Document of The World Bank FOR OFFICIAL USE ONLY RePot No. P-5304-VE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US$300 MILLION TO THE REPUBLIC OF VENEZUELA FOR FINANCIAL SECTOR ADJUSTMENT MAY 21, 1990 Thi document bas a resticted dstribution and may be nsed by recipients only in the performance of their offkial dudtes. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit Bolivar (Bs) US$1 Bs 43 FISCAL YEAR January 1 - December 31 ABBREVIATIONS BANAP - National Savings and Loans Bank r4ANDAGRO - Agricultural Development Bank BCV - Central Bank of Venezuela BIS - Bank for International Settlements BIV - Venezuelan Industrial Bank CORPOINDUSTRIA - Small and Medium Industry Development Corporation DPI - Development Finance Institution FCA - Agricultural Credit Fund FDF - Fru4t Development Fund FICAM - Foreign Exchange Guarantee Fund FINEXPO - Export Finance Fund FINTEC - Industry and Technology Development Fund FIV - Venezuela Investment Fund FOGADE - Deposit Insurance Corporation FONCAFE - Coffee Fund FONCREI - Industrial Credit Fund FONDUR - Urban Development Fund IBRD - International Bank for Reconstruction and Development ICAP - Institute of Credit for Farming and Cattle IDB - Inter-American Development Bank IFC - International Finance Corporation IMF - International Monetary Fund IVSS - Social Security Institute LSP - Letter of Sectoral Policy MH - Ministry of Finance PDVSA - Venezuelan Petroleum Company S&Ls - Savings and Loans SBIF - Superintendency of Banks TA - Technical Assistance T-bill - Treasury Bill FO)R OMCIAL USE ONLY FINANCIAL SECTOR ADJUSTMENT LOAN TABLE OF CONTENTS Pate No. LOAN AND PROGRAM SUMMARY . . . . . . . . . . . . . . . . . . . . i PART I - THE ECONOMY . . . . . . . . . . . . . . . . . . . . . . . . . 1 Background . . . . . . . . . . . . . . . . 1 . . . . . . . . . . . . I The Initial Adjustment Program .... . . . . . 1 The Current Adjustment Program .... . . . . . 3 Status of Negotiations with Commercial Bank Creditors . . . . . . . 3 Medium-Term Macroeconomic and Policy Framework . . . . . . . . . . . 4 PART II - FINANCIAL SECTOR STRUCTURE AND SIZE . . . . . . . . . . . . . 7 Structure of the Financial System .... . . . . . . . . . . . . . 7 Monetary Aggregates and Financial Deepening . . . . . . . . . . . . 8 Monetary Policy: Instruments and Constraints . . . . . . . . . . . 9 PART III - AIN FINANCIAL SECTOR ISSUES . . . . . . . . . . . . . . . . 11 Excessive Government Intervention in the Determination of Interest Rates and Credit Allocation . . . . . . . . . . . . . . . 11 Excessive Public Sector Participation in the Financial System . . . 13 Distortions in the Financial System caused by BCV Operations . . . . 16 Weaknesses of the Institutional and Regulatory Structure . . . . . . 18 Weak Financial Condition of Financial Intermediaries . . . . . . . . 19 Commercial Banks .... . . . . . . . . . ...... . . . . . . 19 Mortgage Banks and S&Ls .... . . . . . . ...... . . . . . 21 Capital Markets .... . . . . . . . . . . ....... . . . . . 22 PART IV - THE PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN . . . . . . . . 23 Rationalization and Liberalization of Interest Rates and Credit Allocation ........................... . 24 Reduction of Public Sector Participation in the Financial System . . 27 Rationalization of the BCV's Credit Operations . . . . . . . . . . . 28 Reform of the Regulatory Framework and Improvements in Bank Supervision .... . . . . . . ...... . . . . . . . . . . . 31 Improving the Strength of Financial Intermediaries and Upgrading the Mechanisms for Dealing with Problem Banks . . . . . . . . . . . . 33 Enhancing the Competitive Environment for Financial Intermediaries . 35 Technical Assistance Component .... . . ...... . . . . . . . 36 This report was prepared by: Felipe Morris (Task Manager), Ignacio Mas, and Mark Dorfman (LATTF) based on the findings of an appraisal mission which visited Venezuela between March 4 and Marc;- 24, 1990. Ramon Rosales (Consultant), Jacqueline Saettone (LATTF), and Claudio Skarmeta (Consultant) also participated in the mission and contributed to the report. Part I and Annex I were drafted by Dan Morrow (LA3C1); and Part VI and Annex X were drafted by K. Uchimura (LA3C1). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. PART V - LOAN FA S . . . . . . . . . . . . . . . . . . . . . . . . 37 Loan Amount, Borrower and Implementing Agency . . . . . . . . . . . 7 Letter of Sectoral Policy .... . . . . ... . . . . . . . . . . 37 Loan Disbursement and Procurement . . . . . . . . . . . . . . . . . 37 Benefits and Risks .... . . . . . ...... . . . . . . . . . . 38 PART VI - COUNTRY ASSISTANCE STRATEGY AND BANK OP=EINS . . . . . . . 39 History of Bank Assistance .... . . . ...... . . . . . . . . 39 Bank Operational Strategy .... . . . . ... . . . . . . . . . . 40 Sectoral Composition of Bank Lending ............... . 40 IFC Operations .... . . . . . . ...... . . . . . . . . . . . 41 PART VII - COLLABORATION WITH THE I .I .. . . . . . . . . . . . .. . 42 PART VIII- RECOMKENDATION ..................... . 42 TMXT TABLES 1. Structure of the Financial System ... . . . . . . . . . . . . . 8 2. Real Interest Rates and Financial Depth, 1980-89 ... . . . . . 8 3. Comparison of Current Versus Proposed Interest Rates ... . . . 13 I. Key Macroeconomic Indicetors .... . . ..... . . . . . . . 43 II. Supplementary Loan Data Sheet . . . . . . . . . . . . . . . . . 48 III. Government's Letter of Sectoral Policy . . . . . . . . . . . . . 51 IV. Policy Matrix ........ ... .. ... .. ... .. . . 63 V. Technical Assistance Component ..... . . . . . . . . . . . . 73 Table 1: Summary of Technical Assistance Component Costs . . 78 VI. Changes in Prudential Regulations . . . . . . . . . . . . . . . 80 VII. Mechanisms for Handling Bank Crises . . . . . . . . . . . . . . 86 VIII. Institutional Strengthening of FOGADE . . . . . . . . . . . . . 89 IX. Program for the Elimination of Managed Portfolios at the BCV . . 94 X. Status of Bank Group Operations in Venezuela . . . . . . . . . . 99 IBRD #22154 VMNEUELA nNCIA SECTOR ADsTMWNT LOAN LOAN AND PROGRAM SUNMARY Borrower: Republic of Venezuela Amount: US$300 million equivalent Terms: 15 years, including 5 years of grace, at the standard variable interest rate Loan Objectives: The main objectives of the proposed Financial Sector Adjustment Loan are to: Mi) liberalize the financial policy environment (interest rates, allocation of credit, foreign ownership, universal banking, etc.); (ii) reduce the Government's direct role in financial intermediation (privatization and liquidation of public banks, consolidation of DFIs, rationalization of housing finance policy, limiting the BCV's role in the financial support of institutions to bank liquidity and monetary management needs); and (iii) strengthen the competitiveness and financial condition of intermediaries (adequate prudential regulations and supervision, capital standards, mechanisms for handling problem banks). Loan Descr1etion: The loan objectives would be achieved bys (i) completely liberalizing commercial bank interest rates except for agricultural lending; (ii) substantially reducing the interest rate subsidy and the portfolio requirement for commercial bank lending to agriculture; (iii) simplifying the plethora of rates offered by government-owned development finance institutions by establishing two preferential rat_s at levels substantially above current levels; (iv) partially liberalizing foreign ownership of financial institutions; (v) privatizing 3 commercial banks owned by the BCV; (vi) liquidating the Agricultural Development Bank (BANDAGRO; 3? of assets of commercial banking system) and restructuring the Industrial Bank (BIV; the largest public commercial bank, with 112 of assets of commercial banking system) and its 4 regional banks; Cvii) streamlining the DFI subsector with the consolidation of at least 5 funds into two new second- tier credit institutions; (viii) revamping prudential regulations, supervision, and the mechanisms for dealing with problem banks; (ix) promoting the transparency of banksI financial statements as a mechanism for forcing the recapitalization of weak institutions; and (x) reorienting BCV credit towards liquidity support of solvent institutions and promoting the use by the BCV of T-bills for open market operations. Benefits: The proposed operation would increase the overall efficiency of the financial system and thus enhance its ability to finance investment and growth. This would result from increased resource - ii - mobilization, improved credit allocation, and a lower cost of credit. The proposed reforms will contribute to these goals by: (i) enhancing competition in the financial sector with the liberalization of interest rates, credit allocation, and the participation of foreign banks; (ii) enhancing the transparency of the condition of intermediaries and depositor confidence in the intermediaries through improved prudential regulation and supervision of banks; (iii) reducing inefficiencies created by the excessive Government participation in the banking system; and (iv) providing adequate mechanisms for dealing with banking distress. Risks: Given the complex nature and political implications of many of the proposed reforms, there is a risk of some delays in the implementation of the reform program. However, the momentum created by the macroeconomic reforms successfully carried out to date, coupled with the recognition within the administration, the Congress, and financial markets of the need for the reform, will help sustain the process. A special coordinating unit has been created within the BCV which, among other functions, will garner support for the reforms. In order to reduce potential volitical opposition to the reforms, high-ranking Government officials have been holding discussions with key members of Congress to ensure support for the proposed legal changes. A further risk, although slight in the case of Venezuela, is that failure to maintain macroeconomic stability could endanger the success oi financial sector reform measures. To reduce this risk, loan conditionality will stipulate that for each tranche release the Bank shall be satisfied that the macroeconomic framework is consistent with the financial sector reform objectives. Estimated Disbursements: Disbursement of the entire loan is expected to be completed ithin three years of loan effectiveness. Loan proceeds will be disbursed under the following categories: (i) financing of debt reduction (25S of the proceeds or US$75 million), tii) three tranches for import financing (first tranche US$71 mill. %n, second tranche US$71 million, and third tranche US$76 million), and (iii) Technical Assistance component (US$7 million). Funds for debt-reduction would be available upon loan effectiveness and agreement betweer. the Bank and the Government on a debt- reduction program satisfactory to the Bank. After February, 28, 1991 unused funds for debt-reduction can be reallocated in equal portions to the three import financing tranches. Each tranche for import financing will be disbursed upon fulfillment ot specific conditions. The first tranche is expected to be disbursed soon after loan effectiveness. The second Pnd third tranches are expected to be disbursed after successive six- month intervals. Retroactive financing in the amount of US$60 million would be available for eligible expenditures incurred after March 31, 1990. Funds for technical assistance are expected to be disbursed within three years. REPORT AND RECOMMENDATION OF TEE PRESIDENT OF TEE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF VENEZUELA FOR FINANCIAL SECTOR ADJUSTMENT 1. I submit the following report and recommendation on a proposed loan to Venezaela for US$300 million equivalent on standard IBRD terms in support of a program of Financial Sector Adjustment. PART I - THE ECONOMY Background 2. In the period since the first oil price shock in 1973, Venezuela has failed to realize the potential for economic development offered by its petroleum and other natural resources. The reasons for this disappointing performance have been fourfold. First, Venezuela lacked a coherent and viable long-term development app-'ach and strategy. Instead, there was a steady increase in the extent and complexity of direct economic controls by ;he state. This led to inLreasing structural rigidities and an inability to generate sufficient growth in productive capacity to sustain the growing population. Venezuela's non-oil productive sectors grew up behind high barriers of protective tariffs and restrictions, which left them ill-equipped to compete externally or to utilize resources efficiently. Venezuela's economy was governed by a highly complex and intertwined set of regulations and subsidies, which affected virtually all modern sector activities and introduced innumerable distortions. Second, as a consequence of those policies, Venezuela has remained dependent on petrolpum, which provided 95Z of its export earnings before the 1986 collapse in price, and still accounts for over 702 of earnings. Third, Venezuela failed to addr' the problems of poverty adequately and develop effective policies and serv a in the social sectors. Finally, Venezuela's public institutions and - blic administration remained weak and could not provide the basis nee'4d for modernization of government operations, in support of a sustainable mediua-term development strategy. 3. Wher the newly-elected Administration of President Perez took office on February 2, 1989, the economic situation was untenable: operating reserves were depleted, imports were accelerating in expectation of devaluation, and the Central Bank had built up arrears to Venezuelan nationals, as it stopped providing foreign exchange at the overvalued official rate. Furthermore, there were shortages of price-controlled staples, such as bread, coffee, sugar, and rice. The new Government almost immediately initiated a sweeping program of reforms, not only to correct the immediate imbalances and distortions, but also to redefine the role of the state in the economy, increase the role of market forces in the allocation of resources, and create an open, competitive economic environment, which would stimulate the efficient growth of the non-oil productive sectors. To address the problem of persistent poverty, the Government moved to convert indirect subsidies into targeted social programs. The Initial Adjustment Program 4. The basic components of the initial adjustment program included: replacing the multiple exchange rate system by a unified market-determined - 2 - exchange rate system (under which the bolivar immediately depreciated to about Bs 36 per US$1.00, compared to th. previous official rate of Bs 14 per US$1.00); rationalizing and liberalizing the trade regime, by reducing the coverage of quantitative restrictions, setting a maximum tariff -ate of 802, and eliminating exonerations of tariffs; allowing most interest rates to be determined by market forces, which led to a substantial increase in deposit and most lending rates; increasing the prices for petroleum products in the domestic market and for most public utilities; dismantling most of the domestic price control system; and curtailing fiscal expenditures. 5. From the beginning of the adjustment program, it was recognized that its success in restoring growth on a sustainable basis would require adequate external financing to permit increases in imports, investments, and international reserves during the period of adjustment toward a more competitive export sector and efficient import substitution, as well as toward higher domestic savings. As a first step, the Government sought the support of the international financial institutions. Based on the strength of the adjustment program, the IMP responded with approval in March 1989 of a First Credit Tranche purchase of SDR 343 million and approval in June 1989 of a three-year Extended Fund Facility of SDR 3.7 billion (about US$4.8 billion equivalent). Likewise, the World Bank approved in June 1989 a Structural Adjustment Loan of US$402 million and a Trade Policy Loan of US$353 million. 6. The economic program initiated in February 1989 has succeeded iin correcting major internal and external imbalances in less than a year. On the internal side, the overall deficit of the consolidated, non-financial public sector has declined from 8.32 of GDP in 1988 to an estimated 1.42 of GDP in 1989. Performance on the external side was also strong: the current account balance shifted from a deficit of 7.5Z of GDP in 1988 to an estimated surplus of 4.62 of GDP in 1989. This surplus was the result of a 201 increase in oil export earnings, due to strong oil prices, a surge of over 302 in non-oil exports, and a 372 decline in imports, the latter due to both the devaluation of the bolivar and a sharp decline in non-oil GDP of 9.32. This current account outcome, helped by significant capital repatriation in recent months, made it possible to begin to rebuild international reserves from the dangerously low level of end-1988. These significant improvements in both public finances and the balance of paymrnts, together with a tight monetary policy, have led to a rapid stabilization of inflation and exchange rates. Domestic inflation initially accelerated from a 1988 annual rate of 242 to an annual rate of 1502 during the first half of 1989, due to the devaluation and increases in Government- controlled prices. However, the annual inflation rate in the second half of 1989 fell to only 322, and is expected to fall below 302 during 1990. In a similar pattern, the bolivar continued to depreciate slightly following the sharp devaluation in March 1989, from about Bs 36 per US$1.00 to about Bs 43 per US$1.00 in October 1989. But, since that time, it has remained stable, in the ran-e of Bs 42 to Bs 46 per US$1.00. 7. The short-run cost of correcting these imbalances has been high. In 1989, total GDP declined by 8.12, and non-oil GDP, by 9.32. Thi' sharper- than-expected decline reflected: (a) overshooting the fiscal target of a 42 deficit, due in part to delays in recognizing exchange losses on letters of credit from the earlier multiple exchange rate system and in legislative approval of the investment program; (b) a sharp reduction in inventories, which had been built up in 1988 in anticipation of devaluation and decontrol of prices; and (c) - 3 - the sluggish response of private sector investment to the new policy environment. However, provided that the external financing constraint can be alleviated, it is expected that growth can reoume in 1990 givens increasing private sector confidence in a more stable economic environment; an end to inventory reductions, as stocks reach normal levels; an increase in public sector investment, consistent with a fiscal deficit target of lee than 22 of GDP; and increased utilization of idle capacity, which will require more imports of intermediate goods. But it should be recogaized that, given the severity of the 1289 recession, even healthy growth in 1990 would not restore output to the 1988 levels. The Current Adjustment Program 8. The Government has continued to adequately fulfill the macroeconomic performance targets established under the EFF, and on May 14, 1990, the IMF approved the purchase under the EFF associated with the December 1989 performance criteria. Also, in recent months, the Government has taken further steps in the reform program initiated in early 1989. In March, the Government announced thAt, consistent with its schedule for trade reform over a two-year period, as agreed under the Trade Policy Loan, the maximum tariff rate was reduced from 802 to 50?, and the share of imports covered by non-tariff barriers was further reduced. These steps, together with recent measures to eliminate barriers to foreign investors, should over the medium term stimulate investment in competitive exports and efficient impo_. substitution. Having completed significant steps toward a macroeconomic policy environment which promises to achieve a sustainable growth path, the Government is now turning its attention to the sectoral, institutional, and legal reforms necessary to support the supply response to the macroeconomic adjustment program. Areas of priority are the programs of financial sector and public enterprise reform, both to be supported by Bank loans. A third critical area in which the Government plans to begin a reform effort is agricultural trade, pricing and regulatory policy. Status of Negotiations with Commercial Bank Creditors 9. As noted above, restoration of growth in 1990 and beyond will also depend on sufficient external financing. For this purpose, Venezuela had been negotiating with its commercial bank creditors on an agreement to reduce the burden of the existing debt overhang. After prolonged negotiations, on March 20, 1990, the Government and members of its Bank Advisory Committee announced agreement in principle on the basic terms of options to be offered to the banks holding about US$20 billion of Venezuela's external debt. The options to be offered to the creditor banks are: principal discount bonds and par bonds with below-market interest rates, which would have principal fully collateralized and interest payments partly collateralized; temporary interest reduction bonds, which would have partial collateralization of interest payments during the five years of below-market interest rates; cash buybacks at a fixed price, taking into account the secondary market price for existing debt; and debt conversion bonds, in proportion to purchases of new money bonds. Soon after achieving this agreement in principie, the Government cleared its arrears with the commercial banks. As soon as the term sheets for these options &re finalized, the creditor banks will be asked to indicate how much of their existing claims would be offered for buyback or exchange under these options. Once this final package is known, Venezuela would formally seek Bank and IMF support, as well as that of official bilateral sources, for this program of debt and debt service - 4 - reduction. The impact of this proposed program is discussed briefly in the following section. Medium-Term Macroeconomic and Policy Framework 10. The Government's medium-term strategy is designed to restore high rates of growth of output and employment in a context of low inflation and viable balance of payments. This growth would be achieved through a fundamental restructuring and diversification of the economy which would result from the implementation of deep-rooted structural reforms aimed at: (a) reducing the scope of the public sector in the economy through fiscal restraint, deregulation, and privatization of selected public enterprises; (b) enhancins the efficiency of resource use by liberalizing trade, allowing prices to move to economic levels, and redefining the relationship between the government and public enterprises; and (c) strengthening the financial sector and increasing its efficiency. The objective is to strengthen national savings, encourage private investment, and increase economic efficiency. 11. Venezuela's medium-term macroeconomic and policy framework, taking into account the possible impact of the proposed debt reduction program, is described by the projections presented in Annex I. These are the Bank's preliminary revisions of projections which had been agreed among the Government, the Bank, and the IMF in late 1989. These revised projections show a smaller financing gap (prior to debt reduction) than the projections of late 1989 due not only to the assumption of slightly higher oil prices but also to the initial impact of the adjustment program in boosting non-oil exports and encouraging capital repatriation (which was apparently used to pay off overextended credit lines and thereby reduces projected interest payments). Discussions will begin soon between the IMF and the Government on targets for the 1990/91 program year under the EFF, and the outcome of these discussions, as well as any further changes in tne medium-term external outlook, may require updating of these projections. The scenario presented is consistent with annual GDP growth of about 5% during 1990-95, and is predicated on the path of roughly constant real oil prices now projected by the Bank. The scenario assumes the Government's continued commitment to the ongoing reform program. Also, the scenario assumes that the proposed program of debt and debt servic. reduction is successfully implemented, with virtually all of the eligible debt offered for buyback or exchange; this results in lower interest paymtents to the commercial banks on the order of US$700-800 million enually.Y Given this assumption, the proposed debt reduction program closes the financing gap which would otherwise arise. Finally, the scenario already takes into account the proposed Bank lending, including the two adjustment loans in FY90 and including the possible Bank support for the debt reduction program which is necessary to achieve this scenario. 12. The most notable features of this scenario, over the next five years, are as follows: (a) Gross fixed investment would need to grow from about 20% of GDP in 1990 to about 25% by 1995, with an increasing share of private sector J/ The scenario arbitrarily assumes a particular allocation of existing debt among options; the results would not change significantly for other allocations. investment; gross n.tional savings also would need to grow to about 262 of GDP by 1995s (b) Per capita private consumption would grow at an annual average rate of 1.32 over 1990-95; (c) The consolidated public sector moves to a fiscal surplus, reflecting rising domestic revenues from the petroleum sector and declining external interest payments as a share of GDP. If this were to occur, the already small stock of public domestic debt would be progressively reduced, and the public sector would be a net lender to the private sector; (d) Non-oil exports would grow at a rate of 10-202 per annum in nominal dollar terms (compared to over 302 growth in 1989); nevertheless, the share of petroleum sector exports would remain high because non- oil exports are starting from a small base; (e) The current account as traditionally defined by the Central Bank would be almost balanced. with deficits of less than 12 of GDP in most years before 1995. However, deducting the imputed private interest income on assets held abroad which is counted in these figures, the deficit would be on the order of 2S of GDP. This favorable current account position reflects the impact of the assumed debt reduction plan, without which the current account deficit would increase by about 1.32 of GDP; (f) Gross international reserves, including gold at US$300 per ounce, would be rebuilt to the level of 7-8 months of imports, which is prudent given the country's dependence on volatile oil revenues and the Government's intention to maintain a floating exchange rate regime and an open capital account. Such reserve accumulation, given the projected increasing oil prices, would provide an essential cushion against temporary oil price declines. Such a level of reserves is essential to provide confidence to foreign exchange and domestic financial markets and thereby to sustain the recovery of investment. Based on fluctuations in the price of oil during the 1980s, one standard deviation reduction in the projected price of oil in the 1990-94 period is equivalent to US$4.6 per barrel. Such a reduction in a single year would reduce Venezuela's export earnings by almost US$3 billion in that year, equal to one third of the average level of liquid reserves projected for the 1990-94 period. (g) 1LT capital inflows would be 3-52 of GDP in 1990-93; this would finance the current account deficit, the buyback and collateralization of some part of the commercial bank debt under the proposed debt reduction program (which will cost US$3-4 billion), and the essential build-up of international reserves. By 1994, as the trade surplus grows toward 32 of GDP, MLT capital inflows would begin to fall toward 22; and (h) Venezuela's external debt ratios, following the debt reduction program, would fall significantly to levels consistent with sustainable growth: tEe debt service to export ratio would decline from almost 40% in 1988 to about 20% in 1991 and beyond. 13. In implementing this macroeconomic framework, particular attention must be given to the following. First, there must be a policy environment conducive to the growth of private investmert, which would generate increased demand for credit from the banking system and require expanded imports of capital and intermediate goods. An important thrust of the Government's program of deregulation and liberalization has been to create such an environment. Defining in a more limited way the role of public Qnterprises, privatizing selected public enterprises, and ensuring efficient provision of essential services (such as ports and telecommunications) by the relevant public enterprises are also essential and would be supported by the public enterprise reform loan. Second, there must be an efficient and sound financial system to effectively channel the investment of both private and public savings. Creation of such a financial system is the objective of the financial sector reform program. Third, to ensure that public sector resources are not wasted on uneconomic investments by the public enterprises, a new and sound relationship must be established between the Government and the public enterprises. A framework must be created, in which the investment decisions of those enterprises (other than natural monopolies) are subject to market discipline and the natural monopolies are guided by appropriate regulations. This is the thrust of the public enterprise adjustment program. Fourth, to ensure that the expansion of net credit to the private sector does not simply lead to capital flight, the Central Bank must maintain sufficiently attractive real interest rates on domestic assets and avoid overvaluation of the exchange rate. And, fiWth, careful attention must be given to the management of international reserves to ensure that, during periods in which the price of oil is at or above its expected trend levels, reserves are accumulated to provide a cushion against future price declines. Achieving all of these objectives will require careful and continuous monitoring. For this, the existence of the IHF's EFF program will make an important contribution in the near-term. Under the proposed operation, maintenance of a macroeconomic fXamework consistent with the objectives of the a'.ustment program is a condition of effectiveness and second and third tranche release. 14. In addition to the crucial contribution made by the international financial institutions (IFIs) to the development of the policy framework described above, the IFIs have an important role to play in the financing required for returning Venezuela to a sustainable growth path. The relative role of the IFIs must be viewed in the context of the proposed debt and debt service reduction program now under negotiation. Under the proposed program, the major contribution of the commercial banks would be to relinquish claims equal in present value terms to 25-30% of the face value of their existing claims. (There is an option under the program for the banks to contribute new money, but the uaximui amount of new money (net of rights for debt-equity swaps at par) is US$700 million.) During 1990-95, the program would reduce by about US$600 million annually the net financing required by the growth path in the scenario presented in Annex 3. Given this assumed level of debt and debt service reduction, the remaining annual average .f net disbursements during 1990-92 would be about US$3.8 billion and during 1993-95 only about US$1.2 billion. During 1990-92, the World Bank would contribute about 22% and the IMF about 38% of these net disbursements; these figures include estimates of additional lending to support the debt and debt service reduction program. These net disbursements would not only support the policy reform programs to which they are directed but -7- also make possible the imp;ementation of the debt reduction program and the continued build-up of Intornatiohal reserves to prudent levels. Over 1990-95, the Bank (based on the current lending program) would contribute about 242 and the Fund, 182. Given the fact that the Bank had no exposure to Venezuela in 1989, the planned increases in net disbursements by the Bank would not be excessives although the Bank's share of the reduced debt stock would rise to about 121 in 1998, projected debt service to the Bank in that year would be only 2.2Z of total ezports. PART U - INANCIAL SECTOR STRUCTURE AND SIZE Structure of the Financial System 15. The Venezuelan financial system is conceptually based on a system of specialized bankcing 'hereby different types of institutions have different functions. Commicia'l'banks wevet r)nceived to borrow and Lend short-term for working capital aiid oth - - hort-term needs. Finance companies were to lend for fixed assets and CoLqfmer goods as well as support the development of commercial companies. Mortgage banks were to borrow using long term instruments and lend for construction, home improvement and expansion, and home and commercial property purchases. Savings and loans (S&Ls) were to also borrow long term and lend for consumer purChases of homes. In practice, there is a de facto universal banking system since financial inatitutions have formed financial groups whereby a group offers clienet a full array of financia' services and diversification options. 16. Table 1 depicts the structure of the financial system as of end- 1989. Presently, there are 41 commercial banks, 16 mortgage banks, 29 finance companies, and 20 S&Ls. There ate also 31 leasing companies, 3 pension funds around 27 liquid asset funds; brokerage houses, and foreign exchange offices.2 As the table shows, commercial banks are the most important banking institutions, accounting for 73S of assets of the financial system. From 1987 through 1989, commercial banks and finance companies increased their share of assets, funds attracted and credits, while rortgage banks and S&Ls decreased theirs. 17. The 9ystem's six largest commercial banks account for 57Z of the total assets of the system and 6S3 of total bank deposits. These commercial banks are part of the six largest finaucial groups which are dominant in the financial sector. This concentration tas increased during the past two years. Below this group are 15 mediua-sized commercial banks which hold between 1* and 4.91 of deposits each (29Z of the total), and 20 small banks which hold less than 12 of deposits each (SZ of the total), with less than 11 of deposits. 21 These latter institutions are not included in the percentages indicated in this section. Table 1: STRUCTURE OF THE FINANCIAL SYSTEM (Billions of Bolivares, as of 12131/89) No. of insti- Assets DeRosits Eauity Lever, tutions Total X TTotal ZI? ageA' Commercial banks: 41 549.3 73 385.8 71 31.7 78 16.3 Private national 31 454.4 61 355.4 66 26.4 65 16.2 Private foreign 2 4.8 1 2.3 0 0.5 1 8.3 Public 8 90.0 12 28.0 5 4.7 12 17.8 Mortgage banks 16 69.9 9 58.9 11 3.2 8 20.5 Finance companies 29 84.4 11 64.3 12 5.9 14 13.2 Savings and loans 20 45.2 6 32.6 6 - - - System total 106 748.8 100 541.6 100 40.8 100 17.4 Source: BCV. a/ Total debt/total equity. Monetary Aggregates and Financial Deepening 18. Over the last ten years, the stock of money broadly defined (M3, which includes currency, demand, saving and time deposits, as well as mortgage bonds) has fluctuated widely (see Table 2). M3 rose over the early 1980s, reaching a peak of almost 42? of GDP in 1984. It has since declined steadily, to 271 of GDP in 1989, the lowest figure in the decade. The drop in monetization coincided with the period of negative real interest rates. In 1987 and 1988, interest rates were negative in real terms by about 10 percentage points. The shift to market-determined interest rates should facilitate a remonetization of the economy in the near future. Table 2: REAL INTEREST RATES AND FINANCIAL DEPTH, 1980-89 k Bl o ¶ iterest rata/ Zatios Rea GDP (;)b/ Real mony indicesc/ Lendig Deposit ml1 3 l m M3 1980 -7.0 -5.4 15.C 31.4 35.4 108.0 87.1 94.0 1981 -1.8 -0.4 14.4 33.1 35.8 104.2 94.4 98.0 1982 5.2 7.5 13.3 34.7 36.4 89.1 91.1 93.2 1983 7.6 10.7 15.0 39.5 40.8 108.8 107.3 107.7 1984 1.0 3.2 15.1 40.6 41.5 100.0 100.0 100.0 1985 0.0 3.2 15.0 39.4 40.1 103.1 99.7 99.3 1986 -1.6 2.1 15.k 37.5 38.0 112.3 103.1 102.2 1987 -14.4 -11.2 14.4 34.1 34.1 107.3 97.2 91.0 1988 -11.8 -8.5 13.4 29.8 29.8 97.3 78.0 77.8 1989 3.0 0.0 10.5 27.0 27.0 56.9 58.9 58.9 Source: The BCV. al Yearly averages deflated by consumer price increase (CPI) over the year; for 1989, end-of-year interest rate is deflated by the increase in consumer prices in the second semester only. b/ Average money stock over the year. c/ Stocks at the end of the year, deflated by CPI, index 1984 - 100, 19. The decline in M3 as a proportion of GDP was accompanied by important changes in the composition of monetary aggregates. Given the extremely low interest rates, the public sought liquidity. From the peak monetization in 1984 to 1988, sight deposits increased from around 292 of M3 to around 38?. This process was reversed in 1989 due to the rise in interest rates. Between February and December 1989, time depos't; rose sharply, surpassing their share in M3 in 1984, prior to the disintermediation period. The opportunity cost of holding non-interest bearing demand deposits rose considerably, and hence the public shifted into fixed term remunerated accounts. 20. Traditionally, the most important source of M3 has been regular deposits. However, liquid asset funds have become one of the most important single sources of funds in recent years. Liquid asset funds are a mechanism to sell fractions of a trust fund, with an obligation to repurchase such fractions at a premium corresponding to interest accrued during the period. Liquid asset funds require a higher minimum investment than ordinary accounts, and their yield to investors depends on the holding period. They are not a true 'investment fund' as they are generally conceived, but are simply a secondary funding mechanism for financial institutions. Commercial banks, mortgage banks, and other financial institutions created liquid asset funds to offer investors higher returns than on other deposit accounts whose interest was fixed by the BCV at negative real rates. Further, liquid asset funds are not subject to reserve requirements. 21. Liquid asset funds represented 16.5? of M3 in December 1986, and reached a peak of 30? by December 1988. Although no reliable figures exist on the volume of these funds, their share of M3 does not seem to have declined in 1989 despite the upward adjustment in interest rates. Given that liquid asset funds were created as a way of circumventing interest rate ceilings in the first place, a financial reform oriented to achieve market-determined interest rates can be expected to be accompanied by stronger substitution of deposits away from liquid asset funds in the future. Monetary Policy: Instruments and Constraints 22. The BCV in the past played a pervasive role in the financing of activities in most sectors in the economy. In particular, the BCV expanded credit by: (i) financing government deficits through the purchase of domestic public debt; (ii) subsidizing public and private enterprises through foreign exchange guarantees at heavily over-valued rates; (iii) providing liquidity to the banking system through a liberal rediscount program, and (iv) supporting special sectoral incentive programs and channelling them through the financial system. 23. Monetary policy was subordinated to the achievement of these objectives, and was made even more precari3us by the virtual absence of flexible instruments of monetary control. The result was that the BCV only had a loose grip over money supply and very little reliance was placed on monetary regulation through the price mechanism. Moreover, some of these activities (like the complex array of sectoral incentive programs) were premised on, and operated through, the application of interest rates well below their market-clearing levels. Reserve requirements failed to have a disciplinary effect on money supply as these requirements were frequently transgressed and their highly differential nature meant that money supply was vulnerable to portfolio shifts - 10 - across different types of deposits and institutions. Mbonetary control was exercised in a rudimentary fashion by ad-hoc policies restricting BCV credit to banks or inducing additional bank deposits at the BCV's .oney desk. However, the flexibility of the BCV's money desk facility as an 1nstrument of monetary contraction had been lost due to the fact that the rate paid was only infrequently adjusted according to the monetary objectives of the BCV. Aside from the relaxation of monetary control, the direct nature of these instruments had other lasting side-effectst (i) it increased the BCV's responsibility for the losses of financial institutions; (iU) it made monetary policy more vulnerable to political pressures; and (iii) it resulted in the bureaucratization of monetary policy-making. Z4. The new economic policies pursued after February 1989 sought to stem the first two categories of credit expansion listed above (para 22) through the reduction of public sector deficits and the unification of the exchange rate. Domestic financing of the budget deficit is estimated to have decreased by 4.7? in 1989. and the budget is expected to move into surplus by 1991. At the same time, the BCV has scrapped all exchange guarantee programs, and the flotation of the exchange rate has reduced the BCV's responsibility f9r losses arising from discrete devaluations. The third source>qf domestic credit expansion, the provision of liquidity to the banking system, has been curtailed significantly since November 1989, with only one bank receiving any BCV credit as of February 1990. From October 1989 to February 1990, rediscounts tadt been cut by 70X. Finally, as regards the BCV's financing of special incentivs programs through the financial system, the actions so far have been mixed and tn some cases have even been regressive. At present, the only sectors that receive preferential treatment by the banking system are agriculture and housing.. However, a network of specialized financial institutions and development funds continues to fragment credit markets. 25. The BCV's efforts at monetary control wil:l be constrained in the future by three sources of monetary expansions (i) the lingering impact of the previous fiscal and exchange rate management practices, as old public long-term debt continues to compromipe the BCV's earnings capacity in the future and prior foreign exchange commitments are satisfied; (ii) liquidity' credits to a few financial institutions that can only be phased out as mechanisms for addressing the problems in ailing institutions are developed and other sources of liquidity emerge; and (iii) the expansion of the external debt/equity swap program under a new auction mechanism. Monetary policy must play a key role in ensuring that these factors or constraints are consistent with,'the broader objectives of sustainable growth, and price stability. 26. The BCV is currently in the process of reevaluating its monetary instruments with a view to enhancing their flexibility and effectiveness while minimizing their disruptive effect on banking. The BCV is aware of the need to move toward a system of open market operations and gradually to phase out its money desk and general or sectoral rediscount operations. To this effect, the BCV has issued short-term paper, is promoting the creatiQn of a secondary market in DCV bills, and is developing an open market capability. The EJV is also in the process of revamping the reserve requirement regie with a unification of all requirements at 12Z. - 11 - PART III - MAIN FINANCIAL SECTOR ISSUES 27. The main issues affecting the financial system are: (a) excessive government regulation of interest rates and credit allocation in the economy; (b) the large number of government-owned financial intermediaries (banks and development funds), many of which are either bankrupt or poorly managed; (c) the insufficient transparency in the BCV's operations with the public sector and the financial system, which makes the evaluation and prioritization of credit policies difficult and undermines the abii4ty of the BCV to carry out monetary policy effectively; (d) a weak institutional and regulatory environment, and inadequate supervision of financial institutions by the Superintendency of Banks (SBIF); and (e) the weak financial condition of an important number of private financial institutions and inadequate mechanisms to deal with ailing banks. Excessive Government Intervention in the Determination of Interest Rates and Credit Allocation 28. Commercial Bank Interest Rates. The liberalization of interest rates was one of the first measures adopted by the new Government in 1989. Complete deregulation was achieved by March 1989, but was subsequently rendered void by a Supreme Court ruling that required the BCV to set interest rate limits. Since then, the BCV has been adjusting interest rate limits. Despite the stated objective of the BCV to adjust interest rate ceilings so as to replicate the market rate, interest rates have remained mostly negative in real terms and adjustments in the ceilings have not reflected a consistent adjustment policy. For instance, after raising the maximum lending rate to 452 in November 1989, the BCV subsequently reduced it in three steps to 35Z by end-March 1990. This experience has shown that a system of flexible ceilings cannot replicate full market determination of interest rates for three reasons: (i) interest rate ceilings are likely to be set in a backward-looking fashion whereas market rates are determined to a greater extent in a forward-looking fashion, (ii) the existence of interest rate regulations increases the vulnerability of the BCV to political and social pressures; and (iii) each adjustment in the ceiling is interpreted by the banks and the public as a signal on monetary objectives, thereby affecting the market's expectations. 29. The liberalization of interest rates will have a small impact on the %.vernment's fiscal accounts from the increased public debt service burden. The volume of public and publicly guaranteed internal debt amounted to Bs 101.5 billion (US$2.36 billion equivalent) as of end-1989. Of this amount, about 71? was issued prior to April 1989 at a fixed inte rest rate in the 8-15Z range. The remaining 292 was issued at a variable rate3y based on the average commercial bank deposit rate, and is currently yielding around 30S. Thus, the annual debt service cost of a 10 pexzentage point rise in interest rates would be US$68 million. Furthermore, 692 of the total volume of public debt is held by public entities including the BCV and the portfolios managed in trust by the BCV. Hence, a significant portion of this increase in the Treasury's debt service would result in a quasi-fiscal gain of US$47 million for these entities. The fiscal cost of a 10 percentage point rise in interest rates would therefore 3I For the purposes of this calculation, it is assumed that the outstanding volume of zero-interest T-bills has been converted to variable rate debt according to the exercise presented in para 48. - 12 - be US$21 million on a consolidated basis. This calculation illustrates that the net fiscal effect of the liberalization would in any case be manageable. Also, given the new policy of fiscal restraint, it can be assumed that the Government's internal borrowing requirement will be near zero and hence it will not need to float much additional debt at the higher interest rates. 30. Since interest rates will become the focal point of competition, credit allocation and financial discipline, it is imperative that the public be aware of and understand the range of services and rates available. The non- competitive nature of the sector in the past has led to a lack of uniformity in interest rate calculation methods and insufficient information disclosure. Users of financial services need to be made more discriminating, so that they can exert the market discipline that will be expected of them in the new envirorment. 31. Preferential Interest Rates. The agricultural sector is the beneficiary of a rediscount and a lending rate ceiling 7 percentage points below those for other sectors. In addition, there is a plethora of interest rates applied by each development fund. In December 1989 when interest rates peaked, nominal lending rates fluctuated between the general adjustable lending rate ceiling of 45% and the 3% fixed rate for peasants under the agrarian reform law. In between there is a wide gamut of rates which, in April 1990, stood at about 15% for subsidized housing, 14% for certain agricultural products, 22-29% for certain industries, and 28% for other agricultural loans. Furthermore, several government-owned financial institutions (funds) segment the market even further by charging different rates based on the activity or sector being financed. The Venezuela Investment Fund (FIV), which acts as second-tier lender to several funds, also charges differential interest rates to the various funds, not based on clear criteria. The first column in Table 3 illustrates the spread in interest rates for a range of development funds. 32. The prerogative to set interest rates is decentralized in each fund, and indeed each fund has its own policy regarding interest rates. Therefore, the adjustment of rates does not occur in a consistent fashion, and an economy- wide adjustment of rates becomes very burdensome administratively and politically. This represents an erosion of the BCV's ability to regulate credit and a loss of discipline for the public sector generally. 33. Agricultural Credit Reauirement for Commercial Banks. Restrictions on the allocation of credit according destination of the funds segment markets and therefore preclude the full market determination of interest rates. Portfolio requirements fragment the credit market, and by themselves result in a proliferation of interest rates. Commercial banks are subject to a 22.5% lending portfolio requirement for agriculture and agroindustry. Agricultural credits are in some cases made at interest rates well below the maximum lending rate applicable to agriculture, which implies that the requirement imposes a binding restriction on banks' activities. Also, there is evidence that some of the credits that purportedly satisfy the requirement are being channeled to other uses. - 13 - Table 3: COMPARISON OF CURRENT VERSUS PROPOSED INTEREST RATES (in percent, as of April 15, 1990) Lending rate floors/geilings Current ProposedY Commercial banks: Commercial lending 35 35 Agricultural lending 28 30 Fondo de Inversiones de Venezuela (FIV): Direct investment loans 18 32 Tourism projects 17-22 32 Loans to public enterprises 28 32 Loans to FONCREI 22 30 Loans to CORPOINDUSTRIA 17 30 Loans to Agricultural Credit Fund 17 30 Fondo de Cr4dito Agropecuario (FCA) 14 30 Fondo de Cr6dito Industrial (FONCREI) 22-29 32 Fondo Financiamiento Exportaciones (FINEXPO) 25 32 Fondo de Desarrollo Urbano (FONDUR) Tourism projects 12 32 Purchase of real estate 12 32 Mortgages 15 32 A/ On development loans to end-users, 85% and 90% of average commercial bank lending rate for agriculture and other sectors, respectively. On second- tier lending, average borrowing rate of commercial banks. It is assumed that commercial bank interest rates continue at current levels--i.e., 35% average lending rate and 28% average deposit rate. Excessive Public Sector articipation in the Financial System 34. Bblic Sector Commercial Banks. The public sector currently owns nine commercial banks in Venezuela. The Central Government owns six (the Industrial Bank of Venezuela [BIV), the Agricultural Development Bank [BANDAGRO], and four regional banks), and the BCV owns three (Banco Repliblica, Banco Italo- Venezolano and Banco Occidental de Descuento). All of these banks have poor asset quality, although the extent of the problem varies from bank to bank. The Government has already agreed to privatize the three banks owned by the BCV, and has named FIV as the agent for privatization. 35. BANDAGRO is one of several financial intermediaries which the State has established to assist the agricultural sector. Since its inception, BANDAGRO, a public sector commercial bank, has had difficulties attracting deposits and has increasingly depended on the Government for support. In fact, - 14 - it has been under intervention since 1981. Several covmissions have been established to restructure the bank, yet none has been successful. Among the findings of an 'intervention committee' in February 1989 weres (i) BANDAGRO's net losses exceed its capital (its bad loan portfolio equalled 612 of total loans at the end of August 1989)s tii) it has US$500 million in foreign currency debt obligations (against US$200 million in total book assets4l); (iii) it is unable to act as the financial arm of the agricultural sector; (iv) during the last few years, the bank's new loans have been limited to short-term financing for cereal production; (v) it has a serious credit documentation problem that has prevented it from obtaining payment on many loans; (vi) it sustains net losses each year, including in 1989; (vi) it lacks a computer system, operating procedures and administrative guidelines, which has led to interest accrual mistakes and other accounting difficulties; and (vii) it is heavily influenced by government agencies and unions which limit its ability to make objective financial decisions. In the committee's view, the institution should be either restructured or liquidated. 36. BIV I.s Venezuela's oldest state-owned commercial bank, and was created to support the industrial sector although in practice it became the bank of the public sector. BIV is very heavily dependent on government funding, with the consequent prevalence of political interference which has impeded it from making its own decisions and attaining its objectives. It is technically insolvent, and confronts serious liquidity, administrative and economic problems: (i) its asset structure is heavily burdened with government paper and commitments which are not properly serviced; (ii) it is heavily dependent on volatile government deposits (482 of BIV's total); (iii) it acts largely as an executor of the Government's short-term financial decisions; (iv) the term structure of its assets and liabilities is heavily mismatched; (v) its loan portfolio is of poor quality with approximately one third of its credits past due at the end of August 1989; (vi) some of BIV's assets are overvalued or represent an activation of losses, while others are undervalued (such as holdings of dollar-denominated bonds which are recognized at Bs 4.3JUtS); (vii) off-balance sheet contingent accounts are very large to the extent that total net worth would be lost if only 7.3? of guarantees and other contingent obligations were called. 37. The four regional banks owned by BIV also have large volumes ot non- performing loans which exceeded their total net worth at the end of 1989 on a consolidated basis. More important, the role and functions of these institutions in BIV's strategy is not clear. 38. Need to Re-evaluate the Functions of Development Finance Institutions. There are 23 state-owned development finance institutions (DFIs)-- excluding commercial banks. While DFIs were created to provide long-term financing, several are used as conduits to implement political decisions through the channeling of funds to particular projects at below-market interest rates. In general, their loan portfolios are of poor quality, their funding comes primarily from the Government, and their management teams need to be improved. DFIs are mostly second-tier institutions operating outside the purview of the regulatory authorities and the BCV. They are controlled by the corresponding sectoral ministries (except for FIV, which has ministerial rank), and obtain their funding from direct transfers of the Government, loans from the FIV, or 41 As of September 30, 1989, valued at a rate of exchange of Bs 43/US$. - 15 - government-guaranteed external financing. The most important DFIs ares the FIV, the Industrial Credit Fund (FONCREI) which supports large and medium-sized private corporations; the Small and Medium Industry Development Corporation (CORPOINDUSTRIA) which finances small-scale private sector companies; the Export Finance Fund (FINEXPO); and the Agricultural Credit Fund (FCA). 39. FIV was established in 1974 to manage the windfall the country obtained from the oil price hike of the early 1970s. It has principally financed state enterprises including electricity generation. Among other functions, it acts as a development finance intermediary. In this role it has mostly acted as a second-tier lender to public commercial banks and development funds. Its current portfolio amounts to only US$65 million. It has in the past lent at very low interest rates (7.5-12? per annum). 40. FONCREI was also created in 1974 to provide medium- and long-terL. credit to industry. It is a second-tier institution which only lends through the commercial banking system yet retains up to 402 of the credit risk of the final borrower. Its main sources of funds are direct transfers from the Government and lines of credit from domestic (FIV) and foreign (Andean Development Corporation, IDB) sources. FONCREI's cost of funds is approximately 24? while the average return on its loan portfolio is 10?. A large part of its loans are at fixed rates, which is gradually decapitalizing FONCREI. 41. CORPOINDUSTRIA is a mostly first-tier lending institution created to finance small-scale industry. It has a few joint programs with the banking system. It lends at longer maturities and lower interest rates than PONCREI, with interest rates ranging from 6Z to 202 per annum. Its main sources of funds are government transfers (70Z) and lines of credit from FlV and foreign sources (30?). As in the case of PONCREI, it confronts a significant mismatch between the average interest rate in its loan portfolio and its cost of funds. In addition, its loan supervision is weak and its procedures for loan recovery are poor. 42. FCA was created in 1976 as a second-tier lending institution to provide medium- and long-term credit to the agricultural sector through commercial banks. FCA's computed cost of funds is 142. but this does not include the opportunity cost of the funds it receives from the Government or the exchange rate risk on a line of credit it obtained from the IDB, its major sources of funds at present. In spite of this measure, FCA is facing losses since the average return on its loan portfolio is below 7.5? per annum while it is charging its borrowers 14? per annum. 43. FINEXPO was created in 1973 to support the country's nontraditional exports. It provides pre- and post-export financing and technical assistance to exporters. FINEXPO's main sources of funds are direct transfers from the Government and BCV rediscounts. Its portfolio amounted to about US$57 million as of June 1989. Short-term credits are provided for pre-export financing to domestic producers. Post-export credits are provided to foreign importers of Venezuelan goods and have longer maturities. It also provides guarantees to third parties, an activity which has grown quite rapidly in the recent past. 44. The most important deficiency of DFIs is that their collective role is not clearly defined and their individual goals and functions overlap. The Government has not clearly determined which areas cannot be supported by private - 16 - financial intermediaries, yet warrant State assistance because of other economic justifications. Once the role of the public sector and individual DFIs has been determined, the appropriate structure of DFIs can be dasign3d to fit this role and clear performance criteria can be developed. Distortions in the Financial System caused by BCV Onerations 45. There are two challenges ahead for the BCVY (i) to make explicit its quasi-fiscal contribution to financing the national budget and the financial system, and (ii) to develop appropriate instruments of monetary control. These two objectives are interrelated to the extent that quasi-fiscal financing by the BCV limits the use of some instruments of monetarv control and places an onerous burden on the remaining instruments. 46. BCV Credit to the Public Sector. BCV financing of government deficits occurs through its holdings of unremunerated Treasury bills (T-bills), its purchases of low-interest long-term Treasury bonds at face (above market) value, and the BCV's holdings of converted government external debt purchased under the debt/equity swap program. BCV credit to the public sector is subject to an overall ceiling based on the average fiscal revenues in the preceding five years. However, this ceiling does not include external debt issued within the last three years, or the BCY's rights to government bonds earned through the external debt swap program. Therefore, credit ceilings have often been surpassed in practice, with a corresponding loosening of fiscal discipline and crowding out of credit to the private sector. 47. T-bills of maturity less than one year must be repaid by the Government within the same fiscal year in which they are issued. The spirit of providing only intra-year financing to the Government is often transgressed when the T-bills are converted into long-term bonds at the end of the fiscal year in order to finance their redemption. Moreover, the lack of fixed-term negotiable T-bills has precluded the use of these instruments in open market operations by the BCV. Instead, the BCV has had to issue its own short-term bills, at the risk of generating quasi-fiscal losses. T-bills must, by law, be placed through a preferential list of economic agents, implying that they need not carry market rates of interest. In practice, only the BCV and commercial banks hold them, the latter as assets satisfying reserve requirements. The use of T-bills as a reserve asset negates the monetary objective of the reserve requirement; the requirement becomes merely a vehicle for forced lending to the Government. 48. As of end-February 1990, the BCV held no T-bills and commercial banks held Bs 11.4 billion (US$265 million equivalent) in T-bills. On the one hand, if these T-bills were eliminated and assuming that the financing requirement of the Treasury remains constant, the Treasury would have to replace them with bonds (which yield a variable rate based on the average commercial banking deposit rate, currently standing at 30Z). The fiscal cost to the Government of paying interest on this amount would be US$80 million per year. On the other hand, T-bills are held by commercial banks In satisfaction of legal reserve requirements; if they were eliminated, this amount would be deposited in unremunerated accounts at the BCV. Thus, the Treasury's fiscal loss would be compensated by a quasi-fiscal gain for the BCV, and there would be no fiscal effect on a consolidated basis. - 17 - 49. Credit to the Financial Svstem. BCV rediscounting, advancing and repurchasing of securities in the hands of financial institutions has often been used to support specific sectors in the economy and bank solvency rather than to provide liquidity to banks or as an instrument of monetary regulation. The liberal rediscount policy has had deleterious effects in many respectss (i) it has had a large expansionary effect in monetary terms; (ii) it has subjected the BCV to political pressures and has implied a sharing of responsibility for bank distress with the monetary authority; (iii) it has inhibited the development of the interbank and secondary debt markets, which has in turn retarded the development of the BCV's open market capability as an instrument of monetary control; and (iv) in so far as it has been used as a covert means of keeping insolvent institutions afloat, it has permitted delays in the resolution of bank crises during which time losses have mounted. Access to the rediscount window had been made attractive by: (a) the heavily subsidized rediscount rate; (b) the relatively long maturity on the rediscounts permitted by law (up to one year): (c) the valuation of underlying instruments or guarantees at face (above market) value; and (d) the lack of penalties imposed on heavy and/or frequent borrowers. 50. The subsidy element of the rediscount window has been cut down significantly in recent months, as the non-preferential rediscount rate has been increased to about market lending levels. However, the persistence of a special rate for agricultural rediscounting still signals the possibility of using the rediscount window for sectoral development purposes. Nevertheless, the volume of rediscounts has been curtailed considerably to only Bs 4.5 billion in February 1990. Some portfolio purchase programs by the BCV remain. As of January 1990, the BCV held Bs 6.3 billion in agricultural credits purchased from commercial banks. Since the banks retain the credit risk on these loans, these programs constitute a less transparent alternative to rediscounting. 51. Credit for Housing Finance. The BCV has indirectly supported the provision of housing finance by financially supporting mortgage banks, S&Ls and BANAP. This support has taken the form of subsidized rediscounted credit as well as the purchase of low-yielding liabilities of these institutions. The BCV currently holds Bs 4.3 billion of the latter instruments. This has represented a quasi-fiscal drain on the BCV and has helped maintain afloat a number of institutions that would otherwise become insolvent. In addition to these indirect forms of support, a recently enacted housing law calls for the allocation of the BCV's profits for financing subsidies to mortgage borrowers. The earmarking of the BCV's profits is not allowed by the BCV's Law, which requires all its profits, after reserves, to be channelled directly to the Treasury. 52. The BCV's Role as Fideicomisario (Trustee). The BCV acts as trustee of several public entities, including the Social Security pension fund and the deposit insurance fund. In this role, it invests their portfolios in government securities and private instruments (mostly mortgage bonds), in most cases at below market rates. The outside portfolios currently being managed by the BCV are utilized as a conduit for financing budget deficits and as a backdoor mechanism for the BCV to acquire government securities at face value. The result is that these funds are being decapitalized. Annex IX presents an estimate of the hidden transfer which amounts to about US$300 million in stock terms. Also, the fact that these public entities do not administer their portfolios directly precludes them from becoming important institutional investors in the capital markets. - 18 - Weaknesses of the Institutional and Regulatory Structure 53. Lack of Clarity on the Functions of the Main ReRulators. There is lack of clarity on the role of the BCV, the Ministry of Finance (MH), the SBIF, and the Deposit Insurance Corporation (FOGADE) with regard to their respective regulatory and oversight functions over the financial system. Several aspects of this indefinition are noteworthy. First, approval of the MNH is required for many actions by FOGADE and the SBIF, which tends to delay actions, diffuse responsibilities, and infuse a degree of politization over the regulatory process. Second, decision-making authority and reporting procedures between the SBIF and FOGADE are vague, creating conflict between the institutions and inconsistency in policy-making. This is exemplified by the lack of norms on who initiates actions in cases of insolvent financial institutions. Third, functions are often overlapping, which further weakens accountability and often leads to inaction as one institution relies on the other to act, For instance, FOGADE and the BCV can both grant liquidity credits to insufficiently capitalized institutions. Finally, some of these institutions are performing functions that clearly overstep their roles. For example, the BCV often acts as a shadow superintendency and is the trustee for investments of several large public sector agencies; similarly FOGADE cannot focus its efforts entirely on handling ailing banks because it is also charged with the management, recovery and sale of assets it inherited from the BCV upon its creation. 54. Lack of Autonomy and Powers of the SBIP. The SI and the other superintendencies of financial institutions (insurance companies and S&Ls) are weak, and lack the ability to establish strict prudential norms and enforce them. There is a need to redefine the status of these superintendencies, particularly of the SBIF, to increase their autonomy. The SBIF is heavily dependent on the National Executive, and lacks the power to undertake several important actions which should be in its jurisdiction such ass (i) intervening ailing financial institutions, (ii) authorizing new institutions, (iii) authorizing changes in the capital base of institutions, (iv) authorizing the sale, merger or liquidation of financial institutions, and (v) suspending or revoking the operating licence of financial institutions. 55. Weak Prudential Regulations. Current regulations are not effective in ensuring the solvency and financial stability of financial intermediaries. Norms on loan portfolio classification, provisioning, capital requirements, lending concentration, lending to related parties, control mechanisms, and fines and sanctions, among others, need to be strengthened. The Chart of Accounts and accounting rules are not sufficiently clear, external audits are inadequate, and information disclosure by banks and by the SBIF is deficient. 56. SBIF supervision of banks is weak because examinations are too infrequent and they tend to focus on enforcing specific monetary, fiscal and other accounting regulations rather than on credit risk analysis and on the assessment of the overall solvency condition of intermediaries. Major problems found in banking regulations and supervision result in: (a) inadequately capitalized banks, (b) insufficient provisioning for bad debts, anLd (c) severe risk exposure due to lending concentration and lending to related parties. 57. Inadequate Mechanisms for Manadn. and Solvina Bank Crises. Although FOGADE is charged with effecting bank rescue operations, this has proven to be - 19 - an inadequate mechanism for handling bank crises for a number of reasons. There is a lack of clear rules on the conditions that can cause the SBIF to intervene a financial institution, and, if required, on the transfer mechanism of an intervened institution to FOGADE. FOGADE's Law does not give it an adequate mandate nor the appropriate mechanisms to rehabilitate or liquidate insolvent banks. FOGADE is often prompted into inaction because of the approval requirements and its precarious financial condition. In any case, since FOGADE's assistance is not made conditional on change of ownership, financial assistance for rehabilitation can be misused to bail out existing shareholders and managers of failing banks. Oftentimes, FOGADE's assistance to banks amounts to liquidity support, which may be provided at preferential rates and for unnecessarily long maturities. Weak Financial Condition of Financial Intermediaries 58. A serious problem in the financial system is the weak financial position and potential insolvency cf some institutions. While available data is limited and suspect, problems identified as afflicting many banks are poor asset quality, lending concentration, foreign exchange risk exposure, inadequate capital, vulnerability to liquidity shortfalls and poor profitability. Commercial Banks 59. Asset Quality and Capital Adequacy. While the magnitude of problems related to asset quality is difficult to estimate because of poor supervision and widespread rolling over of non-performing loans, the registered level of non- performing credits increased by approximately 502 from May to August 1989 for commercial banks not under intervention. The portfolio of non-performing loans for the six largest private banks, while still remaining low at 3.2? of total credits, more than doubled over this period. Of 38 banks not intervened, 12 had non-performing portfolios which exceeded their total estimated capital base in August 1989.51 These insti utions together comprise approximately 22Z of the total assets of the system.96 The assets of the Banco Industrial (BIV) represent over half of the total of this sub-group. None of these institutions was among the six largest private commercial banks. While the implication of these figures is that loan portfolio quality has deteriorated, banks in the greatest danger are likely to be BIV and some smaller banks. While at least three of the six largest banks may need some capital increases, the Bank believes that improvements in the regulatory structure will not render them insolvent. Nevertheless, BIV and some smaller banks may, as a result, have to be heavily recapitalized, merged, or liquidated. 60. Given the asset quality issues indicated above, current levels of capital may be insufficient to compensate for potential losses for several commercial banks. At the end of December 1989, 13 of 38 commercial banks had 5I Capital and reserves data for August 31, 1989, was interpolated from data for June 30 and December 31. Non-performing loans may be overestimated because they are calculated before the effects of provisions, while provisions are deducted from capital and reserves. Provisioning data was not made available to the Bank. 6/ As of December 31, 1989 based on a total of 41 institutions. - 20 - total debt to total equity ratios above 20sl and three were above 25l.7.1 Equity is not alAy insufficient for certain institutions in relation to non-performing assets but also in relation to non-liquid assets. 61. Reform of the bank regulatory requirements will likely result in the recognition of significant losses to commercial banks and other financial intermediaries. As of December 31, 1989, were 101 of loans to be written down or written off, public and private comercial banks would experience losses of approximately US$693 million. In order for banks not to individually violate a 20sl total debt to total equity limit, they would have to increase capital by US$547 million, or 73t of pre-existing capital and reserves. 62. Profitability. Returns on average equity decreased for comercial banks since the liberalization of interest rates in February 1989. Real returns on equity for all commercial banks decreased from 17.82 for 1988 to -14.2? for 1989. An important factor explaining the decline in profitability in 1989 has been the reduction of bank operations in letters of credit which contributed significantly to profits in 1988. In order to increase profitability there is a need to reduce high overhead costs, increase the level of repayment on existing louns, and find creditworthy projects that can bear market lending rates. Evidence suggests that fixed costs from large branch networks remain high and could be reduced. 63. Liquidity. Commercial banks faced liquidity shortages between February and October 1989, although at a declining rate, due to their obligations to honor letters of credit that existed before the devaluation. BC' rediscounts had assisted those institutions facing liquidity shortages helping to restore liquidity to the system. Late in the year, BCV rediscounts were virtually eliminated for banks (except for BIV). BCV rediscounts fell from Bs 15.0 billion during November of 1989 to Bs 4.5 billion in February 1990. Increased borrowing through the BCV's money desk helped to absorb Bs 9 billion in excess liquidity from end-November 1989 to end-February 1990. These high levels of liquidity in the banking system could decline if the relative interest rates offered were to decline or loan demand at high rates were to increase significantly. Further development of the BCV's indirect monetary instruments and the interbank money market would provide greater flexibility to financial institutions to modify their liquidity position as needed. 64. Effects of Reforms. Reforms in regulation and supervision of loan classification and provisioning would likely have additional implications for the financial positions of banks. The reasons are as follows: (i) non- performing loans in commercial banks are often rolled over to new loans which, at least for 30 days, are considered current; (ii) improved scrutiny and enforcement of loan classification would increase the level of provisions required, especially since such a system would require provisions for credits that are current yet reflect a diminished ability to pay by the borrower; (iii) consolidation of financial statements and controls over asset sales would 7/ Neither BCV nor SBIF provides data on the leverage of each bank according to the BCV's methodology which is the basis for the legal 20:1 leverage requirement. Under this methodology, BCV obligations and some debt which is on the balance sheet yet considered contingent are excluded from the debt total. - 21 - expose intra-group transfers of non-performing assets between financial and non- financial enterprises; and (iv) lower levels of earning assets in the financial system would compromise future profits and thus further reduce capital. 65. If improved accounting rules were in place and enforced, the reported financial condition of many institutions would likely deteriorate. Further, the economic adjustment program is likely to worsen the quality of the loan portfolio of many institutions. This will require increases in capital to mitigate risk or decreases in total assets and liabilities. An effective program to attack insolvency problems in individual institutions is therefore needed before they worsen. Mortgage Banks and S&Ls 66. Housing Finance Policy. Mortgage banks and S&Ls are experiencing major financial problems largely due to the mismatch between the maturity and rate structure of their assets and liabilities. It should be noted, however, that mortgage banks and S&Ls only represent 92 and 62 of the assets of the financial system, respectively (see Table 1). M4ultiple goverDment-sponsored programs which provide subsidies in order to limit the rate paid by borrowers have forced most institutions to become highly dependent on government subsidies in order to survive. This is particularly true since the interest rate liberalization initiated in early 1989. The Ley de Protecci6n del Deudor Hinotecario passed in 1989 covers the difference between 25-301 of a borrower's monthly income and his or her monthly mortgage payment (calculated at a variable market rate). All primary homes are covered by this subsidy up to a purchase price of Bs 3.4 million (US$80,000 equivalent). The amount of subsidy required in 1990 to support these loans is estimated at Be 10 billion, or 0.72 of GDP. 67. Mortgage Banks. The financial condition of mortgage banks has weakened since February 1989, as a result of increases in interest rates and their inability to charge market interest rates on non-subsidized loans. Debt- to-equity ratios have increased, in some cases significantll above the already very high 30sl legal ceiling, and profitability has dropped.-/ The performance of the system needs to be monitored closely and steps should be taken to strengthen its capital base, particularly because asset quality deteriorated as a result of higher interest rates (given that not all borrowers are covered by the subsidy). 68. The Savings and Loans System. As with mortgage banks, S&Ls face several problems which stem from the structure of the subsector. S&Ls have severe mismatches between the maturities of their assets and liabilities yet have virtually no capital to cover this risk. As a result, recurrent liquidity shortages have been solved through government purchases of mortgage bonds at full face value and through increases in financial support from the National Savings and Loans Bank (BANAP). S&Ls in general have high operating costs, in part because they effectively have no shareholders to be held accountable to, and in part because government-sponsored housing programs channeled through S&Ls are designed in a way that provides little incentive for efficiency or profitability. While S&Ls are required to allocate a minimum of 802 of net earnings to capital 8/ Even assuming that yet-to-be-transferred subsidies for 1989 are received by mortgage banks. - 22 - reserves, most institutions are highly unlikely to build up a capital base from retained earnings sufficient to serve as a buffer against risk. In general S&Ls may pay relatively high rates on deposits in order to attract funds. 69. Because of their narrow capital base, virtually all S&Ls face quick insolvency in the event that subsidies on preferential rate loans are cut. In spite of these subsidies, however, several institutions are near insolvency. At the end of June 1989, six institutions representing 312 of the assets of the S&L subsector had losses which greatly exceed their capital. S&Ls have been losing their share of the market for deposits since 1987. They have found it difficult to offer attractive rates of interest given their asset margins and cost structures. 70. BANAP, which acts as a second-tier financing institution of the S&Ls, has borne an inordinate share of the multiple risks facing these institutions and has provided a large volume of credits to S&Ls financed from external debt. Several institutions have large obligations with BANAP. While the average amount of obligations with BAAP represented 26.62 of the total liabilities of the existing 20 S&Ls at the end of June 1989, 5 had obligations that represented more than 402 of their liabilities. The perception among some managers is that BANAP will provide for the solvency needs of all S&Ls regardless of the cost. While some mergers have to date been forced ou certain institutions, other measures certainly are needed. 71. BANAP itself faces severe financial difficulties which need to be remedied. First, as of December 1989, 602 of BANAP's total liabilities were loans received from foreign banks. This US$1.5 billion worth of loans is maintained in its books at an exchange rate of Ba 7.5US$. Were these liabilities to be revalued according to the market rate of exchange, BANAP would suffer a foreign exchange loss of US$1.2 billion.91 Second, BANAP likely has set aside insufficient provisions for contingencies in its role as guarantor of credits. Third, BANAP's capital base may be insufficient to cover future losses stemming from the amortization of costs associated with previous mergers of selected S&Ls. Fourth, given the weaknesses indicated in the financial position and capital base of the S&Ls, it is likely that BANAP does not have sufficient resources to provide these entities with the liquidity support they will need unless assisted by the BCV. This raises the question of the self-sustainability of the savings and loans system. Capital Markets 72. Capital markets are not well developed--short-term money markets lack depth and long-term capital markets are minimal. Equity markets have had little significance in mobilizing capital for the country's development. There are several factors which have precluded the growth of capital markets. Subsidized rates of interest and easy credit policies have contributed to debt financing being favored over equity. Weak regulatory authorities and a loose regulatory environment have prevented market transparency and discouraged investor confidence. Investors are skeptical of becoming one of many diverse 9/ US$1.2 billion represents 2.6 times BANAP'S total assets when these assets are valued at Bs 42.5/US$. - 23 - holders of company shares after years of economic concentration and state intervention. PART IV - THE PROPOSED FINNCIAL SECTOR ADJUSTHENT LOAN 73. The financial sector reform program envisioned by the Government aims ats ($) liberalizing the financial policy environment (interest rates, allocation of credit, foreign ownership, universal banking, etc.); (ii) reducing the Guvernment's direct role in financial intermediation (privatization and liquidation of public banks, consolidation of DFIs, rationalization of housing finance policy, limiting the BCV's role in the financial support of institutions to bank liquidity and monetary management needs); and (iii) strengthening the competitiveness and financial conditiot of intermediaries (adequate prudential regulations and supervision, capital standards, mechanisms for handling problem banks). 74. The Government has formed a team which is working on the implementation of these reforms, including the identification of required legislative and executive changes, the evaluation of institutional upgrading needs, and the sequencing of reforms. The Bank has worked closely with this team in the preparation of the loan to ensure both consistency and support for the proposed measures. 75. The proposed loan would support the first phase of the comprehensive financial sector reform program. It would focus on: (a) liberalizing and rationalizing interest rates and credit allocation; (b) reducing public sector participation in the commercial banking system and redefining the role of the public sector in development finance; (c) rationalizing the BCV's credit operations with a view to enhancing their transparency and minimizing their disruptive effects in the financial system; (d) strengthening the regulatory and institutional framework; (e) improving the financial strength of financial intermediaries and upgrading mechanisms for dealing with problem banks; and (f) enhancing the competitive environment for financial intermediaries. 76. The second phase of the financial sector reform program would build on and complete the reforms initiated in the first stage supported by this loan. In particular, it would target: (i) the full liberalization of interest rates and credit controls following the strengthening of the regulatory and supervisory framework; (ii) completing the restructuring of the development finance system; and (iii) a full program for reform of the housing finance system. In addition, it would pursue reforms in the areas of capital markets and insurance which are largely outside the scope of the first phase. The Bank expects to support these reforms either through investment projects (for instance, an industrial restructuring operation) or through a possible second financial sector loan. In addition, the Bank (through this loan) and the IFC will provide technical assistance to the stock exchange and to the National Securities Commission to review the functioning of the securities markets, the trading framework, and the supply and demand of the various financial instruments and securities. The review will also include an analysis of the legal and regulatory framework following up on earlier work done with joint IBRD/IFC financing. It is expected that this work could lead to important areas of improvement in the legislation which could be addressed in the second phase of the reform program. - 24 - 77. The reform program is described in the Government's Letter of Sectoral Policy (LSP) (Annex III). The policy matrix (Annex IV) summarizes the objectives of the Government's financial sector reform program, actions already taken, and actions that will be taken as part of the proposed loan and their expected timing. Key actions which are specific conditions of tranche release in the legal documents are identified with an asterisk (*) in the policy matrix and are underlined in the text. All other actions specified in the matrix are part of the financial sector reform program as described in the LSP, and satisfactory progress in their implementation will also be reviewed prior to tranche releases. 78. The reform program will result in significant costs for the Government, which the loan will help finance. On the one hand there are the costs narrowly associated with the implementation of the program such as institution-building, human resource upgrading, undertaking policy studies or financial analyses, and the formulation of the legislative and executive reforms. These costs will be financed largely through the TA component of the loan. More broadly, however, the reforms will have significant fiscal repercussions which the loan will help defray through its fast-disbursing component: (i) the capital replenishment of FOGADE to cover the unrealized losses hidden in its balance sheet and to allow it to become the prime mechanism for resolving the solvency problems already detected in a number of institutions; (ii) the costs associated with the rehabilitation or liquidation of selected public financial institutions and the subrogation of their external debt; (iii) the assumption by the BCV or the Treasury of the capital losses of the portfolios of some public entities held in trust at the BCV; and (iv) the increased cost of public debt service with the flotation of T-bills and the liberalization of interest rates. It is estimated that these costs will be no less than the equivalent of US$1.2 billion. 79. The financial sector reform is an important element of the overall adjustment program of the Government, and complements other reforms supported by the Bank. The Bank's operational strategy for Venezuela has been framed in the context of the Policy Options Report which was submitted to the Government in early 1989 and of ensuing discussions. The proposed loan complements the ongoing SAL and TPL operations by improving the policy framework of the financial sector and by strengthening and modernizing financial institutions so that they can play a supportive role in the stabilization and adjustment process. It is therefore a critical element of the reform program, and is necessary to ensure the coherence of the overall adjustment effort. On the other hand, financial sector reform presupposes a stable financial environment that is conducive to the monetization of transactions and savings and investment. Therefore, all tranche releases will be conditional on the maintenance of a macroeconomic policy framework that is consistent with the objectives of the financial reform program. Rationalization and Liberalization of Interest Rates and Credit Allocation 80. Interest Rate Policy. The objectives of the reform of the interest rate policy are tot (i) allow interest rates to reflect the opportunity cost of funds in the economy and encourage resource mobilization; (ii) allow variation in interest rates based on relative risks and costs of funds rather than on the nature of the source or the sectoral destination of the funds; (iii) quickly respond to changing economic conditions; and (iv) remove administrative discretion over interest rate determination by any public entity other than the BCV in its capacity as monetary authority. These objectives can be achieved - 25 - by allowing full market determination of interest rates, and by granting the BCV full and exclusive prerogative to set all administered interest rates that cannot be set on the basis of supply and demand. 81. Bank Interest Rates. Pending modification to BCV's Law to eliminate the BCV's obligation to set interest rate limits, the Government has agreed that the BCV will set interest rate limits so that they do not exert pressures on the market. Accordingly, in April 1990 the BCV Board issued a resolution setting the minimum deposit rate at 10? and the maximum lending rate at 60? for commercial and mortgage banks, finance companies and S&Ls. The spread between these limits allows sufficient scope for market determination of interest rates. In the weeks following this liberalization of interest rates, rates remained steady. As the LSP indicates, the lending rate ceiling will be immediately increased whenever it is binding, and the minimum deposit rate will be immediately reduced when it becomes binding. This will remove the discretion which currently exists over the determination of interest rate ceilings. In so doing, it will enhance the credibility of the reform process and will help prevent backtracking. 82. In order to enhance market discipline over financial intermediaries, the BCV intends to promote the transparency and public disclosure of the market interest rate structure. In May 1990 the BCV Board issued a resolutiou dictating daily publication by the BCV of the average and range of interest rates observed in the market (including rates offered to the public, on the interbank market, and the effective yield on BCV bills) as well as the rediscount rate. By second tranche, the BCV will issue a directive to financial intermediaries requiring them to announce and post their rates on all deposit and credit services, specifying the method for calculation of interest and other charges or fees. By third tranche, the BCV will publish in its monthly bulletin the average interest rates offered by a wide range of financial institutions on representative deposit and credit contracts. The interest rate data will be presented according to a uniform interest computation methodology. 83. Preferential Lending Rates. As Table 3 illustrates, the current administrative structure of interest rates contains major differences in rates for different sectors and institutions, resulting in large subsidies and the consequent inefficient use of resources. The Government has agreed to gradually reduce subsidies on development or other sectoral credits and to ultimately eliminate them. The first priorities must be: (i) to simplify the current plethora of interest rates; (ii) to tie the subsidized interest rates to market rates so that the former reflect market developments even though they need not coincide with market rates; and (iii) to set subsidized rates in a way that allows gradual phasing out of the subsidy element without a need to completely rework the interest rate determination mechanism. In other words, the interest rate adjustment process must be consistent with the ultimate objective of market determination. To this effect, the best anchor of rates would be the weekly average lending rate of commercial banks toward which currently subsidized rates will tend during the adjustment period. 84. Following these principles, a new structure of preferential rates was instituted in May 1990. According to the new structure, the preferential interest rate on agricultural lending by commercial banks will be 85Z of the average lending rate of the six largest commercial banks on non-preferential credit. All direct lending by governmen.-owned DFIs for agricultural and non- - 26 - agricultural activities will be set at rates not less than 85Z and 902. respectively, of the average lending rate of the six largest commercial banks on non-Preferential credit. Preferential rates will be revised weekly. As the LSP states, the Government is committed, as a medium-term objective, to gradually reduce and ultimately eliminate the interest rate differential between market rates and preferential rates. 85. Table 3 compares the interest rates prevailing prior to the enactment of the recent changes with the rates currently in effect for a selected range of sectors and institutions. The newly established preferential rates currently stand at 28-302 The table shows significant reductions in interest subsidies relative to the situation in mid-April 1990 and a substantial reduction in the dispersion of interest rates across sectors. Furthermore, given projected inflation of 20-251, preferential rates would be positive in real terms. 86. This interest rate policy will apply to all housing finance programs, except for those covered by the Ley de Politica Babitacional which enjoy lower fixed rates. Mortgage relief provided through budgetary allocation may be granted, as long as the total interest rate received by the first-tier financial institution is in accordance with the above guidelines on banking or preferential interest rates. No other interest rate limitations will apply to banks, finance companies and S&Ls. 87. Second-tier Lending Rates. In the LSP, the Government has indicated that second-tier lending by government-owned financial intermediaries (including BANAP). will be channelled to first-tier institutions at no less than the average cost of remuerated deposits of the commercial banking system. This will ensure that incentives for resource mobilization prevail. First-tier institutions will absorb the entire credit risk of final borrowers. 88. Portfolio Requirements on Commercial Banks. The Government is aware of the distortions caused by forcing commercial banks to lend a share of their portfolio to agriculture at preferential interest rates, and to finance these subsidies from their own resources. Accordingly, the LSP indicates the Government's commitment to a medium-term policy of eliminating all directed credit. The agricultural portfolio requirement was reduced by a Presidential Decree from 22.52 to 17.52 in May 1990, and will be further reduced to 12? by third tranche release. 89. Modifications to the BCV Law. In order to institutionalize the changes in interest rate policy brought about by administrative action, changes in the BCV Law are desirable. These modifications would eliminate the obligation to set minimum deposit rates and maximum lending rates and permit the BCV Board to administer preferential interest rates of the development funds. Accordingly, the Government has agreed to present to Congress by release of the second tranche proposed modifications to the Central Bank Law uesianed to: (i) extend to the BCV the power to regulate interest rates of all government-owned financial intermediaries (including banks and funds): and (ii) eliminate the BCV's obligation to establish interest rate limits for banks and non-bank financial intermediaries, and thus allow interest rates to be determined by the market. With this legal reform, the Government's current policy of not interfering with financial market conditions will be strengthened. At the same time, the setting of preferential and other administrative rates will be centralized at the BCV, - 27 - which should facilitate further future reductions, and the ultimate elimination of, interest rate subsidies. Reduction of Public Sector Participation in the Financial System 90. Privatization of Commercial Banks owned by the BCV. In order to eliminate the BCV's participation in commercial banking, the Government has issued a resolution indicating its intention to privatize the three banks owned by the BCV, and has already prepared preliminary valuations of their net worth. In the LSP the Government has agreed to take all actions necessary to divest its stake in these banks. All three banks will have been brought to the goint of sale prior to the release of the second tranche. To this effect, the Government shall have completed the valuation and tender or bidding documents pertaining to the sale of these banks to the satisfaction of the Bank, and will have issued these bidding documents to prospective purchasers. By third tranche. each of these banks will have been divested from the public sector. 91. Restructuring or Liguidation of Other Public, Commercial Banks. In addition to the 3 commercial banks owned by BCV, the Government owns 6 other commercial banks: BIV, the four regional banks owned by BIV, and BANDAGRO. BIV and BANDAGRO are not viable institutions in their present state. Accordingly, the Government has decided to liquidate BANDAGRO and to restructure BIV and its four regional banks. As a short-term measure, as a condition for first tranche release the Government will issue a resolution forbidding BIV and BANDAGRO from engaging in ew lending ogerations by requiring that all new deposits and loan recov_ries be invested in securities of the BCV or the Treasury. BIV's lending will only resume once its restructuring is substantially under way. 92. Prior to second tranche the Government will present to Congress a Law mandating the liquidation of BANDAGRO within a specified time frame. AX second tranche. the Government will also submit a plan acceptable to the Bank specifyina the future role envisioned for BIV. and the actions to be taken for its restructuring or liquidatilon. The plan should include: mechanisms for asset valuation and sales, a schedule for amortization of losses and debt subrogation, a revised organizational structure and staffing plan, new lending operating procedures, measures to enhance accountability, and the schedule of resumption of BIV's lending activities. The plan will also analyze the situation of the four regional banks owned by BIV and decide on their future. Satisfactory progress in carrying out this plan will be reviewed prior to third tranche release. 93. Restructuring BANAP. Prior to second tranche release, the Government will submit a plan acceptable to the Bank to restructure and promote the financial independence of BAN&P. The plan will contain a phasing-out of government, BCV and any external sources of funding of BANAP, and will define its policies regarding its financial support of S&Ls. Satisfactory progress in carrying out this plan will be reviewed prior to third tranche release. 94. Streamlining the Development Banking Functions Carried out by the Govertment. The Government is aware of the need to reorganize the DFI subsector in order to increase efficiency and create incentives so that DFIs increasingly respond to market conditions. These institutions should have the following objectives: (i) to operate principally as second-tier financial intermediaries, (ii) to lend at market rates of interest, (iii) to assist clients through - 28 - technical assistance, transfer of technology and dissemination of market knowledge, and (iv) to compete for private sources of funds. To accomplish these objectives, the Government has defined in the LSP the role of the major development banks and funds and the main steps that will be taken to start their restructuring. 95. The Government recognizes the duplication created by the existence of multiple development banks and funds. As a means of consolidating and sharpening the focus of development credit, prior to second tranche release the Government will present action plans acceptable to the Bank for the formation of two second-tier credit institutions, one for agriculture and one for industry, and for the liquidation of BANDAGRO in conjunction with the creation of the new agricultural credit fund. These two new institutions will absorb the operations of the largest funds. The new agricultural credit fund will absorb the FCA and the lending activities of the Fruit Development Fund (FDF) and the Coffee Fund (FONCAPE). The new industrial credit fund will absorb FONCREI, FINTEC, and the second-tier lending activities of FIV. By second tranche release the Government will submit to Congress proposed laws for the creation of two second-tier credit institutions (for agriculture and industry, respectively), and for the closure of those existing funds that will be absorbed by the two new institutions. Prior to third tranche release, the Government will demonstrate satisfactory progress in the formation of these two consolidated second-tier credit institutions, and in the liquidation of BANDAGRO. These two new funds will depend from the MH and will be supervised by the SBIF. In each case, commercial banks will be required to take on the entire credit risk of the final borrower for rediscounted lines of credit. 96. In addition to these second-tier funds, the Government owns two first-tier development funds: the Credit Institute for Agriculture and Livestock (ICAP) provides credits to small farmers, and CORPOINDUSTRIA which lends to small and medium industry and to artisans. In light of their focus on segments of the economic agents that would find access to bank credit difficult at least in the first phase of the financial reform program, these funds will remain as separate entities. Relative to the commercial banking system, these funds are insignificant. The Government will prepare prior to second tranche action plans for the restructuring of CORPOINDUSTRIA and ICAP. The plans will assess the need for first-tier lending through these institutions. BY the time of release of the third tranche. the Bank will ensure that satisfactory Progress is being made in the implementation of these plans. Rationalization of the BCV's Credit Operations 97. The BCV's credit operations will be rationalized under the current reform program so as to increase their transparency and reduce their negative quasi-fiscal effects. In broad terms, this will be achieved by: (i) pricing BCV credit according to market conditions; (ii) reducing the BCV's intermediary roe by forcing financial institutions to seek liquidity in the money market, allowing public entities to invest their funds directly in the capital markets instead of placing them in trust at the BCV, and privatizing the three commercial banks owned by the BCV; and (iii) limiting more strictly the Treasury's access to BCV financing of its operations. 98. Credit Operations with the Government. The BCV's credit operations with the Government are obscured by: (i) its holdings of zero-coupon non- - 29 - negotiable T-bills; and (ii) the exclusion from the credit ceiling of some categories of Government debt. Under the current reform program, proposed amendments to the Ley Oradnica de Credito Plblico will be presented to Congress by second tranche to allow the Treasury to issue negotiable fixed-term T-bills that need not be repaid within the fiscal Xear in which they are issued. The revised Law shall explicitly allow market determination of interest rates on T-bills, and will abolish the preferential placement provisions currently contained in the Law. The BCV will purchase T-bills in the secondary market, or, on a residual basis, in primary auctions at the average clearing price. In the interim, the BCV has agreed not to purchase any more zero-yield T-bills after Board presentation. Also by second tranche. revisions to BCV's Law will be presented to Congress to allow the BCV to Purchase these T-bills subiect to the overall credit limit for the Government. This limit will be made to encompass all forms of foreign debt or any kind of claims on, or rights to, government debt. The lending limit will not tL- raised over the level contained in t:he current law, but debt arising from the ongoing external public debt redu,ction and restructuring program will be excluded from this limit on a transitory basis. Finally, the use of T-bills as a reserve asset by banks in satisfaction of the reserve requirement will be eliminated. Accordingly, revisions to the Bank Law will be submitted to Consress by third tranche requiring reserve requirements to be held exclusively in liabilities of the BCV and not in T-bills. 99. These reform measures are designed to strengthen the Treasury's fiscal discipline and improve the financial condition of the BCV. In addition, they will allow the BCV to use T-bills in the future as an instrument of monetary regulation through open market operations. The introduction of BCV bills in November 1989 allowed open market operations to be used for monetary management. In the future, however, the BCV should move towards trade in T-bills rather than BCV bills in order to avoid the quasi-fiscal implications of the latter. 100. Credit Operations with Financial Intermediaries. The BCV's credit operations with financial intermediaries currently take three forms: Mi) advances, rediscounts and repurchase agreements (heretofore referred to together as the rediscount facility) backed by government or private instruments; (ii) credit portfolio purchases; and (iii) purchases of banks' financial liabilities. The Government intends to restrict use of the rediscount facility, eliminate all portfolio purchases by the BCV, and tighten the conditions for purchases of bank liabilities. Aside from streamlining the BCV's operations and enhancing its financial position, these measures are designed to promote the development of money and capital markets. Given that banks are potentially large players in these markets, forcing them to seek liquidity outs-de the BCV will act as a catalyst for their development. 101. As the LSP indicates, under the reform program the rediscount window will be used as a temporary liquidity support facility. While the BCV is developing its open-market capabilities. rediscounts may also be used in the near future as an instrument of monetary expansion (e.g. to accommodate seasonal demand for credit). However, the BCV intends to only use the rediscount facility for monetary control purposes if it is not able to achieve the same effect through its open market operations. In no case will the rediscount window be used for sectoral incentive purposes. - so - 102. To ensure this transformation of the rediscount window, the BCV has implemented or will implement a number of reforms. First, a BCV Board resolution was issued in May 1990 mandating that all general rediscounts (including to FOGADE and BANAP) be offered at the same rate, which will be linked to the wield on BCV bills auctioned. The rediscount rate will be reviewed at least weekly and in no case will be set below the yield on BCV bills auctioned. A special rediscount rate, equal to 852 of the general rediscount rate, will be maintained for rediscounting of agricultural documents. This special rediscount rate will be phased out in step with the program for reduction of agricultural interest rate subsidies. Second, the BCV Board also issued in May 1990 instructions to the Vice-president for monetary operations establishing procedures for automatic referral of large or frequent borrowers to the SBIF for review. Third, the BCV Board will issue a resolution, prior to second tranche, switching to market (or equivalent) valuation of the underlying security or the collateral on rediscount contracts. Fourth, a oronosed revision to the BCV Law will be submitted to Congress by second tranche to restrict individual rediscount contracts with financial intermediaries to a maximum duration of 30 days. 103. The indirect forms of BCV credit to the financial system will be curtailed. Credit portfolio purchases by the BCV will be eliminated, with a BCV Board resolution to this effect being passed before second tranche release. The BCV will also pass a resolution by second tranche requiring that all purchases of private debt instruments from any source by the BCV be priced at market value. The resolution will specify that in no case will financial instruments be bought at a yield less than that offered on BCV bills in the secondary market at the time of purchase of the instruments.101 104. Portfolios Managed in Trust by the BCV. The BCV's intermediation role will be reduced by disengaging the external portfolios it currently manages. As a transitory measure, the BCV issued in May 1990 a resolution terminating direct transactions of securities at face value by portfolios managed in trust by the BCV. The only exception which will be permitted in the future will be the sale at face value back to the BCV of securities purchased at face value prior to Board presentation. In this way, the managed portfolios' holdings of government paper will yield market returns, thereby arresting the chronic decapitalization they have been suffering. Ultimately, the BCV's trustee functions should be discontinued, and the public entities should administer their portfolios directly, with appropriate profitability targets. The trust portfolios can then become institutional investors and as such can become important players in the development of money and capital markets. To implement the divestment of the administered portfolios, the BCV will submit a program to the Bank before second tranche release Presenting the actions to be taken (including required executive And legislative changes). and the timing of these actions. Annex rX outlines the information requirement and content of the disengagement program. Only the Foreign Exchange Guarantee Fund (FICAM) will remain under BCV management. As part of this program, the BCV has submitted a notice to the Venezuelan Petroleum Company (PDVSA) of non-renewal of the management contract upon expiration of the current contract at the end of 1990, and FOGADE's wortfolio will be disengaged by third tranche release. This will 101 If by second tranche release the secondary BCV bill market is still nonexistent or is deemed to be too thin, the yield on BCV bill auctions in primary issues will be used for this purpose. - 31 - require submi9sion to Congress by third tranche of oronosed revislons to the FOGADEIs Law, which currently mandates it to olace all its funds at the IAY. 105. The spirit of the reform is that all subsidy programs should flow through the national budget, and should not originate In the BCV's operations. Therefore, a final area of reform concerning the BCV is that it will not finance the housing subsidies directly either with its profits or with direct contributions. Any housing subsidies envisioned in the LI= de Proteccion del Deudor HiDotecario will be channeled only through the national budget. Reform gf the Ra2g"atory Framerk and- ImMMrovmnt in Blank Sunrvis ion 106. StiXengtbening the Operational Effectivnepgs and the Functional AUtonmy of the Main Regulators. In the past there has been a lack of clarity on the role of the BCV, the NH, the SBIP, and FOGADE with respect to their functions as regulators of financial intermediaries. Under the loan, the legal framework will be revised and amended in order to clarify their roles. The broad objective is to enhance accountability by: (i) establishing clear functions and responsibilities; (ii) increasing the organizational, functional and budgetary autonomy of each agency or institution; (lii) insuring that all the required regulatory functions are being performed by one of the institutioos; (iv) clearly specifying reporting and authorization procedures; and (v) avoiding duplication of efforts and responsibilities. 107. Under the reform, the autonomy and authority of the SBIF will be strengthened. In addition to monitoring compliance with regulations, its bank surveillance and examination capabilities will be geared towards evaluating the condition of individual banks and of the banking system generally. FOGADE will continue to be responsible for guaranteeing bank deposits. FOGADE's functions will be upgraded so as to become the prim, vehicle for resolving bank crises, and it will be responsible for derigning bank rescue operations. In addition, its functions will be expanded to include the liquidation of institutions, currently the domain of the SBIF. The regulatory and formal approval powers of MH will be eliminated. It will not have any executive functions in the operations of the SBIF and FOGADE, although it will exercise oversight over these institutions. The role of the BCV will also be changed to strengthen monetary control and reduce deficit financing functions. Its support of financial institutions will be restricted to the provision of liquidity in cases where solvency is not impaired. The LSP outlines the Government's intentions regarding the specific tasks to be undertaken by each institution. 108. Strengthening Prudential Regulations. Auditing. and Information Digglosure. Improved regulation and supervision is needed to: (i) improve the transparency of bank financing, (ii) improve asset quality and capital adequacy, (iii) regulate loans to related parties and loan concentration, (iv) ensure that banks compete according to a uniform set of rules and accounting standards, and (v) liquidate those institutions that may be insolvent. As outlined in the LSP, the Government has agreed to undertake a major overhaul of the prudential regulations under the discretion of the SBIF. As a first step, by first tranche release the SBIP will igsue the changes reagired to tighten regulations on: loaI classification. provisioning. roll-over of credits and accrual of interest. charge-offs. evaluation of investfent ootflios. and evaluation of property received as collateral. The SBIF will. bq second tranche. issue and implement all changes required to reulat2 the following areas: lending concentration and - 32 - lending to relatgd parties and insiders. controls on intra-groun transactions. consolidation of accounts of financial groups. uniform publication criteria of financial statements, and valuation of foreign exchange risk. Annex VI highlights the more important aspects of these regulations, and policies to be adopted for their implementation. 109. In order to improve auditing procedures and information disclosure, by the time of release of the first tranche the SBIF will issue clear audit guidelines for banks soecifving requirements for auditing of loan quality and loan concentration. The SBIF will require banks to direct auditors to include assessments in these areas in their audits. By third tranche, the SPIF will issue a new chart of accounts which will facilitate full disclosure of the financial condition of banks according to transparent accounting criteria. The following aspects will be treated in the new chart of accounts: a system for loan portfolio classification, a policy to register overdue interest, provisioning guidelines, and criteria to revalue securities and measure foreign exchange risk, among others. Also by third tranche, the SBIF will issue audit guidelines to complement and expand those developed by Board presentation. The guidelines will specify the scope, content and format of audits in accordance with the new chart of accounts. Further, by third tranche, the SBIF will begin to publish and distribute publicly a monthly bulletin disclosing financial statements and indicators of individual financial institutions and of the financial system as a whole. Such indicators will include measures of capital adequacy, lending concentration, loan portfolio quality and adequacy of provisions. 110. The Government has agreed to consolidate the overhaul of prudential regulations by proposing to Congress changes in the Bank Law and by proposing to Congress a new Law of the SBIF. By second tranche the Government will submit to Congress for its apnroval a groposed Law of the SBIF which will tighten norms on -canital reguirements. Ilendin concentration and intra-grou transactions. internal control mechanisms. and will widen the scooe of nonoecuniary sanctions and fines. Annex VI lists some of the required changes in the proposed SBIF Law and discusses additional required changes in the Bank Laa. 111. Improving the Ooerations and Autonomy of the SBIF. Upgrading the institutional capacity at SBIF will be pivotal in the enforcement of the administrative and legal regulations indicated above. These include: (i) significant improvement in on-site inspection; (ii) development of an improved automated risk assessment system for credits, borrowers, banks and economic activities; (iii) development and implementation of internal control requirements by banks for risk management and to detect fraud; (iv) increased emphasis on the financial analysis of banks rather than merely on compliance with legal regulations; and (v) development of a close dialogue between SBIF and banks to enforce public information disclosure. These reforms will be supported with institutional strengthening through the TA component (detailed in Annex V) and with changed in the SBIF's legal standing. Accordingly, as a condition of second tranche the oproosed Law of SBIF that will: (i) reorganize the SBIF as an autonomous entitv with its own sources of revenue (bank assessments based on tlle volume of bank assets. and extraordinary contributions from the Treasurz) and with a budget subject only to the approval of the BCV Board: (ii) eliminate the MH's formal arnroval and decision-making functions in the operations of the SBIF: and (ii) enhance the Superintendent's decision-making authority by stiRulating that only bank liquidations and interventions and raising the minimum caDital reguirement reauires approval Sy a Consultative Committee (composed of the - 33 - Minister of Finance, the Presidents of the BCV and FOGADE, and the Superintendent). By third tranche. the Government will submit to Congress prooosed revisions to the Ba_k Law to ensure its consistency with the new proposed SBIF Law and with the spirit of these reforms. Imirovin- the Strength of Financial Intermediaries and Upgrading the Mechanisms for Dealing with Problem Banks 112. The Government recognizes that the financial condition of the banking system is weaker than reported. In an attempt to identify and attack insolvency problems in a timely fashion, by first tranche release the SBIF will commission or undertake studies of the financial condition of all orivate commercial banks and selected mortgage banks and finance companies. These studies will focus on: portfolio review, fixod asset valuation, loan concentration and foreign exchange losses. The studies will be comoleted to the Bank's satisfaction by the time of second tranche release. 113. Short-Term Measures Designed to Strengthen the Financial Condition of Intermediaries. Given the lax regulatory and supervisory framework in the past, the condition of many institutions is not adequately revealed by their statements. As an immediate short-term measure for increasing the basic financial strength of institions, by first tranche release the SElF will issue directives to banks to establish a general loan-loss grovision of at least 2% of the total loAn gortfolio and to charfe off loans Rast due by more than 36 months. The directives include appropriate sanctions for non-compliance with tUiese requirements. These measures will be fully implemented by third tranche release, with an intermediate 1.5% general loan-loss provision being implemented by second tranche release. Also by second tranche, the SBIF will require additional provisions and charge-offs for those banks which the studies reveal are in need of additional strengthening measures. Provisions established in accordance with a new loan classification system would be counted against the 2% general provision, Charged-off loans will be taken off the balance sheet and written off against any specific attached provisions already created and ultimately against capital. By second and third tranche releases, tis SBIF will submit evidence to the Bank that these requirements are being adequately enforced. Further, by second tranche the SBIF will prepare a program acceptable to the Bank for the amortization of the foreign exchange losses assessed in the course of its studies. The recognition of these losses will help reveal the true financial condition of intermediaries and will help force recapitalization. 114. The Government recognizes that existing requirements for entry of new banks are too lenient and that new banks should not be entering the market while the SBIF is being strengthened and the condition of the banking system is not known with more precision. As a result, another immediate short-term measure indicated in the LSP is that the MH will stop issuing licenses for opening new banks until the SBIF is strengthened. is capable of adecuately scrutinizing aoplications for new bank licenses. and is able to determine the real financial condition of the banking system. 115. It is expected that some troubled institutions will be identified as these short-term measures are implemented and as prudential regulations and accounting standards are stiffened. These will be handled jointly by FOGADE and the SBIF through the mechanisms institutionalized in this reform process. The 34 - increased transparency of the problems will help to prompt support for the necessary actions. 116. Imgrovinx the Mechanisms for Managins and Solving Bank Crises. A key element of the reform program is the establishment of clear and efficient mechanism for handling bank crises. The provision of workable exit mechanisms is an integral part of any liberalization program to the extent thats (i) competition cannot be expected to result in greater discipline unless institutions are forced to bear the cost of their actions; and (li) a more open entry policy that is not accompanied with exit or consolidation devices will result in an undue bloating of the financial system. The LSP indicates the policies and procedures that will be imolemented for the mansaement of ban)k crises. 117. The guidelines for handling bank crises are detailed in Annex VII. In essence, while the shareholders, incapacity or unwillingness to act in a case of insolvency has not yet been determined, the SBIF will assume the leadership in evaluating and/or intervening in the bank. The SCV will provide the necessary financial support with liquidity credits at market rates as long as solvency is not deemed to be impaired. At this stage the SB1F will fully inform and coordinate closely with FOGADE. Once the SBIP has determined that there is a fundamental solvency problem and that rehabilitation is both feasible and cheaper than satisfying the deposit guarantee, it will refer the case to FOGADE by intervening the bank, reducing capital to the extent of losses, and offering a capital subscription to POADE. At that point, FOGADE will assume leaderships the SBSF will stop the intervention, and the BCV will no longer provide liquidity support. FOGADE, acting as majority owner of the bank, will provide financial support and will restructure the bank's operational and administrative procedures. It will be authorized to purchase assets from tne bank or provide loans, both of which will be priced at market value. Concessional assistance will only take the form of additional capital subscriptions by OGADE. FOGADE will be required to sell its ownership stake in any bank within a year of purchasing it. 118. These new procedures will be implemented early on in the reform process subject to the restrictions imposed by the current legal framework. Strengthening the process is essential so that the authorities can deal effectively with any problem banks that are identified in the process of upgrading the regulatory, supervisory and accounting framework. The second step envisioned under the loan is to consolidate these new procedures into the legal framework. This will help strengthen confidence in the system and will prevent back-sliding in the administrative gains achieved. 119. Accordingly, the Bank Law to be revised and submitted to Congress by third tranche. will establish: (i) the events or conditions that will trigger action by the authorities. (ii) the nature and seauencinQ of these actions, and (Uii) the role of the resulatorv institutions at each stage. In addition, for FOGADE to stand up to the new role envisioned under this program, some fundamental reforms are nwwessary in its legal framework and financial position. Revisions to FOGADE's Law will be submitted to Contress by second tranche. Annez VIII details the necessary changes in FOGADE's Law. These changes can be grouped under five categoriess (i) clearly delineating its functions (allowing it to act in liquidationst more detailed rehabilitation guidelines); (ii) enhancing its powers (procedures for gaining control of banks; reduction - 35 - in required approvals); (iii) a new more independent organizational structure (more independence from the National Executive; clear reporting channels with the SBIF); (iv) eudowing it with more adequate and transparent sources of financing (requiring government contributions; charging market rates for BCV credit); and Cv) clarifying FOGADE's accounting and control standards (use of accounting criteria dictated by the SBIF; losses should be reported in a transparent fashion). These changes in FOGADE's operational framework will be incorporated into the institution's manual for internal procedures (Realamento Interno), which will be revised to the Bank's satisfaction prior to the release of the third tranche. Specifically, the Realamento will incorporate those principles established in Annexes VII and VIII that are consistent with the law in effect at that time. 120. It is not possible at this stage to evaluate the financial condition of FOGADE because of the lack of transparency in its accounting (a balance sheet as of end-1989 is contained in Annex VIII). It holds fixed assets and credit portfolios acquired either in the course of (or in repayment for) bank assistance operations, or from the BCV upon its creation. These assets are all valued at the original purchase price, which in turn was given in most cases by the nominal value in the sellers' books. Given that there is no assessment of the current market value or collection prospects of these assets, WOGADE will be required by second tranche to contract an independent study of its asset quality according to the new guidelines issued by the SBIF. On the basis of this analysis, FOGADE and the Dank will jointly analyze the needs for additional capital injections to FOGADE by the Treasury. By third tranche release, the Government will have drawn up a plan. accevtable to the Bank. establishing the targets and schedule for the full recapitalization of FOGADE. Monthly canital contributions will have been made by the Treasury beginning in January 1991. By third tranche release, the total value of these canital contributions will be at least equsl to 5OZ of the capital losses detected at FOGADE. 121. In order to minimize the loss of market discipline inherent in any deposit protection scheme, FOGADE will undertake a campaign to publicize the types of financial institutions and deposits that are covered by its guarantee, and the maximum deposit coverage. This publicity campaign, to be performed prior to second tranche release, will focus in particular on the fact that liquid asset funds are not covered. Enhancint the Competitive Environment for Financial Intermediaries 122. In order to reverse the current fragmentation and lack of dynamism in the financial markets, by third tranche the Government will propose to Congress modifications to the Bank Law to enhance competition amona intermediaries and substantially liberaiize banking activities and foreian ownership. First, proposed revisions to the Bank Law will mermit the creation of universal banks and will allow commercial banks to undertake transactions previously limited to mortga,e banks and finance companies. Second, proposed revisions will establish the same capital reauirement for all commercial banks. mortgage banks and finance companies. The new reauirement will be asset based, and a minimum 5Z equity-to-total assets ratio will be established in the proposed Law. The Law should allow in the future the risk-weighting of assets and the inclusion of some contingencies for purposes of calculation of this ratio. Third, a proposed revision to the Bank Law will increase the minimum capital requirement for entry to at least the equivalent of US$6 million for commercial - 36 - and mortgage banks. The Superintendent could be allowed to raise (but not to reduce) the minimum capital threshold at his discretion. Fourth, in order to facilitate consolidation of institutions, the SBIF will revamp its mechanisms for reviewing and approving requests for mergers among financial institutions. 123. Recognizing that competition from foreign banks can se.ve to reinvigorate the local banking system and can promote the modernization of banking practices, the Government has accepted the need to allow a greater degree of foreign participation in the banking system. Accordingly, by third tranche revisions to the Bank Law will be submitted to Congress to: (i) allow up to 20S foreign ownership of local commercial banks (with discretion being granted to the Executive to increase this to 302); and (ii) allow the National Executive to authorize foreigners to acquire up to full ownership of f;nancial institutions other than commercial banks. The National Executive establish regulatory criteria for the functioning of foreign-owned non-bank financial institutions. As the LSP indicates, the establishment of these operational criteria is not intended to discourage foreign investment in these institutions. 124. Once financial institutions adapt to a new environment of market- determined signals, informatiun disclosure and close supervision, there will likely emerge a system composed of a smaller number of institutions with a stronger capital base that will find sufficient incentives to decrease costs and increase efficiency. Technical Assistance Component 125. The Technical Assistance (TA) component is designed to assist ins the restructuring of government-owned banks and funds; strengthening the regulatory agencies including the SEIF, FOGADE, BANAP, and the Superintendency of Insurance Companies; and assisting in the development of capital markets. In addition, the TA component will provide funds to a temporary coordinating unit in the BCV which will be established to oversee the progress of the financial sector adjustment program and to implement the technical assistance component. 126. Assistance under the TA component will be provided in some or all of the following areas: (i) development of a new legal and/or executive regulatory framework; (ii) reorganization of institutions' structure and internal policies and procedures; (iii) development of training programs; (iv) funding of special studies; and (v) upgrading of information systems, including the procurement of equipmtent. 127. The studies that will be financed under the TA component include among others: (a) external audits of commercial banks and selected mortgage banks and finance companies; (b) -' ,tnalysis of the market value of assets under FOGADE' s management/sale; (c) evaLuation of the financial condition of individual S&Ls and BANAP; (d) a study on the regulatory norms on insurance companies and the design of a new supervision system; (e) restructuring options for BIV; (f) the creation of the two second-tier development funds and liquidation options and procedures for BANDAGRO; (g) action plans to restructure ICAP and CORPOINDUSTRIA; and (h) analysis of the functioning of Venezuelan capital markets. These studies will become the basis for policy actions, and hence they are an integral part of the reform process. - 37 - 128. Annex V details the assistance program, including a schedule of estimated costs. The total cost will be US$7.0 million, which will be allocated as follows: US$4.02 million for SBIF, US$0.35 million for FOGADE, US$0.21 million for BANAP, US$0.45 million for the Superintendency of Insurance Companies, US$1.8 million to support the restructuring of public sector financial intermediaries, US$0.25 million for legal support, and US$0.20 million to support a study of capital markets. US$0.10 million will remain unallocated. PART V - WAN FRATIRES Loan Amount. Borrower and Implementing Agency 129. The Bank would support the financial sector reform program with a fast disbursing loan of US$300 million. The loan would include the financing of complementary technical assistance. The borrower would be the Government of Venezuela, and the implementing agency would be the BCV. The Inter-American Development Bank (IDB) will cofinance this operation. LetteX of Sectoral Policy 130. The basis for the loan is provided by a LSP (Annex III) in which the Government declares its commitment to adopt and implement the previously mentioned reforms. In particular, this letter: (i) describes the Government's macroeconomic and financial sector objectives, (ii) indicates the reforms intended to meet these objectives; and (iii) presents a timetable for the implementation of these reforms. Loan Disbursement and Procurement 131. Loan proceeds would be disbursed under the following categories: (i) financing of debt reduction (25% of the proceeds or US$75 million), (ii) three tranches for import financing (first tranche US$71 million, second tranche US$71 million, and third tranche US$76 million), and (iii) the TA component (US$7 million). The conditions for tranche release are listed in Annex II. Funds for debt-reduction would be available upon loan effectiveness and agreement between the Bank and the Government on a debt-reduction program satisfactory to the Bank. After February, 28, 1991 unused funds for debt-reduction can be reallocated in equal portions to the three import financing tranches. The import financing component of the loan would be disbursed upon fulfillment of the corresponding specific tranche conditions, and would be used to finance 100% of the c.i.f. costs of general imports not contained in a negative list. Ineligible imports comprise goods financed by other multilateral or bilateral sources, luxury goods and goods intended for military use. No more than 15% of the loan amount can be disbursed for imports of foodstuffs. Retroactive financing in the amount of US$60 million would be available for eligible expenditures incurred after March 31, 1990. IDB funds would be released in three equal tranches subject to compliance with conditionality as agreed under this operation. The TA component would finance 100% of the local and foreign costs of approved expenditures. 132. Procurement will be carried out in accordanc with the Bank's Procurement Guidelines. All contracts for the procurement of general imports to cost the equivalent of US$5.0 million or more shall be awarded through simplified international competitive bidding. Contracts of the private sector costing over US$1 million and under the equivalent of US$5.0 million would be - 38 - procured following established commercial practices which should include whenever possible requiring two quotations from eligible bidders from at least two foreign countries. Contracts of the private sector costing less than US$1 million would be procured according to commercial practices acceptable to the Bank. Public sector contracts below US$5 million would be procured according to limited international competitive bidding or shopping procedures acceptable to the Bank. To ensure the acceptability of the procedures, the Bank will exercise strong gS Rost supervision. The procurement of equipment under the TA component costing the equivalent of US$50,000 or less would be made through local or international shopping; above US$50,000 they would be made through Limited International Bidding (LIB). All LIB would have prior review in the Bank. Consultants to be financed with the proceeds of the loan will be employed in accordance with the principles and procedures set forth in the "Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" published by the Bank in August 1981. 133. The BCV will be responsible for maintaining loan accounts, and for preparing and submitting withdrawal applications. Disbursements from the proposed loan would be made on the basis of a summary from ZV detailing individual import transactions in each relevant period, together with a certification of payments of the amounts involved, and of their eligibility under the loan. Applications for withdrawals will be consolidated and submitted in amounts not less than US$1 million. 134. The BCV will maintain separate accounts to record and monitor loan disburs_mnts and repayments. All records and accounts in support of statements of expenditures financed under the proposed loan will be made available to Bank missions and will be audited each year in accordance with sound auditing principles by independent auditors acceptable to IBRD. Benefits and Risks 135. Benefits. The proposed operation would increase the overall efficiency of the financial system and thus enhance its ability to finance investment and growth. This would result from increased resource mobilization, improved credit allocation, and a lower cost of credit. The proposed reforms will contribute to these goals by: (i) enhancing competition in the financial sector with the liberalization of interest rates, credit allocation, and the participation of foreign banks; (iI) enhancing the transparency of the condition of intermediaries and depositor confidence in the intermediaries through improved prudential regulation and sqpervision of banks; (iii) reducing inefficiencies created by the excessive Government ownership participation in the banking system; and (iv) providing adequate mechanisms for dealing with banking distress. 136. 'While it is very difficult to isolate the impact of the proposed reforms from the influence of other economic policies, the major contribution of the reform program in the modium term will be derived from the enhanced financial/monetary stability and fiscal discipline induced by the reforms. In this respect, the reforms are an integral part of the stabilization effort. 137. The proposed reforms are expected to have a positive social impact. On the one hand, interest rates will rise following the liberalization of commercial banking rates and the streamlining of the preferential interest rate structure. However, this will be offset by the following factors: (i) the - 39 - expansion in the range of eligible borrowers as credit programs are rationalized and widened; (iU) the elimination of credit rationing in formal credit markets, so that small borrowers need not go to informal markets where they might pay exorbitant rates; (iii) enhanced small deposit protection with the strengthening of financial institutions and of FOGADE as a last recourse; and (iv) the reduction in intermediation spreads which represents a tax on mobilized resources. 138. Risks. Given the complex nature and political implications of many of the proposed reforms, there is a risk of some delays in the implementation of the reform program. However, the momentum created by the macroeconomic reforms successfully carried out to date, coupled with the recognition within the administration, the Congress, and financial markets of the need for the reform, will help sustain the process. A special coordinating unit has been created within the BCV which, among other functions, will garner support for the reforms. In order to reduce potential political opposition to the reforms, high- ranking Government officials have been holding discussions with key members of Congress to ensure support for the proposed legal changes. A further risk, although slight in the case of Venezuela, is that failure to maintain macroeconomic stability could endanger the success of financial sector reform measures. To reduce this risk, loan conditionality will stipulate that for each tranche release the Bank shall be satisfied that the macroeconomic framework is consistent with the financial sector reform objectives. PART VI - CONTY ASSISTANCE SR=EY AND AN OPERATIONS 139. After a 15-year hiatus in its lending relationship with Venezuela, the Bank in FY89 initiated a substantial program to support the Government's efforts to create a policy environment for sustainable growth. The Bank's current focus is on sustaining and deepening the policy reforms already started. Increasingly, the Bank's focus will shift toward investment lending in the social sectors, public infrastructure, and environment. History of Bank Assistance 140. Between 1961 and 1974, the Bank approved 13 loans to Venezuela, totalling US$383 million, of which US$342 was disbursed. IBRD loans to Venezuela included support for agricultural development (two projects), transport (four projects, including an airport loan), power (four projects, including part of the Guri hydroelectric project), telecommunications (two projects), and water supply (one project). Most projects were viewed a* relatively successful, and funds were fully repaid as of June 1989. 141. After the 1973 oil windfall, Venezuela chose not to borrow from the Bank, and subsequently the country's per capita income increased to levels above the Bank's graduation limit. However, the Bank maintained a Resident Mission in Caracas through 1979 and provided technical assistance to help in the appraisal of proposed projects ard in general economic analysis. 142. The Bank's current role reflects a recent resumption of lending based on the strength of the Government's economic program. However, confronted by the onset of the debt crisis and a sustained decline in economic output in the mid-1980s, Venezuela sought a renewed borrowing relationship with the Bank and was declared eligible to borrow in 1986. As described earlier, the new - 40 - administration of President P6rez introduced a strong program of economic reforms and requested substantial technical and financial support from the Bank and the Fund. The Bank responded with the US$402 million Structural Adjustment Loan (SAL) and the US$353 million Trade Policy Loan (TPL) approved in June 1989. Bank Operational Strategy 143. The Bank's operational strategy in Venezuela has two basic thrusts. The first is to use adjustment lending operations to assist the Government in sustaining and broadening the policy and institutional reform process. The SAL and TPL have supported the basic policy changes required up front to reduce distortions in the economy, increase the role of market forces in the allocation of resources, and expose domestic producers to greater competition through trade liberalization. The Financial Sector Adjustment Loan will support efforts to strengthen and liberalize the financial sector. The Public Enterprise Reform Loan, which is also expected to be approved in FY90, will support efforts to redefine the role of the public sector in the economy and to maximize the productive response to the adjustment program through restructuring of key state enterprises, clarifying their relationship with the central Government, eliminating the barriers to entry for private enterprises, and privatizing selected enterprises. Assuming that efforts to sustain and broaden the reform process are continued, additional lending has been planned for FY91 and rY92, including an agricultural sector adjustment loan and a second loan for trade policy reform. Through such adjustment lending, the Bank will help build an economic environment in which market-determined prices can guide the efficient allocation and utilization of resources, in both the public and private sectors. These adjustments are important prerequisites for achieving greater efficiency of public investment. 144. With the basic policy reforms in place, attention should shift to sector-specific issues which need to be tackled in the context of project lending. The second basic thrust of our strategy is to build up a pipeline of investment projects. The pace of preparation, appraisal, and implementation of investment projects is likely to be slowed by the newness of our relationship with Venezuela and the Government's inexperience with Bank requirements and procedures. To facilitate the preparation of projects, a Technical Assistance Loan (TAL) has been included in the FY90 program. The planned shift toward investment lending will begin in FY91. 145. Our analysis indicates that the country is creditworthy for Bank lending of about US$750 million per annum. The Bank's key contribution is likely to be the assistance provided by Bank staff in designing and implementing the investment projects. Sectoral Composition of Bank Lending 146. Trade. Finance and Industry. Support to these sectors would seek to consolidate the reforms begun with the TPL and to lay the groundwork to make public and private enterprises more efficient. Severe weaknesses in the financial sector would be addressed in the Financial Sector Adjustment Loan (FY90). With these under way, the stage would be set for the Private Sector Restructuring Loan (FY91) intended to assist the restructuring of private sector industry to cope with international competition. The Second TPL (FY92) is - 41 - expected to support the completion of trade reform with emphasis on the reduction of the level os protection over time and on export promotion measures. 147. Agriculture. It would be difficult to undertake viable lending operations without first instituting some basic reforms. Currently there is an interlocking and complex web of price supports, subsidies, directed credit at highly subsidized interest rates and import and export controls. The Agriculture Sector Adjustment Loan (FY91), which will concentrate on liberalizing agriculture trade and domestic pricing, is intended to set the stage for Bank project lending in agricultural infrastructure and support services, possibly an Irrigation Project (FY93). 148. Infrastructure. Institutional and financial reforms are under way in some key agencies in the infrastructure sectors, but Bank assistance is deemed necessary as many of these institutions will virtually have to be rebuilt. The Water and Sewerage Project (FY93) while supporting the reorganization of the sector upon the planned restructuring of INOS (a centralized water and sanitation agency) will also finance high-priority investments in the sector. The Power Distribution Project (FY92) is intended to support the decentralization of a national utility company's distribution services, upon completion of the ongoing sector reforms. 149. Social Sectors and Environment. The program for FY91 includes two investment projects directed towards poverty alleviation and designed to ameliorate the social impact of adjustment, particularly on the poorest and the most vulnerable groups. The Social Development Project is designed to support the nationwide expansion of a program for maternal-infant health and nutrition. The Slum Upgrading Project (FY92) will improve the physical infrastructure and basic services in poor urban neighborhoods. It is anticipated that such social sector projects, with a strong poverty alleviation orientation, will have a central place in the Bank's lending to Venezuela. Environment will be another area of focus. The Environmental Protection Project (FY93) will support establishment of the country's legal and institutional framework for environmental protection while helping to prepare and finance specitlc investment projects to reverse the contamination of Lake Maracaibo and the Tuy River. IFC Operations 150. Because per capita income exceeded the Bank Group's graduation limit, IFC was not active for several years in Venezuela. However, IFC resumed operations in Venezuela in the mid-1980s and now has an active program. Between 1960 and December 31, 1989, total gross commitments by IFC were US$162.3 million, of which US$158.9 million were loans and US$3.4 million were equity. In the past three years, IFC has moved quickly to make major investments in areas that had previously been the preserve of the public sector. In 1988, it approved an investment to VENCEMOS for cement production; in 1989 it approved investments to OPCO and PROPILVEN for hot-briquetted iron production and polypropylene production, respectively. IFC has directed its efforts at supporting the Government's strategy of exploiting natural resources to support the balance of payments and to diversify the economy. - 42 - PART EII - COLtABORATION IM TUE IM? 151. There has been close coordination with the IMF in the preparation of this proposed reform program. The Government requested technical assistance from the Fund's Central Banking Department to help prepare a program for financial sector reform. At the request of the Government, the Fund's technical assistance mission and the Bank's preparation mission visited Caracas at the same time to facilitate coordination. Close coordination was established between both missions which resulted in very similar recommendations for reform. IMF staff have been consulted at different stages during the preparation of the reform program and have expressed their full support. We expect to continue collaborating closely with the Fund, not only in the design of the reform program but also in the assessment of the appropriateness of macroeconomic management for ensuring a stable environment required for the success of the operation. PART VIII - RgCOYWKD&TION 152. I am satisfied that the proposed loan wou'd comply with the Articles of Agreement of the Bank and recommend its approval y the Executive Directors. Barber B. Conable President Attachments Washington, DC May 21, 1990 ENEZUELA - tey Nacroecnamic Indicators .... ......... ................................ Debt Redution Scenorio ..................................................................................................................................................... A c t u a t Pre(a. Esttimte P r o j e c t i o n s Key rdicators 1J 1964 1985 1986 1987 1968 1989 1990 199 1992 1993 1994 1995 eP Growth -1.4K 0.31 5.2n 4.51 6.21 -8.1t 5.31 5.22 S.0K 4.31 4.3x 4.3 GT Growth 0.1X -2.9s -0.6" s.2n 4.1X *5.8s S. 5.1X S.21 5.0X 5.01 S.11 UDT/Cspita Growth tate -2.7X -S.?% -3.41 2.sx 1.51 -8.1K 3.21 2.7? 2.7K 2.7x 2.6" 2.9X Private CownstioCqapita Growth Rate n.s. -S.1 7.11 0.41 3.5X -7.1K 0.1X 0.3X 1.6X 1.2K *.6% 2.2K Debt Service (USS mittioar) 426.4 4290.S 49809.2 4669.0 4989.0 S1S2.0 4998.9 35.7 3787.1 473.7 4902.9 5S76.5 Debt Service/XGS 27.2K 24.5K 42.41 37.2K 39.2K 34.SK 3. 11 20.2K 19.2K 21.51 20.2K 21.2K Debt Service/DP .11 6.9S s.2x 10.1 6.31 12.71 11.3 ?.71X ?.S 8.5 8.01 8.41 Groe fixed Inestmnte P 14.0X 15.2X 20.31 21.8X 22.9% 17.3K 19.91 21.9K 23.71 24.6S 25.11 25.31 Deanstic SevingsCDP 25.21 20.61 20.4K 23.1 20.6X 23.3K 25.01 25.9s 26.4X 27.51 28.2K 28.71 Natimnsi SIrigu/GDP 22.OX IS.2 17.3 19.9X 17.6X 17.11 20.7X 22.SX 23.31 24.51 25.41 26.0X Raroinat Dometic Sawins Rate .. .. .. 4S.41 13.31 53.x 65.51 47.3x 3s.s5 38.9K U."K 27.SX PtMic Fixed Invetment/0P 6.3X 6.41 12.11 10.6" 10.71 10.0K 113.5 12.31 12.9K 13.11 13.11 13.1K P.Mic I ationdl Saviqs/UDP 16.91X 17.3 2.31 10.3s 4.6X 9.6K 12.4K 16.31 18.4K I8.71 18.91 19.21 Private Fixe mestusnt/UP 9.5K 10.4x 6.21 1l.2n 12.1K ?.31 8.4K 9.6K 10.3 11.ts 12.OX 12.21 Private atioatl Sains/P S.11 -2.6K S."K 9.6K 13.0K 7.5s 8.01 6.2K 4.91 s.3 6.ss 6.3 Ratio of PMi/rfvate Intment 66.31 61.5K 147.2x 95.01 88.5X1 13.3 137.8 128.7 119.9 114.6s 10o.4 107.31 Oovarwt R"ewuws/P 31.3 30.0X 26.11 28.91 24.4s 31.4x U." 3s.ss 3r.4s W7.5s 3V.4" 3.41 Cover,mnt UmpE nditures/UP 2.31 25.21 3. 30.91 32.3 32.3 34.1n 33.01 33.51 3.5X 33.n1 32.3 Deficit (-) or Spiw (+)/GIP 4.51 4.81 -2.6 -2.0K -8.31 -1.4K -O.S 2.SX 3.9% 4.11 4.31 4.71 mPtortroth Rte V 5. 1.01 S. t. -1.71t 7.9s 2.1X 9.4K 6.21n S.9 5.n S5 4.9. Exparts/U 2/ 28.31 25.6 19.U 21.U 20.7 33.31 34.7 3S.1s 3SA6 36.21 3.4 3r.0 I_rt Orouthtbte 2/ 56.1K -11.o0 21.5s 2.2x18s. -33.02 3o.6x I1." 103 6A 5.9 S.31 I_ots/U 2/ 17.0S 16.01 20.2 23.41 27.31 24.21 29.71 31.5K 33.3x 33.3 34.O0 34.01 Curren *ccemt CUSS NiWiho) 4580 364.0 -1S5S.0 -110.0 -0513.0 1889.0 332.0 62.0 448.4 -311.7 -111.s 189.1 Cwren Acesfet/P ?.9 6.01 -2.5X -2.4K 7.51 4.11 o.s3 O.K -0.91 -o." -0.21 0.31 ..................................................................................................................................................... 1/ All UP ratios re at eurrnt prices. 0/24190 2/ Expwrt an ipowts of goods a nan-factor services matiamol Accounts). O4M PN Io o, VEIEZUELA - SALANCE Of PAYMENTS ............................... (USS Miltions at current prices) ............................................................................................................................................................... A c t u a I Prelim. Estimate P r o j ec t i o n s 196 198T 1988 1989 1990 1991 192 1993 1994 195 1996 1997 1998 ................................................................................................................................ ............................................................................................... *vo.^ .e@J A. Imports of Goods & UfS 10111.0 11279.0 11206.0 13S98.1 14682.3 16221.6 18024.S 20132.6 22306.3 2480.8 2725.3 30850.4 34385.4 1. lerhmdwie (FOB) 9122.0 10567.0 10269.0 12585.0 13561.1 14960.9 16651.4 18611.? 20701.6 23014.? 25M.0 26591.2 31899.7 2. nm-factor sevtes 969.0 712.0 937.0 1013.1 1121.2 1240.7 1373.0 1520.9 1684.7 186.1 2053.3 2259.2 2485.7 D. laports of goods & IFS 10061.0 10880.0 13946.0 9196.2 12537.2 14S86.6 16867.3 18799.0 20794.4 2280.1 24959.3 2730.6 294.3 1. nercandise (FOB) 782.0 8832.0 11414.0 7138.2 999.6 1128.6 13446.6 1496.3 165.2 18239.9 19697.5 21811.8 23911.3 2. Ian-factor servies 2199.0 2048.0 2532.0 2060.0 2542.6 2958.3 3420.6 3811.? 4217.2 4640.2 5061.6 SS8.8 6062.9 C. Resource klance 50.0 399.0 -2740.0 400.0 2145.1 1634.8 1157.1 1337.S 1592.0 2000.8 2866.0 349.8 4391.1 0. Net factor Imne -1483.0 -1374.0 `1650.0 -2374.0 -1673.0 -1432.8 -1465.6 -1S09.2 -1S63.S -1671.7 -1685.8 *t660.8 -1S79.1 1. Factor Receipts 1734.0 1411.0 1642.0 1472.0 1511.1 1616. 1811.6 1927.5 1M6S.? 1978.2 2028.0 2127.6 2214.1 2. factor Ps mnts 3217.0 278.0 32S .0 386.0 3184.2 3046.8 3277.2 3436.? 3S32.2 3649.9 313.7 376.4 3M93.2 (interest pevuents) 3095.0 2674.0 3082.0 3621.0 2927.3 2747.4 2925.6 3037.4 3080.S 314M.5 31SS.9 3170.9 S311.8 1. let Current Trnsfer* -72.0 -`128.0 -123.0 -137.0 -140.0 -140.0 140.0 -140.0 -140.0 -140.0 -140.0 *140.0 *140.0 1. Current Receipts .. .. .. .. .. .. .. .. .. .. .. 2. Current P ints 72.0 128.0 12. 137.0 140.0 140. 140.0 140.0 140.0 140.0 140.0 140.0 140.0 > f. Current Accotnt Balance -1S05.0 -1103.0 -4513.0 1889.0 332.0 62.0 -40.4 -311.7 -111. 19.1 t040.2 1689.0 2672.0 C. Long-Term Capitol tnftlo -16S.? -1S9.8 -119.0 t1118O 2017.7 1S24.6 2336.4 1720.7 162s.7 1366.8 1516.3 747.5 34.6 1. Direct 1ns t Inet debt/equity sws 16.0 21.0 69.0 213.0 410.0 470.0 500.0 530.0 S25.0 S60.0 600.0 650.0 700.0 2. Officlat Capital Grants 34.0 -22.0 -31.0 -29.0 -34.0 -40.0 -47.0 -53.0 SS.O *s7.0 -60.0 63.0 -66.0 3. let Lt Lons -141s.7 -1458.8 -177.0 S72.6 1401.7 914.6 1733.4 1123.7 1003.? 62.8 976.3 160.5 286.4 . Disbur_emnta 478.5 S18.2 1780.0 2194.0 3413.3 2258.9 3069.9 3018.1 2833.6 3081.0 3253.5 3427. 3565.1 b. Reps ents 1/ 1894.2 1977.0 19.0 1621.4 2081.6 134.3 1336.s 1894.4 1749.9 2255.s 227.3 3266.6 3851.5 4. Other LT Inflows (let) 2/ 0.0 0.0 0.0 361.4 240.0 180.0 1so.0 120.0 75.0 40.0 0.0 0.0 0.0 N. Total other Itt n (not) .1014.3 1439.8 -1S1.0 -1820.0 -3072.1 -44.6 -460.0 56.1 -s55.1 -311.3 -613.3 478.4 -S9t.4 1. let Short-Term Capital 169S.0 2277.3 938.0 -3647.0 405.6 71.4 90.3 1S.9 14.2 -4.6 63.3 -28.4 -47.4 2. Capital Flaws 3.E.I. 3/ -775.0 -866.0 -1083.0 -1090.0 *4227.7 -1016.0 -1050.3 .1022.0 1064.3 406.6 .1050.0 -1050.0 -1050.0 3. Errors ard 6issions 4/ -1934.3 28.5 -6.0 2917.0 750.0 SOO.0 500.0 s5O.0 S0.0 SOO.0 500.0 500.0 SOO.0 1. Changes In net res s 35.0 1123.0 473.O -1187.0 722.3 -1142.0 -1427.9 -902.9 -967.1 -1246.6 43.1 -1858.2 -2422.3 1. Not Credit fram the lIf 0.0 0.0 0.0 998.0 1977.4 160S.0 677.3 .371.9 -S2.6 -6n.8 -672.8 -672.8 -672.8 2. Other reserve change 365S.0 1123.0 47B5.0 -2185.0 -1255.1 -2747.0 -2105.2 .530.9 -394.6 -S73.8 -1270.3 -1185.4 -1749.5 t- indicates increasel .................................................................................................. ........................................... , o.... 1/ lncludes pre-payment of debt via debt/equity swps. 0M/24/90 n 2/ Capital gains an debt/equity swaps. 04:36 PH 3/ Counterpart to private Interest receipt plus funds used for debt reduction operations. 4J Historicat is errors & omission as estimated by government (include net capitat flight). Future is projected reverse capital flight. VEWEZUEtA - BALANCE OF PAYMENTS ............................... (USS millions at current prices) ............................................................................................................................................ ................................................................................... ........ A c t u a I PrelIm. Estiuat P r o j ec t i o n s 1966 1987 1988 1989 1990 1991 1992 1993 1994 199 1996 197 1996 of..................................................................................................................................................... J. Shares of GDP (spot exchange rate) 1. Resource Osltcne 0.1 0.9 4.6 10.8 S.1 3.5 2.3 2.4 2.6 3.0 3.9 4.3 4.9 2. Total Intero t Paymnts 5.1 5.7 5.1 8.9 6.9 5.9 5.8 S.S 5.0 4.? 4.3 3.9 3.5 3. Current Accowut Satn -2.5 -2.4 -7.5 4.6 0 8 0.1 -0.9 -0.6 -0.2 0.3 1.4 2.1 3.0 4. LT Capital Inflow (line 0) -2.2 -3.1 -0.2 2.7 LA 3.3 4.6 3.1 2.7 2.0 2.0 0.9 0.4 S. Set Credit from the IF 0.0 0.0 0.0 2.5 4.7 3.S 1.3 -0.7 -0.9 1.0 -0.9 -0.6 -0.6 Nemut Ite-. UP (Ati Method) 6SO53.8 57317.4 S8964.7 S0374.0 49268.1 6624.0 S0436.6 SS404.7 60654.4 66959.6 C4010.7 61412.0 69442.4 UP (Spot Exchange Rate) 60882.6 468S7.9 60138.3 4071S.6 42280.9 46239.6 S0632.3 S5653.1 61146.9 67261.4 73966.7 61099.0 69091.6 Foreign Exchang Reserves: 1. Internatiosnl Reserves 8264.0 7S91.0 3526.4 4519.2 5184.3 7841.2 9946.4 104?7.3 107T1.9 1144S.7 127T6.0 13901.4 156SO.6 2. Gotd (End-yr at 1300/ox) 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 3439.0 343.0 3. Gross Reserve tml. Cld 11703.0 11030.0 696S.4 7958.2 6623.3 1t260.2 13385.4 13916.3 14310.9 146t4.7 16155.0 1730.4 19039.8 4. Gr. tn. in Months iworts 10.6 9.7 4.6 7.3 6.6 7.7 8.0 7.5 7.1 6.7 6.6 6. 6.6 Exchange ates I. Sm. Off. S-Rate (IFS rf) 8.1 14.3 14.5 34.3 48.0 S3.3 S6.2 S9.2 62.3 65.5 69. n.6 76.0 2. Real Eff. X-lbat ase 19i 00 1000 71.6 63.6 SS.8 53.1 53.1 53.1 S3.1 S3.1 S3.1 53.1 S3.1 S53.1 3. X-Rate for CGP Conersion T.6 11.9 14.8 27.7 41.2 S2.7 56.4 59.4 62.6 6o.9 69.4 73.3 77.7 Inflation Rates I. UP Deflator -O.SS 32.12 20.82 74.32 38.0! IS.S 9.9S 10.41 1O.4" 10.6" 11.23 10.96 11.12 2. Domtic Aborption Deflator 13.22 33.1S 23.72 61.32 39.02 16.02 10.02 10.02 10.02 10.02 10.0S 10.0S 10.0O ............................................................................................................ ................................................................................................................... ....... 0424/90 04:36 PR 00 U' 00 OQ WENEZUELA -rojected Long-tem Firancing Requiremnts ................................................... (Uss milttin. usat averae) 196-89 1M90.92 1993-95 aross Sisbirsosants ....... ....... ....... ................... toig-Tom dStress mdltl.taarl 130.4 1225.5 632.0 of d1icb lr 23.8 S15.0 444.6 llteral 91.6 394.3 201.2 SiWisrs Credits M3.7 44.0 1319.3 fineawilt farkets to PIhte Sector 423.9 233.3 100.0 Private Cun-wrt ared Lt 31.0 240.0 525.0 ISf p2 0Se 249.S 1461.5 0.0 Finrialt Sap 0.0 0.0 0.0 MoTAL 1W.2 4400.6 2977.6 lwt OON amts ................. haltilateral 109.5 1205.9 699.2 of id,fb lrn 15.2 O S... 3n.0 Sitaterlt -39.9 247.9 96.2 S*plters Credits 201.4 453.0 442.6 Fiancmiat Hrkets to "tic Sector -348.9 -106.9 -U.4 Private UonuAranteed LT -516.3 153.7 361.3 If Purcha. 249.5 1419.9 -539.1 et Short-Trm Oebt 207.6 36?.6 267.9 rfinnclal Gap 0.0 0.0 0.0 TOTAL -136.8 3759.2 1239.9 ............................................................................................... 04/24/90 04:36 N o0 oh tnb VENEZJELA - Debt Service Assuqtions (USS miIlIonsh aewl average) ................................................ .................................................................................. ................................ 196689 1990-92 1993-9 Primcipel Reprmnts ....... ....... ....... .................... ntitertaL 20.9 19.5 132.8 ot hmtch IED 13.6 0.0 71.6 of latert 131.7 148.4 105.0 SsWliem Credits 234.3 391.0 876.7 ftrfial Markets to Publc Sector M.7 342.2 188.4 Private Men-Guarnted LT 549.3 66.3 163.? Im repu hae 0.0 41.6 539.1 f$nwcitl Gap 0.0 0.0 0.0 TOTL 113.8 1029.1 2005.6 inteet Pa_its ................. maltIleteral 18. 146.8 36.8 of imAch l68 1.2 85.4 232.0 ot lateral 67.6 91.5 123.3 Suppiers Credits 6S.S 180.1 300.4 FinweiIt aMrkets to Public Sector 2180.6 1432.7 1123.8 Private -Guarasteed LT 469.3 497.0 533.8 off Sere Cares 10.8 2i., 353.7 woort-etr Debt 305.9 222.2 287.0 ftnmctel Gep 0.0 0.0 0.0 TOTAL 3118.0 2866.8 308.6 Key Ratios 1988 1989 1990 199 1992 199 1994 l19 ,.... ...... .. .. .. .. .. .. .. .. total Internt/SS 24.2X 24.23 18.23 1S.5 14.93 13.93 12.7 11.83 ND/SOS 282.43 220.43 18.83 t86."3 181.S 167.13 1515.03 142.13 net Dis as nts/Totael Intest It S.3 10.73 134. 109-.23 102.6X 41.7 33-.3 20.63 et tr,f.rstIP 17 -2.5X -7.93 2.43 0.53 0.T1 -3.28 *3.43 .3*73 onw V' used for Debt C_werslofnP 0.U3 o.03 7." 0.03 0.13 00 0.1 0.33 la ................................................................... .......................... -----------*00----------*--*-w---* e 1/ ienh_ IWS. FAMSI Short-tf CWaital Rears Capital Ft tl ht ad Pro-Pageat r 04/24/90 > ds*Et- ty Se . :s . - 48 - ANNE I Page 1 of 3 pages VNEZUELA - FINANCIAL SECTOR ADJUSTMENT LOAN SUPPlEHiTtAR LOAN DATA SHEET Section I: Timetable of Mey Events (a) Time taken by the country to prepare credit : 14 months (b) Credit prepared by : Central Bank (c) First presentation to the Bank : June 1989 (d) Departure of appraisal mission : March 1990 (e) Completion of negotiations : May 1990 (f) Planned date for effectiveness : June 1990 Section II: Special Bank ImDlementation Action None Section III: Special Conditions 1. The proposed loan will be released in three tranches (excluding the technical assistance component). The release of the first tranche will be subject to the following conditions: (a) The Bank must be satisfied that the macroeconomic policy framework is adequate to sustain the financial sector adjustment program. (b) Studies of the financial condition of commercial banks and selected mortgage banks and finance companies will have been commissioned. (c) SBIF will have issued all the changes required to tighten regulations on: provisioning, loan classification, roll-over of credits and accrual of interest, charge-offs, evaluation of investment portfolios, and evaluation of property received as collateral. (d) SBIF will have issued instructions to banks to: (i) establish a general loan-loss provision of at least 1.5% of loans by December 1990 and 2% of loans by June 1991 (with specific provisions counted against the general provision); (ii) write off loans past due by more than 36 months by June 1991; and (iii) require their auditors to include an assessment of loan classification and concentration in audits. (e) Government will have issued a resolutio. forbidding BIV and BANDAGRO from engaging in lending operations by requiring that any new deposits and all loan recoveries be invested in securities of the Treasury or the BCV. BIV's operations will resume once its restructuring is substantially under way. - 49 - AN 1 Page 2 of 3 peess 2. The release of the second tranche will depend on compliance with the following: (a) Maintenance of a macroeconomic policy framework including adequate management of international reserves, satisfactory to the Bank and consistent with the program. (b) Satisfactory progress will have been made in implementing the agreed reform program as stated in the Letter of Sectoral Policy. (c) Submissiorn to Congress of a proposed new Law of Superintendency of Banks in accordance with suggestions in Annex VI. (d) 3ubmission to Congress of revisions to the Law of the Central Bank. The proposed Law must: (i) allow full market determination of interest rates; (ii) grant the BCV full and exclusive prerogative to set interest rates on all transactions of intermediaries; (iii) allow the BCV to purchase negotiable T-bills subject to the Government's credit ceiling; (iv) include foreign-currency denominated debt in the Government's credit ceiling; and (v) restrict all rediscount contracts given by the BCV to no more than 30 days. (e) Submission to Congress of revisions to FOGADE's Law. Modifications should be in accordance with suggestions in Annexes VII and VIII. (f) Submission to Congress of revisions to Public Credit Law to permit issuance of fixed-term, negotiable, interest-bearing, short-term T-bills. (g) Submission to Congress of proposed laws creating two second-tier credit institutions (for agriculture and industry, respectively) which will absorb at least 5 funds. (h) SBIF will have issued and implemented all the changes required to regulate the valuation of exchange risk, loan concentration limits controls of intra-group transactions, consolidation of accounts of financial groups, and uniform publication criteria of financial statements. (i) The three banks owned by BCV will have been brought to the point of sale. All valuation and tender or bidding documents for the sale of the banks will have been completed to the satisfaction of the Bank, and bidding documents will have been issued to prospective purchasers. (j) SBIF will have completed all studies of financial condition of all private commercial banks and of selected mortgage banks and finance companies. (k) Submission of program acceptable to the Bank to disengage all managed portfolios from the BCV (except FICAM). The program should contain the information listed in Annex IX. - 50 - MM I; Page 3 of 3 pages (1) Submission of action plan acceptable to the Bank for the restructuring of BIV and its four regional banks, inlcuding a specification of their new role. 3. The release of the third tranche will depend on compliance with the following: (a) Maintenance of a macroeconomic policy framework including adequate management of international reserves, satisfactory to the Bank and consistent with the program. (b) Satisfactory progress will have been made in implementing the agreed reform program as stated in the Letter of Sectoral Policy. (c) Submission to Congress of modification of the Bank Law which will include all aspects of the reform program agreed in the Letter of Sectoral Policy and loan documents. (d) Government will have issued decree reducing the agricultural lending requirement on commercial banks to 12% of their total portfolio. (e) Presentation to the Bank of satisfactory program for the full recapitalization of FOGADE. (f) Monthly capital contributions to FOGADE will have been made by the Treasury beginning in January 1991, which together will cover at least 50% of the estimated losses of FOGADE. (g) The three banks owned by BCV will have been divested from the public sector. (h) Satisfactory progress in carrying out the action plan for restructuring CORPOINDUSTRIA and ICAP. (h) FO&ADE's investment portfolio will have been disengaged from the Central Bank. - 51 - ANNEX III Page 1 of 12 pages VENEZIELA - FIANCIL SECTOR ADJSTM LOAN DRAFT 6OVERNMENT'S LETTER OF SECTORAL POLICY May 16, 1990 Mr. Barber B. Conable President international Bank for Reconstruction and Development 1818 H Street, N.W. Washington, D.C. 20433 USA Dear Mr. Conablet 1. The Government of Venezuela hereby requests a World Bank loan to support a financial sector reform program. The objectives of the reforms are: (i) to reduce intermediation costs; (ii) to mobilize greater financial savings, (iii) to allocate resources more efficiently, and (iv) to enhance the stability and solvency of the financial sector. These reforms are of fundamental importance to allow the financial system to carry out the role assigned to it under our country's macroeconomic program and increase its capacity for financing economic development. The reforms will focus on strengthening both the legal and institutional framework of regulatory agencies, improving the financial condition and promoting the competitiveness of intermediaries. and rationalizing the Government's role in the financial sector. 2. The financial assistance hereby requested will release counterpart funds which will help finance the costs associated with the reform program. Among others, these costs includes required capital contributions to the Deposit Insurance Corporation (FOGADE), expenses relating to rehabilitation or liquidation of some state-owned financial institutions and the subrogation of their foreign debt, and increases in the internal public debt service due to the new policy of issuing debt at market-determined interest rates. 3. Before setting out in detail the sector's problems and the scope of the reform program, it is useful to provide a summary of the macroeconomic reform program--of which financial sector reform will be a part--that is now being carried out by the Government. The Macroeconomic Reform ProSram 4. The short-term objective of the reform program has been to stabilize the economy and, in particular, the balance of payments and fiscal accounts. The cornerstone of the stabilization program was establishment of a unified, market-determined exchange rate. This measure alone dampened pressure on international reserves, by restraining import demand and reduced quasi-fiscal - 52 - mX III Page 2 of 12 pages losses of the Central Bank on account of foreign exchange guarantees. The fiscal situation was also improved by the rise in public enterprise tariffs and petroleum products, by tax administration measures, and by spending restraint. 5. While the stabilization effort must not weaken in the medium term, there are clear indications that it is succeeding. The nonfinancial public sector (which includes the Central Bank's quasi-fiscal accounts) registered a deficit equal to less than 2S of gross domestic product in 1989, down from about 92 the previous year. The deficit is attributable to losses on foreign currency guarantees granted under the previous import and exchange regime. The current account of the balance of payments registered a US$2,500 million surplus in 1989, although the overall balance of payments (as measured by changes in the Central Bank's net reserves) was in deficit because of lower than anticipated medium-term comercial bank financing. The exchange rate itself had displayed a notable stability during the first seven months of the program, remaining within a Bs 36.6-38.5/US$l.O0 range. However, it has since depreciated to the range of Bs 43-46/US$l.OO. Monthly inflatiov has been kept at just over 22 per month, following an inflationary surge in the first two months of the program. A resurgence of inflation in September and October 1989 was arrested with effective monetary measures. 6. Beyond stabilization, the longer-term objectives of the adjustment program are: (i) to promote private activity by enhancing the role of markets in resource allocation; (II) to modernize and restructure the public adminis- tration system, so as to reduce unnecessary regulations and interference in private activity; (iii) to establish and maintain a trade regime that is neutral in creating incentives among productive activities; (iv) to reduce the reliance on petroleum by promoting non-oil exports and alternative sources of Government funding; and (v) to increase domestic savings in order to limit foreign borrowing requirements. If these reforms are successful, it is expected that the result would be a sustainable rate of growth, with a greater degree of resistance to external shocks. 7. The measures taken thus far reflect considerable progress in most, if not all, of these areas. The rise in public enterprise prices and tariffs, in addition to contributing to improving the fiscal position, is a useful first step in public enterprise reform, as it allows evaluation of economic costs through the price mechanism. At the same time, ongoing trade reforms and elimination of price controls and subsidies on many products are allowing private sector prices to reflect true economic costs, and have ended the shortages experienced prior to the new economic policy. In the financial area, the liberalization of interest rates in February 1989 was designed to improve the financial condition of Intermediaries and to promote additional resource mobilization. While interest rate ceilings were reinstituted because of a Supreme Court ruling, the increase in interest rate ceilings over time has decreased the distortions in the financial system. Finally, the public investment program and social welfare expenditures are being reviewed to target beneficiaries more precisely, within the constraints imposed by the new fiscal responsibility. 8. Although growth prospects remain good in the medium ternm, the short-term costs of adjustment are proving to be quite severe. Non-oil GDP dropped by about 9.12 in 1989. Given this result, the adjustment process needs to be 53 ANNEX II2 Page 3 of 12 pages implemented in a way that is least disruptive and puts special emphasis on social sectors. In order to achieve this objective the Government has designed and presented to Congress an investment plan aimed at promoting economic growth and specially targeting social needs. 9. The Government will maintain a macroeconomic policy framework consistent with the objectives of its adjustment program. This framework will involve continuation of a unified, market-determined exchange rate and a financial regime in which interest rates are freely set in the marketplace. The fiscal position, together with the rate of growth of monetary aggregates, will be consistent with the restoration of real GDP growth and declining inflation rates. It is expected that the Government will maintain its policy of further improving the fiscal balance of the consolidated nonfinancial public sector. Also, given the impact of oil price movements on Venezuela's external balance, management of international reserves is crucial to macroeconomic stability, and, therefore, in the event of increasing oil prices, increases in the international reserves of the Central Bank are expected. Main Comoonents of the Proposed Refoms of the Financial System 10. There is a consensus within the Government that the financial system has to improve in order to perform its functions more efficiently. The Government has designed a comprehensive program aimed at confronting the following issues: (i) an inadequate framework of regulatory and supervisory institutions (including overlapping functions and imprecise responsibilities among different regulatory entities, weak supervision of financial institutions, and inadequate mechanisms for liquidating or rehabilitating banks); (ii) excessive Government controls over interest rates and credit allocation, which distorts the incentives of intermediariest (iii) solvency problems in a number of financial institutions (including some private commercial banks, public banks, state-run development funds, mortgage banks, and savings and loans [S&Ls]); (iv) the need to define and rationalize the Government's role as a financial intermediary; and (v) the need to provide greater clarity in the BCV's financial transactions with the Government and with financial institutions. I. Reform of the Institutional and Regulatory Framework 11. The Government recognizes that the institutional framework within which the financial system operates suffer.' from major deficiencies that must be corrected. The main deficiencies aret (i) co-existence of various regulators (Superintendencies, BCV, Ministry of Finance [kMH, FOGADE, and the National Savings and Loans Bank [BANAP)) with overlapping functions; (ii) imprecise separation of roles, approval procedures and coimmunication channels between these regulatory agencies; (iii) insufficient powers and independence of the Superintendencies; and (iv) concentration of powers in the ME that should be exercised by the Superintendency of Banks (SBIF). 12. A key element of the reforms will be the bolstering of the regulatory process, aimed at reducing the overlap of functions and ensuring functional, administrative, and financial independence of the SBIF. The SBIF will be responsible for the analysis and control of financial entities under its supervision. FOGADE will guarantee the public's deposits up to an established limit, provide financial support to rehabilitate entities with - 54 - ANNEX III Page 4 of 12 pages solvency problems, and, if necessary, liquidate entities. MH and BCV, each acting within their own jurisdiction, will be the lead agencies responsible for issuing general policies that the SBIF axd FOGADE must follow, yet will not have powers over these agencies' operations other than those specified by law. Finally, BCV will seek to maintain the stability of the exchange rate, money and credit, and will limit its transactions with banking institutions to managing short-term liquidity at market rates of interest. 13. The Government will submit for congressional enactment amendments to the FOGADE Law, the BCV Law, and the Bank Law. The first two will be submitted to Congress by the end of 1990. The Bank Law will be submitted to the Congress by mid-1991. In addition, a proposed new law for SBIF will be submitted to Congress by the end of 1990. In the preamble to these proposed laws, the Executive will stress the importance of the reforms and the need to speed their passage through Congress. 14. Prudential Regulation and Supervision and the SBIF. The proposed SBIF Law will grant autonomy to the SBIF by transforming it into an independent agency. Ample decision-making authority will be granted to the SBIF, and any requirements for approval by the MH on the SBIF's actions will be eliminated. The following actions will require approval from a Consultative Committee composed of the Minister of Finance, the President of the BCV, the President of FOGADE and the Superintendents (i) the intervention, dissolution or liquidation of financial institutions, (ii) the revocation or suspension of bank licenses, (Wi) the fixing of the minimum capital requirement. The SBIP will be financed through direct annual contributions from the entities supervised as a fixed percentage of their assets, but can also receive extraordinary contributions from the Treasury. The SBIF's annual budget will require approval by the Board of Directors of the BCV. The proposed Law will reinfcrce the powers of the SBIF to identify and address financially distressed institutions and will specify its scope for penalties and sanctions. It will also broaden the SBIF's powers to authorize, control, intervene, and proceed with the liquidation of financial institutions. The proposed Law and its implementing regulations will strengthen the SBIF's responsibility for setting capital requirements, standards for loan concentration and lending to insiders or related parties, preventive capitalization procedures for distressed institutions, and the conditions that prompt action by FOGADE. Finally, the proposed Law will also eliminate unnecessary provisions contained in the current Bank Law and will authorize the SBIF to raise minimum capital requirements until the Bank Law can be amended to that effect. The BDank Law and the BCV Law will be amended to include provisions supporting the new spirit of regulatory institutions. 15. The SBIF's enhanced autonomy and regulatory powers will be complemented by upgrading its functional organization and operating procedures. Together, these measures will result in the strengthening of prudential regulations and the SBIP's supervisory capability. 16. By June 1990, the SBIF will issue a series of resolutions to strengthen rules in the following areas: loan portfolio classification and provisioning, loan rollovers and interest accrual, asset write-offs, measures of investment quality, and criteria for the valuation of property received as collateral. By June 1990, the SBIF will instruct credit institutions to contract their auditors to review and render an opinion on the classification 55 ANNEX III Page S of 12 pages of their portfolio and concentration of loans as part of their regular audits. By December 1990, the SBIF will also issue resolutions establishings criteria for valuation of foreign exchange risk, limits on lending concentration, controls on intra-group transactions, uniform criteria for publication of balance sheets with notes to clearly and accurately reflect the financial position of the institution, and a methodology for consolidation of the accounts of financial groups and the accounts of overseas branches. Before July 1991, the SBIF will issue a new Chart of Accounts for financial entities in order to facilitate the analysis of the true financial condition of intermediaries and will issue audit guidelines in accordance with this new Chart of Accounts. By the same date the SBIF will also initiate monthly publication of a bulletin disclosing the status of certain indicators on the financial condition of financial institutions. By that time, the SBIF will have consolidated a number of organizational changes, including: (i) hiring and training of suitable staff, (ii) computerization of its operating systems, (iii) establishment of improved inspection procedures, (iv) internal reorganization to enhance its early-warning capability to detect potential banking problems, and (v) improved management of a credit information system (SICRI). 17. Mechanisms for Handling Bank Crises and FOGADE. The financial sector reform will strengthen FOGADE's capacity to handle bank crises by reinforcing its legal, institutional and financial position. FOGADE's Law will be amended to redefine its procedures for granting financial support in cases of bank insolvency, empower it to carry out liquidations, and enhance its financial position. FOGADE will intervene only by referral of a bank by the SBIF, and will grant assistance to banks only after removal of the bank's Board of Directors. Concessional assistance to financial institutions by FOGADE will take the form of capital contributions, while all credits and asset purchases will be performed at market value. It will administer or financially support institutions only after a majority of shares have been voluntarily sold or pledged to it. To finance FOGADE, the Treasury will make regular contributions matching the amount contributed by financial institutions. BCV management of FOGADE investments in trust will be eliminated, allowing FOGADE to manage its own funds directly. FOGADE will prepare its balance sheet and will account for its losses in accordance with standards established by the SBIF. By December 1990, FOGADE will contract a special study by external auditors to appraise the value of assets received from the BCV and in the course of financial support operations. This valuation will be performed on the basis of market costs and SBIF standards. On the basis of this study, the Government agrees to prepare a program by mid- 1991 for equity contributions by the Treasury to cover all losses. A partial recapitalization of FOGADE will be included in the proposed Budgetary Law for 1991 to cover during the first semester of 1991 at least 50Z of the losses estimated by the study mentioned above. After Budget approval, contributions will start in January 1991. By July 1991, FOGADE will review its internal regulations to make them consistent with this new approach and the law in effect at that time. 18. FOGADE will carry out operations to rehabilitate insolvent banks in those cases where rehabilitation is less costly than liquidation, and when necessary to prevent widespread destabilization of the banking system. To enhance market discipline, the Government will carry out during the second - 56 - ANNEX III Page 6 of 12 pages semester of 1990 a publicity campaign indicating that in the event of liquidation, FOGADE will only cover deposits up to the amount determinet by law. 19. CaDital Markets. The Government has decided that before December 1990 it will undertake a comprehensive evaluation of capital markets. in particular, it will aim to study options for the espansion of market activities, and the promotion of efficiency and technical capacity. II. Rationalization and Liberalization of Interest Rates and Credit Allocation 20. The Government's policy is to allow interest rates to be freely determined in the marketplace. In cases where this is not possible, only the BCV as monetary authority will have the prerogative to set interest rates. The BCV's exclusive authority in setting interest rates will ensure greater consistency with the monetary goals set by the BCV itself. For this purpose. amendments to the BCV Law will be proposed to Congress by the end of 1990 to: (i) transfer to the BCV exclusive power to set interest rates over all financial intermediaries including government-owned development funds; and (ii) allow it not to exercise this power, thereby permitting full market determination of interest rates. 21. Within the current legal framework, deposit and lending interest rates are subject to minimum and maximum limits respectively. These rates will be periodically revised in order to ensure sufficient scope for market determination. No interest rate regulations other than these limits will apply to commercial and mortgage banks, finance companies and S&Ls. The only bank credits that would not be subject to this policy are preferential industrial and agricultural credits (see below) and housing credits financed under the Ley de Politica Habitacional. 22. In order to enhance market discipline in the determination of interest rates, it is important that the public be informed of the interest rate regime offered by banks. With easy and transparent access to this type of information, the users of banking services can better exert the market discipline on which this reform program is based. For this purpose, the BCV will publish average interest rate indicators on a daily basis starting in June 1990, and will issue a directive to banks by December 1990 requiring them to announce and post their rates on all deposit and credit services, specifying the methodology for their calculation. Before June 1991, the BCV will publish in its monthly bulletin a table comparing interest rates offered by the various financial institutions, using a uniform methodology for presentation purposes. 23. Preferential Credits. The Government's medium-term policy is that all interest rates be set by the market. As a first step towards the elimination of interest rate subsidies, the Government has decided to increase preferential interest rates on all direct loans from government financial intermediaries, including development funds, and to increase the interest rates on agricultural loans granted through the commercial banking system. All preferential rates will be based on a market reference rate given by the average lending rate of the six largest banks on non-preferential credits. Beginning in June 1990, lending to agricultural activities by commercial banks 57 ANNEX II Page 7 of 12 pages will occur at a rate not greater than 85Z of the market reference rate, lending to agricultural activities by DFIs will occur at a rate not less than 85S of the market reference rate, and lending to other activities by DFIs will occur at a rate not less than 902 of the market reference rate. The availability of funds for non-agricultural credits at preferential rates will take into account the fiscal restrictions and the need to fimprove the efficiency of credit allocation. 24. For second-tier credits, the Government's financial intermediaries (including BANAP) will lend to the first-tier intermediaries at a rate not lower than the average cost of interest-bearing deposits in the banking system. First-tier institutions will absorb the entire credit risk of the final borrowers. 25. Credit Reauirements. The maintenance of the agricultural credit portfolio requirement is warranted by the need to adjust this sector gradually, but firmly, to the new market conditions prevailing in the financial sector. This measure is temporary in nature, and the Government expects to eliminate it under the current financial sector reform program. Beginning in June 1990, the minimum portfolio requirement on commercial banks will be reduced to 17.5S. The requirement will be further reduced to 122 by June 1991. III. Strengthening the Financial Condition of and Increasina Competition between Private Financial Institutions 26. The Government believes that there are solvency problems in some financial institutions, including both public and private entities (commercial and mortgage banks, finance companies, and S&Ls). Also, the Government believes that competition in the financial sector must be enhanced to reduce intermediation margins and encourage greater banking efficiency. Vith these objectives in mind, the SBIF will issue a resolution before June 1990 requiring all commercial and mortgage banks and finance companies to institute a general loan-loss provision for bad debts of not less than 21 of their total loan portfolio, and further requiring them to write off any loans that have been overdue for more than three years. These write-offs, which will be in addition to the minimum 21 provision, will start in July 1990 and will be completed by June 1991. Accordingly, the December 1990 financial statements of financial institutions will include provisions of at least 1.51 of their respective loan portfolios, and the June 1991 financial statements will at least complete the 21 provision requirement. The SBIF will undertake studies of all commercial banks and some other financial institutions, focusing on their solvency, loan portfolio quality, concentration of risks, and foreign currency exposure and exchange losses. These studies will be completed by end-1990. If as a result of these studies the SBIF determines that some institutions need to increase their provisions or write-offs, it will require them to adjust them in accordance with plans to be agreed upon. Also by December 1990, the SBIF will prepare an analysis of foreign exchange losses of public and private financial entities and a program for their amortization. The Government will not authorize the creation of new banks or finance companies until the SBIF has been strengthened, which is expected to take place by mid-1991. - 58 - ANNEX III Page 8 of 12 pages 27. By mid-1991, the Government will submit to Congress amendments to the Bank Law to promote greater competition in the financial sector. The changes will lncludet allowing the creation of universal banking, unifying and tightening capital requirements of commercial and mortgage banks and finance companies, and gradually liberalizing the entry of foreign banks. The legislated capital requirement will be asset-based, will permit risk-weighting in the future (including some contingencies), and the minimum equityltotal asset ratio will not be less than 5X. Recognizing that an enhanced presence of foreign banks can produce a significant increase in the efficiency of the domestic financial system and could facilitate the Government's task in seeking recovery of selected financial institutions, the following changes will be introducedt (i) foreign banks will be permitted to acquire up to 202 of the capital of local commercial banks; the Executive could further increase this percentage up to 302; (ii) legal power will be granted to the Executive to authorize foreigners to acquire a larger participation up to full ownership of, or to establish new, financial intermediaries other than commercial banks subject to operational criteria established by the Executive. The establishment of the criteria is not intended to discourage foreign investment in these institutions. IV. Rationalization and Reduction of the Government's Role in Financial Intermediation 28. The Government recognizes that its financial intermediation role (acting through state-owned banks and development funds) has brought about significant losses to the Treasury and has contributed to the segmentation and inefficiency of financial markets. The rationalization of the Government's development finance agencies will seek to increase efficiency, target benefits more precisely, and curtail fiscal or quasi-fiscal losses to the State. 29. The Government is profoundly concerned about the inefficiencies noted in state-owned banks, development finance institutions and development funds, including among others: the Venezuelan Industrial Bank (BIV), Industrial Credit Fund (FONCRZ8), Corporation for the Development of Small and Medium Industry (CORPOINDUSTRIA), the Agricultural Development Bank (BANDAGRO), the Agricultural Credit Fund (FCA), the Farming and Livestock Credit Institute (ICAP), the Coffee Fund (FONCAFE), the Fruit Development Fund (FDF). All of these organizations, to a greater or lesser extent, suffer from the following problems: (i) high rates of arrears in their loan portfolios, (ii) inefficient resource allocation, ($ii) little capacity to mobilize private independent resources to finance their operations, (iv) loan portfolios yielding below market rates, and (v) a precarious or sometimes insolvent financial position. 30. The Government has decided to rationalize its participation in commercial banking and in development finance in order to increase the role of market forces and to reduce its losses. For this purpose, it has decided to take a number of measures including the merger of selected funds, and the privatization, restructuring or liquidation of public banks. 31. Those funds that grant financing to productive sectors will be merged Into two large second-tier fundss an industrial credit fund and an agricultural credit fund. The industrial credit fund will absorb, among others, FONCREI, the Industry and Technology Development Fund (FINTEC), and 59 - ANNEX II Page 9 of 12 pages the second-tier financial intermediation functions of the Venezuelan Investment Fund (FIV). The agricultural fund will absorb, among others. the FCA, and the intermediation operations of FONCAFE and FDF. Their respective organic laws, which will be submitted to the Congress by December 1990, will provide for the transfer of operations of the existing funds to the new institution and will stipulate the expiration of their activities. Action plans for the creation of these two new second-tier funds will be prepared before December 1990. Because of their social welfare functions, CORPOINDUSTRIA and ICAP will remain as independent funds, and will only perform those first-tier lending activities arising from programs authorized by the Executive. The Government has also decided to prepare action plans for the restructuring of ICAP and CORPOINDUSTRIA. These plans will be ready by December 1990 and we expect that by mid-1991 there will be substantial progress in their implementation. All existing and newly created funds will be organizationally located under the MH, and supervised by the SBIF. 32. The Government is also aware of the need for actions to strengthen BIV, the largest state-owned commercial bank. To resolve this situation, the Government wills (i) require that any new deposits and portfolio recoveries be invested in securities of the Treasury or the BCV after June 1990; (il) coumission an independent analysis of BIV's financial condition and solvency; (iii) prepare before December 1990 a detailed restructuring plan including an implementation schedule. The plan will contain programs for financial recovery, staffing rationalization, and administrative reorganization of the BIV and of its four regional banks, and the schedule for the resumption of BIV's lending activities. 33. The Government has also decided to resolve the crisis at BANDAGRO, which has been under intervention for the last nine years. The Government will prepare a law to be presented to Congress by December 1990 proposing the liquidation of BANDAGRO in conjunction with the creation of the new agricultural credit fund. This law will specify what objectives formerly pursued by BANDAGRO will be pursued by the new fund. By June 1990, the Government will adopt interim measures to limit the bank's operations and to forbid any new ones. Accordingly, any new deposits or portfolio recoveries will be invested in securities of the Treasury or the BCV. 34. BANAP, which acts as the second-tier bank of the S&Ls, is also beset with serious financial difficulties. The Government will prepare a financial restructuring program for BANAP which will eliminate future needs for financing by the BCV or the Governmet. This restructuring program, including a new, more restrictive credit policy to S&Ls, will be prepared by December 1990. 35. The Government's subrogation of foreign debt obligations will be a significant element of the restructuring, recovery or liquidation programs, as the case may be, of the public financial institutions mentioned above. 36. The Government has initiated the process of reprivatization of the three banks owned by the BCV (Banco del Occidente, Banco Reodblica, and Banco Italo-Venezolano) through the Investment Fund of Venezuela (FIV). All three banks will be offered for public sale before the end of 1990, and the public sector's participation in these banks will have been divested by mid-1991. - 60 - ANNEX III Page 10 of 12 pages V. Increasin& the Clarity of the BCV's Credit ORerations 37. The BCV vill seek greater clarity in its credit operations with both the Treasury and the financial system. The basic criterion w$il be that all subsidy programs be made explicit in the Government's budget- and not be concealed in BCV's operations. This will facilitate better prioritization of public spending and will endow the BCV with greater flexibility in managing monetary policy by eliminating its quasi-fiscal losses. To this end, the Government will propose to Congress amendments to the Bank Law, the Law of the Central Bank, and the Law of Public Credit. 38. Considerable progress has been made toward enhancing the clarity of the BCV's operations. For example, unification of the exchange rate and the elimination of exchange rate guarantee programs have eliminated sources of income and expenditures that were not reflected in the budget and that resulted in quasi-fiscal losses for the BCV. The increase In the BCV's discount rate from 8 percent in January 1989 to the current 33 percent, as well as the new restrictive rediscounting policy, also resulted in the reduction in the implicit subsidy to the financial system. Finally, the issuance of bonds by the BCV at market rates will allow monetary policy to be conducted in an efficient, clear, and non-discriminatory manner. 39. The credit relationship the BCV will maintain with the Government will not be different from the relationship the BCV maintains with other economic actors with regard to rates and procedures. Accordingly, the BCV will no longer buy Treasury bills unless the bills are negotiable and pay market rates of interest. Further, the Treasury's debt instruments will be made more flexible by establishing in the Public Credit Law the power to issue fixed term Treasury bills that are not required to be redeemed within the fiscal year in which they are issued. The value of the Treasury bills will be determined in the marketplace and they will not be placed through preferential purchasing arrangements. The necessary amendments to the Public Credit Law will be submitted to Congress before December 1990. A reform of the BCV law will also be presented to Congress to allow the BCV to acquire on its own initiative Treasury bills, subject to BCV's monetary program and to the overall Treasury debt limit. This limit will be made applicable to any debt or rights to debt in either domestic or foreign currency, and will not be raised from the level contained in the current law. On a transitory basis, debt related to the ongoing external public debt reduction and restructuring program will not be counted within this limit. BCV purchase of Treasury bills will take place after an auction, on a residual basis, and at the average clearing price at such au:tion. Finally, an amendment to the Bank Law will be proposed to eliminate the use of Treasury bills as instruments satisfying the reserve requirement. The reserve requirement will be maintained only with BCV liabilities. These reforms will allow Treasury bills to be used in the future by the BCV as an alternative to BCV bills in open-market operations. 40. In the future, the discount window will be made available exclusively as a last-resort source of liquidity for financial entities (including BANAP). However, rediscounting will be kept as a tool for monetary expansion while the BCV's capacity for indirect monetary regulation is being - 61 - ANNEII Page 11 of 12 pages developed. In any event, the BCV's credit relationship with the financLal system will be revised to prevent subsidization and to ensure that the BCV's financial support is used strictly to accommodate liquidity needs of solvent institutions. 41. Procedures will be established for information sharing and coordination between BCV and SBIF that enable SBIF to ldentify the best program for support in the case of insolvent banks that are not eligible for BCV liquidity credits. With regard to the elimination of mplicLt ubsidies. the Government will set the discount rate based on the yield of BCV bonds, which reflects market conditions. Given the new orientation of rediscounting as an instrument for banking liquidity and monetary policy rather than as a sectoral development instrument, all rediscounts, excluding the rediscounts for agricultural credits at preferential rates, will be granted at a rate not lower than the yield of BCV bonds. Credits offered to BANAP and FOGADE will also be made at this market based rate. Rediscounts of agricultural credits at preferential rates will be granted at a rate not lower than 85X of the discount rate on other rediscounts. This special rate for agricultural rediscounts will only subsist as long as there is preferential credit for agriculture. Furthermore, all rediscount contracts will be issued for a term not exceeding 30 days. The collateral required by the BCV In Its credit operations will be valued at market or equivalent prices, and credit portfolio purchase programs will be eliminated since the same liquidity objective can be attained through rediscounting. Finally, the BCV will buy or sell any security or financial instrument only at market value. To ensure this goal, the BCV will not purchase securities that have an effective yield that Is less than the yield of its own bonds. 42. Trust arrangements and other portfolios administered by the BCV represent an administrative burden, and have frequently been used as vehicles for financing fiscal deficits. The Government proposes eliminating these trust arrangements (with the exception of the Foreign Exchange Insurance Fund [FICAMJ). For this purpose, a plan will be formulated by end-1990 establishing the necessary legislative and executive changes, and an implementation schedule. As part of this program, the management contract with the Venezuelan Petroleum Company (PDVSA) will be cancelled by December 1990, and the trust arrangement with FOGADE will be terminated before July 1991. As long as the portfolios continue to exist, transactions with the BCV will be made only at market value, with the exception of securities that are currently held by the administered portfolios. 43. The Government will not channel subsldies through the BCV, either by means of interest rate subsidies or by any other direct contribution from the BCV. In this spirit, all housing subsidies will be financed by direct appropriation in the Government's budget. ;Mlementation of Financial System Reform 44. The BCV will be the executing agent for reform of the flnuncLal system. Due to the complezity of the reform, the BCV has agreed to create a temporary unit which will be In charge of Implementing the refonm program and of policy-setting. This unit will submit monthly reports to the Executive Branch (through the Minister of Finance) and to the BCV'o Board of Directors, and will oversee '.he implementation of the technical assistance component. - 62 - ANNE III Page 12 of 12 pages The unit will be composed of high level staff or consultants who wiUi work full-tlme on the reform program. The staff will Include economists, administrators, and attorneys, and will be directed by a professional of acknowledged prestige and managerial ability. Sincerely yours, Hinistro de Hacienda Iinistro de Etado Jefe de CORDIPLAN Presidente del Banco Central de Venezuela VDEWELA - FD KIAL SCTOR ADJISEN LOAN PMacy MATRIX Psg 1 Isues and obljctives Actions takien to date By beord preoentationt/ By Second trench- By third trench. 1. Libarlize & ration- aline interest rates A credit *I locution. 1.1 Allow mrket a). Policy Statement Indicte. * Modfitcations to Ka Law determination of that, as long as settino *ubmitted to Congree will cooorcieaI interest rate limit. it llow full *arket determi- interest rates. required In the BCV Law, nation of Interest rates. miniOum deposit (maximum lending) rates will bo reduced (Increased) If the limit becomes binding. b). BCV Board hbo issed rese- lution setting the minimum de_oit rate A aximum lndioo rate at lOX a Mt3 respectively, which are not binding by a wide margin. 1.2 Reduce A ration- *). Policy Statement Indicates alts preferen- that the 4overnment's tial interest medium-term objective is rote. full liberitsetion of Interest rates. Mean- while, *ubeidixed rOtes on direct lending by gOvernment-owned financial Tntermedaeies a other prefe r ntil credit. will be reduced. Rates will be basd on the avereg non- prederential lending rate of the six largest co_nr- etl banks. Proferential Interest rate on agricul- tural eredit by coinr- cial banks will be 85 of this reference rate, while- direct preferential cred- It. by OIs will not bear interest lower tan 86t a3 So of, this referee rate for agricultural A other ectivities, respectively. b)e Policy Statement indicates that government-owned _inDfA - QUWEJ 5E -A ioR ~~~~~~~~~~~~~~~~~~~Pat 2 Zssue ad objectve Acome take. to dat By Btord pree.tetiel _ md trech. by third trenche fiesele ln terediarie (ineludimn SW) *111 o- lead to firat-tier flian- cil lntermdiaries at no low thas the avers" cost of raArated depositsa of the banking ayotm. FPret-tier instittioo will absorb the native ereit rieb of tU final borroer.. 1.3 Acriboe to C e dification to BC Lew the prgeogtive sublmtted to Congrea wi lI to sot I nteret greet flul & esclusive pro- rate datermina- roptive to Kcy to Oet in- tien meckanisnm tereot rates of govern _t- for loller- owned fianciol ;ntOrrdi- tins of *inen- _ s4 . clot tnterndi- wries. 1.4 Public disclo- MCY bard baisso I d Resolu- KYC aowd e1il IISe * dir e- MC? wlt publish In Ito ure of intorert tiOen reqiring daily publi- tiv. to flnsncial intormodi- monthly bulletin interest rate structure. cation by the BCV of the orias requiring thm to rates offered by a rang of average & rngeo it letrest annunce & pest tbeir rates on financial institutions. ratae observed in the morket *Il deposit a credit *srvices (rates offored to the public, specifying tho mechani_s for interbansa A on KCY pepw). their calculation. on well as the "reiscot rat. 1.5 Rduce reatric- a)e Policy Statemn t Indicates * Coverment *TII is u timn on bonks' Covernmnt's mo dit-ters decree reducing gricul- discretteonry polley of eliminating al tural lwnding requtiremnt ollocation of directed credit. on ceommrcial banks to credit. 121 of total portfolio. b)e Government bhs Isscud a Presidential Deerse reue- Ing goricultural lending rquiremen on comemcial ban&s froM 22.52 to 17.53 of total portfolio. fn VEEZUELA - FUIACIAL SECTOR ADJUSTdEM LOAN POLICY O ATRIX Page 3 lesoss and objectives Actions taken to dat By Board pr_sentationsW By second treonche By third tranche 2. Rationalie public *ector participation in the financial 3- 2.1 Commercial CV bas issued resolu- a). The 3 banks owned by the A All a boaks .i I hIet banking system tion starting the pri- BCV will have beon brought been divested fro, the vatization of the a to point of sae. All public sector. commercial bank. it valuation A tender or bid- Owns, ding docu_mnts will have been ecompleted to the sat- isfnction of the Bsnk A issued to prospective purchasers. a). Policy Statement indicates b)s Government will specify an Plan being corried out in intention to restructure action plan to restructure accordance with its time Bxv A its 4 regional banks BIV A Its 4 regional banks, froam. A to liquidate BANDAGRO. including specification of its new role. b)- Government will issue a resolution forbidding BIV c) Submission to Congress of A BANDAGRO to engoge In Low to liquidate BANDACRO. lending operations until thoy are either restruc- tured or liquidated. 2.2 Development a Policy Statment outlins a )o Submission to Congres of banking system. the formtlon of two proposed In for the cree- second-tier credit insti- tion of an agricultural tutions (for industry & soeond-tier c-edit Insti- agriculture, respectively) tution which would absorb which will abaorb the at least 3 funds. largest funds. It *I** Indicated the main steps b) Action plan to close Plan being carried out in to be taken to crete BANDAGRO A form the egri- accordance with its time them cultural credit institution frame. will be presented to the Bank. c)* Submission to Congress of proposed low for the cre- z ation of an Industrial *scond-tier credit insti- w tutton, which would absorb at least 2 funds. d) Action plan to create an Plan being carried out In 0 industrial second-tier aeccordnce with Its time . VBEZIA - FDWCIAL SECTOR ADJUMS LOAN POLICY MATRX Pe 4 Isues and objective Actions taken to dcat By Board presentatlon!/ By second trench. By third trenche credit institution will be frame. prsented to the Bnk. *) Submission to Sank of stra- e Plan being carried out in tegic plan Indicating rolo accordance with its tim of CORPODIXIISTRIA & ICAP as frame. first-tier Institutions A en action plan foe their rostructuring. 2.8 Houing finance Submission to Bank of action Plan being carried out tn sy - _ plan to restructure & promote accordance with Its time the financial independence of frme. BAP, including phasing out of a11 new government, CV or *x- ternal sources of funding A ne pollees In support of SAL. 3. Enhance the trans- parency of tVu's credit opsrations. 3.1 BCV credit to * BCV Board hns issed r_so- a). Modifications to Public * lodifeitions to Bank Law the overnment lution otating that no Credit Law submitted to submitted to Congress should be sub- zero-ylld T-bills will be Congres to permit Issuance will ellmionte us of ject to at all- purchaed at any time of fixed-term negotiable T-bilS as In struments encompasing atter the date of Bord hort-ter -bille; Law for resrve requ remnt. e ling. BCY pr_eentation, shold permit mrket detr- should be free mination of their price, & to Invest In should not specify prfoer- Government debt ontis0 order of placement of any maturity of suh b ll ong differ- subject only to ant types of economic this overlIl agente. credit ceilitng. b)o Modifications to ecv Low submitted to Congress will: (t) alloo tho CV to pur- chase fixed-term T-b111s not n ees orily redeemble In the flescl year In which g they are issued, at the a'verago clearing price of primary issu auctions or in the Secondary market; At (i;) include KY holdings of, or rights to, govern- 0 ment debt obtained through debt equity swaps A any l VEhEIUA - FPDOMEIL SECTOR AD MEN LA POLICO MATRIX Pog 5 Iocu e nd object;ive Actions taken to date Oy Board presentation!/ By second trench. Dy third trench. kind of foreign eurrency deominated debt in the oversil credit lilit to the Govrnm t. The Iilit wilI not be raised from the leovl contalned in th, cur- rent law. On a transitory basis, purchase of overn- *ent debt obtained through ongoing debt reduction A restructuring proprm will not be included In the ceiling. 8.2 All subsidy pro- Volume of redlecounts a) Policy Statement outlines a) BCV Board wlill l;ou reso- glram should has been cut slgn;ti- Government'S Intention to lution switching to market flow through the contly, with only one turn the rediscount window voluation of collateral on notional budget, bank receivlng funds. Into a focility for tepo- rediscounts, advances S & should not rary liquidity support rpurchae contracts. originate In onc open-market capabi II - ECYvs opers- ties ore fully developed. b) oCV Board *ill I sue reso- tions. lution barring any new Rediscount rate hao b) KCY Board has Issued reso- purchase of banr credit been brought up to lution linking r discount portfolIos. close to averogo rate to yield on BCV bills market londing rt. auctiond. The gneral c) 8CV Board will issue reo- rediscount rate will be lution requiring purchase revlewed at le4st *wkly, of all privete debt instru- will not be set below th mnt by the CV fro any yield on DCV bills, will *source at market valu. In apply to *al financalo no case will sueh instru- Intermediaries (including ent. be bought at a yield BANAP A FOUDE). A spe- less than that offered on cial rediscount rate, ECV bills ir4 the secondary equal to 85X of the gn- market at the tine of pur- oral rediscount rate, will chaso of the Instruments. be oppiled to rediscount- Ing of agricultural docu- d)e Modifications to BCV Law _mnt. The Policy State- *ubmottod to Congress will _ent Indicates that the retrlct discounting, specril rediscount rate rediscounting, advoncing or Os will b. phosed out in step repurchose contracts with with agricultural prtefr- financial institut0ion to a ential lending rote. masximu duration of 30 days. c)e KCv Board has Issued in- structions to Vice- presidont of Monetary Operations establishing VBEELA - fDW4 L SECTO AD.JMI LU POLCIC NAIRX po 8 Isues _ nd objective. Actions take, to de by Board pr e_tation!f By second trench. By third trech. tho procodur, for *uto- matic r"ferret of large borrowerr (e.ot thoso with @ut tandlng DCV credit In *xces of 263 of their quity) to SBXF for reVioW. d) Policy Statement indicates that the Government will not fin nce ny hoiotng or related sbeidies with KCV contributions or profit.. a.3 KcY should not a). BCV Bord has Issued a ) Submisston of progam * FOCADS portfolio to be manage extern l Reolution _andating that acceptable to the Bank to disengaged fre KW. portfolIos; oil direct transactions of diseogage a11 poerttollo these portfolIOs securlties betwen th KCY freem KV (xcept FICAM). should not be A its m*nagd portfolios use to finance tako ple at earkot b)o Modifications of FOCADE Low budget daficits. value. The only exception submitted to Congres will lII be the sale of *cur- ollo It to manage itoon c ities previously purchased funds. at face vslue hich can be sold to the BCV at fces we Ium. PDVSA's portfolio *t b) Submission of notice by the BCV has ben drawn KV to POVSA of non- down entirely. renewl of managesmnt contract at *nd-1990. 4. Reform the Regulatory Structure. 4.1 Redefine the Policy Statement describes the o Submission to Congress of r lStory rolo division of labor between proposed nem Low of SBIF to Q *trengthen the institutions. inter alio: (i) reorga- financial auton- n k SBIf *s an autonomous omy of: the entity with Its own sources Central Bank of revenuo; a (ii) elimi- (BCV), Ministry nate Mms formal *excutive ii of Finance (MH), & decision-making functions the Superinten- in tho operations of SIF. dency of Banks (SBIF), a the deposit insur- o ance corporation (FOCADE). VENEZEEA - FDSMICZL SECTO ADJIS1MT LOW PSetY PoIXp 7 e suu and objctivs Actions taken to date By Board prese_tations/ 0y second trancbe By third trench. 4.2 Strengthen prm- a). SBTF WIl iWsue a11 th. a)e SBIF WIel isue A lmplement *) SBIF eii Isueo a new dnttal norpl- choang requtird to a*1 the chaneno required to chart of eccounts which tione *uidit7ng, tighten regulations on: rgulate the valuation of will facilitate full die- & Information provisloning. lose cleaw- exchenp risk loan concen- closure of the financial disclosr. Iu ifcations, roll-over of tretion Imits a controls condition of banks. credits a accrual of of intre-group traneae- Interest, charge-offs, tione, consolidation of b) SB8F will issu *udit evaluation of Investment accounte of finfnciel guidelines in accordance portfolios. a evaluation groups, A uniform publica- with tho mew ehart of of property received as tion criteria of financial account. col late I. t C) S9IF Will sart i suIng a b)+ S8IF will isse* iostrue- b). Submission to Congre of sonthly bulletio diseloo- tion to bonks to *nk proposed ne Law of S8IF to ing the fintc7il coei- auditors to includo tighten norms on capital tion of banks A the 6vor- *cassmt of loan cltss- requirment A lnding con- *lI condition of the feation a concentration e ntration, A video the financial system. In audit. scope of sanctions & fines. dt) Modifications to Bank Law submitted to Congres WI I be pWoposea to ensure consistency with ° the nw proposd SBIF Law and to elimt-ten any retmining redundaneies. . Improving the Finan- cial Strenotb of Intermediaries a Upgrading tho Mechan- ism for Oeltng with Problem Banks. 6.1 Review financial * SOIF will undortakto stud- s Completion of all studies condition of Ioe of the financial con- undertaken by the SSIF to benks. dition of all private teo Sank's satisfaction. commercial banks S selected mortgage banks A finance comapnie. Tho e studies will focus on: o portfolio roview, fixed 3e > asset valuation, loan x coneontration, S foreign exchange loss. es 6.2 Increase provt- a)+ S8IF will issue directive a) Review banks' complianee Review banks' compliance with _ *ions for loan- to banks to establish a with loan-loss provision, loan-loss provision & write- losses, foreign general loan loss provi- Establish additional pro- off requirements. VEZIUELA FLNNIL SECTOR , JUS1M LOMN POLICY Page lssm" and objective Actlono taken to da Sy Board pronentattin!/ By eocond tranche By third trwnch cichag. I oee_ aon of at loest 1.65 of visioning or write-off a charge-off bad loann by December 1996 a requirement. for Institu- *neta. 26 of loans by June 1991. tions that are in vulner- Specific provisions will able positions *ccording to be counted spinet the the studies performod under gen eal provislon. 6.1. b). SSIF will isue directivo b) SBIF wiII prepare A submit to banks to write off to tho onok a program for loans post due by or the aortization by inter- than 86 months by June mediaoro of foreign 1991. exchange lose* assessed under S. 1. 6.8 Establish * Policy Stateen t indicates * Modifications to Bonk Law sounder require- that the UN will stop submitted to Congress Mente for entry. issuing lIcenses for will incr s *inimum opening new banxk until capital requirments for the SBIF is strengthened. entry to at asst the equivalent of USSS milI- lion for co_e reril A mortgag banks. 6.4 Improve the a Policy Statement defines *). Modification to FOCAGE's a) Revioe FO¢ADE's Reg9s- existing ech- the policy A procedures Low will be submitted to mento Interno in accord- anisms for *n- with regard to *anaging Congres to: (;) more once with principles aging a solving bank criso. rOGDE will clearly define Its role in established in Annexes banking cries, be provided with greater the mangement of banking VII a Vill. capcity to handlo crinse crises; (ii) strengthen its Policy Statement outlines mechanis or r solution b)e Monthly capital contribu- progrsm of technical, of crises; (iii) strengthen tions to FOCADE will have legal, institutiontl A ;ts financial position; A bee ade by the reoseury tinancial upgrading of (iv) enhance the transper- after January 199. By FOADE. ncy of Its operations A third tranch* total con- financial condition. tributions should amount to at least 661 of osti- b) FOCADE will eomission Mated losses of FOCADE. study to determine market value of its assets under c)e Presentation to Sank of - > management/ssle program to Complete the z recapitalization of m c) FOGADE will have under- FOCADE. Program wi II taken campaign to publicizo take Into account losse s the types of accounts A uncovered in the study A ° < institutions that *re will contain timing of covered, A its maximum capital replenishment by O coverage limit. the Treasury. 00 VENEZUELA - FINUNCIAL SECT70 ADJUISWNOT LOAN PuLICY MATRIX Page 9 Iuau. and objective. Actions takon to dote By Board pr.oentation!/ By second trancho By third trenche d)* Modfic ations to Bank Law submitted to Congrss wi I establish the pro- cedure. & the rolo of tho vrIots government Ogen- clog In solving bunk Crise, as outlined In Annex VII. 6. Enhance the competi- tivo nature & fInan- cial Strength of financtal tntermedi- aries. 6.1 Permit universal * Modifications to Bank Law bank ing & pro- submittod to Congres mote consol ida- will allo" universal tion of finan- bunking A introduce pro- ctml intrmedi- cedure to focilitate *ries. mergrs & consolidation . (e.g., of specialized bJ banks into universal bankc). 6.2 Untify capital a Nodifications to Bank Law rqu I rementu of submitted to Congroes comercial will establish tho nsa bunks, mortgge minimum ex oqulty:total bunks A fi ;nnce asoett ratio for co_ r- companioe. cial bunks, mortgage bOnks A finance compe- nas. Tho Low should permit tho future intro- duction of a risk- woightod System (includ- Ing sow contingeneso) for theo omputation of the asset base. 6.3 Liberelize for- Modifications to Bank Low oign ownership submitted to Congroes of financial Will: (t) allow up to o institutions. 205 foroign ownerhip o commercial banks (or 561 with the Ezecutivlt approval); (ii) allow o EXecutive to authorize foreign institutions to 0 VeMIA - iDWIAL SMR P§sMEW LOA1 OcC MATRV Pawe 19 Insne and objectives Actions taken to date By Bord proeentation!/ By second tranche By third trench* *cquir. up to futll o r ship of, or to stabli ab now, finincsil lnstite- tions other then cemr- ctol banks under opera- tional criterIs to be estabisihd by the T. Macroeonolc * meI ntance of mroco- * Meintonce of macroeco- * eln ntenanc of uscreee- Fr_ework. nomic policy frameork nomic policy frameork nooiC policy rf nork consistent with the consistent with the objec- consistent with the objective, of the fInann- tive of the fInancial objectives of the tI rform program. reform progra. fn ncial reform program. AlI Bord presontatlon conditions have been oet. a SpecifIC condition for Board presentation or tranche release. * Condition of fir t trncheo release. 40 0 -73 - ANNEX V Page 1 of 5 pages VENEZUELA - FINANCIAL SECTOR ADJUST_ENT CREDIT TECHNICAL ASSISTANCE COMPONENT 1. The technical assistance (TA) component is designed to assist in the restructuring of government-owned banks and funds; strengthen the Superintendency of Banks (SBIF), the Deposit Insurance Corporation (FOGADE), the National Savings and Loans Bank (BANAP), and the Superintendency of Insurance Companies; and assist in the development of capital markets. In addition, it will provide funds to the coordinating unit in the Central Bank. For each institution, financial assistance, among other, will be provided in one or more of the following areas: (i) development of a new regulatory framework; (ii) reorganization of the institutions' structure, policies and procedures; (iii) development of training programs, (iv) funding of special studies; and (v) upgrading of information systems. The TA component will cost Us$7.0 million and is detailed in the table at the end of this annex. 2. A unit will be established to coordinate and implement the financial sector reform program. The unit will submit monthly reports to the Executive Branch (through the Ministry of Finance) and to the BCV's Board of Directors. It will be responsible for ensuring that the program's reforms are effectively coordinated and implemented. It will also approve the hiring of consultants to provide advice and perform studies as indicated below. In order to assist the unit in its work and to coordinate the entire TA component, an International Consultant will be contracted for 24 months at a cost of US$8,000 per month for a total cost of US$192,000. A local consultant will assist the International Consultant for 24 months at a cost of US$3,000/month for a total cost of US$72,000. 3. The a3mounts indicated for each of the institutions in Table 1 shall be global allocations. Each institution will have the flexibility to reallocate funds from one function to another within each's global limit. Reallocations greater than US$50,000 within one institution will require Bank approval. All reallocations between institutions will also require Bank approval. A sixth category of unallocated funds has also been included. These funds can be allocated to each of the five institutions, subject to the approval of the BCV Coordinating Unit Head, Chief Consultant, and the Bank. I. Support for Legal Changes. 4. Professionals with regulatory and legal experience will be contracted, by the BCV coordinating unit, under the TA component to assist in the drafting of amendments to the Central Bank Law, FOGADE Law, Bank Law, Laws for creation of development credit funds, and the Public Credit Law. Such professionals will also assist in the drafting of a new SBIP Law. These professionals (lawyers and consultants) will be hired for approximately 2,300 hours at a cost of US$100/hour for a total cost of US$230,000. II. Support for the RestructurinR of Public Sector Financial Intermediation 5. Assistance to the ministry of Finance (MR) in the Incorporation of New Functions related to Credit Funds. US$200,000 will be allocated under the TA component to assist the MH in the incorporation of credit funds. Studies -74- ANNEX v Page 2 of S pages for their incorporation and restructuring will be contracted for US$104,000 and consultants w$il be contracted to coordinate the implementation of these incorporation and restructuring plans (12 months Q US$5,000 and 12 months e US$3,000). 6. Restructuring of BIV. The TA component vill assist the restructuring of DIY by supporting the development of a restructuring plan (US$100,000) and supporting a consultant (12 months @ US$5,000) to coordinate the implementation of this action plan. 7. Consolidation/Restructuring of BANDAGRO and Agriculture Funds. Consolidation of agriculture funds and liquidation of BANDAGRO will be achieved vith the assistance of an international consultant (US$7,000 x 12 months) and a. local consultant (US$3,000 x 18 months) who vill be responsible for implementing the action plan below. A local or international firm will be contracted for US$90,000 to develop and assist in the implementation w an action plan for the consolidation of these funds. A firm will also be contracted for US$70,000 to develop an action plan for the liquidation of BANDAGRO an incorporation of selected functions into the new agricultural credit fund. 8. Consolidation/Restructuring of Industry and Commerce Funds. As with agriculture funds, consolidation of industry and commerce funds will be achieved with the assistance of an international consultant (US$7,000 x 12 months) and a local consultant (US$3,000 x 18 months) who will be responsible for implementing the action plan below. In addition, a local or lnternational firm will be contracted for US$100,000 to develop and assist in the implementation of an action plan for the consolidation of these funds. 9. Restructuring of ICAP and CORPOINDUSTRIA. Restructuring of ICAP and CORPOINDUSTRIA will be assisted by studies contracted for development of restructuring programs for each (US$55,000 each). Further, a consultant will be contracted for 12 months I US$5,000/month to assist in the lmplementation of the restructuring programs developed in the studies. III. Support to the Superintendencv of Banks 10. The TA component will provide approximately US$3.9 million to restructure and strengthen the SBIF in support of the policy reforms contained in the loan. 11. Rezulatorv Framework. Given the new role envisioned for the SBIF, a new regulatory framework needs to be developed. The TA component will provide funds to hire a highly experienced international consultant to prepare a comprehensive regulatory framework for the SBIF and to direct the implementation of the new regulations. The consultant will assist in preparing the SBIP resolutions and draft legislation required for tranche releases. This consultant will also supervise the work of other consultants, acquisitions, and training at SBIF indicated below. The consultant will be contracted for 24 months, with a salary of US$86,000month for a total cost of -75 - ANNEX V Page 3 of 5 pages US$192,000. A local consultant will assist the Chief Coordinator for 24 months at a cost of USS3.000/month for a total cost of US$72,000. 12. Information Systems. The SBIF's ability to diagnose the financial situation of the institutions under its supervision needs to be strengthened. For this purpose, the TA component will provide US$1.6 million for consultant assistance, computers and other equipment necessary to systematize information collected from banks. This effort will result in an early warning system of illiquidity and insolvency problems. It will consist of software, hardware arid a network system. A MIS consultant will direct equipment purchases, design information systems, adapt software to SBIF's needs, and train staff. The cost of mainframe, personal computer and portable computer hardware will be US$1,200,000, software US$100,000, and peripherals US$200,000. The HIS consultant will receive US$5,000/month for 18 months for a total cost of US$90,000. 13. Manuals. An international consultant (US$5,000/month for 6 months) and a local consultant (US$3,000/month for 12 months) will be contracted to develop an inspection manual. Another local consultant (US$3,000/month for 12 months) will also be contracted to develop a synthesis of revised SBIF norms. The total cost of preparing these manuals will be US$102,000. 14. Trainina. TA component funds will be provided to the SBIF to train personnel and to build up a solid team of bank inspectors who can effectively monitor compliance with prudential norms and regulations. These funds will finance staff participation in courses and seminars held in Venezuela and abroad. Forty training trips abroad will be funded, at a cost of US$4,000/trip. The following in-house courses will be offered: four courses on credit evaluation (US$100,000 each), two courses on financial analysis of banks (US$100,000 each), and two courses on internal control of banks (US$50,000 each). Each in-house course offered will be for 30 people. Total training costs at the SBIF are estimated at US$860,000. 15. External Audlts of Credit Portfolios. The TA component will provide US$1,200,000 to perform external audits of the 100 largest credits in 50 selected institutions ((US$240 per credit) x (100 credits) x (50 institutions)). The estimated cost per credit of US$240 assumes that auditors familiar with each bank audit each credit in 6 hours at a cost per hour of US$40. This will include 31 private commercial banks and 19 mortgage banks and finance companies identified by the SBIF as in the most precarious financial position. These studies should be completed in approximately three months and immediately submitted both to SBIF and the Bank. Such submission will be a condition for second tranche release. IV. SupDort to FOGADE 16. FOGADE's new role will be strictly defined and limited to rehabilitating ailing financial institutions, assisting in their merger, and liquidating banks. The TA component will support the definition of this role and implementation of measures to achieve it through a program costing US$34.,000. - 76 - ANNEXV Page 4 of 5 pages 17. Goals. ManaLement and O2erating Procedures. An international consultant will be contracted for 2 years at US$7,O0o/month (US$168,000) to redefine the objectlves of FOGADE, and develop a new operational plan, procedures and staffing profiles to achieve these objecti . The consultant will advise in the drafting of amendments to the FOGADE Lay and the Bank Law, will coordinate a study of FOGADE's financial condition, and will supervise training of FOGADE staff. 18. Study of FOGADE's Financial Condition. A consulting fLrm will be contracted to assess FOGADE's financial condition and design a medium-term financial management and capitalization plan. In particular, the study will evaluate the market value of the assets which FOGADE purchased from the BCV upon its creation, assets it has acquired in the process of bank assistance operatlons, and assets it can expect to acquire in future operations. The cost of thls study will be US$100,000. 19. TraLinng. The TA component will provide US$80,000 for 20 training trips abroad for selected FOGADE staff, costing US$4,000 each. V. Sunort of Refoms of the Savin_s and Loan System 20. BANAP and the S&L system are facing serious financLal problems, and hence, US$212,000 from the TA component has been allocated to assess the financial position of BANAP and S&Ls, and develop a restructuring program. 21. Studies on SLs and BANAP. The TA component will provide US$90,000 for studles of the value of portfolios of 20 S&Ls (US$4,500 each). US$50,000 will also be allocated to prepare a study of the fLnancLal position of BANA? (lncorporating the findings from the 20 studies) and to develop an action plan for its financLal restructuring. 22. RegulatorX Framework and Financial Restructurkng. A full-time consultant wlll be hired tot (i) develop and implement actlon plans for the merger, restructuring or liquidation of S&Ls taking into account the studies commissioned; and (ii) implement an action plan to financially restructure BANAP in accordance with the restructurlng plan suggested in the study. The consultant's assignment would be for 12 months, at US$6,000/month for a total of US$72,000. VI. SuDiDort to the SuDerlntendency of Insurance Companies 23. A diagnosis of the financial situation of the insurance industry and regulatory changes required to strengthen lt will be supported with US$447,000 from the TA component. 24. Coordination of Studies and Norm Desian. An international consultant wlll be contracted for 12 months (at US$6,0oojmonth) to coordinate studies of individual Lnsurance companies (see below), integrate these studles into an analysis of the insurance industry, and design revised norms for the Superintendency, for a total cost of US$72,000. 25. Evaluation of Condition of Insurance and Reinsurance Companies. Flfty companies wlll be evaluated in order to assess the state of the 77- ANEX V Page 5 of 5 pages insurance industry. The cost of each study will be US$7.500, with a total cost of US$375,000. VII. Capital Markets DeveloDment 26. The TA component will assist the Government in facilitating the development of Capital Markets by commissioning studies to assess the functioning of these markets, determine what legal or institutional constraints exist to their further development, and develop an action plan for legal and institutional reform. These studies will cost US$200,000. VII. Unallocated 27. US$289,000 has been allocated to supplement funds provided in the previous five categories. ANNEX V -78 - Table I Page 1 of 2 pages VENEZUELA - FINANCIAL SECTOR ADJUSTMENT LOAN SUMMARY OF TECHNICAL ASSISTANCE COMPONENT COSTS (US Dollars) International Consultant (24 mos * US$8,0001mo) 192,000 Legal Local Concultant (24 moo Q US$3000/mo) 72,000 1. SuDnort for Lesal Assistance Legal Assistance/Advice (2,300 hre I US$100/hr) 230,000 2. Support for the Restructuring of Public Sector Y vAcial Intermediation Assistance to the Ministry of Finance (MH) in the Incorporation of Credit Funds 200,000 Development of Action Plans for Incorporation of Funds 104,000 Consultant to Coordinate Implementation of Action Plans (12 mos x US$5,000/mo) + (12 mo x US$3,000/mo) 96.000 Restructuring of BIV 160,000 Development of Action Plan for Restructuring of BIV 100,000 Local Consultant to coordinate implementation of BIV Restructuring Plan (12 mos I US$5,000) 60.000 Development of Consolidated Agricultural Credit Fund 298,000 Develop Action Plan for consolidation of Agricultural Funds 90,000 Development of Action Plan for liquidation of BANDAGRO 70,000 International Consultant to coordinate implementa- tion of Action Plans (12 mos I US$7,000/mo) 84,000 Local Consultant to assist implementation of Action Plan (18 moo I US$3,000/mo) 54.000 Development of Consolidated Industrial Credit Fund 238,000 Develop Action Plan for consolidation of Industrial Funds 100,000 International Consultant to coordinate implementa. tion of Action Plans (12 moo 0 US$7,000) 84,000 Local consultants to assist implementation of Action Plans (18 mos x US$3,000/mo) 54.000 Restructuring of ICAP & CORPOINDUSTRIA 170,000 Development of Actlon Plan to Restructure ICAP 55,000 Development of Astion Plan to Restructure CORPOINDUSTRIA 55,000 Consultant to Coordinate Implementation of Action Plans (12 moe I US$5,000/mo) 60.000 Subtotal 1,656,000 S. Superintendency of 8anks International Consultant/Ccordlnator (24 moo I US$8,000/mo) 192,000 ANNEX V - 79 - Table 1 Page 2 of 2 pages Local Consultant(24 moo I US$3,000/mo) 72,000 Information System 1,590,000 MIS Consultant 118 moo I US$5,000/mo) 90,000 Hardware l,lO0,000 Software 200,000 Peripherals 200.000 Manuals 102,000 International Consultant (6 mos 0 US$5,000) 30,000 Local Consultant (12 mos I US$3,000) 36,000 Manual on Rules & Regulations Local Consultant (12 mos 0 US$3,000) 36.000 Training 860,000 Training Trips (40 0 US$4,000/trip) 160,000 Credit/Evaluation courses (4 . US$100,000) 400,000 Financial Analysis courses (2 1 US$100,000) 200,000 Internal Control courses (2 0 US$50,000) 100.000 External Audits (50 institutions @ US$24,000) 1.200.000 Subtotal 3,944,000 4*. Denosit Insurance Cornoration Consultant to establish new Goals, Management & Operating Procedures (24 mos 8 US$7,000/mo) 168,000 Study on FOGADE's Financial Condition & Medium-Term Action Plan 100,000 Training Trips (20 6 US$4,000/trip) 80.000 Subtotal 348,000 S. SaYSngs & Loan System Study of Financial Condition of 20 S&Ls (US$4,500 ea) 90,000 Study of Financlal Condition of BANAP & Action Plan for Restructuring 50,000 Consultant to Restructure BANAP & S&Ls (12 moo 6 US$6,000/mo) 72.000 Subtotal 212,000 6. SunEriltend ev of Insurance Comnanies International Consultant to Analyze Insurance Indus- try & Design of New Rules (12 moo 6 US$6,000/mo) 72,000 Diagnosis of Insurance Companies (50 I US$7,500) 375.000 Subtotal 447,000 7. otmital Markets Develonment Study of Mechanisms to Improve the Functioning of Capital Markets 200,000 8. NhaliocaIed 121.000 Total 76.000.000 - 80 - ANNEX VI Page 1 of 6 pages VENEZUELA - FINANCIAL SECTOR ADJUSTMENT LOAN CHANGES IN PRUDENTIAL REGUATIONS 1. The Government is committed to overhauling its banking regulatory framework and modernizing the Superintendency of Banks (SBIP). Under the loan, the Governmeut will improve the prudential regulatory framework and banking supervision through a combination of proposed legal reforms and changes in administrative norms and regulations at the SBIF. Implementation of a modernization and strengthening program will also be undertaken with technical assistance funds provided by this operation (see Annex V). I.Chanaes in Legislation 2. Under the loan, a proposed new Law of Superintendency (SBIF Law) will be presented to Congress by December 1990. This proposed Law will clarify the role, organization, functions and powers of the SBIF as well as establish key prudential regulations. The proposed SBIF Law will modify the substance and spirit of several articles of the current Bank Law as well as provide new provisions for issues not currently being addressed. 3. A main feature of the proposed Law would be to increase the administrative, functional and financial autonomy of the SBIF. Provisions in the proposed Law would ensure that: (i) SBIF has sufficient autonomy and is shielded from political interference, (ii) the overall regulatory framework is adequate, (iii) SBIF has adequate resources to hire, train and retain competent personnel and acquire appropriate technology; and (iv) SBIF has sufficient authority to enforce its decisions without having to resort to the extreme action of recalling a bank's charter to operate. The proposed Law would provide SBIF with powers to carry out the following actions: impose fines and non-pecuniary penalties, issue cease and desist orders, restrict dividend payments, restrict branching, limit special operations in which managers have no expertise, intervene banks, request administrative actions, remove or fine managers and directors, force write-offs and provisions, force changes in published financial statements, require capital increases, and impose special punitive reserve requirement regimes. 4. The following changes in the Banking Law should be superseded, modified and subsumed in the SBIP Law: o Bank licenses should be authorized by the SBIF. O JBIP should have the power to authorize: (i) the dissolution of financial entities, (ii) mergers, (iii) sales of equity, (iv) capital expansion or reduction, tv) changes of objectives, and (vi) changes in statutes. O SBIF should have the power to suspend or revoke licenses of banks and finance companies. O Variation in reserve requirements according to location should be eliminated. O Reserve requirements should not be allowed to be held in T-bille. - 81 - ANNEX VI Page 2 of 6 pages o New branches should be authorized by the SBIF, if necessary. O Minimum capital requirements for the opening of new banks and finance companies 3hould be increased to the equivalent of US$6 million. This amount should not be made to vary according to geographic location, and should be adjusted periodically to maintain its real value. The Superintendent should be authorized to raise (but not lower) the minimum capital requirement at his discretion. O A global leverage limit should be established of a minimum capital and reserves to assets ratio of 5X for commercial banks, housing banks and finance companies. In the future, consideration should be given to switching to a risk-weighted capital requirement. O The organizational guidelines for the SBIF should be revised to reflect a new authority structure to achieve new goals and objectives. O The scope of provisioning requirements should be broadened and SBIF enabled to issue general provisioning norms and establish more precise rules for accruing interest on credits. Provisioning criteria for investments and other kinds of assets should also be included. o Clearer limits on lending concentration should be established. The definition of related party should be clarified and made more specific. There should not be exceptions based on location, type of business, or public vs. private ownership. O Application of special loss amortization provisions should be limited to those cases of banks undergoing rehabilitation. O Guidelines for bank liquidation should be modified in order to reflect standards provided in Annex VII on Handling Bank Crises. o Law should modify relationship among FOGACE, BCV and SBIF in treatment of problem banks to reflect suggestions in Annex VII on Handling Bank Crises. In this context, SBIF should have the authority to take action (intervention or preventive capitalization) without previous clearance from FOGADE and BCV. O Administrative sanctions for non-compliance with legal norms should be strengthened through increases in fines and updated to maintain their real value. Non-pecuniary penalties should also be prescribed where appropriate. O SBIF's Law should take precedence over the respective laws of specialized banks. O The proposed SBIP Law will grant autonomy to the SBIF by transforming it into an independent agency. O Ample decision making authority will be granted to the SBIF, and any requirements for approval by the NH of the SBIP's actions will be eliminated. o The following actions will require approval from a Consultative Committee composed of the Minister of Finance, the President of the BCV, the President of FOGADE and the Superintendent: (i) the intervention, dissolution or liquidation -82 - ANNEX VI Page 3 of 6 pages of financiaL institutions, (Ui) the revocation or suspension of bank licences, (iii) the fixing of the minimum capital requirement, and (iv) any other matters that the Superintendent refers to the Consultative Committee. II. Administrative Changes in Resulations 5. Beyond legal changes, the operations of SBIF must be transformed in order to strengthen the regulation of financial institutions. This section indicates the reforms of the regulatory framework which should be established through administrative directives or resolutions. These should be used as general guidelines only and further refined to accommodate Venezuelan conditions. A. Asset Quality Assessment. Accounting Regulations and Provisioning 6. Loan Portfolio Classification. Every semester, each financial institution should be required by SBIF to review the quality of most (perhaps 70Z) of its loan portfolio and classify each loan in its portfolio according to specified criteria. Failure to subrit such loan valuations should be sanctioned by fines. Loans should be classified based both objectively on performance and subjectively on the debtor's financial condition and cash flow position. In particular, each bank will examine: (i) the repayment status of loans, including rollovers; (ii) the capacity to pay of the borrower, including earnings from operations, investments which support these earnings, and the indebtedness; and (iii) the quality of loan guarantees, including how the guarantees are legally constituted and the value of rapid liquidation of pledged assets. 7. Using these criteria, commercial loans would be expected to assessed and placed into the following categoriess Normal Loans would be those less than S0 days past duel' and adequately guaranteed. Specially Mentioned Loans would be those which although still current, exhibit some characteristic suggesting the potential for partial uncollectibility in the future. Potentially Problematic Loans would be those that ares (i) 30-90 days past due; (ii) showing signs that liquidity generation may not be sufficient to cover loan payments in the short- term but will generate funds after a short-term lapse; (iii) those where the borrower has increased leverage above a prudent point for the section in which the firm is operating, or (iv) those where guarantees cannot be quickly and easily liquidated or some doubts exist as to their documentation. Doubtful Loans would be those (i) 90-365 days past due; (ii) with payments judicially suspended; those where (iii) information about the borrower is insufficient, confused, not audited or too old to determine potential recovery; (iv) litigation has begun against the borrower; (v) evidence exists suggesting the incapacity of borrower to satisfy contractual obligations and an inability to recover its short-term financial position; (vi) uncertainty exists over total debt recovery; (vii) doubt exists over the ability to exercise guarantees unless at a discount; or (viii) individual borrowers have had their financial position compromised through divorce or through the transfer of key assets to family members or others. Lost Loans would be those where: (i) the borrower or principal shareholder have 11 Past due is defined as: (i) principal or interest past due more than 30 days; (ii) the loan has been capitalized, refinanced or rolled over in such a way as to cover payment of at least 30 days' interest; or (iii) Current accounts (working capital) exceed authorized repayment limits or have maturities of 30 or more days. -83 - ANNEX VI Page 4 of 6 pages declared bankruptcy; (ii) no documentation exists or grave defects exist in the form of the guarantee, legal procedures for asset seizure, or legal processes for execution and adjudication are difficult, slow and probably will be unsuccessful; or (iii) no interest payment has been received in 365 days and no interest has been showed by the borrower in negotiating alternative financing mechanisms. 8. Because consumer loans are generally small and time-consuming to monitor they are best placed into the above categories automatically according to the number of monthly payments past due. Collateralized housing loans generally have predictable collateral and are therefore similarly classified automatically according to the number of monthly payments past due. 9. Classification of Other Investments and Off-Balance Sheet Commitments. Improved mechanisms for evaluating, valuing and provisioning for financial investments, fixed assets and contingent credit obligations should also be developed at SBIF. In particular, losses in the difference between historic and market values of debt (including government bonds) or equity should be appropriately provisioned. Improved mechanisms for valuing guarantees would also need to be developed at SBIF. Finally, as SBTF develops an improved bank accounting and financial reporting system, it should also increase its capacity to assess off-balance sheet commitments and require provisions for such commitments if necessary. Since in Venezuela required provisions will likely be significant for a number of banks, it is recommended that a phased-in program for establishing such provisions be developed. 10. Provisioning. The principal behind adequate provisioning is that full provi ions should be established for the expected loss for each loan category.-I The following percentages are general indicators of possible probabilities of loss and therefore the provision amounts Normal (none); Specially Mentioned Loans (1X); Potentially Problematic Loans (202); Doubtful Loans (50S); and Lost Loans (100X). Since in Venezuela required provisions will likely be significant for a number of banks, it is recommended that a phased- in program for establishing such provisions be developed. A 2U general loan- loss provision should be assessed against the entire amount of the portfolio. When specific provisions exceed 21 of the total portfolio, the general loan- loss provision will not apply. 11. The system to control provisions should be that financial institutions will indicate provisions established according to their portfolio quality assessment and SBEF inspectors evaluate the sufficiency of such provisions. Penalties should be imposed if large discrepancies exist between the institutions' assessment of required provislons and SEIF's. 12. Write-off Procedures. Write-offs should occur independently of the judicial process which often takes several years. At a minimum, after a loan is 36 months past-due it should be required to be written off regardless of its legal status. 2/ The formula for reaching such a provision would bet [(Probability of default) * (Outstanding Loan Balance)) - (Immediate liquidation value of guarantee + legal and administrative costs). -84 - ANNEX VI Page 5 of 6 pages 13. Relrosranmins. Rescheduling or Refinancint of Loans. Reprogramming, rescheduling or refinancing of loans should take place only after a financial institution has verified the financial viability of the borrower and has received a separate strengthened guarantee to ensure the new commitment. The borrower should be required to pay all past-due interest before a loan is rescheduled. Rescheduled loans should in no case enable institutions to cancel provisions for doubtful accounts nor should such rescheduling improve the status of the loan as determined by the financial institution and SBIF inspectors. Rescheduled loans should be shown separately in the balance sheet. 14. Interest Accrual. Separate balance sheet accounts should be established for accrued yet uncollected interest. In any case, no interest should be recognized as income for loans past due more than 30 days. B. Loan Concentration and Lendini to Related Parties 15. Mechanisms should be developed to limit risk concentration or lending to related parties. In this way, banks should limit loans to individual borrowers or to those groups indicated below to a percentage of equity. Such groups would include shareholders, management (or those with relations with members of management that have input into credit decisions,, subsidiaries, affiliated companies, and presumed related parties. SBIP should also develop controls on bank exposure to related economic Rroups and risk units (organizations whose economic solvency, fund generation or future viability depends on one of the above components). 16. While limits on loans to related parties is a legal matter, such limits should include (i) a global limit of loans to related parties (not to exceed 25Z of capital and reserves), (ii) limits on lending to acquire shares in other companies, and (iii) limits on the amount of loans to a single individual, family or financial group. Each of these limits should be determined as a percentage of a financial institution's capital and reserves. It is imperative that a system of fines and sancti-as be developed and enforced by SBIF in order for lending limits to be effectively applied. C. Other Risks 17. It is important that SBIP assess and monitor foreian exchange risk, maturitylinterest rate risk, and sectoral/business risk. The SBIF should consider mechanisms to control net foreign exchange exposure and net maturity risk exposure of fixed rate instruments for financial institutions. Foreign exchange losses could be assessed and provisioned for according to a phased-in program. improved and more clear mechanisms are also needed for the amortization of foreign exchange losses. D. Account Consolidation 18. SBIF should develop a program to consolidate the financial statements of overseas branches with those of domestic operations of Venezuelan banks. Recognizing that such consolidation could significantly increase the leverage of many banks, such a program should involve a phase-in of leverage limitations for the overseas branches. SBIP should also consider the imposition of financial norms for financial groups based on consolidated financial statements. - 85 - ANNEX VI Page 6 of 6 pages E. Information Disclosure and Audit Recuirements 19. Information Disclosure. An adequate level of information disclosure is critical to facilitate public scrutiny of the performance of banks which allows depositors to discriminate between banks. SBIF should publish on a monthly basis a summary of the financial statements of each financial institution and key indicators for the financial system. Such bulletins should calculate key financial indicators of asset quality, capital adequacy, liquidity and profitability for each institution. Further, aggregate data should be provided in such bulletins indicating for example, monetary aggregates, foreign exchange exposure, and system-wide liquidity and asset quality. In addition, financial institutions should be required by SBIF to clearly note to depositors in new account information, passbooks and advertising that their deposits are insured up to the amount established by law. 20. In addition, SBIF should establish mechanisms to consolidate the financial statements of parties within financial groups and disclose summaries of this information in the monthly bulletins. 21. Audit Remuirements. The SBIF should establish clear guidelines and standards on the scope of audits. Auditors should be required to audit the loan portfolio including adequacy of loan loss provisions. As SBIF revises its account manual, it should carefully disseminate the criteria for such accounts to both auditors and financial institutions to ensure that the accounting criteria are well understood and to make it clear that sanctions will be applied when SBIF requires account reclassification. F. Bank Manatement and Internal Controls 22. Internal bank management procedures and control mechanisms are as revealing as the financial statements themselves in determining the condition and risks of banks. Furthermore, the viability of a bank in the long term is given by the current quality of its management. It is important that the SBIF devote more effort to assessing the quality of banks' management and controls. Accordingly, the SBIF should develop a capability to make assessments in this area. - 86 - ANNEX VII Page 1 of 3 pages VENEZUELA - FINANCIAL SECTOR ADJUSTMENT LOAN MECHANISMS FOR HANDLING BANK CRISES The banking legislation proposed to Congress under the financial sector reform program must contain mechanisms that allow the resolution of banking crises in an effective and timely manner. The key is to clearly specify the situations that may require action on the part of banking authorities, and the nature of the actions that will be prompted in those cases. The cases and administrative processes that should be envisioned under the proposed legislation are detailed below. 1. Gradual decanitalization. This case arises when an institution ceases to comply with the capital requirements becauses (i) the institution has, through steady over-borrowing, surpassed the permissible leverage ratio for more than 30 days; or (ii) the financial institution incurs in losses, or the SBIF detects the existence of losses, that would reduce its equity by less than 50Z. When the SBIF determines that such a case has occurred, it will apply a preventive surveillance regime (reaimen de viailancia nreventiva), under which institutions will be subjected to the following measures: a) Neutralization of the lending capacity of the institution until it reaches the required capital ratio. This will be achieved with the imposition of a special non-remunerated reserve requirement held at the BCV in an amount given by: (i) the increase in the level of deposits or other obligations by the bank over and above their level on the date on which the r6gimen was imposed; and (ii) any loan recoveries obtained after that date. b) SBIF authorization will be required in order to the use the BCV's rediscounting facilities. c) Depending on the nature of the problems and the prospects for their solution, the SBEF can impose a special surveillance (veeduria), under which the veedor retains veto power over all Board decisions. If the capital position of the bank deteriorates further, the SBIF's actions will revert, depending on the case, to those for cases of either acute decapitalization (case 2 below) or continued non-compliance with the SBlF's orders and regulations (case 6c below). 2. Acute decapitalization. When the SBIF detects losses in a financial institution that would drive the institution into non-compliance with the minimum capital ratio and reduce its equity by more than 50?, it will apply a capital re! lenishment regime (r4gimen de repcsicifn natrimonial) for a period not to excecd 90 days. The SBIF will summon shareholders to replenish capital within this period, and will subject the institution to the following measures: - 87 - ANNEX VII Page 2 of 3 pages a) Neutralization of the lending capacity of the institution with the imposition of a special non-remunerated reserve requirement to be held at the BCV in an amount given by: (i) the increase in the level of deposits or other obligations by the bank over and above their level on the date on which the reitimen was imposed; and (ii) any loan recoveries perceived after that date. b) No access to BCV rediscounts. c) Special surveillance by the SBIF through a veeduria. The veedor, appointed by the SBIF, has veto power over all Board decisions or operations of the bank. During this 90 day period, SBIF and FOGADE will analyze the viability of the institution. If any more losses are detected that would further undermine the institution's net worth, SBIP will require shareholders to put ip the additional capital during the same period of 90 days. 3. Intervention bI SBIF. If existing shareholders fail to satisfy the SBIF's request for additional capital in the prescribed period, SBIF and FOGADE will jointly determine whether the institution will be rehabilitated or liquidated. The minimum cost alternative will be chosen, taking into account the guaranteed deposit payments required of FOGADE in the case of liquidation (case 5 below). If the rehabilitation option is chosen, SBIF will adopt the following measures simultaneouslyt a) Intervention of the institution, with displacement of the general assembly of shareholders. b) Removal of directors. On a transitory basis, the SBIP will assume the management of the bank. c) Charge-off of losses against equity. d) Capital subscription offering to FOGADE in the amount necessary to consolidate the institution's capital position. These measures will be undertaken in simultaneous fashion so that the SBIF's administration of the bank will not exceed 24 hours. Once FOGADE has subscribed the new capital, the institution ceases to be under intervention, as FOGADE then acts as majority owner of the institution (case 4 below). The procedure is designed to recognize losses and inject new capital without undermining the public's confidence in the bank. 4. Financial assistance by POGADE. FOGADE's financial assistance will occur mostly through capital injections into ailing institutions. FOGADE will administer or financially support institutions only after a majority of shares have been voluntarily sold or pledged to it. If larger than expected losses become apparent later on, FOGADE can subscribe additional capital only if the volume of additional capital required is less than the cost to FOGADE of - 88 - ANNEX VII Page 3 of 3 pages satisfying the deposit guarantee. As the majority owner of the bank, FOGADE will assume the management of the bank. It will be allowed to increase, diminlish, restructure or change the value of the bank's stock. Likewise, it will be authorized to restructure the bank's operations, personnel and internal policies and procedures. To this effect, FOGADE can purchase any assets frow the bank at market value. Liquidity support to the institution will be provided by FOGADE rather than the BCV, but only under market conditions. Within a period of one year, FOGADE must sell its entire ownership participation in the bank. 5. Liquidation. All forced liquLdations must be handled by FOGADE. FOGADE will pay-off guaranteed deposits, and will assume the claim on those deposits. FOGADE's claims on liquidation proceeds will have the same priority as any claims by the Treasury. FOGADE, as the receiver of the liquidated bank, should be authorized to sell any assets individually or In bundles, or to set up trusteeships (fideicomisos) holding those assets under litigation. Consideration should be given to granting FOGADS special coercive powers to recover assets, and to requiring FOGADE to sub-contract all asset recovery and sale procedures. FOGADE should strive to complete liquidation procedures within two years. 6. Intervention by SBIF for other reasons. The following occurrences should prompt an intervention or special surveillance (through a veeduria) by SBTF, depending on the nature of the cases a) Administrative or managerial instability, where serious disputes among managers andlor directors undermine the normal operation of the bank. b) Acute and persistent liquidity crisis, with rediscounts at the BCV in excess of the banks' equity. c) Recurring non-compliance with the SBIF's orders, especially in the areas of loan classification and provisioning, loan concentration, or the special reserve requirement imposed in cases of decapitalization. d) When there are reasons to doubt that the bank's accounts reflect its true financial position. In any of these cases, the actions taken by the SBIF will be geared towards solving the particular problems detected in a period of less than si months. To accomplish this, the SBIF will be authorized to remove directors, replace management, and implement changes in the bank's policies, procedures and operations. If the problem deteriorates into, or makes epparent a process of decapitalization, the sBiP will impose the pertinent regime as described above (cases 1 or 2 above). - 89 - ANNEX VIII Page 1 of 5 pages VENEZUELA - FINANCIAL SECTOR ADJUSTMENT LOAN INSTITUTIONAL STRENGTMIN_ING OF FOGADE I. Reform of FOGADE's Law 1. Below are the proposed changes to FOGADE's Law (Estatuto Oruinico del Fondo de Garantia te Dep6sitos v Proteccion Bancaria). They are intended to: (i) more clearly define its functions and role within the financial sector regulatory framework; (ii) set up a suitable organizational structure that is responsive to the requirements imposed on both FOGADE and the Superintendency; (iii) strengthen the operational procedures of FOGADE by broadening the mechanisms with which it can fulfill its role and by favoring rules over discretion; (iv) provide a level of financing that is commensurate with its role; and (v) clarify the accounting principles by which FOGADE should abide in order to reflect accurately the costs and losses assumed by FOGADE. 2. It is expected that most of these changes will be reflected in the proposed revised Law that should be submitted to Congress by the end of 1990. Some of the items, however, could be implemented with changes in FOGADE's administrative regulations including changes in its Reglamento Interno. A. Definition of Basic Functions and Operations 3. The proposed revised Law should state as a general principle that any financial support from FOGADE should not benefit existing shareholders and should be conditional on the replacement of management. It should also be made explicit that FOGADE will continue being a mechanism to liquidate or rehabilitate insolvent institutions and that it shall not become a mechanism for keeping alive insolvent institutions. 4. The proposed revised Law should specify broad criteria for the determination of the course of action to be followed in crises. FOGADE should adopt the minimum cost alternative including liquidation, subject to the preservation of the stability of the banking system as a whole. This notwithstanding, FOGADE's rescue operations should not necessarily be geared towards recovering its own investments in troubled institutions as its fundamental business is likely to require FOGADE to absorb losses. 5. Aside from its deposit payoff function, the current Law lays out FOGADE's role as an winstrumetnt of supportT for problem banks. This latter role should be strengthened to include active management of bank crises. FOGADE should always be the receiver in cases of liquidation. B. Oraanizational Structure and Relations with Superintendency 6. FOGADE's current two-tier Board system should be replaced with a single Board with members having recognized technical expertise in the banking area. 7. All actions by FOGADE should be prompted by the referral of the SBIF. The proposed revised Law must clarlfy that, while FOGADE participates in the - 90 - ANNX I1I Page 2 of 5 pages solution to the crisis, SBIF continues to be responsible for the examination and supervision of the institution. FOGADE acts in the institution as equity investor, but does not assume SBIF's normal functions as supervisor. 8. SBIF rather than FOGADE should be the one to require banks' submission of semi-annual audits. Audits should be available to FOGADE under specific circumstances. Similarly, SBIF rather than FOGADE should outline wrongful behavior on the part of bank managers and shareholders. The proposed revised Law should specify the cases in which FOGADE could request information from the SBIF. FOGADE should not have an active role in maintaining a data base on the condition of the financial system. The entire chapter on sanctions and enforcement powers could be transferred to the SBIF's new proposed Law as these correspond to SBIF. A single article should establish sanctions against the non- payment of bank assessments. C. Qperational Procedures: Rehabilitation anld Financial Assist.ance 9. No financial assistance will be offered by FOGADE unless a majority of bank shares have been voluntarily sold or pledged to it. Distribution of dividends should be restricted and require the authorization of FOGADE in all cases while the institution is under a rehabilitation program. In the same vein, FOGADE should authorize increases in salaries or other operational costs while the institution is under a rehabilitation program. 10. No long-term assistance should be provided to financial institutions as FOGADE's role is strictly rehabilitation or liquidation. Accordingly, the maximum maturity on loans offered by FOGADE should be reduced from 10 years to 5 years. 11. Any loans provided by FOGADE should be given at average market lending rates. Likewise, any asset purchases should be valued at market price according to the valuation criteria established by the SBIF. No special Board approval procedures should be required for asset purchases from troubled banks as opposed to any other forms of financial assistance. 12. Financial assistance to non-intervened institutions should have the same approval procedures as for intervened institutions, without authorization from the National Executive. 13. Any bank shares purchased by FOGADE should be reprivatized within a year in order to avoid a de-facto nationalization of banking services. D. Operational Procedures: Liquidations and DeDosit Payoffs 14. The procedure for deposit payoffs in cases of liquidation, including the timing of all actions, should be clearly specified, and should not require approval by the Ministry of Finance. Deposit payoffs should be initiated only after liquidation has been declared. In cases where the deposit guarantee must be paid off, the Law should allow: (i) cash payments directly to the depositor, or (it) deposit transfers to other financial institutions, where FOGADE would compensate these institutions at less than the full value of the deposits assumed by them. - 91 - ANNE 1I Page 3 of S pages 15. Interest should accrue on the guaranteed amount of deposits from the day the liquidation is ordered to the day payments on the guarantee are actually adds. This interest would not be counted towards the coverage limit specified in the Law, and would be calculated on the basis of market interest rates. 16. In cases of liquidation, FOGADE assumes depositors' claims on the proceeds of liquidation to the extent of deposit payoffs. The proposed revised Law should specify that FOGADE's resulting claims will have the same priorit; as other Government claims. E. 1n nE.InE 17. The Treasury should be required to contribute to the fund on the same basis as commercial banks. It is suggested that the Government'r contribution match that of the banking system. On the other hand. FOGADE should not be allowed to float its own bonds or to take debt from any institution other than the BCV. 18. Interest should be paid on any debt owed to the BCV by FOGADE. The general rediscount rate which applies to any other borrower should be used for this purpose, as this rate reflects the BCV's opportunity cost of funds. Annual profits should not necessarily be used to repay debts with BCV. Advances from BCV will carry a market rate of interest, and hence FOGADE should decide on its own whether to pre-pay any debts with BCV. 19. FOGADE should be able to manage its own funds. The requirement to hold liquid resources at the BCV should be lifted. Instead, the Law should restrict FOGAJE's investments to domestic or foreign Government securities. F. Accounting Standards and Control Functiona 20. FOGADE should be required to report losses on the same basis as any other financial institutions. Accordingly, the provision allowing FOGADE to disguise losses as deferred charges should be eliminated, and replaced with the requirement thait FOGADE's accounts be prepared using the standards of the SBIF (including regulations on provisioning, rollovers, accrual of interest, revaluation of foreign currency accounts, etc.). Also, FOGADE should be required by Law to be audited externally every six months under the same norms as for any other financial institution. 21. Regular assessments, whether from the Government or banks, should not be booked as capital. The requirement that proceeds from bank assessments be used only to pay-off deposits on liquidated banks should be lifted. 22. FOGADE will inform periodically to the Ministry of Finance and to the SBIF in its capacity as inspector of FOGADE, about its operations and financial condition. II. FOGADE's Financial Position 23. Table 1 shows the balance sheet of FOGADE as of end-1989. There are several noteworthy aspects of the balance sheet. First, all assets under - 92 -ANNEX VIII Page 4 of 5 pages management/sale are booked at purchase price, which in turn was determined on the basis of their book values in the institution they were purchased from (either financially assisted institutions or the BCV). There is no estimate of the market value of these assets, but their nature (including Bs. 4.8 billion in loan portfolios and Bs. 3.2 billion in receivables) suggest that the value of these assets is over-represented in the balance sheet. These assets are only provisioned against in the amount of 6% of their value. Second, credits provided by FOGADE under assistance programs are not provisioned against, despite the fact that these have been given precisely to institutions in a weak financial position. Table 1: Audited Balance Sheet of FOGADE (as of Decemler 31, 1989, in Bs. billion) ASSETS: 17.98 Short-term/liquid assets 4.54 Credits issued under assistance programs 3.09 Assett* under management/sale W 9.74 assets purchased under assistance programs 1.33 assets received in payment 3.68 assets transsferred from the BCV 5.33 Less: provisions and special reserve 0.6 Claims on institutions under liquidation from payment of guaranteed deposits 0.02 Fixed assets 0.21 Other assets 0.3 LIABILITIES: 13.17 Short-term liabilities 0.14 Debts with BCV U.44 Short-term 0.03 Advances 5.83 Debt associated with transferred assets 58 Other Liabilities 1.59 EQUITY & RESERVES: 4.80 ^/ The breakdown of assets under management/sale is: Stocks & bonds 0.78 Receivables 3.16 Land, buildings & equipment 1.56 Loan portfolios 4.79 Other 0.05 Total 10.34 24. These factors suggest that a precise determination of the net worth of FOGADE is not possible at this point. Under this loan, studies will be commissioned to determine the market value of the Bs. 10.34 billion in assets under management/sale and the Bs. 3.09 billion in credits to financial institutions. The valuation should be performed under the principles established - 93 - ARN VnlD Page 5 of 5 pages by the SBIF. Together, these assets amount to 70* of FOGADE's assets, or 270% of its not worth. 25. Finally, it should be noted that FOGADE's debt with the BCV amounts to Bs. 11.4 billion (equivalent to US$265 million) as of end-1989. -94 - AEM Z LI Page 1 of 5 pages VENEZUEIA - FINANCIAL SECTOR ADJUSTMENT LOAN PROGRAM FOR THE ELIMINArION OF MANAGED PORTFOLIOS AT THE BCV I. Status of the Managed Portfolios 1. BCV manages a set of portfolios under management contracts mostly with Government institutions. The conposition of these portfolios is detailed in Table 1. 2. The total value of these portfolios amounts to Bs. 40 billion (equivalent to US$930 million), and the annual weighted average return is equal to 17%. The return is very low as compared to current inflation levels (36% annual rate for the second semester of 1989) or deposit rates in the banking system (around 35% for time deposits), which implies a significant decapitalization of the portfolios. This situation arises because the portfolios contain low-interest instruments purchased at face value. In most contracts, there is an agreement with the BCV for re-sale of the instruments to the BCV at the original purchase price, which means that in case of divestment capital losses would be borne by the BCV. II. Cost of Disinvestment of Portfolios 3. It is hard to estimate the magnitude of the losses that will be incurred in the process of disinvestment of the portfolios because mawy of the private instruments (particularly those of mortgage banks and S&Ls) are not traded due to their poor grade. As a rough estimate, one can assume that the market price of all instruments would be that which would produce a yield equivalent to that on BCV zero-coupon bills, which currently stands at 36%. This measure is likely to underestimate the size of the losses because it does not take into account differences in credit risk between BCV bills and the private instruments held by the portfolios. In addition, it assumes that the current interest rate structure would prevail in the future. Using this procedure, the capital losses would be as indicated in Table 2. The cost of disengagement of all portfolios except FICAM would amount to Bs. 13 billion (equivalent to US$300 million). 95 - ANNEX IX Page 2 of 5 pages Table 1: COMPOSITION OF PORTFOLIOS ADMINISTERED BY THE BCV BY TYPE OF INSTRUMENT AS OF JANUARY 31, 1990 (Nominal Value of Investment in Bs. Billion and Weighted Average Return of Local Currency Investments) Ivss!I FICANbI FOGADE-I PENS. BCV Other4' Total Amt. Rate Amt. Rate Amt. Rate Amt. Rate Amt. Rate Amt. Public Instruments 10.96 23Z 15.80 16X 1.94 152 0.29 402 0.01 132 29.00 -Treasury Bonds-/ 9.66 252 13.32 192 1.94 152 0.05 252 0.01 13Z 24.89 -Housin8 Bondsx1 1.30 92 0.36 112 - - - 1.66 -For. Curr. Bonds - 2.11 na - - - 2.11 -BCV Blalsal - - - 0.24 432 - 0.24 Private Instrumsnts 6.79 72 0.82 372 2.66 102 0.21 342 0.10 362 10.58 -Conmercial Banks - - - 0.21 342 0.09 372 0.30 -Mortgage Banks 3.87 72 0.17 72 2.66 102 - 0.00 92 6.70 -Finance Companies 0.06 112 - - - 0.00 92 0.06 -Savings & Loans 2.87 7S - - - - 2.87 -Other-/ - 0.65 45S - - - 0.65 Total 17.75 17X 16.62 21S 4.60 122 0.49 382 0.11 33Z 39.57 Source: Departamento de Fideicomisos, BCV. a/ Pension fund of Social Security System; does not include other IVSS funds not maintained at the BCV. b/ FICAM holds the insurance premia paid by enterprises on exchange rate guarantees issued by the BCV. FICAM wi:l be used to compensate the BCV for any losses it will have incurred as a result of the exchange rate guarantee program. cl Temporary investment portfolio of FOGADE, as of December 31, 1989, prior to the creation of the new fideicomiso. dl The more active portfolios are: Trabajadores Petroleros, Fundaci6n Bicentenario de Sim6n Bolivar, and FOGADE's Fondo Especial para la Vivienda. The less active portfolios are: Prestaciones Sociales del Sector P1blico, and Corporaci6n Venezolana de Guayana. PDVSA's portfolio currently holds no funds. el Treasury bonds issued after April 1.39 have a variable rate; the rate used here is the one effective on January 31, 1990. fl Bonds of FONDUR and MINDUR. £/ BCV bonds are valued at the discounted price offered in the market. Therefore, the interest rate quoted is the effective yield. h_ Pagares of Elecricidad de Caracas. - 96 - AM x Page 3 of 5 pages Table 2: NOMINAL VS. MARKET VALUE OF ADMINISTERED PORTFOLIOS (As of January 31, 1990, in Bs. Billion) Nominal Current Market ValueW Capital Loss Value Return (assuming 36% yield) (difference) iVSS 17.75 17% d.38 9.37 FICAM 16.62 21% 9.70 6.93 FOCADE 4.60 12% 1.53 3.07 PENSIONS BCV 0.49 38% 0.52 -0.03W OTHER 0.11 33% 0.10 0.01 TOTAL incl. FICAM 39.57 17% 18.69 20.88 excl. FICAM 22.95 16% 10.20 12.75 Al' Calculated as: (nominal value)*(current return)/(market yield), where the market yield is taken to be the current yield on BCV bills of 36%. hI Capital gain is due to the drop in the BCV bill yield after January 31, 1990. 4. This stock loss can be absorbed in three ways: (a) By the entities holdin the managed portfolios themselves. The BCV would purchase the investments from the portfolios at their market value of Bs. 10 billion. The BCV wou1.d then own a stock of instruments effectively yielding a market rate (36%, or the same as its own bills), and hence would not be subjected to losses as long as interest rates don't change. As was said before, this option may not be possible because of contractual obligations of the BCV. Even if it were possible, the Government should cover the cost of the policy it itself imposed by forcing purchases of instruments at face value. Otherwise, the respective funds would be severely decapitalized. (b) By the Central Ban. The BCV could absorb the stock loss and transform it into annual flow losses in two ways. One alternative would be for the BCV to purchase the entire volume of instruments held by the portfolios at their nominal value of Bs. 23 billion. To sterilize this, it would need to issue an equivalent amount of BCV bills on which it currently pays 36%. However, the BCV would derive only a 16% return from the instruments purchased from the portfolios. Assuming that these rates prevail in the future, the annual flow loss to the BCV would be given by the interest rate differential, or Bs. 4.6 billion (36%-16% times 23 billion, or US$175 million). Alternatively, the portfolios could retain the stock of investments they currently hold, and the BCV could complement this with a Bs. 13 billion contribution to the portfolios so as to increase their market value to Is. 23 billion. This contribution would need to be sterilized with a Bs. 13 billion issue of BCV bills. Then the annual flow loss of the BCV is given by the interest - 97 -lq IXl Page 4 of 5 pages payments on those bills, or Bs. 4.6 billion (36% of 13 billion). In either case, the flow losses of Bs. 4.6 billion are the same, and discounting them at 36% gives the original stock loss of Bs. 13 billion. Having the BCV absorb the losses through either of these mechanism is not an acceptable option because it involves large Pinual quasi-fiscal losses for the BCV. (c) By the National TreUggo=. The Treasury could cover the losses with a direct budgetary appropriation. The portfolios would retain their entire investments, and the Treasury would give them a Bs. 13 billion supplement (either in the form of cash or Treasury instruments) so as to increase the market value of the portfolios to Bs. 23 billion. The annual cost of servicing the T-bills will depend on the rate at which they are floated, but should in principle be equivalent to the cost calculated previously for the BCV. However, this would be the cleanest option in so far as it would not undermine the financial position of the BCV. 5. This analysis has assumed that all portfolios (with the exception of FICAII) will be disengaged at the same time. However, in practice this will be done in a staggered fashion according to the plar prepared by the Government. MII. Proaram for DivestMent of Portfolios from BCV 6. The program to disengage all portfolios from the BCY (except for FICAN) should be prepared according to the following guidelines. The program should cover all portfolios with current management contracts, even if no activity has been registered in recent times, and whether or not there is a formal fidelcomiso. It should include all portfolios managed by any department at the BCV including the DeDartamento de Fideicomisos. 7. For each managed portfolio, the following information will be made available for Bank review and approval: (a) A mention of any law or decree requiring that the funds be placed at the BCV. If divestment of the portfolios does require legal changes, the program should suggest a schedule for the modification of the corresponding laws or decrees. (b) The terms of the management contract, highlighting: (i) the amount of advance notice required for cancellation of the management contract; and (ii) any contractual obligation regarding the repurchase price on instruments held by the portfolio. The BCV will present a schedule detailing the date of notification of cancellation as well as the date of effective cancellation of the management contract. (c) A brief letter from the owner of the funds commenting on the divestment schedule prepared by the BCV and explaining the plans for the management of the resources. (d) A detailed list of investments in the portfolio, detailing the nature, volume of investment, and interest rate on each type of instrument. -98 - AM IL Page 5 of 5 pages (e) An estimation of the value of the portfolio according to three valuation criteria: (i) nominal value, (li) original purchase price, and (iII) market value. Where no market price exists, the price will be determined as being that which yields an effective return equivalent to that on similar marketable instruments. From these figures, the program will contain an estimate of the losses to be absorbed by the BCV if instruments were sold at the original purchase price rather than at market price. 8. In addition, the program should specify how the Government plans to absorb the losses that will arise from the divestment program. In particular, the Government will need to propose: (i) whether the portfolios themselves or the BCV will keep the instruments currently held by the portfolios; and (ii) the share of losses to be absorbed by the Treasury and by the BCV. 99 - AM Page 1 of 2 pages VENEZUELA - ;NANCIAL SECTOR ADJUSTMENT LOAN STATUS OF UAN GROUP OPERATIONS Is VENEZUELA A. Statement of World Bank Loans and IDA Credits as of December 31. 1989 (In US$ Killion) Amount (less cancellation) Fiscal Undis- Loan or credit number year Borrower Purv%qe Bank bursed Total 13 loans fully disbursed & closed 342.2 342.2 3091 1989 Government Structural 80.0 322.0 402.2 adjustment 3092 1989 Government Trade 35.0 318.0 !53.0 policy Total 457.2 640.0 1.097.2 Of which has been repaid 314.7 Amount sold 27.5 Of which has been repaid 2,.5 Total now outstanding 115.0 Total now held by Bank & IDA 115.0 Total undisbursed 640.0 640.Q - 100 - Page 2 of 2 pages B. Statsment of IFG Investments as of December 31. 1989 (In US$ million) Date Borrower Type of businesA Loan Equity Total 1964,1968, CAVENDAS Development finance 17.50 1.34 18.84 1971 1971 CONCECA Cement & construction material 2.01 * 2.01 1961 DIABLITOS Food & food processing 0.5V - 0.50 1966,1972 DOMINGUEZ Tin cans 1.00 0.52 1.52 1989 OPCO Iron & steel 73.13 - 73.13 1989 PROPILVEN Chemicals, petrochemicals 47.00 - 47.00 1969,1973 PROTINAL Food & food processing 5.06 - 5.1:6 1960,1964 SIVENSA Iron & steel 2.70 0.44 3.14 1975 SOFIMECA Money & capital markets - 0.70 0.70 1975 VALIVENCA Money & capital markets - 0.35 0.35 1988 VENCEKOS Cement & construction materialy 1QL - lO,OQ Total gross commitment 158.90 3.35 162.25 Less cancellations, terminations & sales 71.49 3.35 74.84 Total commitments now held by IFC 87.41 - 87.41 Total undisbursed 35.26 - 35.26 a/ In addition, IFC provided a guarantee of a local bond issue for US$10.3 million equivalent. 6> >1 ~~~~~~~~~IBRD 7 1, ARUA C s er S A I r c r 12J> - tnnHt A f eo~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~ ,, < S ' VENEZUELA C :,- . - X ,;, ~~~~~~~~~~~~~~~~~~~~~~~~'tjY r'RT : RI1,10AD _ Major Roods ' - ~~~~~~~~~~~-9- - 4, i 1 , .. - .cu - T-ld ow To,erbd Cities and Tobrns \ = - ~ - - . ' . G SoerFdrlTrioyBudre t2- VENEZUELA < ---lnevations:Budre X }a.7< C.' ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~ - { ~ ~ ~ ~~ --1OOMI 0 72o' oo6 r t RoodsI EL~~~~VA~~~~v