79196 This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted. FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE EL SALVADOR PUBLIC BANKS TECHNICAL NOTE NOVEMBER 2010 THE WORLD BANK INTERNATIONAL MONETARY FUND FINANCIAL AND PRIVATE SECTOR DEVELOPMENT MONETARY AND CAPITAL MARKETS VICE PRESIDENCY DEPARTMENT LATIN AMERICA AND THE CARIBBEAN REGION VICE PRESIDENCY ii Contents Abbreviations and Acronyms iii Executive Summary 1 I. Role of Public Banks 2 II. Development Banks in Latin America 4 A. Banco Nacional do Desenvolvimento Económico e Social 4 B. Nacional Financiera Mexicana 6 III. El Salvador’s Public Banks 8 IV. Credit Guarantee Schemes in El Salvador 13 V. Conclusions and Recommendations 14 References 19 Tables 1. Banking Sector Total Assets 10 2. Public Banks’ Financial Indicators 12 Figures 1. Recent Lending and Portfolio Dynamics for Salvadoran Banks 9 iii Abbreviations and Acronyms AFP Pension Fund Administrator BFA Banco de Fomento Agrario BH Banco Hipotecario BMI Banco Multisectorial de Inversiones BNDES Banco Nacional do Desenvolvimento Económico e Social CAR Capital Adequacy Ratio CGF Credit Guarantee Fund DB Development Bank GDP Gross Domestic Product IADB Inter American Development Bank IMF International Monetary Fund MGA Mutual Guarantee Association NAFIN Nacional Financiera Mexicana NPL Non-Performing Loan PB Public bank ROA Return on Assets ROE Return on Equity Executive Summary1 The global financial crisis and ensuing credit crunch has revived the discussion on the role of public sector in the financial system around the world and in El Salvador, authorities have announced plans to step up their activities. 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 the Salvadoran banking system. The Salvadoran 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. The authorities are also considering the creation of a national credit guarantee fund. 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 Executive should define development objectives and the aspirations on the public banking sector. The authorities should develop the strategy and role of public banks (PBs) 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. Beyond the clarification of the overall strategy, the Executive should create coordination mechanisms among the three public banks. Any process of growth needs to accompany by improvement in risk management processes, governance arrangements and enhanced supervision. In order to preserve PBs’ financial conditions, any step up in activities should be progressive and banks need to improve their risk management processes. Credit origination in particular should be professionalized and standardized and collection processes enhanced. PBs needs to adopt business plan and a system of social and financial performance measures. PBs should formulate business plans and adopt 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, hold PBs boards accountable which should in turn hold managers accountable for results. 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. 1 This note was prepared by Hugo L. Secondini (consultant) Eva Gutierrez and Eduardo Urdapilleta (LCSPF). Patricia Caraballo (LCSPF) provided invaluable research support. 2 Going forward, the two public retail banks should increase their specialization in different market segments. The development bank role can be enhanced while maintaining its second tier status. Banco de Fomento Agrario (BFA) strategy should be limited to low value loans for the agricultural sector with an emphasis on microcredit. Banco Hipotecario (BH) should be the bank more focused on SMEs and specialized in funding larger agricultural products, exploiting its better risk management skills. Second tier development banks in other countries (NAFIN in Mexico for example) have expanded their activities by operating with non-bank credit institutions and through guarantee programs, including guarantees for private sector securities. Transforming the Banco Multisectorial de Inversiones (BMI) into a first tier institution would not only require a legal amendment, but also substantial revamping and upgrading of the current 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. To make the guarantee funds effective, in addition to scale their size, several operational features need to be improved. In El Salvador there are three small different government-backed credit guarantee funds (CGFs) and a mutual guarantee association (MGA), but overall coverage provided by funds is rather limited. To enhance program effectiveness the design of the programs should be specific for the market failure the program aims to address. In addition, several operational features of the schemes could be improved including fund administration, pricing, and credit analysis processes. I. ROLE OF PUBLIC BANKS 1. Public banks (PBs) and Development banks (DBs) have been important players in the Latin American financial systems and in many emerging economies, but the 1990s saw a wave of reforms and privatizations. PBs and DBs was a centerpiece of the basic banking development since the 1800s2. Their importance probably reached its highest point in the 1950s and 1960s as instruments of industrial policy and governments’ development programs. In the 1990s there was a wave of privatizations and liquidations, and restrictions were placed on the resources available to PBs reflecting concerns regarding their performance and the justification for their existence given the development of a vibrant private financial sector. Following this wave of reforms, many remaining PBs refocused their activities on areas that the private sector was not serving. 2. The global financial crisis and ensuing credit contraction have 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 2 DBs are a particular type of PBs. Typically, DBs offer long-term capital finance to projects that are deemed to generate positive externalities and hence would be underfinanced by private creditors. DBs also typically finance specific sectors such as agriculture or housing. Rather than taking deposits from the public, DBs typically funds themselves through securities issuance and credits from multilaterals. However, some DBs that has as objective to promote financial inclusion, do take deposits and function in a similar way to PBs. 3 global credit contradiction, as increased risk aversion and tighter liquidity conditions prompted banks to retrench credit, frustrating expansionary monetary policy3. Legal constraints on the activities that many Latin American Central Banks can undertake (placed in many cases in response to hyperinflationary histories and aimed at proving credibility to monetary policy), prevent central banks to intervene directly in financial markets with outright purchases of assets to support monetary policy (as for example the US Federal Reserve has done). Thus, in many Latin American countries such countercyclical interventions have been undertaken in some countries by public banks4. The public development banks members of the Latin-American Financial Development Institutions Association (ALIDE) increased their total assets by 30 percent.5 3. While market failures provide a justification for the existence of PBs, state intervention in the banking sector present risks as well. There is vast literature regarding the role of PBs, particularly in developing economies and their relevance to foster economic growth. The main role relates to mitigation of market failures, promotion of financial development and access to the banking services to some specific sectors of the economy, which are not covered by commercial banks. However, the merely existence of market failures is not enough to justify the existence of PBs as other interventions could address the market failures directly in a less costly, more timely manner. For example, reforms aimed at improve credit history availability and the ability to pledge collateral could be a more effective public intervention to facilitate access to credit than direct credit provision through PBs. Direct lending by PBs could create distortions that inhibit private sector development. Thus it is important to ensure a leveled-playing field between public and private institutions as well as clear accounting of any subsidy component to effectively assess the costs of the policy implemented. In addition poor governance, and sometimes outright corruption, has in many cases prompted dismal financial performance and resulted in PBs insolvency and important quasi-fiscal losses. Given those risks, empirical evidence fails to find evidence that the presence of state-owned banks promotes economic growth or financial development. However, Levy et al. (2004), find that the evidence that state-owned banks lead to lower growth and financial development was not as strong as previously thought. 4. The most effective public banks are characterized by high corporate governance standards and are subject to strong prudential regulation and supervision. While successful public bank stories do not abound, some institutions have proved effective in achieving their objectives while preserving their financial position. The effectiveness of their support has been identified to depend on a range of factors, including a well-defined and sustainable mandate, adoption of best practices in corporate governance. 3 Levy et al.(2004) argued that private banks have limited incentives to lend during periods of economic downturns and low interest rates and do not internalize the fact that, by increasing lending, they would push the economy out of recession. If this is the case, state intervention could solve a coordination problem and make monetary policy more effective. 4 For example, NAFIN (Nacional Financiera Mexicana) launched a program to provide guarantees to commercial paper issuances in the face of severe market disruptions prompted by the bankruptcy of a large corporate due to losses in speculative foreign exchange derivatives. 5 See ALIDE, November 2009. 4 In addition, strong prudential regulation and supervision, and in some cases reliance on market discipline to provide the right signals to the main stakeholders6. II. DEVELOPMENT BANKS IN LATIN AMERICA 5. Different types of DBs coexist in Latin America, including first-tier and second-tier institutions, providing valuable lessons for the design of DBs in El Salvador. First-tier institutions grant credit directly to non-financial sector agents while second-tier institutions channel their resources through other financial intermediaries. At the beginning of 2009, there were 66 first-tier development institutions within ALIDE, 23 second-tier institutions and 12 mixed institutions (i.e. operating both in first and second tier. However, the average size of the second tier institutions was much larger than that of the first-tier ones (US$ 10, 334 million versus US$ 5,702 million). Banco Nacional do Desenvolvimento Económico e Social (BNDES) and Nacional Financiera Mexicana (NAFIN) provide interesting examples of the regional operations of DBs. A. Banco Nacional do Desenvolvimento Económico e Social (BNDES) 6. Brazil has an important PB sector and BNDES is one of the largest development banks in the world. State owned banks have traditionally represented around 40 percent of the Brazilian banking system7. BNDES was established in 1952 under Law 1.628 as a government agency with the mission to promote long-term projects that would support economic and social development. The agency was founded at a time when the import substitution model was being consolidated in Brazil. In 1971, BNDES became a state-owned enterprise with its own share capital. Since then, BNDES has been growing at a fast pace with a total credit portfolio of BRL 283.7 Billion (around US$160 Billion) as of December 2009, making it one of the largest development institutions in the world and the key arm of Brazilian industrial policy. 7. BNDES is the key player in long term financing in Brazil, with a multitude of programs and a mix of first and second tier operations. BNDES’ lending strategy aims to promote private investment in Brazil by providing capital for priority industries and impoverished regions at below-market interest rates. The Bank’s strategic plan highlights the following areas for investment: (i) social development; (ii) infrastructure (transportation, energy, and telecommunications); (iii) exports; (iv) modernization of productive sectors; (v) national technology; (vi) SMEs (especially those oriented towards export markets); and (vii) reduction of regional economic imbalances. BNDES Bank provides direct financing for large investment projects amounting to more than BRL 10 million (US$ 5.5 million), smaller investment projects are channeled through financial intermediaries as BNDES’ on lending (second tier). FINAME, a BNDES wholly-owned subsidiary, finances the acquisition of new machinery and equipment through a network of more than 140 financial intermediaries as BNDES on lending. In 2009, this resulted in 57 6 Rudolph (2009). 7 See Urdapilleta et al. (2008). 5 percent of BNDES’ credit disbursements being channeled as indirect (on lending or second tier) and 43 percent as direct lending (first tier). Lastly, BNDESPAR, established in 1982 as a wholly-owned subsidiary, extends equity investments and debt financing (convertible debentures) to Brazilian companies complementing its industrial policy role. 8. BNDE’s direct lending activities focuses on large and well established corporations as opposed to SMEs. In spite of BNDES’ efforts to target SMEs, its portfolio is quite concentrated, and typically focused in large and well established corporations. As of December 2009 BNDES’ 10 largest borrowers accounted for 34.8 percent of volume, comprising almost BRL 100 billion (US$ 57 billion) in lending. The next 50 largest borrowers receive another BRL 96 billion (US$ 55 billion) and accounting for 33.4 percent. Thus in 2009, almost 70 percent of BNDES’ loan disbursements were extended to large companies while micro, SME and lending to individuals represented less than 15 percent in each of these segments. In other words, BNDES clients are mostly large corporations who already have access to capital markets and international financing, but pursue BNDES subsidized loans to get a competitive advantage to compete in international markets. 9. BNDES has access to low cost government funds, most of them arising from the workers fund, and an important part of it by constitutional mandate. Around 86 percent of BNDES’ liabilities are government funds, while the rest are multilateral loans (5 percent) and non-financial liabilities (9 percent). According to the Brazilian Constitution, 40 percent of the Worker Support Fund8 (Fundo de Amparo ao Trabalhador or FAT) has to be directly allocated to BNDES for long-term finance. Funds for the FAT fund, and before for PIS and PASEP, come from a deduction on salaries9. After unemployment claims are paid out, the remaining FAT funds are distributed among public banks. As a measure to reduce the impact of the global financial crisis, the Treasury of Brazil injected funds to BNDES to raise its lending capacity for companies affected by crisis. In 2009, 40.2 percent of the funds came from the National Treasury. PIS and PASEP, which preceded FAT until 1990, make up another important funding source, amounting to 9 percent of the funding base in 2009. BNDES pays FAT, PIS and PASEP the administratively defined TJLP (Taxa de Juros de Longo Prazo) which in 2009 was on average 6.0 percent, which is below the SELIC rate (8.75 percent in 2009), the rate at which the Brazilian Government funds itself. In summary, by the Constitution, the Brazilian Government is taxing workers to subsidize corporations by giving them a below market interest rate through BNDES loans. 8 The Worker Support Fund or FAT for its initials in Portuguese is an insurance scheme administered by the Treasury which covers for unemployment, accidents and other workers liabilities. The issue with this fund is that it is obliged to invest in BNDES and other Government sponsored activities at the administratively defined TJLP rate of 6 percent, whereas similar funds such as mutual funds and complementary pension schemes existing in the Brazilian market obtained returns between 10 and 15 percent in 2009. 9 PIS (Social Integration Program) and PASEP (Program for the Formation of the Public Sector Employee Capital) are two government managed funds created in 1974 for private sector and public sector employees respectively. They ceased to receive contributions in 1990 when they were replaced by FAT (Workers Support Fund). Still, 40 percent of the resources accumulated in the funds are given to BNDES according to the Brazilian Constitution of 1988. 6 10. Low funding costs and portfolio concentration on second tier activities and blue chip companies facilitate BNDES strong financial performance. BNDES’ net interest margin (NIM), defined as the difference between interest income and interest expense divided by average interest-earning assets, has remained on average around 2.6 percent over the past four years. As a result, as of December 2009, BNDES enjoys returns on assets (2.0 percent) and on capital (25.2 percent) above the average of the system. This is a consequence of lower credit and operational expenses than most banks in Brazil. Good asset quality (non-performing loans of 0.2 percent) is a consequence of the fact that a large portion of its lending is done through intermediaries who bear the risk, and the rest of the lending is to established corporations. This fact also allows BNDES to enjoy the benefits of a lean structure since it does not need a branch network for the delivery. Intermediary banks offer BNDES loans as part of their overall relationship with their corporate clients, and make spreads high enough to cover for credit risks and additional operating expenses. 11. BNDES has professional risk management and high corporate management standards. BNDES credit activity is under responsibility of several units working separately and the final approval for each operation is under responsibility of the Board of Executive Officers. There is a set of internal rules determining credit limits and eligibility criteria for the participant financial intermediaries. The bank has a well developed rating system of its own for evaluation of companies applying for credit and also BNDES has been managing its risk following Central Bank regulations since 1997, and has been under Central Bank’s supervision since then. Corporate management standards and risk control process of BNDES compares well with those of the large Brazilian banks. B. Nacional Financiera Mexicana (NAFIN) 12. In the last decade, Mexico rationalized public participation in the banking system and focused on complementing private sector activities and improving PBs efficiency. Starting with more than a dozen of banks and funds with problems of efficiency and losses, the situation improved substantially after a process of merger and even the closing of some poor performing institutions. Currently only six public development institutions and a fund operate in Mexico. Public intervention on financial markets focused on specific economic sectors through second tier activities, leaving the previous direct lending functions. Legal provisions were introduced mandating DBs to preserve their capital, and new policies regarding corporate governance, transparency and accountability were established. 13. NAFIN has increasingly focused his activities on improving SME access to finance. NAFIN objectives, listed on its creation law, include promoting the overall development and modernization of the industrial sector; stimulating the development of financial markets; and acting as financial agent of the Federal Government in the negotiation, contracting and management of credits from abroad. The liberalization of the country’s banking system in the early 1990s created concerns that new banks would only benefit the largest companies and, despite its static mandate, with the authorities support and the institution’s strong management, NAFIN emerged as an alternative for SME finance. NAFIN’s management identified the asymmetric information and transaction cost access problems that characterize the SME sector to justify and define its core activities. 7 Nowadays, NAFIN is considered a main engine of development for Mexico’s SMEs. The number of clients in 2008 stood at 1.25 million, with the average amount per operation being 81,000 pesos. 14. NAFIN’s second tier nature has been critical in its evolution, resulting in instrument innovations that are more market oriented and incentive compatible. NAFIN is widely recognized for its successful web-based reverse factoring program that in 2008 accounted for about 80 percent of the second-tier business. The scheme which is called “Cadenas Productivas” (productive chains) provides users with an electronic platform to carry out transactions. The program’s idea is to build up links between buyer firms and their suppliers and draw attention to potential lenders to provide funds at attractive costs. Once a chain supplier sells their product to a buyer, the invoice is placed in the electronic platform and it is opened for bids by the factors. There is a cap regarding the interest to be applied in the transaction and there are no additional fees charged by participants in the scheme. The system helps to ameliorate information problems and the use of an electronic platform reduces transaction costs capturing economies of scale and increasing speed of transactions. NAFIN also provides several partial credit risk guarantees products for SMEs as well as lines of credit for on lending to priority sectors in order to generate employment in areas with the highest possible social impact. 15. NAFIN has increased its second tier activities over time and has played an important countercyclical role during the global financial crisis. Lending to financial institutions accounts for about 55 percent of its loan portfolio, while lending to government related institutions amounts to 40 percent. The latter carries less risk, but the former’s risk has increased alongside NAFIN’s countercyclical role. In October 2008, NAFIN introduced emergency programs aiming to reestablish market liquidity and funding for companies after the global financial crisis hit the Mexican economy (see footnote 4). Beside guaranties to SMEs, the board of directors of NAFIN authorized a new line of credits of US$3 billion to a group of national companies. Total loan portfolio increased by 41 percent in 2008. NAFIN has been increasingly operating with unregulated institutions, which find NAFIN funding rates attractive as they cannot access to cheap insured deposits for funding. The additional risk taken up was countered by the high collateral requirements, an adequate loan loss reserve line and improved technological processes for the administration of credit and market risks. 16. Since NAFIN’s turn around early in the decade, the institution has been posting positive net income and reports healthy capitalization ratios. The current balance sheet and income statement reflects an aggressive loan loss provisioning policy that helped clean the books of NAFIN alongside its efforts for operational restructuring. Since 2000, net interest revenue has been growing consistently and costs have been kept steady, even decreasing in the last few years, with periodic high recoveries and a growing stable SME lending portfolio also contributing to profitability. A legal amendment to the NAFIN charter requires the preservation of the capital of the institution, what is achieved by targeting a non-negative real return on equity. The capital to risk weighted assets ratio has been above the regulatory 10 percent with a considerable margin for the past years, largely benefiting from considerable zero regulatory weight for the loans to government related 8 entities. NAFIN is primarily funded by wholesale term deposits and bond issuances in the local debt market. 17. The corporate governance structure in NAFIN has been strengthened over time, reflecting a move towards greater transparency and accountability. Important corporate governance and structural changes were introduced in 2002, including greater independence of the Board, higher accountability of the Board and the General Manager, improvements in disclosure and new committees on risk management and human resources. The auditing committee and the internal comptroller’s office begun operations in 2007. NAFIN is supervised by the Comisión Nacional Bancaria y de Valores de Mexico. III. EL SALVADOR’S PUBLIC BANKS 18. The public banking sector in El Salvador is small for regional standards . The public banks presence in Latin America is relevant in some countries such as Brazil, Argentina and Chile. As of the beginning of 2009 total assets of the ALIDE public-owned institutions represented 26.5 percent of total assets of Latin America’s banking system (US$ 2,258,500 million according to the IMF Global Financial Stability Report)10. Some neighboring countries also have a strong presence of public banks, including Costa Rica (62.2 percent of banking sector assets), and Dominican Republic (30.7 percent). In contrast, the public banking sector in El Salvador holds less than 10 percent of banking assets, similar to their share in Panama and well below the 26.5 percent average for Latin America. However, public bank presence is negligible in Guatemala and Nicaragua. Since 2004, the stated-owned first tier public banks have had an average participation of 4.4 percent of total assets of the universal and commercial banks. This share reached a maximum of 5.1 percent in 2009 as private commercial banks (all owned by foreign groups) retrenched credit in response to the global financial crisis (Figure 1 and Table 1). 10 ALIDE members include private and mixed capital institutions as well as public institutions. The latter constitute the majority, accounting for 70 percent of the members as well as 70 percent of total member assets. 9 Figure 1. Recent Lending and Portfolio Dynamics for Salvadoran Banks – Global conglomerates most affected by the crisis contracted lending the most, while regional conglomerates and public banks maintained or increased lending. Banco Agricola – mild reduction in Citibank – sharp contraction in credit to credit to firms firms 14 12 12 10 Credit to GDP (%) Credit to GDP (%) 10 8 8 6 Consumo 6 Empresa 4 Vivienda 4 2 2 0 2003 2004 2005 2006 2007 2008 2009 0 2003 2004 2005 2006 2007 2008 2009 Vivenda (Cuscatlan/Citi) Empresa (Cuscatlan/Citi) Empresa (Uno) Consumo (Cuscatlan/Citi) Consumo (Uno) HSBC - sharp contraction in credit to Scotiabank – portfolio relatively stable firms 8.0 9 7.0 8 6.0 Credit to GDP (%) 7 5.0 Credit to GDP (%) 6 4.0 5 Consumo 3.0 4 Empresa 2.0 3 Vivienda 1.0 2 0.0 1 2003 2004 2005 2006 2007 2008 2009 0 Vivienda (Scotiabank) Vivienda (Comercio) Empresa (Scotiabank) Empresa (Comercio) Consumo (Scotiabank) Consumo (Comercio) 2004 2005 2006 2007 2008 2009 Banco America Central – strong Public Banks (BFA+BH) - expansion in expansion in lending credit to firms 4.0 2.0 3.5 1.8 1.6 3.0 Credit to GDP (%) Credit to GDP (%) 1.4 2.5 1.2 Consumo 2.0 Consumo Empresa 1.0 1.5 Empresa Vivienda 0.8 Vivienda 1.0 0.6 0.5 0.4 0.2 0.0 2003 2004 2005 2006 2007 2008 2009 0.0 2003 2004 2005 2006 2007 2008 2009 Source: Financial System Superintendence. Note: red line represents the date of merge or purchase of the institution by the foreign bank. 10 Table 1. Banking Sector Total Assets (in US$ Million) TOTAL ASSETS Universal and Commercial Banks 2004 2005 2006 2007 2008 2009 Private Domestic 10,493.5 10,939.5 11,649.1 12,888.5 13,243.0 12,718.0 State-Owned 445.6 458.4 471.8 544.3 638.4 650.3 Foreign 221.7 222.9 168.2 205.2 177.0 149.7 State-Owned Participation 4.2% 4.2% 4.0% 4.2% 4.8% 5.1% Source: Financial Sector Superintendence. 19. The public banking system consists of two PBs and one DB, focused on market segments that lack adequate access to finance. The sector consists of three institutions: two small first-tier retail institutions with a focus on underserved segments such as micro and SMEs and small rural lending (Banco de Fomento Agropecuario and Banco Hipotecario) and a second-tier bank with a focus on long-term financing (Banco Multisectorial de Inversiones)11. 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 first-tier public banks in the market as providers of financial services to underserved market segments by other financial institutions. 20. Banco de Fomento Agropecuario (BFA) is a small bank that provides funding to a large number of micro farmers and SMEs. BFA´s market share was 1.7 percent of the system at the end of 2009. The BFA was created by law in 1973 as a state owned bank specifically oriented to promote the rural sector. BFA's lending activity is primarily directed towards micro farmers and SMEs, mainly in the agricultural and commercial sectors. BFA’s is highly focused in small size loans. In 2009, 90 percent of the loans in the bank portfolio (about 32,000 loans), were below US$ 5,000. In terms of amount however, these loans represent only 49.5 percent of disbursement. 21. The BFA has functioned at times more as government agency for social and agricultural policy than as a bank, although the bank is now working on improving its credit processes. In the past, BFA’s financial position has been negatively affected by loan forgiveness programs and mandates to direct credit to certain sectors without proper viability analysis. The board of directors is presided by the Minister of Agriculture and draws heavily from public sector entities related to agriculture. This structure may have contributed to the lack of commercial perspective at the BFA. In the past, and in contrast to 11 The Public Financial Sector comprises in addition to the three public banks, the Fondo Social para la Vivienda (FSV), Fondo Nacional de la Vivienda Popular (FONAVIPO) and the Corporacion Salvadoreña de Inversiones (CORSAIN). Both FSV and FONAVIPO provide loans for the purchase of low-income housing. At end of 2009 FSV, by far the larger of the two had a loan portfolio of US$ 800 million. CORSAIN manages two fiduciary funds (FONTRA and FINCORSA) and has important investments in sugar mills, coffee industries and ports. 11 normal bank practices, rejected loan applications (as opposed to approved ones) were reviewed by the credit committee. In recent years, the bank has made substantial efforts to professionalize and standardize credit origination, monitoring and collection processes. 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. Nevertheless, according to interviews, the bank still has an image to borrowers as a soft collector. 22. Financial performance at the BFA has improved following a series of recapitalizations and restructurings. In 2000 a institution owned by the Ministry of Agriculture and Livestock but managed by BFA for the purpose of taking over BFA bad loans and extraordinary assets was established (FIDEAGRO). This process of cleaning up the portfolio of BFA required over US$80 million capital inflows from the Government. In exchange for loan sales, BFA obtained negotiable securities issued by FIDEAGRO. Although in practice there is no secondary market for this paper, these securities are computed as liquid assets which overstate BFA liquidity position. As of December 2009, non-performing loans reached 2.6 percent, increasing in the last two years as a result of the global crisis and economic slowdown. Provisions to NPLs amounted to 91.2 percent. The administrative costs of the bank have been reduced drastically although remain high; non- interest expenses account for 61 percent of total income (down from 75 percent in 2005). BFA also has a lower ROE (1.5 percent) than the average ROE of the cooperatives bank system (6.2 percent). While in 2005 BFA had to pay higher deposit rates than the average rate offered by the system in order to attract deposits given the past poor performance, in 2009 BFA rates are in line with the system average. BFA lending rates are higher than private commercial bank rates as it specializes in micro rural lending and other riskier segments not covered by commercial banks. 23. Banco Hipotecario (BH) is as a state controlled institution with the participation of private shareholders, focused on SME lending. BH was set up by a Presidential Decree in 1934 as a public sector controlled institution with minority shareholdings by the coffee producers association and the livestock association. In 1991 a large reform of the bank’s structure gave it a new role of granting credits with mortgage collateral, normally for the benefit of national agriculture and husbandry, but also to include other credit and banking operations. In 2004, Decree 537 refocused the bank on SME financing. 24. The BH has been traditionally better run that the BFA. The BH has been traditionally less subject to political interference than the BFA, although it also has had to be recapitalized in the past. The BH currently has professional management and as it focused his activities on SMEs has launched a series of new products targeted to the segment. Profitability and efficiency indicators compare favorably with the BFA ones and are in line with those of the rest of the system. The BH has stronger credit process than the BFA and it is the policy of the institution to fully provision NPLs. The bank is adequately capitalized and has liquid assets (although most of those assets are domestic securities that may have limited liquidity particularly at times of systemic distress). External ratings are 12 higher for the BH than for the BFA although both institutions are thought to count with the support of the government if necessary12. Table 2. Public Banks’ Financial Indicators Banco de Fomento Agropecuario 2005 2006 2007 2008 2009 Total Assets (US Million) 162.2 173.3 193.7 212.7 216.7 Market Share (%) 1.5 1.5 1.5 1.6 1.7 Total Credit (US Million) 64.7 79.3 97.1 110.1 116.9 NPL to Total Gross Loans (%) 0.1 1.0 1.3 1.7 2.6 Specific Provisions to NPLs (%) n.d 252.8 148.5 100.0 91.2 ROE (%) 11.9 4.8 5.7 3.5 1.5 ROA (%) 1.4 0.5 0.6 0.4 0.2 Regulatory Capital to Risk-Weighted Assets (%) 19.4 17.9 16.0 17.8 16.4 Liquid Assets to Total Short Term Liabilities (%) 69.0 61.9 57.3 58.9 53.4 Non-interest Expenses to Gross Income (%) 74.5 68.2 62.5 66.4 61.0 Banco Hipotecario 2005 2006 2007 2008 2009 Total Assets (US Million) 272.7 275.5 329.8 401.4 413.0 Market Share (%) 2.5 2.3 2.5 3.0 3.2 Total Credit (US Million) 156.1 172.6 220.5 261.8 278.6 NPL to Total Gross Loans (%) 1.9 2.5 1.9 1.8 2.3 Specific Provisions to NPLs (%) 61.4 68.6 92.7 110.4 116.7 ROE (%) 8.5 4.7 6.9 9.2 3.9 ROA (%) 0.8 0.5 0.7 0.9 0.4 Regulatory Capital to Risk-Weighted Assets (%) 14.0 14.0 12.4 13.5 13.6 Liquid Assets to Total Short Term Liabilities (%) 43.6 35.1 27.0 35.9 36.1 Non-interest Expenses to Gross Income (%) 50.7 50.9 45.9 42.1 39.7 Source: Superintendencia de Entidades Financieras. Banco Multisectorial de Inversiones 2005 2006 2007 2008 2009 Total Assets (US Million) 583.3 612.5 652.3 609.3 599.9 Total Credit (US Million) 205.2 175.9 248.7 294.2 266.8 ROE (%) 3.3 3.3 3.1 2.6 2.4 ROA (%) 1.1 1.1 1.0 0.9 1.0 Regulatory Capital to Risk-Weighted Assets (%) 54.0 58.5 49.3 43.2 47.7 Source: Banco Multisectorial de Inversiones. 12 Fitch ratings for the BH short term and long term institutional deposits stand at F2 and BBB+. Same ratings for BFA stand at F3 and BBB, respectively. 13 25. Banco Multisectorial de Inversiones (BMI) is a second-tier development bank focused on funding medium and long-term investment projects, although BMI funding has lost attractiveness. The BMI is fully owned by the central bank and is the development bank of El Salvador. The BMI has traditionally provided credit lines to other banks in El Salvador to fund longer term investments. With the internationalization of the Salvadoran banking system, appetite for BMI funding has declined substantially. The subsidiaries from the global and regional conglomerates that now operate in El Salvador can access long-term funding in dollars at lower rates that the ones offered by the BMI. In recent years, the BMI has started to operate with cooperative associations and non- regulated institutions for which BMI funding rates are attractive. In addition to its on lending activities, the BMI administers several trust funds. 26. The BMI has capital to substantially expand its lending activities. As of December 2009 assets amounted US$599.9 million, and its loan portfolio accounted for 42 percent of total assets. The BMI has a 47 percent capital adequacy ratio. Given its second- tier nature the bank does not have any NPLs. Moreover, any credit risk is greatly mitigated by the BMIs right to directly debit the reserve accounts that banks have to maintain at the central bank in case its loans were not repaid (the only bank that can do so). As the economy is fully dollarized and the central bank cannot act as a lender of last resort, reserve requirements are substantial in El Salvador. 27. The Salvadoran authorities have announced capital increases for the first-tier PBs and are in the process of formulating a strategy to expand the activities of the BMI. Recently, the government announced an increase of the bank’s capital in order to reach US$ 80 million in new loans to micro and small rural firms. To that end, the BFA has requested a US$ 10 million capital increase. President Funes also 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. The authorities are receiving technical assistance from the BNDES to formulate a strategic plan for BMI with a view to expand its activities. IV. CREDIT GUARANTEE SCHEMES IN EL SALVADOR 28. In El Salvador there are three small different government-backed credit guarantee funds (CGFs) and a mutual guarantee association (MGA), but overall coverage provided by funds is rather limited. Two of the funds (PROGARA, and PROGAIN) focused on the agricultural sector and related industries while the third one provides credit to other SMEs and students). The MGA (Sociedad de Garantías Recíprocas) focuses on micro and SME (up to US$7 mil in sales) lending for all sectors. The association is composed by two different types of members: benefactors (protectors) which grant the funds to build up the association, and common shareholders (participants) which are eligible for transactions. BMI is the principal contributor and plays the role of reinsurance company through a special trust fund established in 2001. Average loan size ranges from US$40,000 to US$60,000. Only PROGAIN covers substantially larger loans, with an average size of US$200,000 (about 40 percent of per capita GDP) which seems high for international standards13. At end-2009, the three funds had outstanding guarantees 13 Saadani et al. (2010). 14 amounting to US$48.5 million, while the MGA had US$ 22 million outstanding. Overall outstanding guarantees amounted to 0.32 percent of GDP, well below the 0.6 percent covered by guarantee funds in Chile and in east-Asian countries. In all, the funds guarantee about 1.2 percent of the total banking sector commercial portfolio. 29. Guarantees are granted following a credit by credit analysis, and all public CGFs are managed by private banks. All guarantee schemes use an individual credit approach, as opposed to a portfolio approach where a guarantee is applied automatically to the bank’s loan portfolio under a predefined criterion. In the portfolio approach, the guarantor does not perform an individual credit appraisal, relying on the credit analysis performed by the financial institution that grants the loan. This speeds up the entire credit process and facilitates scaling up the program coverage. The existing public CGFs are under the administration of BMI while the operational management is in charge of private commercial banks. 30. The schemes have experienced very modest losses and the commissions charged and loan coverage provided are similar to international average values. NPLs ratios for the guaranteed loans by the CGFs and the MGA have not exceeded 1 percent. The fact that only clients with good ratings can qualify for the guarantee and that additional collateral requirements are requested from borrowers contributes to explain the good performance, although questions arise whether the guarantee is really facilitating access to credit to credit constrained firms. Different programs offer different coverage ratios, ranging from 50 percent to 90 percent (the latter in case of student loans). The average size of the guarantee granted by the three public GFFs is about 60 percent of the loan value. Both borrower and lender split the fees charged by the guarantee schemes, ranging from 1.5 percent to 2 percent of the outstanding loan per year. MGA fees are substantially higher, amounting up to 5 percent, and are paid by the borrower. 31. Private commercial banks do not consider the existing schemes particularly attractive given sector orientation of the programs and some operational features. Many of the programs are orientated to the agricultural sector, which is only served by few private commercial banks. BFA, despite its small size, is one of the largest users of PROGARA and PROGAIN guarantees. CGFs guarantees are paid 60 days after the loan defaults and payment has been timely. Existing GGF 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 Finance which could result in an administrative payments delay until new additional cash is injected. Also, GGF users requested to change regulations in bank loan accounting treatment, particularly regarding the possibility of applying claim proceeds directly to the NPLs and avoiding the use of an additional order account. 32. The authorities are considering the creation of a National Guarantee Fund. In order to scale up credit guarantee activities, financial authorities are considering the creation of a National Guarantee Fun. With support from the IADB, a consultant with 15 experience in the Fondo Nacional de Garantías de Colombia, will provide technical assistance on how to construct such fund. V. CONCLUSIONS AND RECOMMENDATIONS 33. There is a role in El Salvador banking system for a relative small an efficient public bank sector focused on complementing and crowding-in private sector activity. In El Salvador, micro rural producers and small firms are segments not well covered by the private sector14. Whereas the expansion of foreign conglomerates is usually associated with gains in efficiency and diversification of risks, the recent financial turmoil has shown that foreign-owned banks could also transmit financial shocks through portfolio adjustments reflecting changes in the parents’ appetite for risk. El Salvador is the only country in Latin America where all commercial banks are owned by foreign banking groups. To improve access to finance, diversify the sources of funding and mitigate current reliance on foreign- owned bank financing, the authorities could (i) promote the sound development of niche institutions and microfinance providers, (ii) give a decisive impulse to capital market development, and (iii) focus a relatively small and efficient public banking sector on complementing private sector activities and crowding-in private participants to avoid distortions. To maintain complementarities with the private sector, public banks need to continuously refocus their activities. 34. The authorities should formulate a clearly defined strategy for the public banks, including coordination mechanisms among PBs. To this end, the Executive should define development objectives and the aspirations on the public banking sector. The authorities should 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. The Executive should also create coordination mechanisms among the three public banks. These mechanisms may include a cabinet led by the President of the BMI, and with the participation of the other two in monthly meetings. Coordination mechanisms should be business oriented and thus should not include regulators. Discussions should include the complementarities of their business strategies, sources of funding, operational processes, and product lines. In a further step the other public financial sector institutions can be part of these coordination mechanisms scheme. 35. 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 14 See Technical Note on Financial Inclusion for a discussion on reforms to enhance overall access to finance. 16 measuring systems that combine both financial and social objectives 15. Any subsidy component in the banks’ operations should be clearly accounted for in order conduct a cost- benefit analysis of the policies implemented and compare the cost of such interventions with other alternatives. 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. 36. Governance arrangements of the public banks should be reconsidered to separate and clarify the responsibilities of the owners, board and the management. The adoption of business plans and a system of financial performance measures would facilitate accountability of the public banks and allow for the a clear separation of roles between the ownership function of the government, the control function of a board of directors, and the management function. The government should concentrate on providing directives to the board regarding policy priorities and delegate the control of the institution to a board largely consisting of independent directors and sector professionals. In this way the government could hold the board accountable, which in turn would hold management accountable for compliance with the business plan (formulated by management and approved by the board) and the achievement of performance targets. 37. Supervision of public banks should be strengthened. 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 not only because an issue of equity but also as a way of early identification of problems. A clear on-site schedule of visits and off site review of their financial information should be defined. 38. BFA needs to continue improving its credit risk process before expanding activities and its strategy should be limited to low value loans for the agricultural sector with an emphasis on microcredit. BFA's should focus on financing micro farmers and the smaller SMEs. To better focus the institution on its target segment and continue improving the performance of the institution, any 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 significantly improve its processes of origination, monitoring and collection of credit. Credit origination in particular should be professionalized and standardized. BFA should not expand its portfolio in any significant way unless credit risk processes and governance are improved. 39. BH should be the bank more focused on SMEs and specialized in funding larger agricultural products, exploiting its better risk management skills. 15 Many banks, including for example the South African Development Bank and the Dutch FMO, have a score-card methodology to monitor performance. The association of Latin American development banks (ALIDE) has developed a performance measurement index for their members to use. 17 Complementing BFA activities, loans to SME on excess of US$ 100,000 dollars should be granted by the BH. 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. 40. Going forward, the two public retail banks should progressively integrate their operations to exploit synergies and further reduced operating costs. Public banks can become more effective serving their clients and more efficient in the use of resources by progressively integrating. This can begin with the back office operation, particularly by using a common technological platform. A second step could involve the combination of the administrative support areas. A further step would involve the merge of closely located branches that could then serve both institutions under common facilities. This type of integrations has helped reduce cost-to-income ratios by 10 points in some other countries. It could also significantly improve client service by using the processes of the best institution. 41. The role of the BMI in fostering development can be enhanced while maintaining its second tier status. As of December 2009, the capital of BMI was US$198 million and the loan portfolio was US$ 267 million. Under current circumstances, the BMI loan portfolio could increase by around US$1,200 million (provided the funding is available). Given banks high liquidity levels and the higher cost of BMI funding, as well as the decline in credit demand for investment purposes, growth in BMI discount operations is unlikely. Second tier development banks in other countries (such as NAFIN in Mexico for example) have expanded their activities by operating with non-bank credit institutions and through guarantee programs, including guarantees for private sector securities. 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 (art. 4 (j)), allowing it to provide funds for development projects in a variety of ways other than direct lending. BMI also could be a source to fund increases in Tier 1 Capital of BH. Increases in Tier 1 can go beyond common equity and take the form of long-term debentures. Transforming the BMI into first tier institution would not only require a legal amendment, but also substantial revamping and upgrading of the current 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. 42. 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, placing interest rate ceilings 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 18 ensure that best practices on risk analysis are been applied in its lending activities to unregulated institutions. 43. 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 the Salvadoran pension funds (AFPs). 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 coordination and benefiting from the expertise of CORSAIN. 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. 44. The BMI could provide funding through trust structures for a national credit guarantee fund with increased focus in SMEs. Credit guarantee schemes provide insurance to lenders against borrowers’ defaults. In the present environment, increased global macroeconomic uncertainty has heightened risk aversion. As banks’ retrenched credit they also built important liquidity buffers. In this context, insurance against credit risk would be a better instrument than additional funding lines to promote credit to SMEs Consolidation of the main existing funds in a scaled-up national guarantee fund scheme should be one of the next steps of the authorities. The BMI could invest in a trust that consolidates this public guarantee funds. 45. To enhance program effectiveness the design of the programs should be specific for the market failure the program aims to address. For instance, if market failure is related to access to the financial market due to special transitory economic circumstances (i.e. downturn of the economic cycle), the programs should have broad qualifying criteria and a sunset clause with an irrevocable date for the end of the program. Programs aimed at fostering first time access to bank credit could include a clause with a progressive decline in coverage or limit the number of years the borrower can receive the guarantee as the individual builds a credit history that can replace the guarantee. To stimulate banks to launch SME specific new products, a portfolio approach in which the bank takes the first loss of the portfolio (e.g. up to 4-5 percent delinquency ratio) and the guarantee fund any additional loss, protects the bank from the tail risk when there is uncertainty about expected losses. NAFIN has implemented with success such type of schemes. 46. In addition, several operational features of the schemes could be improved including fund administration, pricing, and credit analysis processes. The BMI should add to its fiduciary role the tasks of administration of the national guarantee fund the fund in order to change the present situation where banks are reluctant to apply not to disclose information about their customer to other market participants. Going forward, funds should be effectively transferred in the fiduciary accounts administer by the BMI to cover expected 19 losses of the guarantee fund in order to provide assurances that claims would be covered in timely manner. The guarantee pricing mechanism could also be improved by taking into account expected loses (given accumulated experience), operational expenses, and funding costs or opportunity cost of investing resources. Finally, adoption of portfolio approaches to reduce processing costs should be considered particularly as the BMI takes the on administrator role. References ALIDE (2007). Indice ALIDE. Metodología de Evaluación de Desempeño para Instituciones Financieras de Desarrollo. ALIDE (2009), Evolución y Perspectivas de la Banca de Desarrollo en Latinoamérica. Beck, Klapper, Mendoza (2008) “The typology of Partial Credit Guarantee Funds around the World”, Policy Research Working Paper Series 4721, The World Bank. de la Torre, Gozzi, and Schmukler, (2007). "Innovative experiences in access to finance : market friendly roles for the visible hand ?," Policy Research Working Paper Series 4326, The World Bank. Honohan P., (2010),"Partial credit guarantees: Principles and practice," Journal of Financial Stability, Elsevier, vol. 6(1), pages 1-9, April. Levy, Micco, Panizza (2004), “ Should the Government be in the Banking Business? The Role of the State-owned and Development Banks? “ IADB Working Paper N, 517. Rudolph (2009) State Financial Institutions, Crisis Response Note 12, World Bank. Urdapilleta, Stephanou, Revilla and Rodriguez (2008), “An Overview of Directed Lending in Brazil”, The World Bank. REGAR (2008), Los Sistemas de Garantías en Iberoamérica. Scott (2007), “Strengthening the Governance and Performance of State-Owned Financial Institutions’,. Policy Research Working Paper Series 4321, The World Bank. Saadani, Arvai and Rocha (2010). Assessing Credit Guarantee Schemes in the Middle East and North Africa Region, World Bank, mimeo.