78481 CONFIDENTIAL FINANCIAL SECTOR ASSESSMENT URUGUAY AUGUST2006 LATINAMERICA& THE CARIBBEAN REGIONALVICE PRESIDENCY FINANCIALSECTORVICE PRESIDENCY BASED ON THE J O N I T IMF-WORLD BANKFINANCIALSECTOR ASSESSMENT PROGRAM This Financial Sector Assessment summarizes the findings o f a joint IMF-World Bank Financial Sector Assessment Program (FSAP) team that visited Montevideo in October 2005 and January-February 2006.’ The purpose o f the assessment was to help the authorities identify financial system strengths and weaknesses with a view to implementing an action plan to increase the system’s contribution to economic development.2 The FSAP assessment i s based o n information provided by the authorities at the time o f the missions. OVERVIEW 1. Uruguay suffered a severe banking and currency crisis in 2002 from the spillover of Argentina’s crisis. Uruguay and Argentina are lmked through deposits and tourism o f Argentines in Uruguay; in addition, they export similar products. Both countries had already been suffering from falling output since 1998. At the end o f 2001, Argentina’s efforts to protect i t s currency board by freezing most deposits and i t s 1 The FSAP team comprised Ceyla Pazarbasioglu, leader (IMF), James Hanson, deputy (World Bank); Marco Espinosa, Ivan Guerra, Socorro Heysen, Silvia Iorgova, Andrei Kirilenko, Jorge Canales-Kriljenko, Andre Santos (all IMF),Mariluz Cortes, Gustavo Demarco, Mario Guadamillas, W. Britt Gwinner, John Pollner, Craig Thorburne (all World Bank), Ernesto Livacic and Walter Zunic (experts). Gaston Gelos (IMFresident representative) and David Yuravlivker (World Bank resident representative) joined some meetings. Elsa Portaro provided administrative assistance. The W C F T team was composed of Manuel G. Vasquez (team leader), Antonio Hyman Bouchereau, Ernesto Lopez, and Nelson Mena. Mr. Esteban Fullin, Deputy Executive Secretary from the South American FATF Regional Style Body (GAFISUD) farticipated as an observer by prior agreement with the authorities. The first FSAP mission reviewed financial sector conditions and conducted two assessments of international codes and standards-Basel Core Principles for Effective Banking Supervision (BCP) and Payments and Securities Settlement Systems. During the missions, staff met with the Minister of Economy and Finance, Mr. Astori; Governor Cancela, Central Bank of Uruguay; and other senior officials and representatives of the Central Bank of Uruguay (BCU), the Ministry of Economy and Finance, and representatives o f the private and public financial sector as well as representatives o f several corporate entities. A separate team conducted an assessment o f anti-money laundering (AML)and combating the financing of terrorism (CFT) in November 2005. -2- subsequent exit from the currency board triggered a withdrawal of Argentine deposits in Uruguay followed by a general run o n Uruguayan banks. Uruguay’s reserves fell sharply and the peso was substantially devalued. 2. The crisis highlighted important underlying weaknesses of the Uruguayan financial sector, many of which were already well known. Dollarization and nonresident deposits were high. In particular, the government mortgage bank (BHU) had a massive currency mismatch between i t s dollar deposits and i t s inflation-indexed loans, as a result o f government policy. The already-large nonperforming loans (NPLs) in BHU and the state commercial bank (BROU) increased sharply, as did N P L s in private banks, reflecting the severe difficulties in nonfinancial companies, especially in servicing their dollar obligations. These problems also highlighted the weak oversight, governance, and inadequate internal controls and risk management system in the state banks and some private banks, including fraud in some cases. Moreover, supervision had been weak, particularly o f the state institutions, and prudential regulations and monetary arrangements had not reduced risks in credit, liquidity, and cross-border activities arising from dollarization and regional contagion. When local private banks failed, their resolution was complicated by the inadequate bank resolution framework and rigid employment practices. Difficulties in resolving the problems o f the state banks were complicated by their autonomous legal status. 3. The authorities acted to resolve the banking problems and implemented a stabilization program supported by the international financial institutions and the economy has recovered substantially from the crisis. New BHU deposit-taking was effectively stopped and, correspondingly, new lending. Most o f BHU’s deposits were transferred to BROU and the government i s currently working o n details o f a further restructuring o f BHU. The state banks’ time deposits were reprogrammed; their assets were substantially restructured and enhanced b y government guarantees. Public sector debt was also reprogrammed. The government closed four insolvent local private banks. The good assets and deposits o f three o f these banks were combined with government capitalization to create a new bank (NBC) that is currently being sold. The foreign banks that survived the crisis did so without government liquidity support. The initial cost o f resolving the banking crisis i s estimated at 20 percent o f 2002 GDP; the final cost will depend o n asset recovery and proceeds from asset sales. Under the stabilization program, and with improvement in the international situation facing Uruguay, GDP has returned to i t s 1998 level (in real term), export growth i s buoyant, inflation has fallen to single digits, interest rates are low, reserves have recovered, and Uruguay has received FDI and re-accessed international debt markets. Nonetheless, public sector debt remains high - 69 percent of GDP-and much o f it i s denominated in foreign exchange. These large foreign currency obligations represent a substantial fiscal risk. 4. Although banks and bank regulation and supervision are now much stronger, macro-economic and financial risks remain, due to the high level of government debt and guarantees and the still-high dollarization and nonresident In addition, the government has contingent liabilities in the form o f a government guarantee on promissory notes to BROU arising from the transfer of deposits from BHU to BROU, the transfer of nonperforming loans from B R O U to trust funds, and guarantees all BROU deposits. -3- deposits. Banks, including BROU, have improved risk management. Banks have strengthened their liquidity and capital adequacy, increasing their capacity to withstand shocks. The remaining foreign banks have already demonstrated their resiliency b y withstanding the crisis. Bank regulation and supervision have improved and measures have been taken to encourage de-dollarization and reduce credit risk. The improved liquidity o f public banks has reduced the need for government support in the event o f a moderate liquidity shock. Nonetheless, a major external shock may lead t o a significant deterioration of several banks’ capital and solvency, according to stress tests. Liquidity problems could develop, especially if access t o international capital markets declined. Given the role o f nonresident deposits in the 2002 crisis, the government may wish t o review the costs and benefits o f further limiting domestic banks’ capacity to attract deposits held by nonresidents. Issuance o f more peso-indexed debt would promote de- dollarization. M o r e fundamentally, strong macroeconomic policies, further reforms o f state financial institutions, and further strengthening o f supervision and the safety net are critical t o increasing the resiliency o f the financial system. 5. The large state presence in the financial system creates significant distortions and risks and hinders sound financial development. The predominance o f state-owned institutions throughout the financial sector raises informational, oversight, and governance issues, makes regulation and supervision challenging, and, because o f the many explicit and implicit government guarantees, represents major risks. In the past, state bank lending was often politically motivated and fostered a poor credit culture. Since the crisis, risk management has improved i n B R O U and BHU i s being restructured. Nonetheless, a rapid increase in credit from BROU and BHU would raise risks o f new N P L s and hurt the nascent private mortgage market. Moreover, the implicit and explicit government guarantees to state-owned financial institutions and their various credit practices and products also limit financial development and the ability o f private institutions to compete with state institutions. 6. The key challenge for the authorities i s to increase financial intermediation while reducing vulnerabilities. In particular, a rapid increase in state bank lending would risk growth o f new NPLs. Nonbank state intermediaries also pose challenges in terms o f the contingent liabilities o f their products. Policies and reforms that would help financial intermediation include strengthening the transparency, governance, accountability and performance o f the state-owned banks, insurance company, and pension company, while eliminating their distortionary advantages; developing local capital markets (including securitization); improving the housing market b y better targeting and accounting of subsidies and allowing the private mortgage market to grow; improving the credit culture and credit registry; strengthening collateral execution and bankruptcy procedures; and enhancing financial infrastructure. These recommendations are discussed below and summarized in Annex 1. The recommendations also reflect the findings o f the Base1 Core Principles for Effective Banking Supervision (BCP), Core Principles of Systemically Important Payments Systems (CPSIPS) and CPSS-IOSCO Recommendations for Securities Settlement Systems (RSSS) and an assessment o f the compliance with AML/CFT, as well as the five Technical Notes.4 Technical Notes were provided on Banking, Housing, Insurance, Pensions, and Securitization. -4- I. FINANCIAL STRUCTURE AND ISSUES A. Overview o f Financial Intermediation and Major Financial Risks 7. Uruguay’s domestic financial system i s smaller than before the crisis and i s still dominated by banks. Total assets o f financial institutions were about US$19 billion and end-2005, compared to US$25 billion at end-2001, before the crisis (Annex 1 1 , Table 1). This decline mainly reflects a fall in the size o f the private banking sector. Nonetheless, the banking sector s t i l l accounts for about 67 percent of all financial institutions’ assets. The banking sector remains large relative t o other countries in South America, with assets of about 78 percent o f GDP at end-2005, though this ratio i s smaller than in 2001(Annex 1 1, Figure 1). The banks remaining after the crisis are: BROU (43 percent of bank assets compared to 23 percent in 2001), BHU (10 percent o f bank assets, compared to 13 percent in 2001), the foreign banks (12 banks with 39 percent o f bank assets, compared to 17 banks with 48 percent o f bank assets in 2001) and Nuevo Banco Commercial (6 percent o f bank assets; it was formed f r o m the good assets, the deposits, and government capital o f 3 bankrupt local banks and i s now being sold t o foreigners). 8. Bank’s dollarization and nonresident deposits remain high. Dollarization i s somewhat higher than before the crisis - at end-2005, dollar deposits were 85 percent o f deposits and dollar credits were 7 1 percent of credit. However, dollarization has been declining, as the peso appreciated and capital returned to Uruguay. Nonresident deposits are about 23 percent o f total deposits, a decline from about 50 percent at end-2001.5 9. Outside the banks, the only important part of the domestic financial sector is the fully-funded portion of the pension system. The assets o f the four firms that operate defined-contribution pensions (AFAPs) are 11 percent o f GDP. They ultimately weathered the crisis w e l l because their initial capital losses were more than offset by capital gains after interest rates fell. The insurance sector suffered during the crisis as holders o f life insurance policies cashed them in; the sector i s s t i l l only 3 percent o f GDP. The equity market (capitalization o f 2.2 percent o f GDP) and the domestic corporate bond market (an outstanding amount o f 0.5 percent o f GDP) are small and illiquid. 10. A substantial part of Uruguay’s financial intermediation, particularly sale of government debt, occurs in internationalmarkets. Offshore institutions, including their derivative transactions, represent 17 percent o f GDP (Annex 1 1, Table 1). Uruguay’s external public debt represents about 60 percent o f GDP. As a result o f the government’s reliance o n offshore borrowing, Uruguay’s banks have little government debt. However, about 80 percent o f AFAP assets are government or central bank debt. Uruguay’s debt ratios have greatly improved since the crisis, because o f primary surpluses, growth and peso appreciation. After a successful external debt exchange i n 2003, Uruguay regained market access, helped by i t s strong macroeconomic performance and easing international conditions. 11. Although the economy i s performing well, macroeconomic vulnerabilities remain high. Financial liabilities in both the private and public sectors are s t i l l largely n foreign currency, while the dollar value o f domestic income i s exposed to expressed i Some nonresidents make deposits through Uruguayan representatives. Hence the reported figures are a minimum estimate of nonresident deposits. -5- high volatility. In addition, public debt remains high and the government’s servicing ability depends o n continued fiscal discipline, moderate world interest rates, l o w sovereign risk premiums, sustained economic growth, and an active debt management. The government also has large contingent liabilities arising from explicit and implicit guarantees to the state banks and nonbanks and the large public sector pension system. 12. The main vulnerability in Uruguay arises from the interplay between the still-high level of public debt, state guarantees to public banks, and high dollarization and nonresident deposits. An external shock such as major economic distress in Argentina o r a sharp rise in foreign interest rates would lead to a significant deterioration o f the capital adequacy o f several financial institutions in Uruguay, according to stress tests conducted by a working group that included the staff o f BCU and the FSAP team. I t could also lead to a fiscal deterioration. The liquidity of banks has improved considerably, including the state banks. This reduces the need for public support in the event o f a moderate liquidity shock. However, a major macroeconomic shock (for example, if the government were to lose adequate market access or face sharp adverse movements in exchange rates or interest rates) could lead to larger liquidity problems. Given the role o f dollarization and nonresident deposits in the 2002 crisis, the government may wish t o consider further measures, such as issuing more peso-indexed debt and conducting a cost-benefit analysis o f further restricting onshore banks’ ability to attract deposits held by nonresidents. More fundamentally, continued strong macroeconomic policies and further reforms o f state financial institutions, as discussed below, would increase the financial system’s resiliency. B. The Role of Public Sector Intermediaries 13. State-owned institutions dominate the financial sector, represent contingent liabilities for the government and complicate financial development. BROU has over 50 percent o f bank deposits; i t s policies have had a large impact o n exchange rates, interest rates and credit and financial market development. BHU’s currency mismatch and high N P L s were a major factor in the cost o f the crisis. I t s l o w rates and weak collections distorted the mortgage market and effectively eliminated private mortgages before the crisis. The approach taken in i t s on-going restructuring will affect the development of the nascent private mortgage market substantially. Box 1 summarizes some o f these issues and, more generally, approaches to improving housing finance. In insurance, BSE has over 60 percent o f the market; it offers unhedged, wage-indexed annuities, has a monopoly o n workers compensation insurance that it does not reinsure, and, by offering low-cost life insurance t o AFAP affiliates, has driven out private competitors. The AFAP Repu’blicu accounts for 56 percent of A F A P s ’ and i s owned b y BROU (51 percent), the state insurance company (BSE), and government social security agency (BPS). I t i s the only AFAP that guarantees a minimum return. -6- Box 1. Housing Finance in Uruguay Uruguay’s costly public sector housing programs failed to deliver a sustainable housing finance system and crowded out private lenders. Until 2002, BHU effectively monopolized mortgage lending to moderate and upper income households because of i t s favorable terms and i t s lack of pressure on borrowers to repay. In addition, the Ministry o f Housing (Mom made subsidized loans via several trust funds. Almost all of this government lending for housing was plagued by poor collection and steep losses, as i s the case for such lending in most countries. Uruguay has many of the conditions required to create a sustainable, private sector-based housing system that could efficiently serve the population. Compared to most of L a t i n America, Uruguay has a relatively small informal sector, high average wages, an active rental market, and unusually, an excess supply of housing. Rental housing could be an important policy tool for reaching the lowest income families. The existing program to renovate the stock of older, vacant units could be extended through private-public partnerships and policies that encourage renovation or transfer of titles to those interested in renovating. However, the greatest challenge lies in fostering private housing finance. With BHU lending stopped, private lenders re-entered the residential mortgage market in 2005, targeting BHU’s former market segment. Private lenders are lending to individuals earning US$700 per month and up, a somewhat lower figure than had been considered the minimum for a BljU mortgage. Experience in other countries suggests private lending eventually could serve even lower income borrowers. Any resumption of BHU lending to this group runs the risk of driving out private lenders as borrowers are likely to assume they need not service BHU mortgages. BHU’s lending on commercial terms means it will have to enforce debt service obligations and execute collateral to change the credit culture of i t s borrowers. Resumed BHU lending also runs the risk of new N p L s and increasing contingent liabilities, even if the financing for the lending i s only through market instruments. Any resumption of BHU lending and MOH programs should encourage the growth of private housing lending. Any renewal of BHU lending should focus on income segments below those targeted by private banks, at market rates of interest and with execution of collateral of defaulters, demonstratingthe viability of underserved segments, The action plan for BHU’s restructuring appropriately eliminates BHU’s role in granting subsidies. T h i s positive move should be accompanied by retargeting M o H subsidies to stimulate private sector participation as i s done in other countries, not just state lending. Any mortgage default insurance (MI) program should wait untilBHU’s collection weaknesses are resolved. Mortgage default insurancehas proved to be a useful means to provide loans to underserved populations in Peru, Mexico, Guatemala, and others. However, i t s success requires efficient mortgage lien enforcement, commercial pricing, and actuarially adequate capital. Given the culture of nonpayment in Uruguay and the lack of transparency and weaknesses inrisk management in BSE, a MI program could create an additional contingent liability to the government without stimulating lending sustainably. The enforcement of mortgage liens should be improved to foster the growth of private mortgage lending. International studies show that rapid enforcement of creditors’ rights, balanced with protections for distressed borrowers, leads to lower mortgage interest rates and increased lending. I t takes a private bank an average of 1.6 years to foreclose on a mortgage and have the property free and clear in Uruguay; some cases extend to 6 years. Extending extra-judicial foreclosure powers to private banks would put them on an equal footing with BHU in their ability to enforce of mortgage liens, although BHU has not used i t s powers. -7- 14. Despite recent changes, government guarantees and other advantages of state institutions mean that state and private institutions do not compete on a level playing field. Deposits in state banks have an explicit full government guarantee, while deposit insurance o f private banks i s limited. Only state institutions can offer unhedged products and guarantees because they represent implicit contingent liabilities o f the state. In addition, state banks receive favorable tax treatment o n consumer loans and have special legal rights to withhold salaries for loan collection and execute collateral o n loans without going to courts, although they have not used these privileges. 15. Moreover, in state banks, politically-motivated lending and weak collection have fostered a poor credit culture and reduced private markets finance. Public banks have a history of distorting market prices and under-pricing credit risks, often under political pressures. Their lax credit evaluation procedures and continued refinancing o f nonperforming loans by state-owned banks contributed to their high nonperforming loans even before the crisis. These policies also have contributed to the n housing and agriculture and the lack o f interest b y business lack o f private lenders i owners in raising funds in financial markets. 16. The state institutions would benefit from improved information, governance, and accountability and a monitoring of the costs and benefits of any subsidies and the guarantees and other advantages enjoyed by state institutions. Supervisory actions and changes i n charters have prevented new unsound lending. Despite the improvements in BROU’s credit systems, additional efforts are needed t o transform an environment that favored a culture o f nonpayment o f debts into one with incentives to service debts. BHU will need substantial improvement. In all state institutions, the costs and benefits o f products, policies, and implicit and explicit guarantees need to be evaluated and carefully monitored, including their impact o n the playing field for private institutions. 11. STRENGTHS AND CHALLENGES IN THE BANKINGAND CORPORATE SECTORS 17. The banking system has become smaller, more liquid, and stronger since the crisis. Commercial bank assets have fallen from US$21 at end-2001 to US$13 billion at end-2005 (Annex 1 1, Table 1). At the same time, banks have increased their holdings o f liquid assets to 36 percent o f total assets at end-2005 compared to 14 percent at end-2001. The increase in the liquid asset ratio i s a response t o the crisis and the post-crisis shortening o f deposit maturities, and also reflects the high liquidity requirements imposed by B C U o n specific banks. Banks’ holdings o f public debt continue t o be low, reflecting the government’s reliance o n offshore borrowing, although BROU’s exposure to the government has increased as a result o f state-guaranteed assets provided i n the aftermath o f the crisis.6 Asset quality has improved but remains an issue for state banks. Private banks largely wrote o f f their NPLs, which are now only about 3 percent o f total loans, and their provisions are about 150 percent o f their N P L s . However, a majority o f BHU’s BROU transferred US$l.4 billion of nonperforming assets to an AMC trust fideicomiso) at an accounting value of US$456 million in exchange for a government-guaranteed, participation certificate. BHU’s obligation to BROU to cover its deposit transfer to BROU i s also government guaranteed. -8- assets are nonperforming. Loan provisioning covers only 42 percent o f N P L s in the state banks. On average excluding BHU, bank capital i s over 20 percent and banks have returned to profitability following a recovery in their collection rates as the economy grew. 18. Corporate debt remains high and profits low, making many f i r m s unattractive to lenders. Although corporate leverage, as measured by the debt-equity ratio, has been reduced since the crisis, the average corporation nonetheless remains highly indebted and vulnerable to peso depreciation according to stress tests carried out by the FSAP mission. In 2004, foreign currency debt represented 65 percent o f total corporate liabilities on average and about 75 percent for the median firm (ina sample of 575 firms). Compared to other firms in Latin America, Uruguayan firms have high ratios o f liability dollarization, exposing them (and their creditors) to risks from exchange rate fluctuations. A substantial number o f firms i n 2004 s t i l l exhibited negative net worth, largely as a result o f the substantial depreciation of the peso i n the crisis. A large number o f loss-making firms remain, despite the economic recovery. N o t only did the cost o f servicing unhedged foreign currency debt more than double, but the temporarily high interest rates also caused an increase i n debt service o n local currency liabilities. 19. Corporate debt restructuring remains on the agenda. Although most financial institutions have reported a sharp decline in nonperforming loans, the high corporate debt levels suggest that corporate nonperforrning debts were restructured by transferring them to AMCs or extending maturities, not by writing them down. Partly this approach may reflect limits o n BROU’s ability t o write down debt. The debt restructuring process can be improved by reforming the insolvency legislation to allow for the reorganization o f viable firms and the faster and efficient liquidation o f nonviable ones as envisaged under the major improvements to the proposed current law. 20. Banks’ risk management has generally improved, but progress has been uneven and could benefit from strengthening of systems in state banks and improvements in the information collected and provided by the credit bureau. As in n the aftermath o f the crisis. many other countries, credit risk standards were tightened i Regulation and supervision were also refocused to stress risk management and to address the risks of a dollarized financial system. Most banks have implemented independent risk management structures and involved senior management i n the development o f a risk culture.’ Many o f the foreign banks have adopted risk-management systems and practices of their parent institutions. However, the public banks s t i l l lack adequate systems to assess their risks fully. Over one-third o f the banks do not conduct independent reviews of the risk management and measurement processes and lack adequate risk management infrastructure, according t o a survey conducted under the FSAP. Managing the risks o f dollarization remains a challenge, but banks are increasingly reducing the share o f foreign currency loans to the nontradeable sector. Improvements in the credit bureau and collateral execution will also help improve risk management. 21, Banks’ intermediation costs, which limit intermediation, reflect high reserve and liquidity requirements, labor market issues, and high, distortionary taxes. The assessment of banks’ risk management practices is based on a survey prepared by the FSAP team and answered b y a l l banks. -9- Bank’s required reserves are high (15 percent o n peso deposits and 25 percent o n foreign currency deposits, o n average) and have l o w remunerations. While liquidity risks associated with foreign currency deposits may justify relatively high reserve requirements, the l o w rate paid by the central bank o n these reserves has effectively become a tax. Banks’ costs reflect the generous salaries and benefits paid t o banking sector workers in the politically important union o f financial sector workers. Benefits paid to dismissed staff have been high in the banking sector (up-front payment o f up-to- 20 months of salaries i nthe banking sector versus a maximum o f 6 months salaries in other sectors). Employer contributions under the pay-as-you-go banking pension system (Caja Bancaria) are also higher than in other sectors, and finance generous benefits - though the decline i n banking workers after the crisis i s creating problems in the system, as discussed below. Uruguayan financial intermediaries are currently subject to an asset tax and a portfolio tax, as well as profit and net worth taxes. A value-added tax (VAT) i s levied o n interest o n bank loans b y private banks. Credit cards are also taxed. Relief from these taxes and the uneven treatment o f private and state banks may come through the tax reform submitted to Congress. This reform envisages eliminating the asset tax, the portfolio tax, the credit card tax, and the value-added tax exemption for state bank loans. 22. A key challenge for the authorities i s to restore financial intermediation while reducing vulnerabilities. Loans to the private sector were only 23 percent o f GDP at end-2005, compared to about 55 percent prior to the crisis. This decline reflects the decline in deposits (relative to GDP) and the rise in banks’ demand for liquid assets, as well as the write-off o f bad assets, the shift o f BROU’s and NBC’s N P L s to asset recovery trusts,* and the l i m i t s o n lending o f BROU (imposed by the superintendency) and BHU (because o f its restructuring). Consumer credit has grown, as it has in most countries, and private banks have begun mortgage lending. However, demand i s lacking from good-quality commercial borrowers. More finance at lower spreads will eventually be needed for growth but increased lending by the state banks, despite the improvement in BROU, raises risks o f new NPLs. Policies and reforms that would help improve intermediation include improvements i n the transparency, accountability and performance o f the state banks; improving the housing market by better targeting and accounting o f subsidies and allowing growth i n the private mortgage market; and improvements i nthe credit culture and credit registry; strengthening collateral execution and bankruptcy procedures; developing local capital markets, including securitization; and enhancing financial infrastructure. 111. STRENGTHS AND CHALLENGES IN PENSIONS INSURANCE AND CAPITAL MARKETS A. Pension Funds 23. Uruguay’s main pension system, the defined-benefit, pay-as-you-go, public pension system, still has a deficit, despite earmarking of tax revenues to fund it. The system’s deficit was 2.6 percent o f GDP in 2005 and i s projected to be 1.5 percent o f In addition to the BROUs AMC, the weak assets of the three banks that were merged into NBC were transferred to an AMC. - 10- GDP in 2010. The deficits persist, despite the high contribution rates o f affiliates (15 percent o f salaries) and employers (12.5 percent) and earmarking to the system o f one- third of the VAT and an additional tax (COFIS), which together represent nearly 3 percent o f GDP. The contributions of employers and employees only finance about 50 percent of the system’s payments. Salaries of about 90 percent o f affiliates are too l o w to pay contributions that would finance the system’s minimum pension. Thus, the deficit not only reflects the aging population but also the lingering effects o f l o w retirement ages and generous benefits, relative to contributions, that existed before the 1995 reforms. Exemptions o f some employers from contributions are another factor i n the deficit - exemptions are estimated t o equal 25 percent o f actual employee contributions. 24. Reforms, some of which have already been proposed, would help narrow the pension deficit. Reducing the deficit and the distortionary impact o f the public pension system would involve further matching of benefits and contributions and raising retirement ages, as well as switching f r o m wage indexation t o price indexation o f benefits. The current tax reform proposal envisages elimination o f the exemptions o f employers from contributions and the COFIS tax, but the actual impact will depend o n the law that i s passed. 25. Some sectoral pension schemes may represent a potential risk to the government, notably the financially weak scheme for bank employees (Caja Bancaria).The Caja Bancaria has generous benefits and i s financially weak, despite high required contribution rates by banks, because o f the post-crisis decline in employment i n financial institutions. Expanding coverage might temporarily reduce i t s financial problem. However, it would worsen problems over time, because o f the intertemporal mismatch between contributions and benefits. Given the economic and political importance o f bank employees, the government may at some point be pressured to inject funds into the Caja, although it has no legal obligation for these pensions. The authorities are considering options to reform the public sector schemes for the military and the police. In general, it would be desirable to move all the sectoral schemes into the combination o f the public pension and AFAP system that apply t o most o f the population. 26. Uruguay’s fully-funded pension system has been fairly successful but i t s limited investment options, the large role of government, and its market concentration remain issues. Over half o f the country’s employees also participate in the full funded, AFAP system, as w e l l as contributing to and being guaranteed a basic pension by the public pension system. The system has had the highest return i n Latin America, partly reflecting i t s large capital gains after the crisis. However, government and central bank debt represent most o f the portfolio - 60 percent and 22 percent, respectively, This means that the system’s main effect has been to make (part of) the government’s pension liability explicit, and that the system has not fulfilled i t s promise to provide long-term resources for the private sector. Moreover, contributors have substantial sovereign risk. In addition, about 7 percent o f A F A P s ’ assets are held in cash due to limits o n exposure and unavailability o f private sector issues. AFAP concentration i s also high - there are only four AFAPs and the BROU-controlled AFAP Repu’blica accounts for 56 percent o f total AFAP assets and 38 percent o f all affiliates. Repu’blica guarantees a minimum return, an unrecognized contingent liability for the government. - 11- 27. Performance of the system could be improved and risks reduced b y various measures. Removal of the minimum return o f Repu'blica would eliminate the government's explicit contingent liability and level the playing field for private AFAPs. Regulation and oversight should include monitoring o f Repu'blica 's pricing practices to ensure competition. Investment regulations governing the A F A P s need to be eased to ensure a prudent asset diversification o f affiliates' investments. Possible measures include: (i)allowing limited overseas investments in high quality assets, an option available for other investments o f Uruguayans; ( ii) allowing alternative pension funds with different risk characteristics; and (iii)allowing AFAPs t o use currency and interest hedging instruments to protect against losses. To some extent, diversification also will depend on developing private sector instruments for AFAP investment by improving the capital market framework, as discussed below. 28. Consider ways to improve competition and transparency and to reduce costs and the AFAPs' commissions, which are the second highest in the r e g i ~ nHigh .~ commissions partly reflect the market's small size and the need for the AFAP owners to recover their initial investment, but they also appear to generate high profits. To some extent better accounting would improve the transparency o f the A F A P s ' costs, sales and profits, which now neglect the inter-temporal nature o f the business. Marketing costs for new affiliates, who tend t o remain with their original M A P , represent about 26 percent o f total costs but the AFAPs actually differ little in portfolios or service currently. Various approaches might be considered for reducing costs, including assigning new affiliates to an AFAP initially (affiliates would retain the option to switch after 6 months), for example to the AFAP with the lowest commission; allowing employers to negotiate terms for new employees; or using secure internet sites for subscription. Another approach would be to allow development o f new funds, some of which could be allowed to charge commissions based o n assets-under-management, as in Mexico." B. The Insurance Sector 29. The Uruguayan insurance sector i s small and i s dominated b y the state- owned BSE, which has 60 percent of life and 67 percent of nonlife business. While the FSAP examined data from all firms, many o f i t s recommendations focus o n the BSE because o f its size and the issues associated with it. Although solvency indicators o f the insurance sector have improved since the 2002 crisis, profitability remains poor and may be overstated by the treatment o f reinsurance in the various insurance firms' accounts. The private insurance fiims' growth has been limited by BSE's actual and potential activities and i t s pricing policies. Finally, the government has difficulty in overseeing BSE, since the timeliness and quality o f i t s data are weak and its transparency, internal controls and risk management need improvement. 30. BSE represents a contingent liability on the government. The state i s effectively BSE's reinsurer and guarantor, T w o particular r i s k s for the government are: (i)BSE's effective monopoly position as provider o f annuities, which legally must be indexed t o wages and for which there are no good market hedges for private providers; T h i s comparison does not control for the maturity and size of the pension funds sector in the countries. loAFAPs already share some back office functions, including account processing and custodial services, so there i s little room for seeking cost efficiencies in these areas. - 12- and ( ii)BSE’s legal monopoly as a provider of workers compensation and disability, a high-risk line o f business. Furthermore, any proposals for B S E to develop a mortgage default insurance system should be evaluated carefully. I f BSE were to offer such insurance at prices that do not reflect the underlying risks, this may lead to a transfer o f losses from BHU t o BSE. I t may also create incentives for BHU to take higher risks, leading t o additional government contingency risks. 3 1. The strategy for the sector should focus on realigning BSE, improving its performance, and encouraging innovation in insurance products and portfolio investments. The BSE will remain a major provider o f insurance for some time. A restructured BSE, with a clear mandate and increased accountability and transparency, could make a significant contribution to the insurance sector and the financial sector i n general. The f i r s t steps would be an improvement in the timeliness and quality o f BSE’s information, as well as pricing policies, internal risk management, and controls. I t would also be desirable t o conduct an independent analysis o f the contingent liabilities in BSE’s products, such as wage-indexed annuities and workers’ compensation. Proposals for any new products, such as mortgage insurance, should be studied with a view to avoiding government contingent liabilities, for example, by greater use o f commercial reinsurance. More generally, oversight should be strengthened o n annuities and composite firms, including reporting, accounting, and asset separation in composite firms, o f which the largest i s BSE. Innovation should be encouraged, as it i s necessary for the sector’s profitability, growth and, ultimately, i t s sustainability. For example, if legal requirements that require wage-indexed annuities were relaxed, B S E were to stop offering this risky product, and concerns about BSE’s pricing were reduced, then private firms might be able t o enter the segment and offer new products and services. The possibilities for commercially-priced products, such as universal third-party motor insurance and a basic life insurance product for a wider market would also contribute to the sector’s growth. C. Capital Markets 32. Capital markets in Uruguay are small and illiquid, reflecting both structural issues and the crisis. In 2004, equity market capitalization amounted to only 2.2 percent o f GDP and trading accounted for 0.5 percent o f market capitalization, with only 11 listed firms. Bond and commercial paper issues peaked in the latter half o f the 1990s at between US$lOO-$200 million annually but have collapsed since 1999. The market’s limited size reflects (i) the country’s small size, which limits liquidity; ( ii) the easy access to and the ability t o roll-over loans from state banks for firms i n the main industry, livestock, and in construction; and ( iiithe full state-ownership o f major utilities that typically would issue ) stock. In addition, confidence i n the market was hurt by the 1999 fraud i nthe commercial paper market by a major issuer, Granja Moro. Issuance costs, public scrutiny and governance, and legal issues and tax treatment, particularly o f securitized instruments in the local market, are also issues. 33. The legal framework i s not sufficiently specific and the regulators have been increasingly resorting to a narrow set of administrative measures. The Securities Market and AFAP Control Division o f the B C U act as the country’s securities markets regulator. The legal framework (based o n the 1996 L a w o n Capital Markets) does not provide specific guidelines o n disclosure o f information by the issuers and reporting standards by the intermediaries. In response to problems i nthese areas, the securities - 13- markets regulator has resorted to using administrative sanctions, including the suspension of trading of some issues. During 2005, the securities markets regulator issued (and made publicly observable) sanctions and citations to 16 entities, which resulted in the suspension of trading of more than 60 percent of traded corporate issues for an average o f 5 days each. The disruptive nature o f these sanctions partly reflects the fact that in the current legal environment the securities markets regulator has limited authority over the brokeddealers whose conduct under the current law i s monitored by self-regulated stock exchanges. I t i s important to broaden the BCU's powers pursuant to which it may investigate and punish problems in brokeddealer conduct without prior involvement o f the Bolsa de Valores and in order to ensure that licensing i s the prerogative o f the B C U and not o f the Bolsa, in line with international best practices. 34. The authorities have repeatedly announced their intentions to develop local capital markets. However, even the forthcoming changes in the legal, regulatory, and taxation regimes may be insufficient to expand capital markets, given the underlying structural issues. Simplifications in taxation would make securitization easier. The powers o f the supervisor over market agents, such as powers to regulate and directly impose penalties o n stock exchange brokers, are limited-they remain with the exchanges. Continuing macroeconomic stability, the growth o f pension funds, and attempts to develop new instruments and strengthen market lnfrastructure and the regulator may lead to some improvement in the role o f capital markets. 35. One product area where the capital market might expand i s in financial trusts (fideicomisos) and securitization. InLatin America, securitizations have been successful instruments, with US$7.8 billion issued in local markets in 2004. Uruguay's 2003 Trust L a w (Ley de Fideicornisos) was enacted with the expectation that securitizations would be an effective instrument the M A P Sand insurance companies would demand. However, only three such instruments have been created since the law became effective, all o f which were highly structured deals based o n special laws and tax concessions to relax the heavy tax burden o n such instruments. In addition, the lack o f standardized instruments has contributed to a lengthy approval process. A wider use o f fideicomisos would require lowering and simplifying o f the tax burden, standardization o f contracts, and an availability o f regulatory resources that could analyze the special features o f each contracts. 36. K e y policy initiatives should focus on fostering new financing and risk sharing structures." For example, the creation o f structured products that would combine several small issues of varying credit quality with some credit enhancements may allow small- and medium-sized companies to offer instruments attractive t o pension funds. Similarly, the development o f markets for hedging instruments should be supported by the establishment o f a reference yield curve for government debt (a task o f the Debt Management Unit at the Ministry o f Finance) and a speedier establishment o f the necessary legal and regulatory basis for such instruments (including the draft L a w o n l1 For example, the corporate bond market in Mexico was marginal until the introduction o f a new - instrument - Certificados Bursatiles (CBs) in the 2001 securities law. The CBs, which combine the structure of medium-term notes and the flexible amortization structure of debentures, contributed to a market takeoff for corporate bonds and accounted for 99 percent of corporate debt issuance in 2004. - 14- Capital Markets). A legal and regulatory framework would also be necessary for developing mortgage securities in Uruguay. 37. A n improved framework for corporate governance could also help develop capital markets for corporate securities. The corporate governance assessment identifies an urgent need to revise the legal framework; improve awareness, understanding, and investor protection; and support a number o f private initiatives. The improved transparency o f the corporate sector would allow for a better assessment o f corporate sector risks, which in turn would encourage capital markets development. The draft amendments to the Capital Market Law, currently under consideration by the BCU’ s legal department, include corporate governance provisions that are in accordance with IOSCO standards. IV. MARKET FINANCIAL INFRASTRUCTURE A. Payments and Securities Settlement Systems 38. The BCU’s recent upgrading of payments and securities settlement systems should be complemented b y strengthening its oversight function and the legal framework. The B C U should create a Payments System Department with clear responsibility for the operations o f its increasingly complex systems and form a small unit in charge of payments system oversight, separate from systems operations. The legal framework needs t o be improved in the following areas: the protection o f the payment systems against bankruptcy procedures and the establishment o f the legal basis for netting arrangements; public securities and repos; custody arrangements; and electronic signatures and documents. T o ensure cooperation o n payments issues, a formal National Payments Council should be formed involving representatives o f a l l major stakeholders. 39. The main payments system of the BCU-the Sistemu Electrbnico de Comunicaciones (SEDEC)-does not comply completely with several CPSS Core Principles (CPs), though improvements are underway. The BCU i s addressing some shortfalls o f the existing system to make it fully compliant. A project to migrate the current RTGS (Real Time Gross Settlement) payments system to a new payments system platform i s underway. Areas for further improvement include development o f clear rules and procedures, establishment o f a secondary processing site, and development o f business continuity and disaster recovery plans. A comprehensive external audit o f the new system should be conducted once the upgrade i s completed. 40. The check clearinghouse operated by the Bolsa Electronica de Vulores (BEVSA) i s a major funds transfer system that handles some large value payments; it does not comply with most CPSS CPs. Payments safety and stability would be greatly enhanced by requiring large-value payments to move to the RTGS system. 41. B E V S A i s developing an automated clearinghouse (ACH) to settle electronic credit transfers, direct debits, and other new means of payment. I t i s expected, in light o f the experience i n other countries, that the A C H will help modernize payments and reduce payments costs substantially. The BCU needs t o provide oversight and to play a catalytic role in encouraging agreements among potential system users in order to help the A C H begin operations o n a large scale and with a sound legal backing. - 15- 42. The payments of public sector institutions and the transactions in the over- the-counter foreign exchange (OTC-FX) market should both be moved to the R T G S or ACH. The B C U should closely cooperate with the Treasury and the BROU to increase the efficiency o f government payments. In the area o f foreign exchange, roughly half o f the transactions are o n the O T C market and exposed to settlement and credit risk because trades are not on a payment-versus-payment (PvP) basis. The B C U should encourage OTC FX traders to shift to SEDEC, where trades are o n a PvP basis. 43. The BCU’s oversight of the securities settlement framework needs to be strengthened. The responsibility of supervision o f the settlement of AFAP instruments i s the Operational Control Management Office o f the Securities Market and AFAP Control Division, and it acts in accordance with AFAP rules. Security settlement oversight i s also done in a limited way by the stock exchange in i t s self-regulatory (SRO) capacity. This SRO function should be complemented by stronger, adequately-resourced B C U oversight to increase investor confidence in the market. 44. The authorities should move toward a single securities depository, linked to RTGS, and strengthen the legal framework for securities custody. The current diversity of custody/depository systems amplifies financial, operational and custodial risks, related to both the lack o f delivery-versus-payment settlement (DvP) and weaknesses in the legal framework. The authorities should consider cost-effective ways o f establishing a single depository. The shift t o a single depository should be done in the context o f a comprehensive reform o f the payments and securities settlement systems, linking it to the RTGS to allow for DvP. The new securities settlement system should observe the “Recommendations for Securities Settlement Systems� issued by CPSS- IOSCO in November 200 1. B. Accounting and auditing 45. International accounting standards are legally required for nonfinancial corporations but are s t i l l poorly understood and compliance i s uneven: financial institutions are subject to accounting rules established b y the BCU and are expected to move to international standards b y 2008. The Accounting and Auditing ROSC found a number o f cases o f noncompliance with international standards in listed companies . 46. Significant improvement in corporate disclosure i s needed to improve lending to corporates and to develop the capital market. Public disclosure o f financial information i s required for most companies, but not adequately observed, except for banks and issuers o f market instruments, where BCU pressure has brought improvement. Information quality i s also uneven, even among listed companies. The stock exchanges do not monitor disclosure quality closely and rarely penalize listed companies for noncompliance with rules o n information. Regulators o f nonfinancial corporations - the National Audit Office (Auditoriu Interna de la Nucion) and the BCU securities market regulators - have limited capacity to conduct investigations o f discrepancies in corporate accounts that may appear.12 Disclosure o f ownership i s also limited. These weaknesses l2 BCU’s securities regulator has made some gains in improving the promptness o f filing of information by l i s t e d companies, but lacks legal power to fine issuers and has limited access to issuers’ accounts. - 16- complicate lending by financial institutions and enforcement o f regulatory rules o n exposure, as well as capital market development. C. The legal system 47. Uruguay has a well-deserved reputation for i t s legal and judicial integrity, but the length of the judicial enforcement proceedings i s often an issue for both secured and unsecured creditors. In the areas o f creditor rights significant improvements in this field could be achieved by taking the following measures: e Revise the legislation for both secured and unsecured credit execution. More efficient, accelerated procedures o f debt-collection, such as out-of-court enforcement, should be considered. Ways t o shorten the current proceedings should also be considered, focusing o n reducing judicial intervention. e Increase t h e resources for overburdened courts to increase qualified staff, auxiliaries and modern equipment. This will help speed up proceedings. e Interconnect the data bases of the National Registry. This will make it possible to obtain nation-wide information on different types o f property and their encumbrances, particularly on a company name basis. 48. Uruguayan bankruptcy legislation i s not effective but a comprehensive legal reform i s under way. The government has recently completed a draft o f a new insolvency law that will be subject to public discussion. The proposed law i s an integral reform o f the fragmented and antiquated insolvency system and envisages approaches to allow both the reorganization of viable enterprises in financial difficulties and the efficient liquidation o f nonviable ones, including procedures similar to the U.S. Chapter 11 approach. Of course, the impact o f the law will depend o n what i s passed. I t will be desirable to track how the new legislation and improvements in the courts speeds up judgments, and publicize this information. D. Credit information 49. Credit information i s reasonably good and will improve as BHU loans and BROU loans to small borrowers are added and if the system becomes easier to use. Credit information i s largely based o n the data B C U collects o n bank borrowers to ensure banks’ ratings are appropriate. This data is made available to all who supply information to the system. Extending the system to the smaller borrowers o f the BROU and including the data from BHU and the liquidated banks w i l l increase the incentive for small borrowers to service debt and let them develop the intangible asset o f a good credit record. This in turn will improve credit access and help banks improve their portfolios. In addition, access to the BCU data could be made more user-friendly. V. THE F N IANCIL A STABILITY POLC I Y FRAMEWORK A. Independence of the Central Bank 50. The proposed amendments to the BCU’s charter are aimed at improving i t s autonomy and accountability. Inthe draft law, the BCU’s main objectives would be - 17 - price stability and regulation and supervision o f the payments and financial systems. Inflation objectives would be set i n coordination with the Treasury. The draft law enhances institutional autonomy o f B C U b y separating the timing of board appointments f r o m the electoral cycle. The draft law also provides for BCU’s operational autonomy and legal protection for the B C U staff in fulfillment o f their duties. Regarding accountability, the B C U would be required to submit an annual report to Congress. The draft law also tightens the financial reporting o f the BCU by requiring publication o f an audited financial statement in accordance w i t h international accounting standards. 5 1. The BCU needs recapitalization to strengthen its ability to conduct monetary policy and improve i t s net income. Currently, seigniorage revenue does not cover BCU’s operating expenditures and the carrying cost o f i t s debt-financed foreign and domestic assets. The deficit constrains monetary policy: for example, the ability to reduce required bank reserves and/or increase their remuneration. It also makes BCU dependent on the Treasury for resources. While BCU’s income position could be improved by downsizing i t s balance sheet, it needs to maintain reasonable levels o f international reserves and domestic public debt. Addressing these issues will require recapitalizing the B C U and, preferably, transferring at least some o f i t s debt t o the government. B. Regulation and Supervision 52. Over the last three years, financial regulation and supervision have improved significantly, especially regarding banks; the draft BCU law envisages integrating regulation and supervision across the whole financial sector. The Superintendency has played an important role in stimulating the banks, particularly BROU, to improve risk management. The authorities have taken various measures to make banks internalize credit risks f r o m dollarization and cross border activities and to limit exposure and risk concentrations. It has also overhauled loan classification and capital regulations. Regulations imposing capital charges for market risk are taking effect. Guidelines o n interest rate and operational risks will need to be issued. Progress has been made in the regulation and supervision o f state banks, although much remains to be done. The bank resolution framework i s being strengthened, although constitutional constraints limit the framework’s applicability t o the state banks. The Superintendency has also systematically increased the disclosure o f financial information to the market, which has contributed to greater market discipline. The proposed new law envisages financial supervision and regulation becoming a separate autonomous unit within the BCU and reorganized to integrate coverage of banking, insurance, securities and pensions. 53. Three key problems hinder the effectiveness of financial sector oversight - across all sectors lack of resources, limits on powers with regard to state institutions, and quality of data that state institutions provide. While technically competent, the supervisory staff i s generally overstretched, and focused o n day-to-day supervisory needs. Funding i s scarce for information systems and training staff in up-to- date supervisory methods, financial practices, and market risks, reflecting the general problem o f the BCU’s net income. Access to resources from multilateral organizations has allowed the Banking Superintendency to partially overcome these constraints, but these resources are temporary. Second, the supervision o f public financial institutions i s limited by the legal framework. The capacity o f supervisors to enforce corrective actions i s limited by their inability to require changes in direction and management in public f - 18- sector financial institutions. Third, the quality and timeliness of data provided by the public financial institutions remain a problem, which affects both their supervision and the general ability of the government to oversee public financial institutions. These issues n the assessment of compliance with the Base1Core Principles (BCP) are reflected i which indicates that, i n spite of recent progress, additional improvement i s required. 54. Efforts are also needed to improve the supervision of banks’ compliance with anti-money laundering (AML) polices and procedures. Uruguay i s vulnerable to money laundering and the financing of terrorism, particularly f r o m its cross-border activities. I t s role as an offshore center exposes it to such risks including f r o m banking, securities, currency exchange and remittance business. Uruguay has put i nplace many o f the basic legal elements for an AML/CFT regime but the legislation does not cover all categories of serious offenses required by FATF. Furthermore, no system-wide review o f money laundering and financing of terrorism risks has been conducted, and awareness o f risks i s generally low. Financing o f terrorism was criminalized in September 2004, but limitations in the law seem to exclude financing o f terrorist organizations or individuals not linked to specific terrorist acts. AML/CFT supervision b y the BCU, an integrated n the banking sector. A key supervisor, i s s t i l l developing but i s more advanced i challenge will be in finding adequate resources for A M W C F T supervision given the many institutions under BCU’s jurisdiction. An in-depth review o f AML procedures was conducted by a separate team o f specialists from GAFISUD. The findings and recommendations were provided t o the authorities. 55. Significant differences exist between the Chart of Accounts for financial institutions issued by the BCU and international accounting standards, which i s expected to be remedied b y end-2008. All enterprises, except financial institutions, must comply by 2006 with International Accounting Standards (IAS) issued b y the International Accounting Standards Board (IASB). K e y issues for financial institutions relate to the accounting treatment o f derivatives, the accrual o f labor costs and taxes as well as lack o f sufficient information in audited financial statements to allow analysts to estimate divergence f r o m IAS. The B C U contemplates updating the Chart o f Accounts by end-2006 and banks’ full compliance with the I A S to commence o n December 31,2008. 56. In the nonbank sectors, the supervision of AFAPs i s generally adequate, though some improvements in regulation and supervision would reduce vulnerabilities and improve their potential. T o implement rapidly the recently adopted risk-based supervision and the regulations o n internal controls systems, the investment allocation rules to improve diversification would need to be liberalized along with an n resources, both generally and for staff training. increase i 57. Regarding the insurance sector, the regulation and supervision of composite companies, annuities and B S E should be improved. There i s a need to strengthen capital and provisioning rules and financial reporting, including a review o f the treatment and transparency o f reinsurance. Composite companies (life and nonlife) represent a special challenge; a clear separation o f results and portfolios i s necessary. Companies providing annuities need t o be better supervised in terms o f capital and financial reporting standards, particularly before annuity growth accelerates as AFAP retirees grow n number. Finally, BSE represents perhaps the most significant challenge. Efforts are i - 19- needed to improve the quality and timeliness o f B S E data. Furthermore, an independent analysis i s needed o f the potential contingent liabilities o f B S E products. C. Safety Nets and Crisis Management 58. Powers to assist and resolve weak banks have been enhanced since the 2002 crisis, but additional measures are necessary. The legal framework adopted in 2002 gives the B C U broad range o f powers to impose corrective actions and resolve problem banks, and substantial discretion in their use. Although supervisors need flexibility, excessive discretion can delay corrective actions and may create legal contingencies. I t i s recommended that the law establish situations in which specific corrective actions are mandatory within a limited time frame. Additionally, the BCU should set up clear internal procedures for applying prompt corrective actions. Most important, the role o f the B C U as liquidity provider “under extreme circumstances� needs clarification. 59. A deposit insurance fund became operational in 2005. The maximum coverage i s US$5,000 for dollar deposits and the equivalent o f US$15,000 for peso deposits, per depositor per bank. This coverage i s more generous than elsewhere in the region. Also, BROU’s charter provides full government guarantees for i t s depositors. (The maturity o f BROU and BHU t i m e deposits was, however, reprogrammed in the 2002 crisis.) 60. The draft BCU legislation establishes the deposit insurance agency (COPAB) as an autonomous institution outside of the BCU with the responsibility for the resolution and liquidation of problem institutions. The draft law stipulates that once the B C U declares a financial institution insolvent or unfit to operate, the COPAB has 90 days to decide whether to liquidate or t o proceed with an alternative resolution plan, based o n least-cost criteria. Deposit insurance funds can be used t o pay depositors o f a liquidated bank or to facilitate the resolution plan. The draft law calls for the COPAl3 to develop a decision-making and accountability framework for the resolution process. It appropriately includes the legal protection for COPAB staff while in fulfillment o f their duties. While the draft law calls for the coordination o f information sharing and other activities between the COPAB and the new Superintendency o f Financial Services, no arbitrator i s specified in case o f a conflict. Coordination and conflict resolution may prove even more difficult once the agency moves outside the BCU. 61. The authorities would benefit from developing a comprehensive contingency plan for handling banking crises and other market disturbances. A Comprehensive contingency plan would allow the authorities to identify probable solutions for alternative crisis scenarios, test these solutions and the effectiveness of the implementation arrangements in place, and identify weaknesses to be addressed. The plan should define the roles of each o f the parties involved in managing a crisis and the means for effective coordination (BCU, Deposit Insurance Agency, MEF and private institutions). - 20 - ANNEX I RECOMMENDATIONS Short-term stability-related issues a Continue close monitoring o f public banks to ensure that their risk management policies and practices are brought up to standard. a Continue to limit lending activities in these banks until such improvements are achieved. Key structural and longer-term issues n particular state banks, to Restructuring and downsizing o f the state institutions, i minimize moral hazard. Require directors and managers o f public financial institutions to satisfy fit and proper requirements applied to the private institutions. Strengthen central bank independence and recapitalize the central bank as n the draft law submitted to congress. envisaged i Remove the selective employer exemptions f r o m contributions t o public pensions as envisaged in the proposed tax law, carry out further reforms t o reduce the public and sectoral pension funds' deficits, and eliminate the guaranteed rate o f nM return i A P Repu'blica that i s implicitly government-guaranteed. Conduct an independent analysis o f the potential contingent liabilities from products offered by the state insurance company, BSE, as well as any proposals for mortgage insurance. Reduce the tax burden and improve the legal and regulatory framework for t r u s t funds and securitizations. Reform the insolvency legislation to allow for the reorganization o f viable firms n the proposed and the faster, efficient liquidation o f nonviable ones as envisaged i bankruptcy law. Strengthen the credit culture by making the credit registry easier t o use, speeding up incorporation o f BHU loans and the small loans of BROU, strengthening the credit and debt relief practices o f public banks, and shortening foreclosure and bankruptcy processes. Implement the shift to an upgraded RTGS system and the launch o f the ACH for retail payments and improve the legal framework related to payments and securities settlement systems. - 21 - Strengthening the supervisory and regulatory framework e Increase resources to carry out effective supervision and to provide training for staff, improve information systems. a Provide legal protection for staff o f supervisory agencies and deposit insurance agency. e Enhance AMUCFT legislation. e Improve cooperation and information exchange with foreign supervisors, including through additional MOUs. e Enhance the regulatory authority over securities intermediaries; improve supervision of BSE, composite life and nonlife insurance companies, and the annuities industry. - 22 - ANNEX I1 Table 1. Uruguay: Structure of the Financial System December 31,2001 December 3 1,2005 Assets Assets Percent of (Inmillions Percent of Number (In millions of Number Total Total Assets o f us. U.S. dollars) Assets dollars) Commercial Banks 22 20,609 82 15 12,951 67 Ofwhich Public sector-owned banks 2 7,457 30 3 7,885 41 BROU 1 4,788 19 1 5,540 29 BHU 1 2,668 11 1 1,318 7 Nuevo Banco Comercial S.A. 1 1,027 5 Domestic private banks 3 3,172 12 0 0 0 Foreign banks 1/ 17 9,980 40 12 5,066 26 Nonbank intermediaries 25 2,834 12 15 3,546 19 Cooperatives 6 478 2 3 211 1 Financial houses 7 540 2 6 157 1 External financial institutions 2/ 12 1,816 8 6 3,178 17 Pension funds (AFPs) 4 1,045 4 4 2,164 11 Insurance companies 17 572 2 15 619 3 Total financial system 68 25,060 100 49 19,280 100 Source: Banco Central de Uruguay. 1/ Includes both foreign branches and subsidiaries. 2/ Includes derivatives transactions. - 23 - Table 2. Uruguay: Selected Macroeconomic Indicators 2002 2003 2004 2005 (Percent change, unless otherwise indicated) .Output, prices, and employment I Real GDP -11.0 2.2 11.8 6.6 GDP (US$billions) 12.1 11.2 13.3 16.9 GDP deflator 18.7 18.4 7.5 1.7 CPI inflation (eop) 25.9 10.2 7.6 4.9 Exchange rate change (Ur$AJS$) (eop) 84.2 7.3 -9.9 -8.3 Average public sector wage (end-of-period) 0.5 7.9 9.7 10.2 Unemployement (in percent ) 17.0 16.9 13.1 12.1 11. Monetary indicators Base Money I/ 22.1 24.9 11.1 34.1 M1 1.7 34.6 13.4 29.4 M3 15.8 21.7 -2.0 0.1 Credit to the private sector (constant exch. rate) 2/ -17.6 -23.9 -11.2 2.7 (Percent of GDP, unless otherwise indicated) 111. Public sector operations Revenue 32.1 32.0 30.9 31.8 Non-interestexpenditure (incl. discrepancy) 32.1 29.3 27.2 27.9 Primary balance 0.0 2.7 3.8 3.9 Interest 4.7 6.0 6.0 4.6 Overall balance -4.6 -3.2 -2.2 -0.7 Public sector debt 31 96 104 92 69 Public debt service (as a percent of GDP) 13 14 19 16 IV. Savings and investment Gross domestic investment 11.5 12.6 13.3 13.2 Gross national savings 14.7 12.1 13.6 12.6 Foreign savings -3.2 0.5 -0.3 0.5 V. External indicators Merchandise exports, fob (US$ millions) 1,922 2,28 1 3,145 3,758 Merchandise imports, fob (US$ millions) 1,874 2,098 2,992 3,826 Merchandise terms of trade (percentage change) 4.3 2.9 -3.1 -9.7 Current account balance 3.2 -0.5 0.3 -0.5 Of which: Excluding cellulose projects 3.2 -0.5 0.3 0.1 Foreign direct investment 1.5 3.6 2.4 3.6 Overall balance of payments (US$ millions) .2,328 1,380 454 95 1 External debt 4/ 87.5 98.2 87.4 67.8 External debt service (percent of exports of goods and services) 55.0 52.3 44.8 47.0 Gross offtcial reserves (US$ millions) 5/ 712 2,087 2,512 3,438 In months o f imports of goods and services 3.7 9.2 8.0 8.7 Inpercent of short-term debt plus FX deposits 7.0 20.0 27.7 32.9 REER (percentage depreciation -,e.0.p.) -20.3 -13.2 9.3 11.9 Sources: Data provided by the Uruguayan authorities; and Fund staffestimates. 1/ Program definition (end of period data). 21Part of the sharp drop in 2003 i s due to the removal of the three liquidated banks from the database in May 2003. 3/ Covers debt o f the NFF'S and the central bank (excluding monetary policy instruments and free reserves). 4/ Excludes nonresident deposits. 5/ Includes reserve buildup through reserve requirementsof resident financial institutions. - 24 - i Figure 1. Banking System Total Assets and Deposits in Latin America, 2004 (In percent o f GDP) 100 1 Total Assets 40 30 20 10 0 1 Total Deposits 70 - 2 I rd C s .- 2 ' 8 2 .e c.l e, 8 3 4 Note: Data for Uruguay i s as o f December 2005. Source: IMF staff calculations based on data from Uruguayan Authorities, Superintendencia de Bancos e Instituciones Financieras - Chile, Federaci6n Latinoarnericana de Bancos, IMF International Financial Statistics and WEO.