This Selected Issues paper and Statistical Appendix analyzes Ecuador’s fiscal policy using the concepts of the fiscal stance and fiscal impulse adjusted for movements in the real effective exchange rate. It finds that fiscal policy has been expansionary in 2000 and 2001. The paper shows that the growth of gross fixed investment was relatively strong during the 1970s; thereafter it slowed, particularly in the public sector. The paper also explores the evolution of oil reserves in recent years and the projections for the medium term.

Abstract

This Selected Issues paper and Statistical Appendix analyzes Ecuador’s fiscal policy using the concepts of the fiscal stance and fiscal impulse adjusted for movements in the real effective exchange rate. It finds that fiscal policy has been expansionary in 2000 and 2001. The paper shows that the growth of gross fixed investment was relatively strong during the 1970s; thereafter it slowed, particularly in the public sector. The paper also explores the evolution of oil reserves in recent years and the projections for the medium term.

VII. Recent Developments in the Banking System, Liquidity Needs, and Next Steps34

93. This chapter describes developments in the banking system after the 1998-99 crisis, explains the main vulnerabilities in the system, analyzes the banks’ liquidity needs and alternative ways to hold liquidity to face the remaining vulnerabilities; and suggests policies to manage the liquidity needs better.

A. Recent Developments

94. Ecuador had a major banking crisis in 1998-99. In the midst of this crisis, the authorities implemented a full coverage deposit insurance rule that soon proved unsustainable, and a deposit freeze was imposed in March 1999. The crisis led also to the intervention and closure of about 16 banks or 65 percent of the financial system on-shore assets, and contributed to the decision to fully dollarize the economy in early 2000.35 After the crisis, Ecuador’s banking system has experienced some consolidation, is being recapitalized, and its financial soundness indicators have improved notably.

95. Deposits grew strongly in the past three years, but most are of very short maturity, reflecting that confidence has not yet fully returned to the banking system (Table VII. 1). In response to the maturity structure of their liabilities, the banks hold large amounts of liquid assets. This large liquidity position is deemed necessary for the banks to face potential runs; however, it is expensive and has contributed to high interest rates spreads (Table 34).

96. Credit to the private sector increased in the past three years, while the ratio of nonperforming to total loans declined (Tables 29 and 36). However, the credit market has been influenced after the banking crisis by Ecuador’s entrenched culture of no payment. In 1999, the government defaulted on its domestic and external obligations and this behavior extended to the private sector. The government-run Deposit Guarantee Agency (AGD), has been managing the closed banks and their large nonperforming loan portfolio. The political and institutional barriers to collect these loans have encouraged private banks to be cautious in their lending practices.

B. Financial System Vulnerabilities

97. Despite significant improvements in its financial soundness, Ecuador’s financial system remains vulnerable. There are several sources of vulnerability. First, the lack of fiscal consolidation. Second, lack of confidence in the system associated with the deposit freeze of 1999. Third, the absence of a lender of last resort, the limited liquidity support provided by the existing mechanisms, and the lack of a credible deposit insurance. Fourth, the gradual strengthening of the financial situation of the banking system. Fifth, the role of the state-owned development banks in the financial system.

98. The fiscal position improved significantly during 2000, but there were policy slippages in 2001-02. The wage bill more than doubled in nominal terms during 2000-02, and the government incurred in new payments arrears. This outcome increased the banking system vulnerabilities through different channels. First, the banks have some government bonds in their portfolios,36 and delays in interest or principal payments would affect their financial soundness. Second, the government’s arrears raise the probability of default on restructured debt with a large potential negative impact to the rest of the economy, including the banks. Third, an increase in default risk increases the EMBI spread and the domestic interest rates and has a negative impact on lending activities. The EMBI spread ranged between 1,000 and 4,712 during 2000-02.

99. The 1999 deposit freeze had a very negative impact on the public’s confidence in the banking system. The open banks returned the blocked deposits rapidly, confidence returned after dollarization and deposits grew fast. However, the closed banks have taken much longer to return the blocked deposits and about US$275 million are still unpaid in early 2003. The slow loan recovery in the closed banks has significantly delayed the repayment to depositors.

100. The legal aspects of dollarization and the transition mechanisms to put it in place were established in the Trole I Law in March 2000. The law established that the central bank would no longer lend to either the public or private sector. In so doing, it took away the role of lender of last resort from the central bank.37 In principle, this responsibility could have gone to the treasury, but the fiscal situation has not allowed it.

101. The law established two transitory liquidity mechanisms, the recycling facility and the liquidity fund. The recycling facility works as an interbank window with the central bank as intermediary. This is a self-financed operation by which the central bank places short-term dollar-denominated bonds among banks and provides repurchase agreements (repos) to banks facing liquidity needs. Since 2000, the recycling facility has had very limited use, and only during periods of instability (mostly associated with Filanbanco) has there been any large placement of paper and repos (Table 30). Banks have been reluctant to use this facility for fear of reputational risk associated with using liquidity assistance.

102. The liquidity fund is a facility pooling together contributions from the banks and the government to provide short-term loans to banks under pressure. The resources in the fund include: (i) a contribution of 1 percent of deposits in the commercial banks, other financial institutions (financieras) and mutualistas, (it amounted to US$43 million at end-2002); and (ii) about US$74 million contributed by the government from a loan by the Corporación Andina de Fomento (CAF).

103. The liquidity fund has rules of access at two different levels. First, it can be used through an open credit line to cover liquidity shortages in the settlement system (cámara de compensaciones). The rules of access for this first tranche include:(i) to be up to date with the contributions to the fund; and (ii) to be in compliance with the agreements and documentation needed to access support in the settlement system. The requirements are assumed to be met when a bank asks for assistance, unless the bank itself notifies the implementation committee otherwise. Access to the first tranche is fairly automatic, but the access limit is each bank’s contribution to the fund.

104. Second, the facility can be used to cover other liquidity shortages. The rules of access for this tranche are: (i) to be current on the contributions to the fund; (ii) to meet all information requirements requested by the central bank (BCE) and bank superintendency (SBS), (iii) to meet technical patrimony requirements or be subject to a regularization program with the SBS; (iv) to be current on payments obligations to the BCE and with the liquidity fund; (v) to present a certificate indicating that the bank is current on its obligations to other public financial institutions and to banks participating in the liquidity fund, (vi) to meet collateral requirements established in the liquidity fund regulations and have their value assessed by the technical secretary of the fund; (vii) present a cash flow of the bank and the financial group to which it belongs, if applicable; and (viii) meet a liquidity ratio of at least 14 percent of short-term deposits and other liabilities in the six months prior to the date of access request.

105. The technical secretary of the fund analyzes the application for the use of fund resources in the second tranche. The SBS determines if the bank faces a liquidity problem and certifies that the technical patrimony requirements are met. The SBS informs the technical secretary within 72 hours with a statement, indicating if the request can be granted and the maximum amount to be granted. If the SBS does not respond within 72 hours, it is assumed that the request is denied.

106. Access limits to the liquidity fund by a single bank cannot be higher than 10 times the technical patrimony of the bank or 10 times its contribution to the fund, whichever is less. At the same time, no more than 30 percent of the fund resources can be given to a single bank and no more than 50 percent can be with two banks.38

107 The first tranche of the liquidity fund has been used regularly since it started operating in early 2001. This has been used mostly by small private banks, requesting tranches of less than US$2 million, and only on two occasions by a large private bank. However the publicly-owned banks received large disbursements in 2001. The second tranche was not available to Filanbanco in 2001, because it did not qualify, but it was drawn by Banco del Pacífico and on one occasion by a small private bank in the same year. The interest rate charged has ranged between 16½ and 20 percent.

108. The existing liquidity fund has several drawbacks: (i) its resources are well below the minimum needed in case of a systemic run (as discussed below), (ii) it is held at a trust fund at the CFN and the banks believe is potentially subject to confiscation by the state; (iii) it is perceived by the banks as subject to interference by the authorities in the decision making process, and (iv) its use represents significant reputational risk for the private banks. In sum, as currently implemented this fund is not an adequate lender of last resort facility.

109. The full-coverage deposit insurance that was established in the midst of the 1998-99 banking crisis soon proved unsustainable. In 2001 congress set the limit on deposit insurance at four times per capita income, or about US$6,000.39 It also determined the contribution of banks to the insurance fund at 0.065 percent of deposits. In practice, there is no deposit insurance, as this contribution has been used by the AGD to cover its operational expenses and pay part of the blocked deposits from the last crisis.

Financial situation of the commercial banks

110. The banking soundness indicators have improved since the end of 1999 (Table 36). This is the result of: (i) system consolidation as the insolvent banks were closed and only the better run private banks survived; and (ii) reductions in operational costs including through personnel retrenchment. The private banks were also aggressive in collecting nonperforming loans or reaching refinancing agreements after the banking crisis, while becoming more selective in their lending practices. As a result, the share of nonperforming loans in total loans declined from 14.3 percent in 1999 to 6 percent in 2002. The private banks’ profit margins have been high in the past two years, explained in part by the high deposits and lending spread. However, as the system consolidates further, and the country risk declines, efficiency gains will be needed to maintain adequate profit levels.

111. The financial situation of the private commercial banks is gradually being strengthened to limit vulnerability. First, in October 2001, the SBS started a program of semi-annual steps (of capital increases) for the banks to reach Basle capital adequacy criteria by November 2003. Under this program, banks should meet a ratio of tier-one to tier-two capital of 100 percent by the deadline. As a result, banks have been improving their capital adequacy ratios.

112. Second, in the past two years, there has been a rapid expansion of consumer lending. This has been triggered on the demand side by the return of confidence in the economy and higher employment levels, and by large profit margins on the supply side. To reduce vulnerabilities to their increased exposure to consumers, the SBS recently tightened the provisioning requirements for these loans.

113. Other sources of vulnerability relate to the public commercial banks. In 2000 there were two large publicly-owned commercial banks, Filanbanco, the largest in the system, and Banco del Pacífico, the fourth largest. Filanbanco was closed in July 2001 and in the months before its closure its liquidity shortages were a source of instability in the system. The government took steps to liquidate Filanbanco in July 2002, but completing the process has been slow. At present several trust funds exist to allocate the bank’s assets and liabilities. These will be used to pay about US$126 million that is still owe to private sector depositors and about US$83 million to repay deposits of public sector entities. At the time of its closure, Filanbanco had a loan portfolio of about US$950 million. The expected recovery value is estimated at a fraction of that, as the legal process for the creation and implementation of the trust funds has taken a long time to materialize.

114. Filanbanco’s difficulties affected also Banco del Pacífico, the other publicly-owned commercial bank. In the second half of 2001, the government decided to transfer ownership of the bank to the BCE who took care of its capitalization. Pacífico was capitalized through the transfer of government bonds for US$129 million in 2001 and US$45 million in 2002 from the BCE; and through a cash transfer of US$75 million from a CAF loan to the government in 2002. The bank has been under a regularization program closely supervised by the SBS and was placed under independent private management in 2001. During 2002 the bank management focused its efforts on reducing the nonperforming loan portfolio and reducing personnel and other operational cost. The corresponding indicators show the ratio of nonperforming to total loans declining from 53.3 percent in 2001 to 32.2 percent in 2002. Banco del Pacífico also reported profits in 2002, reflecting in part nonrecurrent revenues. An independent investment firm is expected to prepare the bank for sale by July 2003.

115. The bank superintendency has been reorganized, the staff has been better trained, and has substantially strengthened its oversight of the banks. This has been possible by increasing the on-site inspections, and by setting well-defined quantitative and qualitative standards that are closely monitored by the SBS. However, a weak judicial system and political interference tend to be obstacles to strong and timely enforcement of the regulations.

Role of the state-owned development banks

116. The government has been managing a number of development banks, including the Corporación Financiera Nacional (CFN), Banco Nacional de Fomento (BNF), Banco del Estado (BEDE), and Banco Ecuatoriano de la Vivienda (BEV) These banks have played an important role in segmenting the credit market through their preferred credit to selected groups. In particular, the CFN channels credit to small and medium firms in the main urban areas, BNF specializes in rural sector lending, BEDE lends to local governments, and BEV has specialized in mortgage financing. The performance of these banks remains a source of concern for the system as a whole. First, the banks have a tradition of poor loan recovery, which discourages repayment of loans to all banks. Second, their lending practices are not transparent.

C. Liquidity Needs

117. In response to the vulnerabilities described above, the commercial banks have accumulated large liquidity cushions, including legal reserve requirements at the central bank, cash in vault, short-term assets abroad, and their contribution to the liquidity fund. Moreover, three major banks have arranged their own contingent liquidity support credit lines from foreign creditors. Deposits in the banking system have grown fast since 2000, and short-term liquid assets expanded rapidly to cover about 46 percent of sight deposits and up to 30-day maturity time deposits by end-2002 (Table VII. 1). The minimum liquidity ratio is 14 percent. This is calculated as the sum of all liquid assets available within 90 days divided by the sum of deposits and other obligations due within the same period. The average for all banks of this measure, known as “first line liquidity ratio,” has normally exceeded the minimum requirement. In addition, as part of its close monitoring of liquidity conditions, the SBS is following on a weekly basis the volatility of the deposits of the 100 largest depositors by individual banks. As their systems become more sophisticated, it plans to incorporate sensitivity analysis of vulnerabilities in deposits and loan portfolios into the regular monitoring process.

118. The recent experience of other highly-dollarized countries in Latin America shows that during a crisis a substantial decline in deposits in a few weeks is not unprecedented. In such an event, Ecuador would need large banking system reserves to cover sight deposits and those with maturities of up to 30 days. In the absence of a lender of last resort, these resources will need to come from the banks’ own liquidity cushions.

Alternative ways to hold liquidity

119. The legal reserve requirement, equivalent to four percent of deposits, must be placed at the BCE and is nonremunerated.40 These resources can be used exclusively by the bank that placed them in the BCE, and they are not pooled to support the banks facing liquidity needs Cash in vault is also non-remunerated and is not pooled.

120. Remunerated short-term assets abroad constitute the bulk of the liquid assets of the banks. These holdings present a supervisory challenge to the SBS as it is necessary to be vigilant with respect to the form of assets held, their immediate availability, and their location to avoid misreporting.

121. Another way for the banks to hold their liquid reserves could be by holding a minimum amount of short-term BCE bonds in the liquidity recycling facility. However, this is likely to generate quasi-fiscal losses to the BCE, as there has been practically no demand for repos, the only possible use of the proceeds of these bonds (Table 30). Placing BCE bonds, not used for repos, would also be inconsistent with current regulations.

122. The liquidity fund was put in place as a transitory mechanism in the absence of a lender of last resort, and its resources have not been adequate to handle a systemic run on the system from the start. Moreover, although access by Filanbanco to the liquidity fund in 2001 was within the rules, the private banks perceived its use as an act of government policy, and that has reduced their willingness to make additional contributions to the fund. Moreover, the second tranche, where banks can borrow beyond their individual contributions to the fund, has been used mainly by Banco del Pacífico, also a public bank.

123. The private banks, BCE and the SBS have been discussing ways to improve the functioning of the existing liquidity fund or to implement a new one. The discussion can be separated on two main aspects. First, the needs of a single bank that may have to borrow to meet its settlement and other obligations. Second, the liquidity needs of one or more banks in the face of a deposit run.

124. In the case of a single bank, with a nonrecurrent and minor liquidity shortage, a properly designed and well functioning inter bank facility would be enough. At present, the recycling facility performs this function.

125. However, in the case of a systemic run, there is a need to have access to an adequate pool of resources. This has been handled through the second tranche of the existing liquidity fund, but its performance has not been fully satisfactory. An improved liquidity fund, may need to resolve the tensions between three main considerations: (i) how much to increase the fund resources and who will contribute, (ii) how to manage it; and (iii) how to institutionalize the interaction between the fund manager and the authorities. Three proposal (discussed below) have been identified to improve on the existing liquidity fund. However, none of these has yet been developed to implementation stage.

126. Several private banks prefer a fully privately-owned and -managed liquidity fund. They have suggested that the fund include only resources from the commercial banks, be administered by an independent manager, and be kept abroad. This idea would relieve the authorities from any lender of last resort responsibility. However, the proposal has not yet established how many resources will be in the fund, how the independent manager would interact with the authorities, or how to deal with banks that decide not to join the fund.

127. An alternative proposal calls for a new liquidity fund using some of the elements of the existing one, including the current contribution of the BCE.41 This proposal envisages to increase the liquidity fund resources by including the reserve requirements now held at the BCE and new contingent credit lines from the FLAR and multilateral organizations. The proposed fund will have the advantage of enlarging the resources available to assist the banks. However, it would involve more resources from the public sector without additional contributions from the private sector. Moreover, while the proposal includes the role of an independent manager for the fund, the roles of the BCE and SBS are not clearly established.

128. A third proposal has been built around the recent experience of other highly-dollarized countries, where a large loss of deposits occurred in a few weeks. Using this as a benchmark, a larger liquidity fund could include the resources that are now invested as short-term foreign assets, the legal reserve requirements at the BCE, and the contribution to the existing liquidity fund (1 percent of deposits) At the end of 2002, these components combined were equivalent to US$1.4 million or about 39 percent of all deposits or 46 percent of sight deposits in commercial banks (Table VII. 1).42. The liquidity needs from banks’ own sources will be less if the existing contribution of the government in the current liquidity fund would be transferred to the new liquidity fund.

129. Regardless of the distribution between public and private resources in a new liquidity fund, questions remain on the role of the BCE in its operations. First, access to the first tranche of the liquidity fund is interrelated to the well functioning of the payment system. Any changes will need to be carefully designed. Second, the BCE participates in the settlement system as it is the fiscal agent of the government. This may need to remain so in the near future as it might be difficult politically to place the treasury’s resources at a commercial bank. Third, if cash reserves were to be part of the liquidity fund, enough cash should be held in Ecuador by the independent manager, in or outside the BCE.

130. The role of the bank superintendency in the operations of the new liquidity fund will need to be clearly defined also, as its mandate is to preserve the well functioning of the financial system. The SBS is responsible for the early warning system, to determine and monitor corrective actions, and to take control of a bank if necessary. The private banks and the independent fund manager would need to work closely with the regulator, and to accept its recommendations as binding under circumstances that are precisely specified in the regulations. In this context, the discussion will need to focus on the use of confidential information provided by the superintendency to the independent manager, and the role of the superintendency in recommending or dismissing requests for the use of the liquidity fund resources.

131. The fees for the use of the liquidity fund will need to increase pari-passu with the level of access to be determined as part of the regulations. Access beyond liquidity needed in the settlement system will need to be at punitive rates to discourage use other than in emergency conditions. Access limits will also need to be established to avoid a situation in which only a limited number of banks can have access in case of a systemic run.

132. An alternative way to have access to funds by banks with liquidity needs could be to use prearranged contingent credit lines. These will be particularly useful if the creditor were to remain vigilant of the quality of the assets that the banks present as collateral, and in that way bring confidence that the lines would remain open when the banking system faces a systemic run This, however, will be difficult when the economic environment deteriorates and the probability of a banking crisis increases.43

D. Options to Move Forward

133. This chapter focused on ways to reduce the vulnerabilities faced by the banking system and to improve the liquidity management. On the government side, an adequate macroeconomic framework with better fiscal policy is of the essence. This will contribute to the elimination of public sector arrears and bring increased confidence and stability to the banking system. At the same time, a better fiscal position with early repurchases of public debt will bring down lending rates and spreads by reducing risks. Privatization of Banco del Pacífico is likely to eliminate a potential source of instability and political interference in the banking system. The restructuring of the development banks and their eventual consolidation in one better run development bank could improve the public finances and take away distortions in the financial sector. The bank superintendency could move forward the ongoing capitalization schedule and make the requirements more stringent than Basle standards. This could put the undercapitalized banks under pressure, but would strengthen the banking system and make it more resilient to shocks Both the authorities and the banks are working on the design and implementation of a better liquidity fund. The future role of the BCE and SBS in the new liquidity fund needs to be carefully assessed, with a view to avoid political interference, but to maintain their regulatory functions.

Table VII. 1.

Open Banks’ Liquidity Position

(In millions of U.S. dollars)

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Sources: Ecuador Superintendency of Banks; and Centra’ Bank of Ecuador
34

Prepared by Mayra Zermeño

35

See IMF, Ecuador: Selected Issues and Statistical Annex, Report No. 00/125, October 2000, Chapters DT and IV.

36

The banks held about 8 percent of their assets in government bonds at end-2002.

37

See Ley para la Transformacion Economica del Ecuador, Law No. 4, RO/Supplement 34, March 13, 2000.

38

See Junta Bancaria Resolution No. JDFL-001-2001

39

Based on the estimate of per capita GDP for 2002, the revised ceiling would now be about US$7,800.

40

See Central Bank of Ecuador Resolution No. 073-2001, January 11, 2001.

41

Fondo de Liquidez Sistema Financiero Ecuatoriano: Un Nuevo Esquema, unpublished mimeo, January 2003.

42

The incorporation of the short-term foreign assets and legal reserve requirement in the new liquidity fund, may not constitute a change in the banks’ liquidity requirements established by the SBS. Rather, these resources will remain the property of each individual commercial bank, but administered by the independent liquidity fund manager. The advantage is that in so doing a larger amount will be “pooled.”

43

Andrew Powell, Ensuring a Sound and Efficient Financial System in a Dollarized Economy: Assessment and Prescriptions for Ecuador, mimeo, January 2003.