A. Background

53. The Peruvian banking system that emerged in 1990 from the period of hyperinflation and financial crisis was weak, and bank intermediation was at very low levels. Since then, the banking system has experienced a comprehensive restructuring, within a framework where the objectives of the central bank have been redefined, in an environment of market-determined interest rates. Meanwhile, the regulatory framework and the oversight capacity of the Superintendency of Banks and Insurance (SBS) have been significantly stepped up. Competition has been fostered as foreign participation restrictions were lifted, all state-owned commercial banks privatized, the development banks closed, and the state financial corporation for development COFIDE downsized and converted into a second-tier financial institution.

54. The new central bank charter of 1992 and the banking laws of 1993 and 1996 have been central components to the overhauling of the banking sector. The December 1992 charter of the Central Reserve Bank of Peru establishes that the objective of the central bank is to preserve the value of the currency, in contrast with the previous central bank law, which stipulated that the central bank had to manage credit conditions and promote output and employment growth while fostering the development of the banking sector. Moreover, the new charter prohibits the central reserve bank from financing directly or indirectly the public sector⁷ or any special fund. Also, the central bank can no longer direct credit allocation to economic sectors or set multiple exchange rate systems, and it must promote market-determined interest rates. In October 1993 a new banking law was enacted extending the supervisory and regulatory framework to nonbank financial intermediaries, improving capitalization requirements to Basle levels, and establishing a system of deposit insurance. The banking law of December 1996 improved and broadened the previous one.

55. These changes gave the Peruvian financial system the direction and appropriate incentives for a stronger foundation and a solid growth. During the 1990s bank intermediation has grown rapidly, with the ratio of broad money to GDP increasing from 12 percent at end-1991 to 21½ percent at end-1997, in a context of disinflation, macroeconomic adjustment, and structural reforms. This development occurred jointly with a radical change in the structure of the banking sector, from a system with large state-owned banks to one privately owned. In addition, foreign participation in the Peruvian banking system has grown from 29 percent of the banks’ capital in 1995 to 40 percent by end-1997. At the same time, the increased competition in the financial sector prompted a reduction of interest rate spreads, particularly in the sol-denominated segment, while the profitability of the banking sector increased from less than 8 percent of equity in 1993 to close to 16 percent in 1996–97.

B. Recent Changes and Current Status of the Regulatory and Supervisory Framework

56. The prudential framework of the Peruvian banking system has been significantly strengthened in recent years. Since 1996 several changes have been introduced to the regulatory and supervisory framework, including the issuance of the 1996 banking law which redefined the general regulatory framework and increased capital requirements; the establishment of new provisioning regulations including the introduction of new procedures to assess and classify loans; and the continued strengthening of the role and oversight capabilities of the Superintendency of Banks and Insurance (SBS).

57. The 1996 banking law updated the regulatory and supervisory framework for the banking and insurance sectors and the charter of the SBS. Its adoption constituted an important element in the authorities’ efforts of strengthening the soundness of the financial sector through new prudential regulations while reinforcing the powers of the SBS. The 1996 banking law establishes, among other things:

• revised entry requirements, SBS intervention clauses, and bankruptcy procedures;

• revised prudential regulations, including capital requirements for credit and market risks, mismatch limits between asset and liability maturities and currencies, and loan concentration and connected lending restrictions;

• the requirement of independent evaluation of banks by private rating agencies;

• the establishment of consolidated supervision of financial institutions;

• updated requirements for the funding and operation of the deposit insurance program and for the development of a credit-risk bureau at the SBS.

58. More specifically, capital requirements have been raised from 8 percent of risk-weighted assets to 8.7 percent in June 1997, a level which is above the Basle-recommended 8 percent capital-to-assets ratio.⁸ The 1996 banking law also specifies that capital requirements will be raised further to 9.1 percent of risk-weighted assets by December 31, 1999.

59. An important characteristic of the Peruvian banking system is that it is highly dollarized. In December 1997, 77 percent of commercial bank loans to the private sector and 73 percent of their deposits were denominated in foreign currency. Highly dollarized banking systems are faced with the risk that, in the event of a sharp depreciation of the currency, borrowers might not be able to service their loans in foreign currency. This is particularly true for economic agents operating in the nontradable sector, with little or no steady flow of income in foreign currency.

60. Given the high degree of dollarization of the banking system and the risks of external shocks and weather disturbances that Peru is subject to, banks need to have strong capital bases. In an effort to strengthen capital requirements and in implementation of the 1996 banking law, the SBS is expected to issue shortly prudential requirements for market risks, which will be effective in early 1999. The issuance of subordinated bonds for that purpose cannot exceed 20 percent of banks’ capital used to cover market risks. The assessment of market risks will be done with a standardized scheme rather than by allowing the use of individual banks’ own internal models.

61. New provisioning regulations were issued in August 1997 as required by the 1996 banking law, which establish a calendar for a stepwise increase in provisioning requirements between March 1998 and June 2000 (Box 3). In Peru risk classification for loans to business corporations is different from that for small firms and consumers. While loans to consumers are classified on the basis of historically available information, including the length of arrears, loans to business corporations also incorporate forward looking information, including financial cash flows.

62. In connection with the objective of broadening the dissemination of information, the SBS has broadened the coverage of the credit-risk bureau (central de riesgo), as stipulated in the banking law. Coverage now includes consumer loans in addition to business loans. In the case of consumer loans (less than S/. 13,000) the database collects information about outstanding loans, available credit lines, and, whenever applicable, the length of nonperformance. The reporting on business loans also includes information on guarantees. In the near future, the SBS database is expected to be linked to that of the tax collection agency (SUNAT) to improve available information. Furthermore, banks also use credit-analysis services of private credit bureaus and the information that they collect on the debt of individuals with retail stores.

63. In recent years, the SBS has been reinforced to better control and enforce banks’ compliance with prudential regulations. The SBS has increased the frequency and quality of inspections, while devising two types of surveillance mechanisms: ordinary inspections (preannounced to banks), and special inspections (without notification). A new unit for market risk has been created within the SBS to assist inspections in this specific area because of the different nature of market and credit risks. Furthermore, in an effort to increase information and transparency in the financial sector, since March 1998 banks have to be rated twice a year by private rating agencies, and the grading must be publicly disclosed.

64. Since March 1998, financial holdings are subject to consolidated supervision, as specified in the 1996 banking law. The purpose of consolidated supervision is to determine to what extent the risks in the rest of the group can affect the bank. The natural difficulties in assessing such interrelations are compounded when conglomerates have international exposure. To this effect, local regulatory authorities need to coordinate with their foreign counterparts to obtain information on the global position of the conglomerate. In Peru both financial and mixed holdings are overseen by the SBS. The SBS is establishing arrangements with other superintendencies abroad for the supervision of financial holdings.

C. Current Standing of the Banking Sector

65. As noted, the banking sector in Peru experienced a strong improvement in its prudential stance during the 1990s, and the capital-to-assets ratio rose from 9.5 percent to 10.2 between 1993 and 1997 (Table 1). In addition to the significant stepping up of prudential regulations and enforcement capacity undertaken in recent years, the Peruvian banking system exhibits other characteristics that contribute importantly to its resilience and strength. These include a high degree of foreign participation; very low lending to public sector entities; flexible banking practices; and a well-designed, albeit small, deposit insurance scheme.

Table 1.

Peru: Commercial Bank Prudential Ratios

Source: Superintendency of Banks and Insurance.

^1/End-of-period data for 1993–94, and annual average data for subsequent years.

^2/Under Peruvian regulations, a commercial loan is registered as nonperforming fifteen days after a non-payment occurs.

Table 1.

Peru: Commercial Bank Prudential Ratios

Ratios	1993	1994	1995	1996	1997
Capital-to-assets ratio	9.5	9.3	9.5	10.0	10.2
Provisions to nonperforming loans 1/	55.2	75.6	77.6	79.0	79.7
Nonperforming loans to total loans 1/2/	9.3	7.0	6.1	5.4	5.8
Profit (net) to equity	7.6	12.6	19.6	17.6	14.3
Operating costs to total assets	12.5	8.9	7.5	7.0	6.7

Source: Superintendency of Banks and Insurance.

^1/End-of-period data for 1993–94, and annual average data for subsequent years.

^2/Under Peruvian regulations, a commercial loan is registered as nonperforming fifteen days after a non-payment occurs.

View Table

Table 1.

Peru: Commercial Bank Prudential Ratios

Ratios	1993	1994	1995	1996	1997
Capital-to-assets ratio	9.5	9.3	9.5	10.0	10.2
Provisions to nonperforming loans 1/	55.2	75.6	77.6	79.0	79.7
Nonperforming loans to total loans 1/2/	9.3	7.0	6.1	5.4	5.8
Profit (net) to equity	7.6	12.6	19.6	17.6	14.3
Operating costs to total assets	12.5	8.9	7.5	7.0	6.7

Source: Superintendency of Banks and Insurance.

^1/End-of-period data for 1993–94, and annual average data for subsequent years.

^2/Under Peruvian regulations, a commercial loan is registered as nonperforming fifteen days after a non-payment occurs.

66. In recent years, the actual ratio of capital to risk-weighted assets has been above the minimum requirement, and averaged 10.1 percent in 1996–97. In addition, although under the banking law banks can comply with the requirement by issuing subordinated bonds for up to 30 percent of total capital, most of the banks’ capital (about 85 percent) is tier one. (The banking law rules that subordinated bonds with a residual maturity of at least five years qualify for this category.) Furthermore, in Peru the fixed assets of banks have to be valued at historical prices and adjusted by inflation (using the wholesale price index) to prevent an overvaluation of capital.

67. The ratio of nonperforming to total loans decreased markedly in recent years, from 9.3 percent at end-1993 to less than 6 percent in 1997 on average while the ratio of provisions to nonperforming loans rose from 55 percent to almost 80 percent over the same period. During 1997 developments have been more contrasted, in spite of the good economic performance, and the ratio of nonperforming loans to total loans deteriorated somewhat; however, the ratio of refinanced loans to total loans declined, so that the composite measure of nonperforming plus refinanced loans expressed as a percentage of total lending remained roughly similar from its level in 1996.

68. In recent years, credit has been growing rapidly, particularly consumer and mortgage loans, which account for about 13 percent of total loans. Mortgage lending has a relatively low nonperforming rate (about 1.5 percent), which has induced banks to seek a larger exposure on these operations. Banks’ exposure to real estate is actually larger than measured by the ratio of mortgage loans to total loans since other lending operations are collateralized with these types of assets. In the Peruvian system, mortgage guarantees amount to 35 percent of total loans.⁹ Currently, the risk of asset inflation and overvaluation of guarantees does not seem to be a leading concern.

69. As noted, foreign participation in the banking system currently represents 40 percent of banks’ capital. Foreign participation presents various advantages, in terms of bringing local technology and managerial practices to international standards, and ensuring the backing of foreign banks to local branches or connected institutions.

70. Experience in other countries has shown that both public ownership of the banking system and lending to public sector entities can be a source of weakness of the banking system, as they can lead to political interference and disregard for project evaluation based on cost-benefit analysis and risk assessment. In Peru there is virtually no bank lending to the public sector, as commercial banks’ credit to the public sector amounts to about 1 percent only of total lending. In addition, the public sector is a net depositor with the commercial banking system, with total net deposits of more than US$2 billion at end-1997. Furthermore, the entire banking sector is privately owned. In the financial sector as a whole, the only two public sector entities, alongside the central reserve bank, are the Banco de la Nación, which operates as the financial agent of the state, and the financial agency for development COFIDE, which operates as a second tier financial institution through commercial banks.

71. One aspect of the Peruvian banking sector inherited from the hyperinflation period is that it makes extensive use of the practices of fully flexible interest rates. A highly dollarized system is vulnerable to changes in interest rates, and this practice constitutes a powerful protective mechanism for commercial banks, which can avoid interest losses through prompt adjustment of their lending rates. With regard to currency risk, banks’ policies aim at protecting them from a depreciation of the currency, and to that effect, they generally keep a long foreign currency position. At present, there is no limit on the net long open position of banks (defined as assets minus liabilities in foreign currency) but their short net open position cannot exceed 2.5 percent of their capital.¹⁰ As noted, the fact that banks keep a long foreign currency position does not isolate them from the credit risks associated with lending in foreign currency to the nontradable sector.

72. The deposit insurance fund established in 1993 provides a limited coverage and is privately funded. It covers deposits of individuals and nonprofit organizations up to a maximum amount equivalent to, approximately, US$5,000. The scheme is funded by banks with quarterly individual premiums depending on the risk rating of each institution¹¹. The fund is held and managed by the central bank according to specific risk and liquidity guidance. However, the size of the deposit insurance fund is relatively small, at about US$80 million in December 1997 (0.7 percent of total deposits).

73. An important aspect of the banking sector in Peru is its relative concentration. Three institutions, out of a total of 25, collect 64 percent of deposits, and seven banks collect 82 percent of deposits. To limit the danger of systemic risks, in recent years the authorities have shown a clear determination to press banks with unsatisfactory compliance with respect to prudential regulations to promptly streamline their situation. This policy is important in the process of the progressive consolidation of the soundness of the financial system. Finally, banks’ reporting of information is comprehensive, although further improvements would still be desirable.

D. Conclusion

74. Since 1990 the banking sector in Peru has shown strong growth in a liberalized environment. At the same time, its standing and prudential framework have also been significantly strengthened and the authorities continue to undertake efforts to fortify the system. These important improvements should be assessed in light of the country’s risks, and the continued strengthening of capital requirements would seem the most appropriate way to ensure the protection of the highly dollarized Peruvian banking system.