IV. Financial Sector Issues: Advances in the Implementation of the Financial Sector Assessment Program Recommendations1
1. Since 2005, the authorities have made considerable progress towards entrenching the financial system stability and fostering financial intermediation. The reforms have been guided by the recommendations of the 2005 Financial Sector Assessment, which focused on: (i) strengthening banking supervision; (ii) putting in place an adequate regulatory and supervisory framework for financial cooperatives; (iii) strengthening the financial position of the Central Bank of Paraguay (BCP); (iv) modernizing the payment systems; and (v) developing capital markets (Box 1).
2. Ahead of the forthcoming FSAP Update, tentatively scheduled for November 2010, this paper conducts a preliminary stock taking of financial sector reforms in Paraguay. Sections B and C discuss the advances in regulation and supervision of banks and cooperatives, respectively. Section D focuses on the progress in strengthening the capital of the central bank. The development of capital markets is described in Section E. Section F focuses on the payment systems. Section G concludes.
B. Banking Regulation and Supervision
3. In line with the 2005 FSAP and Fund’s technical assistance, in June 2007 the authorities designed a strategy to improve banking regulation and supervision and increase compliance with the Basel Core Principles for Effective Banking Supervision (the Basel principles). The strategy envisaged reforms to strengthening the legal and regulatory framework for banking supervision and fostering the Superintendence of Banks (SB)’s capacity to exercise effective supervision (Box 2).
4. To date, the authorities have made good progress in strengthening the legal and regulatory framework for banking supervision. These reforms have increased compliance with the Basel principles from 17 percent, at the time of the 2005 FSAP, to the current 27 percent (Appendix 1). The main areas of progress include:
Strengthening the regulatory framework on credit requirements, portfolio classification, provisioning requirements, credit risk management, and opening of financial institutions. The new regulations establish: (i) stricter information requirements for the granting of loans; (ii) more stringent criteria for portfolio classification; (iii) and higher provisioning requirements, especially for the nonperforming loan (NPL) portfolio. The new regulations, however, still present some weaknesses, including the maintenance of a 0 percent provision requirement for all NPLs with arrears up to 60 days.
Implementing regulations on the opening of financial institutions and credit risk management practices. The regulation on credit risk management introduced a uniform generic provision of 0.5 percent of the total portfolio, bolstering the coverage of provisions.
Adopting new regulations to strengthen on-site and off-site supervision and improve financial and operational risk management practices.
Strengthening the supervisory capacity of the SB by creating the Financial Stability Department and enhancing the legal protection for supervisors.
Abolishing the requirement to publish the CADEF, Calificación de Entidades Financieras, the ranking of financial institutions published by the SB, which sent erroneous signals to the market and affected the reputation and standing of the SB. Instead of the CADEF, the SB has started to publish other financial indicators, starting this year. In addition, by mid-2010, credit rating agencies are expected to start operating in Paraguay and to assess banks.
Launching cross-border consolidated supervision with the supervisors in Argentina, Brazil, and Uruguay. Negotiations with Peru and Spain have started.
Box 1.2005 FSAP: Summary of Main Recommendations
Complete reforms of banking legislation
Approve banking law to improve institutional framework, governance rules for banks, and supervisory capacity of the Superintendence of Banks (SB).
Improve central bank law to streamline institutional responsibilities and adopt a law for the capitalization of the central bank.
Reduce deposit insurance coverage and premia, according to a well-defined plan.
Strengthening bank regulation and supervision
Grant the SB more autonomy, sanctioning capacity and regulatory powers.
Improve quality and quantity of human, material and technological resources in the SB.
Strengthen risk-oriented supervision in the banking sector.
Adapt internal organization and work planning of the SB to accomplish the above challenges.
Take decisive steps to restructure the state-owned National Development Bank (BNF).
Strengthen INCOOP’s capacity to supervise the sector, focusing first on the largest cooperatives.
Enhance SB-INCOOP collaboration with respect to the supervision of the largest cooperatives.
Develop automated credit information-sharing system between banks and cooperatives.
Promote technical assistance for cooperatives to adapt to new regulatory standards.
Developing Capital Markets
Discontinue application of financial transaction tax.
Enhance quality and transparency of firms’ economic and financial information.
Implement an electronic trading system in the context of a payment system reform.
Approve a comprehensive payment system law, establishing a Real Time Gross Settlement (RTGS) system and a National Payment Council.
Separate payment systems for large and small value transactions, avoiding excessive use of checks.
Box 2.Strategy to Increase Compliance with the Basel principles
In June 2007, as part of the last Stand-by Arrangement, the authorities designed a strategy to improve banking regulation and supervision and to increase compliance with the Basel principles. The strategy included the following steps:
Approval of amended Resolution 8 on credit requirements, portfolio classification, and provisioning requirements by September 2007. The resolution was approved and entered into effect in October 2008. This regulation establishes: (i) stricter information requirements for the granting of loans; (ii) more stringent portfolio classification criteria for nonperforming loans; and (iii) higher provisioning requirements for the nonperforming loan portfolio. The main weakness of these rules is that they maintained 0 percent provisioning for all nonperforming loans with arrears up to 60 days.
Implementation of regulations on the opening of financial institutions and credit risk management practices, and strengthening of the SB financial risk unit by December 2007. The SB introduced regulations in August 2008 for the opening of new financial institutions and in January 2009 it issued credit risk management regulations. The SB strengthened its financial risk unit by increasing the number of professionals and launching an active training program.
Implementation, by end-2008, of additional regulatory reforms including those related to the strengthening of on-site and off-site supervision, and the improvement of financial risk management and operational practices.
Modification, by end-2009, of the current legislation (including the General Banking Law and the Organic Law of the Central Bank) with a view to increasing the independence, management capacity, and corporate governance rules of the SB and strengthening capital requirements. These modifications are key for making substantive improvements in the compliance with the Basel Core Principles.
5. The authorities remain committed to increase compliance with the Basel principles even further by the end of this year. In line with MCM recommendations, by November 2010, the authorities plan to modify several regulations to bring banking supervision into compliance with about 50 percent of the Basel principles. These steps include the amendment of several regulations to improve information sharing among supervisors, strengthen licensing criteria for foreign banks, enhance credit risk assessments, set provisions for problem assets, establish exposure limits, improve internal control and audit within banks, and enhance off-site supervision.
6. Further gains in Paraguay’s compliance with the Basel principles would require modifying the banking law. The reform of the banking law is needed to strengthen the application of capital requirements, enhance the imposition of sanctions, improve further the granting of licenses and the exchange of information among supervisors, and reinforce the monitoring and control of credit risk. In particular, a loan overdue up to 59 days needs to be considered as an early indicator of a loan at risk. Further, information should be provided on debts that are 1—30 and 31—59 days overdue for the 100 individual largest debtors of each bank.
7. The authorities have also made significant progress in strengthening public financial institutions. The main improvements refer to the National Development Bank (BNF), which had negative capital at end-2004. By December 2009 the BNF’s capital adequacy ratio had improved to 34.5 percent, and it is no longer systemically important, since its operations have been restricted by law. The new second-tier bank Development Financial Agency (AFD) commenced its operations in 2007. The AFD is funded through long-term loans from the IDB and provides long-term capital to the financial sector, in particular for mortgage financing programs. By December 2009, the AFD held a US$172 million loan portfolio.
C. Regulation and Supervision of Cooperatives
8. Since the 2005 FSAP, cooperatives have steadily increased their participation in Paraguay’s financial system. In 2005, cooperatives’ assets were estimated to account for around 10 percent of the total assets of the financial system (including banks, finance companies, and cooperatives). At the end of 2008,2 the assets of the cooperative sector stood at US$2,088 million, divided more or less equally between the savings and credit cooperatives (SCCs) and production cooperatives (PCs). The assets, loans, deposits, and net worth of the cooperative sector represented, respectively, 24.1 percent, 23.9 percent, 16.0 percent, and 43.5 percent of those of the financial system as a whole. At present, there are over 450 cooperatives with approximately 996,000 members, with the largest 45 cooperatives accounting for about 90 percent of the total assets and total deposits of the sector.
9. While, in general, the inter-linkages between banks and cooperatives are small, there is a high concentration of cooperatives’ deposits in a few banks. At the end of 2009, the banking loans to cooperatives constituted only 2.5 percent of banks’ total loan portfolio whereas the cooperatives’ deposits amounted to 3.3 percent of banks’ total deposits. However, most (up to 90 percent) of the cooperatives’ deposits in the banking sector are located at one of the largest banks in Paraguay (representing about a fifth of this bank’s total deposits).
10. Despite recent progress, the supervisory and regulatory framework for cooperatives could be more effective. A number of reforms have been implemented, such as the enactment of the General Regulatory Framework for Cooperatives (GRFC) in 2007. The GRFC establishes the capital, liquidity, and provisioning requirements and the classification of loans that cooperatives must follow. It also introduces a basic framework for carrying out effective supervision. However, the GRFC norms are less stringent than those for the banking system (Table 1). In addition, an adequate framework to deal with individual and systemic problems in the sector is absent. Moreover, the independence of the supervisory agency for cooperatives, INCOOP, is compromised by, among other factors, the fact that the cooperatives participate in the selection of INCOOP’s governing officers.
|Central Bank regulation||INCOOP regulation|
|Risk assessment based on …||Person (all credits of this person carry the same risk weight)||Individual transaction (one person can have various risk categories assigned to it)|
|Requirement to consult Credit Bureau prior to issuing credit||Yes, mandatory consulting and reporting to Credit Bureau||No, no credit bureau available|
|Documentation requirement for lending||If not sufficient documentation on borrower available, then higher risk category to be assigned, including higher provisioning||Documentation requirements specified, but no sanctions|
|Regulation regarding connected lending||Assessment by institution/ entity||Assessment by individual person|
|Provisioning regulation for overdue loans||Over 90 days: 5% provision||Over 120 days: 1% provision|
|Over 150 days: 25% provision||Over 180 days: 20% provision|
|Over 180 days: 50% provision||Over 360 days: 50% provision|
|Generic provisioning||Uniform 0.5 percent||None|
11. A large program of reforms to strengthen supervision and regulations of cooperatives is under discussion. Lately, particular attention has been paid to preparing contingency plans in the event systemically important cooperatives enter into financial distress (Box 3). In addition, work is underway on several areas, with the technical assistance of MCM, including:
A Memorandum of Understanding between the Central Bank of Paraguay (BCP) and INCOOP to regulate the inclusion of the monetary and financial information of the largest cooperatives in the monetary accounts.
The establishment of a deposit insurance fund (a Cooperatives Insurance Fund, or FGCOOP). Last year, INCOOP proposed a draft law intended to establish a deposit insurance coverage of 55 minimum salaries or US$ 14,000—the coverage for banks and finance companies is of 75 minimum salaries or US$19,000—which would cover approximately 97 percent of the total 600,000 deposits accounts held by cooperatives. However, the cooperatives rejected the draft and proposed instead a self-regulated guarantee fund with voluntary contributions. The INCOOP considered this proposal unlawful and is working now on a new proposal.
The implementation of a Cooperatives Stabilization Fund (FECOOP), which, according to INCOOP’s proposal, would be funded with contributions from the cooperatives and would aim at providing cooperatives with a lender-of-last-resort facility. INCOOP wants the size of the contributions to depend on each cooperative’s credit-rating. However, there is yet no consensus among the cooperatives on the creation of the FECOOP. In the meantime, INCOOP is working on creating a provisional stabilization fund with contributions from the largest five or six cooperatives.
The establishment of a credit bureau (central de riesgos) for cooperatives, so as to mitigate the credit risk they incur and develop a greater payment culture. By mid-2010, technological resources needed for providing credit information on individual consumers in the largest SCCs should be operational.
The improvement of the supervisory capacities of INCOOP, with the technical and financial assistance of the IDB and the German Association of Cooperatives (DRGV). This includes, among other things, setting up a standardized and automated system for the largest cooperatives, to facilitate the provision of financial information to INCOOP, the adoption of staff training programs, the definition of risk management and reporting standards, the creation of a deposit insurance system, the establishment of a credit bureau, and advice for enhancing regulation and supervision.
Box 3.Establishing Contingency Plans for the Cooperative Sector
At present, the Paraguayan authorities are still developing mechanisms for managing and resolving crises in the cooperative sector. In May 2009, at the request of the Paraguayan authorities, MCM provided technical assistance to assist the authorities in introducing a safety net and a framework for resolving crises in the cooperative sector, as well as in designing an action plan consistent with the current legal and regulatory framework to deal with the eventuality of a crisis originated in the cooperative sector. The action plan included the following measures:
Encourage banks to absorb the assets and liabilities of the cooperatives, in a process similar to a merger, but with the capital left aside, i.e., only the assets and liabilities of the cooperative in difficulties should be transferred to the bank.
Set, in advance, clear criteria for identifying the cooperatives eligible for bailout, and communicate such criteria clearly.
Allow both private and public banks (such as the BNF) to participate in the resolution process. If no private bank is interested in participating, the authorities should use the BNF to absorb all the costs to prevent the likelihood of a systemic event.
Establish a map of financial institutions that would be in a position to participate in the bailout of each eligible cooperative, including the way in which the BNF could participate in the process.
Introduce the mechanism—with legal support—whereby banks and cooperatives agree to the transfer of assets and liabilities. A pro forma contract for the transfer of the assets and liabilities of the cooperatives should be drawn and the possible fiscal costs of those scenarios should be estimated.
Estimate the possible fiscal costs of the alternative scenarios.
D. Strengthening the Financial Position of the BCP
12. The authorities have taken important steps forward to strengthen the financial position of the BCP. The law that allows the government to recapitalize the central bank through the transfer of interest-bearing treasury bonds took effect in April 2010. In the coming months, the BCP and the ministry of finance will decide on key details of the transfer, including the interest rates. This step will enhance the credibility of the BCP and give it more flexibility in the conduct of monetary policy. The main elements of the strategy include:
The ministry of finance will issue and maintain outstanding guaraní-denominated government bonds worth up to 6¼ percent of the 2009 GDP (equivalent to US$971 million). The bonds would be swapped for the BCP’s nonperforming assets that represent BCP’s claims on the public sector. The claims are related to BCP’s past quasi-fiscal activities taken on behalf of the government.
It would be best for the recapitalization bonds to be transferable and marketable and thus suitable for developing the domestic bond market. The BCP should continuously replace the stock of its Instrumentos de Regulación Monetaria (IRM) with the treasury bonds, until all open market operations are conducted with these securities. The long-run scenario would see the central bank execute monetary policy through the guidance of a short-term interest rate through the use of repurchase agreements utilizing treasury debt as the underlying asset.
E. Developing Capital Markets
13. Progress with the development of capital markets has been mixed. In February 2008 the authorities formulated a strategy for the development of capital markets, which included: (i) improving the general business environment; (ii) enhancing the securities market regulation; and (iii) developing market infrastructure. In this area, the main developments include:
A draft law amending the requirements for the operation of credit risk rating agencies—which is awaiting approval in the Senate (Law 3899/2009). By mid-2010, at least three credit rating agencies are expected to start operating in Paraguay. Banks, insurance companies, and the four to six largest SCCs are to be rated by a credit rating agency, with the National Securities Commission (CNV) determining the exact details.
Memorandum of Understanding for information sharing between the SB and the CNV was signed in March 2010.
Additional budgetary resources for CNV for the period 2009-10 period—which will allow the institution to increase its staff, provide further training, and expand and upgrade its technological requirements.
The application of the financial transaction tax was discontinued.
Implementation of the electronic trading system of bonds, to commence by mid-2010 (fixed-income instruments account for 90 percent of all transactions).
F. Upgrading the Payment Systems
14. The authorities are working on upgrading the legal framework and information technology platform underpinning the payment systems. The infrastructure for payments, clearing and settlements of securities remains inefficient; and an adequate legal framework for settlement, dematerialization, custody, netting arrangement, repurchase operations, and electronic transactions needs to be developed.
With Fund and World Bank technical assistance, the government has prepared a draft law to address these weaknesses. The law was approved by the Cabinet, sent to Congress, and is expected to be approved by September 2010. The law will cover the legal framework for the Real Time Gross Settlement System (RTGS), the securities depository, and the automatic clearing house. The law will also formally entrust the oversight and regulation of the entire payment systems to the central bank.
A National Payment Council is expected to be established by the end of 2010.
The World Bank is providing technical and financial assistance to the central bank to set up the infrastructure for an automated RTGS. Test runs of the new electronic system are scheduled for the third quarter of 2010. Final implementation date is projected for the third quarter of 2011.
G. Summary and Conclusions
15. Since the 2005 FSAP, Paraguay has made important advances with the reform of the financial sector. The reforms’ main goal was to rebuild trust in the financial system, and reversing disintermediation after several years of financial stress. These reforms have been critical to entrench the stability of the financial system and foster financial intermediation.
16. The main areas of reforms include the following: banking regulation and supervision, the regulatory framework on credit risk management, strengthening public financial institutions, and recapitalization of the central bank. In contrast, progress with the development of capital markets and the automated RTGS has been slower. Relevant laws have been drafted and are awaiting approval.
17. However, Paraguay’s financial system still presents some weaknesses, which calls for continued reform efforts. The most important and urgent weakness is the significant disparity with regard to regulatory and supervisory practices between banks and cooperatives. The authorities should extend the prudential norms for banks to cooperatives to limit the scope for regulatory arbitrage. In the medium term, the regulatory and supervisory frameworks of banks and cooperatives should to convergence to a uniform system.
Appendix 1. Basel Core Principles for Effective Banking Supervision (Basel principles)1
The 2005 FSAP determined that only five out of the thirty Basel principles (about 17 percent) were met or broadly met.2 It is estimated that, absent any deterioration in the implementation of those initially met five principles, reforms undertaken by the Paraguayan authorities since the 2005 FSAP would bring the number of Basel principles met or broadly met to eight (or about 27 percent). These numbers reveal the challenges for the authorities in bringing the regulatory and supervisory framework in Paraguay to a level that may significantly reduce the risks to financial stability.
An important factor explaining the lower-than-envisaged progress in complying with the Basel principles in Paraguay has been the difficulty to modify banking legislation. To illustrate the importance of legal changes in the results of the FSAP, it is estimated that about ten of the thirty Basel principles (about 33 percent) require at least some modification in the banking laws to move to full compliance.3
The Paraguayan authorities still have some degree of maneuver to improve their Basel principles rating by introducing some modifications to the current regulatory regime.4 In addition, improvements in the information systems and technological capabilities at the SB may help in consolidating and deepening the advances made since the 2005 FSAP in the quality of supervision. In fact, changes in regulation and in the operation of the SB may, relatively rapidly, bring the number of Basel principles met or broadly met from five to fifteen (about 50 percent). Figure A1.1 shows, starting from the 2005 FSAP ratings, and the evolution of the Basel principles rankings for Paraguay under two scenarios: (i) no immediate action is taken to improve regulation, and (ii) a short term plan to modify regulation and operations at the SB is introduced.
Figure A.1.1.Paraguay: Percentage of BCPs Met
Notes: Percentage of BCPs met in 2005 (black), in April 2010 (white), and potentially in November 2010, assuming that a short term plan to modify regulation and operations at the SB is introduced (grey). The ratings in the graph are: M = Met; BM = Broadly; MI=Met incompletely; and I=Incomplete.
The changes proposed above are part of a short term strategy proposed to the SB to introduce regulatory changes and operational improvements to bring about rapid improvements in banking regulation and supervision. The strategy focuses on regulatory measures that improve credit risk management and promote sound managerial practices in the banks, improve information availability for the monitoring of credit risks by the SB, and helps in coordinating the work of regulatory agencies in Paraguay, i.e., CNV, FOGADE, SB, and the Superintendence of Insurance.
Prepared by Sylwia Nowak with inputs from Giancarlo Gasha and Marco Rodriguez (all MCM).
The final data for end 2009 are not yet available.
This Appendix is based on several Reports of Technical Assistance provided by MCM to the Paraguayan authorities in the last two years. See especially: Livacic, Ernesto, “Informe de la Misión al Banco Central del Paraguay,” Abril 2010.
The BCPs are a framework of minimum standards for sound supervisory practices and are considered universally applicable. They define 25 principles that are needed for a supervisory system to be effective. See Basel Committee on banking Supervision, “Core Principles for Effective banking Supervision,” BIS, October 2006.
Four of these thirteen Principles require also some modification in the regulatory framework, although this is a less stringent requirement.
These changes are under the discretion of the BCP Board, and even some of them can be made directly by the SB.