Report No. PID11184

Project Name -Guatemala Financial (@) ... Sector Technical Assistance Loan

Region Latin America and Caribbean Region

Sector Financial Sector Development

Public Disclosure Authorized Project ID GTPE76853

Borrower(s) GOVERNMENT OF GUATEMALA

Implementing Agency AND SUPERINTENDENCY OF BANKS Banco de Guatemala Address: 7a. Avenida 22-01 Zona 1, Guatemala, Guatemala Contact Person: Mr. Jose Alfredo Blanco, Subgerente, erea Econ6mica Tel: 502-238 1546 Fax: 502-232 8509

Public Disclosure Authorized Email: [email protected]

Superintendency of Banks Address: 9a. Avenida 22-00 Zona 1, Guatemala. C.A. 01001 Contact Person: Mr. Hugo Daniel Figueroa Estrada Tel: 502-232-0001 Fax: 502-2325301 Email: [email protected]

Environment Category C

Date PID Prepared June 3, 2002 Public Disclosure Authorized

Auth Appr/Negs Date May 3, 2002

Bank Approval Date July 2, 2002

1. Country and Sector Background The Guatemalan financial system is in a vulnerable situation. A number of banks suffer from liquidity and solvency problems and remain in operation thanks to continuous assistance from the Central Bank of Guatemala (BANGUAT). The real situation of the financial system is obscured by the fact that a large number of institutions, representing approximately 50t of the system in terms of assets, is not regulated. Even in the regulated sector, information is not adequate due to poor accounting practices. Official figures show that non-performing loans (NPLs) in the banking system amounted to 14.9w of all loans by mid-2000. It is presumed that the Public Disclosure Authorized real level of NPLs in the financial system is larger since NPLs may have been transferred to the unregulated off-shore segment. If the NPLs loans were provisioned adequately, a number of banks would present severe capital shortfalls. A recent review of the banking sector shows that six out of 34 regulated banks are affected by chronic liquidity and solvency problems. Five of them (representing about 10t of total deposits) had, at the end of 2000, outstanding liabilities with the BANGUAT that amounted to several times their book capital. The sixth one, a larger bank affected by chronic illiquidity, relies on public sector deposits (including deposits from the Social Security System-IGSS). It is likely that the unregulated financial institutions are suffering more acute problems than their regulated counterparts.The financial problems faced by Guatemalan banks are the result of multiple causes, including political interference in the central bank, poor regulation and supervision, inadequate lending practices, weak risk management capacity within banks, and weak market discipline. Specific weaknesses in the financial system in Guatemala include:Central bankmultiplicity of objectiveslack of political, operational, and financial autonomy of the central banklack of accountability and transparency in the conduction of monetary policyweak financial situationexcessive use of the lender of last resort facilitydeficient payment system Prudential regulation and supervisionlack of political, operational and financial autonomy of the regulatordeficient loan classification and provisioning rulesinadequate accounting and disclosure practicesinsufficient powers of the Superintendency of Banks to supervise and enforce prudential regulationslack of adequate prudential rules for off-shores and non-bank financial institutions (NBFIs).Weak legal, institutional and judicial framework weak legal basis for bank intervention, rehabilitation, restructuring and closurepoor judicial procedures for rapid debt collection.weak credit cultureinadequate legal framework for secured transactionsweak anti-money laundering legislation Authorities are aware of the vulnerabilities of the financial system. With the assistance of the international financial institutions (IMF, IDB, and WB), the current administration has defined a comprehensive program to address the above described problems. The program involves the following: (i) a comprehensive legal and regulatory reforms to improve the framework for monetary and financial policy and recapitalize the central bank; (ii) the strengthening of prudential regulation and supervision; and (iii) the resolution of distressed banks via liquidation, mergers or sales.(i) Framework for and financial policy and recapitalization of central bankThe first phase of the Government's efforts in the legislative front have resulted in the presentation to Congress, on September 10, 2001, of four major pieces of monetary and financial sector legislation: (i) Central Bank draft law (Ley Organica del Banco de Guatemala), (ii) Monetary draft law (Ley Monetaria), (iii) Banking and Financial Groups draft law (Ley de Bancos y Grupos Financieros), and (iv) Banking Supervision draft law (Ley de Supervisi6n Bancaria). Approval of these laws is expected for early 2002. The basic norms and regulations to implement the new legislation are expected to be submitted to Congress 30 days prior to the entry into effect of the new legislation. The proposed Central Bank Law grants political and financial autonomy to the central bank and makes the bank more transparent and accountable, requiring central bank's senior officials to inform elected officials and the public about the evolution of monetary policy, as well as exchange and credit policies. Furthermore, it introduces the obligation of the central bank to periodically disclose its financial situation. This law establishes the maintenance of price stability as the main objective of BANGUAT, substituting the "developmental "approach" of existing legislation. It also refines the instruments of monetary policy and establish better mechanisms for the treatment of deficiencies in bank reserves. The law also limits the lender of last resort function of the central bank, while improving the reserve requirement rules. The new Draft Monetary Law guarantees the free convertibility of the currency and the

-2 - free movement of capitals, in line with the Law of Free Acceptance of Foreign Currency, approved in December 2000. The central bank will be audited in 2003 by the Superintendency of Banks, assisted, if deemed necessary, by external auditors. The audit will reveal the magnitude of the central bank's accumulated losses as well as the adjustments required in its balance sheet to restore its long term solvency. The central bank is expected to be recapitalized thereafter. As part of the efforts to strengthen the central bank, the payment system will be modernized. Since most of the transactions and payments in Guatemala are made through checks, the authorities have given priority to the automation of the Checks Clearing Center. This involves the purchase of appropriate hardware and software and the issuing of norms that will regulate the electronic clearing and settlement. The expectation is that the electronic clearing of checks will be in place by early 2002. Subsequently, central bank authorities contemplate the implementation of a payment system for high value transactions, which are the most important from the point of view of the systemic risk for the central bank for large transactions. Central bank authorities have requested technical assistance from the World Bank to help it to comply with the disclosure requirements contained in the proposed laws and upgrade the payment system for large transactions, given its systemic importance. (ii) Strengthening of prudential regulation and supervisionThe proposed Banking and Financial Groups draft law and the Banking Supervision draft law strengthen the legal basis for effective financial regulation and supervision. Among other issues, the laws introduce tough licensing requirements for new financial institutions, foster consolidated supervision, adopt international standards on capital requirements and other prudential ratios, improve corporate governance and transparency, create a limited deposit insurance, establish efficient mechanisms for bank resolution, and improve law enforcement by strengthening the powers and autonomy of the Superintendency of Banks. As part of the efforts to strengthen prudential regulation and supervision, a Money Laundering Law was approved by Congress in October 2001 and became effective on December 17, 2001. This new law contains the relevant elements required in a statutory provision to prevent and deter money laundering activities, namely, (i) makes money laundering a crime and provides for appropriate sanctions; (ii) creates a Specific Unit Against Money Laundering within the SB ("Intendencia de Verificaci6n Especial"); (iii) provides for reporting, collection, and analysis of suspicious or unusual transactions (in excess of US$10,000); (iv) authorizes the freezing and seizing of assets reasonably suspected to be proceeds of crime; and (v) authorizes the sharing of such information with other jurisdictions; and cross border legal assistance in prosecuting money laundering crimes, including collecting evidence and extraditing accused criminals. Authorities are aware that additional amendments to financial sector legislation and/or issuance of new laws are needed to strengthen the legal framework of the financial sector. Since more than 50t of Guatemala's financial system remains unregulated, creating serious risks to the overall economy, a new Non-Bank Financial Intermediaries Law is urgently needed. The new law should set the minimum regulatory and supervisory requirements for this type of financial intermediaries, including conditions for entering and exiting the market, solvency requirements and sanctions to be applied for not complying with the law. A new Insurance Law is also needed. Authorities have agreed with the World Bank that the new insurance law should have the following characteristics: (i) reaffirm the principle that insurance companies will be under the

-3 - supervisory authority of the SB; (ii) incorporate the principle of consolidated supervision; (iii) establish a regime of sanctions against risky practices; (iv) follow international supervision standards (issued by the International Association of Insurance Supervisors); (v) allow local insurance firms to operate abroad and allow foreign firms to operate in Guatemala; (vi) define clearly the functions and responsibilities of the insurance intermediaries; (vii) establish norms for corporate governance; (viii) redefine the insurance market; (ix) actualize the solvency parameters of insurance companies; (x) make information more transparent; and (xi) establish an orderly market exit mechanism.Another important law that would contribute to reduce the constrains that some groups of the economy have to access credit is the Secured Transactions Law. The Guatemalan authorities recognize that such a law would facilitate the use of movable guarantees such as inventory, cattle, equipment, inventories and receivables, opening access to credit to groups that only have this type of guarantees. This use of movable guarantees require the constitution of a registrar. The new law would norm the form in which movable guarantees can be used, reduce the cost of registering these type of guarantees and modernize and transform the process of accepting, registering, controlling and executing movable guarantees.Guatemalan authorities have requested technical assistance from the World Bank, as well as other international organizations, to draft the new laws, but most importantly, help to them implement and enforce them. The IDB is preparing a US$900,000 facility to assist authorities to draft all prudential regulations required to enforce the new Bank Supervision Law, including rules on capital requirements, loan classification and provisioning, limits to connected lending, external auditors, internal controls etc. The IDB is also expected to finance technical assistance to strengthen off-site and consolidated supervision in Guatemala. As explained in the following sections, the WB is expected to finance technical assistance in most of the remaining areas through this FSTAL, including the establishment of a national credit bureau; new draft laws on secured transactions, non-bank financial institutions, insurance companies and collective investment vehicles; update of accounting principles; improvement of legal framework for debt recovery; and establishment of the Special Unit Against Money Laundering. (iii) resolution of distressed banksThe Government's financial sector reform program involves the rapid regularization/resolution of a number of weak and insolvent banks and financial institutions. In early 2001, the authorities intervened and suspended the equity and administrative rights of the shareholders of three small banks: Promotor, Metropolitano and Empresarial, which accounted for about 6.5w of total deposits in the system. These banks have been sent to judicial liquidation, under the provisions of the current banking legislation. The Guatemalan authorities intend to intervene two other insolvent banks under the current banking legislation and proceed with their liquidation. The weak situation of other financial institutions in Guatemala will become clear when the new legislation enters into force and the banks have to apply the new classification and provisioning norms and the information is collected on a consolidated basis. Authorities are committed to restructure/resolve insolvent institutions, while rehabilitating weak but viable banks, using principles of rapid and transparent decisions, minimizing the use of fiscal resources, and implementing least cost solutions. As shown in the following two tables, the costs of closing and resolving insolvent banks, and recapitalizing weak but viable institutions is estimated at US $1.1 billion dollars. It

- 4 - is expected that the large part of this cost would be borne by the banks' shareholders. The allocation of government's funds to support bank restructuring will be ruled by the new Banking Law, as well as the operating rules of the Fiduciary Fund for Bank Capitalization. Estimated Cost of Liquidating and Resolving Insolvent Banking InstitutionsCategories of BanksNet Cost on Q millionNet Cost in US$ millionCommentsl. Banks to be liquidated or resolved under existing banking laws (including off-shore)2,763.0350.7Five banks with total assets of US$570 million2. Banks to be liquidated under new law557.072.8Four banks with assets of US$400 millionTotal3320.0423.5Source: Bank staff estimatesEstimated Capital Needs of Weak but Viable Banks under the New LegislationCategories of BanksNet Cost on Q millionNet Cost in US$ millionCommentsl. Banks in categories 1 to 3 that require additional capital3,110.0393.7Includes 22 banks with total assets of US$6,350 2. Off-shore subsidiaries2,800354.4Total5,910.0748.lMost of the capital should be provided by banks' shareholdersSource: Bank staff estimatesGuatemalan authorities have agreed to undertake a comprehensive examination of the banks in the system to assess their need for additional actions to strengthen their balance sheets and the possibilities for a consolidation of the banking system through mergers and acquisitions. To this effect, private banks will be independently classified using the SUPER classification scheme, which uses a number of rating parameters measuring, inter alia, liquidity, solvency, capital adequacy, portfolio quality and provisioning, profitability, and operational efficiency. (The detailed methodology used for this classification would be agreed with the Bank). The capital shortfall estimations would be made based on information on a consolidated basis, including off-shore entities. The new banking legislation drastically limits the ability of BANGUAT to continue providing funds to distressed banks to recapitalize, restructure or close them. At the same time, it provides a wide framework and several options to restructure distressed banks including: regularization plans (in case of capital deficiency) proposed by the bank and approved by the SB, suspension of operations, transfer of assets and liabilities of a failed bank to other financial institutions, and liquidation. To support and speed up the process of bank restructuring, authorities have decided to establish the Fiduciary Fund for Bank Capitalization.Fiduciary Fund for Bank Capitalization (FFCB)The FFCB would be created as a trust fund outside of the balance of BANGUAT. It would provide subordinated credits for the following three purposes:a) The capitalization of banks in the context of regularization plans approved by the SB and BANGUAT. Banks with regularization plans approved by the SB could receive loans from the FFCB. These banks should have adjusted their accounts according to new prudential regulations. The eligibility requirement would be strict with respect to the initial level of tier-one capital. FFCB assistance would be provided at least, on a matching basis (1:1 ratio), with additional ownership capital. Moreover, the recipient bank would agree to undergo an institutional diagnosis and to prepare a business and institutional development plan approved and monitored by the SB. b)The capitalization of banks in the context of mergers or acquisitions, according to plans approved by the SB and BANGUATBanks that voluntarily enter in a process of strengthening or mergers and acquisitions could receive assistance from the FFCB. To prevent a failed merger, the SB would require that merging banks redress shortfalls in capital requirements, that management is suitable, and that the merged entity has a strong business base. The shareholders of banks that receive FFCB assistance for voluntary

- 5 - restructuring, mergers and acquisitions, would have to make capital contributions in a ratio of 0.6:1. In these cases, the FFCB funds would go to the acquiring or resulting bank. Banks that undergo voluntary restructuring should have adjusted their accounts according to the new prudential regulations and have a business plan approved by the SB.c)The capitalization of banks that participate as acquirers of deposits in the context of the process of bank closure and resolution according to the Banking LawThe bank resolution scheme in the new Banking Law provides for the transfer of assets and liabilities of a failed bank to other institutions. The liabilities (deposits) would be assumed by a solvent bank. To circumvent the problems associated with due diligence practices, the transfer of assets is made through an special purpose vehicle (SPV) for the securitization of the assets. The SPV would charge a fee for managing the assets and issue participations. The institution that assumes the deposits receives in exchange participations in the SPV. The FFCB would be funded by the Ministry of Public Finance from external loans and budgetary or other resources. It would be managed by a Bank Capitalization Commission (BCC) composed of representatives of BANGUAT, the Ministry of Public Finance, and the SB. The FFCB would provide two types of loan to the participating banks, both of which could be counted as Tier 2 capital: (i) the granting of a subordinated loan by the FFCB to a recipient bank; and (ii) the purchase by the FFCB of a subordinated bond issued by the participating bank. At the request of Guatemalan authorities, this loan will finance extensive technical assistance for the rapid and orderly resolution of distressed banks in Guatemala, as well as the capitalization of weak but viable financial institutions.

2. Objectives The Guatemalan financial system is in a fragile condition, with several financial institutions facing liquidity and/or solvency problems. This loan aims at providing technical assistance to the Guatemalan financial authorities to restore the soundness of the financial system by (i) closing and liquidating insolvent banks, (ii) recapitalizing weak but viable institutions, (iii) strengthening overall financial regulation and supervision, and (iv) fostering market discipline and competition among financial intermediaries. These actions will help authorities to prevent a major banking crisis, minimize the use of fiscal resources for bank restructuring, and establish a new legal, regulatory and institutional framework for the sound and efficient development of the financial system. In the medium term, these reforms are expected to widen the access of financial services to the overall population and, thus, contribute to alleviate poverty and support economic growth. This Financial Sector Technical Assistance Loan (FSTAL) is being prepared to support the implementation of a US$ 150 million Financial Sector Adjustment Loan (FSAL), currently under preparation. Both loans will support major financial sector reforms in Guatemala in the areas described below.

3. Rationale for Bank's Involvement With the proposed operation, the World Bank would add enormous value to solve the financial sector problems in Guatemala by: (a) raising international confidence in the Government's program to close and resolve insolvent financial institutions, (b) drawing on its international experience in the design of sectorial reforms and assistance strategies, (c) assisting in the identification of international consultants with specialized expertise in the appropriate project component areas, and (d)

- 6 - building up capacity to prevent money laundering, an area in which Guatemala requires enormous assistance given its large number of non-regulated off-shore financial institutions. The proposed operation would help Guatemala to maintain economic stability and continue the implementation of structural reforms to promote long-term economic growth. This loan constitutes an important component of a comprehensive effort of the World Bank and other international financial institutions to support financial sector reforms in Guatemala. As noted in sections D.2 above, other major lending operations are currently under preparation by the World Bank and the Inter-American Development Bank. This loan has been prepared in coordination with the IDB.

4. Description This loan has 6 components: 1) Rapid exit and resolution of insolvent banks: Under this component, the loan would finance technical assistance to assess the financial situation of individual banks, analyze the feasibility of restructuring options (minimizing the use of fiscal resources and limiting disruptions to the overall financial system), develop mechanisms to transfer assets and liabilities from insolvent banks to solvent institutions, liquidate remaining assets rapidly, repay deposits, and conduct the overall exit of insolvent financial institutions rapidly. 2 Establishment and operation of the Fund for Bank Capitalization: The loan would finance technical assistance to establish the operating rules of the Fund, formulate sound investment policies, assess rehabilitation plans proposed by the banks' shareholders, assess possible mergers among financial institutions, select best financial instrument to capitalize weak but viable banks, monitor the evolution of capitalized banks, formulate policies and strategies to sell the Fund's participations in financial institutions, audit the Fund's operations, and establish a plan to close the Fund once its goals have been achieved. 3. Strengthening of the Superintendency of Banks: This component would finance technical assistance to establish a national credit bureau to centralize, organize and maintain all the information of debtors of financial institutions operating in Guatemala. The loan would also finance the acquisition of software and hardware for the operation of the credit bureau. This should encourage the establishment of better lending practices in Guatemala, reducing the amount of future non-performing loans and improving the efficiency of the overall financial system. Other activities to be financed under this component include: review and update of the draft law on secured transactionsdraft a new laws on non-bank financial institutions, improving the legal framework of this sector in accordance with best international standardsdraft a new law for insurance companies and collective investment vehicles.update accounting principles and disclosure practices for all type of financial intermediaries.review and propose amendments to existing legislation to improve the legal framework for debt recovery. This component would complement the technical assistance to be provided by the Inter-American Development Bank which aims at financing the drafting of new prudential regulations as well as strengthen off-site and consolidated supervision. 4. Anti-money laundering: This component would finance technical assistance to establish a Special Unit Against Money Laundering to prevent and sanction money laundering activities. The new unit would be operating within the Superintendency of Banks. The loan would also finance the acquisition of hardware and software required for the unit's operation, as well as the training of the unit's staff. 5. Strengthening of the central bank: The

- 7 - loan would finance the acquisition of hardware and software to modernize the payment system for large transactions. The loan would also finance technical assistance to conduct an audit of the central bank in order to establish the magnitude of its financial problems and required capital. It is expected that the central bank would be capitalized thereafter. The loan would also finance the formulation of a strategy for the long term development of Guatemala's financial system. 6. Project Management Unit: This last component would finance technical assistance for the adequate and efficient utilization and monitoring of the different components of this loan. Please see Annex 1 and 2 for a detailed description and for a detailed cost breakdown. 1. Rapid exit and resolution of insolvent banks 2. Establishment and operation of the Fund for Bank Capitalization 3. Strengthening of the Superintendency of Banks 4. Anti-money laundering 5. Strengthening of the Banco de Guatemala (BANGUAT) 6. Project Coordination Unit

5. Financing Total ( US$m) BORROWER $0.90 IBRD $5.00 IDA Total Project Cost $5.90

6. Implementation The government agencies beneficiaries of this loan will be the Superintendency of Banks (SB) and the Bank of Guatemala (BANGUAT). The Fund of Savings Protection (FOPA), which will established once the new financial sector legislation is approved, might be eligible to receive the technical assistance envisioned in this loan. Detailed implementation arrangements will be discussed with the authorities in the following stages of the preparation of this project.This loan is expected to be presented to the WB Board together with the Financial Sector Adjustment Loan for Guatemala. An important condition for Board presentation of both loans is the enactment of the four fundamental financial laws submitted to the Guatemalan Congress on September 10, 2001: Central Bank Law, Monetary Law, Banking and Financial Groups Law, and Banking Supervision Law.

7. Sustainability Reforms in the financial sector of Guatemala are being supported by the international donor community, as well as the international financial institutions, including the IMF, the World Bank, and the IDB. The proposed project has been designed to support the implementation of financial sector reforms envisioned in the Financial Sector Structural Adjustment Loan (currently under preparation). This is a complex operation and the project faces risks of delayed or partial implementation. Many factors, beyond the government's control, could affect the implementation schedule of the project. Changes and amendments to the proposed draft laws, for example, could be done by the legislative power in the future, distorting the purpose of the reforms advocated by this TA loan. Possible risks that might affect the implementation of the project are discussed in the following section.

8. Lessons learned from past operations in the country/sector

- 8- Recent banking crises in other Latin American countries have been extremely expensive. Their fiscal cost alone has represented on average 20 to 30t of a country's GDP, reducing future social spending and adding an enormous burden to public finances. Banking crises have caused major social setbacks, in particular because the real of value of savings and investments declines rapidly during a crisis. Moreover, during a banking crisis, banks tend to refrain from providing new credit causing a slowdown of overall economic activity. Authorities should act rapidly to prevent a major crisis. In other countries, financial authorities have frequently failed to prevent a crisis for several reasons, including a poor diagnostic of bank problems and existing losses, lack of a comprehensive strategy to deal with a crisis, weak implementation capacity among financial authorities, unwillingness to dismantle vested interests, etc. The proposed operation aims at assisting Guatemalan authorities to address the financial sector problems promptly. The operation is based on a comprehensive diagnostic of the problems and vulnerabilities of the Guatemalan financial sector carried out by the IMF and the WB as part of the Financial Sector Assessment Program in late 2000. Authorities are well informed about the problems faced by the country's financial sector and willing to address them. A strategy has been formulated by the government, with the advice of the international financial institutions on how to address the financial sector problems. Technical assistance will be required to implement most of the measures discussed above problems. Guatemalan authorities have not had the experience of addressing financial sector vulnerabilities in the past. Many eventual mistakes can be avoided through prompt technical assistance. International experience shows that the cost of policy mistakes can be rapidly magnified in today's financial markets. The proposed operation takes into account best international practices on crisis resolution. It was formulated in order to maximize transparency in the use of public funds to support bank restructuring, minimize moral hazard problems by providing support only to weak but viable institutions, forcing private shareholders to inject capital into their banks or face dilution, speed up the resolution of assets, foster an orderly repayment of deposits, and solve the problems as rapidly as possible.

9. Program of Targeted Intervention (PTI) N

10. Environment Aspects (including any public consultation) Issues Not applicable.

11. Contact Point:

Task Manager Jose De Luna Martinez The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: (202)458-0367

12. For information on other project related documents contact: The InfoShop The World Bank 1818 H Street, NW

9 Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Web: http:// www.worldbank.org/infoshop

Note: This is information on an evolving project. Certain components may not be necessarily included in the final project.

- 10 -