Document of THE WORLD BANK For OfficialUse Only ReportNo. 23996-PA INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAMDOCUMENT FOR A PROPOSEDPROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN INTHE AMOUNT OFUS15MILLION TO THE REPUBLIC OF PARAGUAY March 7,2005 Finance, Private Sector and InfrastructureDepartment Country Department for Argentina, Chile, Paraguay and Uruguay Latin America and the CaribbeanRegional Office This documenthas a restricted distribution and may be usedby recipientsonly in the performanceof their official duties. Its contents may not otherwisebe disclosed without World Bankauthorization. CURRENCYAND EXCHANGERATE (As of February28,2005) Currency Unit Guarani Gi. US$1.OO = GI.6,275 FISCAL YEAR January 1- December31 ABBREVIATIONSAND ACRONYMS AML Anti Money Laundering BANAVI Banco Nacionalde la Vivienda (NationalHousingBank) BCP Banco CentraldelParaguay(CentralBank) BNF Banco Nacionalde Foment0(NationalDevelopmentBank) CADEF Calificacionde Entidades Financieras(local bank rating system) CAH Credit0Agricola de Habilitacion (Agricultural CreditFund) CAMEL CapitaVAssetsiManagementlEamingsILiquidity CAR CapitalAsset Ratio CFAA CountryFinancialAccountability Assessment CONAVI ConsejoNacional para la Vivienda (NationalHousingCouncil) CNV ComisihNacional de Valores (NationalSecurities Commission) DGCP DirectorateGeneralfor PublicProcurement ESW Economicand Sector Wotk FDI Fondo de DesarrolloIndustrial(IndustrialDevelopmentFund) FDC Fondo de DesarrolloCampesino (Rural DevelopmentFund) FG Fondo Ganadero (CattleIndustryFund) FSAP FinancialSector Assessment Program GAFISUD FinancialActionGroupof South America GDPIGNI Gross DomesticProductlGross NationalIncome GOP Government ofParaguay IDB Inter AmericanDevelopmentBank IDP InstitutionalDevelopmentPlan IMF IntemationalMonetaryFund INCOOP InstitutoNacional de Cooperativismo(NationalCooperatives Institute) IOU Invoice of Understanding(or "I you") owe IPS Instituto de PrevisionSocial (SocialSecurityInstitute) LIBOR LondonInterbankOffer Rate LOLR Lender of Last Resort MERCOSUR Mercado Comh del Sur (SouthemCommonMarket) MIC Ministerio de Industriay Comercio (Ministry of Industry and Commerce) MOF Ministry o f Finance NIR Net IntemationalReserves NPL Non-PerformingLoan OAS OrganizationofAmericanStates PFSAL Programmatic Financial Sector Adjustment Loan PETROPAR PetroleosParaguayos(ParaguayanPetroleumCompany) RWA RiskWeightedAssets SB Superintendencyof Banks SBA Stand-ByArrangement SIAF Systemfor IntegratedFinancialAdministration UnidadTecnicaEjecutorade Programs (2ndTier FinancingFacility) woccu UTEP World Council of Credit Unions Vice President: PamelaCox ~ Country Director: Axel van Trotsenburg Acting SectorDirector: JohnHenry Stein Acting Sector Manager: Susan Goldmark Sector Leader: Juan Gaviria LeadEconomist: James Parks CountryManager: Peter Hansen Task TeamLeader: JohnPollner FOR OFFICIAL USE ONLY REPUBLIC OF PARAGUAY PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN TABLE CONTENTSOF Update to the Board of Executive Directors....................................................................................... i Loan Summary ................................................................................................................................... ii PART I Recent Economic Developments and Prospects . ................................................................. 1 A. Economic Context .................................................................................................................... i B. Recent Economic Developments .............................................................................................. 3 C. Economic Prospects and FinancingNeeds ............................................................................... 6 D. Multilateral Coordination......................................................................................................... 7 PART I1. Financial Sector Context and the ReformProgram........................................................... 9 A. Overview .................................................................................................................................. 9 B. The Banking System................................................................................................................. 13 C. The Government ReformAgenda for the Banking System..................................................... 24 The FirstOperation Under the Program.............................................................................. 24 The Second Operation Under the Program.......................................................................... 32 The ThirdOperation Under the Program ............................................................................. 35 PART I11 THE PROPOSED LOAN . ................................................................................................. 38 A. LoanDescription:Objective andRationale for BankInvolvement.......................................... 38 B. Conditionality ........................................................................................................................... 41 C. Disbursement and Auditing ...................................................................................................... 45 D. EnvironmentalAspects............................................................................................................. 45 E. ProgramObjective Categories .................................................................................................. 45 F Benefits and Risks..................................................................................................................... . 46 Annex 1: Policy Matrix ..................................................................................................................... 49 Annex 2: Letter o f Financial Sector Development Policy................................................................. 54 This document hasa restricteddistribution andmay beusedby recipients only inthe performanceof their officialduties Its contents may nototherwise be disclosedwithout World Bank authorization . . Annex 3: Background and Diagnostics o f the Paraguayan Banking Regulatory and Resolution Framework and Technical Issues inthe Reform ................................................................................ 75 Annex 4: Timetable of Key Processing Events................................................................................. 91 Annex 5: Paraguay . IMFlFundRelations........................................................................................ 92 Annex 6: Paraguay . Status o f World Bank Operations .................................................................... 95 Annex 7: Paraguay at a Glance.......................................................................................................... 96 TABLES. BOXES AND FIGURES Box 1: Progress To-Date on `Political Agreement' and CAS Benchmarks ................................... 4 Box 2: Donor Technical Assistance Coordination......................................................................... 8 Box 3: Financial Soundness o f BNF .............................................................................................. 22 Figure 1: Financing Structure for Proposed Deposit Insurance Fund ............................................... 25 Figure 2: Summary o f Bank Resolution Regime............................................................................... 27 Figure 3: Structure o f LoanPortfolio Securitization Scheme ........................................................... 88 Table 1: Selected Economic Indicators............................................................................................. 3 Table 2: Public Sector Debt Sustainability ........................................................................................ 7 Table 3: EstimatedPublic Sector Financing Needs........................................................................... 7 Table 4: Percent Coverage o f Currency & Short TermLiquidityby InternationalReserves............10 Table 5: Monetary Components o f Ratio 3 ....................................................................................... 10 Table 6: The Paraguayan Banking System........................................................................................ 13 Table 7: N o n Performing Loan Ratios inthe Banking System ......................................................... 14 Table 8: Accumulated Cost to date o f Central Bank Rescue Measures ............................................ 15 Table 9: Estimation of Deposit Insurance FundingRequirements.................................................... 16 Table 10: Public (State owned) Financial InstitutionsinParaguay................................................... 20 Table 11: Distribution o f BNF's Deposit Liabilities .......................................................................... 21 Table 12: External Financing Requirements ...................................................................................... 40 Table 13: Sequence o f Adjustment Measures to `Stress Test' Banking System Capital Adequacy ..82 Bank staff who worked on the Programmatic FSAL included: John D. Pollner (Lead Financial Sector Specialist / Task Team Leader. LCSFF). Joaquin Gutierrez (Lead Financial Sector Specialist. OPD). Jose Antonio Alepuz (Senior Counsel. LEGPS). Modibo Camara (Sr. Financial Economist. LCSFF). Peter Hansen (Country Manager. LCCPY). Susana Sanchez (Senior Financial Economist. LCSFF). Luz MezaBartrina (Senior Counsel. LEGLA). Reynaldo Pastor (Senior Counsel. LEGLA). Zeinab Partow (Country Economist. LCSPE). James Parks (Lead Economist. LCC7A). Juan Gaviria (Sector Leader. LCSFP). Peter Hansen(Country Manager. LCCPY). and Javier Bolzico (Consultant) The Financial Sector reformprogramwas developed basedon the findings from a Financial Sector Review . conductedin September 2002. andwhich includedthe following team: John Pollner (LCSFF). Modibo Camara (LCSFF). Mario Guadamillas (LCSFF). Joaquin Gutierrez (BFR) and Sergio Lleras (Consultant. LCSFF). UPDATETO THE BOARDOF EXECUTIVEDIRECTORS The original Paraguay Financial Sector AdjustmentReform Loan (FSAL) was distributedto the Board o f Executive Directors inAugust 2004 and subsequentlywithdrawn at the Government's request given a pendingBoardpresentation condition. The pendingcondition was the submissiono f a new BankingLaw to the Congress. A draft Banking Law, evaluated as satisfactory by the Bank, was submitted to Congress on December 10,2004, thus meeting the pending condition. Boardpresentation o fthe FSALwas also conditioned on progress with the restructuring and consolidation o fthe state ownedfinancial institutions. Inthis context, a draft law was submittedto Congress inmid-2004 covering the consolidation o fthe first tier and second tier public financial institutions. This draft law was not taken up by the Congress and was subsequently replacedby another draft law covering the consolidation o f the second tier public financial institutions only. While the Administration has reaffirmed its commitment to the full scope of the reform o f the public financial institutions, these events reflect the challenging political environment inCongress. This was further reflected inthe recent approval by Congress o f expanded credit limits for the largest first tier public bank (Banco National de Fomento) which hadbeen reducedearlier as a policy action endorsed by the Bank. These developments have increased the perceived risks to the program. Despite the challenges, the Government has made important progress inimplementingreform o fthe regulatory framework for the banking system. The Government's macroeconomic policies and performance remain satisfactory and Paraguay continues to meet the poverty, governance, structural, and portfolio triggers for the CAS base case lendingprogram. OnDecember20,2004, the IMF approved the third review of the Stand-By Arrangement and a six month extension o f the program to September 30,2005 to accommodate the authorities' modified strategy for the financial sector. The Inter-American Development Bank has postponed its policy loan which focused on the state banking reforms, and i s proceedingwith a credit line project to support the operation o f the planned consolidated second tier bank, including implementation o f financial operating rules and risk management policies. Inlight ofdevelopments, the Bankand Governmenthave agreedto proceedwith a programmatic approach to Bank support for Paraguay's financial sector reform. Under this approach, Bank support i s proposed through a sequence o f three single tranche programmatic financial sector loans, the first a Financial Sector Adjustment Loan followed by two Financial Sector Development Policy Loans, to bepresented to the Board as the reform program achieves sufficient, measurable progress. All o f the elements o fthe original financial sector reform remain within the scope o f the program as described inthis ProgramDocument for the first PFSAL, including the agreed triggers for the subsequent two PFSAL operations. While providing up-front support for reformactions already taken, the proposed loan amounts under the new programmatic approach incorporate a back-loading o f Bank support to reflect the increased risks. i REPUBLIC OF PARAGUAY PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: The Republic o f Paraguay ImplementingAgencies: Ministryo fFinance with the assistanceo fthe CentralBank Objectives: To strengthen the financial condition o fthe private andpublic banking sector inorder to reduce vulnerability to future shocks and negative impacts on economic growth and increase the flow o f credit for domestic investement. Description: Financial support to the Borrower for the formulation and approval o f key financial sector laws and regulations including implementationo fthe recently approved deposit insurance and banking resolution law, new loan loss provisioning regulations, revision o f the general banking law, and approval o f a new anti-money laundering law. Beneficiaries: Enterprises o f all sizes requiring improved access to financial services and credit, savers and depositors o f the banking system, taxpayers, banking sector regulatory and supervisory agencies, and the Treasury o fParaguay. PovertyIssues: For the banking system as a whole, the implementation o fbank resolution and deposit insurance schemes will, as apriority, protect the smallest depositors with the least economic assets, and assure prompt repayment o f their deposits inthe event o fbank failures while reducing costly bank bail-outs at taxpayers' expense. Risks: Main risks pertain to political, macroeconomic, governance and institutional capacity. The mainrisk i s that Congress may not approve inhllsome of the key legislation supported by this operation such as the bankinglaw which would underminethe adjustment program. Stricter capital and provisioning regulations may initially lead to further contraction incommercial bank credit available to the private sector, especially ifthe macroeconomic environment is less conducive towards improvement inbanks' financial condition. A public information campaign and consultation with the banking industrywill help to encourage participation inthe reforms, as well as a gradual phasing ino f some o f the tougher reforms such as the increase inbase capital and loan loss provisioning requirements. Institutional capacity 11 constraints are beingmitigatedwith the support o f an accompanying Technical Assistance project. Governance risks are beingaddressedthrough the implementation o f audits o f the reforms, continuation o f the Government's public transparency campaign, and implementationo f the new anti-money laundering legislation to prevent the flow o f illicit funds under more effective institutional arrangements. Amount: US$15 million, to be disbursed in a single tranche. Terms: LIBOR-based fixed spread U S Dollar loan with a grace period o f 5 years, a final maturity o f 23 years, and level repayment o f principal, at the Bank's standard variable interest rate. CommitmentFee: 0.35 percent (net o fwaiver) on undisbursedloan balances, beginning60 days after Loan signing. Front-endFee: 0.50 percent o f the loan amount payable upon effectiveness. Schedule of Disbursements:To be disburseduponBoard approval and compliance with standard effectiveness conditions. Policyconditions metprior to Boardpresentation. EconomicRateof Return: Not applicable. ProjectIdentificationNo.: PE-P039994-LEN-BB ... 111 INTERNATIONAL BANK FOR RECONSTRUCTIONAND DEVELOPMENT PROGRAM DOCUMENT FOR A PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN TO THE REPUBLIC OF PARAGUAY 1. This memorandum proposes a Programmatic Financial Sector Adjustment Loan to the Republic o f Paraguay inthe amount of US$15 million to support the reform o f the banking systemthrough a new framework for banking legislation, and supervision andresolutiono f distressed banks. The program would be implementedjointly by the Ministryo f Financewith the assistance o fthe Central Bank. The Loanwould be fixed spread LIBOR-based, U S Dollar denominated, with a grace period o f five years, a final maturity of twenty three years, and level repayment o fprincipal at the Bank's standard variable interest rate. PARTI.RECENTECONOMIC DEVELOPMENTSAND PROSPECTS A. EconomicContext 2. Following several years of economic stagnation and decline, exacerbated by political stalemates that preventedadvances on important policy reforms, a new Paraguayan administration came to power inAugust 2003. Enjoying substantial political support, the Governmenthas since achieved important advances inits program of economic reforms. Economic performance has also beenpositive in2003 and 2004, following several years o f deteriorating GDP and fiscal indicators. The Governmenthas reached agreement on a precautionary Stand-By Arrangement (SBA) with the IMF and re-activatedthe lendingprogram with the Bank. 3. The shift inperformance and outlook came on the heels o f a major economic crisis in2002, which was the culmination of several years o f fiscal mismanagement and inability to undertake needed policy reforms. A small open economy, with an estimated GDP o fUS$6.6 billion (2004), Paraguay i s one o f the poorest countries inthe region with a per capita income o f about US$llOO1.Heavily dependent on agriculture (cotton, cattle, timber, and recently, soybeans) and on regional conditions, the economy has been aided inrecent decades by an open trading environment which fostered significant contraband trade with neighbors Brazil and Argentina. While Paraguay enjoyed economic booms during the construction of the Itaipu and Yacyreta hydropower projects betweenthe late 1970sand the early 1990s, the prosperity proved to be transitory. 4. Although economic management was gradualist and fairly prudent inthe years following the end ofthe military dictatorship in 1989, with balanced fiscal accounts, small current account deficits and declining inflation, growth performance was disappointing. Protractedslow growth which went negative inrecent years, reflected a decline intotal factor productivity associated with a shrinking investment ratio, little progress instructural reform, fiscal deficits, andwidespread corruption. 5. Poor policy Performance was exacerbated by a series of external and domestic events. Major banking crises in 1995 and in 1997-98 ledto the closure o f a number o f domestic banks, the reduction o f credit to the private sector, and a sharp drop inprivate investment. Paraguay's terms o f trade GrossNational Incomeper capita for 2003, Atlas method. 1 deteriorated significantly after the mid-1990s andthe country suffereddroughts in 1999,2000, and most recently in2002. The economy was battered by adverse developments inits main trading partners, namely the Brazilian devaluation o f 1999 and the recession and financial turmoil inArgentina in2001-2002. 6. The combination of external vulnerability and a poor policy environment resulted in exceptionally poor growth performance, particularly since the mid-1990s. While GDP growth averaged 1percent per year, annual population growth stood at 2.5 percent. The outcome has been a secular decline inper capita GDP to pre-1990 levels. Poverty was estimated at 41 percent in2003 with the extreme poor makingup 20 percent o f the population. Poverty is concentrated inthe rural areas where halfo f Paraguay's population lives, and i s exacerbated by polarized income and land distribution. 7. In2002, worsening economic conditions came to aheadas GDPfellby2.3 percent, leadingto an over 4 percent contraction inper capita income. Inflation rose to double digits, the guarani depreciated by nearly 40 percent, and the public sector's fiscal situation deteriorated sharply, recording a deficit o f 3.1 percent o f GDP. As a result o fthe depreciation, public external debt climbedto nearly 50 percent o f GDP from 33 percent a year earlier. Given Paraguay's lack o f access to financing, either internal or inthe international capital markets, the fiscal gap was financed by a combination o f delays inpublic sector salary payments, postponement o fpublic investmentexpenditures, the drawing down o f deposits at the Central Bank and the accumulation o f arrears to creditors and suppliers.At the end o f 2002, arrears on debt service amounted to almost 3 percent o f GDP. 8. Financial Sector Problems. The Government and Central Bank intervened in four banking crises between the mid 1990s and early 2000s duringwhich a number o f financial institutions accounting for approximately 35 percent o f the financial systemwere liquidated. The currency suffered a loss o f confidence as the Central Bank usedits reserves to rescue insolvent banks (via longterm credits, deposit guarantees, lender o f last resort facilities and other instruments). Overall outlays amounted to almost 12 percent o f GDP with only 5 percent havingbeenrecuperated to date by the Central Bank. The additional liquidityinjectedinto variousbanks ultimately failed, and there was an additional cost to the Central Bank interms o f the interest paid on open market operations to mop up excess liquidity. In2002, arunonBanco Alemhn -which itselfwas healthybut sufferedcontagion from the failure and dissolution o f a mutual fund affiliate - eventually required its closure. Since then and through 2004, an additional four banks closed down, some voluntarily, due to the rising share o fnon-performing loans. 9. The result o fthe financial sector problems has been a reduction inbank credit to the private sector by about a 14 percent at the end o f 2004 compared to two years earlier, although credit beganto grow inthe second halfo fthe year. The banking systemi s highlydollarized, and remains vulnerable to shocks. Another major problem i s the critical condition o f the public developmentbank, the Banco Nacional de Foment0 (BNF), which suffers from both illiquidity and insolvency with non-performing loans constituting more than half o f its portfolio. Other serious issues include weak bank resolution and supervisionprocesses and institutions, accounting practices and norms that do not comply with international standards and that over-estimate local bank solvency, a deposit guarantee system that relies on direct financial support from the State, an antiquated banking law lacking modernresolution procedures2,and vulnerability o f the Central Bank to interference andpressure from the Executive. A modembanking resolution law including a private sector deposit insurance scheme was approved inDecember 2003. 2 B. RecentEconomicDevelopments 10. Economic perfomance improved markedly in2003 and 2004 with GDP expandingby an estimated 2.6 and 2.9 percent respectively (Table 1).The increased growth in2003 was the result o f a 12percent expansion inthe agriculture sector thanks to exceptionallyhigh intemational prices o f soybeans and cotton. Risingagricultural exports bolstered the guarani which appreciated by close to 15 percent with respect to the U S dollar over the year allowing inflation to return to single digits and international reserves to rise by 50 percent. After several years o f deficits, tight spendingpolicies and improved tax administrationresultedinprimary surpluses. These trends strengthenedin2004, as economic growth continued despite a drought, supported by favorable regional and global conditions. Unlike2003, growth was morebalanced across sectors, withnearly all areas contributing to the economic expansion. Thanks to a 36 percent rise intax revenues and to constrained public spending, the Central Government achieved an estimated primary surplus o f 2.7 percent of GDP. The guarani remained stable, depreciatingby 5 percent with respect to the U S dollar, and CPIinflation endedthe year at 2.8 percent. Table 1: SelectedEconomicIndicators 1996- 2002 2003e 2004e 2005p 2001 GDP (% growth) 1.o -2.3 2.6 2.9 3.2 CentralGov. Balance(% o f GDP) -2.1 -3.2 -0.2 1.9 -0.3 CentralGov. PrimaryBalance(% o f GDP) -1.2 -1.7 0.9 2.7 1.o PublicSector ExternalDebt (% of GDP) 24.0 48.4 44.7 39.0 38.1 CurrentAccountBalance(% o f GDP) -3.3 1.7 2.4 0.7 -0.4 CPIInflation(e-o-p, %) 8.6 14.6 9.3 2.8 5.0 Depreciation(avg, %, =depreciation) - -13.3 -39.0 -12.6 -5.1 -6.0 Imports(US$, % growth) -13.1 -13.5 11.0 30.7 6.2 Exports(US$, % growth) -7.8 0.0 12.6 29.7 3.O Source: Ministry of Finance, IMF and Bank Staff estimates e = estimate; p = projection 11. Registeredexports grew bynearly 30 percent inpart due to strong soy prices and access to new export markets for meat. Imports also expanded by 30 percent inthe same period, reflecting both the economic recovery and higher petroleum prices. As a result, the current account surplus declined to 0.7 percent of GDP in2004, from 2.4 percent in2003. Net central bank purchases o f foreign exchange have offset upward pressures on the currency from buoyant export eaming and large private capital inflows, moderating the growth o f the money supply, and increasing intemational reserves to US$1.2 billion at the end o f 2004. 12. DespiteParaguay's lack o f access to international markets, total external debt, mostlypublic sector, i s estimated to have reached 49 percent o f GDP in2002, declining to about 45 percent in2003 as a result o f GDP growth and the appreciationo f the guarani3.The debt-to-GDP ratio i s estimated to have declinedto 39 percent by the end o f 2004 due to economic expansion and a primary surplus, and helpedby low intemational interest rates andthe depreciationofthe dollar. For the mediumterm, and barring a further major depreciation of the guarani, debt service payments are not projectedto increase dramatically as debt i s mainly long-run and concessional. The on-going and projected improvement in the public finances should also ease concerns about debt sustainability. The 2003 debt ratio reflects an increase of over 10percentage points with respect to its 2001 level, largely the result o f the depreciation o f the guarani and poor growth performance, rather than a significant amount o f new debt. 3 13. Policy reforms. The Administration took advantage o f the incipient recovery and strong political support to quickly launch an economic adjustment and reform program. By the end o f 2003, notable advances on a package of core economic laws had enabled the Administration to reach an agreement with the IMFfor a precautionary 15-monthStand-By Arrangement (now extendedby six months) and led to the support inlending for financial sector programs, totaling a combined US$45 million from the Bank and the IDB.Together with the Administration's agreement with commercial banks to reschedule over US$100 million indomestic debt which was complementedby accords with bilateral creditors to reschedule debt service arrears, this facilitated a significant reduction inarrears. 14. The Administration's economic program aims to stabilize Paraguay's macroeconomic situation andbegin a process o f structuralreform, with priority placedon addressing the country's long-standing governance problems and improving the efficiency and transparency o f government operations. In October 2003, the President signed a political agreement with the heads of bothhouses o f Congress andwith opposition party leaders to pass a series o f economic reform laws designed to constrain current expenditures, tackle key fiscal drains on the public accounts, enhance tax and tariff revenues, and address urgentvulnerabilities o f the economy such as those associated with the financial sector and public enterprises. These bills included an austere budget for 2004, the renegotiation o f domestic debt obligations with commercialbanks, a tax reformbillto widen the tax base and eliminate loopholes and exemptions, laws to strengthen the banking system through improved bank resolution and deposit insurance and to reorganize ailing public banks, legislationreforming the government employees' pension planwhich was the major drain on public finances, a new customs code to modernize and strengthen the customs administration, and a plan for the restructuring o f public administration. Ofthe eight bills included inthe agreement, six have already been approved by Congress (the 2004 budget law, debt restructuring, deposit insurance and bank resolution, the government pension law, the tax reform, and the customs code). Box 1:ProgressTo-Date on `PoliticalAgreement' and CAS Benchmarks ReformInitiative StatusinCongress Comment Budget L a w for 2004 Approved Implemented Tax L a w Approved KeyCAS Benchmark: Approved by Congress and in effect Government Pensions Law Approved Key CAS Benchmark: Approved by Congress I and ineffect Debt RestructuringLaw Approved Law ineffect Deposit Insurance and Approved L a w ineffect Bank Resolution Law General Banlung Law Presented To be debated Public State 2"dTier Banks Law Presented To be debated Customs Code Approved Law ineffect Public Administration Restructuring Pending Not yet presented 15. Inadditionto legislative advances, the Government has taken concrete actions to address some of the mainimmediate obstacles impedingParaguay's returnto sustained economic growth and 4 poverty reduction. Steps for improving the soundness and performance o f Petropar, the State petroleum company are undenvaf. Significant steps have been taken to tackle short-run fiscal issues. A number o fmeasures were swiftly implementedto halt growth ofspending includingwithdrawalo f budgetary supplements presented duringthe previous Administration and freezing o f public sector wages. The administration also moved to tackle the pervasive problem o f tax evasion and poor tax revenues. The results of this effort to date have beenimpressive: a 36 percent increase intax revenues in2004 as comparedto 2003. Morerecently, inorderto ensure that fiscal targets for the year aremet, the Government announced the imposition o f a temporary 4 percent tax on soybean industry exporters who traditionally bear a very low tax burden inParaguay. 16. Alongside fiscal measures to contain spending and increase revenues, the Administration has also embarked on a program of administrative measures to increase transparency andreduce waste and corruption inthe public sector. These have included steps to begin the cleaning up o f two state institutions: the state development bank (Banco Nacional de Fomento, BNF) and the state social security institute (Instituto de Prevision Social, IPS). The top command inthe military and national police have been replaced and the Government succeeded inthe difficult political challenge o f changing two thirds o f the judges sitting on the Supreme Court. The Administration has also taken actions inthe areas o ftax and customs administration. A census o f public sector employees was recently completed which, inaddition to playing a keyrole inrationalizing resources and enhancing the performance o f the public sector, i s serving to audit employee rolls inorder to eliminate phantom workers and those illegally collecting more than one salary. Similarly, the government pension rolls are being cleaned, with 1600 non-justified pensions eliminated to date. 17. The Governmenthas made important progress inimplementingParaguay's Procurement Action Plan following the regulationo fthe recently approved Public Procurement Law and the resolution creating the Directorate General o f Public Procurement (DGCP). A procurement portal has been launched on the Web. At this stage, this website i s an informational one which includes the annual procurement plans for state institutions, available biddingdocuments, the bulk o f invitations to bid and contract awards, as well as a list o f ineligible and black-listed contractors. This i s seen as the first step ina full-fledged electronic procurementsystem. Inaddition,a public process for the competitive selection o f the head and key staff of the DGCP has taken place, as have public hearings on the newly designed standard public biddingdocuments. Progress on these measures and the increased transparency o fpublic procurement practices has already led to reductions inspending on goods and services and to more efficient public investment. 18. The Governmentis implementingstrategies to continue to improve financial management in Paraguay. Public sector budgetingand accounting have been transformed and an integrated financial management system (SIAF) has beenimplemented inthe Central Govemment and insome decentralized agencies. The IDBhas been supporting the Government inthis effort through technical cooperation operations. Measures to introduce accrual accounting into the SIAF andto further expand it to other decentralized agencies were supported underthe World Bank's Economic Recovery A CAS benchmarkfor the base case scenario is that the net worth of Petropar shouldnot declinewith respectto its level on December 31,2003. Petropar'snet worth fell in 2004 as aresult of the failure of domestic pricesto keep up with the rising internationalprice of oil. Diesel prices havebeen adjustedonly to the levelprevailing in neighboringcountries. Recently,however, an important change to the way inwhich domestic prices are set has beeneffected allowing Petropar,rather than the Govemment, to set price increases.This should ensure that increaseswill be govemedby economic rationalerather than by political expediency. Moreover, with the assistance of the Bank, anew law for the fuel sector has beenprepared,which would increasecompetitionin the sector, and would endPetropar's defucto monopolyin the import ofdiesel. The framework is currently beingdiscussedby the Cabinet's EconomicTeam, which will present a draft law to Congress. 5 Structural Adjustment Loan approved inDecember 2003. A peer review o f the Comptroller General's auditprocedures is underway, and an internal audit manual for the institution is beingprepared. The Government has announced that it will perform regular, independentaudits o fpublic enterprises which will also be subject to increased data publishingrequirementsto improve transparency. Five such audits were performed in2004, o f the electric power utility, the telecommunications company, the telecommunications corporation, the urbanwater and sewerage company, and the social security institute.This i s part o f an effort to improve efficiency and governance inParaguay's public enterprises which, despitehaving a strong presence inkey economic activities o f the country, have beenplagued byinefficient operations andinadequate financial management. 19. The new Government's track recordhas beenencouraging, and the Administration has shown strong commitment to macroeconomic and fiscal stability. This has begunto engender increased confidence by the private sector and has paved the way for implementinga financial sector reform program developed through years o f collaboration between the Bank and successive governments. In addition to the recently approved Deposit Insurance and Bank Resolution Law, the Government has put inplace a new regimeto phase inhigher cash provisions inthe bankingsystemto guard against potential losses on non-performing loans. C. EconomicProspectsand FinancingNeeds 20. The Government's economic reform program, along with greater external stability, make the outlook inParaguay more stable than it has beeninrecent years. Forecasts are for continued GDP growthon the order o f 3.2 percent in2005, supported by enhanced overall confidence and gradually strengthening domestic demand. While a severe drought affected agricultural yields in2004, other sectors o f the economy are expected to expand. Inflation has declined and the exchange rate has remainedbroadly stable. 21. Public finances improved in2004 as tax receipts grew at 36 percent above their level in2003, generating over 2 percent of GDP inadditional revenues. Implementation of the tax reform bill that was approved in2004, and which i s expected to generate an estimated 1percent o f GDP in additional revenues in2005, will help ensure continued good revenue performance inthe mediumterm. On the spendingside, the growth of current expenditures in2004 was constrained to 8 percent innominal terms, largely reflecting salary increases following 3 years o f a public wage freeze. 22. As aresult, the Government over-performed on its target of a fiscal surplus o f 0.1percent of GDP for the full year, as established inthe IMFSBA, with the estimated surplus standing at 1.9 percent5.Paraguay met the quantitative targets for the third quarterly review o f the program, which was completed and approved by the Fund's Board inDecember 2004. The third review also supported the Government's request for an extension o f the SBA to September 2005, inorder to complete outstanding structural reform measures, especially inthe financial sector. 23. The projected improvement inthe public finances eases concerns about debt sustainability. Fiscal constraint, combined with economic expansion and a stable local currency, translated into a gradual reduction inParaguay's debt-to-GDP ratio in2004. The debt ratio i s estimated to have fallen to about 39 percent o f GDP from 44 percent in2003. Under a scenario o f continued fiscal prudence (with real primary spendinggrowth o f 2-3 percent) medium-termGDP growtho f 3-3.5 percent, a stable real ~~ CentralGovernment. 6 exchange rate and 5 percent inflation, public sector debt i s projectedto decline to about 33 percent o f GDPby 2008 (Table 2). The debt dynamics assume continued accessto official financing at concessional rates. 2003 2004 2005 2006 2007 2008 Public sector debt (% of GDP) 44.7 39.0 38.1 36.0 34.4 32.8 Source: Bank Staffprojections, IMF. 24. GivenParaguay's lack of accessto international financial markets, the Government continues to face financing needs on the order o fUS$200 million for 2005 that are projectedto bemet by multilateral andbilateral lending (Table 3). Inaddition, the balance ofpayments projections for Paraguay show an overall financing need of US$186 million in2005 and US$281 millionin2006, out o f which the expected foreign exchange contribution from multilateral and official flows (net o f new commercial inflows/outflows) would be US$185 million and US$l50million respectively, with this loan's projecteddisbursements o f US$15 million constituting a portion o fthose amounts (also see Table 12). Table3: EstimatedPublic Sector FinancingNeeds Financingsources 118 1.7 203 2.8 Net credit frombanking system -6 -0.1 0 0 Quasi-fiscaldeficit financing -34 -0.4 17 0.2 Multilateral/Bilateral/Official 158 2.3 185 2.6 Project Lending 158 2.3 155 2.1 ProgramFinancing 0 0 30 0.5 Of which World BankPFSAL 15 0.3 D. MultilateralCoordination 25. The Bank is closely coordinatingthe design of a financial sector and state bank reform program with boththe IMF and the IDB(Box 1). The IMF SBA includes structural benchmarks for financial sector reform. The Bank and IDBhaveprepared ajoint financial sector program with actions related to the reform andmodernizationof the bankingsector andthe rationalization and downsizing o f the state banks, IDBhas postponedits adjustment lending and will initiate the process through financial 7 intermediation lendingto support the new consolidation o fthe state banks into a single second tier institution, reflecting the first half o fthe state bank reforms. The Bank has also prepared a parallel Technical Assistance project to support reform implementation and institutional strengthening. The IMFprogram supports the financial sector reformcommitments inthe Bankprogram, but also includes complementary issues such as increasingthe independence o fthe Central Bank, supporting the organizational reengineering o f the Central Bank, providing technical assistance for twinning arrangements with Chile's bankingsuperintendency, and movingtowards obtaining international credit ratings o f Paraguayanbanks. The IDBprogram also supports separatebut complementary issues such as improving the supervision and institutional framework for the cooperatives and credit union sectors. 26. The sectoral program supportedbythis programmatic operation is aimed at financing policy reform efforts to ensure the stability o fthe financial system duringthis critical period. A well functioning banking systemwhich can provide broad access to credit inthe economy, while maintainingprudent reserves against risks, i s essential to achieving a higher sustained level o f investment and GDP. A lack o f investmentfinancing can quickly stifle the renewedgrowth if domestic sources o f financing do not become available due to balance sheet weaknesses infinancial institutions. The reform program intends to prevent such outcomes by undertaking up-front reform actions to fortify the banking system. Box 2 -Donor Technical Assistance Coordination The following delineates the specific policy and technical areas that each donor i s focusing on with respect to technical assistance activities and funding for the financial sector: World Bank: Technical assistance sources include a Japan PHRD grant for use inpreparation o f the PFSAL program and a Technical Assistance project to accompany the PFSAL. Activities include financing o f (i)the regulatory and operational development o f the bank resolution procedures to be used for managing and transferring failed bank assets and deposits, (ii) the design and implementationo f the new deposit insurance fund, (iii) the upgrading o f supervisory processes, systems and procedures, (iv) the strengthening o f procedures and systems for the detection and prevention o f money laundering, and (v) the modernization o f the banking payments system. m:Technical assistance sources include funds from the IMF's internal technical assistance program. These include financing twinning arrangements with Chile's banking superintendency to develop market risk regulatory andprovisioning requirements for Paraguay andupgrade bank examinationtechniques. IMFassistance also includes technical input for the reorganization ofthe Central Bank, auditing requirements for Central Bank financial statements, and advice on payment system issues as they relate to systemic risks. -AssistancefromtheInterAmericanDevelopmentBankisfundedbothbymultilateralinvestment IDB: grants resources and technical assistance loans. Activities include (i) improvement inthe infrastructure and regulatory framework for the supervision o f cooperative credit institutions, (ii) technical assistance for the implementation o f the reform to consolidate the State owned financial institutions, (iii) upgrading o f the systems infrastructure for reporting o n money laundering activities, (iv) upgrading o f the securities settlement systems, and (v) establishing o f a supervisory authority to oversee nonbank financial institutions. U S Treasurv: The U S Treasury has been instrumental inassisting inthe drafting and completion o f a modernized anti money laundering law which centralizes the coordination and data analysis function for detecting and prosecuting potentially illicit money flows. 8 PART 11. FINANCIAL SECTORCONTEXT AND THE REFORMPROGRAM A. Overview 27. The Paraguayan banking systemhas been ina vulnerable state for a number o f years, inlarge part due to the continuing anemic economic growth, but also due to the incidence o f at least three separate banking crises since 1995 to-date, duringwhich twenty one banks and over thirty finance companies were dissolved. Presently, the banking system i s primarily foreign owned. Interms o f deposits, 35 percent o fbanks represent branches o f foreign banks and another 41 percent are either regional banks or locally basedbanks with a majority foreign ownership. Excluding the finance companies which represent under 10percent o f the financial system, the remainder o f the banks are three local banks which hold 24 percent o f deposits including the State bank, BNF with 9 percent. 28. Although deposit growth has beensteady, credit has been contracting, primarily due to a higher share of non-performing loans from slow economic growth, and more recently due to credit defaults o f borrowers highly exposed indollars. Average intermediation spreads inlocal currency remainhigh, easily reaching 20 percentage points. This not only reflects cost inefficiencies, but more importantly highrateswhich compensate for largeportionso floanportfolioswhich are notperforming, particularly those denominated inlocal currency. Banking reserve requirementsare inversely proportional to the maturity term o f deposits. This puts a higherreserve cost on short term deposits and would normally encourage banks to offer longer term instruments. 29. However, given depositor preference for short term deposits andbanks' preferences for shorter term lending, the result i s a relatively highreserve/deposit ratio which increases intermediation costs particularly on dollar denominated loans, and therefore on lendingrates. For deposits indomestic currency the reserve requirement is: 15 percent for depositsup to 1year maturity; 7 percent for maturities between 1and 1?4years; and zero for over 1?4years. For dollar deposits, the requirement is: 27 percent for up to one year; 15 percent for between 1 and 1?4years; 5 percent for between 1?4 to 3 years; and zero above 3 years. 30. Dueto the difficult externalenvironment inthe past three years, generated inpartbyParaguay's large neighbors (Brazil, Argentina), the Paraguayan monetary authorities took action towards managed devaluations inorder to maintain export competitiveness vis-a-vis the country's main trading partners, However, such devaluations have also put indirect stress on the banking system since a large portion (57 percent) o f loans are denominated inU S dollars and for borrowers with no hard currency income (approximately 85 percent o fborrowers), any devaluation translates into a higher debt servicing load in local currency terms, thus increasing credit risk andpossibilities o f default on payments. Therefore, about 48 percent ofthe loan portfolio i s at risk o f payment difficulties due to current and potential devaluations. 31, The devaluation effect has, however, strengthened Paraguay's ratio o f hard currency reserves to national currency since the latter has lost value. Even takingthe most conservative measurement o f available international reserves to back up a potential currency run,the reserve backing appears adequate (see tables below) and the Government does not pretendto defend the currency with a fixed rate policy, particularly given the recent loss o freserves intrying to defendthe currency after the previous wave o f Brazilian devaluations. Nevertheless, while reserves are adequate for this particular purpose, additional shocks related to trade payments and withdrawal o fbanking systemdollar deposits, mayrenderthem somewhat limited for covering internationalpayment obligations, ifneeded. In 9 addition, the dollarization risk which affects the corporate borrowing sector represents a large potential vulnerability problem for banks interms o fthe higher credit risks, and therefore increasingnon- perfonning loans, that this impliesfrom unhedgedborrowers. Ratio 1 Ratio 2 Ratio 3 Total net intemational reserves - Total net intemational reserves / US$ bank reserve deposits at Total net intemational reserves / (currency +open market c.b. bills central bank / (currency + open Currency + callmoney liabilities) market c.b. bills + call money liabilities+bank local currency, deposits at c.b.) 291% 177% 93% Table 5 Monetary Components of Ratio 3 (US$ millions) I.Netinternationalreserves(NIR) 1,168 Less: $ bank deposits inBCP 254 Available NIR 914 11. Currency inCirculation -CentralBankBills 401 Plus: Call 258 Money Liabilities -_- Bank Local Currency Deposits inBCP 320 Sub-total MO (modified) 979 111.Net InternationalReserves (available) / MO bankingsystemliquidity + 93yo IV.Gap for full forex backingo f currency (65) Source: Central Bank of Paraguay(BCP) Data as of December 31,2004 32. Money supply indicators show that M1grew by 29 percent inthe year on year period from end November 2003 through November 2004. Credit to the private sector increasedby 17percent during the same period although this was accounted for inpart because the nominal exchange rate appreciated slightly duringthe same period. M 2 grew by 27 percent duringthat annual period reflectingmore liquidityinthe financial systemwith loweredinterest rates. While the BCP's open market operations continued to place additional paper on the market to absorb excess liquidity, these were priced at lower rates, which, along with the extremely low inflation achieved, allowed the guarani to appreciate against the dollar (the guarani hadreached a devaluation peak inearly 2003). The preference for foreign currency deposits was reversed in2004 with a decline o f 6 percent since the end o f the first quarter, with an increasingshare movingto local currency deposits which increasedby 12percent, inpart due to the very low interest rates offered for dollar deposits and the stabilization o f the exchange rate. While additional dollarization mighthave some benefits such as making the financial system less vulnerable to currency risks, it also generates more structural vulnerabilities due to emergence o f corporate credit risks from increased local currency debt servicing costs on dollar denominated borrowing. The looseningo f monetary policy and overall lowering o f interest rates under a more 10 stable exchange rate environment has de-dollarized the banking system by about 5 percent. The increased banking liquiditywhich now remains at very highlevels has resultedinthe expansion liquid financial investments to compensate for the reduced willingness o fbanksto lendwithin an environment o f lower solvency ratios anddecreasing earnings. System Vulnerabilities 33. The reformprogram supportedbythe PFSAL to a significant extent developed out o fthe Paraguayan Financial Sector Review (Grey Cover Report No. 24249-PAYNovember 15,2002). That Review took an FSAP-styleapproach to diagnosing financial systemrisks and regulatory vulnerabilities. It recommended key reform actions and was discussed extensively with the authorities (particularly the Central Bank and the Ministryo f Finance) who worked closely with the Bank to define the future policy actions impliedfrom that diagnosis. 34. The Review addressed a number o f critical issues inthe Paraguayan banking system, including the need to reform the exit procedures for weak or insolvent banks, the needto strengthenbanking prudential regulations such as loan loss provisioning and capital adequacy norms, the need to establish a banking sector funded deposit insurance scheme versus apublicly guaranteed scheme, and the critical need to reform the State owned banks which requiredcapital injections andmajor reforms to stem losses and limit exposures to smaller borrowers. The Review also conducted a vulnerability stress test o fbankingbalance sheets (described further below) to determine which institutions had capital deficiencies and where existing regulatory norms could be improved to address these and mitigate future risks. 35. The mainchallenge inParaguay's financial system i s to assure stable banking institutions and to manage the smooth exit of financial institutions not capable o f weathering the economic cycles and ensuring an adequate capital base. The financial system remains vulnerable after periodically re- emergingbankingcrises. The first crisis in 1995 was primarily generated by the collusion o fvarious banks representingabout 10percent o f the financial system and the Central Bank, inwhich banking reserves were re-lent on the black market through unregistered institutions. Besides the illegality o f the entire scheme, the derived effects endedup affecting 18 financial institutions and the Central Bank endedup spendingUS$400 million equivalent to bail out the bankingsystemto avoid a systemic collapse. 36. In1997 the secondbankingcrisis occurredwhenBanco Union, followed by Banco de Desarrollo del Paraguay collapsed after a run on deposits. Inpart, the weakness manifested inthese banks also pertainedto the legacy o f the previous banking crisis, since Banco Union inparticular suffered from non-performing assets which were inlarge part linked to the absorption o f repossessed assets as part of a settlement inthe previous crisis. The next crisis occurred in 1998 following the Government's decision to raise domestic interest rates to maintain currency stability and attract foreign investment, The sale o f CentralBank T-bills for this purpose, resultedina sharp contraction o f liquidity from the financial systemprompting some public sector agencies such as the social security institute to begin withdrawingits deposits from banks which appearedweak after the liquidity tightening. This generated contagion effects until finally a total o f eight banks had to be intervened and closed. While not considered a full blown crises per se, there were additional scares in2001 when another local bank, Bancoplus was intervened due to liquidity problems and a regional bank, Banespa, closed. Following that, inmid-2002 the foreign owned Banco Aleman was closed after depositors withdrew their funds, and in2003 Banco de Asunci6n and INGBank closed due to solvency problems. 11 37. The recent crises also highlightedthe problems o fParaguayanbanks due to their over-reliance on public sector deposits for their operations as well as their accounting practices which hidunderlying solvency problems until liquidity crises hit. It also highlighted the risks to pensioners inhaving the Social Security Institute deposit excessive funds inriskybanks, particularly public sector banks. This latter issue i s o fparticular prominence currently as the remaining state-owned commercial bank, BNF, holds a large quantity of social security deposits and i s experiencing liquidityproblems due to borrower defaults. Some of these are due to government initiatives inthe previous Administration to forgive debt repayment inorder to help reactivate the economy as well as by the generally politically motivated lendingpractices seen historically inthe bank. Recently, a new management team was installed to overhaul operations. 38. The Government considers it critical that an updated banking framework beput inplace to both detect banking weaknesses early on and to ensure corrective action, as well as to implement market based financial mechanisms to allow the smooth exit or sale o f insolvent banks from the system. 12 B. The BankingSystem Background 39. The Paraguayan financial system i s dominatedby banks which comprise 85 percent o f all financial intermediaries and 91percent o f licensed deposit taking institutions6. Foreign owned banks hold 75 percent o fbanking systemassets and deposits. The four large international foreign banks which are the strongest group o fbanks inParaguay represent 44 percent o f all bank assets. Credit cooperatives, insurance companies, securities firms, pensionmanagers, and other non-bank financial institutions are currently overseen by supervisory authorities which are separate from the banking superintendency. Table 6 THE PARAGUAYAN BANKING SYSTEM January 31,2005 (Millions of Guaranies) ASSETS DEPOSITS EQUITY Total %of Total % o f Total %of BANKS Total Total Total BRANCHES OF INTERNATIONAL BANKS Citibank N A 1,057403 7% 868,582 7% 158,479 10% Lloyds TSB Bank P L C 1,246,978 9% 1,063,785 9% 134,860 9% ABN Amro Bank N V 1,954,408 14% 1,657,198 14% 223,496 15% Banco Do Brasil S A 352,380 2% 279,927 2% 57,523 4% Banco de la Naci6n Argentina 217,949 2% 177,869 2% 32,992 2% Chinatrust Commercial Bank 48,723 0% 11,269 0% 17,244 1% SUB-TOTAL 4,877,841 34% 4,058,631 35% 624,594 41% MAJORITY FOREIGN OWNERSHIP BANKS lnterbanco S A 2,178,773 15% 1,885,141 16% 173,836 11% Banco Sudameris S A E C A 1,030,052 7% 772,942 7% 150,688 10% Banco Biibao Viscaya Argentaria Paraguay S A 1,997,069 14% 1,744,642 15% 209,858 14% Banco Integraci6n S A 464,327 3% 395,340 3% 53,273 4% SUB-TOTAL 5,870,221 40% 4,798,065 41% 587,656 39% MAJORITY LOCAL OWNERSHIP BANKS Banco Regional S A 874,673 6% 735,418 6% 62,235 4% Banco Amambav SA. 385,871 3% 326,147 3% 41,226 3% Banco Continental S.A E C A 873,370 6% 747,934 6% 79,316 5% SUB-TOTAL 2,133,714 15% 1,809,499 15% 182,777 12% TOTAL PRIVATE SECTOR BANKS 12,681,775 90% 10,666,194 91% 1,395,027 92% STATE PARTICIPATION Banco Nacional de Foment0 1,462,963 10% 1,093,314 9% 118,508 8% SUB-TOTAL 1,462,963 10% 1,093,314 9% 118,508 8% TOTAL BANKS 14,144,739 100% 11,759,508 100% 1,513,535 100% FINANCE COMPANIES (14 Companies) 1,384,068 9% 1,044,413 8% 266,689 15% TOTAL CREDIT INSTITUTIONS IN SYSTEM 15,528,807 12,803,921 1,780,224 Source: Superintendency of Banks, Central Bank of Paraguay Non-Performing Loans 40. As o fJanuary 31,2005, the Paraguayan banking system which represents over 90 percent o f assets o f deposit taking institutions, had an aggregate non-performing loan ratio o f 11percent. Excluding BNFwhich initselfreports 50 percent of its loans as non-performing, the aggregate level Excludes nonbanks such as exchange houses and cooperatives, and non deposit taking State intermediaries. 13 would be 6 percent. If provisions are taken into account, thenthe unprovisioned portion o f the non- performing portfolio for all banks would stand at 5 percent o f net loans. These levels o f non- performing assets may not fully take into account refinanced or restructured loans which in some cases become reclassified if a borrower has paid at least 10percent o fprevious debts, therefore, ifone were to use stricter criteria, these ratios could potentially be higher. 41. The loanclassification system uses standard non-accrual time triggers, although untilrecently, following entry into non accrual status not all interest accruals were hlly reversed as they should. Category 1and 2 loans didnot requireany generic provisioning either and extended to longer elapsed days before beingreclassified, although categories 3-5 use standard provisioning ratios. However, up untilrecently, there was anover relianceonunderlyingcollateral as a substitutefor provisions, and while this might normally be acceptable ifcollateral assets were quickly collectible, the delays inlegal procedures to obtain court judgments, which average three years, effectively reduce or discount the present value o f such collateral substantially. The reported level o fnon-performing loans makes the financial systemvulnerable not only from a general solvency viewpoint but also because such circumstances put pressure on interest rates to rise inorder for banks to compensate their income from losses on the non-performing portfolio andnew provisioning needs. Non-performing loans (NPLs) / Total loans 11% UnprovisionedNPLs / Total loans minusprovisions 5% N P L s / Total loans, excluding BNF 6% UnprovisionedNPLs / Total loans, minusprov.; excl. BNF 2% 42. While the financial condition of the banking system improved through 2004, the fragile state o f the system hadbeencompoundedbypast currency devaluations. While banks' dollar denominated loans and investments surpass their dollar denominated deposits, thus providing them with a "long" hedgeindollars, borrowers are generally exposed to exchange risks on debt servicing costs. About 57 percent o f loans are dollar denominated and it i s estimated that 85 percent o fborrowers (interms o f borrowed amounts) are unhedged. This means that about 48 percent (= 0.85 * 57 percent) o fthe loan portfolio i s subject to risk due to devaluation. While banks themselves are not directly exposed to the foreign exchange risk from a highly dollarized system, the borrowers' exposure generates a significant additional credit risk, and hence risk management issue, for bank portfolios, thus requiring the formulation o fpolicies to mitigate such risks. Experience with Safety Net, Liquidity Facilities and Deposit Insurance Mechanisms 43. The CentralBank o fParaguay has recently institutedchanges inits policies governing the use o f safety net and other Central Bank credit mechanisms, particularly inlight o f the past six years' experience which resultedinsubstantial Central Bank Losses from failed banks which had previously made extensive use o f BCP credit (Table 8). 44. Inapproximate historical costs, 12percent o fGDPhas beenexpendedonvarious rescue packages. Interms of amounts expended, over US$1 billion equivalent was used for such operations, 14 whose historical dollar value of still unrecuperated itemswould have beenabout US$700 million'. However due to ongoing devaluations, the current outstanding balances o f non-repaid BCP credit and/or other funds extended, as o f end 2003, would now equal US$244 million at 2003 andcurrent exchange rates, or equivalent to 12 percent o fpresent banking system deposit liabilities. Some instruments which hadpreviously beenallowed have beenrecently halted as a matter o fpolicy. These include overdrafts on banks' clearing accounts, and the use of discretionary credits from the BCP to banks, most o fwhich were used duringthe 1995-96 banking crisis but have now been discontinued. Table 8 Accumulated cost to-date of Central Bank rescue measures (non-reimbursed credits, write-downs, deposit payments): As of 12-31-03 in millions of Guaranies a/ Total Amounts Disbursed - % Outstandinq "/o Loans to credit institutions 87,493 3% 13,500 I% Loans to banks 647,790 26% 580,094 37% Safety net loans 183,667 7% 46,564 3% Overdrafts 149,395 6% 4,225 0% Rehabilitation plans 338,108 13% 45,438 3% Short term loans 87,000 3% 62,201 4% Subrogated payments 83,524 3% 51,242 3% Receivables 50,271 2% 77,383 5% Deposit guarantee payments 784,999 31% 557,541 36% Accrued interest 92,769 4% 121,919 8% Discounthediscount facilities 28 0% 28 0% BNA bonds 2,651 0% 0% Contract loans 8,395 0% 8051 1% Total 2,516,090 100% 1,568,186 100% $US Equivalent (millions) @ exchange rate 1997 of: 2,178 1155 720 @ exchange rate 2003 of: 6,435 391 244 Paraguay GDP Guaranies (millions): - 20,934,352 Year 1997 in $US millions 9,612 Year 1997 GDP - Guaranies (millions): 35,782,154 Year 2003 in $US millions 5,561 Year 2003 Historical outlays disbursed as % of 1997 GDP = 12% Outlays disbursed at 2003 dollar value, as % of 2003 GDP = 7% Net outstanding amounts historical value, as % of 1997 GDP = 7% Net outstanding amounts at 2003 value, as % of 2003 GDP = 4yo a/ Reflects reference date through which bulk o f payments took place. Source: Central Bank of Paraguay 'Approximatingassumptioni s that bulk of the funds were disbursedduring a periodcenteredaround 1997. 15 Deposit Insurance 45. Untilrecently, Paraguay's deposit insurance schemewas named adeposit "guarantee" scheme since it reflected a guarantee by the State which was not backedby any private premiums contributed by financial institutions inorder to accumulate a fund. The schemewas not funded and dependedon disbursementsfrom the CentralBank when needed8. Inthis regard, the system already induces moral hazard since banks have no stake infunding the cost o f the scheme and depositors have no incentives to monitor bank risks. The level o f covered deposits i s approximately $11,000 per person (Le., not per account) reflecting 75 minimumwages, which i s about 9 times Paraguay's GDP per capita, a level above global and regional averages but also recently biased upwards by the fact that Paraguayan per capita income indollars has decreased inrecent years on account o f currency devaluations. To-date the Government guarantee schemehas disbursedapproximately $700 million equivalent since 1994. 46. The Government i s now developing the creation o f a privately funded deposit insurance scheme. The capitalization o f such a scheme would bebased on the accumulated investedpremiums complemented by State supported funddguarantees inthe initial years of operation. As o f January 31, 2005, total deposits inthe bankingsystem amounted to US$2,032 million equivalent. Ifone uses 5 percent o f deposits as a reasonable target level sought for an insurance fundg,this would needto reach US$102 million equivalent assuming current exchange rates. However, this only reflects 5 percent of the present day level o f deposits and the objective would be to reach at least 5 percent o f ongoing and future levels o fthe deposit base. Based onrecent historical trends, deposits inthebanking systemin Paraguay have grown by 15 percent annually on average. Ifone uses this figure to project the level o f future deposits, say inten years, one obtains the following: Table 9: Estimationof DepositInsuranceFundingRequirements FundingParametersE'rojections Amount (in USS millions) 1. Initial Deposit Base at 113112005 S2,032 2. Deposits after 10 years at 15% annual growth: $8,221 3. Average deposit level in 10 year period: S4,I 11 4. 5% o f average deposit level: S206 5. Proposed premium of 0.45% x Deposits: $18 6. Estimated time for full capitalization: (excluding any Government contribution) 11 years 47. It shouldbenoted that, although 5 percent o f deposits appears small, based on present data on "insured/covered deposits", it would infact cover about 20 percent o f all such portions o f deposits in the systemas of January 31,2005. This means that ifthe fund was capitalized today at 5 percent, its resources would be sufficient to cover at one time, one fifth o f all insureddeposit amounts - any amounts above the insuredlimit for larger deposits would not be covered as i s the present policy under Inthis case, as with others, the central bank inParaguay covers a number offunding costs whichnormally should be attributed to the Treasury. These include medium term funding facilities for systemic liquidityproblems as discussed earlier. In 1999,however, this policy was temporarily modified when proceeds from a Taiwanese credit (issued as a bond of the ParaguayanGovernment) were usedinpart, for the pay-out of depositors. The new Deposit Insurance / Bank ResolutionLaw (2334103) states that the fundwill be capitalized at up to 10percent of deposits. The insured amount per depositor remains at 75 minimummonthly wages as inthe previous system. 16 the deposit guarantee. An "excess of loss policy" sourced from Government funds, for any payments above the 5 percent limit, based on the current banking structure, would cover any portion o f the remaining 80 percent of legally insured deposits. Since a scenario o f more than 20 percent o f insured deposits being at risk at any one time i s almost equivalent to a systemic crisis, it i s unlikely, once such a fund i s fully capitalized, that it would even needto finance such a level o f loss unless a crisis was bank wide. At the current level o fUS$11,000 equivalent per person as the deposit guarantee, approximately 80 percent of individuals holding deposits would be fully covered. 48. The investment regime for deposit insurance funds would be extremely conservative and riskless. For conflict of interest purposes, the funds could not be invested inthe financial sector or if so, likelyunder a trustee arrangement. A more viable option would be for the Central Bank to place investedfunds inhighlyratedcorrespondent banks. Bank Exit /Bank Resolution Mechanisms & Early CorrectiveActions 49. Paraguay's banking law i s clear on the steps and triggers for intervention andmonitoring o f weak banks, and provides clear indications o f shareholders'responsibilities inrestoring capital. In terms o f flexible options for the resolution and restructuring of bank balance sheets to avoid full liquidation, a Law (No. 1420) hadbeen adopted inearly 1999 with Bank assistance" inwhich the modalities o f splittingweak banks into good andbadbanks for the purpose o f transferring viable assets and deposits to other purchasing institutions was included (Articles 22, 24, 25: "Depuracion"). This law, however, only lasted one year since the Government saw it as a crisis resolutionmeasure which the Congress only authorized as a temporary special measure. That law while including the menuo f modalities for resolving failed banks, hadlacked some prioritization inthe sequencing o f steps to be followed as well as the clarification of least cost criteria inthe use o f deposit guarantee andor fiscal funds to restructure and sell banksprior to consideringthe liquidation option. However, since the law was authorized for one year as a contingent emergency measure, there was no opportunity to apply it before it expired. 50. Untilrecently Paraguay's bankingresolutionprocedures were governed by Title E,Chapter 11, and Title X o f the Banking Law (No. 861) which existed prior to Law 1420. While Articles 122-123 o f Title X o f Law 861 permit the sale o f a bank by shareholders, once intervened, this i s the only modality which alludes to market based mechanisms for "saving" badbanks. Once such mechanisms are exhausted, the remainingoption is liquidation, either judicial or extra-judicial which normally entails a higher cost to the State interms o f immediate payments for all insured depositors. The extra- judicial route was traditionally preferredsince it maintained the full control o f the process inthe SB, whereas, underjudicial liquidation, the courts are involved and there are constraints inexecution due to judicial system delays as well as problems inherent inthe bankruptcy law. However, to diminishthe SB's draining o f resources from carrying out such liquidation exercises, the Government intendsto modify the legal framework so that all liquidations are carried out within the context o f formal judicial and improvedbankruptcyproceedings. Under the new Bank Resolution and Deposit Insurance Law, the contingent cost issues and bank dissolution procedures are substantially optimized under a sequenced procedural framework so as to diminishState liabilities while protecting depositors. loA Bank mission visited Paraguay inlate 1998 for the purpose of identifying changes to the existing banking law as part o fpotential conditionality for a fmancial sector operation. Shortly after the mission, political upheavals obviated the possibility o f continuing with the financial sector program. 17 Assessment of Financial System Vulnerabilities 5 1. Inorder to assess latent weaknesses inthe bankingsector, an exercise was conducted in conjunction with the Government to determinethe inherent financial strength o f financial institutions. A number o fbalance sheet adjustments and"stress test" adjustment, beyondregulatory requirements, were made for this purpose. The adjustments include two basic components. First there are adjustments to thefinancial statements presented to the Superintendency o f Banks by the financial institutions, and these adjustments attempt to reflect more accurately the actual financial condition o f the system. These financial reporting adjustments include a change inthe calculation o f solvency capital, as well as four adjustments related to the loan portfolio. 52. Following these, astress test of portfolio impact over selected macroeconomic variables i s conducted (stress test 1for exchange rate devaluation, and stress test 2 for real economic growth). The impact o f the macroeconomic variables on non-performing loans is calculated bymeans o fmultiple regressions intwo scenarios (elasticities calculated for the entire banking systemand by bank categories). Regarding the adjustment to financial statements a fully accurate analysis would still require a validation review on an institution by institution basis, which will be conducted by the Superintendency o f Banks utilizing these results to prioritize its supervisory activity. 53. The net effect is a potential capital deficit inthe banking system on the order o fUS$134million. While these adjustments go beyond existingregulatoryrequirements,they do attempt to scale up, by proxy, the prudential standards to the highest international levels. While the adjustments may be overly rigorous insome cases, the overall diagnosis nevertheless indicates that certainbanks that do not count on capital cushions inany substantial way, are not inthe strongest position. This indicates the needfor close monitoring by the Banking Superintendency incase bank resolution actions need to be applied ifthe conditions o f such banks deteriorates further. Non Bank Credit Institutions 54. The assessment o f sub-sectors requiringfinancial systemstrengthening also include, besides banks, the finance companies which generally represent much smaller scale operations and constitute about 10percent o f the deposit-taking financial system. The primary difference betweenbanks and finance companies i s that the latter are not permittedto offer checking accounts or otherwise constitute a formal part o f the payments system for transactions processing, daily fund transfers and cash settlement. Inall other respect, finance companies require prudential oversight giventheir core business o f lendingagainst funding provided by individual depositors. However, to-date, a much less regulatedand growing sector i s the credit cooperatives (credit unions as known insome countries) sector. While traditionally such cooperatives have beenless regulated since many are not credit providing institutions (e.g.: some farmers' coops) and others are strictly for professionals or trade membersonly (e.g.: inthe agricultural or education sectors), this segment o fthe financial services industryhas begunexpanding rapidly" and more recently membershiprequirements havebecome more lenient. Inthis context, even though the cooperatives are supervised by the Cooperatives Institute (INCOOP) an autonomous agency previously underthe Ministryo fAgriculture, the Central Bank has considered their growth to be systemically important, and since membershipi s now expanding to the general public, it i s felt that cooperatives, particularly those with a significant mass o f I'Estimates o f their size inthe financial system vary with estimates as high as 15%-20% regarding their share within the total of all deposit taking financial institutions. 18 deposits, should beregulated with minimum solvency requirements as the other deposit-taking credit providing institutions are, to avoid an unfair competitive advantage via regulatory arbitrage as well as puttingdepositor funds at risk through unsoundfinancialmanagement practices. While the IDBhas been taking the lead inthis sector, the Bank has provided complementary technical advice and worked inconjunctionwith the World Council ofCreditUnions (WOCCU) to recommend a sound set of regulations for implementation inthe credit cooperatives sector, supervisedby INCOOP. Money Laundering and Combating the Financing of Terrorism 55. Giventhe increased emphasis post September 11,2001, as well as due to the crackdownon contraband trade and drug trafficking activity, the Government will also implement new measures to oversee and detect money laundering activity. Ontop o f the already existing legislation for this purpose, the new measures will require financial institutions to adopt a monitorable code o f conduct in line with Base1Core Principle No. 15, so that banks can better know their clients and report any suspicious operations to the Central Bank and the National Secretariat for the Prevention o fMoney Laundering. 56. Money laundering i s a problem inParaguay which hampers private sector development since illicit funds `compete' unfairly by not having to paymarket interest rates. Besides affecting above board businesses, laundered funds are not subject to taxes and eventually those responsible for such funds accumulate sufficient capital so as to havethe capability to influence or confront the Government itself. Overall, this activity affects the Government inits ability to engender sustainable development. While Paraguay has signed international agreements (U.N.,OAS,Egmont Group, GAFISUD, IMFand World Bank) committing itself to fight money laundering andterrorist financing, much needs to be done at the local implementation level. For the Egmont Group, an association o f financial intelligence unitswith 80 membersworldwide, Paraguay i s currently suspended and under probationary status which has motivated an overhaul o f its AML framework. 57. Previously a special unit for analysis o fmoney/asset laundering was set up inthe Central Bank, and this Unit would coordinate with the Central Bank's Department o f Economic Crimes which would thenliaisewith the National Secretariat for Anti Money Laundering. The Unitwas also meant to maintain contact and seek advice on best practices from the Egmont Group which exchanges procedural information on these matters with participating financial authorities. Technical assistance for the strengtheningo fthe Unit i s beingprovided by the IDBthrough a technical cooperation grant, andthe IMFwill also beproviding advice inthis area. The U.S. Treasury i s assisting the Government indrafting anew framework. TheBank would also support the institutionbuildingefforts as necessary, while considering the funding already available. 58. Other reforms beingput inplace include a new `manual o f conduct' guideline that will apply to all entities supervisedby the Superintendency and emphasize "know thy client" principles. This will require regular reporting on connected businesses and forwarding o f information on potentially illicit activities to the Secretariat for Prevention o f Money Laundering. 59. The reforms underthe framework for anti-money laundering and detection o fterrorism financing will apply to a wider sectoral coverage includingfinancial institutions outside o fthe banking system, such as insurance companies and securities firms which could also potentially channel illicit funds. 60. Inaddition, the SuperintendencyofBankswill, for banking anddeposit taking institutions, include inits `fit andproper' reviews, criteria to assess adequacy o f bank managers andmajor 19 shareholders (both at the licensing stage or for change inownership), factors to assess or identify any potential money laundering connections. Inaddition, under the SB's review o f bank risk management procedures, its evaluation of intemal controls and susceptibility to fraudulent practices, will also assess within the same context, the institutional vulnerability to money laundering. TheState Owned Banks 61. There i s currently one public bank and 6 other state-owned institutions operating inthe Paraguayan financial sector. Together, these public institutions have total assets of about US$450 million, which corresponds to about 17percent o f the total financial sector assets12and 5 percent o f Paraguay's GDP. The Banco Nacional de Fomento i s by far the largest state-owned financial institution inParaguay. It manages about 60 percent o f the total assets inits peer group, and about 11 percent o fbanking sector assets. It i s the only state-owned institution to accept deposits from the public. The remaining entities arejust usedas conduits to channel subsidized funds, mainly from the international donor community. Accordingly, the loans granted by these institutions, including BNF, are offered at rates substantially lower than those o fprivate sector institutions. Three out the seven institutions are offering their services directly to their target group, whereas the remaining ones, UTEP, FDI,FDC and CONAVUBANAVI (see pages 21-23) are operatingas a second-tier institutions, using other financial intermediaries to offer their services. Table 10 Public(State-owned) FinancialinstitutionsinParaguay (Millionsof Guaranies) Total Assets Total Assets 6/30/2001 7/31/2003 Public Financial Institutions 1st Tier Institutions 1Banco Nacionalde Fomento(BNF) 1,156,391 870,216 2Credito Agricola de Habilitacion(CAH) 229,091 338,641 3Fondo Ganadero 181,749 178,499 SUB-TOTAL 1,567,231 1,387,356 2nd Tier Institutions 1UTEP 58,945 89,875 2Fondo de DesarrolloIndustrial 83,171 59,271 3Fondo de DesarrolioCampesino 94,442 118,672 4Banco Nacionalde la Vivienda 129,485 134,250 SUB-TOTAL 366,043 402,068 TOTAL PUBLIC FINANCIAL INSTIT. 1,933,280 1,789,424 TOTAL PRIVATE BANKS13 9,385,855 11,329,892 TOTAL BANKING SYSTEM 11,319,129 13,119,316 Source: Ministryof Finance o f Paraguay 62. Most public financial institutions are loss making primarilybecause o f substantial operational inefficiencies and unsound lendingpolicies. This constant drain on public finances was the primary I*Excludes finance companies and other private non-bank financial intermediaries from calculation. l3Excludes finance companies (non-deposit / non-clearing account intermediaries) representing 10percent of the system, Figures on rightmost column as o f August 31, 2003. 20 motivation behindthe current bank restructuringproposal o f the Government o f Paraguay. Inthe remainder o f this section, a brief assessmento fthe institutional set-up and the financial situation o f each o f these state-owned financial institutions i s conducted. Thereafter, the insights o f these institutional assessments are usedto review the current restructuring plans preparedby the Ministry o f Finance and the Banco Central of Paraguay, and elaborate a selected number o f alternatives to support the decision-making process. First Tier Institutions 63. Banco Nacional de Fomento: The BNF was incorporatedin 1961bymeans o f the Law-Decree 2811 1961with the objective to promote various segments of the Paraguayan economy, inparticular agriculture and selected trade and manufacturing activities. According to its organic law, the bank i s divided into three business areas: an agricultural department, a commercial department and a development banking department. All three areas have their own capital endowment and maintain a separate accounting .However, they are supported by the same administrative systemand operational infrastructure. Art. 1o f the organic law states that BNF's obligations are guaranteed by the Paraguayan State. Inaddition, Art. 12prescribes that any losses from the agricultural department will be absorbed bythe Government o fParaguay (GOP), through the Ministryo fFinance (MoF). 64. The value BNF's assets i s substantially inflated due to nonconventional accounting. After the requiredadjustments, it is shownthat the institutionis decapitalizing at a very fast pace, and thereby destroying value for the taxpayer. It i s more alarming, therefore, to know that nearly a third o f BNF's funds originates from deposits o fthe social security system. Overall, the quality o fthe loanportfolio is very poor with over 55 percent o fthe portfolio inarrears. Over 70 percent o fthese non-performing loans have beeninarrears for more than 360 days. Surprisingly,legal proceedings are underway for only less than halfo f these cases. The analysis o fBNF's arrears statistics indicates that the bad loans are concentrated essentially inthe loanportfolio at the headquarters, which currently shows an arrears rate o f 66.6 percent. After minimumadjustments to raise accounting standards according to international practices, BNFwas found to have a provisioning deficit for bad debts o f about $50 million. Table 11 Source : BNF, Supenntendency of Banks, Central Bank, Ministryof Finance. 21 Box 3 FINANCIALSOUNDNESS OFBNF I n contrast topublished reports, BNF, with an asset base of almost US$200 million equivalent, has an estimated capital gap equivalent to one quarter of its assets, based on the application of bestpractice bank accounting n o m " BNF's operational losseshavebeenhistoricallyabsorbedbythe Government byremoving fromBNF's balance sheet, foreign loans received to hnd BNF's operations (effectively capitalizing such liabilities). Hence, BNFhas been able to technically comply with the solvency requirements o f the Banking Superintendency. But with an accumulating burden o n the M o F and the recent deteriorated public finances, the institutionhas increasingly turned to less sound accounting practices to delay recognizing its losses. T o assess BNF's real equity position, four different types o f adjustments were conducted on recent financial statements. First, the deficit for bad debts provisions was adjusted. Second, BNFwas found to have increased its earnings since 1999 by adding the accruedbut previously not accounted interest on those bad loans which were reactivated or cancelled according to the laws 1418199 and 1470199 - these figures were thus excluded. As BNFproceededwith the debt restructuring, it also dissolved existing provisions for those loans and accountedit as extraordinary income. The thirdadjustment consisted inreversing this procedure. The fourth and last adjustment was to reverse unpaid amounts due from the Ministry o f Finance to cover losses accumulated inrecent years. The assessment o f BNF's liquidity position clearly portrays the fragility o f its financial situation. Its cash, short term investments and reserve deposits at the Central Bank could eventually cover only its current accounts and a small fraction o f savings accounts and other deposits. The loan portfolio i s shrinkingas the consequence o f the insufficient cash- flow generation given the ever increasing delinquency rates and the large operational costs. Receivables from the MoF are not likely to be paid incash or negotiable instruments. Foreign loans and credit lines outstanding are subject to foreign exchange adjustments. At the current devaluation rate, foreign exchange adjustments to multilateral and bilateral loans could further erode significantly the institution's liquidity reserves and its equity base. Unless there i s a strong improvementplan with a capital infusion, rising debt service payments will necessarily lead to a sustained shrinkingo f productive assets inthe near future. Deposits have been declining and have been particularlypronounced inthe last two years, and public sector entities such as the state social security1pension fund (IPS) have recently removed massive deposits from the bank for fear o f eroding the pensionfund savings. A recent law initiated by congressionalrepresentatives, mandated that BNF's non performing portfolio be transferred to the Ministryo f Finance so as to recapitalize the bank. However, the law has not yet been implementedsince the Finance Ministry does not feel it has the capacity nor should manage such `lines o fbusiness'. Encouraginglythough, a new management team for BNF was appointed to stem losses and to downsize the bank. To-date, the team has severely restrictedlendingandlimitedit to small loans consistent with future reforms anticipated for the public banks. Loan collection operations have intensifiedinorder to buildup a stronger loss provisioning base and stem the loss o f earnings, and an overly top heavy management structure has been greatly downsized with a budget estimated for future severance packages and requisite financing being sought. I a/ World Bank estimatesbased on application of intemationalaccounting standards and Bask guidelines. 65. CrBdito Agricola de Habilitacidn (CAH): The C A H i s not a bank, but a state-owned development finance institution with independent legal status which i s dedicated to the promotion o f low-income producers and small to micro-enterprises inrural areas. The institutionwas set-up in 1943 and i s governed by the Law no. 551175. CAH does not take deposits from the public. Its activities are financed mostly by international donors, inparticular Japan and Taiwan, and the Ministries o f Finance andAgriculture. CAHhas over four times as many clients as BNF, particularly inthe agricultural sector, but with a much lighter organizational structure. However its income, much o f it earned via below market loan rates i s sufficient only cover halfof its operating expenses, thus the institution i s decapitalizing. 66. Fondo Ganadero: Like CAH, the Fondo Ganadero (FG) is not a bank, but a state-owned development finance institution with independent legal status, dedicated to the promotion o f the livestock sector inParaguay through subsidized credit and know-how transfer to increase productivity. The activities o fthe FGare profitable inspite o f its below-market interest rates, however the margin is 22 very sensitive to fluctuations inthe exchange rate. With most o fthe FG's funding denominated in foreign currency this has generated added liabilities to the Government, from local currency devaluations. About one quarter of FG's loanportfolio i s inarrears. Second Tier Institutions 67. Paraguay's second tier institutions are non deposit taking funds financedby external international agencies. They are the Unidad Te`cnicaEjecutora de Programas which i s currently housed inthe Central Bank and which extends second tier loans to private finance companies for the micro enterprise and agro sector, the Fondo de Desarrollo Industrial which has a similar funding structure focused on small andmediumindustry, the Fondo deDesarrollo Campesinowhich focuses on the farming sector, and the Banco Nacional de la Vivienda which provide housing finance. 68. Unidad Te`cnicaEjecutora de Programas (UTEP): UTEP i s a special unit o fthe Banco Central de Paraguay set to implement the IDB's Global Program to FinanceMicroenterprises inParaguay, The unitwas set-up in 1994andits activities consist inrefinancingupto 90percent ofloans providedto micro-entrepreneurs byparticipating financial institutions, which inturn receive training on best practice methodologies for micro-enterprise finance, inparticular risk analysis o fprojects. The participating intermediaries are selected according to a CAMEL type o f system and financial information providedby the Superintendency o f Banks. Since UTEP i s fhded at "market rate" by the IDB,loans from UTEP to the intermediaries as well as the loans to the microentreprises havebeto granted on a for-profit basis.14 Inspite of UTEP's remarkableperformance, its income i s not sufficient to cover losses from exchange rate fluctuations. 69. Fondo deDesarrollo Industrial (FDI): FDIi s a second-tier lending fund housed within the Paraguayan Ministry of Finance, which was established to channel intemational donor resources towards the small and mediumindustryinParaguay. The fundwas created in 1993 with, among others, resources provided by the World Bank. FDIhas a total staff o f 10including a director. Inits operations, the FDIworks in a way similar to that o fUTEP, but (i) about half o f its loans, and grants (ii) lessstringentselectioncriteriaforparticipatingfinancialintermediaries.Actually,UTEPused has to be part o f FDIbefore it was decided to transfer it to the Central Bank. Still, a significant link remainedbetweenthe two institutions, as illustrated by the fact that UTEP i s responsible for managing FDI's accounts. UnlikeUTEP, the performance o fthe FDIhas so far beenvery disappointing. The institution didnot manage to attract financially sound institutions such as foreign banks to participate to the project. Dueto these factors, the volume o f FDI's loan portfolio has beenfalling since 1995 with a drop o f more than 50 percent inthe last two years alone. 70. The remaining second tier entities are the Fondo deDesarrollo Campesino (FDC)andthe Banco Nacional de la Vivienda (BANAVI). The Fondo de Desarrollo Campesino does not take deposits from the public, but relies mostly on funds providedbythe international donor community and channeled through the Ministryo f Finance. Related to BANAVIi s the Consejo Nacional de la Vivienda (CONAVI) which oversees BANAVIoperations. The Government expects to unwindand liquidate these entities whose portfolios are effectively not performing and no new lending i s taking place. l4UTEPadjusts its rates on a quarterly basis according to movements inthe 180 days - certificate of deposit rates. 23 C. The GovernmentReformAgenda for the BankingSystem 71, The new Government team which took office inAugust o f 2003, appointed a Minister o fFinance and a new Central Bank President botho fwhich have prioritized addressing the structural problems and risks inthe financial system, particularly given Paraguay's recent history o f financial distress and fiscal losses on an account of such events. To this end, the Central Bank, including the active involvement o fthe BankingSuperintendency andwith the support o f the Ministry o f Finance, agreed to undertake a substantial reform o fthe current banking legal framework inorder to strengthen regulation, supervision, early corrective actionpowers, bank resolutionmechanisms and operation o f the deposit insurance system. The requiredreforms involve substantial modifications to the banking law (implementation o f a new Law for Bank Resolution and Deposit Insurance) as well as related modifications to the overall masterbanking law (Law No. 861) in a number o f areas pertaining to licensing, capital adequacy, portfolio management, relatedparties, and supervisory enforcement and sanctioning. The First Operation Under the Propram 72. Under this first operation, the Government has put inplace the new framework governing the regulation o fthe banking system and inparticular the new exit procedures for banks which are deemed insolvent as well as a number o fprudential preventive actions and strengthenedsupervision efforts as further described below. The loanis inthe amount o fUS$15 million and is presentedto the Board based on all agreed prior policy actions havingnow been met. TheDeposit Insurance System 73. The Government's recent deposit guarantee systemgeneratedmoral hazardsince the banking sector did not contribute to its funding via premiums and there was no loss sharing with depositors to encourage monitoring. Under the reform program, the Government has set up a defined institutional function and financial structure including the implementation o f regulations and operating procedures, for a new insurance systemwhich will be support bank resolution and restructuring processes approved under Law 2334/03. The new insurance fund will be managed by the Central Bank with input from industryparticipants andhave its own statutory identityto insulate it from fiscal influences. Its charter and operations which will definedby regulation under the reform program, will be under the oversight of the Central Bank and the Superintendency. 74. The new deposit insurance system i s fundedby premiums paid by the banking industry, so that a target funding o f 10percent o f the financial system's depositary base i s reached. The insurance fund will have a Government "reinsurance" feature for any losses which exceed the 10percent deposit base, so that losses above that level would be automatically assumedby the Government under an `excess o f loss' policy inits charter. Duringthe early years o fthe fund's accumulation o fresources, a co- insurance feature would be ineffect whereby the Government will provide a funding contribution in realizablebonds, iflosses below the 10percent level occur, before the fund has accrued sufficient financial resources. Insuch an event, the co-insurance feature would finance any insured deposits not covered by accumulated premiumspaid inby the private industry. The co-insurance feature would be structured as a defined initial capital contribution with the possibility of the Government's treasury issuingadditional bonds to finance the insurance fund for special casebank restructuring/resolution operations. 24 Figure1 Financing Structure for Proposed Deposit Insurance Fund Excessof Loss GovernmentFunded ReinsuranceProgram Covers insured deDosits above 10% of total deDosits (Constitutinga Systemic Risk Policy) Private Funded Component Gov't.co-insu- Premiumsfrom financial industry up to rance credit 10% of gross deposit base facility for shortfalls in coverage, during initial (stages 75. Under the reformof the deposit insurance system, the Governmentwill take all the necessary precautions to ensure that the new systemwill be sustainable, particularly as it i s buildingup its finds (which will be invested to obtain additional compounded retums). For this purpose, the potential obligation limitso f the new systemwill be steadily phased inand supported by the State co-funded amounts while the scheme becomes capitalized. 76. The settingo fpremiums will inthe longer term, is expected to be based on the assessedrisk of individual banks, including rating factors to incorporatebank management factors rather than solely the mechanical application of financial ratios. However, to avoid inadvertent signaling via the premiumlevel, the CentralBank is considering an initialflat premiumand a future riskbasedpremium that would be charged at the start o f the year through bank clearing or deposit accounts heldat the Central Bank, followed by potential rebates to banks at the end o fthe period, based on ex-post maintenance o f a low risk financial condition. Currently, the system has started with a flat premium. 77. The deposit insurance fund will also be intricately linkedto bank restructuring responsibilities following their interventionby the SB, interms o f resolving banks through the sale o f their acceptable assets with matching deposits and liablities, andusingthe deposit insurance funds to pay residual insured deposits, so as to minimize use o f insurance or State funds. Residual non-performing assets will betransferred for liquidation to specialized firms. These mechanisms are explained further below. Bank Resolution Procedures 78. One o fthe highlightsof the banking sector reform which the Government will undertake, constitutes the modernization o fprocedures to remove weak banks from the system, usingmarket mechanisms and risk sharing with the rest of the financial industry. This involves implementingunder the new Bank ResolutionandDeposit Insurance Law androlling into the overall banking law, the use o f `good bankhadbank' procedures to carve out viable assets from weak banks, and match them with deposit liabilities, for transfedsale to other banks before considering payment to `uncovered depositors'. These procedures have been approved under a recent Law (Ley 2334/03) developedwith the assistance o fthe Bank and approved under the prior Economic Recovery Loan. 25 79. However, implementation o f this law requires the design o fhighly detailed regulations which will specify the operational procedures for implementing"bank resolution actions" including methodologies for valuing matching liabilities and assets to segregateviable portions o fbalance sheets, optimization and decision criteria to minimize the use o f deposit insurance resources for "gap filling", methodologies for securitizing loan assets before they can be transferred as marketable bonds to other banks, and specification o fthe various new institutional roles for operatingthe new deposit insurance fund and its rules for engagement inresolutiontransactions. Inaddition to the bankingresolution process, the Government reforms also include the institutionalizationo f early corrective actions as part o f the supervisionprocess to permit ex ante preventive measures before banks become completely insolvent. 80. The main features inthe implementation o f the approved law goveming new procedures for bankingresolution including specificationvia regulations o f the sequence o f actions required, involves the following key steps and institutional responsibilities to be carried out by the SB: a. The prioritization and specificity inthe use o f "good bank" asset carve-outs and restructurings to transfer viable loans and other assets with matching deposits and other liabilities to market buyers, while maintaining intervenedbanks as `going concems'. b. The utilization o fpre-specifiedbank restructuring contingency plans developed prior to official intervention, so as to minimize the time inwhich a bank remains closed prior to reopening under new ownership. c. Followingthe preference inthe use o fthe "good bank"modality and definition o f qualifyingassets, the subsequent structuring o fthe residual "bad bank" assets for transfer to collection/liquidation agents. Underthe terms o f recovery o f such assets, these will include agreements for the sharing inlosses and gains among assuming agentshanks and the Government, when such lossedgains fall outside o fprojected ranges o f recoveries contractually agreed. d. Underthe above modalities, the primary criteria inselecting from the available options (including the liquidation option) will be specified as the minimization inthe use of deposit insurance and fiscal resources to accomplish the restructuring, sale, or liquidation, inline with the "least cost" principle. e. The provision o f legal options for setting up trust accounts andtrustees to administer "good bank" asset portfolios and securitize such portfolios through the collateralized issuance o f special purpose bonds backed by such assets. The asset backing (collateralization) o f such securitized bonds will be over-collateralizedvia underlyingloans by a multipleo fbond face value, according to the overall risk established for the subject portfolios, inorder to assure that the bonds minimize their default probabilities and thus are marketable. f. Purchasing banks/institutions/investors o f the bonds listed above, while receivingtheir bond couponpayments from the trust, will simultaneously agree to take on the collection function for the underlyingloan portfolios. Collection fees for suchwork are to be pre-agreed, or altematively, they will be includedas part o f the spread inthe overall couponrate for the bond representingaparticular loan portfolio. 26 g. The trustee will act with the deposit insurance fund as the restructuring administrator and portfolio securitization agency, with the overall management o fthe process beingoperated and overseen by the BCP. 81. The implementation inthe new Bank Resolution and Deposit Insurance law contains changes which impact the overall banking law interms o f incorporatingmodemized procedures for the resolution, restructuring and exit o f insolvent banks from the financial system as summarized inthe diagram below: Figure2 Summary of BankResolutionRegime Implement Structure Contingency "good bank" residual Plans b assets/liabilit. "bad bank" for transfer portfolio I I I Determine Deploy Securitize least cost trustee "good option inuse company/ bank" asset o f "bridge" restructuring portfolios resources agency Sell or Ifrestructuring transfer Liquidation options not securitized viable, proceed portfolio to to full closure purchasing banks 82. Besides the needto specify detailed implementing regulations delineating the sequenced functioning o f these new procedures andtheir operationalization(e.g. : usingjudicially supported trust and securitizationmechanisms), the Central Bank has issueda regulation prohibitingbanks to 27 encumber assets (loan portfolios, securities, etc.) usingthese as collateral to guarantee deposits, as occurred during a recent bank closure o f the Multibanco institution. The banking law didnot explicitly prohibit such action and thus it created difficulties inthe final settlement and liquidation o f Multibanco. However, since such a practice i s inconsistent with the principle o fhierarchies o f creditor preferences both under standard bank restructurings as well as under the new Resolution procedures, the Central Bank intendsto resolve this legal loophole by making explicit the prohibition against encumberingbank assets for the benefito f specified depositors. Banking Exposure to Government Debt 83. While potentially it mighthave generated an adverse development for the balance sheet soundness o fthe banking system, the Government engaged innegotiationsto reschedule overdue treasury securities held as investments by the banking system, without unduly affecting bank solvency or profitability. Because o f severe fiscal pressures during2003 and inability to meet all its fiscal obligations, including the payment o fpublic sector wages, the Government suspended some its principal and interest payments due on government securities leaving an overdue debt owed to the bankingsystemo fUS$130million. As part o fits effort to increase financial transparency, promote confidence ingovernment financial management, and lay the way for future financial sector reforms, the Government and the banking sector (as well as construction contractors) agreed to reschedule bonds which had become due as well as overdue accrued interest. 84. The terms o fthe rescheduling are to extend final maturities o fthe bonds for an additional four years duringwhich the interest rate on the bonds will be reduced after the first two years from the current coupon level o f 9 percent to 7 percent. Since the banking system didnot have alternative liquidinvestmentoptions, the reschedulingo fprincipal has little or no impact on their balance sheets. The reduction inthe interest rate has a small but insignificant effect on bank net eamings. 85. As part o fits reform effort, the Governmenthas successfully completed negotiationswith the bankingsysteminorder to give itselfadditional fiscal space to meet other pendingfiscal obligations. The debt restructuring agreement initiative was well receivedby the banking system giventhat it had already accumulated unpaid overdue debts during2003 with the previous Government and without any certainty on the prospects and terms o f eventual repayment. Regulatory and Supervisory Framework 86. Interms ofstrengthening thebanking sector's prudentialregulations to better assess solvency in line with best practices, the Government's modifications to the banking laws and key regulations governing credit risk management will address a number o fbank accounting and prudential practices including legal requirementsfor classifying loan portfolios and ensuring adequate loss provisioning. Coverage of Regulation 8 Reforms -Loan Loss Provisioning 87. The reform o fthis keyregulation as approved and put into effect by the BCP, involves the phasing ino f stricter requirements, with 100percent compliance o f the regulation's norms requiredby the start o f 2007, including: (a) Reintroduction of interest reversal for loans innon accrual status; (b) Precluding directly or indirectly new lendingto improve loan classification; (c) Minimizing recourse to collateral as a substitute for loan provisioning; (d) Adopting strict rules for collateral appraisal; (e) Increasingminimumprovisioning for category 2 loans from 1percent to between 5 and 10percent; and (g) Establishinga generic provision (0.5 to 2 percent) for category 1loans. 28 88. Inaddition, associated regulatory changes also reflectedinthis initiative and inthe new general banking law, address the computation o friskweightedcapital to ensure that best practices inline with international standards are utilized inthe determinationo fbank solvency. Such measures will include: (a) Minimizing the use o f collateral to reduce risk weights and augment risk limits; (b) Requiring capital adequacy not only on an individual institution, but also on a consolidated basis; (c) Excluding from tier 2 capital, 50 percent o frevaluation reserves after validation; (d) Excluding from tier 2 capital, 50 percent o f current year profits before distribution; (e) For rating loan asset risks, permittinga 50 percent risk weighting only if assets are guaranteed by residential mortgages, but 100percent risk if backed by commercial mortgage collateral; and (f) Adding market risks to the computation o f capital. 89. Inthe area spanning market andportfolio risks there exists an overlapping issuepertainingto foreign exchange risks on account of partial dollarization o fthe banking system. To mitigate the risks from dollarization, of borrowers not being able to repay loans following currency devaluations, the regulatory reform includes the development and implementation o f risk management guidelines regardingthe provisioning for credit risks generated from open foreign exchange exposures o f borrowers. Reform of the General Banking Law 90. The keypillar onwhich the Govemrnent's financial sector reform program is anchored is a wholesale reform of the General BankingLaw (currently LeyNo. 861). Besides the incorporation as part of this law, of the new bank resolution and deposit insurance system which was already approved under a separate law (see section on BankResolutionProcedures above), the newproposedBanking Law includes several major reforms which upgrade Paraguay's prudential regulatory framework and modernize the supervisory approach. Among various other aspects, the new proposedGeneral Banking Law includes the following policy reforms: a. The new law defines categories o fparticular institutions subject to bank regulation, but also regulates any `financial intermediation' activity involvingdeposit-taking. The law also requires credit cooperative to follow prudential rules applicable to the banking sector. b. Financial groups are identified as subject to licensing for banking activity, and linkedparty risks are identified as subject to exposure limits and capital requirements, including cross- ownership and concentration limits. Additional powers are given to the SB to conduct supervision o f consolidated financial groups. Bank credit exposure limits are specified for individual credit risks as well as group risks. c. Governance norms are upgraded in line with internationalpractices. Bank mangers, directors, shareholders, auditors, attorneys and personnel are subject to accountability norms and application of sanctions for duties pertaining to ensuring prudent banking operations. Bank management are accountable not only to prudential financial performance but also for risk management policies and appropriate internal controls. d. The minimumcapital requirements to operate banking businesses are increased substantially, more inline with international standards, and such requirements are subject to periodic revaluation linkedto an inflation index.15 l5 Credit cooperatives do not fall under the banking law. Separate regulations under development with WOCCU, require their meetingphased-in solvency requirements andprudentialriskmanagement and credit classification standards, 29 e. Net income and/or dividends are prohibited from beingrecognized or distributeduntil eamings are received incash. A limit o f 50 percent i s also applied to the amount o f revaluation reserves which can be counted s capital. f. The minimumsolvency ratio is specified at aminimumrequirementbut i s not capped at any upper limit, and the SB has discretion to increase it for any particular bank ifit i s deemed to be at risk andrequiring ahigher capital/solvency cushion. g. The Law gives the SB autonomy inapplying sanctions for infractions committed, without need for prior authorization from BCP. Additional sanctions are added including penalties to banks for not ceasing and desistingor following directives issuedbythe SB previously, for imprudentlyputtingbank depositors at risk, and for not meetingimprovement targets under previously agreed `regularization' programs. Fines are increased inline with international standards and expressed as a percentage ofbank capital. h. The mechanism of judicial liquidation i s incorporatedas a rule once the bank resolution process i s completed. This allows the SB to discontinue the management and oversight o f closed banks and allow their remaining assets to be liquidated as part o f formal bankruptcy proceedings. Reform in Paraguay's Anti-Money Laundering Policies 91. Paraguay has a number of initiatives which reflects its evolution inthe implementation o f an anti-money laundering framework. This recently gained priority and increased importance following the September 11,2001 terrorist attacks inthe U.S.and the discovery o f financing links inParaguay's border towns. The following describes Paraguay's existing AML framework and legislative reforms beingdeveloped inthe sector. 92. The Central Bank serves on the Boards of national agencies set up to detect andprosecute money laundering activities. These include the Secretariat for the Prevention o f Money Laundering and the National Anti-Drug Secretariat. The framework Law No.1015/97 requires from financial institutions, the identificationo fclients, the settingup of a monitoringregistry, andmaintenance o f such registries for at least 5 years. The law was updated inmid 1997 to explicitly define as illegal, the use o f the financial and payments systemfor transacting illicit activities. Liability was definedto equally include the executors o f specified transactions as well as the "moral" authors or planners o f such. All financial (bank andnonbank) institutions as well as funds andNGOs are included interms o freporting requirements and monitoring responsibilities. 93. The Superintendency's (SB's) Regulation 245 of 1997 establishes and defines the specific means o f communication and reporting formats between financial institutions and the SB for operations above US$lO,OOO. Regulation 455 o f 1999 reinforces this by requiringnew intemal control units to be set up ineachinstitution, and specifies their responsibilities inpreventingmoney launderingas well as the additional oversight functions of corporate audit committees. Regulation 536/97 elaborates on external auditor requirements and responsibilities inthis area. 94. A separate regulation No. 2 o f 1997 defines the scope o f institutions, financial activities, operations, clients, and modes of registeringthese for reporting to the designated Government agencies once suspicious activities havebeendetected. Protections are included with respect to lawsuits against reporting banking officials no matter what the outcome o f investigations might be (Le., meaningfulor not). Regulation 153 o f 1998 requires entities which transfer funds abroad to inform the SB and the Department o f Economic Crimes o fthe Central Bank, while providing specific amounts, destinations 30 and origins o f funds. Regulation224 o f 2000 provides additional guidelines andreporting requirements specifically tailored to exchange houses. A separateMERCOSUR agreement also exists to define guidelines for suppressing money launderinginthe MERCOSUR countries and formalizing cooperation among those Central Banks. 95. Act 105 and Regulation 9 o f October 2001 has set up within the BCP, a special purpose Unit for financial analysis on money and asset laundering. This Unit coordinates activities and information with the BCP's Department of Economic Crimes. Most recently, Act 123 and Regulation 1o f November 2001, implementeda "manual of conduct" requirementfor banks to delineate the steps necessary for the identification and preventiono f asset laundering, as related to Base1Core Principle 15 and codes o f ethics. This regulation applies to all entities supervised by the SB. Essentially it emphasizes "know thy client" guidelines and requests reporting on connected businesses. Suspicious operations are reportedto the National Secretariat for Prevention o fMoney Laundering. Reform of the AML Framework 96. The Government with assistance o f the U.S.Treasury, has developed a new draft AML legislation expected to be approved in2005. This would reform the AML framework law No. 1015, and replace it with a modemized AML approach. .97. The new law, already presented to the Congress contains provisions for defining the AMWCTF as specific crimes. Better coordination arrangements inline with best practices worldwide, are set up inorder to centralize the oversight ofAML/CTF activities withinthe Government to avoiddispersed accountabilities, and to operate the relevant Unitunder the President's Secretariat. 98. The law also addresses information technology issues andthe ability for law enforcement to have legal tools to follow up on `high tech' criminal activity. With regard to asset seizures under AML/CTF activity, the new framework i s also specific with respect to procedures to be followed. 99. Financial institutions and other entities under the new framework, will also have reporting obligations with regardto suspicious transactions under standardized formats allowing quick analysis bythe financial authorities. Strategic Plan of the Banking Superintendency 100. As part o fthe reform effort and as part of the process delineated above, the Government considers it essential within the proposed framework and prior to its implementation, to have inplace a strategic planwhereby a more risk management approach to bank supervision would be conducted and a sequenced, and a structured set o f actions would take place before any event o f bank failures occurred which mightprovoke systemic contagion. For this purpose, the following pro-active measures have been identified as part o f the Central Bank's supervisory strategy and a contingency planwhich wouldbeimplementedearly on inthe reform effort, andmaintained as akeytool for effectively leveragingthe new resolution mechanisms. 101. Risk Ratings of Banks: As part o f a pro-active riskbased focus o f a new supervisory strategy, the SB will beginimplementing an intemal rating method usingboth quantitative (e.g., CAMEL criteria) and qualitative assessments o f the soundness o fbanks and their associated management and riskmitigation functions. The riskrating approach will count on advanced financial, economic and balance sheet simulation tools to evaluate varying risk scenarios and capital adequacy for subject 31 banks. This will move beyondthe mechanical application o f financial ratios andprovide ratings based on the intemal risk management practices andcontrols o fbanksbeing supervised. 102. Adaptation Planfor New Norms: With the implementation o f the reformedbanking laws and regulation #8 which requires a phase ino f increased loan loss provisions (and lower dependence on collateral as reserves), the SB will assess the adequacy o fbanks' businessprospects, cash flows and financial cushions, to allow them to successfully transition into a stricter regulatory regime required under the new framework. This will involve continuous oversight and guidance by the SB to the financial sector, to engender corrective actions ifbanks are not taking adequatemeasures to reach their target levels o f reserves under the new norms. While this exercise i s initselfgeared towards establishing regulatory compliance, it will also serve to identifylatent weaknesses ininstitutions and determine their viability for survival inthe longrun. 103. Solvency vs. Liquidity Issues: Once weak banks are identified, and following the application o f prompt corrective actions mandatedby the SB to stop further deterioration, an immediate diagnosis would be made as to whether their problems constitute liquidity or solvency constraints. For those banks that appear solvent, liquidity assistance would be considered by the BCP. For those banks diagnosed as insolvent, a bank resolution strategy would be mapped out a priori. 104. Consolidation Strategy and Resolution Plan: The SB will give highpriority under its strategic planto fully develop and implementregulations to operationalize the procedures for conducting bank resolution and the institutionalization o f the new deposit insurance fund. The BCP and SB would a priori approve a banking consolidation strategy and develop alternatives for promoting the merger o f weak banks (or selected assets therefrom) with other banks inthe market. A set o f models estimating the good bank portions o fthe insolvent banks, would be drawn up, inorder to determine the level o f deposits that can be matched against viable assets before invoking any deposit guarantee funds. Any fbnding gaps would consider resources or securities from the deposit insurance fundprovided they met the `least cost criteria'. 105. Industvy Consultation Process: The above exercises will require ongoing consultation with the banking industryto: (i) determine potentialbuyers o f the remainingviable portfolio assets from the weak banks, (ii) consider alternative market based arrangements for handlingthe weak banks, and (iii) execute these processes ina matter o f days to avoid disruption o f the financial system. TheSecond Operation Under the Program 106. The second operation supported by a loan o f US$15 million, will focus on the implementation o f the reforms andlegal framework set out inthe first phase through, inter alia, the measurement o f improvement inthe banking sector's financial condition. 107. Under this second operation as defined here, the reforms inthe new Banking Resolution and Deposit Insurance framework would be implemented with applicable provisions enforced. Besides the application o f that law (No. 2334/03), this will include the issuance o fkey regulations goveming procedures to minimize the use o f deposit insurance resources (`least cost criteria' rule) inthe pay-out of depositors duringbanking resolution activities. Relatedto this will be the directive to prioritize the mechanism o f transfers o f assets and liabilities to sound banks (versus the outright liquidation process) inorder to minimize State outlays. 32 108. As part o f the above framework, the second operation will have fully developedand applied the legal, regulatory and market mechanisms to allow the securitization o f asset portfolios through the legal establishment o f special purpose trusts which would holdloanportfolios as collateral for securities issued by such trusts to interested banks and investors, as a means o f selling such assets while providing sufficient assurances o f the credit quality o f the security. 109. Inaddition, regulations andpractices governing the operation ofthe new deposit insurancefund will be inplace including the budgetary and institutional set up as well as the fund's accounting and investment regime for premiums collected from the banking system, and the formalization o f the Finance Ministry's capitalization contribution to the insurance fund via special bondissuances. As well, coupledwith the bank resolutionprocedures, the deposit insurance fund will have inplace policies defining its criteria for covering any asset/liability gaps o f failed institutions inline with minimizing costs o f such procedures while compensating all insureddepositors. 110. Underthe second operation, the contingency plans o fbanks and financial institutionswill be presented to provide assurances that they are able to adapt their balance sheets to the more stringent capital and loss reserving requirements. This will ensure compliance with the new capital and provisioning norms meant to strengthenthe financial condition o f the system and be able to withstand future credit portfolio or market risks. 111. The new proposed general banking law that uponits entry into effect will replace Law No. 861, will include application of its norms including those mentionedinthe preceding paragraph, and others such as the application o f new sanctions for breach o fnorms, enforcement o f exposure limits to related borrowers, implementation o frisk management standards as part o fbanks' corporate governance, and new minimumbank licensingrequirementsincluding fit-and-proper criteria for new owners, shareholders and managers. 112, The second operationis also expected to fully bringinto effect the new anti-money laundering law which i s to have beenapprovedby the Congress. The law will correct and improve on the following issues: (a) Under the existing framework, judicial action against AML activity can only be applied once the underlyingcrime involved (e.g.: goods trafficking) is first ruled on. This createsjudicial delays and duplication o f costs acrossjurisdictions. Under the new law, AML activity inits own right will be grounds for immediatejudicial/penal action, independent o f underlying criminal activity; (b) The institutional framework under the existinglaw essentially includes two financial intelligence units, Le., the National Secretariat for AMLprevention andthe Central Bank intelligenceunit. As per best practice and to ensure highest confidentiality and centralization o f information while avoiding problems ininformation sharing, the new law would create only one unique intelligence unit incharge ofoverseeing all AML activity andreportingto thejudiciary, a change which wouldhelpto modify Paraguay's status as seenby the Egmont Group; (c) Under the existing law, the National Secretariat for AML i s managed by a council constituted o f highrankingofficials inthe Executivebranch, whichmakes management ofthe Unitslow and inoperative. Under the reformed law, the Unitwill dependdirectly on the President allowing expedited decisionmakingand related actions. 33 (d) Under the current law, drug trafficking and other `traditional' activities are recognizedas being subject to AML legislation. However, giventhe evolution o ftechniques usedby launderers, and other practices including the use o ftechnology, which have advanced the sophistication o f laundering processes, the current law as well as investigatory methods have become outdated. Under the new legislation, new and unusual types and sources o f money laundering activity will be recognizedin terms o f their expanded scope, allowing for morejudicial and penal follow up without being restrictedto traditional types o f illicit activities. The new law will also provide more flexibility in investigatory techniques subject to judicial control, but more intune with the sophistication o f the crime. (e) The new law will also regulate the reporting requirementsby subject entities to report suspicious cash or financial transactions. This will standardize such reports according to international standards, allowing quicker verification o f information and expeditedfollow up action. (f) The current framework i s not specific on the decommissioning o f assets or funds seized from illicit activities or establishments. Under the new reform, procedures for seizure and decommissioning o f assets as well as their safeguarding, will be specified, inorder to ensure more efficient and transparent processes while protecting individuals and supporting institutions that assist inAML efforts. 113, Underthe second operation, inaddition, the key actions definedunder the SB's StrategicPlan will havebeen executed. These cover the supervision strengthening activities such as the completion of the evaluation o f risks inherent inbanking institutions including focused intensive inspections o f 20 percent o fbanks inthe system deemed more risky, and the undertaking o f corrective actions demonstrating the application o f the new bank resolution framework as well as the provisions inthe new general banking law and implementation o fregulation 8 for loan loss provisioning. 114. As part o f the reform o fthe law governing the Central Bank Charter, the second operationwill supportthe adoption o f additional institutional reforms complementary to the general bankinglaw but developed under as part o f the plannedchanges inthe BCP Charter (Law No. 489) -- these changes will ensure more autonomy and independence o fboththe BCP andthe SB. The BCP's Board o f Directors are currently appointedinstaggeredterms so as to span across more than one electoral cycle andprevent a single Administration from appointing all Board memberswithin one electoral term. Currently, however, ifa Boardmember departs, resigns or is dismissedprematurely, the next appointee begins hidher term and follows through for the full term o f five years. This effectively breaks the "staggering" rule. A reform o f the BCP Charter will require that ifnew appointments occur inthe middleo fthe term of a recent Boardmember, then the new appointment should first runthe remaining course o fthe prior member's term, and then expire before consideration for a new five year term. This would preventthe staggering rule from beingbroken and would maintain appointment periods crossing electoral cycles. Another reform plannedunder the BCP Charter, i s granting the Superintendent more o f a voice on the BCP Board's decisions inmatters pertaining to banking supervision, and granting the SB more autonomy inapplying sanctions based onits owntechnicaljudgment, something already incorporatedinthe reform of the General Banking Law. Inaddition, the BCP Charter which currently includes the schedule o f sanctions, will require a technical modification so that this schedule i s referred to more appropriately under the General Banking Law. 115. Finally, under parallel reforms complementingthe government's program and following consultations among INCOOP the Credit Cooperatives Supervisory Agency, the Banking 34 Superintendency, the World Council o f Credit Unions and the Bank, a new regulatory and supervisory framework will be put inplace covering adequate solvency norms, asset risk weighting, loss provisioning and accounting for capital for the credit cooperatives sector. The Third Operation Under the Propram 116. The priorpolicy actions for the third operationwill constitute reforms pertainingto the restructuring o f the state ownedbanking sector andprogress made under the overall program. This phase o f reforms follows from the prior stages given that the establishment o fthe new State banks requires a baseline regulatory framework from which the design and a sustainable structure for this sub-sector can be established and monitored against future performance. A loan o fUS$30 million would support this operation and its extensive reforms envisioned as described below. 117. As definedcurrently, this third operation will focus on the reform o f the State owned financial institutions. Inorder to address the pressingissues regardingthe financial health o f the state owned financial institutions, andto resolve the deteriorating condition o f BNF,the Government will undertake a reform program through the implementation o f a new legislative framework to rationalize the state owned bankingsector. Through mergers and liquidations, it i s plannedto reshuffle the current institutional landscape and reduce the number o f state-owned financial intermediaries to two consisting o f a first-tier rural agricultural bank, and a second tier institution structured as a fund to channel bilateral and multilateralresources. The reform will be initiatedwith a public information campaign organizedby the Ministryo f Finance to assure all stakeholders o f the benefits o f restructuring loss making state institutions and focusing credit to the sectorswith the highest needs. 118. As first steps inthe reform program, the Government will take measures to prevent any further financial deterioration inBNF. This includes the (a) appointment o f well experienced professional and politically independent bankers to the Management andBoard o fDirectors and revisions o f corporate governance policies, (b) provisioning fully all the non-performing loan assets and closure o f unprofitable branches, (c) elimination o f lendingrate subsidies which did not generate cost recovery and the setting o f rates to hlly cover all administrative and financial costs, (d) halting all new lending to the commercial and development sectors as well as to individual borrowers with over US$15,000 equivalent inoutstanding short term debt to the bank, (e) sharp reductions in administrative and advisory staff and an increase instaff assigned to loadcredit review and collections, (0reorganizing the bank to drastically reduce the number o f departments and linemanagers, and (g) updating the registry o f loan collateral and determination o fthe liquidation value o f such. 119. Underthe first major component o fthis reform, a 2ndtier development finance hndwill be created primarily out the merger o f the existing second-tier institutions, UTEP FDI, FDC, and CONAVI/BANAVI. Whereas the first tier bank will be created with an option as a futurejoint-stock company, the status ofthe 2ndtier fundwould be that o f an autonomous public entity with independent legal status. The 2ndtier fundwill have the mandate to rediscount mediumand longterm investment loans to banks and finance companies selected competitively. Lending would be deemed to promote the development o f various areas o fthe Paraguayan economy by providing loan funds to financial institutions willing to lenddirectly to targeted areas and sectors, for the promotion o f financing o f investmentand development projects by domestic enterprises, housing investment programs, agricultural investments, export-related activities or any other activities deemed fit to its institutional objectives, The institution will not collect any deposits from the public andwould be funded from 35 multilateral, bilateral and government credit lines. The minimumterm o f its loans would be two years. Accordingly, the institution would not be authorized to accept any liabilities with a maturity o f less than 1year. For bothinstitutions (lst tier), the interest rates on loans mustbeequal to the and 2nd administrative costs plus the costs of deposit-taking(inthe case o f lStcost o fborrowed funds, and tier), provision for exchange risks. 120. Underthe second main component of this reform, the first tier bank will be formed primarily from the merger o f the sound portions the existing first tier institutions (BNF, CAH, FG), which will be extracted accordingto a "good bank/ badbank" liquidationprocedure andwith the intento f limitingthe target clientele andportfolio character to smallrural and small enterpriseborrowers, many o fwhich are current BNF and CAH clients. The 1" tier bankwill be limited inits borrowing from the 2ndtier fund, in an amount not to exceed 25 percent o f its liabilities. The portions o f assets which include all non-performing loans, will be aggregated into a bad asset residual fund whose liquidation will bemanaged byprivate contractors underthe oversight o fthe MinistryofFinance. Any well performing assets not included inthe new bank will also be placed inthe residual fund to be wound down, sold to the private sector either as select assets or a going business concern, or securitized if feasible. A temporary Government restructuring commission will be created to consolidate the management and downsizing o f the institutions duringthis restructuring process as well as to re- negotiate or wind down bilateral or multilateral donor financedprojects which do not fit into the framework o f the new 2ndtier institution. 121. The new lStbank will operate as a credit andpayments institution dedicated to the broad- tier based development o f the Paraguayan economy through the provision o f financial services to creditworthy small andmediumenterprises primarily inthe agricultural sector, andwhich lack access to private financial institutions. All loans outstanding providedby the institution will be subject to a credit maximum for individual credit risks, and another for investment loans o f four or more years allowed to be fundedthrough the second tier institution. Public sector entities will be excludedas recipients o f services. For both institutions, the interest rates on loans must be able to cover the administrative costs plus the costs o f funding and any market and exchange risks. To avoid the risk o f over dependence on public sector deposits and/or of relying on social security deposits for funding, the lSt willbeabletotakedepositsfromthepublicsectorlimitedto12.5percentofitstotal tier bank deposits for any single institution (e.g., social security), and to 25 percent for all public sector institutions combined. 122. The lSt tier bank and the 2ndtier fundwill be subject to a more stringent corporate governance than the public financial institutions operatingtoday. Directors at both institutions would be required to have extensive previous business experience inbanking and finance. Boththe new lSt tier and 2nd institutions will operate under the umbrella o f the existing financial sector/banking legislation; and they will have no State guarantees or favorable tax treatment. 123. The special restructuringcommission that will be established to coordinate the process o f the creation o f the new state banks, will also oversee the consolidation o f operations, policy and accounting, andthe contracting o f private specialists to undertake the carving out o f assets and liabilities which will be transferred to the new institutions, and the liquidation ofresidual assets which will be wound down or sold. 124. The reform of the State owned financial institutions will require substantial fiscal injectionsto wind down current unprofitable operations andmatch assetswith existing liabilities duringthe 36 consolidation process into the two new remaining institutions. The main cost will be the reduction and wind down o fBNF andits consolidation at a smaller scale into the new first tier rural and small enterprise bank. Ifa full liquidation procedure was used, the cost to the State would be approximately $74 million to pay for all outstanding liabilities and deposits, net o f asset recoveries. However, the anticipated scenario under the proposed operation, would entail conducting an asset/liability matching and transfer exercise so that all outstanding liabilities neednot be liquidated outright, butrather transferred to the new bank with matching loans incurrently performing status. Good loans which do not qualify under the guidelines under the new first tier bank structure would be sold along with matching deposits to the private banking sector. 125. Underthese reforms scenario, the anticipated cost o f the State to fundthe asset/liability gap, would be US$47 million. Severance payments to reduce the State banking workforce to half o f the current level, would amount to approximately US$7 million. The contracting o f expert bank restructuring consultants and liquidators to carry out the process o f asset disposition and continue management o f institutions untilthe reform i s fully implementedi s estimated at US$1millionI6. In addition, some contingency funds may be needed to make deposit insurance payments and assist in bank mergers iffragile banks inthe systemare forced to close, as well as to pay off depositors from BNFiftheir deposits cannot be transferred to other institutions. Insuch an event, the Governmentmay need to capitalize any initial obligations underthe new deposit insurance fund which requires an initial capital through government bond issuance. Thus, the total "all-in'' cost o fthe reform would amount to about US$55 million excluding any contingencies to pay out funds for deposit insurance. The Bank will work with the Government on the timingo fthe requisite financial support inrelation to any debt service incurred on bonds issuedto capitalize the restructuredbanks and finance the deposit insurance fund. These funds are separate and not included inthe financing provided under the accompanying Technical Assistance project. 37 PART 111. THE PROPOSEDLOAN A. Loan Description: Objective and Rationale for Bank Involvement 126. Loan Objective. The objective o fthe loan i s to strengthenthe Government's capacity to manage weaknesses and stresses inthe financial system and to prevent crisis contagion effects, by utilizing early corrective actions and market risk-sharing mechanisms to transfer and sell good loan assets o f failed institutions, while reducing losses to the State. This objective, by promoting increased financial health, aims to avoid the recurrence o fprolonged bankingcrises, and augment Paraguay's growth prospects by maintaining a banking sector with sufficient underlying capital and improved allocation o f savings to expand the provision o f credit inthe economy. At an institutional level, the objective will be to strengthen the capabilities and financial/supervisory technology usedby the Central Bank and the superintendency o f banks to maintain the health of the financial system. This would be accomplished through invoking stronger capital adequacy rules combined with restructured asset/liability sales, and supported with deposit insurance funding, inorder to resolve insolvencies at the lowest cost. 127. A key aspect o f the proposed program i s the design o f an effective financial safety net feature in Paraguay's financial system, to preventrepetitions o fpast experiences and languishingbanking crises brought on by inadequate regulations. These cost the state enormous resources that might havebeen contained with more effective modernized bank resolution instruments. The weak economic environment inParaguay and inthe region as a whole, pose significant vulnerabilities to financial institutions. The loan's design i s meant to support prompt legal reforms to permit the State to pre- arrange and deploy problem resolution tools inthe event o fnew bank insolvencies. This PFSAL loan program will be accompanied by a small 4-5 year Technical Assistance project which will provide technical support to the bankingsuperintendency for the longer term institutional implementation o f the reform program, including the areas o fregulation, supervision, bank resolution, anti money laundering and others. 128. Loan Amount and Sequencing. The first PFSAL loan will be inthe amount o f US$15 million under a programmatic operation that will consist o f three loans amounting to US$60 million inthe aggregate. Compliance with the first loan's prior policy actions i s requiredprior to submittingthe operation to the Bank's Board for approval. Disbursement will take place immediately following approval and compliance with standard effectiveness conditions o f the Bank. Presentation of the second PFSAL to the Boardwill take place following completion o ftangible implementation indicators and compliance with the policy actions aimed to enforce the application o f the new legislative framework approved under the first loan. Presentation o fthe third PFSAL loan will take place following the approval o f a legislative package and implementation o f actions for the reform and restructuring o fthe State owned financial institutions, and overall progress under the program. Given that the original concept paper for this program was preparedprior to September 2004, this document remains under the guidelines o f the earlier Operational Directive 8.60 rather than under the new Development Policy Lendingframework. However, the subsequent loans under this program will be prepared accordingto Development Policy Lending guidelines under the new Operational Policy 8.60. Rationale for Bank Involvement and Strategy 129. Relation to Country Assistance Strategy. The loan constitutes a mainpillar inthe Bank's Country Assistance Strategy (CAS) as delineated inthe CAS document discussed and approvedby the 38 Board on December 16,2003 (Report No. 27341-PA dated November 26,2003) reflecting the current program. The assistance strategy which relies on the Government completing a number o f structural changes supporting its own economic management strategy, includes strengthening o f the State's policy apparatus to promote fiscal discipline and increased revenue inflows, fortifying the banking systemas amaininstrument for engendering investmentanddevelopment, andreducingpublic pension liabilities. Giventhe Bank's extensive involvement inthis sector and its policy dialogue with the Government through an earlier conducted Financial Sector ESW exercise to examine banking systemvulnerabilities (as specifiedunderPart 11, A, pg. 11o fthis report), the Bank has a comparative advantage inproviding informed policy support for this type o f operation. 130. While current economic andpolicy conditions preclude strong incentives for private bank lending, andthus financial access i s very restricted, the banking systemrequires substantial strengtheningto ensure that once economic activity picks up, financial institutionshave sufficient capital to extend credit to support growth. Inthe current environment, the authorities are not able to deal efficiently with fragile financial institutions, therefore the banking systembecomes encumbered with weak balance sheets, and without consolidation, is not able to reach more optimal levels of financial capacity. Recent growth prospects have improved, however, and the private foreign investmentenvironment is becoming more favorable. Since one o fthe mainpillars o fthe CAS is to increase the role o f the private sector inpromoting growth, an assurance o f strongbalance sheets inthe bankingsystem(via the applicationo frigorousprudentialnorms, prompt and strong corrective actions, and quick resolution and exit o f weak banks) will substantially leverage the Government's macroeconomic tool kit to achieve its stated goals, which would merit Bank support. 131. Timing and Level of Financial Support. The program financing i sjustified on two grounds: (a) a balance o fpaymentsneed, and (b) the overall budgetary cost o fthe reform. At thisjuncture, Paraguay has little ifno access to financing from the international private capital markets, and due to the fiscal situation, there are no reassignable funds. From a balance o fpayments and budgetary perspective, the country's external financing requirement from multilateral, official and other sources, so as to assure a sound level o f international reserves and a sustainable capacity to repay future debt obligations taking into account ongoing capital outflows and elimination o f arrears on external debt service, amounts to an average o f about US$200 million annually through 2006. While commercial banking flows decreased inthe aftermath o f recent period of banking instability through 2003 these were offset by foreign exchange inflows, with additional commercial and net private inflows observed in2004. Commercial andinvestment flows are expectedto riseduringthe periodofthereform program, Therefore, including newprojected capital inflows and net foreign currency deposits, private capital flows are projected to bepositive under a more stable macroeconomic and financial environment. International reserves are expected to modestly rise inorder to maintain a steady coverage o f 41/2months worth o f imports as well as to bolster confidence by assuring an appropriate level o f foreign exchange reserves with respect to Paraguay's partially dollarized banking system. 132. For the subsequent operations under the program, the restructuring o f the State banking sector may require up to US$55 million indirect or indirect capital support to close downand liquidate institutions (assuming modest recoveries inbad loan portfolios, severance payments and the price o f asset disposition contractors) and to create the remainingtwo new State institutions while assuring they are fully solvent. Also, contingent needs exist to pre-fund the new deposit insurance scheme which by law requires that the Treasury provide support with an initial bond infusion to capitalize the fundwhile it builds up premiumbased reserves. The Bank's support o fUS$60 million for this multi-year program will be complemented by IDB support through a financial intermediation loan to launchthe 39 public second tier bank and the possibility o f a later adjustment program. Both institutions will work with the Government on the phasingissues with respect to evolving financing needs. The overall program i s beingimplementedwith a precautionary Stand-By Arrangement with the IMF. The proposedloan would, through the more efficient mechanisms for bank failure resolution and the halting o f losses o f banks, aim to sharply reduce future fiscal outlays and engender solid financial institutions, thus eventually attracting additional external and internal financing and investment. Table 12 ExternalFinancingRequirements (US$ millions) 2003 2004 2005 2006 (est.) (proj.) (proj.) Current Account Balance 132 48 (25) (14) Repayment Obligations (199) (234) (161) (267) Financing, net (gap = ( ) ) (67) (186) (186) (281) Multilateral/Official Flows 213 157 185 150 Commercial Bank Flows (147) 65 83 65 Foreign Currency Inflows 343 54 (53) 100 Other InvestmentsDeposits (40) 91 22 41 Int.Reserves [ (-)=increase] (302) (181) (51) (75) Source: World Bank, BCP, IMF, Economist Intelligence Unit 133. Medium Term Objectivesand Outcomes. The Government's mediumterm goals for the bankingsystemare to ensure the stability and strength o fthe systemso that it may returnto aposition where the provision of credit can be increased to support the reactivationo fthe economy, a key requirement inthe success o f the government's economic program. Within this process, the government intends to reduce its fiscal obligations and contingent liabilities. The reduction o f these obligations would not only provide the government with additional "fiscal space" but also encourage a new policy framework inwhich the private sector might share the risks inherent inthe financial system with the support o f a modernized bank resolution process and deposit insurance system. Outcomes sought include a well capitalized, regulated, supervised, stable and efficient consolidated financial systemthat can effectively intermediate savings andprovide broader credit, capital, and other financial services andproducts for Paraguayan consumers, investors and underserved enterprises while also attracting foreign direct investment into the financial industry. 134. Bank Role in the Medium Term Program. The Bank expects a continued visible presence in the financial sector dialogue with Paraguay inthe mediumterm. Giventhe Bank's regional leadership inthe areao fmodemized `asset carve-out' style bank resolutionprocedures andtransfers o fpartial balance sheets, the Bank has a reputational interest incontinuing to assist the Government inthe implementationo fthe new legal framework and associated financial mechanisms required. In addition, the Bank will be simultaneously implementinga Technical Assistance project to support the institutions incharge of implementingthe new banking regulatory framework, and this project will serve as an instrument to continue the Bank's engagement and assist inimplementation. The Bank will also becommencing inlate FY05, a Financial Sector Assessment Program (FSAP) inParaguay 40 which will helpto deepen the diagnostics and continue the policy dialogue to strengthen ongoing and futurereformefforts. The Bank will also beinvolved intheongoingpreparationofprograms related to both private sector development and pensionreformwhich will have direct links to the financial sector issues addressed under this loan. B. Conditionality Prior PolicyActionsfor BoardPresentation/ FirstOperation 135. Prior to Board Presentation. Summary of Loan Conditions: The Government has: (i) the taken necessary steps to maintain a sound macroeconomic framework and fiscal policies; (ii) to agreed implementan overall mediumterm financial sector reformprogram as indicated inthe Letter o f SectoralDevelopment Policy; (iii) presented the requisite legislative bills to Congress, and (iv) carried out the specified legal, regulatory and institutional reform actions inthe areas o fbanking system reform (prudential regulation, supervision, bank resolutiodexit procedures, deposit insurance). The disbursement o fUS$15 million i s to be take place upon loan signature and completion o f standard proceduralrequirementsfor loan effectiveness. The prior actions are listed indetail as follows: Macroeconomic Framework Maintenance of an adequate macroeconomic policy framework agreed with the Bank, covering fiscal, monetary, exchange, external, andfinancial policies. Modernization of the Bank Resolution and Deposit Insurance System TheBoard of Directors of BCP has issued resolution No. 6 dated March 15, 2004 which regulates Article 6 of the Bank Resolution and Deposit Insurance Law through the establishment of specijlc technical criteriafor subjecting troubledfinancial institutions in Paraguay to adopt regularization actions to improve theirfinancial condition. The Board of Directors of BCP has issued resolution No. 31 dated March 18,2004 which regulates Article 20 of the Bank Resolution and Deposit InsuranceLaw by explicitly prohibiting allfinancial institutions in Paraguay topledge their assets as security for deposits held by individuals and/or legal entities in thefinancial institution. (a) The Government, through MoF, and the association ofprivate banks operating in Paraguay have agreed to renegotiate and restructure thepublic internal debt of Government treasury bonds through the exchange and refinancing of the bonds with new bonds to be issued by the M o F in accordance with the terms and conditions stipulated in the Preliminary Declaration of Intent; and (b) the Congress has approved law No. 2336/03 which authorizes the M o F to issue and circulate the new bonds in accordance with the stipulated terms and conditions as agreed with the banking industry. Banking Legal, Reaulatow and Institutional Framework TheBoard of Directors of BCP has issued resolution No. 8 dated November 27, 2003 which establishes regulations to befollowed by allfinancial institutions (as defined in Law No. 861/96) in Paraguay concerning, inter alia, the classijkation of these institutions' assets and credit risks, 41 and definition of recognition of loan loss reserves, accrued interest payments, and refinancings, resultingfrom financial institutions' loans to individuals and/or legal entities. The Government's executive branch haspresented to the Congressfor approval, the Banking Draft Law which contains provisions for, inter alia: (i) stricter capital adequacy requirements; (ii) loan classification andprovisioning standards; (iii) schedule of sanctionsfor breach of norms; (iv) exposure limits to related borrowers and withinfinancial groups; (v) corporate governance and risk management; and (vi) minimum bank licensing requirements, andprovides for the derogation of Law No. 861/96. The Government's executive branch haspresented to the Congressfor approval, the Anti-Money Laundering Draft Law which contains provisionsfor, inter alia: (a) the definition of money- laundering as a crime; (b) the establishment of a centralized intelligence unit of the Government to deal with anti-money laundering issues; and (c) the definition offinancing of terrorism as a crime. The Superintendency of Banks' (SB) Strategic Plan has been approved by the Board of Directors of the BCP setting out the mission, objectives, strategies and short-, medium- and long-term targets of the SB andprovidesfor SB's institutional commitment to, inter alia: (i) upgrade supervision procedures offinancial institutions; (ii) undertake risk vulnerability ratings of financial institutions; (iii) enforce corrective actions against imprudent bankingpractices; and (iv) establish the institutionalprocedures necessary to implement the Bank Resolution and Deposit InsuranceLaw (as defined above) and the regulations to that law. 136. Implementation Benchmarks and Results Monitoring. All agreed prior actions have beenmet for this first loan covering reform o fthe legal, regulatory and supervisory framework o f the banking system. Monitorable benchmarks will include the passage o fkey legislation such as the reformed General Banking Law and the enforcement o fnew resolutionprocedures for dealing with troubled banks through the application o f the pertinent asset and liabilitycarve out mechanisms usedfor such procedures. Inaddition, the levels and quality o fbank capital inthe systemwill be carefully monitoredto ensure that the solvency o f the banking system i s improving and strengthening given stricter requirements. The execution o f resolution actions to disband and carve out assets and liabilities o fweak or failed bankswill constitute key evidence (where situations warrant) o f applying the new procedures while minimizing State or Deposit Insurance cash outlays. Other indicators such as evidence o fbank mergers or closures as well as corrective actions directives issuedby the SB an adhered to by non-compliant financial institutions, will also be monitored as key implementation benchmarks. Duringthe final stages o f the program, the mainbenchmarks will include the actual creation o f the new State banks and winding down o fresidual operations, and the ensuing provision o f credit to the small borrower population o f entrepreneurs and rural enterprises. Giventhe three stage programmatic approach, subsequent approval o f future operations will also provide key opportunities to verify the implementation o fprior agreed reforms before proceeding to the next loan(s). 137. TheSecond Operation. Summary o f Loan Triggers: The second operation will be available once the Borrower has (i) maintained a sound macroeconomic framework, (ii) approved all legislative and related reforms presented under the first operation; (iii) approved a revised comprehensive banking law and presented a new Central Bank charter to the Congress, (iv) applied the new banking resolution mechanism and deposit insurance functions for implementation o f the reforms, and (v) applied preventivecorrective actions to banks innoncompliance with prudential requirements. The second 42 loan amount o f US$15 million would be presentedto the Board once evidence was receivedthat triggers hadbeen satisfied. The details ofthe triggers for the second operation are listedbelow: Macroeconomic Framework Maintenance of an adequate macroeconomic policy framework agreed with theBank, coveringfiscal, monetay, exchange, external, andfinancial policies. Modernization of the Bank Resolution and Deposit Insurance System TheBoard of Directors of BCP has issued regulations to govern the implementation of the Bank Resolution and Deposit InsuranceLaw, such regulation containing: (a) resolution procedures applying theprinciple of least cost criteria to minimize use of deposit insurance resources; (b) the requirement to transfer matching assets and liabilities tofinancially sound banks; and (c) provisionsfor securitization of such assets. TheBoard of Directors of BCP has issued regulations to govern the implementation of the Deposit Insurance Fund, containing: (a) criteria to be usedfor quantifjiing the asset/liability gap infailed banks to befunded by the Fund; (b) the definition of the organizational, budgetary, institutional and statutoy framework of such Fund; (c) the accounting and investment regime and management of the collected premiums in custody of such Fund. BankingLeaal. Renulatow and Institutional Framework Banks and all Other Financial Institutions subject to the current Banking Law (as referred to in theprior action below) have submitted Contingency Plans to comply with BCP's Regulation 8 loan loss provisioning, and capital requirements. (A) The new Banking Law (which replaces Law No. 861) is in effect, includingprovisionsfor: (9 stricter capital adequacy requirements; (ii) loan classijication andprovisioning standards; (iii) a schedule of sanctionsfor breach of norms: (iv) exposure limits to related borrowers and withinfinancial groups; (v) corporate governance and risk management; and (vi) minimum bank licensing requirements; and (B) the Board of Directors of BCP has issued the regulations to govern the implementation of the law. TheAnti-money Laundering Law (AML) is in effect, containingprovisionsfor: (a) definition of money- laundering as a crime; (b) establishment of a centralized intelligence unit of the Borrower to deal with anti-money laundering issues; and (c) definition offinancing of terrorism as a crime. Key actions under the SBs Strategic Plan have been carried out including: (a) completion of risk evaluation of banks; (b) focused supewisoy examinations of at least 20% of all banks, those banks having been evaluated asfinancially-unsound banks, based on the risk assessments obtained; and (c) actions to address bank weaknesses orfailures, for which corrective measures have been conducted consistent with the new legalframework and the supewisoy framework defined under the SB's Strategic Plan. A law that mod$es Law No. 489 has beenpresented to Congress, containingprovisionsfor: (a) removing the corrective action and sanctions regimefrom such Law 489; (b) investing the SB with increased execution abilitiesfor sanctioning non-complying banks: and (c) having members of the BCP Board of Directors maintain staggered term appointments to ensure BCP independence. 138. The Third Operation. Summary of Loan Triggers: The third operationwill become available andbepresentedonce the Borrower has: (i) maintained a sound macroeconomic framework, (ii) shown 43 verifiable implementation progress under the earlier phases o f the program, and (iii) approved, promulgated a legislative package that has implementedthe restructuring o f the State owned banking sector including the resulting formation o f single first tier public bank and a single second tier development fund. The third PFSALloan o fUS$30 million would be prepared and presentedonce evidence was receivedthat all triggers havebeenmet. The details o f these are listedbelow: Macroeconomic Framework Maintenance of an adequate macroeconomic policyframework agreed with the Bank, coveringfiscal, monetary, exchange, external, andfinancial policies. Restructuring and Consolidation of the State Owned Banks A management and institutional reform for the National Development Bank (BNF) has been undertaken, the bank is reorganized and streamlined, new regulations are approved specifiing credit limits placed on new lending, a staff downsizing program is implemented including a sharp reduction in departments and managementposts, branches are rationalized according to cost recovery criteria. TheLegislative Packagefor the Restructuring and Consolidationof the StateFinancial Institutions and its implementing regulation is in effect, including the establishment of (A) A singlepublicfirst tier bank created via the merger and downsizing of the State's lsttier institutions, with thefollowing features: (i) statutory lending limits per borrower establishedfor both short term and investment loans; (ii) limits on holding ofpublic sector deposits; and (iii) limits on borrowingfrom the public second tier bank; and (B) A singlepublic second tierfund created by merging and/or extinguishing thefive existing second tier financial institutions with the minimumfollowing features: (i) establishment of a reservefund to cover foreign exchange exposure and/or other hedging instruments; (ii) interest rate setting on loans to cover allJinancia1 and operating costs; and (iii) no authority to channelfunds to individual persons or entities that do not constitute banks,finance companies, savings and loans associations or cooperatives, subject toprudentialfinancial regulations. New prudential rules and operational directivesfor setting interest rates on loans, lending limits and risk exposures applicable to all assets of the State banking sector, are in effect and loss resewing standards are being enforced. The reform is underway and in operation and under its legal mandate, contracted specialists are managing, valuing and transferring assets and liabilitiesfrom thepool of State Financial Institutions' assets, toform the new balance sheets of the newfirst and second tier banks. 139. Expected Outcomes,Benchmarks and Follow Up. Followingthe endo f the program, the targeted outcomes inthe banking sector will include a measurable reduction infiscal liabilities and contingent obligations from the resolution o f insolvent institutions. A quantifiable improvement inthe financial health of the sector under the assumption o f moderate economic growth should be observed, as well as a verifiable record o f corrective actions achieved through the financial authorities' improved supervision andprudent application o f sanctions andpenalties to reverse deficient risk management practices. Under the State banking sector, the restriction o f imprudentcredit policies and the consolidation o f the sector into special purpose entities with specified corporate governance mandates and that demonstrate the ability to evaluate andprovide lendingto underservedbut productive sectors, will constitute key outcomes to measure the success o fthe last phase o fthe reform. The programmatic 44 designas well as the FSAP exercise and its recommendations, coupledwith the implementation dialogue that will take place under the Financial Sector Technical Assistance project will allow continuation o f the policy dialogue with the Government to follow up on progress made. As well, the to-date collaborative joint efforts with parallel teams from the IDB and the IMFwill ensure a continuous follow up on financial sector reforms by the three multilateral institutions. C. DisbursementandAuditing 140. Disbursement arrangements will follow the simplified procedures for SALs/SECALs approved bythe Board since 1996 and ineffect presently. Basedon a CFAA prepared bythe Bank withthe IDB during2003, financial management systemcontrols were assessedas weak and inneedof improvement, despite the existence o f a computerized public financial management system platform. For the purpose o f this PFSAL loan, the Government will open an account inthe Central Bank o f Paraguay. Once the Bank formally notifies the borrower that a tranche i s available for withdrawal, the borrower may submit a withdrawal application so that the proceeds o f the tranche are deposited by the Bank inthis account to be usedin accordance with the Loan Agreement. An audit o f the deposit account, as part o f the Central Bank's newly implemented external audit oversight, would be conducted for the project only upon the Bank's request, to assure that proceeds are transferred according to acceptable budgetary procedures and standards, and that sufficient controls exist under the Treasury accounts linkedto the Deposit Account to ensure adequate monitoring and financial reporting o f Government budgetbalances. 141, As part o f the CFAA and a prior risk assessment o f financial management processes, Regional financial management staff o fthe Bank conducted a summary diagnostic analysis and set forth recommendations for improvement in financial controls o f the Government's Treasury, particularly as they relate to fiduciary issues inthe management o f loan funds and adequacy o f Government financial statements. Besides the internal control weaknesses mentioned, the diagnosis also identifiedthe need for Government systems to recordbudget commitments and accruals properly and completely for all public entities receiving central Government funding as well as those with own funding, and to apply generally accepted accounting principles as well as consolidation o f financial statements for all public entities and enterprises. D. EnvironmentalAspects 142. The PFSAL has no direct impact on the environment. For the purposes o f Operational Directive 4.01, it has an environmental category o f C, which does not requirean environmental assessment. E. ProgramObjectiveCategories 143. The PFSAL belongs to the category o fEconomic Management. It supports the Government's economic reform program aimed at improvingthe environment for sustained and stable economic growth, by ensuring a stable, appropriately capitalized, andwell functioning financial system. The PFSAL includes features to improve the Government's institutional capacity to prevent financial system deteriorationand to have financial policy and fundingmechanisms to promptlyresolve and insulate weak financial institutions ifproblems should arise. The reform o f the public bank sector will also significantly reduce financial systemrisks, while lowering the cost to the state o fmaintaining the operating infrastructure and continuing losses from such institutions. Implementation o f the wider financial sector program will also benefit the population at large by eventually generating improved 45 access to finance and savings. The program thus complements assistance by the Bank and other donors designed to directly support the Government's development objectives. F. Benefitsand Risks 144. Benefits. This proposedprogrammatic loan would have benefits ina number o f areas o f the financial system. The new legal framework would significantly modernize and facilitate the management and regulation o f the financial system thus providing the public more transparency and confidence inthe health of financial institutions and eventually attract increased foreign investment into the financial services industry. The modernizationo fbank supervisory practices would cover the early application o f sanctions to halt accelerated deterioration o f financial institutions and correct deficient management practices regarding operational decisions and risk taking, as well as upgrading the Superintendency's monitoring tools for risk assessment. This will reduce future disruptions inthe financial system and `surprise banking crises', and thus engender a banking culture more predisposed to reserve adequately against losses and able to extend credit duringeconomic growth periods. The program would support these outcomes by increasingthe autonomy o fthe supervisory body, and upgrading prudential financial regulations to enhance banking sector surveillance and thus reduce the frequency and severity o f bank failures. 145. Modernization o f the failed bank resolutionprocedures will reduce potential drains on the public budget and thus provide more room for spending on critical social programs includinghealth, education as well as infrastructure. The establishment o f an industryfundeddeposit insurance system will delinkbank resolution funding from the fiscal purse, while providing incentivesto the private banking industryto better safeguard deposit insurance resources. The modernized rapid and efficient mechanisms for bank exit will reduce the likelihood o f contagion effects andthus enable the economy to resume growth quickly without beingunduly affected by bank failures, banking runs andor exchange rate crises. The rationalizationo fthe state owned banking sector will reduce fiscal exposure and generate additional market niches for the private banking system to develop andto increase credit to smaller productive rural enterprises which can contribute to growth and to the export market. State banking rationalization will, inaddition, reduce the misallocation o f resources to highly exposed subsidized borrowers that generate losses, while focusing the provision o f financial services to those populations and sectors with least access and geographically dispersed. 146. Risks. The principal risks to the reform program are the uncertainties o fthe national policy debate and macroeconomic factors, as well as the risk o f incomplete implementation o f the reforms due to weak institutional capacity. The reform o fthe banking system's regulatory framework and the restructuring o f the state owned banking sector may be a politically charged process. Inthe first instance, the stricter prudential regulations to be established for the operation o fbanks may generate lobbying opposition from the private banking sector with appeals to their respective congressmen. The reform will necessitate the eventual regularization or resolution o fweak banks. The Paraguayan Congress has traditionally beena very activist and politically galvanizedbody which does not easily approve reforms proposedby the executive branch ifthey threaten political interests generated from constituency pressures. These factors could threaten the integrityo f the reform program ifthe Congress does not approve any of, or a combination o f these pieces o f legislation under the program, a circumstance which would not allow the second tranche to be disbursed. 147. On another front, and more concerning the latter phases o fthe program, the restructuring o f the state owned banking sector poses additional political challenges: the closure o f credit operations 46 beyond those aimed at the small farmer or entrepreneur, could generate political issues from the influential cattle ranching sector that currently benefits from some o f these programs such as the Fondo Ganadero which would be merged, wound down or privatized. At the other end o f the spectrum, the closing o f certainbranches of institutions across the country, so as to rationalize operations, could spark protests from the rural sectors on which the Government relies heavily for political support. Because o f the large scope o f this reform, the Government i s consideringaltemative strategies inthe latter phases such as beginningwith a reform o f the second tier institutions to be followed by a subsequent stage where the first tier institutions would be addressed. While this to some extent could achieve political consensus, it also carries the risk o f splitting the reform and delaying its subsequent phase. 148. These risks will be ameliorated through a transparent and well disseminated public disclosure and educational campaign carried out by the Ministryo f Finance inconjunction with partner agencies, regarding the intent o f the reforms, showing that they are meant to benefit the economy as a whole, and the poorer rural sectors inparticular. The public information campaignwill also extend to consultations with congressional members to clearly disclose that the financial backing o f the multilateralcommunity i s conditioned on the approval of the reforms, whose implementation would release the needed financial resources to support the national economic program. The Government has also started a closer ongoing dialogue with the key committees inthe Congress that oversee this reform, to ensure that both the Executive and the Congress communicate regularly regarding strategies andproposed changes inthe designo f the reform. 149. On the macroeconomic front, anemic growth could pose a threat to the viability o f implementing bankingsystemreform. Given the higher capitalrequirements for banks under the new legislative framework, low growth would make it difficult for the financial systemto generate sufficient incremental retums to capitalize itselfadequately, therefore, there may be a need to phase inthe reforms over a mediumterm period. The external and regional environment will also have an impact were past competitive devaluations with Brazil to start again, not only from the overall macroeconomic perspective (e.g.: loss o f markets), but also due to the effect on Paraguay's domestic debtors who borrowed indollars and whose debt inguarani terms would continue rising. Other external developments ineither the Argentine or Brazilian economies could adversely affect Paraguay's projected growth. The currency mismatch within a highly dollarized economy can also pose severe credit risks to Paraguayan banks. The program envisages reforms and risk management criteria for the banks to address, ex ante, the issues o f dollarization and devaluation induced effects on the financial system. Ifregional instabilitywere to recur, however, generating new bank failures, the Government might face serious difficulties to sustain implementationo fthe reforms. 150. At a time whenprudential and reserving requirementsas well as capital adequacy standards were becoming stricter, the loss provisioning requiredby banksunder the new norms, coupled with the possibility o f yet higherprovisioning needs (iflocal borrowers were to default due to foreign exchange exposures), could hamper effective implementation o f the reforms if such provisioning implied excessive reductions o f reported capital, and the associated regulatory insolvency status. These measures will be ameliorated bybuildingina grace period for full implementation so as to phase inthe stricter requirementswithout causing undue technical failures or accounting bankruptcies inthe interim. While such instances would provide the Government andthe Central Bank opportunities to deploy the bank exit mechanisms included inthe new legislative framework, any materialization o f a systemic problem might short circuit the reform givenpolitical pressures which could emanate to 47 rescue banks and depositors before an adequate deposit insurance find and its operating staff and procedures were constituted. 151. Other risks pertain to overall govemance issues within an environment susceptible to corruption as well as risks o f illicitly laundered monies within the banking system, either from contraband, drug or terrorist activity. However, the new Government, with Bank support, has embarked on a public anti corruption campaign to clean up the State sector, an initiative which will help to counteract past abuses. Interms o f illicit funds, the program envisages a number o fmeasures to fortify the anti-money laundering institutional framework which i s already supported by a number o fpieces o f legislation developed over the last few years. These are included as part o f the supervisory andprudential aspects under the reform program, and are also beingsupported bymultilateral funding inthe form o f grants and other assistance. Some o fthe perceivedrisks o f corruption and lack o f transparency will be ameliorated, as discussed earlier, through: (a) the audit o fthe special account used for deposit o f loan proceeds as required, (b) new annual audits o fthe Central Bank as an institution, and (c) continued implementation o f the Government's so far successful public transparency campaign, as well as follow up on the recommendations o fthe IMF's safeguards assessment and the Bank's diagnostic o fpublic financial accountability. 48 i 4 3 W e h 49 1 X Q) 1 a I L I 50 I I 1 I 2c3 0 E ri t- 52 53 Annex 2 LETTEROF FINANCIAL SECTOR DEVELOPMENT POLICY Asuncih, March 3,2005 Mr.JamesD.Wolfensohn President, InternationalBank for Reconstruction and Development (IBRD) Washington, D.C. United States o f America Dear Mr.Wolfensohn, Ihavethepleasureofaddressingyouinorderputtoyourknowledgeinformationonthe development o f Paraguay's economy and financial system, and also to present the framework within which the financial sector reform program will be implemented. It i s our intention to request financing from the InternationalBank for Reconstruction and Development for introducing the programmed adjustments for carrying out the reform o fthe financial sector. The assistance requested will facilitate the implementationofthe structuralreforms to be carriedout bythe Paraguayan Government, which are based on an efficient and stable administration o fboth banks and finance companies, with the aim o f establishinga reliable financial systemcapable o f contributing to the economic recovery of Paraguay (Exps. M.H.No. 27.878 and 29.369/ 2004). A. RecentDevelopmentsin the ParaguayanEconomy Inrecent years, the Paraguayan economyhasbeenmiredinadeep recession andpersistent stagnation, with their resulting negative effects on the population's well being. The growth rate of the economy duringthe last twenty years has been runningbelow the rate of demographic growth, and in thepast five years, the average annual growth ofthe Gross Domestic Product (GDP) has been negative. The weakness o fthe financial sector has generated constraints on its capacity to provide financing for the productive sector. Addedto this i s the low level of agricultural productivity and the limiteddiversification of export products. This situation reveals the country's vulnerability to international market fluctuations and its effects within and outside o f the region. The structural crisis prevailing inthe country has beenmirrored inthe recession o fthe last five years and especially inthe significant slump ineconomic activity in2002. The 2.3 percent decline in GDP ledto a reduction inthe goods and services available for the population, low incomes, and fewer sources o f employment. Annual inflation stood at 14.6 percent, as a result o f a scant supply of goods and services coupledwith the effect o f a sharp devaluation o f the guarani against the dollar. The financial sector cut back lendingdue to the cumulative losses caused by the recession and borrower defaults, as many borrowers are exposed to exchange rate risks. This situation has reducedthe private sector's capacity to invest. 54 Inthe monetary sector, the aggregateshave shown ahighconcentration o fdeposits inforeign currency, plus a drop inloans to the private sector owing to the increase inpast due payments on bank loans, which rose from 12 percent to 22 percent in2003, a situation that was compounded by the recurrent financial crises besetting the country since mid-1995. Nevertheless, this situation was addressedimmediately by the Central Bank, at significant cost to the State interms o f funds allocated to protect depositors and also support inthe granting o f emergency loans that have not always beenrepaid. Inthe fiscal sector, considerable increaseshavebeenposted inthe fiscal deficit since 1995,due to the fact that fixed expenditures increased inrelation to tax revenues. This ledto a rise inthe fiscal deficit to 3.1 percent o f GDP in2002. Rationalization andprioritization o fthe allocation o f expenditure, combined with the presentAdministration's efforts to improve collections, subsequently enabled consolidation o f the cumulative deficit to only 0.1 percent o f GDP for fiscal 2003 and a surplusof 1.4percent for 2004. Inaddition, the surpluses generated, facilitated the financing o f fixed expenditures and funding o f active personnel's salaries, pensions, and debt interestpayments. B. Vision, Objectives,andGuidingPrinciplesof the Government'sProgram The situation described above calls for substantial changes inthe economic model applied in recent years and requires transformation o fboththe structure o fproduction and the institutional structure o f the State. This transformation entails the adoption o f a holistic approach to the different dimensions o f the development process andpromotion o f a newmodel o f society based on sustainable economic growth, inconjunction with fiscal, social, and environmental responsibility. To achieve this new country model, clear, fair and transparentlaws are needed, corruption must be combated by ensuring the enforcement o flaws, intemal securitymustbe strengthened,and credibility and confidence inthe nation andits future must be restored. Inaddition, steps must be taken to overcome intemal conflicts derivingfrom the preeminence o f sectoral interests. The present Government is committed to the restorationo fthe State as a legal, administrative, and political entity that ensures preservationo f the rules laid down inthe laws. Inthis context, the Government's program includes as one o f its pillars for economic recovery and financial stability a far- reaching reform o f the financial system. Emphasis i s also placed on the needto reform the banking regulations, the resolution framework for banking institutions, public sector banks, social security systems, bothpublic andprivate, andpublic enterprises. A growing concern on the part o f society is for transparency and the needfor an effective legal system for the conduct o fbusiness. C. EconomicOutlookfor 2004-2005 The present Administration inherited a nation that was plaguedby aprolongedperiod o f stagnation and a persistent economic recession duringthe preceding years, with weak financial institutions and deteriorated public finances which impose limits on the Government's ability to meet i t s domestic and external payment commitments on the public debt. The Government has negotiated an agreement with the IntemationalMonetary Fund(IMF) for economic policy reforms that will help reduce uncertainty by sending clear signals to the private sector and preparing and strengtheningit to become a true catalyst for sustainable economic growth. 55 In2003, the realGDP growthratewas 2.6 percent andgrowthofapproximately 2.9 percent or above i s projected for 2004. Regarding the general price level, annual inflation i s projected at around 2.8% for 2004. The current account should close with a positive balance o f approximately 1percent o f GDP, and the expected figure for public investmentis 3.5 percent o fGDP. The steps takento-date by the Ministryo fFinance, starting since 2003 and aimed at transparency inits actions haveplayed asignificant role inthe improvedtax collectionto datewhich, together with the reduction o f superfluous public expenditure, havepavedthe way for reversal o f the trend infiscal performance for 2004. It i s important to note that the approval o fthe Law on Restructuring the National PensionFundhas resultedina considerable improvement inthe fiscal situation inthe first halfof 2004. Inaddition, various measureshavebeentakento containexpenditure,including elimination of budget supplements submittedduringthe previous Administration and the fieezing o fpublic salaries. The Government has moved to deal with the problem o ftax evasion, resulting ina 36 percent increase incollections inthe fiscal year endinginApril 2004. Other importantreforms havinganimpact inthe fiscal sphere andhelping to mitigate the scope o f corruption and maintain control of expenditure are being carried out proactively inthe areas o fpublic procurement, customs, the Supreme Court, review o fpublic payrolls, financial administration, and strengthening o f the public audit function. The projections o f the mainmacroeconomic variables for 2004 and 2005 show an improvement inthe economic situation. GDPgrowth ofapproximately 3.5 percent is estimated for 2005, inflationis expected to remain at around 6 percent. The guarani-dollar exchange rate shouldremain stable. The 2005 central government budget i s anticipates a primary surplus o f 0.8 percent compared to an estimated primarysurplus o f 2.6 percent in2004, a surplus o f 0.9 percent in2003, and a deficit o f 1.7 percent for 2002. Regarding extemal debt, the Government has begunto honor the commitments to creditors and also to renegotiate debt with the aim o f holding it at approximately 40 percent o f GDP. It is also important to note that the document "Interinstitutional Agenda for the Executive and Legislative Branches" was signed inearly October 2003. This document has beenconverted into a political agreement, as a result o f negotiations with the leaders o f the National Congress and the representatives o f the main political parties forming the legislative body. The Agenda considers reduction o fthe fixed expenditures o f the 2004 budget as a commitment, together with submission for review and discussion o fthe following bills: (i) Pension Reform; (ii) on Administrative Reform Law and Fiscal Adjustment; (iii) Customs Code; (iv) Public Debt Restructuring; and (v) Public Sector New Bank Reform. These are all actions that will complement the reform of the financial system, which seeks to strengthenthe system and insulate it from possible shocks, while at the same time puttingin place appropriate measures to protect depositors. D. The FinancialSector ReformProgram The Government has launched a financial system reformprogram with the aim of strengthening its capacity to regulate the system and prevent contagion from systemic crises. 56 FirstPhase Underthe first phase o fthe program, Law No. 2334/2003 was promulgated, pertaining to Deposit Insurance and Resolution o fFinancial Intermediaries subject to the General Law o f Banks, Finance Companies, and other LendingEntities, as well as accompanying regulations for its implementation. This law forms part o f a complete package o freforms o f the financial system and envisages the creation o f a deposit insurance find which will be established initiallywith capital providedby the State through the issuance o f State bonds, and subsequently be made up of contributions furnishedby the financial institutions. It i s important to emphasize that use o f the deposit insurance fund resources will be subject to the new regularization and resolutionrules for financial entities, laid down inLaw No. 2334/2003. The reform beingimplementedplaces the Paraguayan legislation in a vanguard position and inline with similar regional and intemational mechanisms. Underthe previous system, the taking over and closingo fbanks and financial institutions was a slow process that generally resultedinthe loss o f market value o f the institutions and their collateral. The proposed new regularizationand resolutionprocedures will enable timely,identificationo fviable assets and liabilities, so that attractive balance sheet packages can be offered to other banks. This would make it possible to reduce the use of funds for deposit insurance, since the portfolio o f troubled banks can be transferred immediately to interested banks. Only the remainingdeposits, i.e. those not absorbed by the other banks, will require usingdeposit insurance funds. The proposed bank resolution arrangements envisionmodemmethods of transferring assets and liabilities from troubled banksto sound banks. This will eliminate the delays intransferring assets from troubledbanks resulting from the needto wait for assessments o f asset quality before the transfer i s made. Therefore, the reform accordingly proposes the transfer o f the largest possible number o f deposits together with bonds issuedby means o f securitization o f the portfolio made up o f the assets o f the entity undergoingresolution, employing mechanisms that ensure competition andare consistent with the creditor hierarchy stipulated by law. The instrumentsinquestionwill involve complex regulations requiringtechnical and legal expertise and experience. To that end, the Govemment hired intemational experts inthese areas in order to draft the requisite regulations and implement the proposed scheme. These processes have already advanced and as a result the Central Bank issued Regulation 6 o fMarch 15, 2004 establishing the criteria to subjects financial institutions to Regularizatiodhprovement Plans, andRegulation 31 o f March 18, 2004 prohibiting financial institutions to guarantee client deposits with assets as collateral. Another essential aspect o f the reform process under the first phase i s the Government's commitment to amend the General Law for Banks, Finance Companies, and other Lending Entities. Important amendments have been introducedto this billpertaining to bank licensing, standards to be metbyboardsof directors, tighter requirementswith respect to capital and adjustments for inflation, procedures for corrective actions, and a system for sanctions and assessment o f fines. The bill hrther envisages limits on lendingconcentration, responsibility o f managers with respect to oversight and risk 57 management policies, a 50 percent limit on the inclusion o f the revaluation reserve as capital, greater autonomy for the Superintendency o f Banks inthe imposition of sanctions, regulation o f financial intermediation activity, and management o f related party risks. The General Banking law bill that the Executive has submittedto Congress on December 10, 2004, i s primarily designed push forward the above mentioned reforms and to establish uniform regulatory standards for all entities inthe financial system. The national economic authorities understand that the establishment o f uniform rules and standards i s crucial to establish a framework through which the competition o f financial entities works to maximize efficiency. Inaddition, uniform regulatory standards are also essential for ensuring that the financial intermediaries do not obtain benefits or advantages that encourage them to act less effectively in certain cases due to fewer requirements,and to the detriment o f other types o f competitors and possibly savers as well. The amendments to Regulation 8 o fthe Central Bank, dated November 27, 2003, include new rules concerning the increase of provisions against losses and limitation inthe use o f real estate collateral, rules on assessing collateral, on classifyingrefinanced loans and interest accrual, and regulatory adaptation or contingency plans to be submittedby the banks. Inaddition, the sanctions regimeunderthe CentralBank Charter Law hasbeenamended to incorporatedthis under the General Banking Law. The reform o fthe General Banking Law will facilitate more active oversight o f financial institutions and adoption o f the appropriate measures required by the Central Bank and the Superintendency o f Banks to reduce the level o frisk inthe financial system. To complement these reforms andprevent contamination o f the financial systemwith illicit money, the approval and subsequentenforcement o f a draft law aimed at preventing and suppressing illegal acts intended to launder money and goods will be supported. The draft law on anti-money laundering which was presented to the Congress on May 13,2004, proposes centralizing the detection andmonitoring o f such activities inone agency, together with an updateddefinition o f crimes inthis area: the financing o f terrorism as a criminal offense and money laundering as a separate, independent crime. For these reforms to be implemented, institutional changes will beneeded inthe degree o f oversight. To that end, a Strategic Plan for the Superintendency o f Banks was prepared with the aim o f establishing short, medium, and long-tenn goals relating to targeted oversight o f institutions, contingency plans for dealing with weaknesses, and undertaking appropriate corrective actions. The Strategic Planwas approved and formalized bythe Central Bank's Board o f Directors and will facilitate a more in-depthevaluation o f the bank risks as well as full-scale activation o fthe new rules governing resolution and regularization o f the financial institutions. Second Phase The secondphase o fthe reform anticipates the implementation o fthe new legal andregulatory framework including putting inforce the new BankingLaw. With respect to the BankingResolution and Deposit Insurance Law, actions include the implementation o fprocedures that permit applying the new insurance mechanismusinga least cost criteria as well as standardizing the resolutionpractice o f 58 usingmatching assets and liabilities to transfer those balances to acquiring banks inthe financial system, including the use o f the securitizationmechanism for that purpose. Underthis phase it is also anticipated that the operational procedures o fthe Deposit Insurance Fundwill be institutionalizedincluding the criteria for theuse ofits funds such as the principal o fleast cost, its functional structure andintemal controls, and its custody and investment regime for insurance premiums collected fromthe financial system. Underthis phase ofthe reform, the Central Bank will ensure compliance with the regulations on provisions as defined under Regulation 8, so that banks and finance companies show the adequate allocation o f capital and reserves to cover actual andprojected losses intheir loan portfolios. These actions will be essential to strengthenthe financial systemand better protect it against future economic and financial shocks. To complement these changes, this stage o f the reform will also implement a stremngthened supervisionprocess according to the guidelinesunder the Banking Superintendency's Strategic Plan underwhich banks inthe system will be evaluated against their inherentbusiness risks, andcorrective actions will be taken when consideredjustified according to the new regulatory framework. It is also anticipated inthis phase to have approved and ineffect the new Anti Money Laundering Law. Inaddition, the Government will presentto the Congress a new bill o f law which modified the Central Bank Charter andwhich will cover, among other reforms, a more robust process to maintain at any point intime, a structure o f staggered appointments andterms for the membersof the Central Bank's Board o fDirectors. E. Restructuringofthe State-OwnedFinancialInstitutions ThirdPhase The thirdphase o fthe program deals primarily with the restructuring o fthe public state-owned financial entities. Ifthe implementation o f these reforms were carried out early on, this phase mightbe accelerated. Public Sector financial institutions needto be restructured and consolidated, primarily inlight o f the insolvency o f a number of them, the deficient allocation o f subsidies, political and social considerations regarding the criteria for profitability, solvency and growth, the evident patronage in their portfolios, and their level o fnonperformance. This reformwill apply to the National Development Bank (BNF),the Livestock Fund(FG`),the Industrial Development Fund(FDI),the Technical Project ImplementationUnit (UTEP),the National Housing Board (CONAVI), the National Housing Bank (BANAVI),the Government Agricultural Bank (CAW and the Farming Development Fund(FDC). Taken as a whole, State financial institutions have had efficiency problems andhave generated continuous negative fiscal impacts, jeopardizing the reliability o f the financial system as a whole and negatively impacting the country's international reserves. At this time, the difficulties facing public sector banks, the negative effect o f these problems on the functioning o f the financial system inthe country, andthe consequences o f this situation on the real sectors o fthe economy, have made it imperative to reform the institutions concemed. 59 Against this backdrop, the Law on the Restructuringo f the Public Sector Financial Institutions was elaborated. The objective o f this law i s the overhaul o f the State-owned financial entities, channeling state participation to two entities, one a first tier institution and the other a second tier entity, inorder to eliminate the existing obstacles inthe present configuration o fpublic sector banks which hinder efficient channeling o f hnds available for lending, and to focus their activity on potential borrowers who do not at present have access to the formal financial system. To assure an agile reform effort and gain political support duringthis process, the Government recently modified its strategy for implementingthe reform o f the state-owned banks so as to consider two phases; one through the presentation and approval o f a second tier bank, and another which includes presentation o f a reform bill for the restructuring of the first tier banks. Bothbills have been presentedto the Congress onNovember 2,2004 and February 16,2005, respectively. Inthe first case, the FDI,FDC, UTEP, CONAVIand BANAVIwill berestructured, and inthe secondphase this will cover the BNF, C A H and FG. Giventhe current situation, the original draft bill which hadnot yet beenreviewedby the Congress was replaced by a bill to create the FinancialAgency for Development as the only secondtier bank and the sole channel for loans from the public sector to the financial system. Eventhough this sequential strategy i s considered as the most politically viable currently, the option to consolidate these reforms under a single bill will remain open if subsequent developments lead toward this under this third phase o fthe reform program. At the initiationofthe reform, efforts that were started andwill continue, involve the restructuring o f the National Development Bank (BNF),the largest public sector bank, to trim its size and limit its operations to priority clients and sectors that have scant access to financing through the privatebanking system, and for this purpose, via Decree No. 4818 o fFebruary 3,2005, a Commission was created to monitor the action plan for BNF's reorganization. The reform o fthe State bank system seeks to utilize the advantages offered by the existence o fpublic institutions such as the BNF, which already have a network and a computerized systemcovering the entire country, and the CAH, which has experience with rural micro lending. Since the BNF and the other public institutions are currently indeficit as regards their capital levels, fundingwill beneededto fully capitalize the newlyinstitution. As regards second tier banking activities, the intention is to set up a single entityresultingfrom the restructuring ofthe current development funds that will transfer resources to financial intermediaries at competitive rates. The primary purpose o f the second tier financial entity will be to administer the resources deriving from loans granted by intemational developmentfinancing agencies. With the restructuring o f the first tier banks, which work directly with the public, the aim is to serve clients which, besides qualifying for credits, are those with the most difficult access to financial and banking services, and operating the bank to prevent mismanagement resultinginfinancing from restricted public funds. To that end, limitswill be placed on lendingand borrowing operations and indebtednessfrom the second tier bank, and it will be ensured that all financial and operating costs are covered by the institution's lendingrates, and that its loan portfolio i s adequately provisioned against losses. The reform will be carried out under the coordination o f a special restructuring commission that will contract private specialists to manage the creation o fthe balance sheets o fthe new institutions. Uponthe conclusion of the reform process, it i s expected there will be efficient state participation in the financial system, appropriate and clear assignment o froles inthe financial sector plus better 60 utilization o fthe tax revenues obtained from the population as a whole, inasmuch as they will no longer be financing the losses causedby inefficient management. F. Conclusion The protracted recession that Paraguay has beenexperiencing i s the outcome o f structural rigidities inthe economy that do not foster growth and significantly impact the well being o fthe country's population. The present Administration has begunto designmedium-term policies for achieving a sustainable fiscal and financial sector, with a view to improving the conduct o fpublic administration and the operations of the financial system inorder to reactivate the economy. At the same time, short andmedium-termmeasures havebeen implemented to meet the National Treasury's fundingneeds and cope with the severe budgetary constraints, inparallel with the priority initiatives aimed at puttingthe financial systemon a sound footing. The purpose of the loanbeing requested from the World Bank is to support the Paraguayan State inresolving its present liquidity,balance of payments andbudgetaryneedswhich, among others, will require incremental resources for moving forward with the restructuring o f the public financial institutions. The three phase medium-term program for reactivating and strengtheningthe financial sector the Government of Paraguay i s seeking to promote, will require the requisite funding. As mentioned earlier, the Government has negotiateda Stand-By Arrangement with the InternationalMonetary Fund(IMF) for a period of 15 month^'^, which will be essential for guaranteeing the actions planned for the recovery o f the system inthe fiscal sphere and from the standpoint o f monetary and financial stability, and for enhancing the country's solvency, so that it can honor its commitments with respect to public debt contracted. Inthe present circumstances, the support ofthe World Bank and other multilateral financing agencies will be o f paramount importance andwill lay the groundwork for promoting the structural reform o f the financial sector, thereby achieving economic growth inParaguay. Let me take this opportunity to convey to you my distinguishedregards. [ original signed -Spanish version- see next section ] Dionisio Borda MinisterofFinance and Governor for Paraguay "TheprogramoriginallyspannedfromJanuary2004throughMarch2005,andwassubsequentlyextendedforan additional six months through September 2005. 61 I JAMESD. WOLFENS BANCOINTERNA RECONSTRUCCIONYFOMENT0(BIW) WASHINGTOND. irme a ustedpara poner a su conocimiento informacibn onomia del pais y del sistema financiero, ademds de a1 se desarrollara el programa de la reforma del sector finaizciero. Es nuestro propdsito solicitar recursos del Banco Internacional de Reconstruccidn y Foment0 (BIW) para introducir 10s ajustes prograrnados para llevar adelante la reforma del sector financiero. La asistencia requerida facilitarii la 8 implementacidn de las reformas estructurales que seran implementadaspor el Gobierno Pnraguayo cuyas propuestas est& basadas en una administracidn eficiente y estable, tanto de las instituciones bancarias como de laspnancieras, con el objetivo de lograr un sistema financiero conjable y capaz de contribuir con la reactivacidn econdmica del Parciguay (Exp. M.H.No 39.53/2005). A. Desarrollo Reciente de la Economia Paraguaya. - C! guaya de 10s ziltimos atos se ha-caracterizado por una amiento con sus consecuentes efectos negativos La tasa de crecimiento de la economia durante 10s 'creciendo por debajo de la tasa de crecimiento co aiios la tasa promedio anual de crecimiento del Por su parte, la fragilidad del sector pnanciero ha generado restricciones en cuanto a la capacidad de conceder cre'ciitospara el sector productivo, que se ha sumado CI la bnja productividad agricola y la escasa diversificacidn de bienes para la exportacidn. Esta situacidn rejleja la vulnerabilidad del pais antefluctuaciones de 10s wercados internacionales y ante efectos intemos y externos de la regidn. ..,.*, .'. ' .. ..., ,,. . t.;. ... --, . -2- La crisis estructural experimentadapor el pais, se rejlejo en la recesidn de 10s Liltiinos cinco aiios lapnente en la caida significativa.de la actividad econdmica en el aiio 2002.' %, lo que significa una disminucidn de 10s bienes y sewicios disponibles laqidn, bajos .ingresos y disminucidn de fuentes de trabajo. La irijlacidn 14.6%, como resultado una escasa oferta de bienes y sewicios, estimulada tambikn por unaprofunda devaluacidn del Guaranifrente a1Ddlar. El sectorfinanciero,* redujo 10s niveles deprkstamos debido a pdrdidas acumuladaspor In recesidn econdmica y por la falta de pagos de los prestatarios, estando muchos de ellos expuestos a 10s riesgos de cambio. Esta situacidn redujo la capacidad de invertir del sectorprivado. I En el sector inonetario, 10s agregados han mostrado una alta concentracidn de clepdsitos en moneda wtranjera, y una caida en 10s prkstamos a1 sector privado. debido a1 incremento en 10s atrasos en 10spagos de 10spristamos bancarios, 10s cualespasaron de un 12% a un 22% en el 2003, afectado ademtis por las recurrentes crisisfinancieras iniciadas a mediados del aiio 1995. No obstante, esta situacidn fue atendida inmediatamentepor el .Banco Central, ificativos para el Estado en tkrminos defondos destinados a la ositantes, asi como a1 apoyo en la concesidn de crkditos de traron incrementos considerables en se incrementaron en relacidn a 10s a, en el hecho-de que el ddicitfiscal del 2002 Uegd a la asignacidn del gasto, sumado a1 rte de la Administracidn actual, posibilitaron la consolidacidn del dijkit acumulado de solo el 0.1% del PIB para el ejercicio 2003 y un superhvit del 1.4% en el 2004. Ademas, 10s r e a " excedentes posibilitaron el jnanciamiento de 10s gastos rigidos, sueldos del personal activo, jubilaciones y elpago de intereses de la deuda. "53 ..///... . .. . .. c . I ...///... :.. ces del Progrnmade Gobierno. i.' . El escena arriba, amerita profundas revisiones del modelo econdmico os y requiere transformacibn tanto de la estructura de ra institucional del Estado. Esta transformacidn, implica una visidn integral de las dferentes dimensiones del proceso de desarrollo y la promocidn de un nuevo modelo de sociedad con un crecimiento econdmico sustentable,y con una misidn la responsabilidadfiscal, social y ambiental. Para lograr este nuevo modelo de pais, se requieren reglas claras, equitativas y , transparentes, luchar contra la corrupcidn asegurando la aplicacidn de las. leyes, fortaleciendo la seguridad interna y recuperando la credibilidad y la confianza en la nacidn y su futuro. Ademhs se deben superar conflictos internos que surgen de la preeminencia de 10s intereses sectoriales. El gobierno actual estci comprometido en la recuperacidn del Estado como una entidad legal, administrativa y politica que asegure la permanencia de las reglas leyes. En este contexto, el Plan de Gobierno incluye como uno de sus ctivacidn econdmica-yla estabilidad financiera-una profunda reforma del sistema Jinanciero. Se debe destacar, tambikn, la necesidad de reformar las regulaciones bancarias, marco resolutivo de las entidades bancarias, la bunca estatal, 10s sistemas de iegyidad social tanto pliblico como privado y las empresas publicas. Una preocupacioe creciente de la sociedad hace referencia a la transparencia y la necesidud de operar sistema legal ejcaz. C. Perspectivas Econbmicas para el 2004-2005. La actual administracidn ha recibido una nacidn que ha sufrido un prolongado estancamiento y persistente recesibn econdmica durante 10s aios anteriores, con instituciones financieras dkbiles y deterioradas finanzas publicas que se traducen en limites a la capacidad de 10s compromisos de pago tanto internos coni0 externosde ...///... i ...///... -e-.. ciado un Acuerdo con el Fondo Monstario Internacional (FMI) para reformas liticas economicas que ayuden a minimizar el grado de incertidumbre, en eiiales claras a1 sector privado, capacitcindolo y fortalecidndoio par rlo en el genuino conductor de un sustentable crecimiento crecimiento real del PIB fue de 2.6% y se estima un dedor de 2.9% o mayor para el 2004. Con respecto a1 Nivel General de Precios, se estima una inJtacidn alrededor del 2.8%para el 2004. a La balanza de cuenta corriente cerraria con saldo positivo de aproximadamente 1%del PIB,y la expectativa de inversidn ptiblica seria del 3.5 %del PIB. Las acciones tomadas hasta la fecha, comenzando desde el aiio 2003 por el Ministerio de Hacienda conducentes a la transparencia en su gestidn posibilitaron en buena rnedida el incremento en la recaudacidn tributaria hasta la fecha que conjuntamente con la reduccidn del gastoptiblico super-uoposibilitnran un cambio de la tendencia en el Jiscal2004. Es importante mencionar, que la sancidn de la Ley rmitid mejorar considerablementela situacidn se han tomado para contener 10s gastos, incluyendo la eliminacidn de tarios que habian sido presentados en la Adtninistracion iento de salarios pliblicos. El Gobierno ha tomndo accibn para afrontar elproblema de la evasidn de impuestos lo que resultb en un auniento del 36% en recaudos en el period0 anual del 2004. Otras reformas importantes que cotnplementan el aspect0 fiscal y para reducir la incidencia de la corrupcidn y nzantcner control del gasto, se vienen llevando a cab0 pro-activamente en las cireas de contratnciones ptiblicas, aduanas, la Corte Suprema, evaluacidn de ndminas priblicas, ciilntinistracion financiera yforfalecimiento de lafuncidn de auditoriap~blica. .///.,, I -5- , .II Las proyecciones de las principales variables macroecondmicas para 2005 muestran un mejoramiento de la situacidn econdmica. Se estima que el Product0 Interno Bruto crecerb en torno a1 3.5% en el 2005, mientras que se espera una inflacidn en torno a1 6.0%. Et tipo de cambio guarani-ddlar se mantendria estable. Para el Gobierno Central, la ejecucidn del presupuesto de 2005 anticipa un superrivit primario de 0.8% cornparado con un'superavit primario del 2.6% en 2004, un superrivit en el 2003 de 0.9% y un dkficit de I.7% en el 2002. Respecto a la deuda aterna, el Gobierno ha empezado a honrar 10s compromisos nsumidos con 10s acreedores, ademas de renegociar la deuda, con el objetivo de reducir la proporcidn de la deuda`en relacidn con el PIB a niveles menores del 40%. Es tambie`n importante seialar que el documento denominado "Agenda Interinstitucional pura el Ejecutivo y el Legislativo" fue firmado a inicios del mes de octubre del 2003. Este documento se ha convertido en un acuerdo politico, resultado de una negociacidn con 10s lideres del Congreso Nacional y de 10s representantes de 10s principales partidos politicos que conforman el - cuerpo legislativo. Esta agenda considera como compromiso la reduccidn de 10s gastosfijos del presupuesto del 2004, cisi como In presentacidn para el estudioy discusidn de 10s siguientesproyectos de ley: i) nsiones, ii) Ley de Reforma Administrativa y Adecuacidn Aduanero, iv) Reestructuracidn de la Deuda Ptiblica, y v) lica. Acciones que complementarcin la reforma del sistema alecer el sistema y protegerlo contra eventunles shock, niientras se van lasmedidas deproteccidn a 10sdepositantas. D. Programa deReforma del Sector Financiero. El Gobierno ha iniciado un programa de reformas en el sistemafinanciero con el objetivo de fortalecer su capacidad reguladora en el sistemnfinancier0 y prevenir el contagio de crisis sisttmicas. ...///... . . . ...-....- . - - .. - . 6.6,. - .. . .. ....... . .--.... *,.. . ' I . . . -6- Prinrera Fase Bajo la primera fase del programa fue promulgada la Ley No2334/2003, de Garantia de Depdsitos y Resolucion de Eritidades de Intermediacibn Financiera sujetos de lu Ley General,de Bancos, Financierus y otras Entidades de Crkdito acompaiiada de reglamentacion base para su implementacidn. La Ley citadaforma parte de un paquete integral de reformas del sistema financier0 y contempla la creacidn de un fondo de gurantia de depdsitos, el cuaI sera constituido inicialmente con capital aportado por el Estado, a travds de la emisidn de bonos del Estado, y posteriormente integrado con aportes de Ias institucionmjnancieras. Es importante destacar, que la utilizacidn de 10s rccursos del fondo de garantia de depdsitos estarci sujeta a las nuevas normas de regularizacibn y resolucidn de entidatles financieras establecidas en la Ley No 2334/2003. La reforma que se viene implementando coloca a la legislacidn paraguaya en la vanguardia y en linea con mecanismos similares tanto regionales como ititernacionales. Bqjo el rdgimen anterior, la intewencidn y cierre de 10s bancos e instituciones financieras constituia unproceso lento, que generalmente derivaba en pkrdida del valor de mereado Ias instituciones y garantias. Los nuevos procedimientos de regularizacibn y resolucidn propuestos pemitircin la identficacidn a tiempo de 10s' activos y obligaciones viahles, de manera quepuedan ser atractivospara ofiecer a otros bancos. Esto permf$ria'reducir la utilizacidn de 10sfondos disponibles para el seguro de deppdsito, debido a que la cartera de los bancos con problemas podrcin ser transferidos inniedintcrmentea bancos interesados. Solo el remanente de 10s depdsitos, ayuellos que no fueron absorbidos por 10s delemas bancos requerird la utilizacidn del seguro de depbsitos. El esquema de resolucidn bancaria propuesto contempla mktodos modernos de transferencia de activos y pasivos de 10s bancos conproblemas a 10s bancos sanos. Seran soIucionndas Ins demoras en la transferencia de 10s activos de 10s bancos con oroblehas ...///... .. ..,. --I--- .... - . . ...__ . . . .... . . .. - . .,. . '67 -7- i ... , . . . . <. .- Y I . . / / I . . .I. Por ello, la refo propone como una alternativa 'la transferencia del mayor nlimero posible de depdsitos juntamente con participaciones emitidas a travds de la titulnrizacidn' de carteralformada con 10s activos de la entidad en resolucidiz, utilizando rnecanisnzos que aseguren la cornpetencia y de acuerdo a1 rdgimen de prelacidn establecido en la ley. Los instrumentos mencionados requerircin de regulaciones complejas que iniplicnn capacidad y experiencia, tdcnica y legal. Para estepropdsito, el Gobierno ya ha contratado expertos internacionales en &stas cireas, para desarrollar la reglamentacidn correspondiente, asi como la operativizacidn del esquemapropuesto. Estos procesos ya , hnn avanzado y como resultado el BCP emitid la Resolucidn No6 del 15 de marzo de 2004 estableciendo 10s criterios para sujetar a entidades financieras a un Plan de Regiilarizncidn, y la Resolucion No31 del I8 de marzo de 2004 prohibiendo a entidades financieras garantizar con sus activos, 10s depdsitos del priblico. Otro de 10s aspectos esenciales bajo la primera fase de la rgorma, es el compronziso del Gobierno de modificar la Ley General de Bancos, Financieras y Otras Instituciones de Credito. Importantes cambios se han introducido en el Proyecto de ley concernicntes a li a y esthndares-de 10s directorios de LQS-bancos, aumento de rcyuerimientos de' 1y ajuste por injlacidn, procedimientos de acciones correctivas, rigimen de sanci0nes.y aplicacidn de multas. Asimismo, el proyecto contempla Iimites a la concentracidn'de ' 0, responsabilidad de gerentes en controles y politicas de ricsgo, limite de 50% esewa de revalliopara integrar el capital, mayor autonomia del poder sancionatorio de la superintendencia de bancos, regulacidn de la actividad de intermediacidnfiitanciera, y manejo de riesgos vinculados. El proyecto de Ley General de Bancos que el Poder Ejecutivo ha remitido a1 Congreso de la Nacidn el 10 de diciembre de 2004, time como principal objetivo inipulsar las reformas arriba mencionadasy establecer normas regulatorias uniformes, para todas las entidades que componen el sistemafinancier0 nacional. Las autoridades econdmicas nacionales entienden que el establecimiento de normas uniJormes es crtccial para la determinacidn en el que de la competencia econdmica de las entidades de interm traduzca en la mhima ejkiencia. ...Ill... ------- . ... :. . . .. ..... . ... . .. . .-__ , ,'',;- . , .:' .. , ..I, . ... . -8- I. ( . i . . . .,.." .-:-.. -' . , ...I//... . . _ I ' ... ~. . .,.a- ,. normas regulatorias uniformes son indispensables para que dn financiera no tengan beneflcios o ventajas que les incentive actuar a de deterniinadas clases, por la existencia de menores otros tipos de competidores y potencialmente tnmbidn de 10s ahorristas. Por su parte, la modijkacidn de la Resolucidn No 8 del Banco Central del Paraguay, de fecha 27 de noviembre de 2003, incorpora nuevas reglas referente a1 aumento deprevisiones contrapdrdidas y limitacidn en el us0 de garantias inmobiliarias, reglns de tasaci6n de garantia, de clasficncidn y refinanciacidn de criditos y sobre , clevengamiento de intereses, ademcis de planes de adecuacidn o contingencia a ser provcidos por 10s bancos. Ademcis el rkgimen de sancionesy penalidades establecido actualmente en la Ley Orgcinica del Banco Central ha sido incorporado en el Proyecto de Ley General de a de la Ley General de Bancos, permitirci mayor dinamismo para el nstitucionm financieras y la adopcidn de las medidas oportunas I,BCP y la Superintendencia de Bancos de manera a reducir 10s viesgos del sistemafinanciero. , '_..../' < 1 5 Para complementar estas reformas y para evitar la contaminacidn del sistema jlnanciero con dinero ilicito, se impulsard la sancidn y posterior impbmentacidn de un proyecto de Ley qge preyifne y reprime 10s actos ilicitos destinados a la legitimacidn de diner0 y bienes. Elproyecto de-Zey que ha sido presentado a2 Congreso el 13 de mayo de 2004, propone centralizar en una agekia la deteccidn y monitoreo de este tip0 de uctiikhdes, ademcis de la deflnicibn moderna de 10s crimenes en esta cirea: el financiamiento del terrorism0 conto crimeny el lavado de dinero como delito autdnomo. Para la implementacidn de las rejorrnas,sercin necesarios cambios institucionales en 10s niveles de supervisidn. Por ello se elabord un Plan Estratigico para la Superintendencia de Bancos con el objetivo de contar con metas a corto, medianoy Idrgo plazo que hace referen isiones focalizadas para instituciones, planes de contingenciapara e y tomar acciones correctwas oportunas. ...Ill. 9 I - , - - --- - - --- 69 -9- 1 ...///... -(. . encionadof i e aprobado por Acta del Directorio del BCP,y i rofundidad el riesgo de 10s bancosy operativizar el nuevo rizacidn de las institucionesfinancieras. Secunda Fase La scgundafase de la reforma anticipa la implementacidn del nuevo marco legal y rcgulatorio incluyendo poner en vigencia la nueva Ley de Bancos. Respecto a la Ley de Gurantia de Depdsitoy ResolucidnBancaria, las acciones incluyen la implementacidn de procedimientos que permitan aplicar el nuevo mecanismo de garantia con criterio de , tnctior costo, ademas de normalizar la prdctica de resolucidn utilizando el cake de activos y pasivos para la transferencia de tales balances a otros bancos adquirentes en el sistema Jinanciero, incluyendo el us0 del mecanismo de titularizacibn para estos propdsitos. Bajo efta fase tambidn se anticipa la institucionalizacidn operacional de 10s procesos clel Fondo de Garantia de DepBsitos, incluyendo criterios claros para el us0 de el principio de menor costo, ademas de su estructura defunciones su rkgimen de custodia e inversidn para 10s recursos recolectados depdsitos,del sistemafinanciero. ' En esta etapa.de la reforma, ei Banco Central asegurara el cumplimiento de la normativa sobre gzvisiones definida en la Resolucidn No 8, para que 10s Bancos y enipresas$financieras del sistema demuestren la asignacidn debida de capital y resewas para cubrir las pdrdidas actualesy esperadas en sus carteras crediticias. Estas acciones seran esencialesparafortalecer a1 sisteinafinanciero y protegerlo mejor contra choques econdmicosyJinancieros futuros. Para complementar estos cambios. esta ctapa de la reforma tambitn impleinentard un proceso de supcrvisidnfortalccido de acuerdo con 10s lineamientos del Plan Estratkgico para la Superintendenciade Bancos, bajo el cual 10s Bancos del sistgma s c r h evduaclos por sus n su negocio, y acciones correctivas se tomaran cuando se consid erdo a1nuevo marc0 normativo. ...I//... ._-I.I .-- . . _..- ---- .. -. -,..... .. . . . - ._ . . , '70' I' . , -10- c. ,- Tambidn se anticipa en estafme, tener aprobada y en vigencia la nueva ley que previene y reprime 10s actos ilicitos destinados a la legitimacidn de dinero y bienes .'f (lavudo de dinero). Ademcis,'el Gobierno presentarh a1 Congreso Nacional un proyecto de ley que mbdifique la 'Carta Organica del Banco Central, y que cubra, entre otras reformas, un proc&o mhs robusto para mantener en todo momento, un esquema de nonibramientos de plazos escalonado para 10s miembros de junta directiva del Banco Central. E. Reestructuracio'n de las Instituciones Financieras Pliblicas. , TerceraFase La tercera fase del programa abarca principalmente la reestructuracidn de las eiztidadesfinancieras pziblicas. Si la implementacidn de estas reformas se efectuaran teniprananiente, estafase sepodria adelantar. Las insiituciones financieras pliblicas necesitan ser reestructuradas y i,..' consolidadas, principalmente considerando la insolvencia de algunas de ellas, deficiente asignacidn de subsidios, consideraciones politicas y sociales sobre 10s criterios de rentabilidad, solvencia y crecimiento, el clientelismo de sus carteras y la morosidad de Ins mismas. Esta reforma abarcarri a1 Banco Nacional de Foment0 (BNF), el Fondo Ganadero (FG), el.*Fondo,de Desarrollo Industrial (FDI), la Unidad Thcnica Ejecutora de Proyectos del BCP'( Eliminating the 12percent maximum threshold level for capital adequacy; d) Providing BCP with powers requiring additional capital above the minimum; e) Mandating consolidated accounting to support consolidated regulation; f ) Requiringcapital adequacy also on a consolidatedbasis; 83 s> Including exchange and market risks inthe risk weighted assets formula; h) Dividingtier capital into two levels according to the quality of its components; i>validation; Excluding from tier two of capital 50 percent o f revaluation reserves after j> Excluding from tier two o f capital 50 percent o f current years profits before distribution; k) Delegatingpower to SB within appropriate policy standards; 1) Considering existing liquidity and interest rate risk exposures; m) For rating loan asset risks, permitting 50 percent risk weighting only if asset i s guaranteed by a residentialmortgage, but 100percent risk if backed only by commercial mortgage. n> Factoring inqualitative aspects according to each institution's risk profile; and, 0) Using new powers and standards, as incentives to strengthenthe banking system. Off-Site Surveillance 30. The following processes are beingconsidered to strengthenthe off-site surveillance activities o f SB inorder to enhance its overall efficiency and capacity: Having a separate component for surveillance inthe SB's Institutional Development Plan (IDP), including training; Adopting a surveillance policy aligned to a new proposed supervisory strategy; Revisingas necessary surveillance procedures (manual and work papers); Performing book adjustments per examination before ratio analysis takes place; Developing a methodology to combine quantitative and qualitative measures; Standardizing a uniform bank performance report and ratio analysis system; Developing further waming systems (dynamic, stress, proxy early indicators); Coordinating as a policy matter, the monitoring, examination, and enforcement activities; Using a risk rating profile to anchor the coordinationpolicy; Developing processes to compile and compare qualitative management reviews; Staffing the surveillance function satisfactorily and train analysts to supervise; Forming a rating committee coordinating surveillance and examination functions; m) Consolidating supervisoryresponsibilitybynominating account managers. Institutional Capacity and Modus Operandi 31. Inorder to successfully implement the above standards, the following are considered to strengthen operating policies andprocedures o f supervision inorder to enhance its overall efficiency and capacity: 84 a) Adopting a multiyear institutional development program (IDP) for SB; b) Havinga sub-IDP for each function: examination, surveillance, enforcement; c) Adopting a supervisory strategy that discriminates risk profile among institutions; d) Adopting core policies for each function (licensing, on-site, enforcement,etc.); e) Discriminating (cycle, frequency, extension, tools) as per risk profiles; f, Reviewingandreformingprocedures ofeach function (licensing, off/on-site, etc.); g) Linkingsupervisory functions by means o f a risk profile ratingmethodology; h) Estimating supervisionwork load(monitoring, examination, visitation); i) Staffingmajorfunctionstoadequatelevelsfordealingwithworkload; j) Training staffinimplementingnewpolicies andprocedures andraterisk profiles; k) Providingresident advice alongthe duration ofthe multiyear IDP. 32. Interms ofthe signalingto thepublic regardingoverall bankinghealth, the reform o f the BankingLaw also includes the elimination o f the obligation for the BCP and the SB to makepublic the classification ofbanks as currently required. Forcing SB to rate banks publicly crates unduepressure on SB, brings information o f little value to the general public that can destabilize the system and, under stress, forces the SB to collude against transparency. Thus, under the proposed legal reform, bank ratings by the SB will bekept as internal information o fthe BCP and SB. While amore reliable rating index is developed which should include a larger weight with respect to bank management quality, the SB will only publisha set o f standard financial ratios including those relating to overall exposure, asset performance andprudential indicators for each bank, but without consolidating these indicators into a single artificial rating index as i s currently done. This will provide more transparent information which the market can use to assess bank quality. Inthe meantime, banks will also be required to obtain and disseminate `ratings givenby intemationally recognizedrating agencies. 33. Other institutional issues to ensure the transparency o f operations at the BCP, besidesthe above mentioned areas, include improving intemal controls (as per IMF safeguards assessmentbeing conducted) and carrying out external audits o f the BCP every year versus the bi-annual cycle currently ineffect. e. Lender of Last Resort Facilities and Emergency Liquidity Lender of Last Resort Facilities 34. While seldom usednow following BCP's losses duringprior bankingcrises, the criteria and policy for the use o f LOLR short term facilities as well as BCP credit under supervisedrehabilitation plans, became substantially stricter under more recent norms implemented,to avoid easy accessbybanks with highpotential for insolvency. The current policies and facilities available include inaddition to the call money facility: (i)a short term facility for credits between 1-10 days in a 30 day period; (ii) a `safety net' facility for credits up to 60 days within a 180days period (but renewable for an additional 85 90 days in exceptional circumstance); and (iii)longer term `rehabilitation' facility for a credits potentially up to a maximum o f 5 years. The interest rate on these facilities i s based on a 2 percent spread over an average o f outstanding Central Bank billrates or call money rates. Required collateral for the credits includes Government or BCP paper, other liquidnegotiable securities or IOUs. The BCP i s considering, to avoid moral hazard, that the interest rate charged on these LOLR facilities bebased on a spread above the market rate, and that IOUs be excluded as collateral guarantees which should be limitedto very low risk negotiable securities. Market Based Liquidity Instruments and Constraints 35. The interbank market inParaguay is limitedand mostly relationship based. The size and frequency o f interbank flows, however, can be good indication o f how the market qualifies its memberbanks, since weak banks are generally cut off from access to this credit. However, the direction and size o f flows inthis market has not yet beenused systematically to monitor and provide early warning indicators o f potential bank illiquidity as well as insolvency. Nevertheless, liquiditytransfer mechanisms are crucially neededinthe Paraguayan financial system, particularly at this time. 36. Besides the limitedinterbank market, there are very few liquidity facilities available inthe money market. The Central Bank's call money facility and the extremely limitedrep0 market are some options, but the process o f collateralizing such short term facilities still requires more streamlining to make them effective and widespread instruments. The short term corporate paper market is practically non-existent, with the fixed income money market beingpredominantly drivenby an active primary market in Central Bank bills (monetary regulatiodopen market instruments) for which there i s a very limited secondary market. The current stock o f Government (BCP) bills outstanding i s about $266 millionwhich represents 40 percent o fbanking system usable liquidity (i.e., cash and liquid assets excluding reserve requirements) and 12percent o f total bank assets. Actions under the Reform Agenda 37. To ensure that modernized safety net mechanisms are inplace for the provision o f liquidity and the prompt payment of depositors, the Government's reform agenda includes modifications to legislationcovering ina numbero fkey areas: 38. While not a traditional LOLR issue, the authorities are concerned about financial system instability duringperiods o f currency devaluation, not only on account o f dollar denominated loans which may default, but also from potential currency runs and withdrawal o f deposits from the system, includingdollar denominated deposits. Such instances demand a sufficient cushion o f resources to avoid financial system collapse. The Government cannot rely on a constant source o f contingent international credit (either commercial or multilateral) to affront such circumstances, andthe Central Bank cannot and should not utilize its own resources or international reserves as an automatic response mechanism as has been used inthe past. However, the Government and the Central Bank will reexamine its reserves policy for bank deposits, to permit additional 86 flexibility for increasing dollar deposit reserve requirementsfor use as a potential supply o f emergencyliquidity. 39. By subsequently reducing such reserve requirements or utilizingthe stock of reserves duringperiods of devaluation induced stress, banks will be able to protect their balance sheets untilsuch macro financial tensions stabilize. Inthis regard, under systemically vulnerable situations, the CentralBank would be able to release liquid funds by lowering an already raiseddollar reserve requirement,without having to access its own resources or assume additional debt (which at times may simply be unavailable). Underthe reform program, the Government will develop the criteria underwhichreserve requirements could be adjusted to affront such situations, as part o f its crisis response tool kit. 40. Underthe newBanking ResolutionandDeposit Insurance law, the provision o f emergency liquidity facilities i s contemplated inthe event o fsystemic-wideJinanciaZ crises. Insuch instances, and with the consent o f the President o f the Republic, the Central Bank and the Finance Ministrywould present a contingency plan for illiquid but solvent entities, allowing temporary regulatory forbearance and the availability o f additional liquidity facilities. The measures permissibleunder such crises scenarios would include (a) full coverage o f deposits to prevent systemic runs, (b) increase inthe Government contribution towards the deposit insurance fund, (c) lengthening o f the elapsed times and triggers normally requiredfor bank corrective action programs, (d) case by case exemption o f intervention and resolution o f entities considered temporarily illiquid, (e) increase inthe credit facilities offered bythe Central Bank, (f) imposing timelines for meetingstandard prudential requirements during and after crisis periods, and (8) setting up a temporary fimd for strengthening o f the banking system, with the sole objective o f recapitalizingviable institutions andbringing stability and continuity to banking operations. f. Specificationof Early CorrectiveActions and SecuritizationMechanismsunder the New BankResolutionProcedures 41, The reforms to enhance the prompt corrective actions regime and which would precede the stage o fbank resolution inorder to steer banks toward a sounder financial condition before considering asset carve out, will include: (i)Thedevelopmentofasetofqualitativeindicatorsoffaultybankmanagement practices, and associating each indicator with a set o f sanctions and fines to be applied. Since weak, faulty or purposeful deficient management generally i s an accurate early indicator o fpotentialbank problems, the regulation and establishment o f a schedule o f corrective actions associated with specific fines inthis area, will help to reverse negative trends at an early stage, while insuringcompliance due to the associated monetary penalties.21 Along with the already existing schedule o f corrective actions for the exceedance of prudential limits, the SB will implementa matrix o f corrective actions and penalties covering boththe quantitative and qualitative (management performance) areas. *' Itshould be noted that fines already exist for exceedance of lending and other limits, but such fines are limitedto quantifiable financial indicators but not to qualitative assessments of deficient management. 87 (ii)ThecurrentrequirementfortheBCP'slegaldepartmenttopreparelegal documents before invoking compliance from the industry, while intendedto provide more `force and legality' to the application o f sanctions for inducing corrective action, has can at times result indelays since the legal processes take time to be finalized and documented, and months can elapse before formal sanctions are communicated. Since thebanking law itself does not requirethis step and allows the BCP to directly mandate action under threat o f sanction, this paperwork stage will bereformulatedto expeditethe quick reversal of identifiedproblems. The application o f sanctions under most cases duringthe SB's ongoing supervision work as well as duringits supervisionunder the Vigilance regime, will also be further delegated directly to the SB by the BCP's Board o f Directors. 42. Once the resolution regime i s invoked the asset/liability carve outs would be carried out for purchase and assumption by sound banks. To facilitate this strategy, the a priori securitization o f loan assets would permit purchasingbanks to count on overcollateralization o f the value o f the loan-backed security which would facilitate its acquisition along with matching deposits. The structure o f the securitization scheme for this purpose, is illustratedbelow: Figure3 Structure ofthe LoanPortfolio SecuritizationScheme andParticipationofDepositInsurance Fund - "Good" $10 m. $10 m. bonds and $10 m. loan securitized deposits sold to group of portfolio +bond issued, b participatingbanks who - identified collateralized receive bondinterest and as $20 m. at 2:l ratio portfolios for collection II I Trustee or deposit find places IOUasset inparticipating Trustee/deposit insurance + banksto make up for asset fundreceives subordinated shortfall to match additional securitizedbonds from same deposits loan portfolios, as `guarantee' g. Strategy for Management of Residual Liquidations Bank Closure and Liquidation of Non Performing Assets 43. On assessing the desired separation o f duties, a key differentiation mustbe made betweenthe functions o fbank resolutionhestructuring with deposit insurance operations, 88 and those pertaining to collection o f non-performing loans and/or liquidation o f underlyingassets. The latter function, i.e, the management ofthe residual "bad bank" is not a function of the new restructuringhesolutionprocess established under this reform program, and should not bemixedwith that function. This i s because the resolution process works on short term restructuring arrangements while the `collectiordliquidation' function i s longer term and drawn out and usually subcontracted. 44. InParaguay, the experience since the bankingcrises of 1995-98hasbeento contract individual liquidation experts to collect and/or dispose o f loan portfolios o f closed banks. The strategy o f the Government initiallywas to hire individual liquidation experts and compensate them based on a percentage o fproceeds collected. However, this practice hadsome obstacles for two reasons: (i) some cases, the collection o f bad loans in andthe disposal of assets was done usingcreative `financial engineering' methodswhich technically liquidated assets with non cash instruments(e.g.: bonds to maturity) but did not actually recover the promised amounts inpresent value terms, and (ii) assigning by liquidators to individual banks some o f which were inworse shape than others, the variable percentage commissions were not profitable in some cases and resulted in a non- viable recovery effort. Subsequently the SB modified the contractual terms o f liquidators so that their compensation was based on fixed sums or fixed monthly payments. This system,however,is still beingtweaked; while attractingmore professional liquidators, it sometimes reduces their incentives to recover and collect funds quickly and thus liquidations became protracted, sometimes spanning over 3 years or more. Judicial impediments also prevent assets from beingliquidated at "fire sale" prices. 45. A key ingredientfor an effective mechanism settle liquidation sales o f assets, is the establishment o f a centralizedregistryo f collateral assets. An effective registry should be supported by a comprehensive property titling effort to ensure that all available usable collateral i s documented as a mechanism to help promote credit access. A central collateral/guarantee registry for the financial sector, along with the upgrading o f property assessment/valuation standards would constitute a primary institutional tool to improve the efficiency and criteria for settling debt, bankruptcy and liquidation issues. As a mediumterm issue relatedto the use o freal collateral, the Governmenthas considered a program to register and provide formal title to property owners inParaguay so as to increase access to credit via the provision o f guarantees such as collateral backing. Actions under the Reform Agenda 46. The function o fmanagingthe residual "bad bank" will not be a responsibility of the restructuringh-esolution process or o f the SB proper, andwill not be mixedwith that function. Underthe agenda o fthe Government's reform effort, and to ensure the proper incentives inthe recovery o f assets, the liquidation process will and its institutional set up will be reexamined with the objective o f considering alternative options to align incentives for maximizing proceeds within short time periods: (i) Where significant size portfolios are managed, options for compensationto liquidators will be considered as variable commissions related to proceeds recovered at cash value. Such a modality would provide the best incentives to assure performance in this task. Inorder for the SB to maintain increased control against creative financial 89 engineeringand accounting arrangements to demonstrate asset recovery, while not encumbering its staff by managing such operations directly (as at present), the SB will approve final transactions to liquidate collateral for example, when such transactions utilize securities with unclear market values. Inthis context, the "property assessment" service industryinParaguay has undergone a significant upgrading o f standards established by the SB to ensure consistent and fair valuation o f underlying collateral assets usedto price non cash recoveries. (ii) The biddingsystemto obtain offers from liquidators will consider proposals from firms to oversee an entire portfolio o f assets from many banks under liquidation, rather than limitingthe systemto utilizing individual liquidators for individual banks. This will, besides generating business efficiencies and better diversification o fportfolio risks for non-performing assets, permit a more viable implementation o f the variable (percent-based) commission as the primary compensation mechanism linkedto recoveries. (iii)Theassetrecoveryprocesswillimmediatelybetransferredtodirectjudicial bankruptcyproceedings while providing flexibility to the liquidating firm to sell portions o f the loan asset portfolio for a fee to interested banks, when such assets are considered to beviable interms ofproducing some minimumeamings retums. Such a modality o f `recovery' will supplement the traditional collection mechanismbased on the sole liquidation o f the underlying loan collateral. (iv) Liquidation contracts will also beginincluding exit clauses for the Government including contractual time limits and expiration dates which will allow the BCP and the SB to delink from the direct management o fthe process and replace firms which do not perform or have not met minimumtargets within a specified period. against(v)lawsuits by creditors o fthe failed banks (who would wish to maximize the value Inorder to ensure afair andtransparent process, as well as to protect theBCP o frecoveries and wait until a buyer `shows up'), a triple consecutive auction system will be considered for usage under liquidator contracts. This will help so that the value o f collateral gooddassets which are difficult to sell on the market, are offeredauctioned in three consecutive stages (each time lowering the auction `reserve' price) to ensure that the final purchase offer received fully reflects existing market demand. 47. Inorder to support the efficient useofthe above mechanisms, the Govemment will implementa new centralizedregistryo fproperty appraisers based on recentregulations set forth to value collateral underlyingbanking assets so as to support more streamlined procedures for bank resolution and liquidation. 90 Annex 4 TIMETABLE KEYPROCESSINGEVENTS OF Time taken to Prepare: (Identification to Negotiations) 27 months Preparedby: Government and World Bank Staff IdentificationMissionDeparture: March4,2002 Concept Review April 24,2002 Preparation Mission June 26,2002 FirstManagement Review: September5,2002 Pre-Appraisal Mission: October 2003 Regional Operations Committee February 24,2004 Appraisal Mission: April 27,2004 Technical Discussions: April 29,2004 InitialNegotiations: June 20,2004 ROC FinalReview: February 9,2005 FinalNegotiations: February 24,2005 BoardPresentation: March 31,2005 Planned Date of Effectiveness: July 31,2005 Closing Date: September30,2006 91 Annex 5 PARAGUAY: FUNDRELATIONS NOTE Press Release No. 04/271 InternationalMonetary Fund December 20,2004 700 19th Street, NW Washington, D.C. 20431USA IMP ExecutiveBoardCompletesThird Review UnderParaguay'sStand-By Arrangement The ExecutiveBoard o fthe International Monetary Fund(IMF) today completed the thirdreviewunder an SDR 50 million (about US$76.2 million) Stand-By Arrangement for Paraguay, originally approved on December 15,2003 for 15 months (see Press Release No. 03/218), and granted an extension o f the arrangement by six months,through September 30,2005. Incompletingthereview,the ExecutiveBoardalso grantedthe Paraguay authorities' request for waivers o f the nonobservance o f two quantitative performance criteria and two structural performance criteria, and the modification o f four performance criteria. The remaining amounts available underthe arrangement were also rephasedin four equal tranches inan amount equivalent to SDR 3 million each (about US$4.6 million). However, Paraguay has not made any drawings under the arrangement so far, and the authorities have indicatedthat they continue to treat the arrangement as precautionary. Following the Executive Board's discussion o fParaguay's economic performance, Mr.TakatoshiKato, DeputyManaging Director andActing Chair, stated: "Paraguay's macroeconomic performance has improved significantly under the program supported by the Stand-By Arrangement. Economic growth has been sustained in2004 despite a drought, inflation has declined significantly, international reserves have increased, and the exchange rate has stabilized. "Overall, Paraguay has performed well underthe program. Onthe structural side, the authorities have approved keypieces o f economic legislationover the last 12months, including the fiscal adjustment law, the customs code, the bank resolution law, and the publicpensionreform law. The authorities will needto press ahead with the reform agenda inorder to reduce unemployment andpoverty, which remain stubbomly high. "Reform o fpublic banks remains a critical component o fthe program. It i s important that this process move forward expeditiously, andthat the authorities carefully monitor lending by the public banks inthe run-upto their reform inorder to prevent the resumption o f unsustainablelendingpractices. 92 "Fiscal policy has been placed on a sustainable path and the authorities' 2005 program i s aimed at maintaining this improvedperformance. The fiscal outlook has improved significantly following the improvements intax administration and the approval o fthe fiscal adjustment law. Tax collections have increased while expenditures have beenkept incheck, although capital outlays remainlow. The government has eliminated sizable arrears and taken decisive steps toward normalizing relations with all creditors. The stock o fpublic debt i s now on a declining trend. For 2005, the authorities intendto pursue abalanced overallbudget, with higher projectedrevenues allowing for a significant increase incapital expenditure inneededinfrastructure. It will be important to have mechanisms inplace to limit expenditure to programmedlevels, and to ensure that investment spending supports highquality projects. "Monetary policy has been effective incontaining inflation while allowing for rapid reserve accumulation. However, monetary management has beencomplicatedby large capital inflows, which threatened to generate rapid monetary expansion or a sharp appreciation o f the currency. Inorder to minimize these risks, the central bank has pursued an active sterilization policy while accumulating international reserves. In2005 the authorities intendto use interest rate and exchange rate policies more flexibly inorder to stabilize inflation," Mr.Kat0 said. Press Release No. 05/26 IntemationalMonetaryFund February 11,2005 700 19th Street, NW Washington, D C 20431 USA Statement by IMF Staff Mission to Paraguay The following statement was issuedinAsunci6n by an Intemational Monetary Fund(IMF) staffmission: "A mission from the IntemationalMonetary Fund(IMF)visitedAsunci6n during Februaryl-l1,2004 to conduct discussions for the fourth review under the Stand-By Arrangement (SBA).The missionwas headed by Mr.Alejandro Santos and met with Finance Minister Borda, Central Bank President Gonzilez, senior officials, as well as business and legislative representatives. Considerable progress was made towards completing the review and discussions are expected to continue inthe following weeks. "The missionwill conduct the final assessment o fthis review inWashington in coming weeks. Some technical issues on the budget and aspects of the public banking reform agenda are to be resolved. "The main findings o f the mission were: Macroeconomic performance was significantly better than anticipated in2004. Real GDP grew by almost 3 percent in2004, the highestinalmost a decade. Inflation fell below 3 percent in2004, one o f the lowest in the region, andthe lowest inParaguay inmore than two decades. The fiscal accounts 93 were insurplus for the first time ina decade and intemationalreserves are at record highs. "The program i s broadly on track. The majority o f the program targets for end- December 2004 were observed. An important target ahead i s the approval o f the second- tier public banking law by at least one chamber o f Congress. "Progress was made on all elements o fthe structural reform agenda. Inparticular, several important bankingbills were submittedto Congress, a commission was created to design a restructuringplan for the first-tier public banks, additional external audits for public enterprises were completed, the civil service reformwas advanced, and preparations continue to finalize the domestic bond exchange. "The main challenges for 2005 will beto consolidate the macroeconomic gains o f the recent past and to continue implementationo f the structural reform agenda. An important objective for 2005 will be to maintain fiscal discipline while paying due regard to social spending.Onthe structural side, while there are many challenges ahead, efforts should be concentrated on implementingthe public banking reform agenda. The agreements reached with civil society indesigning a development planwith equity are important steps towards the consolidation o f a medium-term policy framework. "The missionwould like to take this opportunity to thank the authorities and the citizens of Paraguay for their hospitality. 94 Annex 6 PARAGUAY Status of World BankOperations IBRDLoans as ofDecember 31,2004 Loan Proiect Principal Disbursed Approval Closing 37080 Natural ResourceManagement $50,000,000 $40,469,062 22-Feb-94 3 1-Dec-05 42220 FourthRural Water Supply and Sanitation $20,000,000 $ 14,934,037 28-Aug-97 31-Dec-05 42230 FourthRural Water Supply and Sanitation $20,000,000 $ 7,18 1,244 28-Aug-97 31-Dec-05 71090 Pilot Community Development Project $ 9,000,000 $ 1,668,167 2 1-Mar-02 3 1-Dec-06 71900 Education Reform Project $24,000,000 $ 1,000,000 31-Jul-03 30-Jun-07 95 Annex 7 Latin Lower- POVERTY and SOCIAL America middle- Paraguay &Carib. income Developmentdiamond' 2002 Population, mid-year (millions) 5.8 527 2,411 Life expectancy GNI per capita (Atlas method, US$) 1,100 3,280 1,390 GNI (Atlas method, US$ billions) 6.4 1,727 3,352 ~ Average annual growth, 1996-02 Population (%) 2.5 1.5 1.o Labor force (%) 3.2 2.2 I.2 Gross perGNIcapita +I enrollmentprimary Most recent estimate (latest year available, 1996.02) Poverty (% ofpopulationbelow nationalpoverty line) 46 Urban population (% of total population) 57 76 49 Life expectancy at birth (years) 70 71 69 1 Infant mortality (per 1,000live births) 22 27 30 Chiid malnutrition (% of children under 5) 9 11 Access to improvedwater source Access to an improved water source (% ofpopulation) 79 86 81 Illiteracy (% of populationage 15+) 6 11 13 Gross primary enrollment (% of school-age population) 111 130 111 - Paraguay Male 112 131 111 Lower-middle-income group Female 109 128 110 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1982 1992 2001 2002 Economic ratios. GDP (US$ billions) 5.4 6.4 6.8 5.6 Gross domestic investmentfGDP 25.6 22.9 19.8 18.6 Exports of goods and serviceslGDP 12.1 28.1 27.4 33.6 Trade Gross domestic savingslGDP 18.0 12.4 10.8 13.6 Gross national savingslGDP 19.2 12.7 15.8 16.9 T Current account balancelGDP -9.3 -0.9 -4.1 1.7 Interest paymentslGDP 0.8 3.6 1.8 1.9 Domestic investment Total debtfGDP 24.0 25.3 41.2 50.0 savings Total debt servicelexports 17.9 24.2 14.2 11.6 Presentvalue of debtfGDP I Presentvalue of debtfexports Indebtedness - 1982-92 1992.02 2001 2002 2002-06 (average annual growth) GDP 3.3 1.5 2.7 -2.3 1.8 Paraguay GDP per capita 0.2 -1.0 0.1 -4.8 -0.8 Lower-middle-income group Exports of goods and services 12.7 -8.0 -0.4 0.1 6.0 STRUCTURE of the ECONOMY 1982 1992 2001 2002 1 Growth of investmentand GDP (%) (% of GDP) I Agriculture 25.9 24.5 29.0 29.4 ~ Industry 26.0 25.9 18.7 18.2 Manufacturing 16.4 16.5 14.1 14.0 -5 Services 48.1 49.6 52.3 52.4 , ::: I Private consumption 74.9 81.1 79.6 76.8 1-20I I General government consumption 7.1 6.5 9.6 9.6 Imports of goods and services 19.8 38.6 36.4 38.6 -GDI *GDP 1992-02 2o01 2o02 (average annualgrowth) Growth of exports and Imports (%) Agriculture 3.7 2.1 2.2 1.4 lo Industry 3.4 2.8 -9.8 -7.4 0 Manufacturing 0.7 0.8 -6.0 -0.7 , -10 96 Pavaauav PRICES and GOVERNMENT FINANCE I982 I992 2001 2002 II Domestic prices Inflation (%) (% change) 1 " T :p Consumer prices 15.1 0.4 14.6 15 Implicit GDP deflator 5.1 14.7 1.7 16.4 i o Government finance 5 (% of GDP, includes current grants) ~ 0 Current revenue 13.4 17.2 15.8 I ~ O` 97 98 99 89 00 01 0; d2 02 Current budget balance 2.1 1.6 0.9 Overall surplusldeficit -0.6 -1.1 -3.1 1 GDPdeflator b C P I TRADE 1982 1992 2001 2002 (US$ millions) Exportand Import levels (US$ mill.) Total exports (fob) 2,118 I,883 2,241 5,000 7 Soy products 137 356 285 Cotton 209 a4 78 4 000 Manufactures 1,461 1,210 1,374 3 000 Total imports (cif) 1,986 2,499 2,515 2 000 Food 751 1,032 a77 Fueland energy 145 i a i 154 1000 Capital goods 404 491 418 0 01 Export price index (1995=100) 96 97 98 99 00 02 Import price index (1995=100) Exports Imports Terms of trade (1995=100) BALANCE of PAYMENTS 1982 I992 2001 2002 1 (US$ millions) Current account balanceto GDP (X) Exportsof goods and services 670 2,362 I,876 I,078 Imports of goods and services 1,209 2,453 2,495 2,159 Resource balance -539 -91 -619 -281 Net income 32 -26 175 95 Net current transfers 2 62 166 280 Current account balance -506 -57 -278 92 Financing items (net) 382 -303 327 -12 Changes in net reserves 124 360 -49 -a2 Memo: Reserves includinggold (US$ millions) 614 723 641 Conversion rate (DEC, local/US$I 136.0 1,500.0 4.105.9 5,715.9 EXTERNAL DEBT and RESOURCE FLOWS 1982 1992 2001 2002 (US$ millions) Composition of 2001 debt (US$ mill.) Total debt outstandingand disbursed 1,296 1,633 2,820 2,706 IBRD 147 213 205 216 IDA 47 39 27 25 Total debt service 142 626 266 218 IBRD 16 62 25 26 IDA 1 1 2 2 Composition of net resourceflows Official grants a 43 Official creditors 91 -a4 1 -7 Private creditors 152 -166 -29 -30 Foreigndirect investment 37 i i a 82 -a Portfolio equity 0 0 0 -30 E: 406 World Bank program Commitments 0 52 0 9 A IBRD E Bilateral Disbursements 44 10 27 14 B IDA -- D Other multilateral - F Private Principal repayments 6 43 15 17 C-IMF G Short-term --- Net flows 37 -33 12 -3 Interestpayments 10 21 11 11 Net transfers 27 -54 0 -14 DevelopmentEconomics 3/3/05 97