58260 CONFIDENTIAL For Restricted Use Only (Not for use by third parties) FINANCIAL SECTOR ASSESSMENT EL SALVADOR NOVEMBER 2010 FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY LATIN AMERICA AND THE CARIBBEAN REGIONAL VICE PRESIDENCY BASED ON THE JOINT IMF-WORLD BANK FINANCIAL SECTOR ASSESSMENT A joint IMF-World Bank mission visited El Salvador from April 27 to May 10, 2010, to update the findings of the Financial Sector Assessment Program (FSAP) conducted in 20041. This report summarizes the main findings of the mission and the policy priorities identified, focusing on financial development issues. The Financial Action Task Force of Central America (CFAT) conducted an AML/CFT assessment separately in 2009. The Mutual Evaluation Report was agreed in June 2010. 1 The team comprised Eva Gutierrez (Mission Chief, World Bank), Pamela Madrid (Mission Chief, IMF), Patricia Caraballo, Carlo Corazza, Barbara Cunha, Miquel Dijkman, Rekha Reddy, Monica Rivero, Eduardo Urdapilleta, Clemente Luis del Valle, (all World Bank); Jordi Prat, Andrew Swiston, Torsten Wezel, (all IMF); and Hugo Secondini (former Finance Secretary of Argentina and former Director of the Banco de la Provincia de Buenos Aires); Jose Rutman (Former Regulation General Deputy Manager of the Central Bank of Argentina, ex-BCBS member), Javier Bolzico (Former Superintendent of Banks and Board member at Central Bank of Argentina, CEO of Fit & Proper) and Socorro Heysen (former Superintendent of Banks in Peru and ex-IMF). ii Contents Glossary .................................................................................................................................... iii I. Overall Assessment and Main Recommendations ................................................................. 4 II. Macroeconomic Developments ............................................................................................ 7 III. Financial Sector soundness and performance ..................................................................... 7 IV. Financial Sector Oversight .............................................................................................. 110 A. Banking .................................................................................................................. 11 B. Non-Bank Intermediaries ....................................................................................... 12 C. Cross-Sectoral and Cross-Border Issues................................................................. 12 D. Overhaul of the Supervisory Landscape ................................................................ 13 V. Financial Safety nets Arrangements ................................................................................... 14 VI. Financial Sector Development Agenda........................................................................... 165 A. Capital Markets ...................................................................................................... 16 B. Access to Finance ................................................................................................... 18 C. Public Banks ........................................................................................................... 20 VII. Financial Sector Infrastructure ...................................................................................... 244 A. Payment, Remittances, and Securities Settlement Systems ................................... 24 B. Credit Information Systems .................................................................................... 25 Tables Table 1. Financial System Structure 2004 ­ 2009 ................................................................. 27 Table 2. Financial Soundness Indicators ................................................................................ 28 Table 3. Institutions Providing SME and Microfinance: Main Indicators ............................. 29 Boxes Box 1. El Salvador: Main Recommendations of the 2010 FSAP UPDATE 1 ............................ 6 Appendix Appendix 1. Implementation of the 2004 FSAP Recommendations ..................................... 30 iii GLOSSARY AFP Pension Fund Administrator AML/CFT Anti-Money Laundering/Combating the Financing of Terrorism BCR Central Bank of El Salvador (Banco Central de la Reserva) BFA Banco de Fomento Agrario BL Banking Law BMI Banco Multisectorial de Inversiones BH Banco Hipotecario BVES El Salvador Stock Exchange (Bolsa de Valores de el Salvador) CAR Capital Adequacy Ratio CEDEVAL Central Securities Depository CGF Credit Guarantee Fund CPSS Committee on Payment and Settlement Systems FATAF Financial Action Task Force FINRA Financial Industry Regulatory Agency FSAP Financial Sector Assessment Program FSSRL Financial System Supervision and Regulation Law GDP Gross Domestic Product IDB Inter-American Development Bank IGD Deposit Insurance Fund (Instituto de Garantía de Depósitos) IMF International Monetary Fund IOSCO International Organization of Securities Commissions MOU Memorandum of Understanding NPL Non-Performing Loan OTC Over-the-Counter P&A Purchase and Assumption ROA Return on Assets ROE Return on Equity ROSC Report on Standards and Codes RTGS Real Time Gross Settlement SDR Special Drawing Rights SSF Financial System Superintendence (Superintendencia del Sistema Financiero) SMEs Small and Medium-Size Enterprises SRO Self Regulatory Organization SV Securities Superintendence (Superintendencia de Valores) S&L Savings and Loans Association iv I. OVERALL ASSESSMENT AND MAIN RECOMMENDATIONS 1. Despite the global and domestic shocks of 2008-2009, the banking sector remains sound. Salvadoran banks were not directly exposed to the global financial crisis. However, the parent banks of several major Salvadoran banks were and directed subsidiaries to conserve risk capital. The higher risk aversion and recession in the United States, combined with uncertainty about the 2009 elections, led to a sharp economic downturn, and a decline in both credit demand and supply. Banks' nonperforming loans increased and profitability declined. Even so, capitalization remained high. Stress tests indicate that most banks would be able to withstand large deposit withdraws and severe deterioration in credit quality arising from large macroeconomic or sectoral shocks. However, credit concentration risks appear significant. 2. Regulated non-bank financial institutions do not pose significant risks, but pension funds' poor profitability is a concern for the long-term. Regulated cooperative banks and insurance companies report healthy financial indicators. Brokerage houses have reduced drastically their fund management activities, which until recently posed systemic risks due to inadequate regulations and unsound commercial practices. Pension funds have grown considerably and now amount to 25 percent of total financial sector assets. However, investments are mostly in low-yielding public sector securities. To ensure a sound financial footing for the pension system, an in-depth actuarial analysis should evaluate pension reform costs and calculate replacement rates. The type of investments available to pension funds should be expanded progressively to increase diversification, improve returns and foster capital markets. 3. Remaining gaps in banking supervision and safety net arrangements should be addressed. Supervisory practices should include more qualitative judgment and forward-looking risk assessments, and the regulatory perimeter should be reviewed. Key banking regulations (e.g., on corporate governance as well as credit, market, interest and liquidity risks) must be issued and the proposed FSSRL should more comprehensively address shortcomings in legal protection and the remedial action framework. The banking law should also be amended to strengthen the least-cost bank resolution framework as well as the deposit insurance fund. Regulations implementing the central bank's (limited) powers for emergency liquidity assistance, as well as the bank resolution process are also needed. Passage of the proposed FSSRL would enhance the BCR capacity to provide liquidity assistance, although the authorities should also design and test comprehensive policies for systemic liquidity and banking crisis resolution. 4. The proposed Financial System Supervision and Regulation Law (FSSRL) could bring some welcome changes, but will require careful implementation. The FSSRL would merge the supervisors of banks and insurance, pensions, and securities to create one unified supervisor, with stronger powers. To balance this, the FSSRL would shift regulatory power to the central bank. A sole supervisor and a sole regulator are expected to facilitate consolidated supervision, as well as reduce regulatory gaps and the scope for regulatory arbitrage. However, 5 the merger of supervisors and the institutional split between regulatory and supervisory powers will require a great deal of planning and ongoing cooperation between the supervisor and the regulator to ensure effective supervision. 5. The capital markets development is lagging, partly due to a poor and outdated regulatory and supervisory framework. Except for the passage of the Securitization Law (2007), the regulatory framework update has been paralyzed for the last 10 years and El Salvador now ranks as having relatively low regulatory and supervisory standards in the region. These will need to be upgraded to make the integration possible. The current market architecture, in which the existing domestic stock exchange has a natural monopoly, hampers market development. There is an urgent need to overhaul of the regulatory framework (including passing a new capital markets law) to promote sound market development and facilitate regional integration that allows capital market access for an increased number of issuers and to more investors. 6. Financial service provision has expanded in recent years but oversight of unregulated institutions should be strengthened to promote responsible finance. Financial service provision is at comparable levels with other Latin American countries, although access in remoter and poorer departments could improve with correspondent agents and mobile payments. A range of bank and non-bank institutions provide credit and deposit services to the microfinance and SME finance market, only some of which are regulated depending on their size. Institutions that oversee and license the unregulated institutions should gather information and report to the supervisor when size thresholds are exceeded. A system of auxiliary supervision by qualified entities could also strengthen oversight of unregulated institutions. 7. Public banks should remain focused on complementing private sector activity and improve internal processes as they step up their activity to improve access to finance. To expand access and to deepen and diversify the sources of funding, the Salvadoran authorities have announced an expansion in public banking sector activities and are formulating a strategy for the sector. It is essential that this strategy focus on complementing private sector activities to avoid creating market distortions. Public banks must continue improving their risk management and governance. Expansion of activities should not occur unless it can be handled with care and in a gradual way that does not compromise solvency, and should be accompanied by enhanced supervision. 8. The Real Time Gross Settlement System (RTGS) for payments and the upgrade in credit reporting systems have improved financial infrastructure, but further reforms are needed. The Central Bank Law should be amended to fully implement the Treaty on the Payment and Securities Settlement Systems for Central America and the Dominican Republic. Law or regulation on remittances services should also be considered. The launch of the RTGS system has substantially improved infrastructure but its use should be promoted further and inter- linkages with securities settlement systems should be reinforced. Credit reporting systems have improved, although information is still limited and fragmented. The Banking Law should be reformed in order to allow the free circulation of credit information among all the members of the bureaus. 6 9. Implementation of the 2004 FSAP update recommendations has been limited, largely because legal and regulatory reforms have not passed (Appendix 1). The supervisory frameworks for banks, insurance, and cross-border cooperation were improved and partial progress was made in strengthening the financial infrastructure, insolvency process, and restructuring of state-owned banks. However, important legal provisions to strengthen supervision and safety nets, as well as a corporate insolvency law have not yet been approved. Important risk and corporate governance regulations for banks have yet to be issued. Box 1. El Salvador: Main Recommendations of the 2010 FSAP UPDATE 1/ Recommendation Horizon Requiring legal reform: Banking Oversight Approve the proposed FSSRL Law, amending the draft law to include adequate legal protection for NT supervisors and broader preventive supervisory powers prior to regularization. Safety Nets Approve Article 130 of the proposed FSSRL Law, or otherwise modify the legal framework to allow NT the BCR to lend to banks with its own or external funds in case of emergency. Amend the BL: eliminate the 3-day notification period for resolution measures; remove the bank's NT board at star of judicial intervention; limit IGD to the least-cost solution and increase its resources. Capital markets Approve the draft Investment Funds Law. NT Approve a comprehensive overhaul of the securities markets law. MT Amend Pension Funds Law to increase the number and type of investments available to APFs. MT Access to Finance Amend the cooperative banks law to require federations to collect and report information to SSF. NT Amend the legal framework for factoring to allow for the transfer of an invoice to a third party. MT Financial Infrastructure Reform the Banking Law to allow the free circulation of credit information among credit bureaus. MT Not requiring legal reform Banking Supervision Issue regulations for key risks and corporate governance requirements. NT Enhance supervision of credit concentration risks. NT Not requiring legal reform Safety Nets Systemic risk committee (BCR, SSF and MOF) implements a comprehensive liquidity policy, including NT medium-term objectives for liquidity reserves level and structure, and contingency plans. BCR issues regulations to implement its powers to provide liquidity. NT SSF, BCR, and IGD formalize procedures and manuals for banking resolution and crisis management. NT SSF, BCR, IGD and MOF undertake a comprehensive bank resolution simulation exercise NT Capital Markets SV agrees with the Exchange on a road map to reposition its strategic role in the market. MT SV adopts an external yield curve (US yield curve) for valuation of portfolios. NT Accelerate the implementation of the action plan to comply with IOSCO principles. NT Access to Finance Harmonize documentation requirements for credit/ asset registration to exempt low-value transactions. MT Public Banks SSF implements schedule of on-site visits and off site reviews of public banks' financial information. NT Public banks improve credit risk analysis and operative processes. NT Consolidate and redefine the main existing CGFs and scale up the SRG by adding new products. NT Financial Infrastructure 7 BCR implements its oversight functions of the payment systems. NT BCR introduces a liquidity scheme for the operability of systematically important payment systems. NT BCR creates an alternate site for the RTGS, implement linkage between RTGS and CEDEVAL NT 1/ Near-Term (NT) are one to three years and medium-term (MT) is three to five years. This is the timeframe during which it is would be feasible to complete implementation of the high-priority recommendations. II. MACROECONOMIC DEVELOPMENTS 10. The global economic and financial crisis, as well as political uncertainty, negatively affected the Salvadoran economy starting in late 2008. The deterioration in global growth-- especially in the United States--and increased economic uncertainty sharply reduced trade, remittances, and private capital flows. With the intensification of the global financial crisis in late 2008, and in advance of the 2009 elections, the sovereign spread and lending interest rates rose sharply while credit to the private sector declined 4.6 percent. Investment and private consumption plummeted, and real GDP contracted by 3.5 percent. The recession weighed heavily on the fiscal deficit, which reached 5.6 percent of GDP, and public sector debt rose to 50 percent of GDP. In light of the fiscal deterioration, credit rating agencies downgraded the sovereign rating one notch.2 11. Risks to the baseline forecast and near-term macroeconomic stability arise mainly from exposures to external and political shocks while fiscal factors could pose longer-term risks. Growth is expected to remain below potential through 2012. However, a double-dip recession in the United States or increased global risk aversion could lead to an economic downturn and endanger fiscal targets. Deterioration in either external market conditions or political support could raise financing risks, including in light of the need to roll over a Eurobond in 2011, as well as liquidity risks. Longer-term risks could arise from failure to secure measures needed for further fiscal consolidation or from pension-related contingent liabilities3. Funding requirements for pensioners on the old pay-as-you-go system are in the order of 1½ percent of GDP. Lower-than-expected returns under the new defined contribution system may create a wedge between returns earned and the minimum pension that the current system grants, which creates a potential contingent liability for the government. An in-depth actuary analysis would be necessary to evaluate the pension reform costs and calculate replacement rates. III. FINANCIAL SECTOR SOUNDNESS AND PERFORMANCE 12. El Salvador's financial system is comparable in size with its regional peers, but it has been growing slower than the regional average. The Salvadoran financial sector comprises a variety of regulated institutions (Table 1). Financial development varies across sector, but it is broadly in line with the country's economic fundamentals. However, since the banking crisis of the late 1990s, financial deepening has stagnated and has not returned to the 2 Fitch and S&P rate El Salvador BB, while Moody's rating is Ba1. Fitch and Moody's have a negative outlook on the sovereign rating. 3 Under the new stand-by arrangement (SBA) with the IMF the authorities envisage implementing a fiscal pact containing measures to increase tax collections by at least 1½ percent of GDP to fund higher social spending in a fiscal consolidation context. 8 pre-crisis level. Thus, while El Salvador used to outperform the region in terms of financial depth, it is now lagging behind its regional peers. Equity and security markets are still too thin to play a significant financing role. However, there is also financial intermediation taking place through the many unregulated cooperatives and savings and loans (S&L) associations, which are not captured in official statistics. 13. The largely foreign owned banking sector has consolidated in recent years. The 2004-2009 period was characterized by a series of mergers and acquisitions that reshaped the banking sector. El Salvador has now the largest presence of foreign ownership among the Central American countries. In spite of the relatively high concentration, Salvadoran banks are among the most efficient in the region and charge some of the lowest intermediation margins. 14. Mandatory pension funds accumulated a greater share of total financial assets. Private pension funds, originally set up in 1998, have expanded rapidly as younger workers joined the new capitalization system. Currently, pension funds hold a quarter of total financial sector assets. 15. While banks were not directly exposed to toxic assets or wholesale funding, the global financial crisis along with the start of the electoral period led to shedding of riskier assets. The parents of some of the largest banks in Salvador were hit hard by the financial crisis and economic downturn in advanced economies. As a result, some Salvadoran subsidiaries were restricted by their headquarters in the use of risk capital and faced reductions in external credit lines, despite these subsidiaries being well capitalized. Fortunately, reputational risks that could have arisen given identification with the parent financial group were mitigated by the sovereign support put in place for these global banks. However, coupled with uncertainty regarding economic policies prior to the elections in mid-2009, annual deposit growth was negative in early 2009, although no individual bank experienced significant deposit withdrawals. Amid this increased and widespread risk aversion, external borrowing declined close to 50 percent, bank credit contracted by 6 percent and liquid assets increased to over 40 percent of deposits (Table 2)4. 16. With the ensuing credit crunch and recession of 2009, asset quality and profitability deteriorated. Nevertheless, most banks remain highly capitalized. Non-performing loans (NPLs) rose to 3.7 percent of total loan portfolio. However, a wider measure of loans at risk that incorporates restructured and refinanced loans suggests a stronger deterioration in asset quality (10 percent of total loans). Furthermore, write-offs amounted to 2.5 percent of the loan portfolio in 2009. The additional provisions--offset to some extent by a higher interest rate margin-- weighed on already low bank profitability, with the return on average assets falling to 0.3 percent in 2009, well below the rest of the region. Due to the increase in liquid assets, which carry a low risk-weight, as well as capital injections in some banks, the system's capital adequacy ratio 4 Part of the increase in liquid assets in 2008 was due to an additional 3 percent liquid asset requirement that took effect through the course of 2008, but was withdrawn after the elections. As in other dollarized economies, bank liquidity is high due to prudential requirements, and banks self-insurance due to limited central bank capacity to inject liquidity. In addition, there is no developed interbank market in El Salvador. 9 (CAR) of 16.5 percent is high for regional standards, although a couple of banks have solvency ratios close to the 12 percent regulatory minimum5. The quality of capital is also high (Tier 1 capital amounts to 13.7 percent of risk-weighted assets and consists mostly of retained earnings), and the leverage ratio is low (Tier 1 capital is 8.9 percent of on- and off-balance sheet assets). 17. Stress tests indicate that most banks would be able to withstand large deposit withdrawals and severe deterioration in credit quality arising from large macroeconomic or sectoral shocks. However, credit concentration risks appear significant. Banks could sustain a withdrawal of 15 and 30 percent of total deposits within 30 and 90 days, respectively. Even assuming all private domestic securities are illiquid and applying a 25 percent haircut to the face value of eligible government securities. That said, in this scenario a few banks would need to access the third tranche of liquid reserves held at the central bank. The system's CAR ratio remains above the regulatory minimum even in an extreme scenario where close to 50 percent of total loans could require provisioning6. However, some banks with a high concentration of loans in risky segments (such as construction) would see their capital fall below the regulatory minimum, but only in one (non-systemic) case is this undercapitalization critical.7 Downgrading the classification of the system's 100 largest debtors by one or two grades causes the CARs of up to six banks to fall substantially, although all banks would retain a CAR of at least 9 percent. In the case of an outright default of the largest five or ten debtors, up to five banks become undercapitalized, with four banks falling below 10 percent CAR (but with no bank critically undercapitalized). 18. Regulated cooperative banks report healthy financial indicators. Cooperative banks tend to service lower income segments than commercial banks, having large exposures to consumer credit (often used to fund microenterprises) and SMEs. NPLs for regulated cooperative banks (2.9 percent) are higher than in the micro- and SME-focused commercial banks, but well- below the NPLs of S&Ls (4.0 percent) and unregulated institutions, where NPLs can approach 10 percent. Provisions are correspondingly higher as well. Regulated cooperative banks, S&Ls and non-regulated financial institutions affiliated with a federation all report CARs higher than 20 percent (Table 3). Although they have higher financing costs, cooperative banks are among the most profitable regulated institutions. Declining overhead costs are driving increased profits and efficiency. Net interest margins for commercial banks are slightly lower (6.3 percent in 2009) than for cooperative banks and far lower than the regulated S&Ls (21.1 percent) who face less competition. The efficiency of cooperative banks, measured at an average 120 loans per 5 Adjusting banks' CAR to a variety of factors, including elimination of goodwill and increasing the risk weight on domestic public debt securities, did not have substantial effects on banks' solvency. Similarly, adjusting provisions to a debtor's lowest risk classification and adjusting for possible under provisioning of restructured agricultural loans held off-balance sheet in a trust (Ficafe), would also have very modest effects on the CAR for the system. 6 The extreme scenario assumes Salvadoran real GDP declines by 5.4 percent in 2010 and 2.5 percent in 2011--an outcome three standard deviations below the norm. NPLs associated to that macroeconomic scenario were estimated for each of the main sectoral credit classifications using panel data. 7 There is no standard benchmark for undercapitalization, but in the U.S. a bank with CAR below 2 percent are considered critically undercapitalized and must be resolved within 90 days. 10 employee, was higher than for S&Ls and some unregulated institutions, most of which manage smaller loans with higher transaction costs. 19. The insurance sector in El Salvador is small, well capitalized, liquid and profitable. As of December 2009, insurance penetration in terms of premiums was 2.1 percent of GDP, in line with other Central American countries. The sector's statutory solvency has strongly increased in the past five years reaching 120.6 percent in 2009 (from 47.5 percent in 2005), indicating that the insurance sector has enough resources available to cover outstanding obligations. The high liquidity of the sector (liquid assets cover 115 percent of liquid liabilities) reflects conservative investment policies as well as scarce supply of investment opportunities. Profitability trends have been favorable: at end-2009, the return on equity of the insurance industry was 20.9 percent and average return on assets was 10.3 percent. The loss ratio increased from 45.1 percent in 2008 to 47.7 percent in 2009, but remains adequate in terms of international standards. The sector has adequate reinsurance protection with leading international institutions (41.7 percent of the premiums were reinsured in 2009). 20. Pension Funds investments are highly concentrated in public sector securities, which have provided modest real returns in the past decade. Assets under management of pension fund administrators (AFPs) reached US$5.3 billion at end-March 2010 and are invested in fixed-return investments, mostly public sector securities (79.4 percent). About 45 percent of the portfolio is held in a compulsory investment (Certificados de Inversión Previsionales, CIPs) which only pay Libor plus 75 basis points. Only 0.4 percent of the total investments were in foreign instruments. In real terms, the average profitability of pension funds was 3.2 percent during the last decade. Going forward, the Pension Funds Law should be amended to eliminate the requirement of investing only in listed securities in the local stock exchange, which would reduce issuance costs, administrative burden and, once the Law on Mutual Funds is approved, open up the possibility of investing in mutual funds as long as they are properly rated. Modifications of the law should also allow investments in foreign securities to increase progressively up to a prudent limit, for example, 20 percent of total invested assets. 21. Brokerage houses, which until recently posed systemic risks due to inadequate regulations and unsound commercial practices, have reduced their fund management activities drastically. Currently there are 12 brokers, of which foreign financial conglomerates control 10. There is no mutual fund industry in El Salvador due to the lack of a proper regulatory framework, and brokers have traditionally provided fund management services. However, funds have been practically phased out after foreign financial groups acquired the brokerage houses as a reaction to the systemic risks created by the inadequate regulation that does not require mark- to-market valuations, nor does it mandate clear separation of the fund's assets. In addition, the commercialization of investment products by the fund managers as if they were sight bank deposits redeemable on demand at face value, posed substantial risks. As a result, investment funds' assets decreased from US$700 million in 2006 to only US$125million at the end of 2009. Only one fund, which is independently owned, remains (with assets under management of US$79 million). Proprietary positions are minimal. 11 IV. FINANCIAL SECTOR OVERSIGHT A. Banking 22. Following the previous FSAP, an ambitious project to move towards risk-based supervision was initiated, but important challenges remain given resource constraints. The Financial Sector Superintendence (Superintendencia del Sistema Financiero, SSF) was reorganized in 2008 and now has a risk unit so that the supervisory teams may tap specialized expertise in various risk areas, which has helped strengthen supervisory practices. The SSF currently uses CAMELS models in order to establish bank-specific risk profiles. However, more qualitative assessments of risk management are needed. In particular, besides checking whether procedures and policies are in place, the SSF should also assess the quality of risk management and internal controls given the bank's risk characteristics (e.g. size, complexity and risk tolerance capacity). To strengthen the supervisory review process it is essential to further upgrade supervisory capacity, both in quantitative and in qualitative terms. Furthermore, the supervisory department is resource-constrained, as the increased consumer, protection responsibilities entrusted to the SSF have been assigned to this department, diverting supervisory resources away from prudential supervision. Consideration should be given to creating a separate consumer protection department. 23. The existing regulatory framework has significant gaps, which need to be filled urgently. Regulation is lacking in such areas as corporate governance, credit risk, liquidity risk, market risk, operational risk, interest rate risk in the banking book, information technology and investment valuation and derivatives. Many of these are under development, but have faced bottlenecks in the approval process. Although supervisory practices in these areas have improved, the lack of standards puts the SSF at a disadvantage in addressing imprudent behavior by banks. This is aggravated by a lack of legal protection for supervisory staff. Legal challenges not only distract supervisory resources from where they are needed most, it also affects the willingness of the SSF to use its corrective powers. Another concern is that the remedial action framework includes only limited powers for the SSF to take preventive action. 24. Asset classification and provisioning rules were tightened in 2007, but could be improved further while the capital adequacy framework is not fully in line with international standards. Provisioning levels are now broadly in line with international practices, and the SSF monitors banks' delinquent loan portfolio intensively. , a number of weaknesses continue to exist. When debtors with multiple loans with various banks default on one loan, but stay current on others, the classification of the current loans is not affected. Moreover, the practice of granting several mortgages on the basis of one underlying asset could put at risk some creditor banks: although the sum of the mortgages may not exceed the value of the underlying assets, difficulties with collateral seizure may arise if the debtor stays current on the primary mortgage but defaults on another. Intangible assets (mostly goodwill), are not subtracted from capital as required under Basel I. While these are currently of limited significance, further consolidation and investments in the system could elevate these amounts. 12 B. Non-Bank Intermediaries 25. Supervision of the insurance sector has shown improvements in the recent years but more work needs to be done to adopt a risk-based supervisory approach. In 2005, the SSF launched the CARAMEL system, which analyzes the financial indicators of insurance companies and weights them to produce a rating. Going forward, the SSF should continue developing risk- based supervision mechanisms to complement traditional insurance analysis with quantitative models and move beyond assessment of compliance with existing rules, and increase their on- site visits to individual insurers besides the current focus on conglomerates. 26. The supervisory framework presents very low levels of compliance with the international standards (IOSCO) with several areas of high concern and little progress made to address them. In 2004 and 2005, a series of very detailed assessments of the regulatory and supervisory framework were conducted by the IOSCO secretariat and by the US self- regulatory organization (FINRA) that highlighted very low compliance with the international best practices (IOSCO principles). Priority areas for reform indentified in this report include (i) mitigation of investor and systemic risks in the collective investment schemes, (ii) the need of an update of the overall regulatory framework (laws and rules), (iii) implementing risk-oriented supervision, and (iv) strengthening the supervision of the brokers and market surveillance. With respect to the latter, an important factor contributing to the failure of those functions is the inadequate self-regulatory framework in place between the stock exchange and the Superintendence of Securities (Superintendencia de Valores, SV) that is aggravated by the unsatisfactory corporate governance standards of the Salvadoran stock exchange (Bolsa de Valores de El Salvador, BVES) with respect to the independence required between the management and the supervised entities. Five years after, very limited progress has been made on all those fronts. C. Cross-Sectoral and Cross-Border Issues 27. The SSF has made some progress in consolidated supervision, but additional efforts are needed to better assess the risks presented by non-banking local activities at the group level. The SSF now coordinates with other local supervisors of financial entities, to gather information and to conduct simultaneous onsite exams. However, there remains considerable scope for deepening the analysis and translating the outcomes in terms of potential impacts on capital and liquidity. In addition, the threshold for consolidation used in practice (50 percent of capital), is quite high.8 28. The SSF has stepped up its efforts to enhance cross-border cooperation, although more specific cross-border crisis prevention and management arrangements should be established. The SSF has signed Memoranda of Understanding (MOU) with all home supervisors, strengthening the exchange of relevant information. In addition, the Comité de 8 The SSF is empowered to assume existence of control based on other criteria, but this is not commonly done in practice. 13 Enlace of Central American supervisors (CECAS) has stepped up regional coordination through quarterly meetings and monthly teleconferences where supervisors present relevant information, risks and concerns about the banks operating under their jurisdictions. However, crisis MOUs with foreign supervisors or contingency plans to manage a crisis has yet to be put in place. Coordination between home and host supervisors with the aim to avoid and mitigate the effects of a potential crisis should be established by assessing information needs and establishing appropriate communication strategies. 29. The legislation criminalizing money laundering and the financing of terrorism complies with the FATF standard, but preventive measures and the supervisory framework require an overhaul.9 The law has allowed the country to prosecute successfully several cases and cooperate with other countries. Nevertheless, the number of convictions is low relative to the number of crimes that generate proceeds, and prosecutions mostly relate to cash smuggling rather than more complex or higher-impact schemes. The effectiveness of seizing and freezing measures is limited, with precautionary asset seizures imposed in less than half of the investigations. In addition, some financial activities, particularly money remittance, fall outside the scope of any financial sector regulatory and the supervisory authorities (SSF and SV). The Financial Investigations Unit, established within the Public Prosecutions Agency, is the lead agency in the fight against money laundering and financing of terrorism--able to issue enforceable regulations, and responsible for investigating and prosecuting most cases. However, it lacks the necessary expertise, resources and operational autonomy to carry out its functions effectively. Moreover, the concentration of functions (regulator and lead prosecutor) within a single unit seems inappropriate. D. Overhaul of the Supervisory Landscape 30. The law on Financial System Supervision and Regulation (FSSRL) would bring about some welcome changes although further improvements to the current draft could be introduced. The Law, currently in Congress, will: (i) merge the superintendences of banks, securities and pension funds, thus creating a sole supervisory authority with enhanced powers and operational independence and, (ii) transfer the right to issue regulation from the new SSF to the central bank (Banco Central de la Reserva, BCR). The latter aims to balance the power of the new integrated supervisor, while focusing the oversight system on a financial stability objective. The creation of a dedicated regulatory committee may improve the timeliness of issuing prudential regulation.10 A sole regulator should also reduce the scope for regulatory arbitrage by facilitating the homogenization of regulations for similar risks across institutions. Still, it is necessary to use the window of opportunity presented by the discussion in Congress to improve on the current draft. The law only partially addresses the current lack of legal protection for 9 This assessment was conducted by the Caribbean Action Task Force in 2009, and the Mutual Evaluation Report agreed in June 2010. 10 Currently, banking regulations are issued by the SSF council. This oversight body has become increasingly focused on operational and administrative matters. In the superintendence of securities, capacity constraints have hampered the timely issuance of regulations. 14 supervisors and, despite the improvements in the remedial action framework, the SSF's room to maneuver preemptively remains restricted. In particular, it lacks the power to restrict dividends, activities or purchases prior to regularization. Finally, while new provisions limit industry interference on the regulation committee, the risk of political interference in the issuance of regulations still exists given the participation of the ministries in this committee. 31. Furthermore, the separation of regulatory and supervisory functions will require strong cooperation and coordination between the SSF and BCR. The separation of regulation and supervision in two different authorities will serve to check and balance the power of the integrated supervisory agency and allow for a more macro prudential perspective in regulation and more effective crisis management arrangements. To avoid hampering the effectiveness of supervision, it is essential that the BCR acquire technical skills in the area of prudential supervision, and that the BCR staff responsible for drafting regulations and the SSF supervisory staff work together closely. This cooperation needs to be effective promptly in order to finalize existing draft regulations whose issuance is long overdue. V. FINANCIAL SAFETY NET ARRANGEMENTS 32. Several legal, operational, and resource constraints should be addressed to allow the BCR to provide timely emergency liquidity assistance. Central banks in dollarized economies such as El Salvador cannot issue their own currency, although they can use excess international reserves or on-lend external funds to provide liquidity support in an emergency. However, the BCR cannot lend to banks to channel such resources, and such prohibition should be lifted as contemplated in the FSSRL. In recent years, the BCR has taken steps to strengthen its balance sheet by retiring a significant portion of the monetary base and lowering outstanding debt. Nonetheless, El Salvador's excess ("free") reserves remain low for a dollarized economy. Over the medium-term, the government should seek to fully capitalize the BCR to provide it with additional resources.11Although the BCR can sell or buy investments and loans from banks, it has proven very cumbersome in practice. The BCR can conduct repos with securities held as part of the required liquid reserves and other public sector securities only when the government has deposited funds expressly for this purpose (otherwise this operation is considered government credit) and regulations on repos still need to be issued. This legal restriction on repos should be revised. Finally, the BCR should design a collateral policy and define clearly the processes to carry out permissible operations. 33. The authorities should establish and implement a comprehensive systemic liquidity policy, which should include contingency plans and consideration of a liquidity fund. Banks maintain large liquidity levels as self-insurance against systemic liquidity shocks, which affects profitability and reduces credit availability. Setting up a liquidity fund, as done in other dollarized economies such as Ecuador, would reduce the costs of liquidity protection for 11 The Treasury issued long-term bonds for US$704 million to securitize a government liability with the BCR, but there is still an outstanding issue of bank resolution trust fund (FOSAFI) debt, arising from the purchase of failed bank assets from the late 1990s, that the government should honor. 15 individual banks as well as for the economy. The liquidity fund would allow for pooling liquid resources, and would complement the still incipient interbank market and the limited capacity of the BCR to provide systemic liquidity. The availability of the pooled resources could reduce the volatility of domestic liquidity for individual banks and in turn reduce the need for self-insurance against liquidity shocks, while providing an additional buffer prior to accessing scarce public funds. Short of this, the SSF could require irrevocable letters of credit from parent banks to provide additional assurance of access to external liquidity. 34. The Banking Law (BL) establishes criteria for regularization and resolution of a troubled financial institution, but lack of some regulations and legal protection may hamper timely action. The main triggers for regularization are: (i) a capital asset ratio below 10 percent; (ii) use of the third liquidity tranche; and (iii) other situations that put at risk the bank´s solvency and liquidity (e.g. deficient risk management). During regularization, the law authorizes the SSF to take a wide range of corrective actions. Failure to present a regularization plan or noncompliance triggers restructuring. Shareholders must then adequately capitalize the banks within 30 days or else the SSF may use other mechanisms to resolve the bank, including purchase and assumptions (P&A) of assets and liabilities. The Deposit Guarantee Fund (Instituto de Garantía de Depósitos, IGD) can participate in these operations when it is necessary to protect guaranteed deposits. However, lack of regulations on various risks and on sanctions limits enforcement of the regularization criteria and the SSF has not formally defined the responsibilities and intensity of follow-up of corrective actions, based on risks. Furthermore, regulations and manuals to make P&A operational are still pending. These gaps may delay regularization or resolution, in particular given the lack of legal protection for supervisors, which are in turn likely to lead to greater asset dissipation and higher costs for the deposit insurance fund or for the government in case of a systemic banking crisis. 35. The authorities should address deficiencies that could stymie effective bank regularization and resolution and establish appropriate roles and responsibilities for resolving a systemic banking crisis. In particular, the authorities should (i) eliminate the requirement to notify a bank 3 days prior to the suspension of operations or other resolution measures; (ii) remove the bank's Board upon the commencement of a bank's judicial intervention; (iii) introduce the least cost solution (total amount of guaranteed deposits) as the measure of the maximum support by the IGD for a bank resolution, and (iv) establish a target for IGD's reserve fund and adopt measures to reinforce its funding. A high-level stability committee should decide on whether a systemic risk situation exists (based on different variables such as size, interconnectedness, regional impact, contagion risk, payment system, etc.) and how to proceed according to well-defined roles and responsibilities12. The authorities should carry out a comprehensive bank resolution simulation exercise and use the results of this exercise to make necessary legal, regulatory, and procedural changes. 12 Currently, the IGD must assess whether a bank failure could create systemic risk and financial instability, a role and responsibility beyond the mandate and competencies of the deposit insurer. 16 VI. FINANCIAL SECTOR DEVELOPMENT AGENDA A. Capital Markets 36. The capital markets in Salvador are small and relatively underdeveloped, and have played a very limited role in the economy. At end 2009, there were only 40 listed stocks and few private corporate bond issuers. Stock market capitalization was about US$5.2 billion (24.6 percent of GDP, 5.6 percent excluding the shares of the financial institutions that are largely controlled by foreign institutions with a minimum floating in the market). Outstanding government securities amount to 28.7 percent of GDP out of which 66.7 percent is represented by Eurobonds issued in the international markets. On average, institutional investors invest less than 10 percent of their total assets in capital market instruments. In 2009, there were only 4 new issuance of private fixed income securities and none in the case of equity. Banks and pension funds are the main institutional investors. 37. The current market architecture, which grants a natural monopoly to the existing exchange, hampers market development. All products and players are required by regulation to be listed in a domestic exchange. Given market size, the BVES has a natural monopoly as the current regulatory framework for alternative electronic trading facilities combined with BVES exclusive control of the only central depository in the country (CEDEVAL), limits the possibilities of competition in the short- to medium-term. That framework has created unnecessary costs to different types of transactions where the BEVSs in fact add little value (e.g. buying and selling of foreign securities between brokers and their clients). It also reduces the possibility of providing avenues of access to the capital markets for potential issuers other than initial public offerings that could tap the institutional segment of the market where the assumptions of protection and liquidity are very different from those of the retail market. It has also prevented the development of over-the-counter (OTC) markets. BVES concentrates all local secondary market transactions through its members (supporting brokerage services), and trading commissions are reported to be high.13 Trading activities are very limited with the majority of transactions carried out in short-term repo operations of government securities. 38. To facilitate the connection of the supply and demand of resources and promote sound market development, the regulatory framework needs to be updated. Such reform should follow a comprehensive strategy aimed at subordinating the role of the exchange to such a goal. These necessary changes constitute the primary reforms to be included in a new and comprehensive Securities Law. These changes aim to elevate the standards of the market, enhance the capital market role in the economy and facilitate the regional integration. These include: 13 In the secondary market, the annualized cost of a total round trip of an outright transaction is of the order of 0.75 percent of the bond's market price. 17 Elimination of the obligations for listing and trading in the exchange starting initially with the fixed income products and the foreign securities from recognized jurisdictions; Allow private placements targeted to institutional investors (registered in the SV) and OTC transactions to develop in the country; Eliminate the local rating requirements for rated foreign instruments from recognized jurisdictions; Grant the government with powers to make the regulatory changes needed to expedite the regional integration (e.g. remote access, mutual recognition); Redesign the self-regulatory framework in place to formally minimize its use given the small size of the market and the demutualize nature of BVES. 39. The Investment Funds Law should be finally approve to broaden and diversity the investor base. Approval of the Law would allow for the development of the mutual fund industry. The importance of this reform is paramount as the current reliance on just two main institutional investors (the pension funds) with limitations to invest per issue (35 percent each) creates a major limitation for new issuances. However some few improvements could be quickly introduced to the current draft including (i) extension of the concept of the oversight board to the open funds, (ii) allowing pension funds to invest in foreign asset funds up to a limit of 20 percent of total AFP portfolio. 40. Adoption of an external yield curve would facilitate the valuation of the portfolios while a local yield curves gets built in the medium term. Adopting for example the US yield curve as the reference rate this would facilitate the valuation of the different portfolios while the government gradually develops its own curve through a series improvements in the debt management capacity of the ministry of finance, or by outsourcing such a functions to the central bank. Other dollarized countries, like Panama, have been using a short reference rate such as Libor to price bonds in the local markets. 41. Moderate regional integration effort has been made but any significant progress would require relevant legal changes. AMERCA project led by the three Exchanges (Salvador, Costa Rica and Panama) aims to grant a remote access14 to the local brokers of any country into the exchanges of the other two markets. However, the project has been slow given that only Panama has the legal power and authority to approve the access. Both El Salvador and Costa Rica would require legal reforms in their capital market laws. In the case of El Salvador, there seems to be high consensus between the government and the industry on this change, but it will have to await for the next legal reform on capital markets to be presented to Congress. The possibility of a more aggressive process of integration is very unrealistic in the short term given the very uneven state of their regulatory frameworks, with El Salvador being the one with the lower standards. 14 Remote access allows a brokerage house from a given country to access directly the electronic trading platform of the other countries Exchanges and buy or sell securities listed in those markets. 18 B. Access to Finance 42. Financial service provision has expanded in recent years and is comparable with other Latin American countries, although disparities remain within El Salvador. An estimated 47 percent of adults in El Salvador have deposit accounts at a financial institution, similar to the Latin American average. However, inequities between departments remain. Mapping financial services available at the municipal level including unregulated institutions and remittance service providerswould provide a solid basis for identifying severe physical barriers and other needs that could be met through financial inclusion strategies. Providing an enabling framework for the use of retail agents and new technological channels such as mobile banking has the potential to increase access. 43. Increased consumer credit has been accompanied by concerns of over-indebtedness, prompting legislation on loan workouts and stronger consumer protection provisions. Between 2004 and 2009, the number of loans to individuals increased 33 percent. Lack of complete credit history information available to non-regulated financial institutions, which service mostly the lower end of the market, may be exacerbating the problem among small debtors. Some lenders have exited the under US$1,000 market, which they view as increasingly risky. A recently proposed law would require increased transparency about costs and any lack of clarify in a loan contract should be interpreted in favor of the client. A special loan work out unit would be created in the Salvadoran consumer defense agency to assist borrowers in loan restructurings. However, consumer protection provisions could be further strengthened by requiring lenders to publish the total dollar cost over the life of the loan. 44. A range of bank and non-bank institutions serves the micro and SME finance market. The regulated entities include commercial banks, cooperative banks,15 Savings and Loans societies, certain worker's banks and a federation of worker's banks, and cajas de crédito (FEDECREDITO), S&L societies, certain worker's banks and a federation of worker's banks, and cajas de crédito (FEDECREDITO). Savings and loans cooperative associations, cajas de crédito, non-bank finance companies (mortgage, leasing, factoring), associations and foundations (NGOs) are unregulated and serve this market. Each entity occupies different market niches, with savings and loans, cooperative associations and the NGOs generally serving poorer clients than the banks. Credit from all regulated institutions to firms classified as micro, small or medium size totaled US$1.3 billion at end 2009 (US$1 billion of which corresponds to SMEs). Including non-regulated institutions, this total is likely closer to US$ 2 billion, although little data is available for many of the cooperatives and finance companies. 45. Significant unregulated financial services provision is occurring, and mechanisms to determine when institutions become sizeable should be strengthened. Both regulated and unregulated institutions can provide credit, accept member deposits and issue credit cards. 15 As defined in Article 2 of the Law on Cooperative Banks and Savings and Loan Societies, regulated cooperative banks include: savings and loans cooperatives that also capture savings from their members and the public, and savings and loans cooperatives where the sum of deposits and members' equity contributions exceeds 600,000 colones ($84 million dollars in today's prices). . 19 However, SSF has no way of determining when unregulated institutions pass the US$84 million of member deposits and member equity contributions threshold under which they automatically become regulated. In December 2009, there was at least US$387 million in member deposits at unregulated institutions, representing data from only 88 of the more than 300 institutions. The limited information systems of INSAFOCOOP, the licensing and oversight entity of more than 300 savings and credit cooperatives, and the Superintendent of Mercantile Obligations (which has jurisdiction over cajas de crédito) should be strengthened given the power to penalize institutions that do not report required information. Also, the two federations of largely unregulated institutions that engage in voluntary oversight of their member institutions: regulated FEDECREDITO and unregulated FEDECACES (organization of cooperatives) should be required by an amendment to the Law of Cooperative Banks and Societies of Savings and Loans to provide material information to SSF. 46. Oversight of currently unregulated entities institutions should be strengthened through a system of auxiliary supervision and the regulatory architecture reconsidered. SSF supervision of all of these deposit-taking institutions is neither feasible nor desired by most institutions. It is perceived as costly with the main benefits being access to IGD and improved reputation. However, a system of auxiliary supervision through federations with a critical mass of institutions such as FEDECREDITO and FEDECACES would enable these entities to perform supervisory tasks on behalf of SSF, the principal supervisor, such as data collection, processing and recommendations of procedures. This would be a fast and practical way to get information and oversight of the majority of "gray area" activity, and allow these newly supervised entities to have a more formal status. However, auxiliary supervision carries risks, as the ultimate responsibility of the functioning of the regime rests squarely with SSF, and auxiliary supervisors may require significant strengthening to fulfill their responsibilities. Furthermore, providing institutions with a semi-regulated status may provide further disincentive to enter the regulatory system. Under an auxiliary supervisory approach, unregulated institutions with deposit-like liabilities should be required to affiliate themselves with an approved federation. 47. Poor judicial efficiency results in high collateral requirements and inhibits SME credit. Delays in executing collateral through the legal system, which reduce the value of the pledge and lack of complete credit histories, prompt banks to request high collateral levels. In El Salvador, the value of collateral required (151 percent) is higher than the regional average. SMEs face the most stringent requirements (175 percent of the loan value), far higher than for large firms. Higher collateral requirements are probably due to the long delays in executing collateral and enforcing contracts, which could negatively affect the value of the pledge assets16. 48. Documentation requirements and certain regulatory norms also limit access to commercial credit of microenterprises and SMEs. Although SSF norms state that financial institutions can establish their own documentation requirements for credits under US$100,000, 16 In 2010, World Bank Doing Business reported that contract enforcement in El Salvador takes 786 days, longer than the regional average, The 2004 Insolvency and Credit Rights ROSC found that the execution of collateral through the judiciary system seems to be the main cause of delay in the execution of collateral. 20 overlapping requirements from the commerce code, tax code and AML regulations have led many financial institutions to require financial statements and proof of tax compliance for loans of all sizes. This limits access to more informal firms, who then seek consumer credit to fund productive activities. These documentation requirements should be reduced and harmonized for low-value transactions. Existing prudential norms may also favor granting consumer loans; NCB-022 has stricter past-due classification treatment for enterprise loans than for consumer loans (despite the latter's higher rate of delinquency) and requires a detailed economic analysis for firms of all sizes, but not for other types of loans. 49. SME access to credit could improve by strengthening the legal framework for factoring and providing institutional support for an electronic factoring platform. Factoring activity is growing rapidly outside of the banking system, and this instrument has the potential to be an important source of finance for small and medium enterprises. Currently, the commerce code does not allow firms to cede to factoring intermediaries the invoices they receive from the distributors they supply. Therefore, invoice discounting as opposed to true factoring is prevalent. A special negotiable invoice that was recently introduced (factura cambiaria) allows factoring intermediaries to take action to collect on the debts of distributors to their providers in the case of default, but as in other countries, large firms are reluctant to use it. There is interest in the electronic platform that recently begun operating, but it has yet to achieve scale. Development of factoring requires strengthening of the factura cambiaria instrument and support of the authorities for its use by the largest Salvadoran firms at the top of the productive chain. In addition, factoring intermediaries should be allowed to participate in the electronic platform as well as distributors. 50. Leasing, which has significant outreach to SMEs in many other countries, remains limited in El Salvador. A legal framework exists for leasing through regulated financial institutions (Ley de Arrendamiento, 2002), but the product has not yet reached scale. Last year, financial conglomerates booked 837 leasing loans totaling just US$1.7 million. Tax laws in El Salvador discourage banks from offering leasing, as they pay more income tax on leasing operations than on loan operations, even if the same interest rate is charged. Like factoring, much of the activity in leasing is occurring outside of regulated financial institutions. C. Public Banks 51. The global financial crisis and ensuing credit crunch has revived the discussion on the role of public banks around the world. In several countries, development institutions have expanded their balance sheet to mitigate the effects of the increased risk aversion and tighter liquidity conditions, which prompted banks to retrench credit. This behavior has been more exacerbated in large international banks that were particularly affected by their exposure to US subprime assets. Some of these banks are among the biggest players in El Salvador. The authorities are in the process of formulating a strategy for the public banking sector with a view to limit the economy's dependence on foreign banks for funding domestic productive activities. 52. The public banking sector in El Salvador is small and focused on market segments that lack adequate access to finance. The public banking sector in El Salvador is small by 21 regional standards. The sector consists of three institutions: a second-tier bank with a focus on long-term financing (Banco Multisectorial de Inversiones - BMI) and two small first-tier retail institutions with a focus on underserved segments such as SMEs and small rural lending (Banco Hipotecario - BH and Banco de Fomento Agropecuario - BFA). The main role of public banks in El Salvador is to mitigate market failures, particularly by facilitating access to some specific sectors of the economy that are not covered by commercial banks. Private commercial banks value the role of the public banks in the market as providers of financial services to underserved market segments. Stated-owned first tier public banks increased their market share from 4.4 percent to 5.1 percent in 2009, as they expanded credit to partially compensate for the credit contraction of some foreign banks. 53. A clearly defined strategy for the public banks, focused on complementing private sector activity, is necessary as their activities expand to improve access to finance and diversify the sources of funding. To this end, the authorities should define development objectives and the aspirations on the public banking sector and develop the strategy and role of public banks in terms of the development plan of the country. The business focus and strategy, industry and customer segments and specific financial products of these banks should be a consequence of these objectives and aspirations. In order to avoid creating additional distortions through public intervention, the strategy should aim at complementing private sector activities and try to crowd-in private commercial banks into providing services to priority sectors. 54. In addition to complying with the formulated policy objectives, public banks need to preserve their recently recovered financial solvency by adopting a business plan and a system of social and financial performance measures. In the past, the BFA and BH had required multiple recapitalizations, amounting to more than US$300 million since 1991. Complying with the social objectives cannot be made at the expense of financial sustainability. To clearly define targets and facilitate accountability, public financial institutions are increasingly formulating business plans and adopting performance-measuring systems that combine both financial and social objectives. The government, as the owner of the public banks, should be unequivocally committed to preserve public banks sustainability, monitor, and hold bank managers accountable for results. Public banks' portfolio quality has been substantially affected at times by governmental loan forgiveness programs for the agricultural sector. Any subsidy component in the banks' operations should be clearly accounted for. 55. Supervision of public banks should be strengthened to accompany their planned growth process. Besides their role in development policy, public banks should be under the same regulatory conditions and supervision burden as any other bank in the system to ensure a leveled playing field and early identification of problems. A clear on-site schedule of visits and off site review of their financial information should be defined. 56. BFA needs to continue improving its credit risk process and governance before expanding activities and its strategy should be limited to low value loans for the agricultural sector with an emphasis on microcredit. BFA's loan portfolio is concentrated in 22 the financing of small and medium enterprises, mainly in the agricultural and commercial sectors17. As an internal policy, loans should not exceed US$400,000 as typically the largest loans in the BFA portfolio have exhibited the worst performance. Due to the characteristics of BFA's client's segment, its low capacity of increasing revenues and high operational costs, its efficiency (although improving) compares unfavorably to that of the system. The Minister of Agriculture is the president of the board of directors. Other board members tend to be drawn heavily from public sector entities related to agriculture, reflecting BFA's original role. As a result, the board may not have the commercial perspective and experience necessary to provide wise guidance to BFA implementation of its present role as a bank. Recently, the government announced an increase of the bank's capital in order to reach US$80 million in new loans to micro and small rural firms. To that end, the BFA has requested a US$10 million capital increase. To better focus the institution on its target segment and continue improving the performance of the institution, the increase in lending should be gradual. The internal lending limit for the BFA should be lowered substantially to US$100,000 so more flexible lending standards can be applied in compliance with existing regulations. The gradual restructuring of the BFA loan portfolio would help funding the increase in small loans in an ordered way and a small capital increase would be necessary to achieve the announced target. BFA should not expand its portfolio in any significant way unless credit risk processes and governance are improved. 57. BH should be the bank more focused on SMEs and specialized in funding larger agricultural products, exploiting its better risk management skills. BH is a state controlled institution with the participation of private shareholders specialized in granting credits with mortgage collateral and orienting its activities to the SMEs, especially in the rural sector18. The bank has been improving its efficiency, it is professionally managed, and its financial indicators are in line with system wide indicators. President Funes announced that the capital of the BH would increase from the current US$35 million to US$100 million by the end of his mandate. Such capital increase should be linked to a clearly defined strategy, better supervision and to the development of internal control policies. The step increase in Tier 1 Capital should be progressively used over a period of 3 to 5 years to incrementally expand lending at a pace in line with BH's institutional capacity to prudently underwrite and monitor loans. Private shareholders should be part of any capital increase to maintain their role in the institution. 58. The role of the BMI in fostering development can be enhanced while maintaining its second tier status. The BMI Law allows the bank to constitute administer and participate in trusts funds, syndicated loans and other financial structures using its own resources or resources from third parties, allowing it to provide funds for development projects in a variety of ways other than direct lending. Transforming the BMI into a first tier institution would not only require a legal amendment, but also substantial revamping and upgrading of the current 17 In 2009, about 32,000 loans (90 percent of total number of loans and about 50 percent of the loan portfolio) were below US$5,000. BFA market share in terms of loans is only 0.14 percent. of the banking system. 18 The bank is currently owned 95 percent by Fondo de Saneamiento y Fortalecimiento Financiero (FOSAFFI) and 5 percent by private shareholders. 23 capabilities for credit risk analysis, changing the culture of the bank, and adopting the highest governance standards. This would be particularly important in the case of BMI, as its strong growth potential needs to be extremely well managed to ensure the bank sustainability. 59. The BMI has developed some experience in working with financial cooperatives and other NBFIs and activity with this sector could be stepped up. Since the funding cost of cooperative banks, non-bank financing companies (mortgage, factoring, leasing) and microfinance entities is higher than that of the BMI, especially for longer maturities, this sector provides a natural venue to funnel BMI liquidity. The BMI should operate through the associations' federations, with limits on the credits granted with their funding to ensure the federations charge a reasonable spread to the cooperatives. Direct lending to non-regulated entities should continue to be restricted to the operations of small trust funds for specific programs partly funded by donors. BMI should ensure that best practices on risk analysis are been applied in its lending activities to unregulated institutions. 60. BMI could play an investment bank function and an active role in capital market development. There is a lack of domestic financial players with capabilities to structure products to fulfill the investment needs of pension funds. BMI´s new functions could include a proactive role in supporting capital market development, by providing wraps and credit enhancements with a view to improve the rating of debt issued by large and medium-size firms so AFPs can invest on it. BMI could also provide funds for private equity funds to invest in companies. In addition, the BMI could be a key participant of the planned expansion of some public projects acting as an investment bank and applying its technical resources to structure new financial products in order to provide for funding alternatives for its development. 61. The BMI can also provide funding through trust structures for a national credit guarantee fund. Currently the guarantee system in El Salvador consists of three different small government-backed credit guarantee funds and one mutual guarantee firm (Sociedad de Garantía Recíproca). They are targeted at specific productive sector's or firm's categories (SMEs). Consolidation of the main existing funds and scaling up the mutual guarantee scheme should be one of the next steps of the authorities in order to achieve efficiency in SMEs programs. The BMI could invest in a trust that consolidates this public guarantee funds. 62. To make the guarantee funds effective, in addition to scale their size, several operational features need to be improved. The existing public credit guarantee funds (CGFs) are under the administration of BMI while the operational management is in charge of private commercial banks. BMI should add to its fiduciary role the tasks of administration the fund in order to change the present situation where bank are reluctant to apply not to disclose information about their customer to other market participants. The guarantee pricing mechanism could be improved taking into account expected loses, operational expenses, and funding costs or opportunity cost of investing resources. Currently the existing CGFs are funded solely through specific yearly budget appropriations of the ministry of finance. However, funds are not effectively placed in the fiduciary's account and instead there are monthly budget transfers to the fund's administration, to cover bank user's requests. If the amount of these transfers is not enough to cover the requirements, an additional special demand has to be done to the ministry of 24 finance which could result in an administrative payments delay until new additional cash is injected. Going forward, funds should be effectively transferred in the fiduciary accounts with a liquidity provisions to cover claims in timely manner. The funds´ design should be flexible taking into consideration the economic sector on which they will be working on and targeted on SMEs building up on successful experiences elsewhere. VII. FINANCIAL SECTOR INFRASTRUCTURE A. Payment, Remittances, and Securities Settlement Systems 63. Gaps in the legal and regulatory framework for payment systems should be addressed promptly. The Central Bank Law should be amended to fully implement the Treaty on the Payment and Securities Settlement Systems for Central America and the Dominican Republic. The amendment, already drafted, would provide the BCR with the adequate powers to regulate fees and sanctions in the payments system. However, while the Treaty introduces a specific legal framework exclusively in the payments systems area, the BCR would still need to develop a new regulatory framework for payment services. 64. A law or regulation on remittances services should also be considered. Remittances are disbursed mainly through banks or other entities supervised by SSF. However, unregulated entities, such as money transfer operator agents, microfinance institutions and cooperatives, handle a non-trivial amount of remittances. Given the lack of oversight of these unregulated entities, some consumers are without any protection in case of defaults, problems or misconduct. For the same reason, in El Salvador some operators may be non-compliant with AML/CFT requirements 65. The BCR should also strengthen its oversight function on the national payment systems. The BCR should define more clearly, possibly through regulation, its powers to collect data and information from the participants of the system and to adequately oversee the payment systems, particularly at the retail level. Currently, information is provided by the private sector on a voluntary basis, without the possibility for the BCR to neither apply specific methodologies nor request periodic updates. 66. If the banks decided to transfer part of their reserves out of the country, the question arises as whether there would be a domestic payments system in the country. Banks might find it more convenient to settle their inter-bank payments abroad in an offshore settlement bank or execute transfers via Fedwire in the U.S in cases of systemic distress. In addition to this, the recent implementation of the Real Time Gross Settlement system (RTGS) system brings to light the risk that, in such an environment, there might be difficulties in the implementation of the system due to the impossibility for the BCR to award collateralized intra- day credit on a continuous basis. Thus, within the limits established by the current legislation the BCR should consider creating services that both provide incentives for reserve balances not to be moved out of the country and at the same time allow a smooth and efficient functioning of a RTGS system. Such services might include an array of tools both to ease high quality cash management by the Treasurers of financial institutions and perhaps some form of intra-day liquidity for the RTGS system, for example via a specially designed intra-day Repo facility to be 25 conducted on a regular basis. Modifying which reserve tranches can be maintained abroad should also be considered. To ensure control over the payment systems banks should maintain the first tranche of the reserve at the BCR while part of the last tranche, used only in exceptional cases, could be maintained abroad. 67. The recent launch of the RTGS system has been a substantial improvement, although the system is exposed to both financial and operational risks. The RTGS system improved the integration between the BCR and the banks and other financial institutions, allowing for a growing share of large-value payments to be channeled through safer payments mechanism. However, the system is vulnerable to financial and operational risks. Financial risks arise from the legal limitations on the BCR to provide systemic liquidity. Lack of a contingency site to guarantee complete business continuity exposes the system to operational risks. As the system started being operative only recently, there are not yet specific evidences to evaluate its performance. Access to the system is clearly defined but transparency and accountability of the RTGS system management could be enhanced to improve its governance. 68. The BCR should encourage and foster the use of the recently implemented RTGS system and reinforce it's interlink ages with securities settlement and government payment systems. The former would progressively eliminate the use of cheques for systematically important payments while the latter would ensure proper delivery versus payment (DvP) and meet international standards and best practices. CEDEVAL, BCR and the SV should also fully complete the process of dematerialization of all securities and avoid future emissions of any security in physical form. Authorities should consider the creation of a centralized system for government payments fully connected with the national payments system and the settlement government payments in an efficient and secure manner. B. Credit Information Systems 69. Credit reporting systems have improved in recent years, although information is still limited and fragmented. There are three private credit bureaus and a public credit registry managed by the SSF. The latter covers only one month of credit history and the data are collected only from supervised financial institutions. Some of the information collected by the SSF is not available to private credit bureaus, and each of those has different information set. The Banking Law should be amended to allow for the free circulation of credit information among all the credit bureaus, as well as regionally. Currently, banks can access information gathered from the credit bureaus from all the sources (including credit cooperatives, NGOs, leasing companies, etc.) while non-banks cannot have access information from banks. Nonbanks should have reciprocity in order to equalize the playing field. 70. An adequate legal framework for credit information systems is needed. The Banking Law should be amended to Currently the SSF manages a public credit bureau under the provisions of the Banking Law and Law of Cooperative Banks, but there are no specific laws regulating private credit bureaus. Provisions on private credit bureaus should address (i) for the role and responsibilities of the oversight authority (SSF) with respect to the credit reporting industry, (ii) licensing by, or registration with, the SSF, (iii) minimum capital and operational 26 requirements (i.e., security and data protection), (iv) governance and risk management policies, and (v) enforcement (sanctions) regime. Specific aspects that should be analyzed, among the others include the minimum amounts beyond which a default must be recorded, the number of years after which negative information ceases to be publicly available, judicial mechanisms for consumer protection and compensation in case of misuse of the costumers' data. 27 Table 1. Financial System Structure 2004 ­ 2009 28 Table 2. Financial Soundness Indicators 2005 2006 2007 2008 2009 Feb. 2010 Capital adequacy Regulatory capital to risk-weighted assets* 13.5 13.8 13.8 15.1 16.5 16.8 Regulatory Tier I capital to risk-weighted assets* 10.4 10.6 10.9 12.1 13.6 13.7 Capital to total assets 7.4 7.7 7.8 8.5 9.3 9.2 Leverage ratio 2/ 7.1 7.4 7.4 8.1 8.9 8.9 Asset composition Sectoral distribution of loans to total loans* Households 43.0 44.0 47.0 50.0 52.0 53.0 Agricultural sector 3.9 3.7 3.7 4.0 3.8 3.6 Mining sector 0.0 0.0 0.3 0.3 0.3 0.3 Electricity, water, services, oil and gas sector 1.3 1.1 1.4 1.7 1.5 1.5 Construction sector 7.7 6.2 5.7 5.5 5.4 5.6 Transportation and communications sector 1.4 1.9 1.9 2.0 2.5 2.6 Non-residents 6.0 5.2 5.5 4.4 3.7 3.9 Geographical distribution of loans to total loans Domestic 94.9 95.1 95.8 95.6 96.7 96.7 Foreign 5.1 4.9 4.2 4.4 3.3 3.3 Central America 3/ 4.7 4.4 3.9 3.5 3.0 2.9 United States 0.3 0.5 0.3 0.3 0.3 0.3 Asset quality NPL to gross total loans* 4/ 2.0 1.9 2.1 2.8 3.7 3.9 Specific provisions to gross total loans 2.5 2.3 2.5 3.2 4.2 4.4 NPLs net of provisions to capital* -3.4 -2.1 -2.9 -1.8 -2.7 -2.6 Loans at risk to total loans 5/ 4.5 4.2 5.2 6.7 10.0 ... Earnings and profitability ROAA* (annualized) 1.4 1.8 1.5 1.2 0.4 0.8 ROAE* (annualized) 12.9 16.6 13.4 10.7 3.4 5.9 Net interest income to gross income* 77.2 81.3 79.8 76.3 76.8 78.2 Noninterest expenses to gross income* 50.3 48.6 47.0 48.7 51.3 48.7 Personnel expenses to noninterest expenses 52.1 54.4 53.4 52.0 50.6 51.2 Spread between reference loan and deposit rates 301.0 275.0 328.0 420.0 477.0 501.0 (bps) Liquidity Liquid assets ratio 6/ 33.5 32.3 34.0 35.8 41.3 41.8 Customer deposits to total (non-interbank) loans 97.2 94.2 100.1 95.6 105.1 105.0 Source: BCR, SSF and staff calculations. * Included in the "core and encouraged set" of FSIs. 1/ Includes public commercial banks 2/ Tier 1 capital to total on- and off-balance sheet assets. 3/ Excluding Belize and Panama. 4/ Loans past-due more than 90 days. 5/ Including restructured and refinanced loans. 6/ Liquid reserves plus liquid asset to deposits and other bank liabilities. 29 Table 3. Institutions Providing SME and Microfinance: Main Indicators 30 Appendix 1. Implementation of the 2004 FSAP Recommendations I. Main Recommendations 2004 Recommendation Current Status A. Role of the Central Bank Capitalize central bank paper and government Partially Implemented: The Treasury issued long-term deposits at the BCR bonds for US$704 million to securitize a government liability with the BCR, but there is still an outstanding issue of bank resolution trust fund (FOSAFI) debt, arising from the purchase of failed bank assets from the late 1990s, that the government by law should honor. Build up international reserves Not Implemented: Excess ("free") reserves (i.e., net international reserves minus Monetary Base): Dec. 2004: US$303 million. Feb 2010: US$251 million Assess the personnel deployment and functions of Partially implemented: Assessed for national accounts, the BCR statistics and balance of payments tasks. B. Strengthening bank regulation and supervision Provide legal protection for Superintendent and Not Implemented: Legal framework is unchanged. The SSF staff draft law includes provisions on legal protection for bank resolution, but is not adequate. Establish the tenure and terms for removal of the Not Implemented: legal framework is unchanged. Superintendent of the SSF Adopt enforcement policy, graduating sanctions Not Implemented: legal framework is unchanged. according to gravity of breaches Specify division of powers between Not Implemented: legal framework is unchanged. Superintendent and SSF Board Provide powers to suspend distribution of Not Implemented: legal framework is unchanged. dividends Improve loan classification Implemented: new regulation effective as of 2007. Bring provisioning rules more in line with Implemented: new regulation effective as of 2007. international good practice Reduce participation threshold from 50 to Not implemented: Legal framework is unchanged. 20 percent to require consolidation of accounts Follow up on MoUs with other regional Implemented: use of regional committee and MOUs supervisors to share information on conglomerates observed in practice. Provide powers to inspect the books of non- Not implemented: Legal framework is unchanged. financial related parties Increase reserves of the deposit insurance fund to Not implemented*: IGD funds as percent of: 5 percent of insured deposits -insured deposits are 4.2 percent; and -total deposits are 1.1 percent. *Status should be compared to total deposit, consistent with paragraph 44 of 2004 FSAP. Adopt contingency plans to coordinate official Partially Implemented: BCR, SSF and IGD coordinate action among BCR, IGD, and SSF on weak bank with respect to sharing information on stress tests and resolution early warning indicators, but better coordination is hampered by the lack of regulation, procedures and manuals, as well as training. Limit rights of investors to assets owned by off- Not implemented: No further action undertaken. balance sheet vehicles Require regular and transparent reporting of Implemented: According to Art 68 of the Banking Law, information on bank trusts banks must report to the SSF. However, these are no longer a major issue. 31 2004 Recommendation Current Status Prevent regulatory arbitrage through the repo Not implemented: No further action undertaken, but not market a major issue, as repo market is very limited. C. Strengthening microfinance Limit public action to providing an appropriate Partially Implemented: Ley de Bancos Cooperativos and regulatory framework Sociedades de Ahorro y Crédito enacted. Some direct public action in microfinance remains via government funds (e.g., FOSOFAMILIA). Adjust capital requirements to systemic risk Partially Implemented: the above law establishes factors minimum capital requirements for different categories of microfinance institutions. No requirements exist for unregulated microfinance institutions. Regulate comprehensively the purchasing and Partially Implemented: Regulations exist that have financing of loan portfolios facilitated bond issuances by microfinance providers. Incorporate an explicit insurance component in Not Implemented: As the domestic presence of BMI second-floor lending international banks increased, BMI lost its role as a second floor liquidity provider as BMI's cost of funds is higher than the foreign-owned banks. D. Enhancing the insolvency and creditor rights system Draft and enact unified insolvency law and Partially Implemented: The law was drafted but it was liquidation proceedings not enacted. The discussions on the Insolvency Law were on hold for some time, but re-started under the current government. However, there is no concrete time frame for voting on the law. Reform procedural legislation for efficient Not Implemented: There is an on-going debate on laws enforcement proceedings and reforms that would contribute to efficient enforcement proceedings (Ley de Garantías, Ley de Insolvencia). Complete reform of real estate registry system Partially Implemented: The Central Nacional de Registros (CNR) (with support from the WB) completed the first reform phase, creating a centralized electronic registration of all properties in 6 departments. The CNR is currently starting to implement the second phase of the reform. This phase is expected to complete the registration of all properties in the remaining 8 departments. Create and implement a single registry for Implemented: The CNR manages collateral registries for securities on movable assets both movable and immovable assets. Build institutional capacity and modernize Not Implemented: Despite the significant administrative commercial courts reforms on the justice system, commercial courts still face the same constrains. Lack of adequate institutional capacity prevents efficiency gains, particularly in an environment of increasing demand for commercial courts (disputes increased from 60 per months in 2009 to more than 110 per month in 2010). Create an enabling environment for voluntary Partially Implemented: A Consejo de Mediación y out-of-court workouts Arbitraje was created in Cámara de Comercio e Industria. However, the number of out-of court workouts is still small. II Additional Recommendations E. Improving the supervisory framework Assess expertise, background, training, and Partially Implemented: Periodic compensation and skills compensation of SSF staff assessments are done. Carry out an in-depth review of current and Partially Implemented: The SSF makes use of annual expected operational work load of SSF inspection plans 32 2004 Recommendation Current Status Train examiners to assess credit, fiduciary, and Implemented: SSF staff is sent to specialized training operational risks Adopt procedures to review and evaluate the Not Implemented: No new regulation, nor special business of financial conglomerates procedures established for financial conglomerates Combine qualitative with quantitative analysis to Partially Implemented: Greater use of qualitative better assess risk and motivate prompt corrective judgment is required. action Organize dedicated teams of examiners for Not Implemented. conglomerates F. Strengthening risk management by financial institutions Regulate non-dollar foreign exchange risk and Not Implemented: no new regulation issued on foreign interest rate risk (BCP 12) exchange and interest rate risks Provide guidance on systems to identify, Not Implemented: no new regulation issued specifying measure, monitor, and control risks (BCP 13) corporate governance Fully implement Article 63 of the banking law on Not Implemented: no new regulation issued governance, risk management and controls, and provide best practice standards G. Developing early warning systems and conducting stress tests Conduct regular stress tests on bank asset quality Partially Implemented. The safety net providers (BCR, and liquidity SSF and IGD) have each made laudable progress in analyzing banking risks, and an interagency risk committee has been established. Even so, the current stress test methodology is not fully in line with best practices, and activities are not well coordinated across the safety net providers. The newly formed committee should therefore focus on unifying and upgrading the approach with a view to conducting stress tests regularly. Collect and analyze data on size and Partially Implemented: Data on size, concentration and concentration of deposits and on maturity ladders of maturity of deposits are still not available. assets and liabilities H. Developing the money market and strengthening the payments system 1/ Introduce an RTGS system Implemented: BCR started operating an RTGS system in February 2010 Strengthen unwinding procedures N/A: The implementation of the RTGS system avoids the need for unwinding procedures Implement full dematerialization of securities in Partially Implemented: Most securities have been CEDEVAL dematerialized, but the majority of the securities of bank conglomerates are still in physical form. Establish a "National Payments Council" Not Implemented: Not established. I. Insurance supervision and state-owned banks 1/ Strengthen supervision of insurance companies Partially Implemented: SSF launched a new and reduce duplication of efforts qualification system (CARAMEL) to assess solvency, assets and liabilities, reinsurance, profitability and admin costs of insurance companies. On-site visits with risk personnel and coordinated visits for conglomerates are under way. The SSF is still developing risk-based mechanisms to move beyond accounting rules. Restructure and privatize state-owned banks Partially Implemented: none of the state-owned banks have been privatized or divested. On the other hand, they have been restructured and cost-to-income ratios have declined.