Report No. 20199-UR Uruguay Financial Sector Review November 15, 2000 Finance, Private Sector and Infrastructure Sector Unit Argentina, Chile and Uruguay Country Management Unit Latin America and the Caribbean Region Document of the World Bank CURRENCY EQUIVALENTS Currency Unit = Uruguayan Peso US$1.00 = Ur$11.4 (11/15/2000) Fiscal Year July 1 to June 30 ABBREVIATIONS AND ACRONYMS ADR American Depositary Receipt AFAP Pension Fund Administrator BCU Central Bank of Uruguay BEVSA Electronic Stock Exchange (Bolsa Electr6nica de Valores) BHU Mortgage Bank of Uruguay (Banco Hipotecario del Uruguay) BPS Social Security Administration (Banco de Prevision Social) BROU State Bank of Uruguay (Banco de la Republica Oriental del Uruguay) BSE State Insurance Agency (Banco de Seguros del Estado) BVM Stock Exchange of Montevideo (Bolsa de Valores de Montevideo) CDs Certificates of Deposit CND National Development Corporation (Corporaci6n Nacional de Desarrollo) EFI External Financial Intermediary GDP Gross Domestic Product IAS International Accounting Standards IPO Initial Public Offering LIBOR the London Interbank Offered Rate MERCOSUR Common Market of the Southern Cone MVOTMA Housing Ministry OTC Over the counter PAYG Pay-as you-go Pension System ROA Return on assets ROE Return on equity S&Ls Savings and Loans Cooperatives SIIF Superintendency of Financial Institutions SML Securities Market Law SMV Superintendency of Securities SSR Superintendency of Insurance and Reinsurance UR Unidad Reajustable (Wage adjusted pesos) VAT Value Added Tax Vice President David de Ferranti Country Director Myrna Alexander Sector Director Danny Leipziger Sector Manager Fernando Montes-Negret Task Manager Mariluz Cort6s Introduction This report on Uruguay's financial sector started as a diagnostic background for the preparation of the Financial Sector Adjustment Loan to Uruguay. The wealth of information collected in preparing this loan, convinced us that it would be useful to present it as a self standing piece of financial sector work. Some of the policy recommendations presented in this report have been already implemented or are in the process of being implemented by the Uruguayan authorities. Other recommendations will be discussed with the new Uruguayan authorities that took office in March 2000. Several people have collaborated in the preparation of this report, under the coordination of Mariluz Cortes (task manager). In the section on the banking sector, the main authors were Mariluz Cortes (LCSFP), Robert Cull (DECRG), and Mario Guadamillas (LCSFP). This section has benefited from the contributions of Walter Zunic (LCSFP), Felipe Morris and Adolfo Diaz Solsona (consultants), and comments and suggestions from Augusto de la Torre (LCSFP), Paul Levy, Myrna Alexander (LCC7C) and Juan Ortiz (LCSFP). The sections on capital markets and contractual savings were put together by Mario Guadamillas, based on the findings and policy recommendations made by Patrick Conroy and Alberto Musalem (CMD), after a mission to review Uruguay's capital markets at the end of 1998. These sections have also benefited from the contribution of Adolfo Diaz Solsona and comments from Anjali Kumar (LCSFP), Thomas Glaessner (FSP), and Bob Mathias Traa (IMF). URUGUAY FINANCIAL SECTOR REVIEW TABLE OF CONTENTS Page No. EXECUTIVE SUMMARYY .................................1 BACKGROUND ................................... 11 I. THE BANKING SECTOR ................................. 13 GENERAL OVERVIEW .................................. . 13 BANKING INSTITUTIONS AND THEIR ACTIVITIES ............... ................... 15 PUBLIC AND INTERVENED BANKS ............. .................... 16 STRUCTURE OF THE BANKING SYSTEM ............. ..................... 21 BEHAVIOR OF THE SYSTEM ................................. . 24 COMPETITIVENESS OF URUGUAYAN BANKS ............. .. ................... 26 BANKING REGULATIONS AND SUPERVISION ............... ................... 31 LEGAL FRAMEWORK ................................. . 32 CONCLUSIONS AND RECOMMENDATIONS .. ................................ 35 II. CAPITAL MARKETS ................................. 39 GENERAL OVERVIEW ................................. . 39 THE STOCK EXCHANGES AND THEIR ACTIVITIES ............... ................... 40 LEGAL AND REGULATORY FRAMEWORK ............. .. ................... 44 SECURITIES CLEARANCE AND SETTLEMENT ............... .................. 45 CONCLUSIONS AND RECOMMENDATIONS .. ............................... 45 III. CONTRACTUJAL SAVINGS SECTOR .................................. 49 PENSION FUNDS .................................. . 49 AFAP's OPERATING IN THE SYSTEM ................................. 50 INVESTMENT REGULATIONS ................................. 52 INVESTMENT OPPORTUNITIES .................................. 53 EFFICIENCY INCENTIVES ................................. 53 CONCLUSIONS AND RECOMMENDATIONS ................................. 55 INVESTMENT FUNDS .................................. . 58 REGULATORY FRAMEWORK ................................. 59 CONCLUSIONS AND RECOMMENDATIONS .................................. 60 INSURANCE COMPANIES .. ................................ 61 REGULATORY FRAMEWORK ................................. 62 CONCLUSIONS AND RECOMMENDATIONS ................................. 63 Annex I .................................. 66 Annex II ................................... 76 EXECUTIVE SUMMARY 1. Relative to many Latin American countries, Uruguay has a well-developed banking sector. Financial and insurance services contributed to about 10.2% in 1999, up from 7.6% in 1995, most of it by the banking sector. The degree of monetization measured as M3/GDP was 40.9% in 1999 (40.8% in 1998). In both these measures, Uruguay scores higher than its two neighbors Brazil and Argentina. The relative development of the banking sector in Uruguay reflects the growth of off-shore banking, stimulated by the region's bouts of macroeconomic instability and Uruguay's strict banking secrecy law. By contrast, Uruguay has an underdeveloped capital market, which has a market capitalization of less than 1% of GDP', compared to an average of almost 10% in emerging markets. Operations in the stock exchanges in 1999 amounted to about 10.8% of GDP2, compared to 12.4% in 1998. The minimal development of the capital markets appears to be related to the fact that potential issuing companies are either family owned, and reluctant to cede--even partially--effective control, or government enterprises. Similarly, the contractual savings sector, including pension funds, mutual funds and insurance companies is very incipient. Pension funds accumulated by the pension funds administrators amounted to about 3.8% of GDP in 1999, up from 1.3% in 1998, and the amount of mutual funds managed amounted to 1.1% of GDP in 1999, down from 1.8% in 1998. The direct insurance premium in 1998 (latest information available) amounted to 1.7% of GDP, down from 3.1% in 1997. 2. Uruguay is a small open economy and this has important implications for its financial sector strategy. For countries such as Uruguay, the domestic economy may not be large enough to sustain some elements of a domestic financial sector, particularly now that there is increasing border trade in financial services via electronic banking and electronic securities trading. The altematives for Uruguay are either to import everything or to become very competitive in some banking services and become exporters of these services. The evidence of this report suggests that the comparative advantage of Uruguayan banks is gradually eroding. However, if Uruguayan banks made an effort to become more competitive, Uruguay could remain an exporter of some banking services. But, the small size of the Uruguayan economy may not justify having an stock exchange (let alone two). Since the tendency in Latin America and in other regions is to concentrate capital market transactions in a few large exchanges, the Uruguayan authorities should consider exploring with its MERCOSUR partners the setting up of a regional stock exchange (this has been suggested by both Argentina and Brazil recently). Such a regional market may better reward efforts to improve liquidity than the revival of the local exchanges. 3. All the financial sub-sectors in Uruguay share three common characteristics: (i) there is a preponderant role of the state and unequal treatment between public and private entities; (ii) they suffer from weak regulation and supervision; and (iii) they have a limited developmental impact in the country. In addition, the banking sector, which is the most developed in relative terms, is losing competitiveness with respect to other banking sectors in the region. If Negotiable Bonds on issue are added, the share raises to 3% of GDP. 2 However, many of this operations do not reflect trading (secondary market), but primary market issues or banking system operations. See section on securities markets for details. I Preponderant role of the state 4. The Uruguayan state has a preponderant role in all aspects of the financial sector, a situation that acts as a constraint to private sector development in these areas. The two largest banks in Uruguay are public banks: Banco de la Repiblica Oriental del Uruguay (BROU) and Banco Hipotecario del Uruguay (BHU). There are two commercial banks under state administration: Banco de Credito and Banco Caja Obrera. There are 19 private banks, all of which, except one, are foreign owned. Public banks, not counting the intervened banks, account for about 40% of total assets, 35% of the system's deposits; provide 45% of the loans to the non financial sector, account for about two thirds of the system's total capital, and for more than half of all bank employees. To some extent, public and private banks operate in different markets. BROU specializes in loans to agriculture and BHU in housing loans, while private banks concentrate in off-shore banking, consumer loans and external trade. 5. The preponderance of state owned banks poses potential fiscal implications. Although BHU and BROU have distributed dividends to the Government, these banks may be distributing cash on an accrual basis, stripping the banks. If the non-performing loans of these banks were properly written off, their net worth would probably be much less than it appears in the books. The intervened banks are in more fragile financial conditions. There is an urgent need to estimate the contingent liabilities of the public and intervened banks for the Uruguayan Treasury. These contingent liabilities could become a potential problem down the road, if the macro-fiscal situation of Uruguay deteriorates as a result of external shocks. 6. There is a similar situation in the contractual savings sector. Out of six established pension fund administrators (AFAPS), the government owned AFAP Republica clearly dominates, with 38% of affiliates and 56% of total administered assets. Similarly, the government owned Banco de Seguros del Estado (BSE), dominates in the insurance sector, in spite of the liberalization process that started in 1993. At the end of 1998, BSE had 78% of the total assets of the insurance sector and its equity was a 56% of the total equity of the sector. 7. Trading in government debt securities also dominates in the capital markets. Until 1992, securities traded in Uruguay's capital markets were almost exclusively public debt securities denominated in foreign currencies. The private securities market started to be active in 1996, when private companies started issuing bonds (negotiable obligations). 8. Public entities in the financial sector tend to receive preferential treatment in a number of areas, which gives them an advantage vis a vis private entities operating in the same markets. Public banks have the advantage of a deposit insurance that they receive from the Government, which is explicitly mentioned in their statutes. Although the deposit insurance is implicitly extended to the rest of the banking system, the public trusts more the public banks. This allows the public banks to receive deposits at lower cost than the rest of the private banking system. BROU has other privileges such as being exempt from paying VAT on interest collected on consumer loans to certain groups (public workers and pensioners), which enables it to provide consumer loans at lower interest rates than private banks. In addition, BROU has a monopoly on the Central 2 Government accounts, and the Central Government judicial and administrative deposits made by private entities in guarantee of contracts with the public sector. These are all sources of low cost deposits for BROU. In addition to similar privileges, BHU enjoys an extra-judicial regime for the liquidation of debts and, until recently, a monopoly in issuing asset backed securities. Another important advantage enjoyed by public banks is that prudential regulations are not enforced with the same rigor as with private banks. 9. In the area of pension funds, one reason for the prevalence of AFAP Repiublica is that it is the only AFAP in which a minimum return on the administered funds is explicitly guaranteed by the Government. Similarly, the BSE has the monopoly of insurance contracts involving public entities, government purchases and insurance for working accidents. It also enjoys preferential tax treatment (while the premium tax is 15% on fire and 10% on car, BSE pays 10% on the first and is exempt from the latter). On the other hand, these public entities are required to carry out activities on behalf of the Government, which are not always properly reimbursed. For example, BROU acts as trade tax collector and BSE is required to offer medical services in case of workers' accidents. Weak regulation and supervision 10. The Central Bank of Uruguay (BCU), acts as the regulatory and supervisory agency for the banking, capital markets, and contractual savings sectors. The BCU has made an important effort to strengthen banking regulations which are, in general, adequate, although there is still some ways to go to reach full application of Basle norms for capital requirement and for interest and market risks. Capital market regulations have also been strengthened. However, the absence of uniform accounting standards and proper disclosure detracts from capital market credibility and integrity. There is also very limited risk management capability among the regulators, the banks, institutional investors and the exchanges. BCU's regulations in the area of pension funds are limited to the issuing of norms to enforce the investment regulations of the Pension Law, which are very restrictive, with established investment limits on different categories of investments. Insurance regulation, including the Insurance Law, does not correspond to the modem needs for insurance, particularly in view of the insurance requirements of the capitalized pension system. 11. Supervision in all these areas is hampered by lack of independence of the supervisory units within the BCU, and lack of human resources, aggravated by the current freeze in public sector hiring limits. The supervision of banks and other financial intermediaries is carried out though the Superintendency of Financial Intermediation Institutions (SIIF), which has technical independence but is hierarchically under BCU's Board. The SIIF is limited in its efforts to supervise and inspect the public banks because all its staff is fully occupied supervising the private banks. To extend the same supervisory effort to the public banks would require doubling the number of in-situ supervisors. The SIIF is also limited in its capacity to supervise the public banks because of uncertainty about its legal capacity to impose sanctions on these banks in cases of non compliance with BCU's norms. This uncertainty is caused by the fact that the Boards of Directors of the public banks have the same hierarchy under the Constitution as the Board 3 of Directors of the BCU. This means that, in principle, a BCU director cannot apply sanctions to a director of any of the other public banks. 12. The regulatory authority for capital markets and investment funds is the Superintendency of Securities (SMV), which is a department within the BCU. The authority of the SMV and the resources available to it in terms of experienced professional staff are extremely limited. Although Uruguay has adopted a self-regulatory model, the self-regulatory capacity of both exchanges is also very limited. In the area of pension funds, supervision is performed by a division within the BCU, which implies that it does not report directly to the Board of Directors but through the President. Because of inadequate resources, supervision of pension funds is limited to compliance with investment regulations. There is no supervision from the time that contributions are deducted by employers until the time they are credited to the individual accounts. The Superintendent of Insurance and Reinsurance is also a department within the BCU. As in the case of the public banks, the Superintendent has limited power to enforce regulations and apply significant sanctions to the BSE. Limited developmental impact 13. The financial sector in Uruguay has a rather limited development impact in the country. The activities of the banking sector, which is the most developed, are limited to traditional banking operations based, almost exclusively, on financial intermnediation and external trade. There is little involvement in cash management, securities underwriting, derivatives, securitization of assets, leasing and the like; or in risk control instruments such as futures, options, forwards, and foreign exchange insurance. Banks invest a significant share of their assets in public securities and loans to the financial sector in detriment of loans to the private sector. Lending to the non financial sector (about 50% of assets in 1998) is directed mostly to the largest local firms and multinationals. Lending to small and medium enterprises is limited and subject to liquid guarantees. The reluctance of the Uruguayan private banks to lend to local firms is, to some extent, the result of the perception among banks that Uruguay's legal and judicial systems are biased against creditors. This perception was strengthened by the forced refinancing of bank loans in the late 80s and early 90s. Even if there is no bias against creditors, the judicial system proceeds very slowly, which tends to have negative consequences for creditors. Another reason for lack of involvement of private banks in lending to local firms may be the large presence of public banks in these markets. 14. Similarly, the concentration of transactions in government debt and bank certificates of deposit shows that the securities markets in Uruguay is of little or no relevance as a source of direct financing for private sector investment. This means that, at this stage, securities markets play a little or no developmental role. Institutional investors are also not yet relevant as a source of finance for private sector investment. Accumulated funds transferred to the AFAPs are being invested monthly in low-yielding government securities (59.6%) and bank certificates of deposit (28%). This is partly the result of overly restrictive investment regulations, which, among other things, forbids investment of pension funds in foreign securities. Investment of pension funds in private securities began in 1998, when rating agencies started operating in Uruguay, but it is still a little over 5% of total investments. Half of the funds administered by mutual funds are 4 invested in local public securities, and less than 20% in local private securities, mostly in bank term deposits. Loss of competitiveness in the banking sector 15. The evidence in this report suggests that the comparative advantage of Uruguay's banks in the region is gradually eroding. The Uruguayan banks may be suffering from problems both of supply and demand. Loss of competitiveness in the region due to inefficiencies of local (particularly public) banks may be coupled with falling demand for banking services from abroad, due to greater stability in neighboring countries. Some inefficiency in the sector is due to structural problems. For example, market segmentation, especially the dominance of the non-financial credit market by public banks, is troubling. In addition, the intervened banks cannot contribute to improved productivity of the banking sector until their portfolios are cleaned, past losses are transparently absorbed and, subsequently, they are sold or liquidated. More generally, the data on operating overheads indicate that Uruguay is a relatively high-cost banking environment. Increasing costs per employee are, no doubt, partially attributable to technological improvements. At the same time, however, these cost increases have not coincided with substantial productivity gains. For exarnple, the ratio of overhead costs per asset - a measure of the cost associated with intermediation - has declined slightly since 1994 in Uruguay. Over the same period in Argentina, that ratio has declined dramatically, and Argentina appears poised to overtake Uruguay on this measure. 16. High labor costs are an important factor in the low rates of return of the Uruguayan banks. Labor costs in Uruguay represent a high percentage of total operating costs (80% compared with about 64% in Brazil and 50% in Argentina). High labor costs and the difficulty to reduce staff, because of the trade union's strong bargaining power, have led to a reluctance on the part of the banks to hire new employees and has displaced other investment expenditure possibilities, particularly in technology. Future efficiency gains, and the introduction of new banking products and technology, may be limited by the serious deficit of skills in the banking sector, resulting from low investment in training activities. 17. Uruguayan banks face an increasingly competitive international market for financial services. The strengthening of the banking sectors in neighboring countries and the growth of on-line banking will contribute to a deterioration of the competitiveness of Uruguayan banks in the years ahead, unless urgent reform actions are undertaken. Some combination of technological improvement, employee training and increased labor market flexibility appears necessary to achieve substantial productivity gains. In addition, efforts should be made to develop the political consensus necessary to achieve needed structural changes, including a reduction of the role of the state in the banking sector and an improved legal and regulatory framework. However, improving competitiveness may not be sufficient if there is a net fall in external demand for banking services in Uruguay. 5 POLICY RECOMMENDATIONS 18. In establishing priorities and the sequencing of a financial sector reform agenda, it is clear that if actions are not taken to reform the banking sector, other reforns in the capital markets and contractual savings sectors will not be as effective as they could be. Reducing the role of the state in the financial sector. 19. The preponderant role of the public entities in the financial sector, and their preferential treatment, reduces competitiveness and the possibility of greater private sector involvement in some areas, and poses a fiscal risk for the Treasury. However, it should be recognized that public banks remain the main sources of finance for agriculture and middle income housing and that they enjoy high popular prestige in Uruguay. Reducing the role of the state in the financial sector will, therefore, require a process of discussion and consensus building among stakeholders to define new boundaries between public and private activities, and a phased approach for its implementation. 20. Privatization of the intervened banks. An important step in reducing the role of the state in the banking sector would be to re-privatize or close the two commercial banks, currently under govermnent management. Financial advisors should analyze the resolution alternatives for these banks, in particular the options of financial support versus liquidation. They should assess these banks' real value, through an evaluation of the quality of their portfolios and of the real value of their investments and fixed assets, and advise on whether it would be less costly to the Government to sell these banks as going concerns, after capitalizing and restructuring their balance sheets; or to close them, paying off their depositors and inter bank liabilities 21. Privatization or liquidation of the intervened banks could be prevented by the absence of a market exit mechanism for insolvent banks. A key problem is lack of a legal framework to recognize and absorb the losses (i.e., recognize the current insolvency) transparently, perhaps even through explicit bond issues. Without adequate legal rights, government officials would be reluctant to sell these banks at below their book value, or to liquidate them, in fear of being accused of corruption. The focus should be on creating the political consensus to recognize that the resolution of the intervened banks will generate losses to the Government (and in the case of Banco de Credito to the private shareholder), and on developing a solid legal basis to absorb these losses in a transparent way. The resolution of the intervened banks will have to take into account the reluctance of the banking labor union to any job losses resulting from the sale or liquidation of these banks. 22. The adoption of an orderly market exit mechanism for troubled banks would allow the Government to play a more indirect role in banking crisis resolution. As part of this strategy, the authorities should consider the adoption of a limited deposit insurance scheme. While the prevalence of solid foreign banks in Uruguay reduces the possibility that the Government will again have to bail out the private banks and guarantee the depositors, even foreign bank are not immune from insolvency. A limited deposit insurance scheme, funded by the banks themselves, would reduce the need for Government involvement in case of crisis and reduce the possibility of moral hazard 6 23. Leveling the playing field between public and private banks. Remaining inequalities in the treatment of public and private banks should be eliminated, including applying the same tax treatment for transactions carried out by both types of banks. Another important step would be to complete the restructuring of the public banks and discontinue the practice of using public banks to carry out non-baking activities on behalf of the Government. At the very least, these activities should be separated from their banking activities. The capacity of the BCU to supervise public banks and enforce compliance (including imposing penalties) should be strengthened. This may require modifications to the Charter of the BCU. 24. Restructuring and privatization of public banks. BROU has initiated an institutional transformation process aimed at improving its effectiveness and productivity. There is still much to be done, however, especially on the financial side of the bank. BHU should initiate an institutional transformation similar to the one being implemented by BROU. As part of the restructuring process, the activities of the public banks could be refocused on the mobilization of long term resources as second-tier institutions, to facilitate term lending through private banks. In the longer run, however, the Uruguayan authorities should consider privatizing the public banks. This could be done in steps, by incrementally selling shares of BROU and BHU to the private sector. Being subject to the scrutiny of private investors would improve the incentives for greater efficiency and reduce the pressure to use the banks to fulfill political mandates. Privatization of these banks would also stimulate the development of the local capital markets. A study of the contingent liabilities for the Government from the publicly owned and intervened banks is likely to provide a compelling argument in favor of privatization. 25. Leveling the playing field between public and private entities in the contractual savings sector. An important measure to improve competition among pension fund administrators would be to eliminate the Government guarantee of the minimum profitability of the funds administered by the Repuiblica AFAP. It would also be advisable to convert this AFAP into a corporation to launch shares in the market. In line with this recommendation, the Republica AFAP has recently announced its intention to sell part of its equity to the private sector. The BSE should have the same tax treatment as private insurance companies, and not be required to carry out government activities, unless it is compensated financially. The BSE should also be allowed to establish premiums on worker compensation coverage free of political influence. In addition, measures should be taken to enforce the timely submission of information by BSE to the regulatory authorities. In line with these recommendations, the draft Budget Law for 2001 proposes the elimination of some of the special advantages of the BSE, including its monopoly on the insurance of public entities, and the elimination of preferential tax treatment. Finally, the authorities should evaluate the possibility of transforrning BSE into a corporation, allowing it to place part of its shares in the market and to change governance accordingly. Improving efficiency and competitiveness in the financial sector 26. Improving efficiency in the banking sector. High labor costs and the difficulty to reduce bank staff are important factors in the low rates of return of the Uruguayan banks. There is a need for a dialogue between the Government authorities and the labor unions 7 on the effect of labor relations on the competitiveness of Uruguayan banks. A formula could be found to increase labor flexibility to allow the banks to implement labor and training policies that would make them more efficient. The new labor relations could include providing incentives for early retirement to open job opportunities to younger workers with more flexible working conditions; and implementing the same legal level of severance payment to bank redundancies, that applies to all the other sectors in Uruguay. 27. Improving efficiency of the capital markets. Uruguay's capital market is extremely small. One possible way to develop the capital markets in Uruguay would be to partially float financially attractive state-owned enterprises. The issuing of securities by public enterprises in the local market would provide alternative investment instruments to pension fund administrators and help develop an equity market culture. 28. However, even if more securities could be issued through partial privatization of state enterprises, the size of the Uruguayan market may still be too small to support a stock exchange, let alone two. While a decision is made about setting up a regional stock exchange, some measures could be taken to reduce the problem of small market size. The options are to merge the two exchanges or to allow the two exchanges to operate in separate markets, which trade different instruments. An alternative approach would be to keep both exchanges, but to have a common price discovery mechanism through electronic trading (like the combined tickets for exchanges in the USA), which would allow cross-listing to continue, while getting rid of the price arbitrage problem. However, new listings may not create a liquid or deeper market if there is no increase in trading. Strengthening the legal and regulatory framework 29. Two needed reforms that cut across several sectors are the adoption of International Accounting Standard Standards and the replacement of wage by price indexation. Passage of a bill of law, now in Congress, that would make mandatory the application of IAS to all enterprises, including banks, should be a priority. Replacement of wage by price indexation would reduce the problem of risk mismatch in mortgage lending, in disability insurance and annuities payments. 30. Strengthening banking regulation. Although banking regulation is in general adequate, there is a need to implement full application of Basle norms for capital requirement and for interest and market risks. There is also a need to improve transparency of information. This would require to reconsider the strict interpretation of the banking secrecy rules and restrict them to deposit transactions and not to lending activities. In the capital markets, it would be important to improve both disclosure at issue by issuers and of transactions by insiders/controlling interests, as well as ongoing disclosure. 31. Improvement in contract enforcement and creditor rights. To encourage the willingness of banks to lend to Uruguayan firms, specially small and medium ones, requires strengthening the ability of the judicial system to enforce contracts between lenders and borrowers. There is a need to strengthen foreclosure procedures and enhance the provision of credit through the creation of alternative collateral mechanisms (such as 8 movable collateral) and the strengthening of property and commercial registries. Also, the new bankruptcy law that is under discussion in Congress should be approved, as soon as possible, to provide banks with a more efficient legal process for repossessing collateral from borrowers who default on their loans, and to establish time limits for the judges to settle bankruptcy proceedings. 32. Strengthening capital markets regulation. The regulatory framework for capital markets needs to be strengthened in several areas. It is necessary to standardize valuation processes using internationally accepted methodology and adopt IAS. The abundance of securities in physical form (such as bearer bonds) renders the clearance and settlement system inefficient and poses unnecessary risk exposure. It would be advisable to develop an appropriate registration and immobilization practice (this refers to keeping the paper in some central depository). It would also be useful to gradually develop scripless issues (i.e. dematerialize), to limit the use of physical certificates. Although the use of physical instruments cannot be eliminated, it can be dramatically reduced. Also, given the deficiencies associated with asset valuations, accounting standards and disclosures (as well as the prevalence of potentially unprofitable government owned banks), risk exposures may be significant. Risk management capabilities by the regulators, the banks, institutional investors, issuers and the exchanges needs to be developed. 33. Strengthening pension funds regulation. The regulatory framework in the area of pension funds needs to be modernized. Some proposed measures include: * Increasing portability. It would be advisable to merge the five social security systems into the national scheme to allow full portability, and to cover the self- employed under the national system. * Improving property rights of insured It is advisable to draft legislation vesting compulsory contributions when the insured reach the retirement age, and to treat voluntary contributions as open-ended mutual funds. This would solve the problem of vesting and liquidity and encourage savings mobilization. * Improving risk management. Currently, the system allows for one fund per AFAP and one account per insured, which constraints attaining optimal portfolios and a more efficient investment frontier. It would be convenient to reform the regulation to allow for more than one fund per AFAP, and to allow the insured to choose the composition of their portfolio from these funds. Two or more accounts per insured could be allowed in either the same or different AFAP. Given the limited investment options for pension funds in Uruguay, these funds should be able to invest abroad and in closed ended mutual funds and derivatives with proper risk weights. This would increase the returns and improve diversification of their portfolios. It would also be convenient to enact regulations establishing a maximum exposure to a single issuer and to limit the exposure on related parties. * Improving efficiency of funds management. The authorities should study the possibility of changing the commission structure from one based on the current salary base of the affiliate, to one based on the assets managed. This change would result in: (i) increased return on assets in the early years of contribution of the affiliates; (ii) 9 increased cost efficiency efforts by the AFAPs; and (iii) a deterrent against the AFAPs departing from the Uruguayan market once the growing size of the assets managed and the up-front loading of commissions result in commission rates that are considered too low for them. 34. Strengthening regulation of capital markets and investment funds: It is necessary to standardize valuation processes using internationally accepted methodology and adopt IAS. Mutual fund assets should be routinely marked-to-market to reflect an accurate value, reducing the use of "maximum prudence" criteria. Also, to ensure the quality of investments, credit ratings should be required. 35. Strengthening regulation of the insurance sector: The current Insurance Law needs to be modernized and new regulations adopted to introduce compulsory car insurance, end the discrimination against savings in life insurance, as opposed to purchasing a mutual fund, and ensure freedom of choice of insurance agent. The introduction of adequate consumer protection legislation is also recommended. Strengthening Supervision 36. There is an urgent need to strengthen the capacity of all the supervisory departments in BCU by enabling them to hire more professional staff and to implement training programs. They should also be able to have revenues from fees and fines. In the longer run, however, the authorities should consider the possibility of separating these activities from the BCU. One option, given the need to maximize scarce human resources, could be the establishment of one regulatory and supervisory agency, with representatives of the BCU and the Ministry of Economy and Finance in its Board. 10 BACKGROUND 1. Uruguay is a middle upper-income country, with social indicators among the best in Latin America. Its per capita GNP, at over US$6,000, is above that of other Latin American countries such as Brazil, Chile, Colombia and Mexico. Its highly urbanized population, of approximately 3.3 million, has the highest adult literacy rate in the region, and the lowest percentage of households below the poverty line. 2. Uruguay has been undergoing slow, although steady reform since the 1970s, when it took the first steps to reduce the role of the state in the economy and liberalize the trade regime. At that time, the Government reduced import quotas, price controls and price subsidies. In 1974, the Government liberalized international financial transactions, allowed residents to hold foreign assets and eliminated exchange controls, making the peso a fully convertible currency. The liberalization of the economy resulted in rapid growth rates during the second half of the 1 970s, accompanied by an expansion of bank lending. However, double digit inflation and the Government's policy of pre-announcing the exchange rate for a period of six months, led to a severe overvaluation of the peso and a growing debt overhang. A loss of confidence on the sustainability of the exchange rate regime and a number of external shocks, including the oil crisis of 1979, led to mounting capital flight. In November 1982, the Government allowed the peso to float, triggering a 140% devaluation in a period of five months. The devaluation increased the peso value of the dollar denominated loans and the level of non-performing loans in the banking system soared, resulting in the failure of a number of local banks. 3. The Government responded to the crisis by making the Central Bank of Uruguay buy the non-performing loan portfolios of the banks and by enacting laws obliging the banks to refinance the debts in pesos at lower interest rates. The crisis of the early 1980s, triggered a deep transformation in bank ownership. Through the second half of the 1 980s and the first years of the 1990s, almost every private bank was converted into a subsidiary (or branch) of an important international bank. Attempts to strengthen regulation and supervision coincided with these ownership changes, which eventually resulted in a restoration of confidence in the banking system. Sorting out the lines of causation is, of course, difficult but the relative stability of the Uruguayan banking system in the 1990s would seem to owe at least as much to foreign ownership as to improved local regulation and supervision. 4. Open financial markets, strict banking secrecy laws (which protect the identities of liability holders), and the region's bo-ts of macroeconomic instability, allowed Uruguay to become a regional financial center, attracting capital inflows mostly from Argentina and Brazil. As a result, Uruguay's banking system has become increasingly dollarized. Currently, over 80% of the deposits in the banking sector are in US dollars, and more than half of them belong to non-residents. Over 60% of the loans are also in US dollars. 5. During the 1990-1999 period, real GDP grew at 3.6%, compared with population growth of only 0.6%. During this period, there were some fluctuations such as a mild recession in 1995 (growth rate of -1.8%), due to the Mexican crisis, but growth recovered afterwards, reaching rates of 5.3% in 1996; 5.1% in 1997 and 4.5% in 1998. 11 Inflation went down from 44.1% in 1994 to 8.6% in 1998. Uruguay's domestic and external financing environment tightened substantially after the Russian debt crisis in August 1998. The authorities responded to this external shock by strengthening the financial sector through additional prudential measures, including increased capital adequacy requirements for the banking system, and tighter loan qualification regulations and increased risk weighting applied to consumer lending. The economic slowdown started in the first quarter of 1999, when GDP growth turned negative (-1.0%), as the external environment became less favorable to Uruguay with increasing oil prices and lower prices for agricultural conmnodities. The slowdown continued during 1999, due to: loss of competitiveness of Uruguayan products in Brazil, following the January 1999 depreciation of the Brazilian real; the slowdown of economic activity in Argentina; and higher oil prices and interest rates. By year-end 1999, GDP had contracted by about 3.4% with respect to the previous year. Despite the negative effect of the economic slowdown on public finances, the Government remained committed to its medium term strategy of cautious fiscal and monetary policies. As a result, the public sector deficit went down in 1997 and 1998 to 1.4% and 0.9% respectively (although it increased to 4% in 1999). The rate of inflation, as measured by the CPI, also went down in 1999 to 4.2% (from 8.6% in 1998), due, in part, to the economic slowdown. 6. Structural reformns continued in Uruguay during the 1990s. Main reforms include the reform of the social security system, the educational system, the role of the state, and of the non-financial state enterprises. However, legislative reform attempting to allow the privatization of some government enterprises was rejected through a plebiscite. Reforms in Uruguay tend to proceed at a slow pace, reflecting an aging, conservative society and a consensus style of policy making through essentially coalition governments. However, once reforms are agreed upon, there is little chance that they will be overturn by succeeding administrations. Nevertheless, the changes that are occurring in Uruguay's neighboring countries and the challenges of globalization make it imperative for Uruguay to accelerate the pace of reform. One of the most important areas in need of further reform is the financial sector, where less efficient publicly owned institutions still occupy a predominant role. Greater macroeconomic stability in its neighboring countries and the surge of electronic banking are eroding Uruguay's comparative advantages as a center for off-shore banking in the region. The future role of Uruguay as a sub-regional financial center will depend increasingly on the efficiency and competitiveness of Uruguay's financial institutions and on the strength of its legal and regulatory framework. Uruguay also faces the challenge of developing its capital market, which has remained very underdeveloped compared to the banking sector. 12 I. THE BANKING SECTOR GENERAL OVERVIEW 1.1 Relative to many Latin American countries, Uruguay has a well-developed banking sector. In 1999, the banking sector contributed to about 9.3% of GDP (Figure 1), and the degree of monetization, measured as M3/GDP, was 40.9%. On both of these measures, Uruguay scores higher than its two neighbors, Brazil and Argentina. However, in absolute terms Uruguay's financial sector is small, generating value added on the order of only US$2 billion per year. 1.2 Table 1 provides additional indicators that permit a more detailed comparison of the Uruguayan banking system with those of other countries in the region. In terms of financial sector liabilities (as measured by the ratio of liquid liabilities3 to GDP), Uruguay ranks just behind Bolivia and Chile, and ahead of Argentina, Brazil, Colombia, Ecuador, Paraguay and Peru. 4 Indeed, when financial development is measured as the ratio of deposit bank assets to GDP or of private sector credit to GDP, Uruguay fares somewhat worse in international comparisons than on the liabilities measure. Although Uruguay ranks third among the countries listed in Table 1 in private sector credit and fourth in deposit bank assets, its ratios (27.4% for private credit, 31.3% for bank assets) are well below those for regional leaders such as Chile and Bolivia (45-55%).5 By contrast, Uruguay's liquid liability ratio (liquid liabilities/GDP) was 38.7% compared to 44.4% for Brazil and 42.0% for Chile. 1.3 Although these ratios provide a useful summary of the current state of financial development, they provide little information on trends over time. After years of severe financial disintermediation, due largely to price instability, some of Uruguay's neighbors have experienced relatively rapid recent financial development. In particular Argentina, which at the start of the decade had low financial ratios by international standards (i.e., relative to its level of per capita income), has enjoyed substantial financial deepening throughout the 1990s. Continued financial development by its neighbors could erode any comparative advantage enjoyed by Uruguay in the provision of financial services. 3 Liquid liabilities include cash plus public securities. 4 A host of factors influence these ratios. For example, the exchange rate regime plays an important role. Uruguay's is an adjustable band exchange rate regime. The Central Bank of Uruguay (BCU) authorizes the entities that can freely operate in the exchange market and monitors them. Foreign transactions are cleared and settled in US dollars. There are no capital controls and banks can open accounts in pesos or dollars with residents and non-residents. The figures in Table I should be seen as statistics that summarize financial sector outcomes owing to these (and other) factors across countries. 5 The data in Table 1.1 come from: A New Data Base on Financial Development and Structure, Thorsten Beck, Asli Demirguc-Kunt, and Ross Levine, World Bank, March 1999. Those authors rely on a number of primary sources in assembling their dataset. For the liquid liabilities, deposit bank assets, and private credit ratios, figures are drawn from IFS statistics. Using different sources, other authors have drawn similar comparisons between Uruguay and its neighbors. See, e.g., Jorge Caumont: Modernizaci6n y Desarrollo del Sistema Financiero Uruguayo, working paper, December 1997. 13 TABLE 1.1. COMPARISON OF BANKING SYSTEMS INDICATORS IN THE REGION Country Liquid Liabilities/GDP Deposit Bank Assets/GDP Credit to Private Sector /GDP Argentina 21.7 24.2 18.0 Bolivia 44.4 49.7 45.9 Brazil 28.0 39.0 25.0 Chile 42.0 55.1 54.1 Colombia 35.6 21.8 19.3 Ecuador 32.5 27.9 26.3 Paraguay 29.6 21.9 21.5 Peru 22.8 20.4 19.1 Uruguay 38.7 31.3 27.4 Source: "A New Database on Financial Development and Structure, " Thorsten Beck Ash Demirguc-Kunt, and Ross Levine, World Bank March 1999. Data for all countries are from 1997, except for Colombia and Paraguay, whose data are from 1996. Figure 1.1. Financial Sector added value (%GDP, current value) 14 12 _ 14 ___ __ ___ -_ 412 __ __ __ _____ ______ 2 - ___ _ 2 _ - - _l l I0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Source: Statistical Information Management and Analysis System (SIMA), World Bank 1.4 A potential sign of the underdevelopment of the Uruguayan banking system is the narrow range of financial services that it provides. Core financial activities are traditional banking operations, based almost exclusively on financial intermediation and external trade. Banks' involvement in other activities like money market accounts, securities, options, futures, and swaps remain inconsequential. Moreover, even with respect to certain core banking activities, the Uruguayan system appears to be slow to develop. For example, consumer banking is only recently beginning to take hold as some private banks are now more actively competing for deposits and improving services while, for the first time, developing consumer lending portfolios. This point should not be overdone, however, as the financial systems of most developing countries reflect a range of services similar to that of Uruguay. 14 BANKING INSTITUTIONS AND THEIR ACTIVITIES6 1.5 The agents and entities of the Uruguayan financial system include the traditional participants in many financial sectors: At the end of 1999, there were 49 financial entities operating in Uruguay: 2 official banks; 2 intervened banks; 19 private banks; 9 financial houses; 6 savings and loans cooperatives; and 11 external financial intermediaries. The number of institutions has been relatively stable during the last few years (Table A1.1 in Annex I). The banking system had 483 branches in 1999, 146 of them owned by the official banks, and 337 by the private financial intermediaries. The main characteristics of the Uruguayan financial entities are the following: * Public and Intervened Banks. The public banking system in Uruguay is currently composed of four institutions: two official banks and two commercial banks taken- over by the Government as a result of financial difficulties. The two official banks are Banco de la Repuiblica Oriental de Uruguay (BROU) and Banco Hipotecario del Uruguay (BHU). The other two institutions are Banco Caja Obrera and Banco de Credito (which recently acquired the good assets and liabilities of Banco Pan de Azucar, another bank that experienced financial difficulties and was under Government control). * Private Banks. The vast majority of the private banks are subsidiaries or branches of important international banks. Only one of the private banks' capital is entirely national. Thy obtain deposits from residents and non-residents to lend to firms and to invest in local and foreign assets and securities. They also engage in activities related to foreign trade and provide services such as currency exchange, money market accounts, and sale of credit cards. Most are concentrated in the wholesale market, although some are now increasing their activity in the retail sector. The number of banks in Uruguay appears to be too high relative to the size of the banking system (and the country).7 * Savings & loans cooperatives (S&L). These cooperatives belong to their local members and obtain deposits to lend to small and medium-sized firms and to consumers. They engage in money market activities and, more recently, in foreign trade operations. These cooperatives emerged in the early 1980s after the banking crises, profiting from the market vacuum that resulted from the rash of bank failures8. Though not nearly as large in terms of total assets, the S&Ls rival the private banks in terms of the number of individuals that procure their services (loans). * Financial houses. These financial institutions are very similar in their operations to the private banks with the exception that, by law, they can only obtain deposits from non-residents. Foreign banks own the vast majority of them, and they conduct their 6 Unless otherwise noted, all figures in this sub-section are drawn from BCU, Boletin Informativo, several issues. 7 Argentina, for example, a country 10 times larger than Uruguay in terms of population has only 2-3 times more banks. 8 Caumont (1997), Adolfo Diaz Solsona: Informes Sobre el Sistema Financiero Uruguayo, working paper, 1999. 15 activities mainly in foreign currency. They also intermediate in foreign trade and service the banking needs of non-residents. * External Financial Intermediaries (EFIs). EFIs can only service the banking needs of non-residents, which implies that their assets and liabilities are all held abroad. They are, therefore, "pass-through" financial vehicles whose existence is, apparently, attributable to tax and regulatory advantages offered by Uruguay relative to other countries. They intermediate between foreign depositors and foreign borrowers and conduct securities transactions and maintain checking accounts for non-residents. * Credit administrators. These financial institutions provide credit to consumers, both in local and foreign currency. Their operating costs are significantly lower than banks', in part because they face more flexible labor conditions9. Credit administrators have traditionally depended on banks for funding, and they offer banks a low-cost way to serve a new segment of the consumer credit market."" Credit administrators tend to offer very small lines of credit (US$150-US$250). They also provide consumer credit accounts that can be directly debited for payment of utilities and other bills. Regulation and restrictions regarding their sources of finance may be limiting their expansion. 1 PUBLIC AND INTERVENED BANKS 1.6 Banco de la Republica Oriental del Uruguay (BROU). BROU, founded in 1896, is the country's most important commercial bank, with about 23% of both total assets and total deposits of the banking system. As of March 2000, its total assets were US$5 billion and the official book value of its net worth was US$732 million. The bank has a branch network of 107 offices nationwide (including its headquarters). As of November 1998, it had 4,751 employees. BROU is a financial institution that functions both as commercial and development bank. It underwrites almost all types of loans, serving as wholesale bank and corporate lender, as well as a consumer lender (a more recent activity is providing loans to government employees and employees of other large institutions). It is also the main provider of foreign trade services to the economy, acts as financial agent for the Government, serves as import tax collector, and handles the export tax rebate system. The development bank functions, which are not clearly defined, result from its status as a governrment-owned bank. 1.7 As of March 2000, BROU's loan portfolio stood at US$3,860 million, 23% of the loans in the system. It is important to note that BROU's market share has decreased only slightly over the last few years and mostly in the private non-resident sector, both in terms of deposits and loans. BROU is as heavily dollarized as the rest of Uruguay's banking system. Only 20% of BROU's total loans are denominated in national currency (versus 19% for the system). Moreover, over the past few years, the proportion of BROU's operations conducted in local currency has continued to decline. 9 Bank employees are covered under a bargaining agreement separate from employees of the credit administrators. '° As these entities are owned in many cases by private banks and their size is not large, they are not included in a separate way in the quantitative analysis that follows. " Diaz Solsona (1999). 16 1.8 Its portfolio is diversified but high-risk, largely because the agricultural sector represents 34% of its loans. The industrial sector represents 29%, consumer loans 17%, and commerce and services 14%. 12 By way of comparison, the average private bank devotes 38% of its portfolio to commerce and services, 26% to industry, and 26% to consumer lending. Only 10% of private banking loans are allocated to the agricultural sector, presumably because of its high-risk nature. It is possible that the very presence of BROU may discourage private banks from financing this sector. In recent years, BROU has become involved in other modes of consumer finance, introducing new products such as credit cards and financing for automobile purchases. 1.9 BROU's official net worth significantly exceeds current minimum capital requirements. However, this excess of capital may not be as high as reported, as there are some doubts about the adequacy of the loan classification procedures and the real value of the bank's credits. Assessing the performance of BROU is difficult due to lack of detailed infornation. Official data indicate that BROU has a satisfactory financial situation, and that it has been making profits during the last few years. It posted profits of US$53.9 million in 1999 and of US$7.5 million in the first quarter of 2000. However, the quality of BROU's portfolio is below the system's average,'3 and it is likely that if BROU's non-performing loans were properly written off, its net worth would be much less than it appears in the books. This situation would pose a significant contingent liability for the Uruguayan Treasury. 1.10 BROU has initiated an institutional transformation process aimed at improving its effectiveness and productivity. The process has involved - inter alia-a significant downsizing, reorganization of the administrative structure, process rationalization/re- engineering, improvements in cost effectiveness, the modernization of its information technology (still in the process of being implemented), advances in accounting and internal controls, and, more recently, the phasing in of modem systems to measure and manage credit risk. There is still much to be done, however, especially on the financial side of the bank, and eventual privatization should be seriously considered. 1.11 The Mortgage Bank of Uruguay (BHU). BHU was created in 1892 and acquired by the state in 1912. BHU is the second largest bank in the country with assets totaling US$3,600 million. As of March 2000, the official book value of its net worth was US$1,390 million. It has more than 290,000 savings accounts with deposits totaling over US$1,190 million. Depositors include not only private individuals but also government enterprises and the pension funds of bank employees, college professors, and others. As of December 1997 the bank had 1,626 employees, of which 1,383 worked in headquarters and 243 in its 26 branches. BHU's staff estimate that its current portfolio includes about 12 Portfolio breakdowns for BROU come from BCU statistics. 13 As of March 2000, BROU had a ratio of non-performing to total loans of 5.6%, compared to 1.1% for private banks, including the two intervened banks, which had a ratio similar to public banks (4.0%). Figures from December 1999 indicate that only 51.4% of BROU's portfolio fell under classification 1, the lowest risk category, while 19.9% of its portfolio was classified under the highest risk categories (4 and 5). The quality of BROU's portfolio may have deteriorated in 1999 due to the impact of the draught on many of its agricultural clients. 17 70,000 loans. While there are no official figures for housing loans, it is estimated that BHU's loans represent more than 90% of the stock of mortgage credits in the country. 1.12 BHU's statutes allow it to undertake all activities permitted to commercial banks (subject to Board approval), but mandate that it specialize in mortgage credit and carry out functions as a development bank promoting the construction and housing industries. In essence, BHU is the principal provider of housing credits in the country (offering loans for construction, acquisition or refurbishment of houses). BHU also acts as promoter and investor in housing developments that are later sold to the public. In recent years, private banks have started to provide housing loans, but they have concentrated on the high-end of the market (not attended to by BHU), granting dollar loans at rates which are higher than BHU's. Rates are not strictly comparable because BHU mostly lends in special inflation adjusted units (unidades reajustables or URs) which are linked to the increase in the average salary index of the country. 1.12 Since 1993, the policy in Uruguay has been that people with different income levels have access to different forms of financing. Borrowers with monthly incomes below 30 URs (about US$511) are serviced exclusively by MVOTMA14 at subsidized rates. Borrowers with monthly incomes between 30 URs and 60 URs (about US$1,022) are serviced jointly by MVOTMA and BHU, through a program administered by MVOTMA that has two components: (i) a one-time direct subsidy from MVOTMA as partial payment for a home and (ii) complementary financing from BHU (without subsidies). BHU lending to borrowers with monthly incomes above 60 URs does not involve subsidies. Although this policy was designed to minimize the role of BHU in providing housing subsidies, valuation problem and the resulting large proportion of delinquencies and refinanced loans may imply that BHU de facto acts as an institution that subsidizes the sector. These subsidies are not reimbursed by the State and are eroding the bank's financial condition. The subsidies are, moreover, implicit - that is, not directly accounted for in BHU's balance sheet and profit and loss statement, and hence are absorbed into its general operating/financial charges. 1.13 One of BHU's main problems as a financial institution is the significant currency and term mismatch between assets and liabilities. The maturity mismatch is evident because the stated average term of its housing loans is 15 years, while the average maturity of its liabilities is eight months (with the exception of a long-term loan provided by BCU). BHU is in the process to reduce the maturity mismatch through the issuing of long term bonds. The currency mismatch is more worrisome. The bulk of BHU's assets are denominated in URs, while the largest percentage of its liabilities are dollar- denominated. The URs are units of account that adjust automatically to reflect changes in the index of average salaries. This mismatch is cause for concern because of the significant gap between devaluation and inflation in the past decade, with devaluation lagging behind inflation. This implies that BHU's assets have adjusted at a faster pace than its liabilities, resulting in accounting gains and increases in its net worth which are not substantiated by the real value of its assets. In other words, the value of BHU's loan portfolio has increased because the URs have been rising much faster than the devaluation of the local currency, but the underlying assets backing these loans have not increased in values at the pace of the URs, since house prices in Uruguay are valued in 4 MVOTMA stands for Ministerio de Vivienda, Organismos Territoriales y Medio Ambiente. 18 dollar terms. This encourages delinquency, since debtors realize that due to the UR adjustments, in many cases the value of their loans exceed the market value of the properties acquired. Up to recently, the currency mismatch had played in favor of BHU, at least theoretically. However, the growth of the UR has decelerated in recent years as a result of lower inflation rates, with negative impact on BHU' s earnings. 1.14 Another source of concern about BHU is the high level of loans overdue. As of March 2000, about 28% of BHU's loan portfolio was overdue (including loans overdue one or more payments) and 18% of the loans were non-performing. To some extent, the high level of arrears is a consequence of the currency mismatch, because as the rate of devaluation falls short of the UR growth rate, the loan indexation scheme leads to a continuous increase in the ratio of loan to collateral value, and thus to a rising default risk which is not counter-balanced by an increase in provisions. 1.15 BHU's collection efforts do not encourage its debtors to pay their debts according to the agreed payment schedule. On average, BHU initiates legal execution procedures on about 50 properties each month, which is a very low number considering its high overdue portfolio. Annual loan recovery (including principal and interest) amount to about 7% of the total loan portfolio, a very low percentage. This situation has generated cash problems for the institution. BHU's Board, in some instances, has unilaterally decided to postpone loan payment adjustments, resulting in lags between actual inflation and increases in payments. 1 In December 1998, Congress approved a law obliging BHU to refinance all those loans that were three months overdue as of October 31, 1998, extending the maturities of the loans without penalties. The Law also authorized BHU to provide debt relief to current debtors by reducing the principal balance of their adjusted loans to 90% of the appraisal value of the property (deducting principal payments)'6. This law has had severe financial implications on BHU because it has not only affected its already low financial margin, but has force it to increase provisions and to write-off the portions of loans that have been condoned, which has had an immediate impact on its net worth. 1.16 BHU posted losses in 1997 (US$35 million), and small profits in 1998 (US$35.7 million) and in 1999 (US$4.2 million). However, in the first quarter of 2000, BHU posted losses of almost US$51 million. 7 This deterioration is the combined result of two factors. First, the bank's financial margin has been significantly reduced as a result of the debt relief measures explained above. Secondly, since a major component of BHU's earnings is the readjustment of its loans according to the evolution of the UR, the deceleration in the UR in recent years, as a result of lower inflation, has had a negative effect on its earnings. There is, nevertheless, a perception that BHU has a solid financial situation, with a large capital base compared to its indebtedness (less than 2 to 1 leverage ratio). However, if BHU's non-performing loans were properly provisioned, its net worth would be much lower or negative. As in the case of BROU, this situation poses a '5 For instance, in 1997 loan payments were "frozen" during four months in the case of UR adjusted loans and six months in the case of dollar loans. 16 To be eligible to these new terms debtors must be current in payments and should have paid at least 50% of the total monthly payments agreed at the beginning of the contract. 17 According to declarations of BHU's president to a gropu of Parlamentarians, total losses of the bank amounted to US$150 million at the end of the third quarter of 2000 (El Pais, November 2, 2000). 19 significant contingent liability for the Uruguayan Treasury. It is therefore very important to estimate the magnitude of these contingent liabilities. Unlike BROU, BHU has not initiated an institutional transformation process. 1.17 Intervened Banks. In the first half of the 1980s, in response to a generalized financial crisis in Uruguay, the Central Bank (BCU) implemented a bank-rescue program to save banks by buying their bad loans. Most banks were eligible to participate in the program except four of them, which were intervened by the BCU and subsequently managed by the state during many years. At the beginning of the 1 990s, two of the four entities merged. One of the remaining intervened banks, Banco Comercial, was privatized in 1990, after the Government took over a portion of its bad loans. It was acquired by a consortium of international banks and has become profitable. The second intervened bank, Banco Pan de Azuicar, was privatized in 1994, but had to be intervened again in 1996 due to bad management and alleged fraud by the buyers. The third intervened bank is Banco Caja Obrera. Towards the end of 1998, another private bank, Banco de Credito, which was controlled by a foreign group, experienced financial difficulties (a deposit withdrawal of about US$80.0 million which led to its inability to meet reserve requirements'8) that led to its intervention by BCU. The Government decided to have Banco de Credito acquire the good assets and liabilities of Banco Pan de Azzucar and create a new, more viable bank. The Government now owns 51% of the new Banco de Credito through the Corporaci6n Nacional de Desarrollo (CND), a Government development agency. The two intervened banks account for 6.4% of the deposits and 6.5% of the loans of the banking system. 1 .18 When the merger took place, Banco Pan de Azucar had not only lost all its capital, but had a capital deficit estimated at between US$50 and US$70 million, that the Government would have had to cover in order to privatize the bank. Since Banco de Cr&dito had a positive net worth (even though it did not comply with capital limits set by the BCU), the merger of both banks made it possible to dilute Banco Pan de Azucar's losses without a significant injection of new capital. The CND contributed US$25 million in exchange for 51% of the shares, and the foreign group committed itself to contributing another US$27 million (including interest payments) for the remaining 49%. CND's participation was through the issuance of seven-year, 7.5% fixed rate treasury bonds. The foreign partner's capitalization is in installments over the next three years, in accordance with a pre-established agreement. The Government's intention is to restructure and cleanup the bank before privatizing it. 1.19 Although the merger saved the Government from taking a loss on Banco Pan de Azucar, the reality is that the loss recognition has only been postponed since the capital deficit of the new bank is still about US$50 million (losses could be even higher if it is determined that some of its loans are not adequately classified and provisioned). There is a need to carry out a careful review of the new bank's loan portfolio. While the merger has not solved the main problems of the bank, it had some positive aspects: (i) it reduced the number of government-controlled banks, and (ii) it isolated the legal problem with the 18 It is worth noting that during several months before its intervention BC had not been complying with several important BCU regulations, such as capital requirements and credit limits to related parties. For instance, it is estimated that the foreign partner's debt to the bank is about US$50 million, exceeding many times the legal limit. 20 previous owners of Banco Pan de Azucar from the "good bank", facilitating its future sale to a third party. 1.20 Banco Caja Obrera was one of the first banks to experience problems during the 1980s. In 1984, the BCU acquired part of its bad loan portfolio to facilitate the bank's rehabilitation. In 1989 the state began to capitalize the bank and finally assumed control over it through BROU. In 1990, the Govemment took control of the bank through CND as the majority shareholder. The bank's net worth situation is very weak. The ratio of equity to assets was 2% by the end of 1997, significantly below BCU's minimum capital requirements. At the end of 1998, to avoid a negative equity situation due to increases in provisions, the bank revalued various assets, reportedly to adjust them to real values. The revaluation of $20.9 million made it possible for the bank's net worth to remain positive (US$9.8 million). With the purpose of accelerating the sale of the bank, the BCU, at shareholder's expense, hired an international financial advisor. The process began in 1997. Initially, four interested parties acquired the bidding documents and were qualified to submit a bid. However, the only offer received by the sellers was a joint offer made by two Uruguayan banks. In June 1999, the Government rejected the purchase offer because the buyers had proposed to take the US$235 loan portfolio with the condition that after three years they could return up to 30% of the bad portfolio to the Government. This proposal was considered unacceptable because it would have created a contingent liability for the Government of about US$70 million. STRUCTURE OF THE BANKING SYSTEM 1.21 Employment Since 1981, employment in the private banks has declined by roughly 35%.I9 In recent years, employment declines have come primarily from the official and the administered banks (Table A1.3 in Annex I). The total number of employees in the sector stood at 12,046 at the end of 1999, with just over half of them working for the official banks. The decreasing trend in banking employment reflects both the freeze in public hiring, which affects the public banks, and a substitution of capital for labor as a response to high labor costs. While technological improvement stemming from automation is partially responsible for that substitution,20 the international comparisons in Table 1.7 indicate that overhead costs and net interest margins in Uruguayan banks are relatively high, which can be attributable, at least in part, to high labor costs. 1.22 Assets. The assets of the system totaled US$22 billion (108% of GDP) at the end of 1999. Banking assets are concentrated in a handful of institutions. The two official banks' assets account for 39% of the total assets of the banking system, and private banks, including the administered banks, account for 50% of the assets. Concentration of assets in the public banks is, however, slowly declining. Just over five years ago, these banks held almost 45% of total assets in the system. It is also interesting to note that, after years of steady increase, the asset's share of the EFIs declined sharply in 1998 and 19 Caumont (1997). 20 The number of ATMs has significantly increased in the 1 990s 21 2 1 1999, to reach in 1999 about 5%, the same share as in 1994. In absolute terms, the assets in the EFIs have declined from about US$2.4 billion in 1997 to US$1.1 in 1999. This may reflect the increased competitive pressures in the provision of financial services in the region. In particular, Argentine funds that were previously intermediated through the Uruguayan off-shore market may increasingly stay at home. 1.23 Credit activity is also concentrated in the two official banks, but their share of total credit has dropped from 49% in 1994 to 37% in 1999 (Table A1.5 in Annex I). It is instructive to consider separately credit to financial and non- financial sectors. The official banks are particularly active in providing credit to the non-financial sector, presumably due to their development objectives. BROU and BHU provided 45%, of total non-financial credit in 1999, but only 20% of the financial credit (Tables A1.6 and A1.7 in Annex I). By contrast, private banks accounted for 64% of all the credit to the financial sector, and 50% of the credit to the non-financial sector.22 Lending to the non- financial sector is directed mostly to the largest local finns and multinationals. Lending to small and medium enterprises is limited and subject to liquid guarantees. The extreme cautiousness of Uruguayan private banks is a result of the experience of the financial crisis of the 1 980s, when banks were forced to restructure their loans through subsequent refinancing laws, and to inadequate legislation concerning the execution of guarantees. The agricultural sector, which was particularly affected by the refinancing laws, now get credit mostly from BROU. Private banks slowly began returning to the consumer credit market in the last few years. Consumer credit comprised 6% of the portfolios of private banks in 1989, rising to 16% in 1994, and to 25% in mid 199823. This type of credit accounts for about 14% of BROU's lending. This expansion has been aided by a relatively good information system about credit history of borrowers, which is privately managed. TABLE 1.2. ASSETS (%) 03/31/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 39.06 39.09 39.87 40.16 42.55 43.33 44.72 (BROU) 22.91 Na 23.70 23.16 23.55 Na na (BHU) 16.15 Na 16.18 17.00 19.00 Na na Administered 5.30 - 4.96 5.65 5.95 6.31 7.13 banks Private banks 44.22 50.12 38.32 35.05 33.30 33.39 33.08 Financial houses 3.89 4.05 5.04 4.63 4.22 4.48 8.38 S&Ls 1.78 1.76 1.86 2.82 2.42 2.33 2.12 EFI 4.62 4.98 9.94 11.69 11.56 10.16 4.56 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU 21 BCU reports figures for EFIs in a separate section of the Boletin Informativo, presumably because their "pass-through" activities are qualitatively different from the intermediation undertaken by the other institutions. 22 Caumont (1997) indicates that much of the financial sector credit extended by private banks is in the form of discounted bills and in loans extended to institutions that rely on the interbank market rather than public deposits to acquire funds for intermediation. Such institutions presumably lack a branch network extensive enough to attract their own deposits. 23 The figure for 1989 comes from Caumont (1997). Those for 1994 and 1998 are Bank calculations based on data provided by BCU's SIIF. 22 1.24 To summarize, the figures presented to this point indicate that, while highly concentrated at first glance, the credit market is also highly segmented: * Much of the concentration stems from the official banks, which grant nearly 45% of the total credit to the non-financial sector. * High concentration levels are much less attributable to the private banks. The largest private banks are less than one-fourth the size of BHU or BROU, and the smallest 70% of Uruguay's financial institutions comprise just over 25% of the system's total assets. These private banks have traditionally dominated the market for financial credit, although in recent years they have made strides to reach the consumer market. The non-consumer, non-financial credit markets remain the province of the official banks. * S&L cooperatives and credit administrators serve the "low end" of the consumer credit market. Although the S&Ls cooperatives provide only 5% of the overall credit to the non-financial sector, they service a high number of customers because their typical loan size is relatively small. The same is true of the credit administrators, some of which have recently been absorbed by private banks. * In recent years, the EFIs have become less able to capture funds from non-residents. Since these financial agents do not lend to the local market, their decline does not affect the availability of credit in Uruguay. However, since public and private banks also receive funds from non-residents, the decline in the EFIs may provide a window on the evolution of this type of activities in the rest of the banks. 1.25 Liabilities. The total liabilities of the system amounted to US$18.8 billion in early 2000. The private banks account for over half of the total deposit base, while the public banks account for around 35%. In the last few years, the private banks have increased their share of total deposits, both from the financial and the non-financial sectors, at the expense of deposits in public banks and in other non-banking financial institutions. TABLE 1.3. TOTAL DEPOSITS (%) 03/30/00 12/31/99\ 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 34.92 34.26' 34.14 34.71 35.00 35.60 35.86 (BROU) 23.06 Na 23.31 23.25 22.80 na na (BHU) 11.86 Na 10.83 11.46 12.21 na na Administered 2.22 - 5.97 6.67 7.00 6.87 7.45 banks Private banks 52.85 55.31 42.28 39.77 37.31 35.61 33.80 Financial houses 4.18 4.33 5.55 5.17 4.63 4.62 8.47 S&Ls 1.87 1.82 1.89 3.03 2.54 2.38 2.05 EFI 3.97 4.36 10.46 10.65 13.51 14.92 12.37 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 Source: BCU 1999 datafor administered banks is included in the private banks category 23 1.26 In terns of financial structure, the Uruguayan banking institutions rely mainly upon demand deposits and equity. There is, however, an important difference between the official banks and private banks on this dimension. The forner have a higher proportion of equity (around 32% of total liabilities) and the latter have a higher proportion of deposits. In the case of private banks, equity accounts for 8% of total liabilities. As indicated above, the capital of the public banks appears to be substantially overstated for a number of reasons, including insufficient provisions on assets. To the extent that financing through (state-owned) equity is cheaper-from the public bank's perspective- than through deposits that require a 'market-based' interest rate, the relatively high operating margins found by other authors for the official banks should be expected.24 Moreover, as those authors have noted, to the extent that these are artifices of financial structure, high operating margins at official banks should not be viewed as a signal of their relative efficiency. BEHAVIOR OF THE SYSTEM 1.27 Leverage and capital adequacy. Leverage (the ratio of total assets to equity) is lower for public banks than for private banks. Private banks' leverage ratios have, however, declined over the last few years from 26 in 1994 to 14 in 1999. On the other hand, leverage of public banks increased slightly from 3 to 4 in the same period. Stated another way, official banks are highly capitalized. However, it may be important to consider that because the ratio of non-performing loans is high for the official banks, their actual capitalization ratios may be lower than reflected here, especially if their provisions are not sufficient. The two official banks, BROU and BHU, report ratios of equity to assets of 14% and 38%, respectively in the first quarter of 2000. By contrast, the private banks report a ratio of about 8%. Other banking entities have capitalization ratios slightly higher than the private banks but nowhere near BHU's. TABLE 1.4. EQUITY/rOTAL ASSETS (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 24.20 25.05 26.16 28.00 30.91 35.39 37.08 (BROU) 14.23 na 14.81 15.95 18.29 na na (BHU) 38.36 na 42.79 44.42 46.56 na na Administered 1.93 - 1.20 3.10 2.84 4.94 21.28 banks Private banks 8.05 7.14 6.84 7.11 7.78 7.22 3.83 Financial houses 11.10 10.34 7.56 8.80 9.82 9.76 8.66 S&Ls 11.41 11.69 12.16 11.01 12.12 10.19 11.26 EFI 29.77 26.61 Na 14.43 13.42 17.81 33.14 Total 13.89 15.32 15.53 16.32 18.17 20.54 21.85 1999 data for administered banks is included in the private banks category Source: BCU 24 Caumont (1997). Of course, from the Government's perspective the marginal cost of financing through equity (likely by borrowing) is more expensive than through interests paid on deposits. The borrowing costs associated with equity financing do not, however, appear on the bank's balance sheets or operating statements. In addition, although the costs of equity financing are lower for the banks than deposit interest rates, the interest rate paid on official banks' deposits is not truly market-based (i.e., does not reflect the quality of the bank or its portfolio) due to the 100% implicit deposit guarantee which appears to be in place in Uruguay. The same could, however, be said for deposits of the private banks, unless the guarantee applies differentially to public versus private banks. 24 1.28 Liquidity. Liquid assets (cash plus public securities) appear to comprise an adequate proportion of short-term liabilities for the vast majority of banks operating in Uruguay, although the liquidity of the whole system was lower (15%) in 1999 than in any previous year since 1994. The BHU has a low liquidity ratio (3% in the first quarter of 2000) and that figure has been falling in recent years (Table A1.12 in Annex I). In contrast, the other official bank, BROU, has a liquidity ratio of 23%. All the other financial institutions also have high liquidity ratios. In recent years, the liquidity ratio of the EFIs has dramatically increased. This seems to indicate that these intermediaries are having some problems in investing their funds in their traditional market. 1.29 Portfolio quality. Until recently, rapid asset growth had not coincided with deteriorating portfolio quality. In fact, non-performing loans as a percentage of total loans declined from 6% in 1994 to 3.7% in 1998, as a result of portfolio improvements in the public banks. Despite the improvements, these banks have still a much higher percentage of non-performing loans,25 around 8% compared to less than one percent in the private banks, if the administered banks are not included. The situation of BHU is worse for BHU, which even before the 1999 crisis had 13% of its loans non-performing. The improving trend reversed in 1999, when non-performing loans increased to 6.7% of total credits for the whole system, due to economic slowdown in Uruguay linked to the international crisis. The deterioration in 1999 reflects the increase in non-performing loans in the public banks, which reached almost 15% of total loans. Although the March 2000 figures show some improvement in this area, BHU still had a very high percentage of non-performing loans (14%), followed by BROU (5%) and the intervened banks (4.5%). BHU's situation is largely attributable to the repayment problems encountered by its borrowers due to indexing which was described above. The ratio of non- performing loans to total loans among private banks (excluding the administered ones) has remained below 1%, despite the economic downturn of 1999. TABLE 1.5. NON-PERFORMING CREDITS/TOTAL CREDITS (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 8.81 14.71 7.38 8.58 8.49 10.34 10.87 (BROU) 5.09 Na 4.23 5.68 6.50 na na (BHU) 14.11 Na 12.71 12.84 11.20 na na Administered 4.50 - 5.51 2.24 4.17 3.33 3.76 banks Private banks 0.81 2.05 0.53 0.66 0.75 0.96 0.79 Financial houses 0.08 0.20 0.32 0.48 0.63 0.84 0.51 S&Ls 2.33 5.99 5.35 3.32 4.65 4.94 5.06 EFI 0.51 0.98 Na na 0.50 0.50 0.17 Total 3.97 6.70 3.69 4.30 4.70 5.81 6.07 1999 data for administered banks is included in the private banks category Source: BCU 1.30 Although a high share of BHU's loans are classified as non-performing, their provisions are quite meager. The result is a very high ratio of non-performing credits to provisions of 32 in the first quarter of 2000 (Table A1.14 in Annex I). Given the 25 Non-performing loans are unrecoverable loans, which are a subset of the overdue loans. 25 indexing problems and the repayment relief, BHU's non-performing loans and provisioning figures tell little about the efficiency with which it intermediates funds. By contrast, at BROU the ratio of non-performing loans to provisions was 6, much higher than in the which was 2.6, including the administered banks. The amount of regulatory forbearance afforded BROU is difficult to gauge, which makes it difficult to ascribe too much faith to the ratios in Table A1.14. 1.31 Profitability and Efficiency. There are significant differences among public and private banks in both return on assets (ROA) and return on equity (ROE) in Uruguay, and among the public banks themselves. Calculations based on official data show that, as of December 1999, the profitability of the public banks was much lower than that of the private banks. The most striking contrast is between the profitability ratios of the private banks and those of BHU. These calculations have been made without sufficient information on the portfolio quality of the official banks, which is below the system's, or the adequacy of their provision coverage. A more strict provisioning could result in even greater differences in profitability between public and private banks. This is a worrisome situation given the fact that the public banks account for nearly half of the banking system in Uruguay. While BHU's profitability is clearly lower than that of BROU, BHU presents somewhat better efficiency indicators in terms of assets per employee and structural costs26 over operating income. This suggests that improving BHU will depend more on reforming its business practices (such as solving its currency and term mismatches) than on organizational reforms. TABLE 1.6. COMPARISON OF PROFITABILITY AND EFFICIENCY INDICATORS (12/31/99) Private Public Banks BROU BHU Banks Return on Assets 1.35 0.64 1.01 0.11 Return on Equity 18.01 2.55 6.83 0.28 Structural Costs/Operating Income 81.00 92.26 93.54 76.93 Equity/Total Assets 7.52 25.04 14.77 39.62 Overdue loans/Total Loans 2.42 15.20 10.10 21.05 Provisions/Total Loans 3.25 13.14 17.81 7.80 Assets/Employee (000US$) 2,147 1,076 2,408 Average Salary (OOOUS$) 54.3 37.9 42.1 Source: Own calculations based on official data. COMPETITIVENESS OF URUGUAYAN BANKS 1.32 Regionalization in the market for financial services makes the efficiency of the Uruguayan banking system increasingly important. The future role of Uruguay as a sub- regional financial center will be affected by the success of its neighbors in achieving macroeconomic stability, and by the efficiency and competitiveness of Uruguay's banking sector. Since many of the foreign banks operating in Uruguay also have subsidiaries and branches in other countries in the region, their decision on where to expand their banking activities will increasingly depend on the rates of return obtained in 26 Structural costs include personnel, overhead, rent and amortization of fixed assets. 26 the different locations. Two recent studies27 compare the returns of the Uruguayan banking system with that of other countries in the region, in terms of return on assets (ROA) and return on equity (ROE). The picture that emerges is that the profitability of the Uruguayan banking system as a whole is relatively low compared to that of other countries. However, if only private banks are included, their profitability is among the highest in the sample with a ROA of 0.9% and a ROE of 13.4%.28. TABLE 1.7. COMPARISON OF BANKING SYSTEMS EFFICIENCY INDICATORS IN THE REGION Country ROA ROE Overhead Net Interest Costs/Total Margin Assets Argentina 0.88 6.65 6.7 4.2 Bolivia 0.77 10.8 4.4 5.2 Brazil 1.20 7.3 7.8 Chile 0.85 12.4 3.0 3.9 Colombia 7.9 6.2 Peru 1.03 12.3 7.8 9.1 Uruguay 0.70 4.0 6.5 5.6 Priv. Banks 0.90 13.4 Source: Beck, Demirguc-Kunt, and Levine (1999). Data for all countries are from 1997, except for Colombia whose data are from 1996. Data on ROA and ROE for Uruguay are from 1997, from Roberto Zahler: Eficiencia y Competitividad de la Banca Uruguaya, working paper, December 1998, for all countries, except for Argentina, which are from Caumont (1997). 1.33 Figures on overhead costs and net interest margins give a better flavor of the competitive situation faced by the Uruguayan financial sector.29 Table 1.7 shows that Uruguay has the third lowest ratio of bank overhead costs to total banking assets, but at 6.5%, that figure is much more similar to those for the less financially developed countries than the 3-4% figures for Chile and Bolivia. Argentina, for example, has a ratio of 6.7%. Uruguay's net interest margin (the ratio of net interest income to total banking assets) is the fourth lowest in the region at 5.6%, behind Chile (3.9%), Argentina (4.2%), and Bolivia (5.2%). Uruguay's relatively high overhead costs and net interest margins indicate that its financial system is not intermediating funds as efficiently as it might. High labor costs are likely to be a major cause of these difficulties. Unless that situation is rectified, Uruguay will likely become an increasingly unattractive location in which to bank. Given the system's reliance on foreign capital (ownership) this may be a cause for concern. 27 See Caumont (1997) and Zahler (1998). 28 The ROA and ROE of the private banks in Table 1.6 are higher than those in Table 1.7. The differences may be due to improvements in the March 2000 ratios as compared to December 1997, or to differences in the methodology used for the calculation. 29 The level of regional coordination is also influencing the evolution of the Uruguayan banking system. At the moment, MERCOSUR measures appear to be primarily focused on commercial integration with the final objective of a customs union. However, differences in tax systems influence the movements of funds from some countries to others inside the MERCOSUR region, and these too may be phased out over time. More generally, under MERCOSUR, Basle recommendations for consolidated global banking supervision have been adopted, and some advances have been made in terms of financial statement harmonization. All of this standardization makes it more likely that fnancial systems in Latin America will increasingly rely on their own productivity (rather than on legal or tax constructs) for their survival. This would appear to have important implications for Uruguay. 27 1.34 The comparison of various indicators for the Uruguayan system with that of an important neighbor, Argentina, can provide a good indication of the competitive pressures facing the Uruguayan banks. Ideally, one would like reliable profitability figures for purposes of comparison. Banks' returns, or profits, however, depend on charges for under-coverage of non-performing loans, which are a direct product of the regulatory and supervisory regime in a given country. Since differences in regulation, accounting, and supervision make international profit comparisons difficult, the analysis that follows focuses on other indicators that are less subject to measurement error. 1.35 A simple measure of banking sector efficiency is the ratio of deposits to employees. Table 1.8 shows that while Uruguay's financial sector is more efficient than that of Argentina's (deposits per employee in Uruguayan banks are US$970,000 compared with US$596,000 in Argentinean banks), that gap is closing rapidly. In Uruguay, real deposits per employee have increased by about a third since 1994, while in Argentina they have nearly doubled. Comparisons between the private banks are even more striking - real deposits per employee have increased by 106% in Argentina compared to only 22% in Uruguay. Another remarkable difference is that while in Argentina efficiency gains of the private banks outpaced that of the public banks; in Uruguay the reverse was true. Recent efficiency gains of Argentinean banks are attributable, in part, to the severe financial disintermediation that occurred there in the 1980s. But, if the trend continues, Argentinean banks could soon overtake Uruguayan banks in efficiency. Moreover, as Table 1.7 indicates, Uruguay already lags Bolivia and Chile on some indicators of efficiency. 1.36 While 'deposits per employee' is one reasonable measure of the efficiency of financial intermediation, measures of total revenues and total costs are more direct indicators of economic efficiency. A more useful measure to make efficiency comparisons is net revenues (prior to provisioning) divided by operating costs. Because they are based on the 'flow' of income and costs rather than the 'stock' of deposits, the revenue/cost figures, which also appear in Table 1.8, are more volatile than those for real deposits per employee. In at least one respect, however, the two indicators tell a similar tale. Uruguay's financial system out-performed Argentina's on this measure in 1995, and the gap closed thereafter. In fact, by 1998, Argentina's financial system had overtaken Uruguay on this measure (1.59 versus 1.40). This indicates that the current flow of investing funds in Argentina is being intermediated more efficiently than in Uruguay. 1.37 It is also interesting to note that Argentina's private banks have outscored Uruguay's in terms of revenues per unit of cost in all the years for which direct comparisons are available (1995-1998), and that the gap has not grown over time. This suggests that the reason why Argentina overtook Uruguay on this measure was attributable to the relatively improved performance of its public banks. Indeed, Argentina's public banks displayed some improvement on this measure while Uruguay's experienced a decline. During this period, Argentina privatized a number of its public banks, many of which had performed inefficiently over an extended period. This structural transformation is, at least partially, responsible for the improved figures for Argentina's public banks. 28 TABLE 1.8. EFFICIENCY /PROFITABILITY 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Deposits per Employee (US$000s, 1990) Official Banks 753.0 700.3 626.4 568.3 547.9 (BROU) 679.4 618.0 538.6 na na (BHU) 975.2 959.3 900.6 na na Administered Banks 700.3 707.4 650.0 552.7 551.5 Private Banks 1409.6 1506.5 1356.1 1248.2 1150.6 Financial Houses 4429.9 4136.4 3271.8 2975.3 4808.6 S&L Cooperatives 293.6 340.8 267.1 236.5 205.0 Total Uruguay 970.3 935.4 822.9 738.4 729.6 Argentina 595.8 542.9 428.6 351.8 309.2 (Public) 517.6 446.0 347.4 291.1 297.0 (Private) 658.6 620.4 489.7 399.1 319.4 Net Income/Administrative Costs 1.54 1.35 1.66 2.48 2.65 Official Banks 1.55 1.50 1.51 2.23 2.08 (BROU) 1.50 0.86 2.14 3.30 4.66 (BHU) 1.77 0.86 0.72 0.84 0.90 Administered Banks 1.28 1.11 1.16 1.06 1.04 Private Banks 2.29 1.73 1.97 1.85 1.71 Financial Houses 0.94 0.95 0.96 0.96 0.98 S&L Cooperatives 1.40 1.19 1.33 1.63 1.69 Total Uruguay 1.59 1.17 1.28 1.49 na Argentina 1.82 2.19 1.24 1.44 na (Public) 1.42 1.18 1.30 1.52 na (Private) Sources: Uruguay data are from BCU 'Boletin Inforrnativo,' various issues, and other inforination provided by the Superintendencia de Instituciones de Intermediacion Financiera. Argentina data are drawn from 'Informaci6n de Entidades Financieras,' Banco Central de la Repuiblica Argentina, Superintendencia de Entidades Financieras y Cambiarias, various issues. 1.38 While Table 1.8 documents the narrowing of the gap between Uruguay and Argentina in the efficient provision of services, Table 1.9 points to an underlying cause: relatively high operating costs. Measuring costs under different accounting systems is difficult. The comparative figures that appear at the bottom of Table 1.9 are based on the ratios of overhead costs to total banking sector assets provided by Beck, Demirguc-Kunt, and Levine (1999), who tried to apply a consistent methodology across countries. These figures are consistent with those for the efficiency measures. Uruguay held an advantage over Argentina as of year-end 1994 (7.02% versus 9.11%). Over the ensuing four years, Uruguay improved slightly, while Argentina improved dramatically. By December 1998, the two had almost identical ratios of overhead costs to banking assets. 29 TABLE 1.9. COSTS 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Operating Costs per Employee (US$000s, 1990) Official Banks 33.6 46.5 43.5 36.0 31.8 (BROU) 34.9 46.5 43.1 36.6 31.5 (BHU) 29.6 46.6 44.7 34.3 32.7 Administered Banks 23.7 58.6 58.0 52.5 49.2 Private Banks 70.0 80.0 76.2 71.1 65.2 Financial Houses 94.5 91.4 85.3 80.8 71.6 Savings&Loans 49.6 51.1 43.1 36.0 32.2 Cooperatives 46.0 57.9 54.1 47.1 42.5 Total Uruguay Overhead Costs/Assets (%) na 6.49 5.86 6.75 7.02 na 6.74 7.46 7.91 9.11 Total Uruguay Total Argentina Sources: BCUfor operating costs per employee; Beck Demirguc-Kunt, Levine (1999) for the ratio of overhead costs to assets. 1.39 Figures at the top of Table 1.9 on operating costs per employee, at constant 1990 prices, indicate that Uruguay's improvement in its ratio of overhead costs to assets from 1994-1998 was not likely attributable to declining costs. Real operating costs per employee increased from US$42,500 in 1994 to US$57,900 in 1997. The figure did decline to US$46,000 for 1998, but the data for that year are preliminary and may require upward revision. To the extent that they do not require updating, however, the 1998 data provide one indication that real operating costs may be declining. If, on the other hand, the 1994-97 trend for real operating costs is an accurate predictor of the future, real output will have to keep pace with sizable increases in real inputs to maintain current profitability and efficiency levels. In an increasingly competitive regional banking environment, this may be difficult. 1.40 From 1991 to 1995, the ratio of overhead costs to banking assets in Uruguay rose from 5.1% to 6.8%. By 1997, the figure had declined slightly (to 6.5%). At the same time, the number of banking employees remained more or less steady from 1994-97; while, as table Table 1.9 indicates, operating costs per employee increased substantially during the same period. Taken together, these facts suggest that the increase in overhead costs during the period cannot be attributed to increased hiring in the banking sector. Rather, the rising costs are attributable either to growth in per worker wages and benefits or to increased capital costs, or, most likely, both. The increase in the ratio of real deposits per employee (Table 1.8) suggests that per worker intermediation (deposit taking) has increased, which is likely attributable to automation and the associated increase in capital costs. On the other hand, Caumont (1997) provides evidence that compensation per worker is much higher in Uruguay's banking sector than in those of neighboring countries. 30 1.41 High labor cost30 and the difficulty to reduce staff, because of trade union's strong bargaining power and militancy, have led to a reluctance on the part of the banks to hire new employees and has displaced other investment expenditure possibilities, particularly in technology. As a result, employment in the banking sector, as a whole, has decreased from 13,900 people in 1992, to 12,600 in 1998 (most of this decrease has occurred in the official banks). Another result is that the average age of bank employees is 45 years, which is rather high in an industry that is experiencing rapid technological change. A decreasing labor force has resulted in efficiency gains measured as deposits per employee and as loans per employee, which increased by nearly 38% and 48% respectively between 1992 and 1996; but these efficiency gains were more than compensated by cost of labor increases in the sector of over 111%.31 Future efficiency gains, and the introduction of new banking products and technology, may be limited by the serious deficit of skills in the banking sector, resulting from low investment in training activities. High operating costs among the banks have stimulated the development of non banking financial intermediaries in Uruguay, such as financial houses and credit administrators. These intermediaries are able to compete with the banks with lower costs, because their workers do not belong to the banking trade unions and do not contribute to the banking pension fund. BANKING REGULATIONS AND SUPERVISION 1.42 The Charter of the BCU establishes that supervision of banks and other financial intermediaries is to be carried out though the Superintendency of Financial Intermediation Institutions (SIIF). The SIIF, established in 1991, has technical independence but is hierarchically under BCU's Board. In recent years, the SIIF has undertaken a number of technical improvements through a program of technical assistance financed by the IDB. Also, in the context of a Bank adjustment operation,32 the regulatory authorities have issued a number new norms and regulations to: (i) control risks by requiring public and private banks to adopt a policy of flows matching between assets and liabilities for those transactions with maturity in excess of 3 years; calculate their capital adequacy ratio on a consolidated basis, apply rating and provisioning norms with respect to loans to public enterprises, and disclose to the BCU the risk models utilized for assessing their adequacy; (i) improve transparency in the financial sector by requiring banks to publish financial information and make available their external audits; and (iii) improve valuation of assets by requiring banks to value their assets according to the mark-to-market valuation method. Regulation is in general adequate, although there is still some ways to go to reach full application of Basle norms for capital requirement and for interest and market risks, although they are applied for credit risk. Also, International Accounting Standards (IAS) are not yet widely applied and there is no prudential regulation for derivative transactions. There has also been an effort by the regulatory authorities towards incorporating the public banks into the sarne regulatory framework as private banks. Starting in 1999, public banks are required to have external 30 Salaries of bank employees tend to be more than twice the salary levels of similar employment categories in other sectors. Social security contributions are also higher in the banking sector (employer contributions are 26 ¼/4% compared with 12.5% in the rest of the economy). 31 From Caumont. 1997. 32 Financial Sector Adjustmnent Loan, approved in February 2000. 31 audits. The regulatory authorities have also determined that the external audits of both public and private banks shall be made public. 1.43 Until recently, the SIIF devoted its efforts mostly to supervise and inspect the private banks, while giving a less rigorous treatment to the two public banks, which represent close to half of the banking system. The role of the SIIF with respect to these banks was limited to helping them to convert their accounting plans to the format of the official statements provided by the rest of the banks. Since 1997, the SIIF has been carrying out limited inspections of selected activities of these two banks, such as the valuation of their loan portfolio. In 1998, the SIIF undertook an evaluation of BHU's assets and liabilities and detected a number of weaknesses in the credit area that were reported to BHU's Board. While all private banks are periodically qualified by the SIIF using the CAMEL methodology, until recently the public banks were not subject to qualification. In July 1999, the SIIF carried out, for the first time, a global inspection of BROU applying the newly adopted CAMELS methodology BHU has not yet been qualified using this methodology. 1.44 The capacity of the BCU to inspect public banks is severely constrained by the limited number of inspectors it has, aggravated by the freeze in public sector hiring. At the end of 1999, the SIIF had 33 inspectors who in 1997 were fully occupied in inspecting the private banks.34 To extend the SIIF inspection to public banks, which account for about half of the banking system, the BCU would have to at least double the number of inspectors. It is also necessary to strengthen the legal capacity of the BCU to enforce compliance of prudential norms and regulations in the case of public banks (see par. 1.51). LEGAL FRAMEWORK 1.45 Uruguay has made significant improvements in modernizing its financial sector legal framework. The Financial Intermediation Law, approved in November 1992, expanded the regulatory and supervisory function of the Central Bank, and the new Charter of the Central Bank, also approved in 1992, helped to eliminate some limitations that the BCU had in carrying out its supervisory function. Nevertheless, the legal framework is still somewhat disperse and incomplete, and has internal inconsistencies that limit the full application of the existing financial regulation to the public banks. 1.46 Inadequacies of guarantee and bankruptcy laws. There are important legal constraints that restrict the development of the credit market in Uruguay. One constraint is the difficulty to execute pledged assets and guarantees. Procedures to execute security interest in pledged assets are extremely slow. The system of pledging movable assets does not function because the laws governing enforcement and collection are unclear, and tend to offer excessive protection to debtors. The inability to use movable resources as collateral affects mostly small and medium enterprises, which are unable to use equipment as collateral for bank loans. As in other countries, in Uruguay there is no 33 CAMELS stands for capital, assets, management, earnings, liquidity and sensitivity to risks. 34 The SIIF has under its inspection 51 financial entities plus 58 other entities such as credit administrators, exchange houses and others, of which 16 are subject to full inspection. 32 provision for a floating pledge such as animal herds. This means that the value of the collateral may drop over time, as the herd ages. This prevent small farmers from pledging their herds as collateral, a major restriction in a cattle raising country such as Uruguay. The only bank that accepts herds of animals as collateral for loans is BROU. Another legal constraint to the development of the credit market in Uruguay has been the inadequacy of its bankruptcy legislation, which does not favor easy exit of firms, particularly large ones35. Since the banking crisis of the early 1980s, some intervened firms have remained in limbo, due to lack of easy exit mechanism for firms. To close a firm in Uruguay, the procedure is to work out an agreement "concordato" with debtors and labor, in which labor must be paid first. This procedure is not only extremely costly, but it can last for 4 to 5 years. A new bankruptcy law was submitted to Congress in June 1998, but it has not yet been approved. 1.47 Secrecy Law. Uruguay has one of the most stringent banking secrecy laws in all the region. Banking secrecy can only be lifted by founded resolution from the criminal or civil justice if there is an obligation to provide for somebody's sustenance. Due to one interpretation of article 302 of the Penal Code, the doctrine has extended the banking secrecy to both active and passive banking operations. The structure of the banking secrecy has become an obstacle for inspection activities and for the transparency of credit activities. The strict banking secrecy restricts the capacity of the supervisory authorities to share information and experiences with authorities in other countries, as indicated in a recommendation of the Basle committee of February 1998. 1.48 Asymmetries in tax treatment. Segmentation of the Uruguayan financial market is encouraged by substantial asymmetries in the tax treatment of similar financial transactions carried out by different financial entities. One example of this is the different treatment by the BCU and by the tax authorities with respect to the time allowed to write off bad loans from the books. Banks are permitted by both the tax regulators and BCU to write off bad debts in six months. However, the tax regulators do not allow other financial agents, outside BCU's regulatory authority, to obtain tax credits on their writes off, until after 30 months. During that time, non banking financial intermediaries have to pay IVA over accrued interests, even if the loans are non performing. Another tax asymmetry is that cooperatives are exempt of income and equity taxes paid by other financial institutions. 1.49 Preferential treatment of public banks. Public banks have traditionally received preferential treatment in a number of areas, which gives them an advantage vis a vis private banks. The most important advantage is the deposit insurance that they receive from the Government, which is explicitly mentioned in their statutes, and implicitly extended to the rest of the banking system. This allows the public banks to receive deposits at lower cost than the rest of the private banking system. BROU has other privileges such as being exempt from paying VAT on interests collected on consumer loans to some clients such as pensioners and public employees, which allows BROU to provide consumer loans at lower interest rates than private banks. In addition, BROU has a monopoly on the Central Government accounts, including the Central Government judicial and administrative deposits made by private entities in guarantee of contracts 35 Uruguay: The Private Sector, World Bank, 1993 33 with the public sector and, until recently, a monopoly on deposits and salary payments of public enterprises.36 These are all sources of low cost deposits for BROU. Furthermore, BROU has an extra source of income as a result of its role of trade tax collector.37 In 1998, BROU received for these activities an amount equivalent to its total profits during the first eleven months of the year. In addition to similar privileges, BHU enjoys an extra-judicial regime for the liquidation of debts and, until recently, a monopoly in issuing asset backed securities. This has been eliminated with the approval of the Securitization Law, in September 1999. 1.50 Even if public banks are now under the same regulatory framework as private banks, one important advantage that they enjoy is that they are not subject to the same enforcement procedures as private banks if they fail to comply with BCU's prudential norms and regulations. One case in point is that public banks and the intervened banks do not fully comply with the provisioning and capital requirement regulations that apply to private banks.38 In cases in which the BCU has detected equity shortages, these banks have received an extended period of time to adjust to the BCU's requirements. This unequal treatment creates a bad precedent, as other banks may feel entitled to similar preferential treatment. The difficulties that BCU has in enforcing prudential norms and regulations in the case of public banks is, to large extent, due to the fact that the Charters of BROU and the BHU have the same hierarchy under the Constitution, as the Charter of the BCU, and, therefore, a director of the BCU cannot sanction a director of any of the public banks. 1.51 The Uruguayan authorities have taken important steps to create a more level playing field and stimulate competition between public and private banks, including reducing some special privileges enjoyed by public banks. For example, since December 1998, public agencies, previously obliged to have their deposits in public banks, are allowed to open deposits in public or private banks (this right was regulated by an Executive Decree issued on July 1999). 1.52 Lack of adequate market exit mechanism for banks. Experience in Uruguay over the last twenty years indicates that the Government is not willing to allow banks to fail. Any institution that has become insolvent was "intervened" by BCU and the Government has assumed its management, presumably in order to avert bank runs by assuring depositors that they will not lose their money. This results in an implicit 100% deposit insurance guarantee underwritten by the Government. Although the intention has been to restructure these banks and sell them to the private sector, in practice, the Government has been saddled for many years with the management of the intervened banks. By intervening, the Government not only forestalls potential runs, it also defers the recognition of losses stemming from the poor quality of these banks' portfolios. 36 State funds are subject to 100% reserve requirements, which makes them unattractive and expensive for BROU. 3 It charges a fee of 1% on the country's imports (except for imports under.the temporary admission regime) and 0.5 per thousand on its exports. 3 BCU requires that banks maintain a ratio of capital to risk-based assets of 8.5%. While officially BROU and BHU meet capital requirements, the intervened banks do not. 34 1.53 Legal and political constraints militate against the rapid re-privatization of the intervened banks. An important limitation of the financial legal framework is the absence of an adequate legal mechanisms to allow banks to exit the market in an orderly fashion. 39 A key problem is loss absorption. For the intervened banks to be sold, the Government must find a way to recognize and absorb past losses (i.e., recognize the current insolvency) transparently, perhaps even through explicit bond issues. Such steps would enable the full clean up of the banks, making their sale much easier. Indeed, there exists no positive price at which these insolvent banks could be sold without addressing these problems. In the absence of an appropriate legal resolution mechanism, government officials fear that if they approve the sale or an intervened bank at its market value (as opposed to its inflated book value), they could be subject to accusations of mismanagement or corruption. However, the difficulties to close banks go beyond the lack of a legal mechanism to do so. The militancy of the labor unions to preserve the jobs of its members is also a stumbling block to the exit and eventual liquidation of any troubled and even solvent bank. 1.54 Judicial and legislative practices. A major constraint to the expansion of credit markets in Uruguay is the distrust that lenders have with respect to the legal system, as a result of the forced restructuring of bank debts during the financial crisis of the 1980s. There is a need to accelerate the definition of property rights over intangible assets (such as a loan) in cases of bankruptcy, and to strengthen the judicial legislation and practices to redress the perception that they are biased against creditors. Similarly, it is necessary to take measures to redress the perceived bias of the labor justice in favor of workers and debtors. Even if there is no bias against creditors, the legal system proceeds very slowly, which has negative consequences for creditors. 1.55 The difficulty of getting financial legislation approved is an obstacle to the development of new financial products.40 Many of the legal initiatives in the financial sector that are presented to Parliament take a long time to be approved, or are never approved. In part, the delays are due to lack of concerted efforts to build consensus and to adequately respond to questions raised by members of Parliament and other stakeholders with respect to the proposed legislation. CONCLUSIONS AND RECOMMENDATIONS 1.56 Relative to its neighbors, Uruguay has long enjoyed a more developed banking sector. The evidence in this report suggests, however, that this comparative advantage is gradually eroding. Some inefficiency in the sector is due to structural problems. For example, market segmentation, especially the dominance of the non-financial credit market by public banks, is troubling. In addition, the intervened banks cannot contribute to improved productivity until their portfolios are cleaned, past losses are transparently absorbed and, subsequently, the banks are sold to new owners or they are liquidated, if they cannot be sold. More generally, the data on operating overheads indicate that Uruguay is a relatively high-cost banking environment. Increasing costs per employee In April 1999, the BCU issued new regulation concerning the voluntary cease of activities of solvent banks. 40 A Securitization Law was recently approved by Parliament after more than two years of having been submitted. 35 are, no doubt, partially attributable to technological improvements. At the same time, however, these cost increases have not coincided with substantial productivity gains. For example, the ratio of overhead costs per asset - a measure of the cost associated with intermediation - have declined slightly since 1994 in Uruguay. Over the same period in Argentina, that ratio has declined dramatically, and Argentina appears poised to overtake Uruguay on this measure. In an increasingly competitive international market for financial services, this should be of concern. Some combination of employee training and increased labor market flexibility appears necessary to achieve substantial productivity improvement. In addition, work must begin to establish the political consensus necessary to achieve the structural changes described above. Reducing the role of the state in the banking sector 1.57 The preponderant role of the public entities in the financial sector, and their preferential treatment, reduces competitiveness and the possibility of greater private sector involvement in some areas, and poses a fiscal risk for the Treasury. However, it should be recognized that public banks remain the main sources of finance for agriculture and middle income housing and that they enjoy high popular prestige in Uruguay. Reducing the role of the state in the financial sector will, therefore, require a process of consensus building among stakeholders to define the new boundaries between public and private activities, and a phased approach for its implementation. 1.58. Privatization of the intervened banks. An important step in reducing the role of the state in the banking sector would be to re-privatize or close the two commercial banks, currently under government management. Financial advisors should analyze the resolution alternatives for these banks, in particular the options of financial support versus liquidation. They should assess these banks' real value, through an evaluation of the quality of their portfolios and of the real value of their investments and fixed assets, and advise on whether it would be less costly to the Government to sell these banks as going concerns, after capitalizing and restructuring their balance sheets, or to close them, paying off their deposits and inter bank liabilities. Privatization or liquidation of the intervened banks could be prevented by the absence of a market exit mechanism for insolvent banks. 1.59 Leveling the playing field between public and private banks. The authorities have taken important steps to create a more level playing field between public and private banks However, remaining inequalities in the treatment of public and private banks should be eliminated, including applying the same tax treatment for transactions carried out by both types of banks. On the other hand, the practice of using the public banks to carry out non-banking activities on behalf of the Government should be discontinued. At the very least, these activities should be separated from their banking activities. There has also been an effort to incorporate the public banks into the same regulatory framework as private banks. However the capacity of the BCU to supervise public banks should be strengthened with an increased number of trained inspectors. BCU's capacity to enforce compliance of public banks with its norms and regulations (including imposing penalties) should be strengthened. This may require modifications to the Charter of the BCU. 36 1.60 Restructuring and privatization ofpublic banks. The restructuring of BROU needs to be completed in areas such as credit processes and the management information system. BHU should initiate an institutional transformation similar to the one being implemented by BROU. As part of the restructuring process, the activities of the public banks could be refocused on the mobilization of long term resources as second-tier institutions, to facilitate term lending through private banks. In the longer run, however, the Uruguayan authorities should consider privatizing the public banks. This could be done in steps, by incrementally selling shares of BROU and BHU to the private sector. Being subject to the scrutiny of private investors would improve the incentives for greater efficiency and reduce the pressure to use the banks to fulfill political mandates. Privatization of these banks would also stimulate the development of the local capital markets. A study of the contingent liabilities for the Government from the publicly owned and intervened banks is likely to provide a compelling argument in favor of privatization. Improvement of efficiency and competitiveness in the banking sector 1.61 Uruguayan banks face an increasingly competitive international market for financial services. Some combination of technological improvement, employee training and increased labor market flexibility appears necessary to achieve substantial productivity gains. High labor costs and the difficulty to reduce bank staff are important factors in the low rates of return of the Uruguayan banks, particularly of the public banks. The authorities should increase the dialogue with the labor unions on the effect of labor relations on the competitiveness of Uruguayan banks, and arrive at a formula to increase labor flexibility to allow the banks to implement labor and training policies that would make them more efficient. The new labor relations should include providing incentives for early retirement to open job opportunities to younger workers with more flexible working conditions; and applying the same legal level of severance payment to bank redundancies as to redundancies in any other type of enterprise. Adoption of a market exit mechanism for insolvent banks 1.62 The resolution of the intervened banks may be prevented by the absence of a market exit mechanism for insolvent banks. The focus should, therefore, be on developing the political consensus to recognize that the resolution of the intervened banks will generate losses to the Government (an in the case of Banco de Credito to the private shareholder), and on creating the legal basis to recognize and absorb the losses in a transparent way. The resolution of the intervened banks will also have to take into account the reluctance of the banking labor union to any job losses resulting from the sale or liquidation of these banks. The adoption of an orderly market exit mechanism for troubled banks would allow the Government to play a more indirect role in banking crisis resolution. Adoption of a limited deposit insurance scheme 1.63 In the absence of an explicit and limited deposit insurance scheme, all deposits are implicitly guaranteed by the Uruguayan Government. In the past, in cases of bank insolvency, the Govermment has allocated public funds to take control of the banks and 37 guarantee the depositors. A universal implicit guarantee contributes to moral hazard by bank shareholders, managers and depositors. While the prevalence of solid foreign banks in Uruguay reduces the possibility that the Government will again have to bail out the banks and guarantee the depositors, even foreign bank are not immune from insolvency. A limited deposit insurance scheme funded by the banks themselves would reduce the need for Government involvement in case of crisis and reduce the possibility of moral hazard. Improvement in contract enforcement and creditors rights 1.64 The reluctance of Uruguayan banks to lend to local firms is a result of the perception among banks that Uruguay's legal and judicial systems are biased against creditors. To encourage the willingness of banks to lend to Uruguayan firms, specially small and medium size firns, requires the strengthening of the ability of the judicial system to enforce contracts between lenders and borrowers. There is a need to strengthen foreclosure procedures and enhance the provision of credit through the creation of alternative collateral mechanisms (such as movable collateral) and the strengthening of property and commercial registries. Also, the new bankruptcy law being discussed in Congress should be approved to provide banks with a more efficient legal process for repossessing collateral from borrowers who default on their loans, and to establish time limits for the judges to settle bankruptcy proceedings. Finally, judicial procedures should be streamlined to accelerate the resolution of conflicts in commercial and financial matters. Strengthening banking regulation and supervision 1.65 Although regulation is in general adequate, there is a need. to implement full application of the Basle norms for capital requirement and for interest and market risks. Also, passage of the bill of law that would make mandatory the application of International Accounting Standards should be high priority. In order to carry out complete supervisions of the private and public banks, the SIIF needs to be able to hire more professional staff and implement training programs to familiarize its inspectors with modern practices for reviewing risks in foreign exchange, money markets and derivative areas. It would also be advisable to separate the functions of inspection and analysis in two separate units within the SIIF. In the longer run, the efficiency of the SIIF could be enhanced by separating it from the BCU. 38 II. CAPITAL MARKETS GENERAL OVERVIEW 2.1 Uruguay has an underdeveloped capital market, which has a market capitalization of less than 1% of GDP,41 compared to an average of almost 10% in emerging markets. Since its creation in 1867, until 1994, the only stock exchange in Uruguay was the Montevideo Stock Exchange (Volsa de Valores de Montevideo - BVM). An Electronic Stock Exchange (Bolsa de Electr6nica Valores S.A. - BEVSA) was established in September 1994, for exclusive use by banks and other financial institutions. In April 1999, the BCU licensed the third stock exchange in the country, called "Latin America Futures Exchange S.A.- Bolsa de Valores". This third exchange is not yet operative, although contracts in various currencies and government debt have already been approved. As of December 1998, the aggregate securities trading volume in Uruguay's two exchanges amounted to US$2.536 billion, representing 12% of GDP. Following regulatory changes that disqualified certain transactions, the aggregate securities trading volume as of December 1999 dropped to US$1.697 billion, about 10.7% of GDP.42 The capitalization of the stock market was about US$156.5 million as of December 1999 (1% of GDP). The minimal development of the capital markets appears to be related to the fact that potential issuing companies are either family owned, and reluctant to cede--even partially--effective control, of government enterprises. 2.2 The main participants in the securities market are banks and a few institutional investors. Participants in both exchanges deal with typical financial products including the trading of money market instruments. The banking desintermediation process has forced banks to search for new business lines, creating investment department that specialize in capital markets operations. These departments act as lead managers of private securities issues and/or underwriters. This activity is still incipient, but may increase as a result of the introduction of securitization, following Parliament's approval of the Securitization Law in September 1999. 2.3 Securities issued by both domestic and foreign entities are traded in Uruguay. Most domestic securities are issued by banks, the public sector and local companies. Foreign securities, which tend to be more diversified and sophisticated, generally are issued by foreign banks, government entities, companies and foreign portfolio managers. The activity in foreign securities stems, in large part, from the fact that since 1974 Uruguay has served as an important offshore banking center for countries in the Region.43 Table 2.1 shows the securities traded in Uruguay's capital markets, classified by origin (domestic or foreign), by type (fixed income, equity or derivative), and the currency denomination. 41 If Negotiable Bonds on issue are added, the share raises to 3% of GDP. 42 However, many of this operations do not reflect trading (secondary market), but primary market issues or banking system operations. See section on securities markets for details. 43 Indeed, residents of neighbors countries transfer financial resources to Uruguay basically through time deposits denominated in foreign currency (mainly dollars and a much lower amount of yen and deutsche marks). Today the market is more sophisticated and includes more instruments as shown in table 2.1. 39 2.4 Until April 1999, there was no formalized facility for trading futures or options in Uruguay, or for trading financial instruments of "second or third generation" such as forwards, FRAs, futures, swaps, caps, options, etc. In recent years, an increasing number of institutional investors (pension fund administrators (AFAPs), mutual funds and insurance companies), as well as conventional stock brokers have begun trading in these markets. Table 2.1. Types of Securities traded in Uruguayan capital markets Financial Instrument Local Currency Foreign Currency Domestic origin l_1 - Fixed Income Securities Public Securities Treasury Bills _ _ _ Notes NW Treasury Bonds Mortgage Bonds Private Securities Negotiable Bonds Bank Certificates of Deposit - Equity _______. _ ._. Stocks Foreign origin - Fixed Income Securities Public Debt Securities Treasury Bills Euronotes Treasury Bonds Eurobonds Private Mortgage Bond Commercial Paper Corporate Bonds Other -Equity ______________ Stocks Mutual Funds O ther ___________________ - Derivatives Note: A shaded area indicates the existence of the instrument in Uruguayan markets. Source: Caumont, (1997). THE STOCK EXCHANGES AND THEIR ACTIVITIES 2.5 Table 2.2 shows that primary issues in the stock exchanges are higher than trading (secondary market) in some of the instruments. Trading is mainly concentrated in negotiable bonds and Treasury bonds and bills (T-bonds and T-bills), and more recently, bank certificates of deposit (CDs). Some of the operations made through the exchange do not reflect securities trading activity. In this regard, it is worth mentioning that participations are global securities issued by foreign companies (mostly banks) in the BVM, which were used to obtain financing from the Uruguayan banking system. They have been recently suppressed, so they will disappear with their redemption. In terms of trading, public debt continues to represent the bulk of the market. However, there is a 40 trend towards the increase of private securities trading, basically negotiable bonds and CDs. The equity market could be considered almost non existent. Table 2.2. Consolidated Stock Exchange Securities Trading Operations in Uruguay (Millions of US$) June 1999 1998 1997 1996 1995 1994 2000 Private Sector Securities 460.9 943.3 663.0 384.6 268.3 169.9 311.9 Equities 0.4 15.3 14.6 3.3 4.5 4.8 9.9 Of which secondary market: 0.4 1.5 4.3 3.3 N/A. N/A. N/A. Negotiable Bonds 48.5 128.4 116.4 231.1 104.4 16.9 28.5 Of which secondary market: 35.4 85.2 92.6 74 N/A. N/A. N/A. Global Custody Certificates 0.0 0.0 0.1 0.3 13.0 35.9 20.3 Participations 0.0 135.9 174.3 149.4 145.4 112.2 251.4 Bank Certificates of Deposit 412 663.7 367.2 0.1 0.1 0.1 0.8 Of which secondary market: 126.6 57.7 10.3 0.1 N/A. N/A. N/A. Other 0.1 0.5 0.4 1.6 0.0 1.0 Public Sector Securities 368.2 653.3 1862.6 563.7 429.1 530.3 293.0 Treasury Bonds 155.4 366.7 555.7 319.8 306.5 265.6 182.2 Of which secondary market: 152.0 316.2 538.6 296.1 278.4 N/A. N/A. Treasury Bills 12.3 63.1 239.6 132.3 92.0 213.3 95.9 Of which secondary market: 10.0 42.5 202.8 82.3 18.1 N/A. N/A. Eurobonds/Notes/Global 169.4 190.7 1041.1 108.3 23.0 12.9 3.0 Bond Issued by: Public Entities (including 31.0 32.8 26.2 3.3 7.6 38.5 11.9 BHU) Central Government 337.2 620.5 1836.4 560.4 421.5 491.8 281.1 Total Securities 829.1 1596.7 2525.6 948.3 697.4 700.2 604.9 Source: BCU, Exchange Trading Bulletin. 2.6 Public debt securities. Until 1992, securities traded in Uruguay's capital markets were almost exclusively public debt securities denominated in foreign currencies. Before 1992, public securities accounted for 99% of the securities traded. Public sector securities include T-bills and T-bonds, eurobonds and some government enterprises bonds, including securities issued by the BHU. Public sector issues are made using different strategies. T-bills are issued by a weekly auction to determine the interest rate; eurobonds are issued in foreign countries denominated in various currencies (dollars, yens), being traded through underwriters; and T-bonds are issued by auction to determine the interest rate (over LIBOR), denominated in dollars and being bought by institutional investors (banks and brokers) through the stock exchanges. T-bonds have been the main instruments used by the Uruguayan Government to finance the gap between its expenses and revenues. The issuance of the Global Bond (with maturity in 2027) in 1998 resulted in a significant increase in the share of public securities operations, and a change in the composition of the securities used to finance the public deficit. The short-term instruments used by the Government are the T-Bills. - 2.7 Private Securities. Private sector securities consist of CDs, bonds and stocks. Since April 1998, CDs operations have grown dramatically due in large part to 41 regulations that require AFAPs (private pension fund administrators) to make all of their transactions through formal markets. However, in terms of trading, negotiable bonds are the most active instruments among private securities. Figure 2.1. Negotiable Bonds in circulation 759.5 800 T_ 700 62 s: 6fK)A- ~~~~~544.760. a 600- 500 -* W400 309.8 200 r 56.3 300 1605 0 77! 961it-+ - Dec- Dec- Dec- Dec- Dec- Dec- Dec- 93 94 95 96 97 98 99 (*) It does not include banks certificates of deposit Source: BCU, Exchange Trading Bulletin 2.8 Negotiable bonds (obligaciones negociables)44 started trading actively in 1996, following the approval of new regulations for this type of security. As of December 1999, there were 44 companies in the securities registry that had debt in circulation for a total of US$759.5 million. Two banks accounted for nearly 50% of the amount of negotiable obligations in circulation. This market was negatively affected in 1998 by the failure of a private issuer in honoring its debt. In 1998, primary issues of negotiable bonds fell from US$211.7 to US$24.8 million following this event. In August 1999 there was an issue of US$50 million by an Uruguayan firm that helped the recovery of the primary market. This issue, made outside the exchanges, was the largest made by a non bank in Uruguay since the approval of the Capital Markets Law. However, the secondary market seems not to be totally recovered yet. 2.9 The equities market is almost insignificant. Only a few open companies list their equity in the stock exchange. Approximately two thirds of the equity activity is in the primary market. The activity is very concentrated (89% of 1999 trading-until September--in shares of 3 firms). This situation stems from a number or reasons, including: the prevalence of government ownership of the main utilities and the largest banks; the scarce fiscal or legal advantages to issuing shares; and the fact that small and medium-size companies are mostly family-owned and unwilling to open up their capital. Unlike most countries in Latin America, Uruguay has not privatized its public enterprises. In a plebiscite held in 1992, citizens expressed themselves against the privatization process. Nevertheless, public companies are entitled to issue bonds as stated in the Securities Markets and Bonds Issue Act. 44 These securities are not taxable by the Bank Assets Tax that is applied to bank loans with a rate of 2%, although decreasing from 1998. 42 Table 2.3. Number of Listed Companies 1999 1998 1997 1996 1995 1994 Equities 22 19 8 i 18 18 19 Bonds and other 65 45 43 27 17 11 debt issuers Total 87 64 61 45 35 30 2.10 BMV's bylaws were modified in 1993 to permit legal entities to operate in the exchange (previously, only natural persons were allowed to operate). Until recently, the main activity in the BMV was trading of public securities, but now an increasing number of securities issued by private entities are traded, although it is still an incipient market. Currently, the BVM has 74 stockbrokers45 (natural persons as well as legal entities, e.g. corporations) and 20 special partnerships, a category created in 1995, and increasingly being adopted by official and private banks, and pension funds (cajas paraestatales). These entities do not have full rights like brokers, but they can trade in the stock market with the same rules as a typical broker. 2.11 The types and amount of securities operations in this exchange are shown in Table A2.3 in Annex II. Operations in the BMV have expanded at a slowly pace as a consequence of the increasing activity of the electronic exchange. The total value of the operations in this exchange was US$717 million in 1999 (4.6% of GDP). Treasury Securities account for approximately 90% of the exchange trading activity (secondary market) with the majority relating to the trading of Treasury bonds. Private sector trading is dominated by negotiable bonds. The equity market trading in this exchange is very low. 2.12 The BVESA has currently 26 partners including 20 of the 22 private banks operating in Montevideo, the two official banks, BROU and BHU, two financial houses, one S&L cooperative and one credit administrator. It also has 12 special partners including the BCU, the Banco de Seguros del Estado (BSE), six AFAPs operating in the financial center, three mutual funds and one caja paraestatal de la seguridad social. The activities of the exchange are divided into three segments: the foreign exchange market, the money market and the securities market. The instruments traded can be public or private and denominated in local or foreign currency. Table A2.4 in Annnex II shows the amounts of operations in each of the three segments. 2.13 The majority of the transactions in the BVESA are in instruments denominated in foreign currencies. In 1999, the total value of securities operations in this exchange was US$880 million (5.4% of GDP). Until 1998, only fixed income securities were traded. There is a high concentration of operations in public securities, especially in 1998, as a result of the issue of the Global Bond The most important change in the pattern of securities operations on this exchange has been the increase in operations on banks' CDs, 45 Under its own rules, there may only be up to 90 brokers. The broker status is acquired at a public auction of the existing vacancies. After the auction there are two requirements that the applicants must fulfill: i) approval by a special majority of the Stock Exchange Board of Directors and ii) a technical test. Stockbrokers are not subject to accounting information or reserve requirements. 43 although the trading (secondary market) of these instruments is still very narrow. These instruments constitute the only private sector security with a meaningful amount of activity occurring. Trading in public securities continues to represent the bulk of the secondary market. The high fluctuations in securities' trading patterns reflect the early stage of the Uruguayan securities markets development. LEGAL AND REGULATORY FRAMEWORK 2.14 The first regulation of the securities markets appeared in 1982 with the Financial Intermediation Law and its Regulatory Decree. This law stated that the regulation of the securities exchange had to be done by Executive Power in consultation with the Central Bank. Congress passed two important laws in 1996, that set the basic regulatory framework for the development of the securities market. The Securities Market and Bonds Act (Ley del Mercado de Valores y Obligaciones Negociables- Law No. 16,749) regulates the general environment of securities market, public offerings and bond issues. The most outstanding features of this law are: (i) stock exchanges self-regulation principle, (ii) new regulatory and supervisory duties entrusted to the Central Bank, (iii) stock market transparency and disclosure principle, (iv) procedures for new bond issue and new incentives in order to develop the market. The Investments Funds Act (Ley de Fondos de Inversi6n- Law No. 16,774) defines the necessary characteristics and terms for the regulation and supervision of investment funds, provides management guidelines and includes general definitions related to professional secrecy and adequacy terms and investment periods for investment managers that begun working before the law was passed. In September 1999, a Factoring and Asset Securitization Law was enacted. Under the provisions of this law, the so called close-end credit investment funds are entitled to operate under similar provisions as those contained in Law No 16,774 of Investment Funds. 2.15 The BCU is the entity in charge of the regulation and supervision and enforcement of entities of the securities market, pension funds managing companies and insurance companies, as well as banks. In 1996, a new regulatory body was established the Superintendencia de Mercado de Valores (SMV), within the BCU. In addition, the Auditoria Interna de la Naci6n, under the authority of the Ministry of Finance, is the entity in charge of controlling open companies, from their creation to their dissolution, from a statutory and accounting point of view. 2.16 Both stock exchanges have their own regulations, approved by the BCU, and their Boards of Directors are entitled to apply penalties to brokers, including suspensions. They must respect self-regulatory rules, though taking into account the stronger government presence assumed by the BCU. Stock exchanges must request authorization to operate, and they are required to submit specific information to the BCU. Securities dealer are not required to obtain a government authorization or to fulfill registration procedures. The OTC market is included in the new legal framework, but its rules have not been set up yet. 44 SECURITIES CLEARANCE AND SETTLEMENT 2.17 In Uruguay, global bonds (public or private), CDs and T-bills are always issued in a dematerialized form. T-bonds, negotiable bonds and other public offering securities are issued either in physical or book-entry form while shares are usually issued in physical form. There is no legal requirement in one way or the other, but most of the securities traded are bear physical certificates. There are some special features in terms of securities immobilization. AFAPs46 have all their securities under custody of the BCU. BVM brokers have their own securities, or those they have on behalf of their customers, under a private bank custody due to the special arrangement that BVM has with this institution. In addition, there is a so called "custodia cautiva" for some negotiable bonds. In this case, there is an issue of physical certificates, but they are retained in a custodian bank. 2.18 There is no central securities depository and the clearance and settlement process varies depending on the exchange where the operation is done, the counterparts involved and the institution in custody of securities. Since the end of 1997, the BVM has had a general arrangement with a private bank for clearance and settlement. In BEVSA there are no specific arrangements for the securities clearance and settlement. Once the transaction has been done through the exchange, the counterparts agree in the terms and conditions to settle the operation. There is no follow-up by the exchange to ensure that the operations have been effectively settled. In this exchange the operators are usually institutional investors (banks, financial entities, pension funds, mutual funds and insurance companies), and thus it is common that payments are credited and debited in the accounts that these institutions have in the BCU. CONCLUSIONS AND RECOMMENDATIONS Expanding securities trading 2.19 The market for tradable securities is clearly dominated by public sector debt instruments and bank CDs, which fund bank assets. In other words, the securities markets is of little or no relevance as a source of direct financing for private sector investment. This means that, at this stage, securities markets play a little or no developmental role. The minimal development of the capital markets appears to be related to: (i) the fact that potential issuing companies are either family owned, and reluctant to cede, even partially, effective control, and (ii) the predominance of government enterprises. None of these limitations can be easily overcome. The first limitation seems to indicate that there may be governance factors at work, and issues related to the protection of minority shareholders that should be further studied. With respect to the second limitation, full privatization of state owned enterprises is currently precluded by the outcome of a recent referendum on the issue. One possible way to further develop the capital markets would be to partially float financially attractive state- owned enterprises in order to commence developing an equities market culture. The State can still retain effective control of the enterprise. The privatized portion may be 46 Article 126 of the Social Security Law, No. 16.713, states that securities representing AFAP investments must be under the custody of a single institution. In practice, this institution is the BCU. 45 floated solely in the domestic market, in other MERCOSUR countries and/or through ADR's in US market. The issuing of securities by these enterprises in the local market would provide alternative investment instruments to institutional investors. 2.20 However, even if more securities could be issued through partial privatization of state enterprises, the size of the Uruguayan market may still be too small to support an stock exchange, let alone two. Globalization has generated a liquidity drain from even the largest markets in Latin America, as blue chip firms have access to cheaper finance in the USA or European markets. Although the hardest hit are the smaller markets (Peru, Venezuela, Chile), even Brazil has felt the need to consolidate equities trading in its leading stock exchange in Sao Paulo. In this context, the Uruguayan authorities should consider exploring with its MERCOSUR partners the setting up of a regional stock exchange (this has been suggested by both Argentina and Brazil recently). Such a regional market may better reward efforts to improve liquidity than the revival of the local current exchanges 2.21 In the meantime, a way to reduce the problem of small market size could be to merge the two exchanges or, alternatively, to allow the two exchanges to operate separate markets, which trade different instruments. For example, one can support trading in large issues while the other can support trading in smaller high growth issues. An alternative approach could be to keep both exchanges, but to have a common price discovery mechanism through electronic trading (like the combined tickets for exchanges in the USA), which would allow cross-listing to continue, while getting rid of the price arbitrage problem. Strengthening regulatory framework and market supervision 2.22 The authority of the SMV and the resources available to it are extremely limited. A total staff of 10 (6 professionals) is in charge of the oversight of both stock exchanges, all companies issuing securities, all mutual funds, their products and rating agencies. In addition, the SMV is a department within the BCU possessing few powers to sanction regulated entities for compliance failures or regulatory infractions. Thus, there is a need to increase professional staff to promote adequate regulatory coverage and the BCU should delegate to the SMV sufficient authority and powers to enforce compliance and market integrity. 2.23 The self-regulation approach adopted by the Uruguayan authorities requires the stock exchanges to assume a meaningful self-regulatory role. Currently, neither exchange performs meaningful regulatory activity over their respective markets. Further, the BVM has thus far failed to comply with certain regulatory requirements (e.g. formal filing of exchange rules with SMV). Given Uruguay's adoption of the self-regulatory model, it is necessary to increase the self-regulatory capacity of both exchanges. 2.24 For securities intermediaries to operate on the exchanges, they are required to be members of the stock exchanges only and need not be licensed by the SMV. The absence of direct regulatory supervision of intermediaries by the SMV, combined with the previously discussed deficiencies in the self-regulatory process, detracts from overall market integrity and performance. The authorities should consider delegating to the 46 SMV sufficient powers in relation to the licensing of intermediaries. These powers should relate to not only initial licensing requirements, which would include among other things the ability to determine prospective brokers' fitness and properness to function as an intermediary, but also continuing obligations such as the requirement to satisfy minimum capital requirements. 2.25 The Uruguayan legal definition of "public offering" appears to be somewhat restrictive. Although no quantitative parameters are specified, numerical (number of shareholders) threshold is extremely low. When registering a prospective IPO with the SMV, an enterprise can either go directly to the SMV, or process a listing application with one of the stock exchanges. If the latter route is selected, the exchange assembles all required information and documentation and then passes it to the SMV for approval. Applications received via the exchanges are frequently incomplete and once received, the SMV than has only 10 days to approve or disapprove the application. The registration process is disclosure based (versus merit based). Although disclosure represents an appropriate model, given the almost total absence of liquidity, once securities are publicly floated, adjustments to the offering process are appropriate. Several recommendations could be followed to deal with these issues: * Provide a mechanism for private placement with streamlined processing features and requirements. * Implement processing standards applicable to the exchanges and provide the SMV with the authority to enforce compliance therewith. Provide mechanism for extending approval time parameters where circumstances warrant. * Require issuers wishing to have their securities traded on the exchanges to have initially, and on an ongoing basis, a minimum number of shareholders holding various quantities of securities to enhance market liquidity. Improving information transparency 2.26 The absence of uniform accounting standards detracts from capital market credibility and integrity. In July 1998, a bill of law was presented to Parliament which if enacted, would require all companies in Uruguay, including banks, to follow internationally accepted accounting standards (IAS). Passage of such a law should be considered a priority by the incoming administration in Uruguay. However, if the adoption of IAS for use in Uruguay turn out to be too complex and time consuming, an alternative to be considered could be the adoption of USA accounting standards. 2.27 There is a prevalence of (debt) securities iP bearer form. Given the closely held nature of many non-government enterprises listed in the stock exchanges, bearer securities may be frequently used by controlling interest to affect transactions. This, together with the disparate pricing produced by the market, could detract from market transparency and directly affect the rights of minority shareholders. and provide investors access to inadequate market information. 47 2.28 Information provided by issuers to the regulatory authorities and the market (shareholders and other stakeholders) is inadequate in both content and timeliness. Material information must be promptly disclosed to the market. It is important to improve both disclosure at issue by issuers and of transactions by insiders/controlling interests, as well as ongoing disclosure. The first refers to the rules for a prospectus etc for an IPO; the second is about quarterly or annual reports to shareholders. All market borrowers should provide quarterly and annual reports (audited for the annual ones). Also, dissemination of material financial information including secondary market prices in a timely fashion should be made mandatory. Where an issuer fails to comply with the disclosure requirements, the regulatory and/or self-regulatory authorities must possess adequate powers to sanction. Improving market performance 2.29 The issuance of government debt instruments aims at addressing the Government's financing needs. However, it does not assist in market development through the establishment of a yield curve. The authorities should consider issuing debt instruments with a view to establish a benchmark for the market. To issue a significant amount of debt on a periodic basis with terms ranging from short term (30 day) to long tern (30 year) could provide the market with a necessary pricing frame of reference. 2.30 The abundance of bearer bonds renders the clearance and settlement system inefficient and poses unnecessary risk exposure. Further, bearer securities trade at a premium to their book entry counterparts. It would be advisable to develop an appropriate registration and immobilization practice (this refers to keeping the paper in some central depository). It would also be useful to gradually develop scripless issues (i.e. dematerialize), to limit the use of such bearer instruments. Although the use of bearer instruments cannot be eliminated, it can be dramatically reduced. 2.31 Although credit rating agencies operate in Uruguay, their involvement in the capital markets is quite limited (there are currently 3 international and 3 local rating agencies). The use of rating agencies is sporadic and the methodologies employed need to be improved. The authorities should require the rating by a recognized agency of instruments eligible as investments by pension funds, mutual funds, etc. The use of rating agencies should be expanded, and to the extent practicable, the methodologies employed standardized. However, the authorities should make sure that required ratings are not used for regulatory purposes which would discourage the independence of rating agencies. 2.32 There is an absence of risk management capabilities by issuers, institutional investors and exchanges/clearing houses. Given the deficiencies associated with asset valuations, accounting standards and disclosure (as well as the prevalence of potentially unprofitable government owned banks), risk exposures may be significant. Regulators have limited capabilities to evaluate these risks or the methods by which regulated entities manage these risks. Risk management capabilities by the regulators, the banks, institutional investors, issuers and the exchanges must be developed. Also, it is advisable, over time, to develop appropriate hedging tools such as forward contracts to assist market participants in their management of risks. 48 III. CONTRACTUAL SAVINGS SECTOR 3.1 The contractual savings sector in Uruguay includes pension funds, mutual funds and insurance. This sector is very incipient. Pension funds accumulated by the pension funds administrators amounted to about 3.8% of GDP in 1999, up from 1.3% in 1998, and the amount of mutual funds managed amounted to 1.1% of GDP in 1999, down from 1.8% in 1998. Similarly, the direct insurance premium in 1998 (latest information is available) amounted to 1.7% of GDP, down from 3. 1% in 1997. PENSION FUNDS 3.2 The reform of the Uruguayan pension system took place in April 1996.47 Before the reform, Uruguay had exclusively a PAYG pension system. It was confronted with rising life expectancy, low retirement ages, a high replacement ratio, indexation of benefits to net-of tax average wages in the economy, poor administration and a high rate of evasion of contribution payments. Contributions were covering only half of the expenditures, with the Government providing the remaining financing. The old system was not sustainable as the population dependency rate and the system's dependency rate were diverging48 reflecting problems of two types: the number of paying contributors was smaller than should be, because of evasion and informal sector labor markets, and the number of collecting retirees was greater than should be, because of early retirement, excessive disability claims and lax enforcement of eligibility requirements. 3.3 The old system was replaced by a new one which restructured and downsized the public PAYG system and added a complementary capitalization regime of individual accounts administered by independent pension funds administrators (AFAPs). The main objective of the reform was to improve the actuarial balance of the PAYG system and reduce the Government's future liabilities to pensioners. The new system was expected to have the effect of improving capital markets; although at the same time it has the challenge of the early stage of development of the Uruguayan capital markets. 3.4 Currently, three different pension systems coexist: The Old System, a defined benefit, PAYG public pension system, which applies to all those eligible for retirement by end-1996. It is administered by the Banco de Prevision Social (BPS); The Transition System, also a defined benefit, public PAYG pension system administered by BPS, but with lower benefits than under the old system. This system applies to workers 40 years of age or older on April, 1996, who did not opt for the new system and who were not eligible for retirement by end-I 996; 47 Uruguay passed a major Social Security Reform Law (Law 16,713) in September 3, 1995. The implementation of the reform began in April 1996. 48 In 1996 there were 706,986 pensioners and only 746,306 contributors. These data suggest a dependency rate in the pension system of 0.95 (or 1.06 workers per pensioner). With a contribution rate of 27.5 of the average wage and a pension replacement rate about 65% of the average wage, there was no way that 1.06 workers could support a pensioner at the given payment rate. 49 The New System, consisting of three pillars. This system is mandatory to all new entrants to the labor force and all those under 40 years of age on April 1, 1996: (i) a defined benefit, public PAYG system financed with employees' contributions on the first 5,000 pesos per month of earnings (at May 1995 values, equivalent to US$728). (ii) a fully funded capitalization regime administered by AFAPs for employees with earnings between 5,000 and 15,000 pesos per month, and optional for other workers; and (iii) a voluntary pillar for workers with incomes above 15,000 pesos per month, who choose to invest a proportion of their income above 15,000 pesos per month in individual retirement accounts. Special Regimes, applicable to the military, police, bankers, notaries, and university professionals. While the eligibility requirements for pensions have been moved closer to requirements of the new system, professionals and notaries largely financed by special earmarked taxes, and the others are PAYG systems. 3.5 The newly created AFAPs, together with three official pension funds (Cajas Paraestatales de Fondos de Pensi6n), operate in the market as institutional investors. Neither the BPS nor the rest of official pension funds constitute a source of funds for the capital markets due to their participation in the PAYG system and not in the fully funded capitalization regime. AFAP's OPERATING IN THE SYSTEM 3.6 There are currently six AFAPs operating in Uruguay. Of these, the largest is AFAP Repuiblica, which is 51% owned by the state bank, BROU; 37% by BPS, and 12% by the state insurance company, Banco de Seguros del Estado (BSE). AFAP Repuiblica clearly dominates, with 38% of affiliates and 56% of total administered assets. The share of AFAP Repuiblica in the market has remained constant almost since the beginning. Its portfolio market share appears to be larger than its affiliate market share on the basis of both attracting higher income affiliates and attracting those who contribute most regularly. The other five AFAPs are privately owned, similar to the pension funds found elsewhere in Latin America. All of them are subsidiaries of commercial banks operating in Uruguay. Another reason for the prevalence of AFAP Republica is that it is the only AFAP in which the minimum return on the administered funds is explicitly guaranteed by the Government. 50 TABLE 3.1. AFAPS OPERATING IN URUGUAY (As of 06/2000) Affiliates Value of Commission Gross Net Returns Pension s Returns 1/ Funds % % Ur$ millions Capital 73,261 669.8 2.200 12.90 8.02 Comercial 95,208 914.4 1.955 12.20 8.93 Integraci6n 73,298 732.0 2.200 12.30 8.21 Republica 208,972 4,722.9 1.970 12.34 7.56 Santander 69,350 767.8 2.250 12.38 7.77 Uni6n 31,925 658.9 1.820 12.98 9.11 Total 552,014 8,515.9 2.066 12.46 Source: BCU, Boletin Informativo, various issues. 1/ Projected returns based on the results for the last 5 years in URs. 3.7 Accumulated funds transferred to the AFAPs increased from US$101 million in December 1996, to US$637 in December 1999 (2.9% of GDP), and to US$706 million in June 2000. Since their creation, the funds accumulated in the AFAPs are being invested mainly in low-yielding government securities and bank certificates of deposit. This pattern of investment is the result of both restrictive investment regulations and the underdevelopment of Uruguay's capital market. Following the Government's decision, in early 1998, to reduce the required minimum investment of pension funds in government securities, the share of these investments decreased from more than 80% in mid 1997 to about 60% in late 1999, but increased again in mid-2000 to nearly 66%, as investment in bank CDs decreased. The bulk of the investment is in the Government's US-dollar denominated Global Bond issues (44.3%) and Treasury bonds (about 9.5%). Investment of pension funds in private securities began in 1998, when rating agencies started operating in Uruguay and begun rating private securities. Investment of pension funds in private securities remains very low, although it has increased steadily from 4.2% of AFAPs' investments by October 1998, to 5.4% of investments by October 1999 and 5.7% in June 2000 TABLE 3.2. INVESTMENT OF PENSION FUNDS (%) 06/2000 10/1999 10/1998 7/1997 Government Securities 65.8 59.6 69.0 81.4 BHU Securities 7.9 2.0 0.4 1.0 Bank CDs 15.3 28.0 20.7 17.3 Enterprises' Securities 5.7 5.4 4.2 0 Loans to Affiliates 1.7 1.8 3.3 0 Cash 3.5 3.2 2.5 0.2 Total 100.0 100.0 100.0 100.0 Source: BCU, Boletin Informativo, various issues. 51 INVESTMENT REGULATIONS 3.8 The Social Security Reform Law establishes the type of financial instruments in which pension funds are allowed to be invested. The investment regime for AFAPs is heavily biased towards government securities. Although limited financial sector instruments currently exist in Uruguay, this policy of investment restrictions appears to be driven more by the Government's concern for financing the transition costs than by financial market considerations. Initially, a minimum of 80% and a maximum of 100% of AFAP's administered assets had to be invested in government securities (defined as treasury bonds, treasury bills and pension bonds). The Social Security Law allows for yearly reductions of 5 to 10 percentage points of both limits, to reach a maximum of 60% in such securities. In April 1997, the Government reduced the minimum to be invested in govemment securities to 75% and subsequent reductions have brought the minimum to 55% since April 1999. 3.9 Conversely, in the first year of implementation of the reform,49 investment in securities not issued by the Uruguayan State had a threshold of 20%, increasing 5% yearly up to a maximum of 70%. The funds can be placed: up to 30% in securities issued by the BHU, up to 30% in domestic or foreign currency denominated deposits of banking institutions operating in Uruguay, up to 25% in equity or negotiable bonds of private or public entities listed in an exchange (BVM, BEVSA), up to 20% in securities issued by real sector companies guaranteed by banking entities through issuance of CDs, and up to 15% in banking entities that use the funds invested to grant personal loans to affiliates and beneficiaries of the Social Security System. However, the sum of investments in the last three categories cannot exceed 30% of the fund assets. The Social Security Law forbids investments in securities issued by other AFAPs, insurance companies, foreign companies (except for banks allowed to operate in Uruguay), financial investment companies (sociedades financieras de inversi6n), and unrated equities. The Law also precludes investment by AFAPs in foreign assets, although it allows foreign owned AFAPs to operate in the Uruguayan market. 3.10 Since the beginning, AFAPs have shown little interest in government issued "pension bonds." These bonds are issued in wage adjusted values (UR) and may be held only by AFAPs, greatly limiting the secondary market in this security. Furthermore, the interest rates on these bonds were determined solely by the BCU, and are well below market rates. Understandably, AFAPs have been reluctant to invest in these bonds (they accounted for only 7% of pension funds investments in June 2000). On the other hand, insurance companies are currently required to invest reserves arising from death and disability insurance premiums and annuities related to retirement savings in the same assets in which AFAPs invest, but are not allowed to invest in pension bonds. This is a shortcoming of the Law, since both disability insurance and annuities are paid in wage adjusted values, making the insurance companies one of the few parties interested in investing in "pension bonds," in order to be able to match their assets and liabilities. In April 1997, the authorities presented a bill of law to Parliament which, if enacted, would allow the Government to issue pension bonds in different currencies and allow their purchase by all types of enterprises. 49 Implementation began in April 1996. 52 INVESTMENT OPPORTUNITIES 3.11 As shown in the previous section, Uruguay has a very incipient capital market, even for developing country standards. There is a need to widen the supply and availability of investment instruments to keep pace with the rapid growth of funds in the capitalization regime. Development of the equities market has been partly constrained by popular plebiscites that have forestalled Government's efforts to privatize major public companies. The strategy of the previous and ongoing administration has been to promote concessions and eliminate the monopolies enjoyed by public enterprises. The Parliament approved a partial restructuring of the electricity sector which will allow competition in generation; the water and sanitation sector is working on a proposal which will allow for an expanded role for the private sector through regional concessions; gas distribution is now done by a private concessionaire. The Government is in the process of privatizing infrastructure related to the critical tourism industry by concessioning the roads between the capital and the tourist beaches and the port, airport and the water supply company servicing these areas. The financing needs of these concessions are a potential area of investment for AFAPs. However, special regulation is required to allow AFAPs to invest in securities issued by this type of enterprises. A major potential source of private securities is the housing market. Banks in Uruguay have started providing mortgage loans in US dollars and the BHU has been providing housing loans for some time. The recent approval of the Securitization Law is likely to stimulate the supply of securitized assets in Uruguay, which would expand the investment opportunities of AFAPs. EFFICIENCY INCENTIVES 3.12 Initially, the commission structure and reporting requirements by the AFAPs were not geared to induce efficiency and lower management cost of the pension funds. Uruguay's Social Security Reform Law adopted a cormnission structure and reporting requirements for the capitalization regime similar to those pioneered by Chile and adopted by Peru, Argentina and others. All of these countries have identified extensive problems of high commissions, high sales costs, excessive account switching among affiliates, and the resulting low returns for the affiliates, and some have implemented changes in AFAP regulations and commission structure to promote efficiency. 3.13 Commission Structure: By law, AFAPs are required to charge a commission on the affiliate's current contribution to the fund, at freely market determined rates. Effectively, the law prescribes that commissions can only be charged on the current salary base each month and not on assets managed. Currently, an affiliate contributes 15% of his base wage each month to the fund, and the AFAP charges a commission, of between 1.95% and 2.25%, on the same base wage (the sector's average was 2.066% in June 2000), regardless of the assets under management. In addition, the AFAPs charge insurance commissions of around 0.64% of the base wage. This means that only around 12.3% of an affiliate's wage goes into a capitalized account. This commission structure results in very high commissions compared to assets for the early years of contributions-- around 18-19% on assets managed in the first year. If the rate of commissions is unchanged, they would result in very low commissions as percentage of assets beyond 20 years or so, possibly well below the costs of managing investments. This extreme front- loading of commissions (essentially a single lifetime up-front commission for every 53 dollar contributed) provides powerful incentives for the AFAPs to incur very high direct marketing expenses to get a high initial market share. This situation produces several problems, including: (i) negative net return on assets in the early years of contribution for the affiliates, (ii) early excessive entry of AFAPs unsustained by the asset base, followed by likely departures later, and (iii) a strong tendency for the AFAPs to neglect cost efficiency in favor of market shares and thus lower the long term return to the affiliates. 3.14 Reporting Requirements: Initially, AFAPs were only required to report gross returns in wage adjusted units. Reporting gross returns hides the fact that the affiliate's net returns, after considering commissions, are substantially lower and indeed negative during the initial 4-5 years, given the existing front-loaded commission structure. If AFAPs were to report net returns to the affiliates, they would be able to make a better informed choice among AFAPs, and the AFAPs might be compelled to reduce costs and change their competitive strategy from one based on sales force to one based on the level of return offered to the affiliates. However, given the current fee structure, short-term returns can be misleading, as the AFAP fees in theory cover the management of currently invested funds for an average of 20 or more years. To improve transparency of financial information to affiliates, since the first quarter of 1998, AFAPs are required to report to their affiliates net returns of the funds administered, but calculated on the basis of a formula that takes into account the longer term effect of these investments.50 3.15 Accounts Switching. One cost-increasing feature in many privately administered pension funds involves the freedom of individuals to potentially change frequently their pension fund. While this encourages competition, most pension funds employ large sales forces which receive substantial commissions for convincing people to switch, raising administrative costs considerably in the entire system. Marketing techniques involve door to door canvassing, direct inducements in the form of gifts or cash, and occasionally outright deception. The Uruguayan authorities have looked at the experience of their neighbors and decided to limit the number of transfers among AFAPs to two per year per customer, with 6 months worth of contributions required before any such change can be considered. The original legislation also requires that the individual appears in person to the office of the AFAP from which he was withdrawing to allow the AFAP an opportunity to convince him to stay. 3.16 Despite these restrictions, switching in Uruguay's AFAPs seems to reflect, with one important exception, a better understanding by the affiliates of the AFAPs' financial returns. Accumulated transfers of affiliates as of October 1999 were the following. Capital: -3,092; Comercial: +3,134; Integraci6n: -4,164; Repuiblica: +8,997; Santander: - 8,819; and Uni6n: +3,633. It is clear that the AFAPs that lost affiliates are the ones with lower returns and that those that gained are the ones showing higher returns. The big exception is Repuiblica, which showed low returns, compared with the others, but gained more affiliates. One explanation could be that in uncertain electoral times, affiliates put a premium on the Government's guarantee of the minimum returns on the funds administered by this AFAP. 50 The first reporting of gross returns by AFAPs was in early August 1997. The range of returns in wage adjusted units was between 9.29% and 6.45%. 54 3.17. Capital Requirement. Pension funds in Uruguay are required to ensure a minimum return of the lower of 2% in URs and the average of the industry minus 2 points. To cover this contingent liability, AFAPs are required to hold a capital reserve valued at 2% of fund assets, excluding holdings of government bonds. By contrast, in other countries like Argentina, pension funds are required to hold a reserve valued at 2% of all assets. This type of regulation reinforces the bias toward pension funds' holding most of their assets in government bonds. Thus, even as the legal minimum falls, if this regulation is not changed, it would not be surprising to see little change in the AFAP's government bonds holdings. 3.18 Treatment of Related Companies. Investment by AFAPs in related companies is restricted to 10% of the pension fund. Up to now, most investments of AFAPs in related companies have been in the form of investments in CDs of their parent banks. To prevent related parties to agree on arbitrary prices for these transactions, in 1998, the BCU issued regulations requiring that all security transactions (whether with related or non related companies) be made through formal markets (i.e. the official markets of the stock exchanges registered in the BCU). CONCLUSIONS AND RECOMMENDATIONS Increasing portability and coverage 3.19 There are five pension systems beside the national scheme covering professionals, bank employees, the military force, the policy force, and the notaries. Portability is an issue since it is quite difficult to change from one system to another. In addition, self- employed are not covered. It would be advisable, in the short-run, to draft legislation that would eventually merge these five systems into the national scheme allowing full portability, and also to draft legislation allowing self-employed to be covered by the national system on a voluntary basis. In a medium term, this legislation should be enacted and implemented. Improving property rights of insured 3.20 Compulsory contributions to pension funds are not fully vested. This is the case when the insured does not retire (e.g., does not comply with eligibility criteria, or leave the country). It is advisable to draft legislation vesting compulsory contributions when the insured reach the retirement age or leave the country. 3.21 In spite of the fact that any voluntary contribution to this scheme does not provide tax benefits and it is an illiquid asset (it can only complement retirement benefits), it still has vesting problems. If the insured does not retire, the voluntary accumulation is kept by the fund. It is recommended to draft legislation to treat voluntary contributions as open-ended mutual funds, while providing tax incentives for holding long terrn maturity accounts. This would resolve the problem of vesting and liquidity encouraging saving mobilization. 3.22 The stabilization fund is constituted with profitability higher than 2 percentage points above the system average rate of return. When the rate of return is below the 55 system's average less 2 percentage points, the fund is diminished in favor of the insured. The stabilization fund does not belong to the insured. This creates incentives to move accounts to AFAP with higher accumulated funds and it also generates intergenerational transfers. This goes against the principle of property of individual accounts. Implementing regulations to eliminate the stabilization fund and to credit individual accounts with their fair share of the balance in the stabilization fund is recommended. Improving risk management 3.23 The system allows for one fund per AFAP and one account per insured. In addition, investments are heavily regulated, including a band around the system's average rate of return. This constraints attaining optimal portfolios (including to individuals) and a more efficient investment frontier. The problem could be solved through legislation/regulations allowing two or more funds per AFAP. One fund would be a fixed income fund with Uruguay sovereign being the minimum investment grade paper allowed. A second fund would have no restrictions except to have a maximum risk tolerance measured by a risk model. These funds should have limits on single currency and single/group/sector/country exposure. It implies that these funds will be able to invest abroad and in closed ended mutual funds and derivatives with proper risk weights. The insured will choose the composition of their portfolio from these two funds with the restriction that the fixed income fund should represent, for example, a minimum of 10% at age 20 and to increase by two percentage points per year (implies minimum of 90% in fixed income at age 60). Two accounts per insured could be allowed in either the same or different AFAP. 3.24 Currently, there are single issuer exposure limits of 10% on shares and 20% on bonds. This represents a maximum exposure on a single issuer of 30%, which is high. There are no exposure limits on sectors and no special limits on investment in related parties. It would be beneficial to enact regulations establishing a maximum exposure to a single issuer, for example, of 10% of the fund assets, and not to represent more than 5% of the issuer capital. The exposure limits on related party could be 5% and 2.5% respectively. Sector exposure limit could be set at 20% of the fund assets. 3.25 While insurance companies have some liabilities (disability insurance and annuities) fixed in wage adjusted values, they cannot hedge against them because insurance companies are not allowed to purchase pension bonds which are wage adjusted although illiquid. To resolve the problem of risk mismatch, while promoting liquid securities markets, the following is suggested: (i) replace wage by price adjusted disability insurance and annuities payments; (ii) replace wage by price adjusted pension bonds; and (iii) allow these bonds to be freely traded by all market participants. Improving competition 3.26 AFAPs do not pay for collection, custody or settlement services. The first is provided by the BSP and the rest by the BCU. Drafting regulations for collection, custody and settlement fees from the AFAPs would eliminate these subsidies. 56 3.27 The Government guarantees minimum return in Republica AFAP, which holds more than 50% of the market. Passing legislation removing the guarantee to Repuiblica AFAP, and converting it into a corporation to launch shares in the market is recommended. 3.28 Sale agents are not required to have a certification. Delegating to the Association of AFAPs regulation and certification of sale agents would permit to improve their qualifications. Improving efficiency 3.29 The Government should study the possibility of changing the commission structure from one based on the current salary base of the affiliate, to one based on the assets managed. This change would result in: (i) increased return on assets in the early years of contribution for the affiliates; (ii) increased cost efficiency efforts by the AFAPs; and (iii) a deterrent against the AFAPs departing from the Uruguayan market once the growing size of the assets managed and the up-front loading of commissions result in commission rates that are considered too low for them. Strengthening supervision 3.30 Supervision is performed by a division under the BCU, which implies that it does not report directly to the Board of Directors but through the President. In addition, it has inadequate resources. Elevating the hierarchy of supervision to the level of a department and increase resources allocation is recommended, as well as to agree on an action plan to improve monitoring and auditing of the system (including manual, software, training). In the long run, however, it would be worth considering the creation of a separate and independent supervisory agency for pension funds. 3.31 Supervision performed by the BCU is limited to compliance with investment regulations. There is no supervision from the time that contributions are deducted by employers until the time they are credited to the individual accounts. There are problems with falsifications, errors with payments, and delays in transfers of funds from the BPS. It is necessary to agree on an action plan to introduce supervision of contributions from the time they are made until the time they are credited into the individual accounts. The plan should include enforcement of compliance of BPS and timely transference of contributions to the AFAPs. 3.32 The lack of a yield curve constitutes an obstacle for implementation of mark to market method (deposits are valued at par). There is a need to harmonize valuation systems across intermediaries through drafting of regulations establishing a clear standard of valuation, compatible with international best practice, which has to be harmonized for all financial intermediaries. It is also advisable to restrict investments in instruments that quote in formal markets. (For example, do not allow investment in bank deposits but allow bank bonds.) 3.33 AFAPs are owned by other financial intermediaries. Transactions between an AFAP and an owner may involve manipulation of prices that may not reflect market 57 prices. Regulation should be enacted to limit transactions with related parties and establish special monitoring of these transactions. Liberalizing investment regulations 3.34 While the intent of the restrictive investment regime may have been to reduce the risks of the capitalization regime, the results may be the opposite. In fact, analysis by the World Bank's Pension Department shows that tighter investment restrictions actually increase the risk of the investment portfolio at any expected level of returns. The authorities should consider further liberalization of the investment regime as the industry matures. Also, given the small size of Uruguay's capital market, it would be desirable to allow AFAPs to invest part of their portfolio in appropriate foreign securities, to increase the returns and improve diversification of their portfolios. INVESTMENT FUNDS 3.35 The first investment funds started operating in Uruguay in 1992, but their expansion accelerated after the passage of the Investment Funds Law (Law 16,774) in September 1996. In Uruguay there are domestically managed mutual funds as well as sellers of foreign managed mutual funds. At the end of 1999, here were 9 fund managers administering 23 funds. Most of the fund managers are owned by commercial banks. In the first half of 1999, no new fund managers entered the market, although three new investment funds were created, increasing the total number to 26. One investment fund manager has 54% of the funds under administration. 3.36 The total amount of funds managed reached US$405 million at the end of 1996, but since then the total amounts have decreased to US$233.8 million (1.8% of GDP) as of December 1998 (1.8% of GDP), and to US$181 million as of December 1999. Investment funds seem to have recovered partially in the first quarter of 2000, reaching US$190 million Figure 3.1. Amounts managed by mutual funds 400 T332.2 348.3 352. 350 i 300 233.8 250 214 214 i20018 150 100 50_Ii 0 - Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Source: BCU, Mutual Funds Activity Bulletin 3.37 As of June 1999, about three fourths (74.7%) of the administered funds were invested in local assets and only one fourth (25.3%) were invested in foreign assets 58 (mostly of Argentine origin). The bulk of the funds' local investment is in public assets, while the contrary is true for investments in foreign assets. Half of the funds invested in domestic private securities is invested in term deposits and the rest in negotiable obligations. The share of funds invested in negotiable obligations has decreased since the problem with an issuer in 1998. The decreasing trend in the amount of managed funds is the result of lack of credibility of the regulatory framework, particularly of the valuation of the administered funds. This lack of credibility was justified in early 1999 with a problem of valuation of the funds administered by one administrator. Figure 3.2. Mutual funds' investments by type of issuer 70 57.2 60.8 61.6 60 ~5. Z' 40 ~~ ~ 17.5 19 1. 20 13 1. 1 010 6.3 6.119T Jun-99 Mar-99 Dec-98 * Domestic public securities Domestic private securities o Foreign public securities o Foreign private securities _ Source: BCU, Mutual Funds Activity Bulletin REGULAToRY FRAMEWORK 3.38 The Investment Funds Law5' establishes that domestically managed mutual funds are regulated by the SMV, and that mutual funds should be administered by companies with no ownership in the fund. The manager of the fund must be a stock company with the exclusive objective of being fund portfolio management. Its authorization to operate is granted by the BCU. The minimum capital of fund managers must be, at least, three times higher than the minimum level established for a normal stock company. Banking institutions can be, as stockholders, mutual fund managers. Fund management companies can create several funds, but they must ensure the financial independence of each fund. Foreign managed mutual funds are covered by the Uruguayan regulation. 3.39 Funds managers must deliver a prospectus to all investors, which should include, inter alia, the terms and conditions for the subscription and redemption of quotas, a detailed description of the different types of investment to be carried out by the fund, criteria to determine the return, commissions and fees charged, etc. In addition, there is a regulation that establishes the information that mutual funds managers should periodically provide to their investors and the BCU. 3.40 The funds can be invested in securities registered at the BCU. These include: domestic and foreign securities, sight and term deposits of financial intermediaries, 51 Regulated in 1997 through Circular No. 1,549. 59 securities issued and listed in official exchanges authorized by third countries and other securities authorized by the BCU. However, they cannot be invested in securities issued by themselves or their manager companies. Investments are also subject to certain limits. They can invest in stocks of the same company up to a maximum of 30% of the issuer's equity. Investment in securities issued or guaranteed by the same company or financial group cannot exceed 35% of the fund, except if the securities are issued or guaranteed by the State. 3.41 New investment fund regulations52 were issued in 1999 to strengthen the regulatory framework of mutual funds. Some of the new rules include the following: * Allowing the investment of the funds in other asserts than money market, as long as there is no tax arbitrage, and establishing limits to investments in enterprises' equity; * Establishing the requirement of external audits of the funds; * Establishing new security norms; * Prohibiting the administration of the fund by a third party; * Allowing banks to sell funds administered by third parties; • Establishing the general criteria of mark to market valuation of investments, but allowing the use of maximum prudence criteria for low liquidity securities. CONCLUSIONS AND RECOMMENDATIONS Strengthening of the regulatory framework 3.42 As in the case of the regulation of the stock exchanges, the SMV has inadequate resources to regulate investment funds. This is a constraint particularly important for the development of this new activity in the Uruguayan capital markets. Indeed, applications for authorization of new funds experience significant processing delays. It would be advisable to provide the SMV with adequate experienced professional resources. This will not only serve to ensure the integrity of the process, but will also facilitate capital raising needs that would improve market depth and liquidity. 3.43 As in the case of AFAPs, investment funds value similar assets using different methodologies. Further, the absence of uniform accounting standards creates investors confusion and apprehension. It is necessary to standardize valuation processes using internationally accepted methodology and adopt IASs. Until recently, funds were frequently valued at purchase price or at last sale if that price enabled the fund to reflect a profit. The new regulation requiring mark-to market valuation is a positive step. In this regard, mutual fund assets should be routinely marked-to-market to reflect an accurate value, reducing the use of "maximum prudence" criteria. Finally, there is no requirement for investments to be rated by a rating agency. To ensure the quality of investments, credit ratings should be required. 52 Circulars No. 1617, 1628, 1652, and 1656. 60 Expansion of investment opportunities 3.44 Mutual funds face a problem of limited supply of suitable investment instruments, common to all investors in the Uruguayan capital markets. They all invest mostly on government debt. Furthermore, the available investment instruments are often illiquid. It is necessary to develop the equity and corporate fixed-income securities markets to further expand the instruments available to institutional investors. INSURANCE COMPANIES 3.45 From 1911 to 1993, the Banco de Seguros del Estado (BSE) was the only insurer allowed to operate in Uruguay. The monopoly of the BSE ended in 1993, with the passage of the Law No. 16,426, allowing free choice of insurance companies to sign contracts insuring against any type of risk. The unique exceptions were those contracts involving public entities, government purchases and insurance for working accidents and professional illness. The latter insurance contracts can only be done through the BSE. 3.46 At the end of 1998 (the last data available, due to a delay of disclosure), there were 16 private insurance companies authorized to operate in Uruguay, plus the BSE. Nine of them were operating in the general insurance market, five in the life insurance market, and three in both market segments. There were also 30 reinsurance companies and twelve insurance brokers in this market. The insurance market production was US$382.8 million in 1998, an increase of 2.1% compared to the 1997 production figure. General insurance represented 63.2% of the total activity, and life insurance activity the remaining 36.8% (composed of 11.9% in life insurance, 2.0% in pension related life insurance, and 22.9% in work related accident insurance). These figures imply a premium per capita of US$116.4, below Argentina and Chile but ahead of other countries in the Region. The total net equity of the market, at the end of 1998, reached an amount of US$83.6 million and total assets of US$467.8 million, of which 39.2% corresponded to financial assets, mainly securities issued by the Uruguayan State and investments in financial intermediaries. Technical reserves were US$285.4 million, representing 74.3% of the sector liabilities and 3.4 times net equity. Between 1997 and 1998, equity and assets, in pesos, increased by 18% and 13.2% respectively. The direct insurance premium in 1998 represented 1.7% of GDP, down from 3.1% in 1997. 3.47 In spite of the liberalization process, the BSE represents the bulk of the market activity. At the end of 1998, it had 78% of the total assets of the insurance sector, down from 80% in 1997, and its equity was a 56% of the total equity of the sector, down from 62.3% in 1997. BSE has a monopoly on the lines of workers compensation and with all lines of business of the Government and the government owned enterprises. The following tables show the importance of each type of insurance activity and the investments, equity and technical reserves of the insurance sector. 61 Table 3.6. Insurance Sector Portfolio Composition (1998 Millions of US$) Direct Premium Retained Premium General Insurance 166.4 148.8 Fire 12.4 5.8 Vehicles 108.2 108.2 Theft and similar 24.1 23.1 Civil Liability 3.1 0.5 Caucion 4.8 2.4 Transport 7.9 5.3 Other 7.5 5.3 Life Insurance 30.7 28.3 Non pension insurance 25.9 24.1 Pension insurance 4.7 4.2 Work Accidents 87.6 87.6 Reinsurance (0.1) (0.8) TOTAL 284.6 264.0 Source: BCU, Superintendent of Insurance and Reinsurance Table 3.7. Insurance Sector Consolidated Balance Sheet (1998 Millions of US$) Total Investment Assets 244.7 Total Liabilities 384.2 Cash assets 17.8 Debts 53.4 Gov. Securities 84.8 Technical reserves 285.4 Local companies securities 5.1 Other liabilities 45.4 Foreign securities 5.6 Equity 83.5 Invest. in fmanc. interm. 25.7 Life insurance loans 11.2 Other investments 18.9 Pension investments 14.5 Total Financial investments 183.6 Real State investments 61.1 Debtors 175.3 Intangible Assets 47.8 TOTAL ASSETS 467.8 TOTAL EQUITY AND 467.8 LIABILITIES Source: BCU, Superintendent of Insurance and Reinsurance. REGULATORY FRAMEWORK 3.48 Law No. 16,426 states that insurance companies must have the exclusive objective of insurance and reinsurance activity. They must adopt the form of stock companies with registered shares, except the BSE, and their authorization has to be granted by the Government with the favorable advice of the Superintendent of Insurance and Reinsurance (SSR), which was created by the same law. The SSR has responsibility over the public and private companies' activity in this market. The minimum capital requirements and reserve requirements are established depending on the insurance activity. For general insurance activity (including loss or damage in goods or equity, fire, vehicles, robbery and similar, liability, caution and transport among others) minimum 62 capital is the higher between the basic capital and the solvency margin. The basic capital was fixed at Ur$$2.5 million in June 30th 1994 and, since then, it has been adjusted by the Wholesale Price Index. The solvency margin is fixed following the European Union model. In the case of life insurance activity, the minimum capital is also the highest between the basic capital and the solvency margin. 3.49 The investment of insurance companies' assets is specified in the SSR regulations. They are: securities issued by the Uruguayan Government (T-Bonds, T-Bills, bonds issued or totally guaranteed by the Government) up to 70% of the minimum capital, plus technical reserves; securities issued by financial institutions operating in Uruguay up to 50% of minimum capital plus technical reserves and with limits by financial institution; securities issued by public or private companies listed in an exchange up to a 40% of minimum capital plus technical reserves with limits by issuer; and insurance credits, Uruguayan real state securities and foreign securities rated by a prestigious rating agency up to 20% of the minimum capital plus reserves. CONCLUSIONS AND RECOMMENDATIONS Leveling the playingfield between the BSE andprivate insurers 3.50 There are market uncertainties due to differential treatment favoring BSE. Removing uncertainties by a commitment to regulate the sector as a whole or alternatively, a prohibition to regulate in favor of a particular company could help to increase competition in the sector. 3.51 BSE enjoys preferential tax treatment. While the premium tax is 15% on fire and 10% on car, BSE pays 10% on the first and is exempt from the latter. It is advisable to draft legislation granting all insurance companies (BSE or private) the same tax treatment. 3.52 The BSE does not comply with on time submission of information to the SSR. Penalties and enforcement are weak. A plan of action should be developed for effective enforcement of information disclosure of BSE. The plan should empower the Superintendent to effectively sanction BSE. 3.53 BSE's Charter requires that its profits be transferred to the Treasury while it should absorb its losses. The Charter also limits BSE investments (e.g., it cannot invest in shares). In addition, BSE as a government agency has to procure through public bidding and its employees are subject to government employment policies set for the civil service, including the on going hiring freeze and full stability of employment. It is recommended to draft legislation giving BSE the same treatment as private insurance companies (e.g., profit and losses, investment regulations, and employment policy). It should also transform BSE into a corporation allowing it to place part of its shares in the market and to change governance accordingly 3.54 The Law of Workers Accident requires BSE to offer medical services but not to deliver them. However, BSE runs its own hospital. It is advisable to agree on terms of 63 reference for a study to assess the convenience of BSE delivering the medical services or to outsource them. 3.55 Civil Servants are required to participate in controlling the national and local elections voting process. BSE has to pay expenses incurred by its employees. This represents about US$500,000 per year. This cost should not be covered by the BSE. 3.56 Although BSE establishes the premiums on worker compensation coverage in all sectors except agriculture and construction, political pressures influence them. It is recommended to assess the adequacy of BSE's methodology for establishing premiums on workers compensation for each sector, and possibly by enterprise. 3.57 BSE does not participate in the determination of premiums received for coverage in the agriculture and construction sectors. These premiums are received from the BPS which collects the unified tax (comprising social security contributions and health insurance and workers compensation premiums). About 7% of BPS' collections go to BSE, which in turn represent about 13% of BSE's premiums, while death and permanent disability in these two sectors represent about 1/3 of BSE's casualties. It is advisable to pass legislation whereby BSE should intervene in the determination of the premiums on workers compensation coverage to ensure actuarially fair pricing which is collected as part of the unified tax by BPS. Strengthening of regulatory framework 3.58 The current Insurance Law is based on the Commercial Code from last century. It would be advisable to pass a new law as the basis for modern development of the industry. 3.59 The professions of insurance agent and adjuster are not regulated and no certification is required. It is recommnended to issue regulations delegating to the Insurance Association the power to self regulate these professions and to provide for certification. 3.60 There is no compulsory car insurance. It is advisable to pass legislation introducing compulsory car insurance including civil as well as property responsibilities. 3.61 Government and state enterprises and agencies must purchase all their insurance, including bonding, from BSE. Removing restrictions on purchasing insurance by government and state enterprises is a requisite for a competitive market. 3.62 Currently, investment income from life insurance reserves (including pension insurance) is subject to corporate tax. This discriminates against saving in life insurance as opposed to purchasing a mutual fund or contributing to a pension plan. Also, while life insurance is subject to a 1/2% tax on gross premium, pension insurance is exempt. Passing legislation exempting investment income from life insurance reserves (including pension insurance) from the corporate tax is recommended. Also, if life insurance companies are to be considered pass through vehicles as mutual and pension funds are, life insurance should be exempt, as pension insurance is, from the gross premium tax. 64 3.63 The minimum interest rate on pension insurance is regulated at 1.75% per annum based on indexation of the principal to wages and independently of maturity. Allowing insurance companies to purchase pension bonds, which are indexed to wages, would improve their risk management. However, it would be preferable to replace wage by price indexation. 3.64 Banks indicate the insurance agent to be used on purchasing insurance coverage related to banking services. It is recommended to enact regulation enforcing freedom of choice of insurance agents. Strengthening the Insurance Supervision Department at the BCU 3.65 The Superintendent informs the Board of Directors of the BCU which takes decisions. It is advisable to empower the Superintendent to enforce regulations and to apply significant sanctions to offenders. 3.66 The department has about 10 professional to regulate and supervise the BSE and 16 private companies. Its budget is part of the BCU's budget. The Superintendent does not collect fees of any kind. It is recommended to agree on a plan of action to strengthen the Superintendent capacity of monitoring the sector. Also, the Superintendent should be able to have revenues from fees and fines. Introducing an effective consumer protection scheme 3.67 There is no consumer protection in place. It is necessary to pass legislation to ensure adequate consumer protection. 3.68 Some companies mail insurance contracts with the condition that, if they are not rejected in a given period of time, they will become effective and premiums will be charged to a credit card. It is necessary to draft regulations forbidding this practice. 65 Annex I STRUCTURE AND BEHAVIOR OF URUGUAY'S BANKING SYSTEM Structure of the Banking System 1. Number of entities, branches and employment As of December 1999, there were 49 financial entities operating in Uruguay: 2 official banks; 21; private banks, including two publicly administered banks53; 9 financial houses; 6, S&L cooperatives; and 11 EFIs. There are no investment banks operating in Uruguay. The number of institutions has been relatively stable during the last few years (Table Al.1). TABLE A1.1. NUMBER OF INSTITUTIONS 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 2 2 2 2 2 2 Administered banks 2 2 3 3 3 3 Private Banks 19 19 20 20 20 20 Financial houses 9 9 10 10 10 11 S&L Cooperatives 6 7 8 8 8 8 EFI 11 11 1 1 1 1 1 1 n.a. Total 49 50 54 54 54 44 Source: BCU, Boletin Informativo, various issues. 2. The banking system had 483 branches in 1999; 146 of them owned by the official banks and 337 by the private financial intermediaries. Neither the financial houses nor the EFIs have significant branch networks, owing to the nature of their businesses. By contrast, official banks and S&L cooperatives have branch networks that spread over Uruguay and enable them to service the agricultural sector and the low income population. Private banking activity is, however, focused in the Montevideo area, and 80% of those banks' branches are located in or around the capital city. The number of offices (branches plus main offices) fell precipitously in the 1980s due to the banking crisis54. Following that crisis, a number of mergers and acquisitions took place. Banking offices have declined by an additional 26% in the last decade55. The S&L cooperatives, which were not a part of the 1980s shakeout, have not experienced these branch reductions, and the number of ATMs has significantly increased in the 1 990s. 53 The administered banks are included in this group by the SIIF, although in this annex they tend to be considered a separate group for purposes of the quantitative analysis. The available data for 1999 does not permit to separate the figures for administered banks from that of private banks. 54 Caumont (1997), Diaz Solsona (1999). 55 Caumont (1997). 66 TABLE A1.2. NUMBER OF BRANCHES 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official Banks 146 135 135 135 135 138 (BROU) 108 108 107 107 109 (BHU) 27 27 28 28 29 Administered Banks 77 78 80 78 78 Private Banks 188 161 155 144 141 Financial Houses 13 13 13 13 13 Savings&Loans 42 71 72 70 72 Cooperatives n.a. n.a. 16 8 0 EFI Total 483 n.a. n.a. 471 448 442 Excluding EFI 455 458 455 440 442 Source: BCU, Boletin Jnformativo, various issues 3. Employment has followed a similar declining trend. Since 1981, private bank employment has declined by roughly 35% 56 In recent years, however, employment declines in the financial sector have come primarily from the official and the administered banks (Table A1.3). The total number of employees in the sector stood at 12,046 at the end of 1999, with just over half of them working for the official banks. The decreasing trend in banking employment reflects substitution of capital for labor as a response to the strength of the banking trade unions, which has made negotiation over salaries problematic. TABLE A1.3. NUMBER OF EMPLOYEES 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official Banks 6,201 6,323 6,744 6,954 7,268 7,281 (BROU) 4,751 5,118 5,267 5,546 5,717 (BHU) 1,572 1,626 1,687 1,722 1,564 Administered Banks 1,246 1,283 1,341 1,443 1,502 Private Banks 3,995 3,592 3,424 3,310 3,268 Financial Houses 159 170 176 180 196 Savings&Loans 880 1,208 1,184 1,167 1,115 Cooperatives n.a. 167 170 171 111 EFI Total 12,046 n.a. 13,164 13,249 13,539 13,473 Excluding EFI 12,603 12,997 13,079 13,368 13,362 Source: BCU, Boletin Info-rmativo, various issues 4. Assets. The assets of the system totaled US$22 billion (108% of GDP), at the end of 1999. Banking assets are concentrated in a handful of institutions. The two official banks account for 39% of the total assets in the system and private banks, including the administered banks account for 50% of the assets. Among private banks, concentration is not severe, with banks holding between 0.31% and 6.49% of the assets of the system. Financial houses, S&L cooperatives and EFI comprise 4%, 1.8% and 5% of total assets, respectively. Concentration of assets in public banks is, however, slowly declining. Just over five years ago, the two public institutions held almost 45% of the assets of the banking system. It is also interesting to note that, after years of steady increase, the share of assets held by the EFIs has sharply declined to reach in 1999 about 5% of total assets, 56 Caumont (1997). 67 the same share that they had in 1994. The financial houses are another group that has experienced declining market shares due, in part, to the transforrnation of some of them into EFIs. They comprised 8.4% of total assets in 1994 and 4% in 1999. TABLE AI.4. ASSETS (%) 03/31/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 39.06 39.09 39.87 40.16 42.55 43.33 44.72 (BROU) 22.91 na 23.70 23.16 23.55 na na (BHU) 16.15 na 16.18 17.00 19.00 na na Administered banks 5.30 - 4.96 5.65 5.95 6.31 7.13 Private banks 44.22 50.12 38.32 35.05 33.30 33.39 33.08 Financial houses 3.89 4.05 5.04 4.63 4.22 4.48 8.38 S&Ls 1.78 1.76 1.86 2.82 2.42 2.33 2.12 EFI 4.62 4.98 9.94 11.69 11.56 10.16 4.56 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU Figure 1.2. Assets (%) | 60 50 _ _ _ _ _ _ 40 12/31/94 30 ' _12/31_95 20 - C *12/31/96 10 12/31/- 0 1 .12/31/98 'O", OSi # , . * 12/31/99 5. Credit activity is also concentrated in the two official banks, but their share of total credit has dropped from 49% in 1994, to 37% in 1999 (although it recovered to nearly 39% in the first quarter of 2000 - Table Al .5). The official banks are particularly active in providing credit to the non-financial sector, presumably due to their development objectives. BROU and BHU provided 45% of total non-financial credit in 1999, but only 20% of the financial credit (Tables A1.6-Al.7). By contrast, private banks provided more than two thirds of total credit to the financial sector and 50% of the credit to the non-financial sector. Consumer credit accounts for a large part of private banks' increasing share of the non-financial credit market. Private banks slowly began returning to this market segment, having been bumed by the 80s crises and the accompanying - Refinancing Laws that permitted borrowers not to repay debts in full. Consumer credit 68 comprised 6% of the portfolios of private banks in 1989, 57. rising to 16% in 1994, and to 25% in mid 1998. TABLE A1.5. SHARES OF TOTAL CREDIT (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 38.61 36.70 40.47 43.51 45.75 48.17 49.40 (BROU) 22.72 na 25.44 25.89 26.34 na na (BHU) 15.94 na 15.03 17.61 19.41 na na Administered banks 5.19 - 5.58 6.78 6.77 6.68 6.66 Private banks 49.82 56.58 46.23 40.55 38.99 36.90 32.53 Financial houses 4.40 4.87 5.56 5.49 5.55 5.52 9.07 S&Ls 1.92 1.85 2.16 3.67 2.94 2.74 2.34 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU Figure 1.3. Share of Total Credit (%) 1 60.00 _ _ _ __ _ _ 50.00 _ __ 40.00 12/31/94 30.00 Z=.xxt23 9 20.00 l ___ * _ 12/31/95 10.00 012/31/96 0.00 *12/31/97 ~~ 1~~12/31/98 sOqZ d° "12/31/99 TABLE A1.6 SHARES OF TOTAL FINANCIAL CREDIT(%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 17.36 20.78 24.39 27.52 24.55 27.21 30.70 (BROU) 16.37 na 24.32 27.00 24.50 na na (BHU) 0.94 na 0.07 0.52 0.05 na na Administered 0.47 2.57 4.31 5.68 6.13 7.32 banks Private banks 70.03 67.61 58.04 52.15 54.72 52.04 43.02 Financial houses 11.61 11.16 14.77 15.04 14.61 13.96 18.54 S&Ls 0.51 0.46 0.24 0.98 0.43 0.66 0.42 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU 57 The figure for 1989 comes from Caumont (1997). 69 TABLE A1.7 SHARES OF TOTAL NON-FINANCIAL CREDIT (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 45.71 44.97 47.85 48.14 53.41 54.62 55.65 (BROU) 25.50 na 25.95 25.05 26.45 na na (BHU) 20.21 na 21.89 23.08 26.97 na na Administered 6.57 - 6.97 7.80 7.03 7.01 5.93 banks Private banks 43.40 50.85 40.82 37.71 34.00 32.66 30.01 Financial houses 1.63 1.60 1.33 1.59 1.57 2.01 5.03 S&Ls 2.69 2.58 3.04 4.77 3.99 3.71 3.38 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU 6. Liabilities. The private banks accounted for over half of the of the total deposit base in 1999, while the two official banks accounted for around 35% (Table A1.8). Unlike in the assets side of the balance sheet, when the official banks are counted together, there is no difference between the official and the private banks on their share of financial and non-financial sector liabilities. However, taken separately it is clear that BHU has a much higher share of non financial sector deposits than BROU. The S&L cooperatives also receive a higher share of their total liabilities from the non-financial sector than do private banks. The financial houses rely on financial sector liabilities more so than either the official banks or the S&Ls, while the EFI show no strong tendency toward either source of liabilities (Tables A 1.8, A 1.9 and A1. 10). 7. In terms of fmancial structure, the Uruguayan banking institutions mainly rely upon demand deposits and equity. There is, however, an important difference between the official banks and private banks on this dimension. The former have a higher proportion of equity (around 32% of total liabilities) and the latter have a higher proportion of deposits. In the case of private banks, equity accounts for only 8% of total liabilities. As indicated above, the capital of the public banks appears to be substantially overstated for a number of reasons, including insufficient provisions on assets. TABLE A1.8. TOTAL DEPOSITS (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 34.92 34.26 34.14 34.71 35.00 35.60 35.86 (BROU) 23.06 Na 23.31 23.25 22.80 na na (BHU) 11.86 Na 10.83 11.46 12.21 na na Administered banks 2.22 - 5.79 6.67 7.00 6.87 7.45 Private banks 52.85 55.31 42.28 39.77 37.31 35.61 33.80 Financial houses 4.18 4.33 5.55 5.17 4.63 4.62 8.47 S&Ls 1.87 1.82 1.89 3.03 2.54 2.38 2.05 EFI 3.97 4.36 10.46 10.65 13.51 14.92 12.37 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 Source: BCU 1999 data for administered banks is included in the private banks category 70 Figure 1.4. Total deposits (%) 70.00 60.00 - 50.00 - _12/31/94 30.00 - o 12/31/95 10.00 -ti iI I~ 20.00 - -12/31/96 10.00 * _h- 12/31/97 I .°° 12/31/98 TABLE A1.9. NON-FINANCIAL SECTOR DEPOSITS (%) 03/30/99 12/31/99 12131/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 37.55 36.64 41.17 40.72 42.19 43.00 41.22 (BROU) 27.49 na 31.31 30.51 30.94 na na (BHU) 10.07 na 9.86 10.21 11.26 na na Administered 7.44 - 7.46 8.75 9.42 9.57 9.96 banks Private banks 48.91 57.40 44.53 41.82 40.49 39.80 36.21 Financial houses 3.79 3.77 4.30 4.65 4.34 4.30 9.83 S&Ls 2.30 2.20 2.53 4.06 3.56 3.33 2.77 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 data for administered banks is included in the private banks category Source: BCU TABLE A1.10. FINANCIAL SECTOR DEPOSITS (%) 03/30/00 12/31/99 12/31198 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 35.88 31.74 26.81 31.75 33.16 36.73 39.60 (BROU) 6.59 Na 6.62 8.94 6.92 na na (BHU) 29.29 Na 20.20 22.82 26.24 na na Administered 2.06 - 2.76 2.57 2.50 1.47 2.02 banks Private banks 53.38 59.63 56.81 54.76 54.38 50.97 48.98 Financial houses 8.19 8.14 13.09 10.09 9.64 10.39 8.96 S&Ls 0.48 0.49 0.53 0.83 0.31 0.44 0.45 Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 1999 datafor administered banks is included in the private banks category Source: BCU 71 Behavior of The Banking System 8. Leverage and capital adequacy. Leverage (the ratio of total assets to equity) is lower for public banks than for private banks. Private banks' leverage ratios have, however, declined over the last few years from 26 in 1994 to 14 in 1999. For S&L cooperatives and financial houses, leverage ratios in 1999 were 9 and 10, respectively58. Stated another way, official banks are highly capitalized. Because the ratio of non- performing loans is high for the official banks, their actual capitalization ratios may be lower than reflected here, especially if their provisions are not sufficient. The two official banks, BROU and BHU, report ratios of capital (equity) to assets of 14% and 38%, respectively (Table Al .11). By contrast, the private banks report a ratio of 8%. Other banking entities have capitalization ratios slightly higher than the private banks but nowhere near BHU's. TABLE A1.11. EQUITY/TOTAL ASSETS (%) 03/30/00 12/31i99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 24.20 25.05 26.16 28.00 30.91 35.39 37.08 (BROU) 14.23 - 14.81 15.95 18.29 Na na (BHU) 38.36 - 42.79 44.42 46.56 Na na Administered 1.93 - 1.20 3.10 2.84 4.94 21.28 banks Private banks 8.05 7.14 6.84 7.11 7.78 7.22 3.83 Financial houses 11.10 10.34 7.56 8.80 9.82 9.76 8.66 S&Ls 11.41 11.69 12.16 11.01 12.12 10.19 11.26 EFI 29.77 26.61 na 14.43 13.42 17.81 33.14 Total 13.89 15.32 15.53 16.32 18.17 20.54 21.85 1999 data for administered banks is included in the private banks category. Source: BCU Figure 1.5. Equity/total assets (%) 50.00 ___ _ _ _ _ _ _ 40.00- 40.00 - a ~~~~~~~12/31/94 30.00 _ X -i 12/31/95 20.00 - x [12/31/96 10.00 - a~~~~~~~~~ 12/31/96 10.00 jJ 12/31/98 | 0.00 l 1;t 1 1 l 12/31/98 I ~ ~ O s These ratios can be deduced from the information in Table Al.12. 72 9. Liquidity. Liquid assets (cash plus public securities) appear to comprise an adequate proportion of short-term liabilities for the vast majority of banks operating in Uruguay. The only bank with a low liquidity ratio is BHU (2% in 1998) and that figure has been falling in recent years (Table A1.12). The other official bank, BROU, had the highest liquidity ratio in the system (23% in March 2000). In recent years, the liquidity ratio of the EFIs has dramatically increased. This seems to indicate that these intermediaries are having some problems in investing their funds in their traditional markets. The system as a whole had a liquidity ratio of about 16%, in the first quarter of 2000, down from a peak of over 21% in 1995 and 1996. TABLE A1.12. LIQUID ASSETS/LIABILITIES (%) 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 16.21 10.47 15.18 17.28 15.90 15.98 11.89 (BROU) 23.00 Na 21.30 23.99 22.07 na na (BHU) 2.81 Na 2.00 3.66 4.39 na na Administered 13.47 - 14.44 16.32 19.10 21.12 26.61 banks Private banks 13.44 13.38 15.33 21.58 18.58 18.71 22.98 Financial houses 15.13 12.54 26.11 21.49 9.75 9.76 15.63 S&Ls 13.55 11.51 9.60 8.97 13.26 11.74 11.58 EFI 61.12 63.82 Na Na 27.24 25.40 8.83 Total 16.53 14.48 17.67 19.08 21.17 21.54 19.02 1999 data for administered banks is included in the private banks category Source: BCU 10. Portfolio quality. Until recently, rapid asset growth had not coincided with deteriorating portfolio quality. In fact, the percentage of non-performing loans declined from 6% in 1994 to 3.7% in 1998 (Table Al.13), as a result of portfolio improvements in the public banks. The official banks have a much higher share of non-performing loans than private banks and other financial institutions. Even in 1998, before the crisis, the official banks' non-performing credit ratio was 7.4%, which was much higher than the 0..5% of the private banks. The situation was worse in the case of BHU (13% non- perforning59), although the ratio at BROU (4%) was also very high. The BHU's situation is largely attributable to the repayment problems encountered by its borrowers due to indexing which was described above. The declining trend in non-performing loans reversed in 1999, when it jumped to 6.7% of total loans for the whole banking system. The deterioration of this ratio is, however, mainly the result of the deterioration in the portfolio of the public banks, as a result of the economic down turn experienced by Uruguay in 1999. The public banks ended the year with nearly 15% of their loans classified as non-performing. 59 Non-performing loans are unrecoverable loans, which are a subset of the overdue loans. 73 TABLE A1.13 NON-PERFORMING CREDITS/TOTAL CREDITS 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 8.81 14.71 7.38 8.58 8.49 10.34 10.87 (BROU) 5.09 Na 4.23 5.68 6.50 Na na (BHU) 14.11 Na 12.71 12.84 11.20 Na na Administered 4.50 - 5.51 2.24 4.17 3.33 3.76 banks Private banks 0.81 2.05 0.53 0.66 0.75 0.96 0.79 Financial houses 0.08 0.20 0.32 0.48 0.63 0.84 0.51 S&Ls 2.33 5.99 5.35 3.32 4.65 4.94 5.06 EFI 0 51 0.98 Na na 0.50 0.50 0.17 Total 3.97 6.70 3.69 4.30 4.70 5.81 6.07 1999 data for administered banks is included in the private banks category Source: BCU Figure 1.6. Non preforming credits/total credits 10 _ _ L [.12/31/94 I12/31/95 5 - [:]~~~~~~~~12/31/96 *12/31/99 o IIL I 111S * 23rz9ss~~~~~~~~~11~ 1~ 11. The ratio of non-performing loans to total loans among private banks (excluding the administered ones) has remained below 1%, despite the economic downturn of 1999. On the other hand, this among the administered banks was almost as high as BROU's in the first quarter of 2000. Data on the first quarter of 2000 indicate that the arrears problem for the whole system is again declining, although BHU still presents a non- performing ratio of 14%. 12. Although a high share of BHU's loans are classified as non-performing, their provisions are quite meager. The result is a very high ratio of non-performing credits to provisions (Table Al.14). Given the indexing problems and the repayment relief, BHU's non-performing loans and provisioning figures tell little about the efficiency with which they intermediate funds. BROU's ratio of non-performing loans to provisions is much lower than BHU's, but at 6 in the first quarter of 2000 is twice as higher than that of the private banks (including the administered banks). The amount of regulatory forbearance 74 afforded BROU is difficult to gauge, which makes it difficult to ascribe too much faith to the ratios in Table Al.14. TABLE A1.14 NON-PERFORMING CREDITS/PROVISIONS 03/30/00 12/31/99 12/31/98 12/31/97 12/31/96 12/31/95 12/31/94 Official banks 12.90 9.85 5.12 9.94 6.20 3.58 4.58 (BROU) 5.94 na 2.01 4.03 3.31 na na (BHU) 32.38 na 39.31 205.89 19.77 na na Administered 6.67 - 5.86 4.02 6.29 4.93 5.23 banks Private banks 1.67 3.34 0.95 1.17 1.28 1.68 1.30 Financial houses 0.23 0.50 1.20 1.57 2.34 0.94 1.58 S&Ls 3.42 9.76 4.13 3.93 7.39 8.74 7.95 EFI 2.39 2.13 na na 6.14 6.14 1.93 Total 7.52 7.16 3.89 6.23 4.98 3.38 4.11 1999 datafor administered banks is included in the private banks category Source: BCU 75 Annex II STRUCTURE AND BEHAVIOR OF URUGUAY'S STOCK EXCHANGES 1. The Bolsa de Valores de Montevideo (BMJ) was created in 1867. BMV's bylaws were modified in 1993 to permit legal entities to operate in the exchange (previously, only natural persons were allowed to operate). Until recently, the main activity in the BMV was trading of public securities, but now an increasing number of securities issued by private entities are traded, although it is still an incipient market. Currently, the BVM has 74 stockbrokers (natural persons as well as legal entities, e.g. corporations) and 20 special partnerships, a category created in 1995, and increasingly being adopted by official and private banks, and pension funds (cajas paraestatales). These entities do not have full rights like brokers, but they can trade in the stock market with the same rules as a typical broker. Table A2.3. BVM Operations (Millions of US$) l________________________ _ 4 June 2000 1999 1998 1997 1996 Private Sector 106.5 263.4 264.2 380.3 268.1 Equity 0.4 1.5 2.7 3.3 4.5 Of which secondary market: 0.4 1.5 2.7 3.3 4.5 Negotiable Bonds 37.6 106.1 86.6 160 104.3 Of which secondary market: 28.7 66.8 74 70.1 12.6 Global custody certificates 0 0 0.1 0.3 13.0 Participations 0 135.9 174.3 149.4 145.3 Bank Certificates of Deposit 68.4 19.9 0 0.1 0.1 Of which secondary market: 6.1 0 0 0.1 N/A Other 0 0.5 0.4 1.6 Public Sector 211.5 453.3 429.0 301.6 335.7 Treasury Bonds 135.8 338.7 296.3 219.3 241 Of which secondary market: 132.4 286.6 279.2 195.6 212.8 Treasury Bills 6.2 13.8 42.8 53.9 75.3 Of which secondary market: 3.9 4.9 6.1 3.9 1.4 Eurobonds/Notes/Global Bond 62.9 100.4 80.7 27.5 16.8 Issued by: Public Entities (including BHU) 204.9 9.5 9.3 0.9 2.6 Central Government 6.6 443.8 419.7 300.7 333.0 Total 318 716.7 693.2 681.9 603.8 Source: BCU, Exchange Trading Bulletin. 2. The types and amount of securities operations in this exchange are shown in Table 2.3. The BMV has experienced a reduction in its activity as a consequence of the increasing activity of the electronic exchange. The total value of the operations in this exchange was US$720.4 million in 1999 (4.6% of GDP). Regarding trading (secondary market), Treasury Securities account for approximately 90% of the exchange trading activity with the majority relating to the trading of Treasury bonds. Private sector trading is dominated by negotiable bonds. The equity market trading in this exchange is very low. 76 3. The Electronic Stock Exchange (BE VSA) was created in 1993 and has been operating since 1994. The original aim was to improve transparency in the foreign exchange, money and securities markets. Currently, it has 26 partners including 20 of the 22 private banks operating in Montevideo, the two official banks, BROU and BHU, two financial houses, one S&L cooperative and one credit administrator. It also has 12 special partners including the BCU, the Banco de Seguros del Estado (BSE), six AFAPs operating in the financial center, three mutual funds and one caja paraestatal de la seguridad social. The Board of BEVSA must approve new members that can be either natural persons or legal entities. Each member owns one share and there may be up to one hundred brokers. Each operator is assigned a guarantee (bond), a credit line, and operating margins. Operators have to abide with information requirements, such as annual financial statements. The activities of the exchange are divided into three segments: the foreign exchange market, the money market and the securities market. The instruments traded can be public or private and denominated in local or foreign currency. Table A2.4 shows the amounts of operations in each of the three segments. Table A2.4. BEVSA Operations (Millions of US$) 2000 1999 1998 1997 1996 Money market 4,815 14,458 16,689 17,570 10,325 Foreign exchange 874.3 1,481 1,882 1,889 1,912 market Securities market 460.3 880 1,832 266 93 Source: BEVSA Website. 4. In the securities market, the majority of transactions are in instruments denominated in foreign currencies. In 1999, the total value of securities operations in this exchange was US$856.4 million (5.4% of GDP). Until 1998, only fixed income securities were traded. There is a high concentration of operations in public securities, especially in 1998, as a result of the issue of the Global Bond. The most important change in the pattern of securities operations on this exchange has been the increase in operations on banks' CDs, although the trading (secondary market) is still very narrow. These instruments constitute the only private sector security with a meaningful amount of activity occurring. Trading in public securities continues to represent the bulk of the secondary market. The high fluctuations in securities' trading patterns reflect the early stage of the Uruguayan securities markets development. 77 Table A2.5. BEVSA Securities Market Trading (Millions of US$) June 2000 1999 1998 1997 1996 Private Sector 354.4 679.9 398.9 4.4 0.1 Equity 0 13.8 11.9 0 0 Of which secondary market: 0 0 1.6 0 0 Negotiable Bonds 10.8 22.4 19.9 4.4 0.1 Of which secondary market: 6.6 18.5 18.6 4.4 0.1 Bank Certificates of Deposit 343.5 643.7 367.1 0 0 Of which secondary market: 120.5 57.7 10.2 0 0 Public Sector 156.7 200.1 1433 262.1 93.4 Treasury Bonds 19.7 36.3 259.4 100.5 65.6 Of which secondary market: 19.7 36.3 259.4 100.5 65.6 Treasury Bills 6.0 39.3 196.7 78.4 16.6 Of which secondary market: 6.0 39.3 196.7 78.4 16.6 Eurobonds/Notes/Global Bond 106.6 101.0 960.4 80.9 5.0 Issued by: Public Entities (including BHU) 24.5 23.3 3.0 2.4 6.3 Central Government 132.2 176.8 1416.6 259.7 87.2 Total 511.1 880.0 1832.5 266.5 93.5 Source: BCU, Exchange Trading Bulletin. 78