Uruguay: Third Review Under the Stand-By Arrangement and Request for Modification and Waiver of Applicability of Performance Criteria Supplementary Information—Report on the 2002 Banking Crisis

Uruguay's performance under the Stand-By Arrangement (SBA) has been favorable, and commendable progress has been achieved in containing the crisis and stabilizing the economy. Executive Directors welcomed this development, and stressed the need to implement policies in the fiscal, banking, and structural areas. They commended the floating exchange rate regime, and the efforts of political and legal institutions in dealing with the financial crisis. They agreed that Uruguay has successfully completed the third review under the SBA, and approved waiver.

Abstract

Uruguay's performance under the Stand-By Arrangement (SBA) has been favorable, and commendable progress has been achieved in containing the crisis and stabilizing the economy. Executive Directors welcomed this development, and stressed the need to implement policies in the fiscal, banking, and structural areas. They commended the floating exchange rate regime, and the efforts of political and legal institutions in dealing with the financial crisis. They agreed that Uruguay has successfully completed the third review under the SBA, and approved waiver.

I. Introduction and Summary

This note summarizes developments in the Uruguayan banking sector during 2002. It discusses the main characteristics of the banking system prior to the onset of the crisis in early 2002. The policy responses of the authorities to the escalating withdrawals of deposits from Uruguayan banks triggered initially by contagion from Argentina and later by a decline in confidence are described. This includes financial support provided by the authorities and an estimation of their likely recovery. Finally, the note assesses the future challenges faced by the banking sector in Uruguay.

II. Structure of the Banking System: Strengths and Vulnerabilities1

A. The Banking System Prior to the Crisis

1. At end-2001, the financial soundness indicators of Uruguay’s banking system were mixed. Overall, capitalization and liquidity of the banking system appeared adequate, but bank earnings were generally negative because of the economic recession. Exposure to the public sector was limited, as the government met its financing needs chiefly through the issuance of debt instruments outside the domestic banking system. At end-2001, bank holdings of government debt amounted to less than 3 percent of total bank assets, and were mainly concentrated in a few banks. Private banks had in general low, though rising, nonperforming loans.

Deposit Structure at end-2001

(In millions of U.S. dollars)

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Includes banks and COFAC (largest cooperative).

2. Prudential regulation and banking supervision, although reinforced, remained weak. In 2001, the capital adequacy ratio was increased from 8 percent of risk-weighted assets to 10 percent, and loan classification regulations were tightened. The Superintendency of Banks lacked specific prudential rules to mitigate the risks associated with the high degree of dollarization of the banking system and the large inflows of non-resident deposits. In particular, there were no special liquidity requirements on such deposits, no direct limits on exposure to currency risk or quantitative limits on foreign currency lending, and no limits on maturity mismatches. Also, the Superintendency has been unable to adequately supervise and sanction the state-owned banks because, under the Constitution of Uruguay, the authority of the central bank over these banks is unclear. State banks suffered persistent delays in their submission of financial reports to the central bank which hampered monitoring of banking system vulnerabilities.

Uruguay: Banking Soundness Indicators, 2001

(In percent)

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Sources: BCU and Fund staff estimates.

3. The financial position of the two large state-owned banks was very weak. State-owned banks were subjected to lending practices motivated by political decisions, as well as legislated bank loan restructuring and other debt relief schemes for distressed bank borrowers. As a result, their balance sheets were weak, with a much higher proportion of nonperforming loans than in the rest of the banking system, higher costs, and lower profits. In addition, the state mortgage bank has a structural imbalance, stemming from a mismatch between liabilities in U.S. dollars and a portfolio of loans in domestic currency indexed to wage developments. The state banks lent primarily to the agricultural and mortgage sectors, which were severely hit by the downturn in economic growth.

Main Characteristics of the Banking System at End-2001

  • The banking system was highly segmented. It was dominated by two large state banks, Banco de la Republica Oriental de Uruguay (BROU) and Banco Hipotecario del Uruguay (BHU), accounting for one third of total deposits. It also included 23 private banks, 9 investment banks, and 6 savings and loans cooperatives.

  • Total bank deposits were relatively high by regional standards, at close to 85 percent of GDP at end-2001. However, some 44 percent of total deposits were held by nonresidents, mainly Argentines, which was a major source of vulnerability. Foreign banks had 80 percent of non-resident deposits but only 20 percent of resident deposits.

  • Public banks accounted for 33 percent of deposits, foreign bank branches and subsidiaries for 45 percent, and domestically owned private banks for 22 percent. In addition, off-shore banking catered mainly to clients from Brazil and Argentina, taking advantage of Uruguay’s strict bank secrecy provisions and full respect of financial contracts.

  • The degree of dollarization of the banking system was high, covering 93 percent of deposits. A high proportion of bank loans (70 percent) was also denominated in foreign currency (mainly U.S. dollars), half of which were to borrowers with no dollar earnings. Foreign bank subsidiaries and branches were generally more prudent than public banks, internalizing the potential risk from exchange rate fluctuations and avoiding exposure to the non-tradable sector.

  • The level of freely available international reserves was low. At US$3.1 billion, the level of gross reserves appeared adequate, equivalent to 200 percent of the monetary base and 8 months of imports. However, freely available reserves (gross reserves net of the deposits of banks and other non-bank holdings at the central bank) amounted to only US$1.4 billion, or about one-tenth of total dollar deposits (compared to 40 percent in other dollarized systems).

  • Uruguay does not have a formal deposit insurance scheme. However, the government had a history of bailing out depositors in earlier episodes of bank distress. State banks operate under statutory laws that imply that their operations are fully guaranteed by the government.

4. Among private banks, foreign-owned banks were generally better run that domestically-owned ones. Foreign bank branches and subsidiaries were generally careful not to lend to domestic residents in U.S. dollars, except if they had well-identified sources of income in foreign currency, including those stemming from trade-related activities. Foreign banks generally held the counterpart to their large holdings of non-resident deposits in liquid assets abroad. In contrast, domestic bank management of liquidity risks and implicit exposure to exchange rate fluctuations was weak or nonexistent. Domestic banks were chief providers of U.S. dollar bank loans, where the dollar lending rates were consistent with international rates and substantially lower than peso lending rates.

B. The 2002 Crisis

5. The crisis was triggered by contagion affecting the liability side of bank balance sheets.2 Following the introduction of a deposit freeze and pesification of bank deposits and assets in Argentina in late 2001, cash-strapped Argentine depositors began withdrawing their funds in Uruguay. At a later stage, contagion was compounded by a sharp decline in confidence due to concerns that the government might be unable to simultaneously service its debt and support distressed banks. The crisis developed in three distinct episodes:

  • A first wave of bank runs started in February–March, during which deposits (mostly nonresident) fell by 12 percent, reflecting contagion from Argentina. Two banks suffered sharp withdrawal of deposits held by non-resident Argentines: (a) the local subsidiary of an Argentine bank (Banco de Galicia); and (b) Banco Comercial, a Uruguayan bank with foreign capital. While vulnerabilities in Banco Galicia stemmed from restrictions placed on its parent bank and main clients based in Argentina, the problems in the second bank arose from alleged fraudulent practices by its management which depleted its capital. The authorities suspended the operations of the first bank and recapitalized the second which, together with the announcement of a financial program with the Fund, provided temporary respite. In January 2002, the authorities also introduced greater exchange rate flexibility and widened the crawling exchange rate band.

Uruguay: Dollar Deposits (changes)

(In millions of U.S. dollars)

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uA03fig01

Reserve Coverage

(in millions of U.S. dollars)

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A003

  • A second wave developed in April–May, during which deposits fell by an additional 20 percent, amidst growing uncertainties stemming from a sharp deterioration in market sentiment about Uruguay’s prospects and further contagion from Argentina. Deposit outflows spread to resident depositors, following Uruguay’s downgrade from investment grade status, while domestic banks began to experience significant liquidity shortages (mainly Banco de Montevideo, Caja Obrera, and Banco de Crédito). Market confidence sagged, the exchange rate weakened, and government bond spreads nearly doubled amidst heightened concerns that political turbulence could lead to an Argentina-like scenario.

  • The third wave began in late June, reflecting a further fall in market sentiment and a sharp devaluation of the peso. By end-July, 42 percent of deposits had been withdrawn and most domestic banks had become insolvent. Gross official international reserves fell to a critically low level (US$0.6 billion) as a result of sizeable liquidity support provided by the central bank and banks’ withdrawals of excess reserves. A bank holiday was declared on July 30, and lifted on August 5 after a new policy strategy was put in place.

III. Policy Response

6. Given that the banking crisis had originated primarily from the liability side of balance sheets, the initial policy response had been the provision of liquidity support. As expected, the response intensified as the crisis deepened. Initially, acting on the premise that the crisis would be temporary, the authorities urged banks to resort to their own liquid resources and credit arrangements to meet withdrawals. However, as outflows intensified and spread to domestic banks, the central bank began to provide several forms of liquidity assistance while differentiating between the needs of a core group of domestic banks and those of foreign bank branches and subsidiaries.3

  • Core banks. Liquidity assistance was provided to core banks,4 defined as banks with a critical participation in the payment system, a large branch network and client base, and provision of essential banking services.

  • Noncore banks. No overt discriminatory policies were put in place against non-core banks, but the authorities did intensify their contacts with the management of foreign banks to signal that these banks were expected to use their own resources. Over this period, foreign banks did finance their deposit outflows with liquid assets held abroad and a gradual reduction in their assets, including their loan portfolio.

A. Financial Assistance

7. The lender-of-last-resort facilities of the central bank quickly became insufficient. The sheer size of dollar deposits in the system relative to the central bank’s international reserves put in question its ability to act as a credible lender of last resort. Moreover, under its Charter, the central bank’s ability to provide liquidity support to banks is limited by several safeguards (Box 2). In practice, however, these safeguards were not fully adhered to as affected banks were allowed to maintain large overdrafts with the central bank for prolonged periods of time prior to the bank holiday. As outflows intensified and international reserves declined, it became apparent that the lender of last resort facilities were not sufficient to foster confidence and stop the crisis.

8. In June 2002, a U.S. dollar facility, the Fund for Fortifying the System of Banks (FFSB), was created, aimed at supplementing the lender-of-last-resort facilities of the central bank. By June, some banks had also started experiencing solvency problems, and the facility also aimed at providing resources for bank recapitalization. The FFSB was to have an authorized capital of US$2.5 billion, to provide liquidity and equity support to core banks.

The initial resources of the FFSB came from the first augmentation of the Stand-By Arrangement in June, and additional resources were to be provided by other multilateral institutions and the government in the form of U.S. dollar-denominated bonds. Although the original plans required that legislation would be needed for the establishment of the FFSB, a presidential decree empowered a steering committee to implement the provisions of the FFSB in the period up to legislative approval. In the event, legislation was never passed.

Central Bank Lender of Last Resort Facilities

Banks have access to central bank liquidity support under four modalities:

  • Automatic overdraft facility. This facility can be used to meet settlement requirements in peso and in dollar accounts. This overdraft must be repaid within 24 hours, and carries an interest charge, which is 50 percent above the average annual interest rate in the bank credit market. If overdrafts are not repaid, banks are suspended from payment and referred for intensive supervision to the Superintendent of Banks.

  • Rediscount of central bank CDs. Banks holding excess CDs issued by the central bank to constitute reserve requirements may discount such CDs, provided they are solvent. The discount rate is the highest of: (a) the average market price for similar treasury instruments plus 200 basis points; (b) the marginal price of similar treasury instruments plus 100 basis points; or (c) the price at the emissions of similar central bank CDs plus 50 basis points.

  • Advances in pesos. Under Article 37 of the central bank law, solvent banks can obtain advances from the central bank for up to 90 days on the basis of eligible collateral, without exceeding the equity capital of the bank. Eligible collateral includes highly rated commercial paper and government securities. The rate of interest is substantially above prevailing market rates, and banks accessing this liquidity support are subject to intensive supervision by the Superintendency of Banks.

  • Sale of government and central bank paper. Under Article 36 of the central bank law, solvent banks can sell or rediscount government or central bank paper with a maturity of up to one year. The central bank may also purchase or rediscount high quality commercial paper. The rate of interest is similar to that used under Article 37.

As the crisis intensified, the FFSB also proved insufficient to cover the dollar liquidity needs of the banking system and was finally suspended at end-July, when a bank holiday was imposed. During June–July, it provided US$449 million in liquidity support, and no capital support. The main regulations for the provision of funds by the FFSB are described in Box 3.

9. With international reserves at critically low levels, the strategy was modified, and the FFSB replaced with the Fund for the Stability of the Banking System (FSBS). The creation of the FSBS was part of the strategy associated with the lifting of the bank holiday in early August, which included administrative measures to stop deposit withdrawals at the state banks and the restructuring of intervened domestic banks. Liquidity support was to be provided as a safeguard to the payment system, to reestablish confidence in the Uruguayan banking system. To that effect, no restrictions were placed on dollar and peso sight and savings deposits, which stood at US$2.7 billion. As part of this strategy, foreign bank branches and subsidiaries would continue to seek to secure their liquidity requirements on their own, and they would not be subject to the government-mandated reprogramming applied to public banks. Meanwhile, the operations of four private domestic banks (Banco Comercial, Banco de Montevideo, Banco La Caja Obrera, and Banco de Crédito) were suspended except for paying out sight and savings deposits with FSBS funds. After a protracted process, the four banks were placed into liquidation in early 2003 (see the next section on their resolution).

FFSB Rules and Regulations

  • Liquidity support. To obtain liquid resources, banks needed to be solvent and provide a stand-by guarantee from a highly rated international bank, or high-quality collateral in a ratio of 2:1, together with a pledge of an equivalent amount of bank equity shares. The National Development Corporation (CND), an existing government-owned corporation, was the conduit for the provision of liquidity assistance. The interest rate was high, at LIBOR plus 500–800 basis points. In the event, liquidity support was provided to four private domestic banks.

  • Capital support Working with the Superintendency of Banks, the steering committee was to determine the eligibility of a qualifying bank for capital support. A plan for the restructuring of a qualifying bank to regain viability, agreed with the Superintendency of Banks, was a required condition. The FFSB did not provide capital support to any bank.

  • Repayment terms: For liquidity support, repayment was expected to take place over a reasonable period, negotiated on a case-by-case basis. Since banks were expected to be solvent and penalty interest rates charged, this period was expected to be short. Failure to repay would result in the exercising of associated collateral. For capital support, recovery would ensue through the requirement that the FFSB stake had to be divested within two years.

Uruguay: Deposit Structure (as of July 29) 1/

(In millions of U.S. dollars)

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Peso deposits evaluated at Ur$24.9 against U.S. dollar. Excludes Banco Galicia.

10. The law establishing the FSBS was enacted on August 4, 2002, providing sufficient resources to fully back all U.S. dollar sight and savings deposits at core banks5 (about US$1.4 billion). The central bank provided peso liquidity assistance, where needed, outside the context of FSBS to sustain the payment system. The FSBS law also provided for the mandatory reprogramming of the maturities of U.S. dollar time deposits of the state-owned banks. No restrictions were placed on peso deposits, the operations of foreign bank branches and subsidiaries, and the remaining domestic banks, mainly cooperatives (Box 4).

Operations of the FSBS

  • Resources: The approved size of the FSBS was US$1.5 billion, to be provided by multilateral institutions, including the Fund. To date, US$ 1.4 billion has been paid, sufficient to back total sight and savings deposits of core banks. A cash balance of US$376 million remained in the FSBS at end-May 2003.

FSBS fund-Initial stock

(in millions of US dollars)

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  • Management: The resources of the FSBS have been kept at the central bank in a separate escrow account managed under the same investment guidelines that apply to the international reserves of the central bank.

  • Cost recovery: Banks are charged an annual interest rate equivalent to the average borrowing cost from the IFIs plus ½ percent (currently about 6 percent), payable monthly. The duration of the loan was to be specified by the Ministry of Finance, and recovery of access by suspended banks would be based on the recovery of proceeds from their resolution.

  • External audit: An external audit is scheduled to take place by September 2003 to ascertain appropriate utilization of the resources of the FSBS.

Use of the FSBS

(in millions of U.S. dollars)

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11. The creation of the FSBS helped stabilize confidence in the banking system. By covering 100 percent of the unrestricted dollar deposits in the public banks,6 while at the same time differentiating between sound and unsound banks, the strategy succeeded in gradually restoring confidence to the banking system. While initially, as expected, sizeable outflows were registered after the bank holiday was lifted, outflows subsided progressively, and a reflow began in October 2002. Most of the eligible deposits with the suspended banks and about two-thirds of eligible deposits with the state banks have been withdrawn to date. Additional policy actions aimed at fostering confidence in the banking system were adopted, including changes in reserve requirements and the establishment of a special 100 percent reserve requirement on all new U.S. dollar sight and savings deposits with the public bank BROU.

uA03fig02

Private Sector Deposits (excl. Banco Galicia)

(in millions of U.S. dollars)

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A003

B. Reprogramming of U.S. Dollar Time Deposits at Public Banks

12. The FSBS law mandated the reprogramming of all U.S. dollar time deposits with the state banks, with extended maturities of up to three years. The total amount of deposits covered by the reprogramming amounted to US$2.2 billion. The terms of the reprogrammed dollar time deposits included repayment of 25 percent of principal amount at the end of the first year, another 35 percent after two years, and the remaining 40 percent by the third year. Reprogrammed time deposits were to carry interest rates slightly above market interest rates for similar maturities and are to be payable quarterly; this rate was set at 6 percent a year. Depositors had the option of converting their claims into CDs or bonds, which would be freely tradable in the secondary market. These securities could also be used to cancel loans (at face value) contracted with BROU and the BHU before July 30, 2002. While there were some initial demands to loosen the terms of the reprogramming for affected groups of depositors (e.g., elderly), no changes have been made. Unlike the situation in Argentina, there has also been no substantial legal challenges to the government’s measures thus far.

IV. Official Financial Support Provided

13. Financial support from the government in response to the financial crisis amounted to US$2.4 billion, equivalent to about 20 percent of 2002 GDP.7 This amount includes US$33 million in capitalization of Banco Comercial, US$564 million from the central bank, US$449 million from the FFSB, and US$1.4 billion from the FFSB (of which US$370 million remains in the form of cash holdings).

14. The government is expected to recover only about half of the liquidity extended to the banking system in 2002. Financial assistance to state banks and private domestic banks was split about evenly and, for the future, it is expected that:

  • Total recovery from the US$1.2 billion extended to public banks could reach US$0.8 billion, including $370 million of unutilized FSBS balances. An obligation of US$432 million of the public bank BROU to the FSBS was canceled against its claims on the government of an equivalent amount (US$135 million in Treasury bonds and US$297 million in other debt) in December 2002. However, most of the liquidity extended to the state mortgage bank BHU (US$380 million) was turned into long-term subordinated loans as part of its recapitalization, and is unlikely to be recovered.

Total Government Assistance to Banks (as of August 2002) 1/

(in millions of U.S. dollars)

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Includes assistances in pesos evaluated at Ur$28.8/US$.

  • Recovery of the US$1.2 billion extended to domestic private banks would not exceed US$300 million, including US$150 million in the form of capital in the newly created state-owned Nuevo Banco Comercial (NBC) bank. The government is expected to get some recovery from the disposal of the remaining assets of the failed banks; however, after such a considerable delay the recoverable value of these assets is likely to be small. Amendments introduced in the banking law in December 2002 provided that the claims of the central banks on the liquidated banks would be transferred to the government and used, together with the claims of the government, to improve the recovery of depositors from these banks (estimated to be US$215 million).

Deposit Structure 2001–2003

(In millions of U.S. dollars)

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Includes Galicia in 2001 only, balances of four liquidated banks and COFAP (largest cooperative); dollar deposits.

V. The Current Structure of the Banking System

15. By end-2002, banking system dollar deposits were only about half their level at the end of 2001. Furthermore, if the deposits of liquidated banks (US$$920 million) were excluded, total deposits would amount to only 37 percent of their level at end-2001. Nonresidents deposits are only one-fifth of their earlier level, reflecting a loss of about two-thirds of deposits by foreign banks, the largest holders of nonresident deposits. The share of deposits held by foreign banks fell by 13 percentage points to 32 percent at end-2002, despite an increase in their share of resident deposits, suggesting a possible flight to quality and some migration of sight depositors from suspended banks to foreign banks.

16. The financial performance of the banking system has deteriorated sharply. Nonperforming loans rose markedly during 2002, almost doubling by year-end (to 36 percent), with private banks suffering a greater deterioration. The banks registered large losses, associated in part with much higher provisioning as nonperforming loans surged and the value of loan collateral fell. However, except for the intervened banks and BHU,8 all banks continued to comply with prudential capital norms, albeit with much lower margins relative to the requirements. Excluding intervened banks, the risk-weighted capital ratio of private banks was well above the norm of 10 percent by end-2002 while the large deficiency in capital of BHU brought capital below the norm in the group of public banks.

VI. Bank Resolution Policy

17. The authorities agreed that a prompt and satisfactory resolution of insolvent banks was important to sustain the stability regained by the banking system. They also introduced the principle that for any new bank to reopen it needed to demonstrate that it had a sound business plan that assures viability under robust conditions, meets all prudential requirements, and does not a pose a potential risk to the rest of the banking system. To underpin future growth prospects, the authorities were also determined to restore banking services in certain areas of the country while ensuring that depositors would not bear all the costs of bank resolution. These considerations led to protracted discussions between the government and the various stakeholders, including depositors and other bank creditors, the powerful bank employees union, politicians, and other interested economic agents. During this lengthy process, unsurprisingly, a sharp deterioration in the value of the recoverable assets of suspended banks has taken place.

Uruguay: Banking Soundness Indicators, 2001–02

(In percent)

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Sources: BCU and Fund staff estimates.

Excluding the four liquidated banks, the CAR for private banks was 13.3 percent for end-2001 and 18.4 percent end-2002.

A. The December 2002 Banking Law

18. A new law was passed by congress in December 2002, aimed at modifying various banking laws and facilitating bank resolution. The new law defines more precisely the role of BCU in the liquidation of banks and establishes guidelines for the utilization of the proceeds of government recovery from bank resolution, which include increasing the recovery of depositors. The new law provides for the establishment of trust funds to manage the assets of each liquidated bank and facilitate recovery for depositors and other creditors. The use of a trust fund mechanism is designed to insulate the asset disposal and sales process from litigation and other residual claims against the legacy banks.

19. The new law authorized the government to top up the recovery of depositors in the affected banks up to a maximum of US$100,000. To that effect, the government de facto agreed to forego part of the proceeds from its claim from the liquidation process. The restructuring of intervened banks focused on two proposals: (i) the three-in-one proposal aimed at creating a new bank from the assets of three suspended banks (Banco Comercial, Banco Montevideo and Caja Obrera); and (ii) the reopening of Banco de Crédito (previously 51 percent owned by the government) as a private bank with the former minority shareholder as sole owner. The new bank law approved at end-2002 provides that all state banks will now be subject to the same prudential regulations and sanctions that apply to all other banks.

B. The Resolution of Suspended Banks

20. In January 2003, the authorities placed the three suspended banks into liquidation, with a view to creating a new bank (Nuevo Banco Comercial—NBC), akin to a purchase and assumption model. Trust funds were established to manage the assets of the liquidated banks, and the government provided the minimum required paid in capital (US$4 million) to charter the new bank. In late February, the NBC purchased packages of assets simultaneously offered by the three individual trust funds in an open competitive bidding process. It also bid on nonperforming loans, but was given a put option that allows it to return to the trust funds any loan that it cannot satisfactorily restructure by the end of 2003. NBC bought the assets by issuing a series of its own CDs—carrying a 2 percent interest rate, and repayable quarterly over a period of up to six years. It is estimated that, to top up the recovery of depositors to value of US$100,000, the government would cede some US$215 million of the proceeds to depositors. The government chose to return its recovery to depositors as part of the political consensus to resolve the insolvent banks and because it felt that reducing the losses suffered by depositors was important for restoring confidence in the banking system.

NBC Opening Balance Sheet

(in millions of U.S. dollars)

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Difference between the purchase price and the net book value.

21. The trust funds are to distribute the NBC CDs to all general creditors, including the government, on a pro-rata basis (net of CDs to cover the NPL put back). Since the government retained its collateralized claims, it received first payment and immediately used a portion of its proceeds (equivalent to about US$120 million) to increase the capital of NBC to the required prudential amount relative to estimated assets of NBC. It is expected that remaining assets in the trust funds will be disposed of quickly and their proceeds distributed on a pro-rata basis.

22. NBC opened for business on March 24, 2003, after the Superintendency of Banks declared it to be viable and in full compliance with prudential norms. The new bank was chartered under the commercial bank law with capital provided wholly by the government. Under its business plan, NBC was to open with about 750 employees from the liquidated banks and 43 branches—about half the size of the three liquidated banks combined. The bank opened with a capital-to-assets ratio of about 18 percent (risk-weighted) and total assets of US$822 million, including nonperforming loans with a book value (net of provisions) of US$460 million. Consistent with the requirement placed on BROU, the Superintendency of Banks has also imposed reserve requirements of 100 percent for all new U.S. dollar sight and savings deposits at NBC.

23. The fourth intervened bank, Banco de Credito, was placed into liquidation in February 2003, when protracted discussions with the minority shareholders of the bank for its reopening failed. A trust fund was also established under the new banking law to assume the assets of Banco de Credito for disposal This trust fund has recently published a proposal seeking the agreement of depositors and other creditors for the disposal of assets and distribution of the proceeds. It includes the repayment of the debt owed by a related party of the minority shareholders with government bonds at face value. Depositors’ agreement was secured at end-May. The government has indicated that it would give up its share of the proceeds in the recovery in favor of depositors. In addition, the proposal also contains a commitment by the government to purchase assets up to a nominal value of US$40 million with government bonds if the proceeds from the sale n the public auction fall short of the amount needed to satisfy the claims of all depositors. Although this runs against the previous policy decision not to provide any additional financial resources for bank resolution, the authorities chose to provide this assistance in part to staunch legal challenges that would have forced the government to do more because it was a majority owner of this bank.

24. Completion of the bank resolution process requires additional steps to dispose of the remaining loans and other bank assets in the individual trust funds. Additional recovery from these assets would primarily accrue to the government, whose residual claim would be the largest. A concrete plan needs to be developed to deal with the remaining nonperforming loans and other assets to preserve the value that is left. Completion of this process is critical for maintaining creditor discipline and the repayment culture in the Uruguayan financial sector.

C. Public Bank Restructuring

25. The public mortgage bank BHU has been transformed into a nonbank entity. As noted, this bank suffered from a major structural imbalance, as its liabilities were primarily in the form of short-term dollar deposits, while its assets were long-term peso housing loans linked to a wage index. The sharp depreciation of the peso in 2002, together with the economic recession, led to major balance sheet mismatches. The authorities have been working on a reform plan for BHU with financial support from the World Bank. As part of this process, in December 2002, congress approved a new charter transforming the BHU into a non-bank housing institution. This law provided for the transfer of all U.S. dollar deposits, including reprogrammed deposits, to BROU in August 2002. In turn, BROU received bonds issued by BHU with a guarantee of the government. However, in the absence of significant progress in its restructuring plan, BHU has so far been unable to meet its financial commitments to BROU arising from these bonds, representing a fiscal cost, as the government must provide the cover. The restructuring plan being monitored by the World Bank calls for steps to reduce costs, including a halt to construction programs, a freeze on new lending (except if securitized), greater efforts at recovery, and reductions in staff.

26. The restructuring of the public bank BROU needs additional impetus. Prior to 2002, with assistance from the World Bank, efforts had been initiated to improve BROU’s efficiency and bring its operations and management in line with modern practices. Its loan portfolio was reclassified by end-2002 to fully meet prudential norms, with an increase in provisions, while improvements were made in the information system of the bank. In recent months, BROU has strengthened its process for monitoring repayment and collection of loans, and devoted special attention to assist distressed borrowing customers to reach agreement on repayment terms consistent with their new capacity to repay. These actions set the basis for a plan to accumulate sufficient liquidity to meet the repayment of the first tranche of reprogrammed deposits. Even with these improvements, nonperforming loans have risen sharply and the earnings outlook continues to be alarmingly negative in a situation where BROU’s risk-weighted capital is just at the minimum required level of 10 percent.

VII. Challenges to the Banking System

27. The Uruguayan banking system will need further consolidation. As it continues to stabilize and recover from the crisis, it is unlikely to return to the level and structure exhibited at the end of 2001. While the banking system benefited from unusually large non-resident deposit inflows in recent years, mainly from Argentina, the perception of a safe haven has now been largely dispelled. It is expected that the banking system will experience a period of consolidation and move away from attracting volatile non-resident banking business. The state-owned BROU, when appropriately restructured, would remain to service the domestic banking needs together with the NBC and cooperatives, and there are indications that some foreign bank subsidiaries and branches will likely consolidate regional operations and relocate. Against this background, restoration of adequate financial intermediation and bank credit in Uruguay may take some time.

28. The banking crisis has highlighted important shortcomings. In addition to the limitations to policy responses in a dollarized system, the crisis has shown the importance of effective coordination by a crisis management team in charge of policy implementation on a day-to-day basis and of developing contingency plans. The authorities did very well in claiming ownership on policy initiatives and were very successful in garnering political and social consensus to take actions. However, on balance, this required too much time in a situation where the need for quick decisions and actions were also of great importance. Finally, information on bank deposits and assets from the state banks, which make up more than half of the banking system, continues to suffer from unusual delays-, and insufficient coverage.

A. Bank Supervision

29. Bank supervision needs to be strengthened. While some of the problems experienced in Uruguay were triggered by external events, they also reflected some weaknesses in the prudential framework for banks. Steps to strengthen bank supervision regulations and procedures will need to include the following:

  • Upgrading the resources devoted by the BCU to bank supervision. This will require both increasing the number of staff and improving its skills, especially for on-site examinations. Technical assistance will be needed to bring supervision procedures in line with international standards. This assistance could be provided by MFD in close coordination with the Inter-American Development Bank.

  • Adopting regulations requiring banks to internalize foreign exchange risks associated with the high degree of dollarization. Traditional foreign exchange gap limitations are not sufficient in countries where borrowers in dollars do not have regular flows of income in foreign exchange, and risk-hedging instruments are not available. A more preventive and risk-focused approach is required.

  • Introducing consolidated supervision. Information from this practice would have helped detect vulnerabilities in Banco Comercial and Banco Montevideo. External audit of banks should be made mandatory, and controls and regulation on this process strengthened.

  • Prompt corrective actions in dealing with distressed banks. Inappropriate bank management practices need to be firmly dealt with, and shareholders should not be given too much flexibility to negotiate the capital injection needed to comply with prudential norms.

  • Revising the prudential norms for liquidity, to reflect the continued instability in the region and ensuring that the risks from foreign exchange and duration mismatches are better managed and covered.

B. Role of Public Banks

30. Government-owned banks (BROU and NBC) currently account for over 55 percent of total banking system assets. Given the past history of problems in government owned banks, it is critical that steps be taken to ensure that these banks operate in conformity with all prudential norms and are independent from political interference. The government has indicated that it plans to divest its stake in NBC as soon as conditions permit. To increase the chances for a successful privatization, the following steps need to be taken: (a) the management structure of NBC needs to be improved by having an independent board of directors consisting mostly of qualified nonexecutive directors, and of a sufficient size to ensure proper governance and risk management; (b) annual audits should be performed by an internationally-recognized audit firm; (c) the central bank should monitor its business plan to ensure that the risk profile does not change significantly; and (d) consideration should be given to bringing in a strategic investor, as soon as possible, who would assure good governance and proper banking operations.

31. BROU should undergo a thorough restructuring. Its governance structure should be overhauled and, at a minimum: (a) the appointed members of its Board should be subject to normal fit and proper tests; (b) it should meet all prudential norms, and the Board should be held accountable on the basis of a business plan formulated on commercial criteria and meeting the viability tests of the Superintendency of Banks; and (c) an independent Internal Audit unit should be established to ensure proper financial and operational control of the activities of the bank. The quality of the loan portfolio and other assets must be enhanced, and a well-designed program to reduce the level of nonperforming loans (60 percent at end-March 2003) introduced. The financial outlook of BROU would also be improved if its holdings of BHU securities (US$790 million) were replaced with more liquid securities. Greater efforts to reduce and rationalize the operating costs of BROU are also needed. The size of the bank and its branch network need to be streamlined in accordance with efficiency levels similar to those of private banks operating in Uruguay.

C. Financial Safety Net

32. Developing a limited deposit insurance scheme will be a challenge. The current explicit full guarantee for state banks and implicit guarantee for other bank deposits stemming from past behavior during times of crises need to be overhauled. This is needed to restore depositor confidence and reduce uncertainty in the banking system, while strengthening incentives for sound banking business and limiting moral hazard. Given the high degree of dollarization of bank deposits, experience has shown that an explicit guarantee generally cannot be honored because of the lack of foreign exchange resources. Thus, a properly funded limited deposit insurance scheme would serve to shield the government from having to assume most of the cost of the banking crises, which have so far been borne with no explicit pricing for the protection. The challenges are compounded by a highly segmented and concentrated banking system dominated by state-owned banks and slowly emerging from a deep confidence crisis.

33. A better framework for bank resolution should be developed to facilitate timely action to resolve distressed and/or insolvent depository institutions. The law passed last December was a stop-gap measure designed for the crisis at hand, and the legal procedures for bank receiverships and liquidation will need to be further enhanced.

1

This supplement was prepared by C. S. Lee and S. Seelig (both MFD), in collaboration with M. de Bolle (PDR), and K. Honjo and G. Terrier (both WHD).

2

This factor is important in understanding the policy responses and in separating this crisis from earlier episodes in Uruguay and in other countries. Rather than reflecting the weakness and solvency of Uruguayan banks, withdrawals stemmed from a desire of non-resident depositors to protect their savings from regional instability. Thus, some deposits withdrawn from international banks based in Uruguay were redeposited with the same banks in their home country or outside the region.

3

The high degree of dollarization and rapid loss on international reserves circumscribed the policy responses to the crisis in Uruguay (see recent Board papers SM/03/112 and SM/03/126 for details on policy measures for dollarized economies). The Uruguayan authorities made special efforts to distinguish their policy responses relative to those pursued in Argentina. Deposits freeze, pesification, and outright default on contractual obligations were avoided, even though ultimately administrative measures, in the form of a reprogramming of deposits and the suspension of insolvent banks, were implemented. Closure of banks also represented a move away from the previous experience of open bank resolutions.

4

Core banks comprised the two public banks, four domestic banks (Comercial, Banco de Montevideo. Caja Obrera, and Banco de Crédito), and some cooperatives, all of which accounted for 55 percent of deposits.

5

Cooperatives were excluded from access to the FSBS, but the depositors of an intervened cooperative were allowed access after its liquidation.

6

Thereby serving as a credible lender of last resort facility for the core banking system.

7

By comparison, the Asian governments provided assistance in the range of 13–55 percent of GDP in the wake of the Asian crisis, Chile 33 percent of GDP after the early 1980 crisis, and Argentina 6.5 percent of GDP more recently.

8

The BHU is in the process of being transformed into a nonbank financial intermediary.

Uruguay: 2003 Article IV Consultation and Third Review Under the Stand-By Arrangement and Request for Modification and Waiver of Applicability of Performance Criteria—Staff Report; Staff Supplement; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay
Author: International Monetary Fund