Outline: PNC for Colombia DPL



PROGRAM INFORMATION DOCUMENT (PID)

CONCEPT STAGE

Report No.: AB4747

|Operation Name |Colombia Finance and Private Sector Development |

|Region |LATIN AMERICA AND CARIBBEAN |

|Sector |Capital markets (100%) |

|Project ID |P116088 |

|Borrower(s) |REPUBLIC OF COLOMBIA |

|Implementing Agency |INISTRY OF FINANCE AND PUBLIC CREDIT |

|Date PID Prepared |April 28, 2009 |

|Estimated Date of Appraisal Authorization |June 1, 2009 |

|Estimated Date of Board Approval |July 30, 2009 |

I. Introduction

This program information document describes a single-tranche Development Policy Loan (DPL) in the amount of USD300 million, which is being proposed for the Republic of Colombia. The operation is being prepared at the request of the Government of Colombia (GoC) and is expected to be discussed at the Board in July.. The GoC is facing significant macroeconomic challenges from the current global financial crisis, which has resulted in lower capital inflows and substantially increased borrowing costs. Recent growth and poverty reduction in Colombia has been supported by a stable expansion of the financial system, following the financial crisis that Colombia suffered at the end of the1990s. As the ongoing global crisis impacts Colombia, the GoC is committed to preserving these gains in financial sector development as part of its broader development strategy.

The proposed operation supports ongoing reforms to strengthen financial sector resilience and develop securities markets to sustain growth. In particular, the operation supports recently implemented prudential and supervisory measures for credit institutions, enhancements to the framework to intervene and liquidate unauthorized financial intermediaries −such as pyramid schemes that collapsed recently− as well as securities market regulations. The recently adopted prudential measures increase banks’ capital and provisioning buffers and enhance the supervision of liquidity and operational risks. The securities market regulations, part of the securities market reform initiated in 2005, will reduce systemic risks and improve the supervision of securities markets as well as the professionalization of its intermediaries. Several reports contributing to the current debate on financial sector architecture and regulation have underlined the importance of many of the reforms supported by this operation (see footnote 8).

II. Country Context

A. Recent Economic Developments

The sustained period of strong growth and moderate inflation experienced by the Colombian economy in recent years ended in 2008. During 2004-2007, high external demand, improved terms of trade and lower cost of international credit created a favorable environment for growth. The improved security situation in Colombia, stable macroeconomic polices and wide-ranging structural reforms also supported the economic recovery. During 2008 economic growth slowed down, reflecting past monetary tightening that resulted in a significant reduction in credit growth (from 26.6 percent y-o-y at end-2007 to 17.1 percent at end-2008) and weakening commodities prices and global demand. The deceleration intensified following the renewed global financial turbulence at end-September 2008. In the last quarter of 2008, growth contracted by 0.7 percent y-o-y and growth for the year as a whole stood at 2.5 percent. Shocks to fuel and food prices pushed inflation to 7.7 percent at end-2008 well in excess of the Central Bank (BdR) target of 5 percent for 2009.

As the global financial turbulence intensified in the second half of 2008, Colombian financial markets were negatively affected in line with developments in other Latin American countries. The stock market index declined by a third. The exchange rate appreciation experienced in the first half of the year −prompted in part by tightening monetary policy− reversed course and international reserves declined by USD 750 million (about 3 percent of total reserves). In this context the BdR acted swiftly and removed the controls to capital inflows that had been previously introduced as a temporary measure to prevent excessive exchange rate volatility. Reserves recovered and for 2008 as a whole the loss was limited to USD 125 million. Increase in credit risk premiums and funding costs pushed the lending rate on commercial loans by 71 b.p. in the last quarter of 2008. As market sentiment improved, partly due to the authorities’ actions, the Colombian government was able to successfully place a ten-year 1 billion dollar bond on January, and an additional 1 billion on April.

Sound macroeconomic policies implemented in recent years have substantially improved the country’s economic resilience against external crisis. The flexible exchange rate, the decline in foreign external debt −which has halved since 2004 due to the sustained FDI flows− and adequate reserve level (about USD 23 billion) well in excess of total short-term external debt, contribute to ensure current account financing even in the difficult global conditions. Fiscal discipline, strong growth, and the government public debt management strategy put public debt on a declining path and reduced the share of foreign denominated debt, ensuring debt sustainability (see Table 1). The authorities’ strategy of placing USD 1.0 billion of 10 year bonds in the international market in addition to securing USD 2.4 billion funds from multilaterals in order to meet public sector external financing requirements further reduces external vulnerabilities. As a preventive measure, the GoC obtained authorization to negotiate additional credit from multilaterals up to USD 1 billion.

C. The Financial Sector

Colombia’s financial sector is mid-sized compared to its Latin American peers, and its capital markets are relatively underdeveloped. With private sector credit amounting to 26.3 percent of GDP, the financial market is larger than Argentina and Mexico but smaller than Brazil and Chile. Foreign owned banks control less than a fifth of banking assets but intensively compete with local banks. The stock market is underdeveloped according to regional standards; the number of issuers is relatively low and the market is relatively illiquid.

At end-2009, the banking system appeared sound and well supervised although the crisis heightens existing vulnerabilities. The Colombian banking system is reasonably well capitalized and still profitable. The Banking system capital adequacy ratio (CAR) stood at 13.4, with all Colombian banks having a CAR well above the 9 percent regulatory minimum. Asset quality has deteriorated due to the economic slowdown, and non-performing loans (NPLs) now reach 4.7 percent of total loans while loans classified as on watch or worse amount to 8.9 percent of total loans. Current provisions cover all non-performing loans but only 59.6 percent of classified loans on average, with some banks having substantially lower coverage levels. System level financial sector indicators appear healthy. However, they compare unfavorably to those of other countries in the region and most Colombian banks have low credit ratings. In this context, the actions undertaken by the authorities and supported by this operation are particularly appropriate.

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The collapse of fraudulent pyramid schemes prompted swift action from the authorities avoiding contagion effects to the supervised system. Some fraudulent pyramid schemes −which obtained resources from the public by promising of exorbitant return rates− had appeared in Colombia under sophisticated structures. The companies masked their fraudulent money-collecting activities under the disguise of service provider companies and prepaid card sales. These fraudulent companies operated in 12 departments with substantial number of investors, mostly in the low-income bracket. So far, the authorities have received more that 700,000 claims from investors amounting to about 1 percent of GDP. In November 2008, the government closed the pyramid schemes, enacted legislation to strengthen the powers of supervisors to act against such illegal operations, and began liquidating assets to return the recovered funds to investors. To help address the social costs, the authorities reallocated funds in the 2008 budget toward targeted social spending. Authorities also indicated investors of the pyramids will not be bailed out. Swift action from the authorities prevented contagion effects to credit cooperatives and other supervised institutions operating in the same market segments.

III. The proposed operation

The proposed operation supports ongoing reforms to strengthen financial sector resilience and deepen capital markets to sustain growth. Recently adopted prudential measures increase banks’ capital and provisioning buffers and enhance the supervision of liquidity and operational risks. Also, in the wake of the recent collapse of the pyramid schemes, the framework for the intervention of unauthorized money-collecting institutions has been substantially strengthened. The latest securities market regulations complete financial markets to ensure efficient risk-sharing and capital allocation, reduce systemic risks and improve the supervision of securities markets as well as the professionalization of its intermediaries. The proposed operation would help achieve the objective of promoting savings, investment and finance to achieve sustainable growth as identified in the Colombian National Development Program and supported by the current Country Partnership Strategy (CPS).

Strengthen Prudential Regulation and Supervision

Regulations introducing counter-cyclical provisions and the instruction to capitalize 2008 profits have increased provisions and capital buffers.

• Counter-cyclical provision regulations for commercial and consumer loans entered into effect in 2007 and 2008 respectively. Under the new regulations, lending institutions constitute additional provisions in the boom part of the cycle that can be used to compensate for higher-than-provisioned deterioration in portfolio quality during the downturn. At present, the SFC instructs each year whether the institutions need to provision in excess or below expected losses according to two transition matrices provided in the norm. In 2007 and 2008 the SFC instructed institutions to provision according to the transition matrix with higher probabilities of default (i.e. accumulating provisions in excess of requirements through the cycle). Since July 2007 −when the countercyclical provisions for consumer loans enter into effect− until end-2008 new provisions reached USD 565 million Currently, the SFC is contemplating the possibility of allowing the institutions to determine themselves whether they should overprovision or use previous provisions according to their delinquency experiences and financial strength.

• To increase capital buffers, the SFC instructed lending institutions to retain part of the 2008 earnings to constitute a capital reserve[1]. The Superintendence established the percentage of earnings to be capitalized (ranging from 90 percent to the average profit capitalization of the last three years) as a function of the institutions’ non-performing loan portfolio, provisions and regulatory capital. If shareholder meetings failed to approve the retention of earnings proposed by the SFC, a norm would be issued forcing the capitalization. All institutions approved the retention of earnings for −at least− the amount indicated by the Superintendence. Total retained earnings for the system amounted to USD 720 million or 6.5 percent of the capital at end-2008. In January 2009 the CAR of the system increased to 15 percent, up from 13.4 percent at end-2008, close to the level in other countries in the region.

Recent regulations enhanced the supervision of operational and liquidity risks. In 2008 credit institutions had to adopt internal systems to measure and administer operational and liquidity risks according to parameters established by the SFC. The internal systems comprise policies and procedures to deal with each type of risks − including internal limits, remedial actions, and contingency plans− as well as a framework to measure such risks. In the case of liquidity risks, new regulation provides a standardized framework for the institutions to compute the liquidity gap (i.e. liquid assets minus liabilities) for different time brackets, including very short maturities. Institutions shall maintain a zero liquidity gap for 1 week maturities. For operational risks, institutions have to set up a registry of events that cause such risks and the associated losses. Historical loss experiences will be used in the future to determine capital charges for operational risks.

The authorities have also increased their preparedness against an eventual emergency. The 2005 FSAP found that the framework for resolution of banking institutions was adequate. In 2008, the financial supervisory authorities conducted a crisis simulation exercise designed and executed with the assistance of World Bank staff to test the framework for resolution, largely introduced after the 1999 crisis and therefore untested. The exercise pointed out the need for greater clarity in the sequencing of actions and responsibilities of the different institutions involved in the process. In light of the experience, the authorities have requested funding from FIRST to finance technical assistance on mechanisms for liquidity provision and resolution of non-bank financial intermediaries, and are drafting internal protocols to clarify resolution procedures. The Financial Surveillance Committee −including representatives of the SFC, the Ministry of Finance, the BdR and the Deposit Insurance Fund (FOGFIN)− has intensified its activities to coordinate actions across agencies involved in financial sector stability issues and develop contingency plans.

Strengthen the Framework for the Intervention and Resolution of Unauthorized Financial Intermediation Activities

The framework for intervening unauthorized financial intermediaries has been substantially strengthened. The GoC issued several decrees under the “State of Social Emergency” declared in the wake of the collapse of the fraudulent pyramid schemes. Under the previously existing regime, the SFC had to extensively document and prove that financial resources were being collected from the public over an extended time. The Superintendence of Companies did not have powers to intervene and adopt measures against such companies, which are not supervised by the Financial Superintendence. The recently issued framework corrects these shortcomings. The framework for intervention and resolution has also been bolstered as local authorities can intervene to temporarily cease the activities of such intermediaries until staff from the Superintendence arrives to the location. Penalties for unauthorized financial intermediation resulting in loss of resources for the public have been increased temporarily through a decree until modifications to the penal code are approved by Congress.

Securities Market Reform

The proposed operation supports recent regulatory efforts implementing the remaining key aspects of the securities market reform initiated in 2005. Over the medium term, the policy actions supported by this DPL are expected to produce substantial improvements in the operation of securities market, providing alternative means to channel savings to finance productive investments to promote sustainable growth. Specifically, they will contribute to achieve the medium term objective by (i) promoting the development and efficiency of the securities market, (ii) preserving the well functioning, equity, transparency, discipline and integrity of the securities market, and the public trust in it, (iii) protecting investors’ rights, and (iv) preventing and managing systemic risk in the securities market.

Some recently introduced regulations enhance the supervision and professionalism of market participants. One handicap to effective supervision has been the amount of supervisory resources devoted to audit the financial statements of issuers. The new regulation limits the cases in which such audits will be required. Audits are now only required in those cases in which factors of concern justify additional inspection, including firms which have experienced substantial capital decline or those in which the financial statements were not approved in the shareholders meeting. In ordinary circumstances − as commonly done in most jurisdictions − investors will rely on the external audit, thus SFC will be able to devote a larger part of its resources to inspection activities and ensure enforcement of the existing regulations. Supervision has also been strengthened with the introduction of a new resolution mechanism. The new mechanism is in essence an administrative procedure akin to the one applied to banks and other entities subject to the banking law. Under this regulation, FOGAFIN will appoint the management and liquidator of the failed institution −as in the case of banks− and supervise their activities in this area jointly with the SFC. Before this decree was enacted, the responsibility for failed institutions was not clear. Another important improvement is the regulation of the activities of the institutions that certify securities professionals. Certification for certain activities will be renewed periodically (every 2 or 3 years) through exams.

The supported reforms include regulation to upgrade market infrastructure which increases efficiency and reduces systemic risks. To ensure efficient and smooth functioning of the systems, the adoption of these infrastructure upgrades need to be properly regulated. New regulations establish the concept of finality of settlements, providing legal security to all transactions. Previously, trades could be nullified although they had been agreed by participants creating market instability and insecurity. The reform forces participants to settle their positions executing the guarantees if necessary to secure payment and preventing the unwinding of positions in case of bankruptcy. The regulation also establishes requirements for the administrators of securities settlement systems (SSSs)[2]. Another important infrastructure upgrade to foster market development is the adoption of automatic trading systems. To ensure the efficient functioning of the trading systems the authorities need to regulate trading systems bylaws, the duties of trading systems administrators and IT security and transparency requirements. The reform responds to the needs introduced by the technological changes with a view to protect investors’ rights and reduce operational risks in trading systems. Finally, the development of exchange-traded derivative products requires establishing a central counterparty clearing house (CCCH). In this area key aspects of the reform include the corporate structure and governance of the CCCH, registration and capital requirements.

The authorities have also placed substantial efforts on regulating the intermediaries and the transactions that can be negotiated and executed in the market. In this area three new regulations introduced substantial improvements

• A new regulation regarding intermediation activities reflects stricter requirements for transparency, corporate governance and professionalism imposed by the Securities Law in order to protect investor rights. In particular, the regulation establishes the distinction between “professional investors” and “investor clients”. The latter need to be offered advice consistent with their lack of expertise. Only brokerage houses can act as securities brokers. Proprietary investments of the brokerage house need to be strictly separated from clients’ investments to be protected in case of legal actions against the broker and to avoid misuse of client resources on risky investments on behalf of the broker.

• Another new regulation establishes an appropriate framework for collective investment vehicles other than pension funds −which have their own regulatory regime− as collective investment mechanisms with collective results. Previously, inadequate regulation prevented an effective development of the sector. The regulation establishes the responsibilities of the administrator, the type of collective vehicles that can be established and their objectives. It also regulates the nature of the participations and the need for contracts to align the interests of administrators and investors.

• Finally, derivative products have been regulated for the first time in Colombia to promote hedging of market exposures among market participants, particularly pension funds and insurance companies. Risk hedging products are fundamental to cope with the macroeconomic and financial volatility that characterizes emerging economies and pose significant growth risks. In addition, the development of derivative products fosters securities market development which in turn supports economic growth. Risk hedging will stimulate trading in other products as investors will be better equipped to manage their exposures to different risks while deep and liquid derivative markets enhance price formation for the underlying products.

The reforms supported in the proposed operation have strong analytical underpinnings and conform to emerging consensus on new financial regulation. The 2005 FSAP update identified the modernization of the regulatory framework for securities markets as key to increase liquidity, to stimulate investment and to promote economic growth. The report indicated that the amendment to the regulatory framework planned by the GoC was in line with best international practices and that the planned reforms would reduce systemic risks due to the upgrade in securities settlement systems and the development of exchange-traded derivatives markets. As a result of the ongoing financial crisis, a global consensus is emerging reinforcing the need to improve securities market supervision, foster exchange-traded derivatives, and standardize payments and settlement procedures to avoid disruptions in payments chains. Worldwide, regulators are calling for increased capital and provisioning buffers, as well as enhanced liquidity supervision to protect banks against systemic risks in light of recent developments. Several recently issued reports underline the need for macro-prudential regulation to mitigate pro-cyclical effects of current regulations and tame lending boom-bust cycles, recommending the introduction of counter cyclical capital and/or provisioning requirements such as those recently introduced by the Colombian authorities and supported by this operation[3].

Environment Aspects N/A

Contact point

Contact: Eva M. Gutierrez

Title: Sr Financial Sector Spec.

Tel: (202) 458-7153

Fax: (202) 522-2106

Email: egutierrez2@

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[1] The instruction pertains to earnings in the second semester of 2008.

[2] SSSs are a critical component of the infrastructure of securities markets. Weaknesses in SSSs can be a source of systemic disturbances to securities markets and to other payment and settlement systems. As pointed in the CPSS-IOSCO recommendations, problems at a major user of an SSS could result in significant liquidity pressures or credit losses for other participants. In addition, disruption of securities settlements can spill over to any payment systems used by the SSS or any payment systems that use the SSS to transfer collateral

[3] See for example“ Restoring Financial Stability: How to Repair a Failed System”, by the NYU Stern School of business, “The Fundamental Principles of Financial Regulation” by M. Brunnemeier , A. Crockett, C, Goodhart, A. Persaud, and H. Shin, and the “Report on Enhancing Market and Institutional Resilience” by the Financial Stability Forum

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