, this set of reforms are the result of wide consultations with Colombian civil society and the private sector, policy work and analyses conducted within the Govemment, as well as the extensive initerchange of ideas with the World Bank and the Inter-American Development Bank, as well as with the Intemnational Moneuuiy Fund. I would like to provide you a summary of the objectives of the reforms we are and will be undertaking, our vision of the type of financial system that should emerge out of it, and our proposed strategy and principles that will be followed in achieving that vision. I also provide here a brief summary of other measures vhich were implemented over the last 12 months, including those related to the declaration of economic emergency oriented towards providing relief to the most vulnelrable groups of the civil society that have been affected by adverse financial sector developiments. Macro-economic Context and Proposed Framework Overall macroeconomic conditions have a direct impact on banks and the soundness of the finiancial sector. Recently, that impact has been definitely negative in Colombia. After decades of girowth and cautious macro management, its economic performance has deteriorated sharply in the last three years: (i) the GDP growth rate declined from an average of 4.6 percent per year in 1970- 95, to 1.9 percent in 1996-98. Further, during the first half of 1999, GDP shrank by about 6 percent compared to the previous year; (ii) the fiscal accounts of the non-financial public sector (NFPS), which were roughly balanced in the first halt of this decade, showed a deficit of 3.7 percent of GDP in 1998 and a projected 6 percent of Gi)P in 1999 (usin- IMF methodology); and (iii) the current account of the balance of payments showed a deficit of over 5 percent of GDP in 1995-98, but is expected to faIl to about 2.5 percent of G3DP in 1999, largely due to a steep decline in imports (by 32 percent in the first half of the year). Economic decline has been accompanied by a rapid increase in unemployment, which reached 19.8 percent in the urban areas in June 1999. -29 - Annex 2 Deteriorating external conditions aggravated Colornbia's situation in 1998 and 1999. The country was hit by severe external shocks: (i) a trade shock due to the sharp drops in oil and coffee prices. estimated at 1.5 percent of GDP; and (ii) the events in international credit niarkets which have had a direct impact on the cost of borrowing. After the Russian default in August 1998 and the viltual closing of international credit markets to developing economies, Colombia's spread skyrocketed (as it did for most countries in the region) to a peak of over 900 basis points (bsp) At the same time, additional public resources were needed to rebuild the areas affected by a devastating earthquake which hit the country in January and to shore-up the ailing financial sector. 'I'hus, the autlhorities had to tum to the domestic market for financing, thereby putting additional pressure (apart from the direct effect of extemal markets) on domestic interest rates. Also, facing attacks on the currency and in order to avoid extensive losses of reserves and even higher interest rates, the Central Bank shifted (devalued) the exchange rate band in September 1998 and in July 1999. Reflecting this situation, Colombia's investment-grade status has been recently downgraded by Moody's, which also pushed down the credit ratings of five Colombian commercial banks. Shortly thereafter, another credit rating agency (Duff & Phelps) downgraded Colombia's bonds while still maintaining their investment rating. T'he down-grading of the country's bonds could raise the costs of external financing. Interest rates are a key link betveen the overall macroeconomic conditions and the real and financial sectors. Beginning in November 1997, real interest rates on deposits had risen from about 4 percent to around 18 percent in the last quarter of 1998. Real interest rates on loans increased from about 14 percent to 26 percent per year. Although the external shocks described above contributed to this rise, several domestic factors may have also contributed, including greater demand for credit by the public sector to finance the fiscal deficit and an increase in the flow demand for funds due to distressed borrowing by both debtors and credit institutions. Since the end of 1998, however, the Colombian authorities have taken concerted measures to bring down interest rates, whose reduction is seen as essential for any reactivation of the economy. T'he benchmark 90-day DTF, has dropped from its peak of 37 percent in September 1998 to I percent in September 1999. Further reductions in real interest rates, and in spreads, can be achieved by continuing to pursue fiscal adjustment, which would reduce the borrowing requirements of the public sector. Furthermore, restructuring of the financial system as planned would reduce distress borrowing and strengthen public confidence, which would also lead to lower interest rates, higher investment and renewed economic growth. Restoring macroeconomic stability is a necessary condition for the recovery of the banking and financial sectors. Consequently, the Goverrnment has made reducing the fiscal deficit The situation has improved since then. [n April 1999. the country's spread had fallen to about 450 bsp, although it has risen to about 630 bsp in Septetnber 1999 as a result of a number of factors, including the continuing economic problems and the escalation in Colombia's internal conflict. -30 - Annex 2 one ot its key macroeconlomic objectives. Since taking office in August 1998, the Government has taken several revenue enhancing and expenditure reducing measures, including widening of the VAT base and improving tax collection, increasing the gasoline surcharge, and cutting the operational costs of the Central Government. Notwithstanding these measures, the fiscal situation dleteriorated this year, partly as a result of the deep recession and unexpected expenditures to cover earthquake reconstruction as well as the costs of resolving the financial sector crisis. However. within the context of the National Development Plan., in the first half of 1999 Congress has approved legal amendments that would improve the fiscal situation in the medium term, including: (i) reform of the resources and competencies of local governments (Law 60). and increasing efficicncy of expenditure in education; (ii) improving efficiency in public universities (Law 30): (iii) changes in royalties allocations, to attract private investment; and (iv) reforms to the 13udget Law. to reduce earrnarking and improve the allocation of local expenditures. Further, proposals for additional structural reforms are being introduced in the July-December 1999 legislative session: (i) the Law to Rationalize public finances to curb their expansion: (ii) changes to continue the relonn of social security, including elimination of several special regimes; (iii) measures to curtail current expenditures of local governments; and (iv) a constitutional amendment to save part of the transfers to local government, to fund local pension funds. fo consolidate and expand these reforms, the Government has put together a comprehensive stabilization program that would be supported by an IMF three-year Extended Fund Facility, which is expected to be approved by the IMF Board of Directors in the fourth quarter of 1999. The Government will seek passage by the Colombian Congress of the required fiscal measures and the structural measures described above. The government's plan calls for a reduction of the NFPS deficit from a projected 6% of GD)P' in 1999 to 3.5% of GDP in year 2000. 2.5% of GCOP in 2001, and to 1.5% of GDP in 2002 (using INIF methodology). This fiscal adjustment will be accompanied by a gradual reduction in CPI inflation from a projected anlual rate of 12% this year to 6% in 2002. In turn, the current account of the balance of payments will remain below 3% of GDP on average throughout the period - a level that can be financed in a sustainable manner by FDI and long terrm capital flows, In particular, the multilaterals will make up for the reduced access to foreign credit nmarkets this year. Foreign direct investment is projected to increase substantially as coal, electricity and telecomnmunications companies are privatized in 1999 and 2000. for an expected revenue of around US$ 2.5 billion. While closing the fiscal imbalance, the Government will make a special effort to protect social expenditures targeted to the poor. In addition, social safety net programs may be needed to ameliorate the impact of the recession on the most vulnerable segments of the population. Thus, within the above mentioned fiscal targets, the govemment will allocate approximately S300 million (0.3% of GDP) per year in 2000-2002 for additional social expenditures, above and beyond their level in 1999. t'he Bank will work together with the Colombian authorities in developing, implementing and financing these programs, so that they can meet tneir objectives - 31 - Annex 2 S6g -r a a;aZ69y0g/#o^-Xc= with efficiency and efficacy. Iinancial Sector Backgroutnd Stailting in 1996, the health of several important segments of the Colombian financial sector progressively deteriorated, with a notable acceleration of negative trends with respect to the liluidlity, solvency and non-performing loan ratios of financial intermediaries over the last year and a half. This was in part a reflection of growing macro-economic imbalances and the progressive slow-down of economic activity during the period 1996-1998, but was significantly accentuated by the volatility in international capital flows induced by the South East Asian financial crisis, the Russian default and the Brazilian currency crisis, and by the sharp fall in oil and coffee prices. As a result, non-performing loans in the banking system reached 14% by the end of the second quarter of 1999, compared to 8% a year before. Solvency conditions deteriorated significantly, and during the last twelve months several institutions were forced to use the last resort facility of the central bank and restructuring assistance from FOGAFIN, the bank deposit insurance and resolution agency. Although all sectors weakened significantly, the worst problems were in the portfolios and management of the state-owned banks, the cooperatives system (cooperat6vasfinancieras) and the savings and loans sector (C'orporaciones de A,horro y Vivienda --CAVs). By mid-1999, the strains in the other institutions (e.g., private banks) also became very evident. In line with its stated overall strategy for improving the health of Colombia's financial system. the Covernment has already initiated steps to restructure the cooperatives sector, separating clearly the treatment of the smaller credit unions which do not accept deposits from the general public from that of the "financial cooperatives" which have faculties to accept such deposits and therefore need to be supervised on par with other general or special purpose financial interm-ediaries. A separate supervisory and deposit insurance system has been created under Law 4i4 olf 1998 to attend to the former group (credit unions) while a major restructuring and resolution process of financial cooperatives is being undertaken to ensure that the new institutions fully comnply with applicable prudential and other regulations. This was later complemented by provisions of the economic emergency decrees (2330, 2331 and 2333 of 1998 and related amenidments), which, among other things, provided some strictly capped relief to the very small depositors of credit unions to redress the prior deficiencies in deposit protection for this segment. Among the staie-owned banks, the situation of the Caja Agraria, the institution devoted to mleeting the credit needs of small farmers and certain social and regional development objectives (e.g., the provision of payment services), had become particularly troublesome Other state-owned or public sector banks, including Bnco de[ &ftado. Banlgco v/e C'redito Hlipotecario (BCI) afld Banco Cafrtero also experienced significant portfolio and management problems, and are in need of urgent restructuring, resolution and/or privatization, with the latter being the desired ultimate objective in all cases except that of the Caja Agraria. The housing finance system was severely affected by the very high real interest rates in the system, which together with falling real estate prices, the large degree of term transformation -32 - Annex 2 kC< aS3i in the financing provided by CAVs and other housing finance institutions, and the specific characteristics of the mortgage loan indexing systems (including automatic capitalization of large components of interest payments due), led to many housinig loans becoming unviable, severely weakening the pottfolios of these institutions. In addition, the earthquake which struck the coffee growing r egion of Colombia on January 25, 1999 caused major damage to real estate in that region and fibrther weakened housing loan portfolios and the capacity of borrowers in that region to pay. The Government issued two important decrees (Decrees 196 and 350 of 1999) to address the special needs of the population in this region resulting from earthquake related damage. 'I'he economic and earthquake emergency decrees were aimed at redressing the urgent needs and providing relief to the most vulnerable housing loan recipients, families affected by eartlquake damages, and depositors of the cooperatives system who suffered losses as a result of the absence of an adequate small deposit insurance system. They also assist in the resolution of the financially stranded state-owned banks. 'I'he emergency relief assistance has been carefully circuLmscribed within strict limits and will be subject to strict eligibility criteria, in order to keep its fiscal impact within manageable limits. In fact, a temporary transactions tax of 2 per thousand (0.2%) on financial transactions related to demand deposits, savings accounts and other deposits is in effect through the end of 1999 to finance a significant part of-the costs of economic emergency assistance, and during 2000 to provide relief for earthquake victims. More recently, taking into account the increasingly acute portfolio problems and consequent erosion of capital that became evident by mid-I 999 in other segments of the system, the Government announced special support to facilitate recapitalization of institutions deemed to he viable but experiencing temporary capital inadequacy. 'Ihe support is provided in the form of medium termn loans from FOGAFIN to owners of those institutions that fully adjust their assets and capital to reflect the true economic value of their assets, following stringent standards that require writing off most non-productivc assets. The loans would be subject to strict collateral r 1quirements, and would be available only to those institutions that decide to adopt this course by the end of 1999 and have submitted a satisfactory plan to restore financial viability in the medium terrm. FOCJAFIN and the Superinlendencia Bancaria will closely monitor and supervise the implementation of the performance agreements (cornvenios de desempefio) reached with the respective recapitalized financial institutions. Financial Sector Reform Strategy Against this background, the Government has formrulated a comprehensive financial sector reform vision and a strategy to address the main structural issues affecting the sector. The principal ingredients of the Government's strategy are to: coordinate and ensure consistency of the use of public funds for financial sector reform with the broader macroeconomic and structural reform policy goals outlined above; strengthen prudential supervision of banks following international standards through improved off-site an(d on-site inspections; facilitate rapid resolution of non-viable financial intermediaries; where necessary and fully jtustified, help recapitalization of viable institutions in connection with such resolution, with provision of any capital assistance strictly subject to clearly specified criteria and conditions, including realistic -33 - Annex 2 evaluation of bank assets and equity positions, financial, management, and/or administrative restructuring, resolution and work-out arrangements for problem assets, and equitable distribution of losses incurred: and put in place an incentive structure for the future that discourages recurrence of banking vulnerabilities. Over the medium term, the objective would be to develop a competitive and robust financial system that is private sector driven and able to provide efficiently the financial services required by households and the real sector. 'IThe World Bank and the D1D3 have been closely involved in discussing specific strategies and options for financial sector reforms in these various areas, and together with the IMF, have advised the Government on the main elements of the program. In implementing the above vision and strategy, the Government will focus major attention over the next two years on two broad sets of parallel activities related to banking system restructuring. First, to address the problems already identified in specific segments of the financial system, including, in particular, the state-owned and "ofYicialized" banks, cooperatives and housing finance institutions (CAVs), the Govemment is undertaking a series of strong actions in each of these areas to obtain prompt resolution of the problem institutions. In doing so, full attention will be paid to ensuring that any institution permitted to continue to operate will fully respect the standards laid down by the Banking Superintendency (Superintendencia Ban7caria) fur the respective category of instilutions, and that they will indeed be able to achieve solvency and operate as viable institutions in the medium term; in the contrary case, actions will be taken, within the framework of the banking law, to close and liquidate them or sell their component parts. Througb a decree issued in June 1999 (Decree No. 1065). the Government has dissolved ('anu Agrariau, dismissed all of that institution's employees and created a substantially downsized new institution, Banco Agrario, by closing most branches of the Cajtl in locations where there are private financial institutions available, and closing or consolidating other branches where justified, after taking into account the payments and other basic service needs of these areas. The non- performing part of the Caja has been separated and will be liquidated according to agreed procedures. The new Bantco Agrai-io will be a much leaner institution which will operate under clearly laid out banking principles, separating out the channeling of any subsidies for social development purposes which would be funded directly from govemment budget resources. Banco Agrcria will concentrate its activities in areas currently not served by other financial inter-mediaries, and will be subject to strict limits on the size of the loans and the total amount of credit exposure it can assume. Attachments I and 2 provide additional details of the restructuring of the Caja Agrairia. and the policies of the new Bunco Agrurio. In the case of the other five major state-owned and "officialized" banks, the Government strategy is to privatize them within the next eighteen months, or if this does not prove feasible, achieve within one year thereafter an alternative financial resolution of these institutions in a manner that does not result in any net additional fiscal cost to the Government and maximizes the value of assets recovery. In preparation for the privatization effort, the Government has issued decrees to consolidatc these institLutions into three "packages", which offer greater synergies and -34 - Annex 2 :3G~e i eZeZ ? e g ZVLgg> W help overcome certain legal obstacles that have until now hindered the sale of the banks to prospective buyers. FOGAFIN will act as the Government's agent to undertake the privatization of these institutions and to manage them tightly during the transition. For the first package, comprising, CGraiahorrar and Banco de C)redito Hipotecario (BCH), FOGAFIN has already contracted an investment bank (Goldman SSachs) to prepare and execCute the process to brinig them to the point of sale by June 30, 2000. For the other two packages comprising Banco C'afetero, and lhe result of the Banco cdel ,stado-Banco Uconal merger, FOGAFIN expects to hire qualified investment banks within the next six months and bring them to the point of sale by about the end of 2000. To minimize the fiscal and economic costs associated with continued operation of the state-owned banks during the transition period, individual transition plans have been forrnulated for eaCh of the state-owned banks, which encompass strict limits imposed on them by the Sn-perintendencia Bancaria andlor FOGAFIN on the use of deposits and loan recoveries for making fresh loans, as well as other restructuring actions to help improve their financial health and solvency ratios in preparation for privatization. Any continuing support to state-owned institutions (e.g.., to pursue certain high priority social goals) would come entirely from the Government's budget or specially mobilized resources (e.g.. those raised through the emergency provisions) in a transparent manner, without causing any further financial burden to FOGAFIN. Attachments I and 2 contain the details of the background, the privatization strategies and the transition plans for these institutions. The restructuring of the cooperativ'as financieras and other institutions of a cooperative nature. that are under the supervision of the Superintendencia Bancaria will take place following clearly specified principles goveming their operation as monitored by the Superintendencia Baticwearia, with timely actions to close or liquLidate non-compliant institutions. The SuperintWendnica Hancaria will promulgate and put into effect regulations for the licensing and operation of the cooperativasfinancieras under its supervision, whlich will be consistent with the goals of promoting competition, improving efficiency and providing equitable regulatory treatment. 'I'he operation of those parts of thei cooperatives system not tinder Superiniendencia Bancaria supervision will be governed by the principles set forth in Law Number 454 and subsequent relevant decrees, and wvill be supervised by the specialized institutions created for their oversight. Attachment 3 provides the details of proposed actions to reform the cooperatives sector. Second, in parallel with the above actions, the Government prepared major financial sector legislation to amend the Financial System Framework Law. This major amendment, Xwhich wvas approved by the Colombian Congress on June 30, 1999 and became law on Auglst 3, 1999, put into effect key structural improvements that: (i) create the required faculties for supervision and bank resolution for the Stperintendencia Banicaria and FOGAFIN; (ii) provide them sufficient independence and autonoomy of action and facilitates their institutional strengthening to undertake timely detection and preventive actions; (iii) enable and promote the use of appropriate nmarket driven resolution instruments and techniques; (iv) put in place certain improvements in capital adequacy rules and prudential rules of financial intermediaries, as well as rules applicable to the housing finance system, securitization and capital markets institutions: and more generally, (v) foster healthy competition within the financial system subject to transparent rules and promotes -35 - Annex 2 4& Je4~, fi W K1,-Zo capital mnarkets development, thus laying the foundatiotn for the development of a healthy and etticient financial system in the long term Among the major objectives of the reforms contemplated in the legislation are to minimize the risk of a possible systemic crisis developing in the financial system, minimize the economic costs associated with banking systcm problems, and avoid recurTence of the type of problems we have recently witnessed in the system, through the application of effective preventive measures and rapid resolution. The ensuing operating regulations will provide clear rules and criteria which the Superintendtecia Bancaria and FOCiAFIN will apply in using their new faculties. In particular. the detailed regulations, norms and procedures of the Superintendencia will provide specific rules and criteria that would be applied in determining appropriate preventive actions, loan classification and provisioning norms and procedures, and a well specified set of progressively strict prompt corrective actions, including intervention in and closing of troubled financial institutions whenever appropriate. The regulations pertaining to FOGAFIN operations will clearly delineate circumstances under which FOGJAFIN will provide financial assistance to support bank resolution (e.g., only subject to an agreed set of restructuring, resolution andilor recapitalization actions that wxould assure return to solvency of the institution), the principles of resolution (e.g., the need for existing shareholders to bear the cost of their actions, burden-sharing principles between sihareholders, creditors, depositors and the deposit insurance agency), and criteria for application of different types of resolution techniques. Attachment 4 contains a summary statement of the main principles for detecting and addressing bank solvency problems and resolution of problem batiks. 'Tlhis strategy will be implemented in conijunction with a sustainable macroeconomic framework along the lines articulated above, paying special attention to minimizing the fiscal costs of the financial sector reform and policies to help achieve a continued reduction in the level of real interest rates in the economy. Supplementary support being channeled via emergency relief measures to the most critically affected home mortgage holders and depositors of the cooperatives system is also expected to help reduce the magnitudes of unrecoverable loans while providing relief to vulnerable groups most affected by financial system problems. We will also put into effect comprehensive institutional strengthening programs for the Superintendencia Bancaria and FOGAFIN to align them institutionally to meet the requirements of their respective responsibilities under the above strategy, enhance their technical capacities to undertake the expanded responsibilities, strengthen enforcement and ensure consistent application of agtreed prudential requirements, supervision and r esolution principles, and provide for necessary staff development and training. The Government has already decreed a restructuring of the Sul7erinlendencia Bancaria to provide the grounding for some of these impr-ovements. Attachments 5 and 6 provide the detailed institutional strengthening programs of the Superintendk,encia Bancariez and FOGAFIN respectively. Among other things. we will ensure that the financial accounts and resources of FOGAFIN related to its deposit insurance and bank resolution functions are clearly separated and financially protected from its other activities. In particular, any support provided by FOGAFIN for administering emergency relief programs will be f'ully financed by the government directly from budget or other separately earrnarked resources, -36 - Annex 2 %4pfzaM. a
Группа Всемирного банка · President's Report
Colombia - Financial Sector Adjustment Program Project
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