Morocco - Financial Sector Assessment

b 27414 FOR OFFICIALUSE ONLY SECTOR FINANCIAL ASSESSMENT MOROCCO 2003 NOVEMBER MIDDLEEASTAND NORTHAFRICAN REGIONVICE PRESIDENCY SECTOR FINANCIAL VICEPRESIDENCY ON THE JOINT BASED SECTOR ASSESSMENT IMF-WORLD BANK FINANCIAL PROGRAM 1. Joint IMF-World Bank Financial Sector Assessment Program (FSAP) missions visited Morocco in February and May 2002 to undertake an assessmentof the financialsector. The principal objective of the missionswas to assist the Moroccan authoritiesin evaluating the potential vulnerabilities and key development priorities in the Moroccan financial system.’ 2. This report provides a summary of the main findings of the mission and the policy priorities identified.’ 1 The FSAP team comprised Messrs./Mmes. Christian Durand (IMF, Mission leader), Wafik Grais (World Bank, Deputy Leader); Annabelle Assemat, Ferid BelHaj, Luc Cardinal, Loic Chiquier, CharlieGarrigues Gregorio Impavido, Andres Jaime, Alain Laurin, Giovanni Majnoni (all World Bank); Laurent Bouscharain, Fernando Delgado, Wim Fonteyne (all IMF); Dominique Bauer and Michelle Svetchine (both Bank of France), Badreddine Barkia (Bank of Tunisia), Olivier Raynaud (French Banking Commission). Ms. Roxana Nikdjou (IMF) and MS Nicole Wautiez De Blaye (World Bank) provided assistance for the first and second mission respectively. 2 The present document, Financial Sector Assessment (FSA),is prepared by World Bank staff asa parallel document to the Financial Sector Stability Assessment (FSSA),prepared by theIMF staff and discussed in the context of the address: Article IV consultation. The authorities’ views on the FSSA can be found at the following www.imf.org/externalfpubs/cat/longres.ch?sk=16726.0.  ENVIRONMENT: I. THEMACROECONOMIC BETWEEN A N UNEASY TRADE-OFF CONCERNS FOR STABILITY AND DEVELOPMENT 3. Morocco’s macroeconomic policies and practices as a whole tend to err more on the side of the concerns of protecting the economy from external shocks. Exchange controls,a fixed exchangerate regime, a low degree of economic openness, and the govemment’s central role in the financial sector and the economy of in general, are designed with the objective protecting Morocco from instabilities that may arise from international capital movements and exchange rate fluctuations. They may allow for a stable environment for economic activity, at least in the short term, albeit a constrained one. Consequently national savings are intermediated essentially within the country, providing a stable basis for financing budgetary requirements at rates often below those prevailing on international capital markets. 4. The cautionary approach to overall reforms has had costs in terms of economic growth and development. This is not to deny the substantive efforts of economic liberalization and promotion of economic and social development since 1993 and even earlier. However, the process has been carried out in the a highly conservative manner as it aimed at: (i) strengthening competitive capacity of the real sector; (ii) ensuring the solvency and profitability of financial institutions; and (iii) maintaining fiscal discipline. While progress has been achievedon all three of trade and finance awaits to fronts, the economy’s ability to fully participate in the global world be tested. Undoubtedly further strengthening the economy’s resilience to external shocks while increasing the sustainability of its growth, and improving the robustness of its financial and fiscal balances do call for significant additional efforts. They need to be concomitant with programs to achieve a level of openness that can help put the economy on a socially-beneficial higher-growth path. 5. The approach followed did not leave the financial sector out of the process of reforms and institutional modernization. The sector is now characterized by an increased role of theprivate sector, thougha continued substantial state presence remains. The state presence is reflected in the existence of a still influential public financial sector and the sizable financial weight of the public debt. Thestate controls the largest commercial bank in terms of assets, as well as four specialized banks (the former OFSs3). It is estimated that the public banking system represents 40 percent of total banking sector assets. In addition, the state owns the Caisse des depots et de Gestion (CDG), which carries considerable financial weight because of the partit plays in the management of institutional savings. Looking ahead, the ongoing restructuring of certain troubled public institutions could provide the state with an opportunity to undertake a comprehensive reviewof its role within the financial sector and send unequivocal signals on the orientations it wants to pursue. In this respect, the authorities have indicated theirintention to disengage fromthe sector gradually. 6. It has permitted an uneven development of the financial sector. Bank credit to the is high private sector is at levels comparable to those in neighboring countries, and monetization 3 The former OFS banks include Banque Nationale de developpment Economique (BNDE), Fonds d’Equipement Communal (FEC), Crtdit Immobilier et Hotelier (CIH), and Caisse Nationale de Crtdit Agricole (CNCA). ‘ 3 with broad money equivalent to 56 percent of GDP. However the sector is characterized by low geographic coverage, and a sizable weight of liquid asset aggregates. The coverage of the retail banking system is low-estimated at 18 percent compared to40 percent in Tunisia and 100 percent in the most advanced economies. Furthermore, while credit toprivate sector the stands at 55 percent of GDP, close to thatof Tunisia (59 percent), it is well below levels found notably in Western Europe whereit reaches 95 percent of France’s GDP for example. The non- bank components of the financial system have limited influence over the economy. Contributors to pension funds represent only 24% of the labor force and apart from life insurancethat is developing, other forms of optional insurance are underdeveloped. This weakness in institutional savings hampers the development of capital markets. In addition, access to financial services forthe poor is limited, as micro-finance institutions serve only a small fractionof the demand for servicesfrom the low-income population, and cannot offer deposits or savings products. 7. It has not also allowed the emergence of clear financial market benchmark prices. The closed character of domestic financial markets segments them from external ones and limits the usefulnessof the information contentof their prices. Furthermore the state of the primary and secondary markets in Treasury bills does not allow rate to establish a reliable benchmark interest and yield curve. This absence of of external or domestic benchmarks likely hinders the quality resource allocation decisions, which in turn may adversely affect growth. II. STRUCTURAL CHALLENGES THE MOROCCAN FACING FINANCIAL SYSTEM 8. Morocco’s financial system focuses on financing the Kingdom’s economy, which has followed an uneven growth pattern. Growth, driven by exogenous factors, has been too to low create sufficient jobs for a rapidly growing labor force. Fiscal deficits and a high public oflevel debt, at 75 percent of GDP have been associated with a pegged exchange rate, capital account restrictions, limited economic linkages with the global economy and with neighboring countries. To date, the economic landscape presents a dichotomy of a relatively prosperous, modern, urban economy and a poor, under-developed, rural one. 9. The financial institutional infrastructurehasdevelopedbutfinancialpractices lag behind. As a result of sustained efforts undertaken since 1993, the Kingdom now presents all the components of a modem financial system.At the same time, it retains many characteristics of emerging and centralized systems, including extensive state involvement. With the exception of the primary market for government securities, financial markets remain under-developed. Even in the primary market for government securities, government-controlled entities account for a significant proportion of demand for Treasury bills, thereby creating a potential conflict of still interest that could distort the formation of interest rates. The payment system isdominated by cash transactions and the physical circulation of paper instruments. 10. The private financial sector is dominated by three conglomerates, one of which also of concentration has limited the competition has extensive industrial interests. This high degree and transparency necessary for the financial system to contributeto its full potential to economic 4 growth, development and poverty-reduction. Current efforts to open bank and insurance activities to foreign investors are likelyto help remedythis situation. 11. The commercial banking sector is globally healthy and growing but the specialized banking system is in dire straits. The most important factors that might threaten the overall stability of the system include the large amounts of non-performing loans: the downward trend of intermediation margins, the commercial banks’ reliance on demand deposits, and the insufficient solvency of the specialized banks. Other factors support the system’s stability. They include the strong growth, year after year, of customer deposits. This growth may require however alertness from banks managers to the potential of the reallocation of these deposits to alternative more attractive assets. Commercial banks equally enjoy a comfortable solvency, liquidity, andprofitability situation and diversified loan portfolios. The system’s stability benefits also from the limited financial links between the banks. 12. The degree of disintermediation away from the banking sector remains limited, with banking accounting for approximately 60 percent of the overall balance sheet of the financial system. For instance, eight of the nine leasing companies are affiliates of banks. Furthermore, the stock market experienced price declines that went hand in hand with a decline in 1995, in liquidity since late 1998. It brought the market back to the activity levels observed even asthe capitalization of the securities market had grown by a factorof five andthe number of the of securities increased from 44 to 53. This decline in activity directly reduces the earnings securities brokerage firms and poses a longer-term threat to the viability of the Securities Exchange itself. 13. Financial services to the population at large remains also fledgling. Outstanding housing loans, estimated at 13 percent of total credits, are growing rapidly, with30 a percent rise in the number of loans granted in 2001. However, the unsatisfied demand for urban housing continues to be high,while reportedly banks finance only 20% of the value of total housing construction. Similarly the micro-credits sector is fairly new. Four out of the twelve approved associations de micro-credits AMC cover 92% of all beneficiaries and 95 % of total activity of the sector. The sector’s overall assets stoodat around DH 3 10 million at end-2001. The soundest of the AMC recently recorded an annual growth in its microcredit business of more than 80 percent - a reflection of the enormous need for their product. 14. The insurance market has expanded rapidly in the late nineties with premiums of about 3% of GDP, below the 8% world average. The assets of the insurance companies remain limited at about 17% of GDP. Like is engaged mainly in most developing economies the sector of policy in non-life activities, though life insurance is growing rapidly with the development issuance through associations between banks and insurance. Recent consolidations and the new to be insurance code should strengthen the sector. Its supervision and internal controls need brought more in line with international practice. 4NPL stood at 19% and 7.1% of total assets for the specialized and commercial banksrespectively at the end of 200 1. 5 15. The pension system mobilizes significant resources but is financially imbalanced, as it is estimated thatits existing reserves will be fully depleted 2040.5 by The generosity with which pension rights are accrued andthe demographic pressure of ageing population are likely to lead to an exponential increase of required contributions to keep the scheme in balance. Furthermore, thepossibilities for diversifyingmanagement and portfolios as well as investing in long-term bonds appear limited given the dearth of domestic options and the existence of capital controls. While the system has undergone adjustments, it remains fragmented. It limits the ability of participants to anticipate their retirement cash flows due to portability difficulties. Limited transparency does not encourage employees’ participation. III STRENGTHS AND WEAKNESSES OF THE MOROCCAN FINANCIAL SYSTEM 16. The main strength of the system lies in the apparently robust health of the private commercial banks. Based on the data reported to the BAM, the large commercial banks seem relatively well-placed to cope with a range of plausible short-term shocks. The most important risk towhich they are exposed - credit risk- appears contained, as they would appear able to withstand a significant deterioration of their loan portfolios arising from sectoralor economy- wide shocks. For example,a shock in which 15 percent 50 of performing loans are classified, and percent of classified loans are downgraded, would still leave the commercial banking system with a risk-weighted capital ratio of 10.7 percent. On the other hand, because of the importance of government debtin their balance sheets (23 percent) and income statements (one third of their net banking product), Moroccan banks could be adversely affected by disruptions in government debtservice that persist for any significant period of time. This would however appear unlikely and hasnot occurred in the past. Commercial banks are also exposed to transformation risk. Up to now, they have benefited from an increasing abundance of unremunerated demand deposits (41 percent of the balancesheet of commercial banks). However, any development that would significantly reduce depositors’ willingness to hold such deposits would affect the banks’ liquidity and profitability and could, if occurring suddenly, even trigger a liquidity crisis that could requireBAM intervention. Finally, the commercial banks’ profitability is vulnerable to a further reductionin the intermediation margin, which could result from increasedcompetition. 17. The main immediate banking system vulnerability is the precarious solvency and liquidity At this stage, the systemic risk appears situation of the three large state-owned specialized banks. contained, thanks to the support of the state and some state-owned financial institutions. However, this support has weakened those institutions that have provided it, introducing a risk of contagion within the state-owned financial system. The approach chosen also risks providing only breathing time at the expense of an increased ultimate cost to the budget. Finally,the decision to exempt these distressed institutions from prudential regulations for five years risks undercutting the credibility of the banking supervisor and distorting competition among banks. The EU is currently assisting the Moroccan authorities in designing a restructuring strategy forthese banks. The implicit debt is estimated at 45 percent of GDP. 6 18. In the medium term, the main vulnerabilities relate to the fragility of certain non- bank financial institutions and the weakness of supervision. The country’s pay-as-you-go pension systemis imbalanced and some funds will be entirely depleted by 2008. It appears that the present system of pension management does not contribute adequately to the country’s financial development, and has assets in part invested in projects with a modest profitability level. It is important thatthis pitfall be avoided and reform of the overall pension system be launched urgently. 19. The overall weakness of financial sector supervision implies that problems may not be detected early enough to allow adequate corrective action aimed at preventing such problems from becoming systemic.The main weaknesses of prudential supervision are its limited coverage,6 insufficient independence, inadequate resources, and a of coordination lack between the different supervisory institutions in the face of a substantially interlinked financial sector. For the banking system, the Base1 Core Principles assessment revealed a high degree of non-observance of international standards.In addition, many regulatory improvements have only in internal control and recently been introduced and are not yet fully operational. Improvements external auditing that are being contemplated would be a step in the right direction, but they cannot be relied upon to make up for the shortcomings in prudential supervision. 20. Some weaknesses may be underestimated as a result of problems with financial and accounting statements7and data reported to supervisory agencies, and an inadequate degree of to interlinked and related borrowers. consolidation in the assessment of credit risk exposure 21. While not unique to Morocco, the low efficiency of the legal and judicial systems is an impediment to the development ofthe financial sector.It could become a source of risk as well, when increased competition would prompt the banks to seek out less viable customers. The judicial framework, in particular through the creation authorities’ efforts to improve the legal and of commercial courts,are likely to bear fruit only in the long term.In addition, Morocco’s legislation does not conform with international standards on combating money laundering and the financing of terrorism. 22. The macroeconomic framework constitutes a source of medium-term risks. The authorities’ decision to finance the budget deficit mainly from domestic sources has resulted in a preponderance of government debtwithin the financial system’s assets. As a result,the soundness and liquidity of the system are dependent to meet its on the state’s sustained ability obligations in a timely way. This abilityitself is undermined by the levels of public debt and of non-discretionary public expenditure. In addition, the government is increasingly exposedto roll- over risk due to its increased relianceon short-term debt. 23. Variations in agriculture production, the terms of trade, and competitiveness introduce volatility in the economy, which in turn affects the creditworthinessof Some institutions appear to be exempt from any form of prudential supervision though effortsare ongoing to remedy this situation. 7 See World Bank, 2002, “Report on the Observance of Standards and Codes: Kingdom of Morocco - Accounting and Auditing”, July 25, 2002. 7 borrowers. The volatility of agricultural production and international commodity prices affects the variability of Morocco s economic growth rate and introduces a significant degree of uncertainty in financial decision-making.In addition, while the policy of pegging the Dirham to a basket of currencies has provided a nominal anchor to the economy, in the it has led to variations real exchange rate and thus in competitiveness. Nevertheless, the real effective appreciation that occurred during the 1990s has been significantly reduced since2001, and the external position has been further consolidated. 24. The ban institutional investors face on investing abroad limits the diversification needed in their portfolios. Under the current circumstances, pension funds, insurance companies, and mutual funds are faced with an inadequate choice of domestic investment instruments. The present capital controls prevent them from compensating for that, and thus from in foreign assets. optimizing their and their clients' risks and returns, through diversification IV. KEY FSAP RECOMMENDATIONS FOR BALANCING OPENNESS AND DEVELOPMENT 25. To fully exploit its economic potential, and create sufficient jobs for a rapidly growing labor force, Morocco needsto mobilize thebenefits that exchange at the global level can bring. Considerable progressin this direction has been achieved in recent years, but continued efforts need to be made to accelerate Morocco's integration with the global economy. Careful institutional preparation, micro and macro risk management implementation, as as well adequate sequencing will be requiredto maximize the benefits and minimize the risks of such to aim at reducing state integration. With respect to the financial system, these efforts will need presence and the degreeof concentration in the system, and also at the creation of an appropriate infrastructure to foster the system's development. 26. Sound macroeconomic policies remain core to the stability of the financial system in an open economy. I a major vulnerabilityin a n particular, fiscal problems would constitute more open context. The initiatives to strengthen macroeconomic management coordination and develop the necessary information systems will be most helpful. In addition, there is a need to foster a market-driven diversificationof the economy, to make it less vulnerable to agricultural developments andprice volatility on international commodity markets. Measures to enhance the ability of the real economy to diversify are beyond the scope of the present report. 27. A comprehensive strategy to strengthen the financial system would need to include the following elements: 0 Resolution of the most troubled state-owned banks. Given that these banks operate in exemption of key prudential ratios, early action needs beto taken towards rehabilitation or closure of these institutions. 0 A review of current procedures used to cope with problembanks, with a view to increase transparency and reduce moral hazard that ensue from the present policy of avoiding bank closures at all costs. 0 Efforts to address the fragility of non-bank financial institutions, including in particular the pension funds. These efforts should encompass the identification ofall 8  troubled institutions, audits of their finances, the design of effective and transparent restructuring strategies, the introduction of a clear delineation between public services and commercial activities, and safeguards to avoid the distortion of competition. The independence and responsibilities of the pension system management structuresto need be well defined and guaranteed, ensuring transparency through the use of audits and reporting to the Parliament, and delegating management to separate bodies similar to those managing collective investment schemes (OPCVM). At the same time,it is essential that “parametric” measures be introduced without delay, is, measures aimed that at modifying the characteristics of contributions and benefits with the ultimate objective of delaying the erosion of reserves. A clarification of the role of the public financial institutions. At present, these institutions fulfill public mandates and pursue commercial activities at the same time, which may distort competition. A clearer definition of their role in attracting and managing funds, lending, and providing other financial services is needed. Thisis crucial in the caseof financial institutions significant by the relative size of their assets or the their wide presence across the country. Spinning off to the private sector purely commercial activities need to be pursued actively. In addition, the central bank needs to withdraw from the capital of financial institutions and the central bank law should be revised to prohibit such participationsin the future. 0 A reinforcement of financial supervision. To help detect vulnerabilities at an early stage, ensure healthy competition, protect consumers and shore up public trust in the financial system,there is a need for independent oversight bodies equipped with adequate resources. This independence should be accompanied by mechanisms of accountability and reporting, and witha commitment from other authorities to refrain from using public agencies to rescue problem institutions. The supervisory bodies themselves will need to increase their effectiveness by developing a more risk-based approach to supervision, and by establishing greater coordinationor integration among them. 28. Furthermore the development of the financial system can be fostered through the creation of an environmentthat is supportive of financial activities. To that effect, the and authorities need to extend efforts already underway in the legal judicial areas, among other things by introducing more expeditious conflict- and problem-solving procedures, such as arbitration and amicable settlements. The central bank should also work with professionals in the area of payment systems, to develop modern means of payment (credit cards and inter-bank cards) and a large value settlement system. The effectiveness of monetary policy could be strengthened through strengthened central bank autonomy, accompanied by policy a clear mandate and transparency rules. Finally, the financial sector would benefit from the removal or relaxation of several distortions created by taxes and price restrictions, suchas the tax on foreign exchange transactions, the “usury” rate, and the ceilingon automobile insurance premiums. Since currently microcredits can only finance a limited scope of activities and needs, it would be beneficial to expand the allowed purposesto other social needs, such as housing, and connection to running water and electricity. 29. The authorities will want also to take steps to ensure the long-term development of financial intermediation. Financial intermediation requires sound financial statements and thus 9 a well-developed accounting and auditing framework. Credit provision would be facilitated also of greatly by the establishment of credit registries which would facilitate the management consumer and small and medium enterprise credit risk as well as encourage stronger borrower’s of financial discipline. Credit information bureaus have proved their ability to increase the reach services to consumers and small and medium enterprises. More generally, information and a stronger financial culture education initiatives are needed to develop public awareness and among professionals as well as the general public. 30. The foregoing actions need to belong to a consistent and comprehensive strategy receiving broad national support. This strategy should be broadly based and coordinated with interested parties outside government, so as to seek consensus and avoid potential policy errors. Such a course would require and a public communication strategy to explain proposals build consensus. In that regard, the way the troubled state-owned financial institutions are handled will send an important signal to the market,as will any decisionon the level of independence of financial oversight bodies. The adoption and implementation of a comprehensive strategywill permit a more determined and robust integration of the Kingdom in global economic and financial markets, an essential path to higher sustainable growth. 10