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CENTRAL AMERICAS T R U C T U R A L F O U N D AT I O N S F O R R E G I O N A L

F I N A N C I A L I N T E G R AT I O N

A Staff Team Led by

Patricia Brenner

I n t e r n a t i o n a l M o n e t a r y F u n d©International Monetary Fund. Not for Redistribution

© 2006 International Monetary Fund

Production: IMF Multimedia Services DivisionCover design: Luisa Menjivar

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Cataloging-in-Publication Data

Mackenzie, G.A. (George A.), 1950–

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Central America: structural foundations for regional financial integration/[authored by a staffteam lead by Patricia Brenner]—Washington, D.C.: International Monetary Fund, 2006.

p. cm.

ISBN 1-58906-492-5Includes bibliographical references.

1. Intermediation (Finance)—Central America. 2. Insurance—Central America. 3. Securi-ties—Central America. 4. Migrant remittances—Central America. I. Brenner, Patricia DeCoster. II. International Monetary Fund.

HG185.L29C36 2006

©International Monetary Fund. Not for Redistribution

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Preface vii

Abbreviations and Acronyms ix

1. Overview and Background 1Patricia Brenner and Jens Clausen

An Overview of Financial Intermediation in Central America 4Cross-Border Financial Intermediation and Consolidated Supervision 6Development of the Insurance Sector 11Harmonization of Payment and Securities Settlement Systems 14Conclusions 17References 17

2. Consolidated Supervision of Financial Groups in Central America 18

Patricia Brenner and R. Armando Morales

Regional Financial Integration 18Financial Conglomerates Operating in Central America 21Regional Financial Groups: Risks and Regulatory Responses 27Conclusions and Elements of an Action Plan 36References 47

3. Development of the Insurance Sector 49Daniel Hardy and Miguel Palomino

Structure and Performance 51The Legal and Regulatory Framework 61Insurance Sector Development and Regional Issues 68Conclusions 70

4. Payment and Securities Settlement Systems 71Massimo Cirasino and Mario Guadamillas

Legal Framework 71Interbank Exchange and Settlement Circuits 75Retail Settlement Systems 76Government Payments 79Foreign Exchange and Cross-Border Settlement Mechanisms 80Interbank Money Market 81Securities Settlement Systems 82Transparency, Oversight, and Cooperation in Payment Systems 92Conclusions 96Appendix 99References 114

Contents

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CONTENTS

5. Migrant Remittances in Central America 116Dilip Ratha

Remittances and Retail Payment Systems 116Remittance Costs 120Remittances and Financial Institutions 122Securitization of Remittances 122Conclusions 126References 127

Boxes

1.1 Summary of Recommendations 32.1 Status of Legal Protection of Supervisors 222.2 Institutions Conducting Cross-Border Financial Transactions in

Central America 232.3 Consolidated Supervision of Regional Financial Conglomerates

in Panama 332.4 Comparison of Legislation on Consolidated Supervision in

Central America 342.5 International Experience with Cross-Border Consolidated

Supervision 372.6 Harmonization of Supervision of AML/CFT Requirements 413.1 Mass Insurance Products 553.2 Product Bundling 563.3 Crop Insurance Initiatives 574.1 Public Policy Goals, Central Bank Minimum Actions, and

Range of Possible Additional Actions for Retail Payment Systems 78

4.2 Oversight Role of the Central Bank 925.1 Remittance Transaction Structure 1195.2 Banco do Brasil’s Nikkei Remittance Trust Securitization 124

Tables

1.1 Financial Soundness Indicators for the Banking Sector, June 2004 52.1 Country Distribution of Assets of Regional Financial Groups 212.2 Banks Operating in the Region 242.3 Market Share by Bank Category, June 2004 262.4 Selected Financial Ratios, June 2004 262.5 Central America and Dominican Republic: Regional Financial

Links, June 2004 292.6 Regulations on Loan Concentration and Related Lending 302.7 Regulations on Loan Classification and Provisioning 302.8 Overview of Legal Framework for Banking Resolution in

Central America 443.1 Financial Situation of the Insurance Sector 503.2 Insurance Sector Indicators 533.3 Insurance Contracts 543.4 Structure of the Insurance Sector 583.5 Summary of Main Insurance Sector Regulation 624.1 Assessments of Payment and Securities Settlement Systems 72

A4.1 Legal Frameworks for Payment and Securities Settlement Systems 99A4.2 Use of Cash and Transferable Deposits, 2004 100

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Contents

A4.3 Systemically Important Settlement Systems 101A4.4 Use of Cashless Instruments for Retail Payments, 2001 101A4.5 Government Payments 102A4.6 Foreign Exchange and Cross-Border Mechanisms 104A4.7 Interbank Money Market 106A4.8 Securities Settlement Systems 107A4.9 Management of Settlement Risk 107

A4.10 Operational Reliability of Securities Settlement Systems 108A4.11 Management of Custody Risk 109A4.12 Regulatory and Oversight Issues 110A4.13 Organizational Arrangements for Central Securities Depositories 111A4.14 Cross-Border Settlement of Securities 112A4.15 Transparency, Oversight, and Cooperation in Payment Systems 113

5.1 Remittance Flows, 2003 1175.2 Securitization of Future Remittances in El Salvador 123

Figures

1.1 Indicators of Financial Deepening, 2003 41.2 Foreign Currency Deposits to Total Deposits 51.3 Bank Assets by Type of Bank, 2003 62.1 Asset Share of Financial Conglomerates 192.2 Regional Trade, 1999–2003 192.3 ICRG Political Stability Index, March 2004 202.4 Central America: Foreign Currency Deposits to Total Deposits 202.5 Private Bank Profitability 202.6 Total Loans, June 2004 272.7 Capital Ratios, December 2004 282.8 Share of Government Bonds in Bank Assets, 2003 312.9 Foreign Currency Lending to Nontradable Sector 313.1 Relative Insurance Indicators, 2003, by Indicator 513.2 Normalized Insurance Indicators, 2003, by Country 525.1 Cyclical Stability of Remittances, 1990–2003 1185.2 Remittance Costs, April 2005 121

v

The following symbols have been used throughout this paper:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the itemdoes not exist;

– between years or months (e.g., 2004–05 or January–June) to indicate the years or monthscovered, including the beginning and ending years or months; and

/ between years (e.g., 2004/05) to indicate a fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

The term “country,” as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers someterritorial entities that are not states, but for which statistical data are maintained and pro-vided internationally on a separate and independent basis.


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This book was prepared as part of the Central America Financial Sector RegionalProject (FSRP) by staff of the IMF’s Monetary and Financial Systems Departmentand Legal Department and of the World Bank. The countries covered in the FSRPcomprise the six Spanish-speaking countries of Central America: Costa Rica, El Sal-vador, Guatemala, Honduras, Nicaragua, and Panama. The chapters provide anoverview of the principal issues and findings of the project, and background on fi-nancial development and soundness in the six countries, trends in regional financialintegration and supervisory responses, development of the insurance sector, develop-ment of payment and securities settlement arrangements, and worker remittances.

The book is the product of a team effort led by Patricia Brenner. The team in-cluded Massimo Cirasino, Jens Clausen, Mario Guadamillas, Daniel Hardy, R. Ar-mando Morales, Miguel Palomino, and Dilip Ratha, with contributions by JoaquínBernal, Katharine Christopherson, Luis Cortavarría, Marco Espinosa, WimFonteyne, Antonio Hyman-Boucherau, Ross Leckow, Maike B. Luedersen, MichaelMoore, Marina Moretti, Gabriela Rosenberg, Moni SenGupta, Debbie Siegel,Manuel Vásquez, and Rogerio Zandamela. The team is indebted to numerous col-leagues throughout the IMF for detailed comments on the papers, to Janet StanfordKing and Carolina Worthington for assisting with numerous drafts, to ClaudiaPescetto and Lani Wu for research assistance, and to Archana Kumar of the ExternalRelations Department for editing the manuscript and coordinating production of thepublication.

The opinions expressed in the book are those of the authors and do not necessarilyreflect the views of the IMF, its Executive Directors, or the authorities of the coun-tries covered in the study.

Preface

vii


ACH Automated clearinghouseAML/CFT Anti–money laundering/combating the financing of terrorismATM Automated teller machineBANGUAT Banco de GuatemalaBCCR Banco Central de Costa RicaBCEAO Banque Centrale des États de l’Afrique de l’OuestBCH Banco Central de HondurasBCN Banco Central de NicaraguaBCR Banco Central de Reserva de El SalvadorBdB Banco do BrasilBEAC Banque des États de l’Afrique CentraleBFI Bank with links to other regional financial institutionsBIS Bank for International SettlementsBMI Banco Multisectorial de Inversiones (El Salvador)BNP Banco Nacional de PanamáBVDN Bolsa de Valores de NicaraguaBVP Bolsa de Valores de PanamáCABEI Central American Bank for Economic IntegrationCAFTA-DR Central American–Dominican Republic Free Trade AgreementCAMC Central American Monetary CouncilCCS Central American Council of Superintendents of Banks,

Insurance, and Other Financial InstitutionsCEBS Committee of European Banking SupervisorsCEMAC Central African Economic and Monetary CommunityCEMLA Center for Latin American Monetary StudiesCEO Chief executive officerCEDEVAL Central de Depósito de Valores (El Salvador)CENIVAL Central Nicaragüense de ValoresCEPROBAN Centro de Procesamiento Bancario (Honduras)CEVAL Central de Valores (Costa Rica)CHIPS Clearinghouse interbank payment systemCIASA Centro de Intercambio Automatizado, S.A. (Panama)CLC Cámara de Compensación y Liquidación de Cheques

(Costa Rica)CLS Continuous linked settlementCNBS Comisión Nacional de Bancos y Seguros (Honduras)CNV Comisión Nacional de Valores (Panama)COBAC Commission Bancaire de Afrique CentraleCONASSIF Consejo Nacional de Supervisión del Sistema Financiero

(Costa Rica)CPSIPS Core Principles for Systemically Important Payment Systems

Abbreviations and Acronyms

ix


ABBREVIATIONS AND ACRONYMS

CPSS Committee on Payment and Settlement SystemsCSD Central securities depositoryCUT Cuenta Única del Tesoro (Panama)DPR Diversified payment rightDvP Delivery versus paymentEBC European Banking CommitteeECB European Central BankECCB Eastern Caribbean Central BankECCU Eastern Caribbean Currency UnionEFTPOS Electronic funds transfer at point of saleESCB European System of Central BanksEU European UnionFATF Financial Action Task ForceFDI Foreign direct investmentFOGADE Fondo de Garantía de Depósitos (Nicaragua)FOSADE Fondo de Seguro de Depósitos (Honduras)FSA Financial Services Authority (United Kingdom)FSAP Financial Sector Assessment ProgramFSRP Financial Sector Regional ProjectGAAP Generally Accepted Accounting PrinciplesIAS International Accounting StandardsIBRD International Bank for Reconstruction and DevelopmentIDB Inter-American Development BankIFI International financial institutionIFRS International Financial Reporting SystemIGD Instituto de Garantía de Depósitos (El Salvador)IOSCO International Organization of Securities CommissionsISIN International securities identification numberITIN Income taxpayer identification numberMEF Ministry of Economy and Finance (Panama)MFI Microfinance institutionMIB Mecanismo Interbancario de Dinero (Costa Rica)MIT Mecanismo Interbancario de Transferencias (Guatemala)MONED Mercado Organizado para la Negociación Electrónica de

Divisas (Costa Rica)MOU Memorandum of understandingMTO Money transfer operatorNPL Nonperforming loanOECD Organization for Economic Cooperation and DevelopmentOFAC Office of Foreign Assets ControlOTC Over the counterP&A Purchase and assumptionPML Probable maximum lossPROFECO Procuraduría Federal del ConsumidorPvP Payment versus paymentRFC Regional financial conglomerateRNVI Registro Nacional de Valores Inmobiliarios (Costa Rica)ROA Return on assetsROE Return on equityRTGS Real-time gross settlementS&P Standard & Poor’s

x


Abbreviations and Acronyms

SAT Superintendencia de Administración Tributaria (Guatemala)SB Superintendencia de Bancos (Guatemala)SBOIF Superintendencia de Bancos y Otras Instituciones Financieras

(Nicaragua)SBP Superintendencia de Bancos de PanamáSICOF Sistema Contable Financiero (Guatemala)SINEDI Sistema de Negociación Electrónico de Divisas (Guatemala)SINPE Sistema Interbancario de Negociación y Pagos Electrónicos

(Costa Rica)SIPS Systemically important payment systemsSITE Sistema Integrado de Transacciones Electrónicas (Costa Rica)SML Securities Market LawSPID Sistema Interbancario de Divisas (Guatemala)SPV Special purpose vehicleSRO Self-regulatory organizationSSF Superintendencia del Sistema Financiero (El Salvador)SSS Securities settlement systemSTP Straight-through processingSUGEF Superintendencia General de Entidades Financieras

(Costa Rica)SUGEVAL Superintendencia General de Valores (Costa Rica, Panama)SV Superintendencia de Valores (El Salvador)SWIFT Society for Worldwide Interbank Financial TelecommunicationsTEBEL Transacciones Electrónicas Bursátiles en Línea (Costa Rica)TEF Transferencia Electrónica de Fondos (Costa Rica)TPL Third-party liabilityTTS Transferencia Telefónica Segura de Fondos (Nicaragua)WAEMU West African Economic and Monetary UnionWHF Western Hemisphere Payments and Securities Settlement

ForumWOCCU World Council of Credit Unions

xi


Overview and Background

Patricia Brenner and Jens Clausen

A lthough Central American countries are indi-vidually relatively small, they are large as a

group and confront many common policy chal-lenges. With about 40 million people, CentralAmerica’s population is as large as Spain’s or Ar-gentina’s. Besides geographic proximity and a com-mon language, the region shares a dependence onraw material exports, close economic ties to theUnited States, and vulnerabilities to natural disastersand terms-of-trade shocks. Several of the countrieshave also suffered from long periods of civil strife,which slowed economic growth generally, and ham-pered the development of legal and judicial systems.

Banking is the most developed component of theregion’s financial system, and intraregional financialactivity has increased substantially in recent years fol-lowing macroeconomic stabilization and rapid finan-cial liberalization in the 1990s. In this period, severalcountries upgraded financial legislation, introducedpension reforms, removed interest rate controls, pro-vided for the diversification of financial instruments,and enhanced central bank independence. Liberaliza-tion in other areas was also significant.1

While there are important similarities and eco-nomic linkages among Central American countries,the analysis of regional issues must take into ac-count the heterogeneity of countries as well. Infor-mation is sometimes not available for all countries,

and data are often not fully comparable. Thus, re-gional analysis will always need to be adapted care-fully to an individual country’s circumstances.

Across the region, although financial sector open-ness is high (absence of or negligible capital con-trols; free entry of foreign banks), overall institu-tional quality needs considerable development.Weak governance, connected lending, and uncer-tain property rights pose particular problems inmuch of the region for financial intermediation andeconomic growth, notwithstanding initiatives tocombat these problems. All six countries havestrengthened the quality of regulatory governanceand reforms are ongoing, but they are incomplete.Among other areas, it is crucial to improve the inde-pendence of financial oversight agencies and pro-vide adequate legal protection for supervisors. Thisis needed to ensure that supervisory laws and pru-dential regulations are applied in an even-handedmanner, free from interference by vested interests.

Regional financial groups are a distinctive featureof the Central American financial sector. Thesegroups have expanded their activities, and at pres-ent account for a larger share (about one-third) ofbanking assets in Central America than do foreignbanks (about one-sixth). Contributing factors tothis development, besides the history of economicand political instability in several countries of theregion (which may have discouraged entry by for-eign banks), include increased regional trade link-ages; the benefits from economies of scale andscope; the proximity of Panama as an internationaland regional financial center; reputation improve-

1

1

1Progress in establishing a regional common market and onthe Central American–Dominican Republic Free Trade Agree-ment (CAFTA-DR) with the United States show the authori-ties’ commitment to openness and market-oriented regionaleconomic integration.


ments as regional financial groups survived crisisepisodes; and declining intermediation costs, appar-ently associated with increasing dollarization in theregion. There may also be cases where intragroupcross-border transactions are designed to take ad-vantage of regulatory arbitrage.

The success of regional financial groups holdspromise for supporting economic development inthe region while, at the same time, presenting in-creased vulnerabilities and risks. In particular, theauthorities face challenges in supervising cross-border operations of financial groups and containingthe risk of regional contagion. The countries haveestablished the Central American Council of Super-intendents of Banks, Insurance, and Other Finan-cial Institutions (CCS) as a regional forum for facil-itating cross-border supervision of financialinstitutions. Harmonization of countries’ financialsupervisory frameworks would discourage regulatoryarbitrage. At the same time, this would reduce thecosts of regulatory compliance and make the re-gional financial groups more competitive.

Dollarization, another common feature of the fi-nancial landscape, is also a mixed blessing for finan-cial sector development and stability. The earlieroutright prohibition of financial intermediation inforeign currency in some countries in the regionhelped to motivate the establishment of banks off-shore, many of them in Panama, where the econ-omy has been dollarized since the beginning of thetwentieth century. Official dollarization in El Sal-vador in 2001 has accompanied an ongoing trendtoward dollarization elsewhere in the region. Dollar-ization has been associated with lower interest ratespreads and increased domestic financial intermedi-ation. At the same time, credit risk has increased insome countries because of lending in dollars toclients who do not have dollar earnings. The offi-cially dollarized economies, however, have largelyeliminated exchange rate risk.2

The underdeveloped insurance sector constrainsthe development of the whole financial sector. Thesector is small and fragmented in much of the re-gion. While better-off households and larger firmscan obtain most insurance products, much of thepopulation (e.g., in the agricultural sector) doeswithout them. The scarcity of insurance affects wel-

fare directly, reduces the availability of financing orincreases its cost, and constrains insurance compa-nies’ role in deepening financial markets.

Most indicators of the soundness and perfor-mance of the insurance sector do not raise immedi-ate, systemic concerns, particularly because heavyuse is made of reinsurance from the large interna-tional reinsurers. Companies’ investment portfoliosare typically not very diversified; investment abroadis modest and constrained by regulations.

Positive and innovative developments in somecountries, such as the successful bundling of an in-surance component in small agricultural loans in ElSalvador, might be replicated in other countries. Inseveral countries, insurance supervisors lack re-sources and are constrained by outdated laws. Regu-lations need to be adapted to a more risk-based ap-proach, with a greater role played by actuarialcalculation of risks, as is done in Costa Rica. In par-ticular, technical reserves need to be related to theexpected value of losses, their variances and covari-ances, and other risks, especially reinsurance risk.

More effort is needed to bring national paymentsand securities settlement systems in line with inter-national standards and best practices. Most coun-tries in Central America have launched reforms intheir payment and securities settlement systems inrecent years with a view to strengthening their fi-nancial infrastructure. These countries should seekto harmonize those systems toward establishing themicrofoundations of more developed national, andpotentially regional, capital markets.

As national systems converge toward interna-tional standards, there is a growing interest in theregion in the efficiency gains that could be achievedby adopting integrated frameworks for regional pay-ments and securities settlement. Projects on re-gional clearance and settlement of large-value trans-actions and on integrated regional large-value,real-time gross settlement (RTGS) payment systemshave been launched by Central American govern-ments, the Central American Monetary Council,and the Inter-American Development Bank. Ongo-ing reforms at the national level provide an oppor-tunity for further harmonization at the regionallevel and the eventual integration of payment andsecurities settlement frameworks.

Efforts are needed in all six countries to improvethe legal framework for payments and securities set-tlement, for example, as regards the irrevocability offinal settlement; protection of the systems against theeffects of bankruptcy procedures; and legal basis or

2

OVERVIEW AND BACKGROUND

2There remains exchange rate risk vis-à-vis third-country cur-rencies; this risk is relatively contained since the United States isthe most important trading partner of each of the Central Amer-ican countries.


definitions for custody arrangements, repurchase op-erations, multilateral netting arrangements, immobi-lization and dematerialization of securities, pledge ofcollateral and securities lending, and oversight pow-ers, which are typically the responsibility of the cen-tral bank. The adoption of a comprehensive paymentsystem law, as is well advanced in Honduras andGuatemala, would help address many of these issues.

International migrant remittances are a signifi-cant portion of cross-border payments in the regionand the largest single source of foreign exchange inEl Salvador, Guatemala, Honduras, and Nicaragua.Remittances to several countries have continued toincrease much faster than export receipts in the pastfew years. Remittances also seem to have an auto-

matic stabilizer effect, because they typically rise inthe face of natural disasters or during periods of eco-nomic slowdown in the recipient country.

Fees for sending cross-border remittances are highand regressive. Remittance costs can be reduced byencouraging competition, introducing new remit-tance instruments, harmonizing payment systems,and increasing access to banking services to remit-tance senders and recipients. If a larger proportionof remittance flows were channeled through finan-cial institutions, it might encourage saving andwould also help alleviate concerns related to anti-money laundering and combating the financing ofterrorism (AML/CFT) (see Box 1.1 for a summary ofrecommendations).

3

Overview and Background

Box 1.1. Summary of Recommendations

Banking Supervision and Regulation• Improve the independence of financial oversight

agencies and provide adequate legal protection forsupervisors.

• Develop a regional approach to cross-border con-solidated supervision:– enhance cross-border cooperation and exchange

of information;– incorporate parallel banks and booking offices

into the scope of consolidated supervision;– clarify the legal definition of a financial group;– strengthen legal powers to regulate financial

groups; and– address a minimum set of priority risks in the first

stage, notably risks associated with connectedlending and loan concentration, loan classifica-tion and provisioning, and capital requirements.

• Develop a regional approach to dealing with po-tential stress of financial conglomerates:– set specific rules and procedures applicable to

cross-border bank bankruptcy proceedings; and– increase harmonization in resolution procedures,

notably as regards triggers and duration of bankintervention, and treatment of bank managersand shareholders.

Development of the Insurance Sector • Upgrade the legal and regulatory framework for

the insurance sector, with a view to moving to-ward harmonization of regulations:– better relate technical reserves to actuarial cal-

culations of risk;– gradually ease investment restrictions on insur-

ance firms;

– ease remaining restrictions on foreign entry inthe insurance industry; and

– strengthen regulation and supervision of opera-tional risk.

• Launch regional efforts in related areas, including:– jointly collect and disseminate demographic, me-

teorological, agronomic, and other information;and

– jointly develop catastrophe insurance programs.

Harmonization of Payment and Securities Settlement Systems

• Continue ongoing efforts to bring national pay-ment and securities settlement systems in linewith international standards:– upgrade the legal framework governing the

operation and oversight of the payment system;

– introduce, or finalize introduction of, real-timegross settlement (RTGS) systems;

– modernize public sector payments, includingthrough enhanced coordination among relevantagencies;

– upgrade clearing and settlement processes in se-curities settlement systems, notably by eliminat-ing physical handling of securities and reducingcustody risk; and

– devote adequate resources to securities settle-ment oversight, and enhance cooperation in thisarea among the central bank, self-regulatory or-ganizations, and the private sector.

• As part of these efforts, lay the groundwork for further harmonization and integration throughthe interlinking of the different systems.


An Overview of FinancialIntermediation in Central America

Financial Soundness and Development

Central America’s financial sector has grown sub-stantially in the last decade. The average credit-to-GDP ratio rose from 26 percent in 1993 to 39 per-cent in 2003, while average M2 to GDP in CentralAmerica rose from 32 percent to 48 percent. Finan-cial intermediation in Central America, excludingPanama that exhibits substantially above-averageratios, is similar to the average in Latin America, al-though financial depth varies significantly from onecountry to another (Figure 1.1).

Although financial sector openness in the regionis high, overall institutional quality is relatively low.There is free entry of foreign banks and there are norestrictions in any of the countries on foreign cur-rency purchases by residents. At the same time, ac-cording to cross-country databases such as the Her-itage Foundation’s Index of Economic Freedom and

the PRS Group’s International Country Risk Guide,in much of the region, weak corporate governanceand corruption reportedly pose problems and prop-erty rights are not well established.

Some countries in Central America have concen-trated banking systems. In Costa Rica and El Sal-vador, the financial system can be characterized asmoderately concentrated (three banks account formore than 60 percent of total assets), whereasNicaragua’s banking sector is highly concentrated(three banks account for more than 70 percent oftotal assets). Government-owned banks account foronly a small share of total assets in the banking sec-tor in most countries in the region. Only in CostaRica is the public share of banking assets signif-icant—around 60 percent—whereas for the othersit is 15 percent or less.

Banking systems exhibit significant cross-coun-try variations (Table 1.1). Financial soundness in-dicators show that the ratios of liquid assets to totalassets range from about 14 percent in Costa Rica to32 percent in El Salvador. The ratio of capital tounweighted assets are reported as between 7.3 per-cent for Honduras and 12.9 percent for Panama.Profitability, measured by return on assets, variesbetween 1 percent in El Salvador and 2.1 percentin Nicaragua and Panama. The ratios of nonper-forming loans (NPLs) to total loans range between1.8 percent for Costa Rica and 9.6 percent forHonduras.

All of the countries have strengthened the qualityof banking supervision during the past few years andare in the process of bringing their systems further inline with the Basel Core Principles. Laws governingthe financial sector have been revised, new regula-tions that strengthen loan classification and provi-sioning have been issued, and efforts to enforce cap-ital adequacy ratios have been undertaken. Limitson large exposure and related-party lending havealso been tightened.

Among other areas, cross-border supervision ac-tivities need to be made more effective (see Chapter2), and there is room to improve the independenceof banking supervisory agencies. International expe-rience has shown that operational and financial au-tonomy and adequate legal protection for supervisorsare essential if they are to carry out effective over-sight of financial institutions free from interventionby vested interests. In El Salvador, specifying in thelaw the conditions for dismissal of the head of thebanking supervisory agency as well as providing ade-quate legal protection to all supervisors would be im-

4


Figure 1.1. Indicators of FinancialDeepening, 2003(In percent)

0

10

20

30

40

50

60

70

80

90Private Credit/GDPM2/GDP

Averagein LatinAmerica

PanamaNicaraguaHondurasGuatemalaElSalvador

CostaRica

Sources: IMF, International Financial Statisitics; and national authorities.


portant measures to increase the independence of supervisory authorities. Increasing legal protection isalso an issue in Panama. In Honduras, protecting thebudgeting process of the supervisory agency from po-litical interference would enhance independence. InNicaragua, frequent judicial decisions overturningsupervisors’ actions raise concerns about the bankingauthorities’ autonomy.

Increasing Dollarization

Dollarization in the region is high and increasing.With the exception of Panama, which was alreadydollarized, dollarization became entrenched in theregion as inflation accelerated during the 1990s.Following a long period of a virtually fixed exchangerate, El Salvador decided to adopt the U.S. dollar asa domestic currency in 2001. The proportion of for-eign currency deposits to total deposits increased inall five Central American countries (excludingPanama as a dollarized economy) from 1997 to 2003(Figure 1.2). The measure of dollarization would beeven higher if deposits indexed to the exchange ratein Nicaragua were included, and if all the foreigncurrency deposits in offshore banks in Costa Ricaand Guatemala were accounted for.

Salvadoran and Panamanian banks operate in for-eign currency throughout the region taking advan-tage of their foreign currency deposit base.Nicaraguan banks also operate in foreign currency,with domestic loans in national currency indexed tothe exchange rate against the U.S. dollar. Domesticbanks in the region must offer the same services toprime customers, even if those customers do notgenerate foreign currency revenue. It appears thatoffshore operations stimulated by the prohibition offoreign currency deposits and loans in some coun-tries (Costa Rica and Guatemala) have not been

fully brought back onshore following the removal ofthose restrictions.

Migrant Remittances

Remittances are a large and stable source of exter-nal financing in Central America, especially for thepoorer countries. In addition to officially recorded re-mittance receipts, flows through informal (unmea-sured) channels are significant, and some remittancesare misclassified, for instance, as export revenue or

5

An Overview of Financial Intermediation in Central America

TABLE 1.1Financial Soundness Indicators for the Banking Sector, June 20041

(In percent; as of June 2004, unless stated otherwise)

Costa Rica El Salvador2 Guatemala3 Honduras Nicaragua Panama

Capital/assets 9.7 10.1 8.2 7.3 8.1 12.9Nonperforming loans (NPLs)/total loans 1.8 2.1 5.3 9.6 2.7 2.0ROA 1.9 1.0 1.3 1.4 2.1 2.1Liquid assets/total assets 14.4 31.6 29.1 27.6 23.5 20.5

Sources: Central American Monetary Council; country authorities; and IMF staff estimates.1Unless stated otherwise.2Data on return on assets (ROA), liquid assets as of September 2004.3Data on return on assets (ROA), liquid assets as of July 2004.

Figure I.2. Foreign Currency Deposits toTotal Deposits(In percent)

0

10

20

30

40

50

60

70

80

90

100

2003

2000

1997

PanamaNicaraguaHondurasGuatemalaEl SalvadorCosta Rica

Source: Central American Monetary Council (2003).


tourism receipts. Formal remittances to CentralAmerican countries are largely originated by moneytransfer operators (MTOs) and banks in the sourcecountries, channeled using mostly private proprietarypayment systems, and distributed through banks andagents of the MTOs.

Remittance costs, typically paid by senders to theremittance agent at the time of sending, range froma fixed $3–$5 per transaction to as high as 20 per-cent in the case of some MTOs. The average remit-tance cost seems to be around 4–6 percent in Hon-duras, 5–7 percent in El Salvador, 6–8 percent inGuatemala, and 6–9 percent in Nicaragua. On topof that, remittance agencies charge a 1–3 percentforeign exchange commission (except when fundsare delivered in U.S. dollars). Remittance costs aresignificantly higher for smaller remittance transac-tions used by poorer migrants. Conservative esti-mates suggest that the true cost of transactions—labor, technology, setting up networks, andrent—add up to only about $5 (or less) per transac-tion. These high mark-ups reflect market phenom-ena (e.g., large sunk costs that impede entry to themarket), regulatory measures that restrict competi-tion or raise compliance costs, the lack of access topublic infrastructure (e.g., payment systems), anduse of outdated remittance technology. Improvingtransparency in remittance transactions would raiseconsumer awareness, and reduce unfair remittancepractices, and might have a significant effect oncosts.3 Efforts to reduce costs, however, will have tobe carefully balanced with those to fight moneylaundering and the financing of terrorism.

Cross-Border FinancialIntermediation and Consolidated Supervision

Trends

In recent years, cross-border financial intermedia-tion activity in Central America has increased,mostly through regional financial conglomerates.The share of regional banks in deposits and loans inCentral America has increased in parallel with con-solidation in recent years, in some cases associated

with the absorption of failed financial institutions fol-lowing crisis episodes. Although banks are dominantwithin financial conglomerates, such conglomeratesmay also conduct nonbank operations.4 They arenormally part of larger corporate groups. Some othergroups do not consolidate operations and operatethrough parallel banks—separate institutions operat-ing in different jurisdictions with almost the sameownership structure. Other banks operate throughbooking offices that basically record operations notreported to the home supervisor, and where the un-derlying operations may be carried out offshore.

Four regional financial conglomerates operate inthe region, whose countries of origin are El Sal-vador, Nicaragua, and Panama (Figure 1.3).5 Eachholds an international license to operate fromPanama, where they consolidate operations of theirsubsidiaries. Three Nicaraguan groups are parallel

6


3The World Bank and the Bank for International Settlements(BIS) Committee on Payment and Settlement Systems (CPSS)have set up a task force, with IMF participation, to develop vol-untary principles that service providers, regulators, and supervi-sors should adopt for improving transparency in the market.

4A financial conglomerate is defined in this book as a group ofcompanies under unified control, primarily engaged in financialservices in at least two of the banking, insurance, and securitiessectors, showing significant cross-border operations in the region.

5These are Cuscatlán and Agrícola (of Salvadoran origin);Banco de América Central (Nicaraguan); and Primer Banco delIstmo (Panamanian).

Figure 1.3. Bank Assets by Type of Bank, 2003(In percent)

Sources: Individual banks; and IMF staff calculations.

0

10

20

30

40

50

60

70

80

90

100

Foreign banks Public banks Private domestic banks

Other regional financial groups Regional financial conglomerates



bank–based. There are other banks with links toother regional financial institutions operating in theregion, some of which were originally created to cir-cumvent limitations regarding operations with sightdeposits and/or foreign currency deposits (CostaRica and Guatemala).

Regional financial groups account for about one-third of assets of the regional financial system. For-eign bank branches account for only 3 percent ofthe system (this does not include operations from fi-nancial hubs such as Miami). Domestic banks repre-sent one half of the regional financial system. Theshare of public banks (about one-sixth) largely re-flects their high share of the financial market inCosta Rica.

Regional financial conglomerates appear to havehigher profitability, measured by return on assets,relative to other groups of banks. The conglomer-ates’ higher capitalization and profitability seem toreflect their success in servicing prime customers.Domestic private banks have a larger share of de-posits on-lent to borrowers as they concentrate onlocal clients. Foreign banks show overall lower prof-itability that may be partly related to more strict ac-counting guidelines required by their parent offices.

A trend toward consolidation in the regional fi-nancial system has been taking place. Between 1998and 2003, 24 banks were closed and 31 mergers tookplace, more than offsetting the number of new banks(8 banks started operations in the region in the sameperiod).6 Total assets denominated in U.S. dollars in-creased by 38 percent between 1998 and 2002 forCentral American countries (excluding Panama,which experienced a slight decline). Concentration,measured by the share of assets of the five largestbanks, increased to 73 percent in 2002 for the region.At the country level, this phenomenon is observed inall countries except Costa Rica, with Nicaraguashowing the highest concentration (96 percent).Banks maintain a dominant position in the region,holding 80 percent of financial sector assets.

Regional financial groups have consolidated theirposition in regional financial markets.7 In additionto the expansion of Salvadoran and Nicaraguangroups, Primer Banco del Istmo (Panamanian) hasparticipation in Honduras and Costa Rica, and Cus-catlán (Salvadoran) acquired the regional banks for-merly owned by the British bank Lloyds. Banks be-longing to regional groups acquired selected assets of

failed banks, including through cross-border acquisi-tions: Banex (Panamanian) in Costa Rica absorbedfour banks between 1998 and 2001; Lafisse andPromérica (Nicaraguan) absorbed assets and liabili-ties of failed banks in Nicaragua and El Salvador;and Cuscatlán and Agrícola (both Salvadoran) inCosta Rica and Guatemala.

Factors contributing toward integration throughthe activity of regional financial conglomerates include

• increased cross-border economic linkages.Trade within the region has expanded graduallyand represents a significant share of total inter-national trade for El Salvador and Nicaragua(where most regional financial conglomerateshave emerged);

• political uncertainty in some countries. In sev-eral countries, particularly El Salvador andNicaragua, a long period of social unrest andpolitical uncertainty led major corporate groupsto diversify their operations across the region.These concerns may also have discouraged for-eign banks from aggressive entry into the re-gional markets, leaving space for large regionalfinancial groups;

• improved reputation of large domestic banks.Depositor confidence in large banks belongingto regional groups improved after these institu-tions survived crises and, in some cases, ab-sorbed assets and liabilities of failed banks.Also, some groups have been able to obtaincredit ratings, which opens access to interna-tional capital markets;

• contribution of dollarization to achievingeconomies of scale. Full dollarization in El Sal-vador and Panama, and high dollarization inNicaragua, have helped lower operating and in-termediation costs in the region. The adoptionof official dollarization by El Salvador in 2001may have helped level the playing field be-tween foreign banks and regional groups thatoriginated locally; and

• facilities provided by Panama, an internationalfinancial center in the region. Most regional fi-nancial groups have active offices in Panamausing an international license to conduct opera-tions throughout the region. Easy access fromtheir home countries provides an opportunityto put in place significant managerial capabili-ties in Panama.

7

Cross-Border Financial Intermediation and Consolidated Supervision

6Central American Monetary Council (2003).7Barraza (2003).


Vulnerabilities Associated withRegional Financial Integration

While financial integration in Central Americahas contributed to the diversification of financialoperations and thus reduced risks, increased vulner-abilities may have emerged at the same time. Re-gional cooperation and coordination is required foradequate detection of these vulnerabilities. Interna-tional experience with cooperation between homeand host country regulators, however, is generallyinadequate worldwide. Moreover, effective financialsupervision at the home country level may be con-strained by institutional weaknesses, insufficientmarket discipline, and lack of independence of andlegal protection for supervisors.

The main challenges associated with the supervi-sion of cross-border financial intermediation are

• assessing the capitalization of regional financialgroups. Accurate assessment and proper moni-toring is complicated by differences in the defi-nitions and calculations of both actual and re-quired capital across borders, differences inaccounting standards, and lack of proper finan-cial and auditing consolidation. Despite similarrequirements, effective capitalization varies sig-nificantly across countries;

• detecting undue intragroup transactions. Unde-tected intragroup transactions may result in (1)capital or income inappropriately transferredfrom a regulated entity to an unregulated en-tity; (2) terms disadvantageous to a regulatedentity; (3) an impact on solvency, liquidity,and/or profitability of individual entities; or (4)circumvention of regulatory requirements;

• anticipating contagion within groups and acrossborders. Asset dumping—transfer of nonper-forming assets to a more lenient jurisdiction—may hide overall credit risk and cross-bordertransfer of deposits may magnify liquidity risk.Regulatory treatment of the sale of loan portfo-lio bundles varies among countries; and

• minimizing the risk of regulatory arbitrage. Reg-ulation of large credit exposures is uneven inCentral America, with El Salvador imposingthe most stringent regulations overall. Regula-tion on related lending is relatively strict in ElSalvador and Panama, but several countries donot have an aggregate limit on overall lendingto related parties. Differences in loan classifica-tion and the treatment of collateral make asset

transfers a likely means for achieving regulatoryarbitrage, including between different sub-sidiaries in a conglomerate.

Individual Country and RegionalResponses

To implement consolidated supervision, supervi-sors in the region need to overcome the hurdle ofadapting the legal framework for financial activities.Legislation in Costa Rica and Panama includes long-standing provisions for consolidated supervision, butonly Panama has been able to effectively combine,to some extent, supervision of domestic financialconglomerates and of cross-border intermediation(including of regional financial conglomerates). ElSalvador approved amendments to its banking law in2002 defining financial conglomerates, and financialinstitutions have already formed conglomerates.However, the Salvadoran superintendency does notconduct supervision of cross-border financial activi-ties because the two Salvadoran conglomerates con-solidate their international operations in Panama.Guatemala and Honduras recently approved modifi-cations to the legal framework, and the process ofimplementation has yet to be completed. Changes inthe legal framework for financial activities are pend-ing approval by congress in Nicaragua, where the su-pervisory authority has relied on isolated legal provi-sions and ring fences (more strict prudentialregulation for entities presumably belonging to agroup and not submitting consolidated financialstatements to any supervisory authority) to controlcross-border transactions within financial groups.

The main problems with the legal framework foreffective consolidated supervision include the lackof a clear definition of a financial group and the lackof enforcement of legal powers to regulate suchgroups. Heterogeneous and unclear definitionsacross countries hinder conduct consolidated super-vision. Weak legal powers of supervisors to regulatefinancial groups prevent imposing effective limitson intragroup operations or requiring corrective ac-tions when dubious transactions are observed. Im-plementation of legal modifications is also made dif-ficult by the limited exchange of information, withmore sensitive information not being shared amongsupervisors in the region.

Ring fences have been put in place but are difficultto implement because of institutional limitations. Inlight of the importance of cross-border operations byparallel banks of Nicaraguan origin, the superinten-

8



dency has put in place ring fences on the operationsof the domestic bank to limit opportunities to cir-cumvent regulation, including limits to investmentin financial institutions and special accounting rules;higher capital adequacy requirements; regulation ofdeposits and investments; 100 percent provisioningon sales of loan portfolio bundles; and restrictions onthe use of a common name. However, recent at-tempts to expand certain powers of the superinten-dency based on ring fences have been subject to courtinjunctions.

In some countries, only partial progress has beenachieved in the incorporation of booking officesinto the scope of consolidated supervision. In CostaRica, reluctance to report continues despite highercapital adequacy requirements (20 percent for non-reporting groups and 10 percent for groups allowingfull access). In Guatemala, the superintendency hascompleted a first round of on-site inspections of alloffshore entities. However, reporting deficiencies re-sult in the unreliability of financial statements ofbanks and groups.

Panama is the only jurisdiction where consoli-dated supervision is conducted consistently. Re-gional financial conglomerates have chosen to con-solidate in Panama as a recognized internationalfinancial center. Upgrades of financial legislation inEl Salvador pertaining to such conglomerates andsupervisory procedures in Nicaragua have not yetbeen tested since groups have decided not to consol-idate in those countries despite significant mind-and-management presence.

Individual country measures will not be fully ef-fective in the absence of a regional approach thatleads financial groups to consolidate their financialreporting. A regional approach is just starting to bedeveloped. Despite a long-standing overall frame-work for memoranda of understanding sponsored bythe CCS and signed in 1998, the lack of a centralauthority, legal restrictions in some cases (e.g., se-crecy provisions in several countries), unclear focuson what information is to be exchanged and re-ported, and reluctance of supervisors to providetimely and detailed information have conspiredagainst a smooth exchange of information.

The CCS has been instrumental in promoting anopen exchange of views among regional supervisorson the need for cross-border consolidated supervi-sion. The CCS was founded in 1976, with the goalsof encouraging cooperation and exchanging infor-mation between regional superintendencies, and fa-cilitating the implementation of regional agree-

ments. Discussions on plans to harmonize regulationacross countries in the region have taken place withthe Inter-American Development Bank (IDB), withthe main goal of identifying the gaps for the applica-tion of international standards for banking supervi-sion. Coordination to implement International Fi-nancial Reporting System (IFRS) criteria wasassisted by the Central American Bank for Eco-nomic Integration (CABEI). Specific steps to im-prove regional banking supervision include thepreparation of assessments and action plans. TheCCS is at a crucial juncture to define a roadmap andlay out the priorities in improving consolidated su-pervision of regional financial institutions.

In the context of internal discussions, the CCShas prepared a regional initiative for consolidatedand cross-border supervision. The main objectivesare to (1) eliminate opportunities to elude supervi-sion; (2) use adequate prudential standards; (3) de-fine the structure, ownership, and management ofconglomerates; (4) establish adequate capital re-quirements; (5) assess asset and liability manage-ment, including credit management; (6) identifyglobal risks of conglomerates; (7) ensure trans-parency of information; (8) establish links to trans-mit risks; (9) determine contagion risks; and (10)verify compliance with the legal framework. Theproposed arrangement among supervisors has thefollowing main features:

• The host supervisor would notify the home su-pervisor of requests to obtain licenses, and thehome country would report on compliance withlaws and regulations in the home country of therequesting financial group.

• Information exchange would be open, with theexception of the identification of depositors.

• Supervisors would commit to provide assis-tance to on-site inspections of other countrysupervisors.

• Cooperation would be promoted, especially onAML/CFT issues.

Systemic Risk Considerations

The growth of cross-border banking activitiesposes significant challenges for banking resolution.In the event of failure, regional financial groups maybe split into their national legal entities, each sub-ject to different bankruptcy proceedings. In the ab-sence of internationally recognized insolvency rules,

9

Cross-Border Financial Intermediation and Consolidated Supervision


equitable banking resolution may therefore be ham-pered if creditors in one jurisdiction receive highercompensation than creditors in other locations.8

Continuous coordination and communication be-tween regulators is critical to ensure orderly resolu-tion. A decision to intervene or close a domesticbank with operations abroad or a subsidiary of a for-eign bank could have unintended, but significant,consequences for other countries. Thus, bank super-visors should coordinate their actions, including toensure that insider creditors do not exit prior to thecommencement of a liquidation.

Further harmonization in the legal and regulatoryframework for bank exit would also help to ensureorderly resolution. Progress in upgrading processesand procedures for banking resolution in CentralAmerica has already been substantial. For instance,many countries have introduced a system of promptcorrective actions, specified triggers for interventionin case of bank insolvency, and broadened the rangeof available resolution tools. Areas where further ef-forts are needed include the following:

• Triggers for bank intervention. A uniform defini-tion of insolvency—currently ranging from 2 to8 percent of risk-weighted assets—would allowthe authorities to coordinate the timing of in-tervention of members of a financial groupacross countries, thereby minimizing the risk ofcontagion and asset stripping.

• Duration of bank intervention. Compulsory bankintervention prior to possible liquidation variesin length, and in some countries is not well defined. This can pose problems for orderly liquidation.

• Treatment of bank managers. Bank managersshould be prevented from participating in keybank resolution decisions to ensure fairness, butthat is not always the case in all Central Amer-ican countries.

• Rights of shareholders. Similarly, shareholders’rights should be suspended as part of bank inter-vention, but the law in this respect is unclear ina number of Central American countries.

Although the six Central American countries aresignatories to a regional convention on cross-borderbankruptcy proceedings, further efforts are needed.The 1928 Convention on International Private Law(the “Bustamante Code” or “Havana Convention”)only sets certain principles applicable to cross-borderbankruptcy proceedings as to the extraterritorialityof a bankruptcy order. In the absence of an interna-tional agreement specifically governing cross-borderbank insolvency, the authorities may want to con-sider entering into a regional treaty that would setspecific rules and procedures applicable to cross-border bank insolvency proceedings, particularlyaimed at dealing with regional banking problems tohelp ensure fair, timely, and transparent treatment ofclaims of depositors and other creditors.

Policy Recommendations

The minimum standards for the supervision of in-ternational banking groups established by the BaselCommittee on Banking Supervision stipulate that(1) all international banks should be supervised by ahome country authority that capably performs con-solidated supervision; (2) the creation of a cross-border banking establishment should receive theprior consent of both the host country and thehome country authorities; (3) the home country au-thority should possess the right to gather informa-tion from cross-border banking establishments sub-ject to their oversight; and (4) if the host countryauthority determines that any of these three stan-dards is not being met, it could impose restrictivemeasures or prohibit the establishment of bankingoffices.

Given the significance of existing cross-border in-termediation, it may not be possible to implementthese standards within a short time frame. More-over, the presence of banks that do not consolidatefinancial statements in the international bankingcenter and the likely substantial mind and manage-ment in the home country of shareholders are areasto be addressed within the framework of a regionalapproach. Also, some phasing-in may be requiredfor bank operations in different jurisdictions autho-rized long ago and for most already well-establishedregional financial groups. In addition, host supervi-sors in locations with significant “mind and man-agement” presence perceive that information shouldflow also from home to host supervisors.

The proposal for regional supervision by the CCSdescribed above is a step in the right direction. It

10


8In contrast, in jurisdictions following a single-entity approachthere is only one set of insolvency proceedings in which the fi-nancial institution is treated as one entity, and its assets, no mat-ter where they are located, will be included in a single liquida-tion or reorganization process. There is no “best practice” as towhich approach should be followed in the legislation governingbank insolvencies.


would benefit from the definition of a road mapwith appropriate sequencing and a clear prioritiza-tion of goals. Moreover, it appears that more forcefulaction could be called for in several areas, for exam-ple, (1) a no-objection letter from the home regula-tor would be required to grant licenses in anothercountry in the region; (2) information on depositorscould be made available to the home supervisors onan exceptional basis, for example, to identify groupexposures and concentration; and (3) cooperationon AML/CFT issues should allow for specific gate-ways such as for testing compliance with the applic-able group requirements and in relation to suspi-cious activity reports.

Elements to be considered for prioritization andsequencing of a common strategy include

• take as a starting point the decision of financialgroups to consolidate in Panama. Rather than“fighting against the wind,” the strategy to bedevised should aim at maximizing the potentialbenefits that consolidating in a jurisdictionwithin the region may bring, while reinforcingthe mechanisms that would allow more effec-tive identification, monitoring, and mitigationof risks in each country;

• commit to a plan to require parallel banks andbooking offices to report on a consolidatedbasis, with regional ring fences facilitating enforcement;

• strengthen the role of host supervisors in theprocess of consolidated supervision. The strat-egy to be followed should be mindful of thestrong “mind and management” presence in thecountry of origin of shareholders of financialgroups. Consideration should be given to a two-way exchange of information;

• address a minimum set of risks considered prior-ity in the first stage. Risks associated with related-party lending and loan concentrations,loan classification and provisioning, and capitalrequirements seem to be candidates to be ad-dressed in the first instance, by establishingminimum standards and a time table to makethem more in line with international standardsand best practice. Later on, AML/CFT andcountry risks could be addressed;

• enhance cross-border cooperation. CentralAmerica has a history of formal Memoranda ofUnderstanding (MOUs) that lack effective im-plementation. Discussions at the CCS should

highlight examples when implementation ofMOUs has proven effective. Further neededimprovements include clarifying the nature ofinformation to be exchanged and reported,with firmer commitments to provide timely anddetailed information on more specific areas. Se-crecy laws or other limitations on sharing infor-mation may need to be modified in some coun-tries; and

• put in place transitional arrangements. Morestringent requirements for opening new officesin the region while consolidation of largegroups is completed could be considered. Work-ing toward a clear common definition of finan-cial groups among Central American countriesshould also be a priority.

Development of the Insurance Sector

Structure and Performance

The insurance sector remains small in most ofCentral America. The market for insurance prod-ucts in most Central American countries is modestby any measure, but in line with what is seen incountries at a comparable level of development.9The number of policies is low relative to the popula-tion. Larger firms and more affluent households canobtain most forms of insurance, but the poor aregenerally lacking in insurance services. Agriculturalinsurance has only recently been introducedthrough a number of pilot projects.

The scarcity of insurance affects welfare directly,and may also reduce the availability of financing orincrease its costs, because lenders are discouragedwhen they must bear both the economic risks associ-ated with a project to be financed and also insurablerisks from damages. In addition, the limited assets ofinsurance companies imply that they cannot bemajor players in domestic financial markets. Hence,measures to promote the insurance industry couldyield multiple benefits if they are well targeted. Someof these measures would be more effective if under-taken on a regional basis, and at a minimum thecountries can learn from one another in this area.

The prevalence of non–term life insurance, thatis, life insurance with an important savings element,

11


9It should be borne in mind that data are sometimes not fullycomparable across countries.


depends on whether or not other savings vehiclesare available. Given the heterogeneity of fiscal, dis-tributional, and demographic factors affectingnon–term life insurance, this report concentrates onnon–life insurance.

The insurance sector in most of the region is highlyfragmented, and many insurance companies tend tobe relatively small affiliates of banks. Thus, the aver-age company is small (Costa Rica, which has aunique state monopolist insurer, is an exception).Some insurance companies are linked to broader in-dustrial-financial conglomerates. The numeroussmall companies almost certainly operate well belowefficient size, and in many cases their revenues are in-sufficient to support the employment of their own ac-tuary or the development of a fully computerized sys-tem for record keeping, data analysis, and claimsprocessing. Their portfolios of investments may alsobe too small to achieve full diversification.

Most indicators of soundness and performance dis-play stability and do not raise immediate, systemicconcerns.10 There have been no major failures in re-cent years, but the occasional failure of small compa-nies has been widespread. Recent experience withheavy losses from both Hurricane Mitch in most ofthe region and two earthquakes in El Salvador in2001 indicates that, in all affected countries, the in-surance sector as a whole was capable of covering itsliabilities, largely because it was properly reinsured.Heavy use is made of reinsurance from the large in-ternational reinsurers, although the Panamanianreinsurers also accept risks in the region.

Companies’ investment portfolios are typicallynot very diversified, at least by type of investment.Most companies place assets in bank accounts or, insome cases, in securities issued by their respectivenational governments. Investment abroad is modestand in all countries is severely constrained by regu-lations. For non–term life insurance business, com-panies are often severely constrained by the lack ofsecurities with a maturity approaching that of liabil-ities to policyholders.

Legal and Regulatory Framework

All countries have a law on insurance. Supervi-sors and market participants are generally awarethat certain legal provisions may unnecessarily ham-

per the development of the sector, but enacting thenecessary amendments is not high on the legislativeagenda. The Honduran Law was substantiallyamended in 2001, and, in other countries, legisla-tive amendments are being prepared. Many firmschoose to establish internal financial policies thatare much stricter than what regulations require.11

The supervisors generally monitor the condition oftheir insurance industries closely, and are aware ofregulatory developments elsewhere. However, inseveral countries, they acknowledge that they lackthe budgetary resources to retain as many well-trained staff as they would prefer.

Certain common features can be identified in theregulations of many (if not always all) of the coun-tries of the region. Some potentially problematicfeatures include the following:

• Minimum required technical reserves (alsocalled provisions) for non–life insurance policiesare defined as a proportion of premiums net ofthe amount ceded to reinsurers, rather than re-lated to the actuarial value of expected losses,which is a company’s true exposure. Further-more, this specification of minimum reservesmay create an incentive for companies to in-crease risk by competing via lower premiums be-cause by doing so they both gain market shareand reduce the expense of holding reserves. Ifthe proportionality factor is too high, the af-fected products will be needlessly expensive.

• On a connected point, the treatment of insur-ance premiums ceded to reinsurers does not dif-ferentiate sufficiently according to the specificsof the reinsurance contract, which might givethe reinsurer more or less scope to limit reinsur-ance payouts in case of loss. If the regulationsdo not allow for this possibility, primary insurerscan have an incentive to reinsure as cheaply aspossible while also reducing the expense ofholding reserves.

• All countries established solvency requirements(“solvency margins”). A few supervisors sug-gested that the minimum solvency require-ments may be too low.

• Investment by insurance companies is restrictedin various ways. While these restrictions are

12


10However, the insurance business is inherently vulnerable torare but large risks; performance can be satisfactory for manyyears, but the true soundness of the system is often apparent onlyafter a major event such as an earthquake.

11In Panama and Guatemala, the insurance sectors have fivetimes and three times the required level of capital and reserves,respectively.


mainly intended to preserve the solvency andliquidity of companies, some may be counter-productive or inefficient. Certain restrictionsstrongly favor investment in securities issued bythe national government. Additionally, in allcountries, investment abroad is severely lim-ited, and in some countries returns on foreigninvestment are taxed much more heavily thanreturns on domestic investments. Given thelimited size and development of regional capitalmarkets, restrictions on foreign investment de-press investment yields and increase risk by lim-iting diversification.

• Entry by foreign firms is generally permitted,subject to standard licensing procedures (exceptin Costa Rica). However, there are restrictionson the form in which a company can be incor-porated, and branching is prohibited. All coun-tries prohibit the purchase of most forms of in-surance from abroad. These restrictionsconstrain regional integration.

• In most countries, presumably because of therecent nature of the service, specific regulationsregarding bancassurance are weak. When bankssell insurance products through their branches,the scope for bundling financial products—suchas a loan with an insurance requirement—givesrise to issues of consumer protection and the de-finition of fiduciary responsibilities.

• Few countries have extensive requirements oncompanies to prepare and publish regular re-ports on their actuarial situation (Nicaragua isan exception). Regulations for and supervisionof information management systems, computersystems, and other forms of operational risk arevery limited. The lack of requirements in theseareas, where effective systems are characterizedby high fixed cost, helps smaller companies tosurvive.

• The tax treatment of insurance differs acrosscountries. In some, but not all, countries, pre-miums for life insurance and certain other cate-gories of insurance are deductible from incometax. Sometimes certain insurance expenses areexempt from sales or value-added taxes. Thetreatment of insurance payouts also varies.

The weaknesses noted above suggest an agendafor regulatory modernization. The authorities hopeto move toward a more risk-based approach to regu-lation and supervision, with a greater role played by

actuarial calculation of risks. In particular, technicalreserves need to be related to the expected value oflosses, their variance and covariances, and otherrisks (such as reinsurance risk). Also, companiesneed more scope to manage their portfolios tomatch underwriting risks. Many measures neededfor prudential purposes, such as introducing morerisk-based reserve requirements, mandating the pro-duction of actuarial reports, and introducing mod-ern information management systems, would likelyhave a greater impact on smaller companies, andcould spur consolidation. However, while the regu-latory and supervisory framework can be improved,it will be important to allow room for less sophisti-cated products aimed at providing basic coverage atlow cost.

Insurance Sector Development andRegional Issues

Besides the regulatory issues raised above, the au-thorities may have a role in providing other supportservices. There may be a role for direct subsidies oradministrative support for crop insurance, providedthat the cost is made transparent in the budget. In-sofar as farmers are poor, there may be distributionalreasons for these types of support. Moreover, theavailability of crop insurance may be held back byfixed costs, such as centralized information process-ing; government action may be needed to reducethe substantial start-up costs.

Governments could also contribute to the devel-opment of the insurance sector by insuring more oftheir own risks instead of relying on implicit self-insurance. Greater insurance volumes by the gov-ernment could help in creating critical mass andeconomies of scale for the sector. Taking out insur-ance policies on important assets, such as roads andbridges, as is done in many countries,12 could add toexplicit planned expenses, but it would also allowfor an improved budgetary process and less need forcostly last-minute reallocations of budget revenuesto attend unforeseen reconstruction expenses andother losses.

Another potential area for government action isgeneral catastrophe insurance. A large volume of pri-vate sector assets in Central America are uninsured

13


12In Bahrain, for example, government or quasi-governmentagencies insure petroleum-related facilities and other infrastruc-ture, and premiums from government insurance constitute abouthalf of all property-related premiums.


and the potential losses from a major event, such asan earthquake, can create a negative macroeco-nomic shock that multiplies the direct losses fromthe event. To the extent that governments typicallyassume some responsibility for disaster recovery andreconstruction in the case of catastrophes, there is animplicit public sector liability. Recognizing these po-tential liabilities and dealing with them through ap-propriate insurance contracts may reduce the associ-ated costs.13 The government would be involved bymaking insurance compulsory for specified catastro-phes, conducting risk analysis, and selecting one ormore providers. (In the United States, for example,there are several earthquake, flood, and hurricane in-surance and relief arrangements.)

Insurance sector development offers scope for re-gional cooperation and the exploitation ofeconomies of scale. One set of measures might be di-rected at the harmonization of regulations, in linewith international best practice. The authoritiescould coordinate the introduction of risk-based regu-lations, and eventually there could be a presumptionthat a company operating in one jurisdiction wouldbe free to offer insurance products and to open abranch or subsidiary in another country of the re-gion. In this way, competition could be preservedeven as the sector consolidates within individualcountries. This type of effort appears particularly rel-evant given the expected results of the CAFTA-DRand Free Trade for the Americas negotiations.

Regional efforts could be worthwhile in otherareas, including (1) the collection and dissemina-tion of demographic, meteorological, agronomic,and other statistics needed for actuarial calculationsthat underlie insurance pricing, notably but not ex-clusively in relation to crop insurance; and (2) jointdevelopment of catastrophe insurance programs, es-pecially where geographic or climatic regions withsimilar risk characteristics extend across borders.

Harmonization of Payment andSecurities Settlement Systems

There is a high degree of heterogeneity in pay-ment and securities settlement systems in Central

America. Most countries in the region havelaunched substantial reforms in their national sys-tems in recent years, with assistance from the inter-national financial institutions (IFIs), but significantdifferences remain from one country to another.Overall, more is needed to bring national paymentand securities settlement systems in line with inter-national standards. The proper design and function-ing of national systems should be pursued with aview to contributing to the overall soundness andstability of the financial system, a further deepeningof financial markets, and preventing systemic risk.

In parallel with the development of national sys-tems, there is growing interest in the region in the ef-ficiency gains that could be achieved by adopting in-tegrated frameworks for regional payments andsecurities settlement. Projects on regional clearanceand settlement of large-value financial transactionsand on integrated regional large-value, RTGS pay-ment systems have been launched by Central Ameri-can governments, the Central American MonetaryCouncil (CAMC), and the Inter-American Develop-ment Bank. The ongoing reforms at the nationallevel provide an opportunity for further harmoniza-tion at the regional level and the eventual integrationof payment and securities settlement frameworks.

Current Situation

There are serious deficiencies in the legal frame-work governing national payment and securities set-tlement systems in Central America. Legal provisionsare either lacking or have not resulted in adequateregulation in a number of key areas, such as centralbank oversight powers, irrevocability of final settle-ment, protection of the systems against the effects ofbankruptcy procedures, custody arrangements, repur-chase (repo) operations, multilateral netting arrange-ments, and immobilization and dematerialization ofsecurities (notably public securities). Weaknesses inthe legal framework create uncertainty about the sys-tems’ and participants’ risk exposures, and create im-pediments to financial market development.

Most countries in the region already operate orhave launched RTGS systems, but manual or semi-manual systems remain prominent. Costa Rica has asafe and efficient RTGS system, and new systemsmore in line with the CPSS Core Principles for Sys-temically Important Payment Systems (CPSIPS)14

14


13Turkey has established a catastrophe insurance pool for dam-age to dwellings from earthquakes. Initiatives to develop catas-trophe insurance are under way in several other countries, withthe assistance of the World Bank, the Inter-American Develop-ment Bank, and the International Finance Corporation. 14See Bank for International Settlements (2001).


are being launched in El Salvador, Honduras, andGuatemala. Overall, however, checks represent asignificant portion of large-value interbank pay-ments, thereby maintaining a “systemically impor-tant” status. In some countries, checks are the pre-dominant or the only system available to channelinterbank payment transactions. Slow progress inthe full adoption of RTGS systems has come at acost in terms of efficiency and vulnerability to creditand systemic risks.

Cashless instruments for retail payments are littleused in the region despite recent efforts. New appli-cations to process retail electronic credit and debitinstruments have been a major element of efforts tomodernize national payment systems. Automatedclearinghouses (ACHs) have been launched in somecountries (Costa Rica, El Salvador, Guatemala, andHonduras). In most countries, however, ACH proj-ects are either too slow to keep pace with customerneeds or too limited in scope (e.g., the project onlyfocuses on improvement of check-clearing proce-dures). Moreover, countries have often failed to fullyintegrate government-related payments (tax collec-tion, salaries, purchase of goods and services, and soon) into the national payment systems, despite thefact that public sector institutions are major playersin the system.

There is room to improve the safety and effi-ciency of clearance and settlement mechanisms forforeign exchange transactions. These transactions—whether domestic or cross-border—are typically notsettled on a payment-versus-payment (PvP) basis,which generates significant credit and liquidity risk.Risks related to cross-border transactions are alsorelevant in view of the important flow of remit-tances to countries in the region. In particular, alarge share of remittances is still channeled throughnonregulated specialized institutions, for whichthere are no standards for aspects such as trans-parency of fees and other charges or the timing ofaccreditation of funds to end-beneficiaries.

The underdevelopment of the interbank markethas been a key obstacle to the smooth functioning ofpayment and securities settlement systems in the re-gion. Interbank money markets are not very activein most Central American countries, with the no-table exception of Costa Rica. This has hamperedliquidity management by financial intermediaries, inaddition to impeding monetary policy transmission.

Significant shortcomings remain in the securitiessettlement process across countries in the region.Manual handling of securities is common and cre-

ates inefficiencies and risks that limit the develop-ment of the markets. Settlement cycles tend not tobe standardized, and automatic securities lendingand borrowing facilities are not available, whichhampers effective risk management. In most coun-tries in the region, securities transactions are notsettled on a delivery-versus-payment (DvP) basis,and full dematerialization and immobilization of se-curities have not been achieved. In addition, overallthere is an absence of risk management tools used tocover settlement failures.

In general, there is scope for improving the over-sight of payment and securities settlement systems.Central American central banks do not fully ob-serve the main responsibilities of the Core Princi-ples for Systemically Important Payment Systemsregarding payment system oversight. Specifically,central banks in the region lack explicit oversightauthority over the securities settlement system andfull transparency on major policies affecting thepayment system; progress toward compliance of thesystems with international standards has been slow,as noted; and cooperation with other relevant au-thorities, both at the national level (i.e., the min-istry of finance, the banking supervisor, the securi-ties commission, and other relevant regulators) andacross the region, remains weak.

Policy Recommendations

Central American countries should continue intheir efforts to bring their national payment sys-tems in line with international standards. Byadopting a comprehensive approach based on in-ternational standards and best practices, eachcountry would move toward a set of paymentarrangements, services, and circuits able to servethe needs of all users in the economy. Not onlyshould the scope of reform be broadened in termsof systems (to include, for instance, retail and gov-ernment payments in addition to large-value pay-ments), but it should incorporate an upgrading ofthe underlying legal, regulatory, and oversight en-vironments. In conducting the reform, the logicalsequencing process would be (1) diagnostic analy-sis; (2) vision development; (3) conceptual designand implementation planning; (4) user require-ment specifications; and (5) acquisition, procure-ment, development, testing, and implementation.

As the authorities prepare for the next stage of reforms, they should lay the groundwork for furtherregional integration among the different payment sys-

15

Harmonization of Payment and Securities Settlement Systems


tems. Appropriately reforming each national pay-ment system in the region will create the conditionsfor further harmonization and integration throughthe interlinking of the different systems. Centralbanks should, therefore, work in parallel in reformingas a first priority their national payments systems and,at the same time, work toward closer integrationwithin the region by discussing and preparing mini-mum common features and a realistic timetable.

A number of improvements are needed to bringnational payment and securities settlement systems inline with international standards and best practices:

• All countries in the region should move towardan appropriately designed RTGS system. Thedesign of the system should include (1) a robustand efficient communications network to re-duce and eventually eliminate the use of man-ual and paper-based procedures; (2) strict secu-rity measures for physical and electronic accessto the system; (3) contingency plans and disas-ter recovery mechanisms, including the setting-up of a secondary site; and (4) measures forbusiness continuity and resilience.

• Central banks have a role to play in ensuringthat the existing retail circuits support cus-tomers’ needs and are safe, convenient, and effi-cient for the economy as a whole. Centralbanks should (1) ensure that the legal and regu-latory framework keeps pace with market devel-opments; (2) monitor competitive market con-ditions and behaviors and take appropriateactions to foster such conditions; (3) supportthe development of effective standards and in-frastructure arrangements; and (4) adapt as nec-essary its provisions of settlement services forsystems operated by other entities to contributeto efficient and safe outcomes, allowing all suchsystems to settle in central bank money.

• Central banks and relevant government agen-cies should foster coordination to ensure thatcollection and disbursements of public sectorinstitutions that are major players in the pay-ment system be processed electronically andtimely through an appropriate system, such asan automated clearinghouse for retail electronicpayment instruments.

• Central banks should monitor trading and set-tlement platforms and procedures for foreigncurrency and cross-border transactions, notablyremittances, to ensure that the principles of

safety and efficiency can be applied to clearanceand settlement.

• The interbank money market should be devel-oped further to ensure the smooth functioningof the payment and securities settlement sys-tems. A key element would be to create a spe-cial system for large-value payments. Thisshould provide secure electronic interbanktransfers with immediate settlement, connectedto an electronic book-entry securities registra-tion system.

• Clearing and settlement processes in securitiessettlement systems should be upgraded. Themain aspects to be improved are achieving fulldematerialization and immobilization of secu-rities; establishing DvP procedures; upgradingrisk management tools; mitigating credit andliquidity risk in the cash leg settlement (in-cluding eliminating the use of checks as a cashasset); providing better access to liquidity forsystem participants; and developing a compre-hensive strategic approach to the reform ofsystems, as opposed to technology-driven andpurely operational reform projects.

• There is room for efficiency gains in the securi-ties settlement infrastructure. Physical handlingof securities should be eliminated to increasesafety and efficiency. Clearing and settlementshould aim at achieving straight-through pro-cessing. Plans for backup sites and disaster re-covery facilities should be accelerated or estab-lished when they are nonexistent. Externalaudits of the systems should be undertaken, es-pecially when they were developed in houseand/or oversight is weak.

• The legal framework needs to be strengthenedto reduce custody risk—that is, to guarantee theprotection of customers’ assets in the event ofbankruptcy of the depository or the custodian.The country authorities should ensure that thesegregation of accounts for securities and fundsunder custody has a clear legal basis; that allcustomer assets are appropriately accounted forunder their beneficial owners in the depositoryor in the custodian’s omnibus accounts; andthat customer assets are protected against theinsolvency of custodians.

• The securities depository should be well capital-ized, autonomous, and capable of expeditingsettlement of transactions and accessory rights.

16



This is crucial for the development of the secu-rities markets.

• The authorities should analyze the risks associ-ated with cross-border links among securitiesdepositories. At the international level, thelegal framework governing the cross-borderpledge of securities as collateral should be im-proved. In this respect, some depositories andsecurities regulators participate in the HagueConvention efforts to develop internationallyaccepted principles in this area, but they be-lieve that market participants have not beensufficiently involved.

• There is scope for improving the oversight ofpayment and securities settlement systems. Leg-islation should clarify in detail the responsibilityand enforcement authority of the central bank aspayment system overseer. In addition, adequateresources should be devoted to securities settle-ment oversight and an effective cooperativeframework established with other agencies, self-regulatory organizations (SROs), and the privatesector. In performing the oversight function andas system operators, central banks and securitiesregulators should ensure transparency in theirpolicies and conditions for services offered.

Conclusions

Central American countries share the bonds ofgeographic proximity, a common language, and sim-ilar histories. Country authorities have seen the mu-tual advantages of cooperating in areas critical toeconomic growth and development, including pro-moting financial sector development and stability.There appear to be significant economies of scaleand scope that can be exploited by serving a sizableregional market.

The private banking sector has already expandedthroughout the region, contributing to an increasein financial intermediation in line with that ob-served elsewhere in Latin America. At this stage,prudential regulation and supervision need to catchup with the activities of financial conglomerates, toreduce the potential risks arising from regulatory ar-bitrage and cross-border contagion. Several coun-tries need to increase the financial and operationalindependence of financial sector supervisors becauseinternational experience has shown that this is cru-cial to ensuring the implementation of prudentialregulation free from intervention by vested inter-

ests. Continuous upgrading of the technical capacityto conduct consolidated supervision of financial in-stitutions in all of the countries is also advisable.

To back up efforts by the Central American coun-cil of financial sector regulators to improve supervi-sion of regional financial groups, recommendationsinclude the sharing of information by supervisors incountries where regional financial groups have sig-nificant activity; consideration of joint on-site in-spections; and establishing a regional timetable toaddress irregular arrangements such as parallel banksand offshore institutions. With the relaxation orelimination of restrictions on domestic financial in-stitutions to conduct operations in foreign currency,there should be less legitimate incentive for offshoreoperations. In addition, supervisors in the regioncould benefit from an exchange of views on neces-sary changes to the respective legal frameworks forachieving an effective regime for cross-border bankinsolvency.

Insurance and capital markets in Central Amer-ica are much less developed than the banking sector.The development of these sectors seems to be con-strained by legal restrictions (cross-border sale of in-surance products is generally closely controlled orprohibited), and there are limits on the investmentof insurance assets abroad. Furthermore, paymentand securities settlement arrangements are countrybased with no regional trading platform. The coun-tries are encouraged to increase the technical re-sources and strengthen legal frameworks for over-sight of insurance and payment and securitiessettlement arrangements. This would be a precondi-tion for the development of individual country in-surance and capital markets and, eventually, of a re-gional stock market.

References

Bank for International Settlements, 2001, Core Principlesfor Systemically Important Payment Systems, Commit-tee on Payment and Settlement Systems, January(Basel).

Barraza, Rafael, 2003, “Integración financiera Cen-troamericana,” presentation at the 40th Anniversaryof the Central American Monetary Council, Teguci-galpa, Honduras.

Central American Monetary Council, 2003, “Característi-cas básicas y evolución reciente de los sistemas bancar-ios de Centro América, Panamá y la República Dominicana,” Documentos de Trabajo, June (CostaRica).

17

References


18

Consolidated Supervision of Financial Groups in Central America

Patricia Brenner and R. Armando Morales15

F inancial groups are becoming the dominant in-stitutional structure in the financial services in-

dustry around the world (Figure 2.1).16 Financialglobalization and innovation have also stimulated in-creasing cross-border operations in Central Amer-ica,17 particularly by financial groups operating re-gionally. These operations have benefited fromeconomies of scale and scope as well as from deregula-tion and international liberalization. The associatedconsolidation process has favored the emergence offinancial groups with complex management and cor-porate structures offering a range of financial serviceson a cross-border basis. Meanwhile, products and ser-vices offered by banks and other financial institutionshave become closer substitutes.

Regional Financial Integration

Financial liberalization in Central America hascontributed to the growth of large regional financialgroups that originated locally. Thus, financial inte-

gration has progressed concurrently with the growthof large regional financial groups under a variety ofcorporate structures competing successfully with for-eign banks for prime customers. Explanations forthese developments include

• increased cross-border economic linkages.Trade within the region has expanded gradually(Figure 2.2), and represents a significant shareof total international trade for El Salvador andNicaragua (where most regional financial con-glomerates have emerged). Regional operationsof most of the large local corporate groups ex-panded quickly after the peace process in theregion was firmly established in the 1990s. Inthis period, the Salvadoran Kriet Group, ownerof TACA airlines, acquired several smaller do-mestic airlines and became the dominant com-pany in the sector. The Nicaraguan PellasGroup absorbed several small domestic com-petitors in the beer market and established astrategic alliance with other domestic groups.Often, these large corporate groups have own-ership participation in financial groups;

• political uncertainty and a weak rule of law. Insome countries, notably El Salvador andNicaragua, a long period of social unrest andpolitical uncertainty led major corporate groupsto diversify their operations across the region(Figure 2.3). Concerns over the enforceabilityof property rights may also explain this diversi-

2

15The authors would like to thank Katharine Christopherson,Jens Clausen, Luis Cortavarría, Marco Espinosa, Wim Fonteyne,Antonio Hyman-Boucherau, Ross Leckow, Maike B. Luedersen,Gabriela Rosenberg, Moni SenGupta, and Debbie Siegel for con-tributing sections of this chapter.

16De Nicoló and others (2003).17For purposes of this chapter, the countries of Central Amer-

ica are Costa Rica, El Salvador, Honduras, Guatemala,Nicaragua, and Panama.


fication (Costa Rica and Panama being the ex-ceptions). These concerns may also have dis-couraged foreign banks from aggressive entry tothe regional markets, creating a vacuum thathas been filled by large regional financialgroups.18 Although some of these concernshave been addressed in recent years, the regionis still often perceived as less stable than therest of Latin America;

• improved reputation of large domestic banks.Depositor confidence in large banks belongingto regional groups improved after these institu-tions survived crises and, in some cases, ab-sorbed assets and liabilities of failed banks (Fig-ure 2.4). Also, some groups have been able to

obtain credit ratings, which opens access to in-ternational capital markets;19

• economies of scale that may arise from dollar-ization. Official dollarization in El Salvador andPanama and high dollarization in Nicaraguamay have helped to lower operating and inter-mediation costs regionally. The adoption of of-ficial dollarization by El Salvador in 2001 mayhave helped level the playing field between for-eign banks and regional groups (Figure 2.5).Banks have also become more aggressive in im-plementing cost-cutting strategies, chargingfees for their services, and slowing provisioningto consolidate gains in profitability followingthe initial boost from dollarization;20 and

• existence of Panama as an international finan-cial center. Most regional financial groups haveactive offices in Panama and use an interna-

19

Regional Financial Integration

Figure 2.1. Asset Share of Financial Conglomerates(In percent)

Sources: De Nicoló and others (2003); and Worldscope.

0

20

40

60

80

100

120

2000

1995

Banksworldwide

in the Top 500

Financial institutions in Latin Americain the Top 500

Top 500financial institutions

worldwide

18A review by Fitch concludes among other things that be-cause of “de facto barriers of entry (including corruption, poorcontract enforcement, and weak credit cultures), large interna-tional financial players have, up until now, shown little interestin having a larger and/or retail presence in these countries”(Fitch Ratings, 2004), p. 1.

19Fitch rates the capacity to meet foreign currency commit-ments of Panamanian and Salvadoran banks as BB+ (higher thanBrazil, Ecuador, and Uruguay, lower than Chile and Mexico).

20 Standard & Poor’s (2004).

Figure 2.2. Regional Trade, 1999–2003(In percent)

Source: IMF, International Financial Statistics.

0

5

10

15

20

25

30

35

40

Imports from Central America

Exports to Central America

PanamaNicaraguaHondurasGuatemalaElSalvador

DominicanRepublic

CostaRica


tional license to conduct operations throughoutthe region. Easy access from their home coun-tries provides an opportunity to put in place sig-nificant managerial capacity in Panama (Table2.1). Tax advantages may also be a factor whenthe tax difference is substantial.21

Financial integration in Central America is a pos-itive development because the diversification of op-erations across activities and markets helps to re-duce business risks (those less correlated acrossmarkets). However, financial integration may alsomagnify financial vulnerabilities and requires a con-solidated view of regional financial group operationsto ensure appropriate supervisory oversight.

Need for Consolidated Supervision

The complexity of regional financial groups andcross-border operations of financial institutions poses

20

CONSOLIDATED SUPERVISION OF FINANCIAL GROUPS IN CENTRAL AMERICA

Figure 2.3. ICRG Political Stability Index,March 2004

Source: International Country Risk Guide (ICRG).

50

55

60

65

70

75

80

Braz

il

Mex

ico

Chi

le

Pana

ma

Nic

arag

ua

Hon

dura

s

Gua

tem

ala

ElSa

lvad

or

Dom

inic

anR

epub

lic

Cos

taR

ica

Average:64.25

Average:72.25

Figure 2.4. Central America: Foreign Currency to Total Deposits

Source: Central American Monetary Council (2003).

0

10

20

30

40

50

60

2003200220012000199919981997

Figure 2.5. Private Bank Profitability(Gross profits over operating expenses, in percent)

Source: National authorities.

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

Banks from outside the regionCosta Rican banks

Salvadoran, Nicaraguan, and Panamanian banks

20041999

21Offshore financial transactions that originate in the interna-tional banking center are not subject to income tax in Panama.There are also corporate income tax exemptions on interestearned when borrowed funds are used abroad, even when capitaland interest are repaid in Panama. The local-source-based taxstructure in Panama treats the distribution of dividends from for-eign earnings as not taxable.


challenges for the uniform application of prudentialregulation across countries and sectors. Consolidatedsupervision shows room for improvement in many ju-risdictions worldwide. In particular, consolidation ofaccounts and consolidated monitoring of compliancewith prudential standards, and cooperation betweenhome and host country regulators, are generally inad-equate.22 In Central America, the supervisory author-ities have responded in several ways to the challengeof adapting supervisory methods to consolidated su-pervision. On the whole, however, supervisoryarrangements lag behind the development of cross-border operations by financial groups.

Consolidated supervision should aim at a com-prehensive assessment of the safety and soundnessof financial groups. Effective consolidated supervi-sion, including on a regional basis, may not beachieved unless supervisory authorities have mech-anisms in place to discourage or prevent regulatoryarbitrage, encourage collaboration among supervi-sors within and across borders, respond to emergingproblems in individual banks, and anticipate and/orconfront systemic crises.23 In the case of CentralAmerica, the agenda for putting in place adequatesupervisory and legal tools as well as a politicalcommitment to regulate large financial conglomer-ates, including harmonization of regulation and su-pervision of institutions offering similar products,remains to be completed. An overarching require-ment would be effective coordination and informa-tion sharing among all country regulatory agenciesin the region.

The absence of adequate preconditions and infra-structure for effective banking supervision has also

hindered the development of consolidated supervi-sion of financial institutions in the region. Recentprogress in achieving sound and sustainable macro-economic policies still faces uncertainties, and theregion generally lacks an environment that fostersthe honoring and enforcement of financial con-tracts. Effective market discipline based on trans-parency and corporate governance is a work inprogress. Moreover, problems in terms of opera-tional independence of supervisors and adequate re-sources affect several countries in the region,24 andlegal protection for supervisors is weak or nonexis-tent (Box 2.1). Political difficulties often precludeimplementation of laws and regulations, even whenthe legislation itself is adequate.

Financial ConglomeratesOperating in Central America

Definitions

In Central America, financial groups are gener-ally financial conglomerates dominated by banks. Afinancial conglomerate is a group of companiesunder unified control, primarily engaged in financialservices in at least two of the following areas: bank-ing, insurance, and securities.25 A group is charac-terized by a parent-subsidiary relationship, by a rela-tionship based on a participation, or by a horizontalstructure.26 Some of the groups in Central America

21

Financial Conglomerates Operating in Central America

TABLE 2.1Country Distribution of Assets of Regional Financial Groups(In percent)

Country of Origin Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Total

Costa Rica 81.4 0.0 0.0 0.0 0.0 18.6 100.0El Salvador 4.1 78.4 4.4 1.2 1.3 10.5 100.0Guatemala 0.0 0.0 77.0 0.0 0.0 23.0 100.0Honduras 0.0 0.0 0.0 69.5 0.0 30.5 100.0Nicaragua 17.6 16.1 6.2 11.6 29.4 19.2 100.0Panama 20.6 0.0 0.0 13.0 0.0 66.3 100.0


22See International Monetary Fund (2004a and 2004b).23Majaha-Jartby and Olafsson (2005).

24Basel Committee on Banking Supervision (1997).25This book focuses on financial conglomerates involving at

least one bank.26Gruson (2004).


are parts of larger corporate groups (mixed financialconglomerates).

Among groups with cross-border operations, re-gional financial conglomerates (RFCs) have signifi-cant cross-border activities. Banks with links to otherregional financial institutions (BFIs) have a minor re-gional presence. For purposes of this book, RFCs areclassified by having physical presence in at least twocountries in the region, in addition to the homecountry of shareholders. The RFCs and several BFIsperform some form of accounting consolidation.

A number of banks with common ownership op-erate in different countries in the region but do notconsolidate their operations and thus operate as par-

allel banks. Each parallel bank reports to a differentsupervisor in the region. Other banks run bookingoffices that basically conduct booking operationsnot reported to the home supervisor. Shell banksconstitute an extreme case (Box 2.2). Parallel banksreport to two or more home supervisors, but there isno consolidated supervision of the entire group.

The Basel Committee on Banking Supervisionstrongly discourages allowing operations of parallelbanks, shell banks, and booking offices.27 “Parallel-owned banking structures present greater risk for su-

22


Box 2.1. Status of Legal Protection of Supervisors

There are some provisions in Central America forthe legal protection of supervisors performing their of-ficial duties in good faith. Formal procedures for thecoverage of legal expenses to staff of the superinten-dency deriving from lawsuits initiated in connectionwith actions undertaken in their capacity as financialsystem supervisors and regulators have been estab-lished in Guatemala, Honduras, and Nicaragua. Otherfeatures of legal protection of supervisors in individualcountries are listed here.

Costa Rica: Supervisors are subject to the GeneralLaw of Public Administration, by which all public ser-vants are fully accountable in performing their duties.Thus, there are no provisions on legal protection forsupervisors’ good faith actions. By board resolution,the central bank provides for the coverage of legal ex-penses of supervisors for acts related to the exercise oftheir duties.

El Salvador: The Banking Law (Art. 160) estab-lishes that cases against the directors of the DepositGuarantee Institute (IGD) must be initiated withthe approval of the Supreme Court. It also authorizesthe IGD to provide legal assistance to IGD directorsand ex-directors facing lawsuits associated with theperformance of their duties. The Superintendency of Banks holds an insurance policy to cover legal expenses.

Guatemala: The Financial Supervision Law (Art.15) generally establishes that criminal actions againstthe Superintendent of Banks and other specified offi-cials may be initiated only with the approval of theSupreme Court. Legal expenses for the defense oflegal actions related to the performance of official du-ties are covered by the Superintendency of Banks.

Honduras: Three mechanisms in the banking lawprovide for legal protection of supervisors: (1) no judi-

cial action can be initiated against superintendentsand other officials for decisions adopted according tothe law, without the prior ruling of the administrativecourt; (2) supervisors may request a pre-trial hearingas provided in the Law of Organization and Court At-tributions; and (3) the National Council of BankingSupervision provides legal defense for its staff, whenprosecuted.

Nicaragua: The Superintendency of Banks ap-proved procedures for the coverage of legal expensesto its staff deriving from lawsuits initiated in connec-tion with actions undertaken in the performance oftheir duties. The Law on the Deposit Guarantee Fund(Art. 11) provides that board members and staff of theDeposit Guarantee Fund shall not be sued for actionstaken in the performance of their duties unless an ac-tion has been previously brought against the DepositGuarantee Fund and such action has been decidedagainst the Deposit Guarantee Fund. Recently, theconstitution was modified to grant immunity to thesuperintendent and the deputy superintendent, bywhich no action of any nature can be initiated incourt while they are in office.

Panama: The Banking Law does not provide statu-tory protection for superintendency personnel or anindemnity against expenses of litigation. Decree No.49 of 1998 (issued by the Ministry of Planning andEconomic Policy) establishes that “the actions of thesupervisory personnel of the Superintendency ofBanks undertaken in the discharge of their duties areauthoritative” and a veracity presumption in favor ofthe supervisory personnel as to their declarations,with the burden of proof falling on whoever chal-lenges the supervisors’ decisions. However, it appearsunclear whether this provision would be upheldshould it be reviewed by the courts.

27Basel Committee on Banking Supervision (2003a, 2003b).


pervisors who may be unaware of the nature and ex-tent of any relationships and transactions betweenthe banks that may have an impact on its safety andsoundness. This opaqueness may also provide an in-centive to the controllers to use the banks to pro-vide undisclosed support mechanisms or to mask thetrue risks within the group.”28 This makes it difficultfor a supervisor to apply prudential norms to the do-mestic bank operations, while fully understandingthe impact on the overall financial position of thegroup. In the case of shell banks and booking offices,there is uncertainty as to where mind and manage-ment are located.29

Foreign banks operate as branches or subsidiariesin host countries. A branch is primarily regulated by

the home country supervisor responsible for thelegal entity overall but also monitored in its localoperations by the host country supervisor, while asubsidiary is primarily regulated by the host countrybut subject to additional home country oversight atthe group level. Some of these institutions operateas banks with an international license based inPanama but intermediating resources within andoutside Central America.

Domestic financial institutions operate either asstand-alone firms or as part of domestic financialconglomerates. All countries in the region performconsolidated supervision of domestic financial con-glomerates, albeit with different degrees of effective-ness. A particular case is Banco Nacional de CostaRica, which owns 80 percent of BICSA, a bank op-erating in Panama with a general license.

Mapping of Financial Groups Operating in the Region

Four regional financial conglomerates from ElSalvador, Nicaragua, and Panama operate in Cen-

23


Box 2.2. Institutions Conducting Cross-Border Financial Transactions in Central America

• Branches of foreign banks have an identifiable head office located abroad but donot have a separate legal status, and are thus an integral part of the foreign parentbank. Reportedly, some foreign banks operate regionally from branches located inone particular Central American country (Panama, Honduras). These banks arenormally institutions of sound reputation (for example, Citibank, HSBC).

• Subsidiaries of foreign banks are legally independent institutions that are incor-porated under the law of the host country. Operations are consolidated in the cor-responding parent company’s home country. Three Salvadoran banks and oneNicaraguan bank operate through subsidiaries or affiliates (local banks in whichthey have purchased a majority share) in other Central American countries.

• Parallel banks are banks licensed in different jurisdictions that, while not beingrecognized as part of the same financial group for regulatory consolidation pur-poses, have the same beneficial owners and consequently often share commonlymanaged and interlinked business.

• Booking offices normally provide only basic administrative services to a bank or anumber of banks in a jurisdiction where the bank has no meaningful mind andmanagement. Usually, no local operations are originated in the branch. Thesebranches are normally domiciled in an offshore financial center.

• Shell banks are banks that have no physical presence in the country where theyare incorporated and licensed, and are not affiliated with any financial servicesgroup that is subject to effective consolidated supervision. The mind and manage-ment are located in another jurisdiction, often in the offices of an associated entityor sometimes in a private residence.

28Basel Committee on Banking Supervision (2003a), p. 5,“Controllers” refer to the persons in control of the bank.

29The Basel Committee on Banking Supervision defines“meaningful mind and management” located within a jurisdic-tion as “physical presence.” The existence simply of a local agentor a low-level staff will not constitute physical presence. Man-agement is used to include administration, that is, books andrecords. See Basel Committee on Banking Supervision (2003b).


24


TABLE 2.2Banks Operating in the Region

Country of Physical Country ofOrigin1 Presence Group Origin1

Regional financial groups Domestic banksRegional financial conglomerates Private banksAgrícola El Salvador El Salvador Agrícola Salvadoreño El SalvadorAgrícola El Salvador Panama Agrícola Industrial GuatemalaCaley El Salvador Nicaragua Agrícola Comercio El SalvadorCuscatlán El Salvador El Salvador Cuscatlán Del Café GuatemalaCuscatlán G El Salvador Guatemala Cuscatlán De Desarrollo Rural GuatemalaCuscatlán CR El Salvador Costa Rica Cuscatlán Ficohsa HondurasLloyds (Cuscatlán) El Salvador Honduras Cuscatlán BAMER HondurasCuscatlán P (Lloyds) El Salvador Panama Cuscatlán Bancredito Costa RicaBAC San Jose Nicaragua Costa Rica BAC Agromercantil GuatemalaBAC ES Nicaragua El Salvador BAC BANPAIS HondurasBAC G Nicaragua Guatemala BAC De Occidente GuatemalaBAC H Nicaragua Honduras BAC Reformador GuatemalaBAC N Nicaragua Nicaragua BAC Credito Hipotecario Nacional GuatemalaBAC International Bank Nicaragua Panama BAC De Exportacion GuatemalaPrimer Banco del Istmo Panama Nicaragua Banistmo Internacional GuatemalaPrimer Banco del Istmo Panama Panama Banistmo Banco General PanamaBGA Panama Honduras Banistmo Banco Continental PanamaBANEX Costa Rica Costa Rica Banistmo Improsa Costa RicaBANEX Costa Rica Guatemala Banistmo Del Quetzal GuatemalaBANEX Costa Rica Panama Banistmo BANCON Honduras

Banhcafe HondurasParallel-bank-based groups De Comercio GuatemalaBANCENTRO Nicaragua Nicaragua Lafise Ficensa HondurasLafise Nicaragua Costa Rica Lafise Procredit El SalvadorFuturo Nicaragua Honduras Lafise Bancotrab HondurasPromérica ES Nicaragua El Salvador Promérica Americano El SalvadorPromérica CR Nicaragua El Salvador Promérica Inmobiliario GuatemalaPromérica H Nicaragua Honduras Promérica Corporativo GuatemalaBanpro Nicaragua Nicaragua Promérica De la Republia GuatemalaSt. Georges Bank and Company Nicaragua Panama Promérica SCI GuatemalaUNO CR Nicaragua Costa Rica UNO Promotor GuatemalaUNO ES Nicaragua El Salvador UNO de Antigua GuatemalaUNO H Nicaragua Honduras UNO Privado para el Desarrollo GuatemalaUNO N Nicaragua Nicaragua UNO Vivibanco GuatemalaUNO P Nicaragua Panama UNO Americano GuatemalaUNO G Nicaragua Guatemala UNO Metropolitano Guatemala

Empresarial GuatemalaBanks with links to other financial institutions Comercial El SalvadorBDF Nicaragua Nicaragua BDF Bancatlán HondurasBDF Nicaragua Panama BDF Multicredit Bank PanamaBCT Costa Rica Costa Rica Banco Atlantico PanamaCathay Costa Rica Costa Rica Banco Aliado PanamaInterfin Costa Rica Costa Rica Interfin Towerbank PanamaG&T Continental Guatemala Guatemala GTC Banco Aleman Platina PanamaGTC Bank Guatemala Panama Banco Transatlantico PanamaDe Occidente (BANCOCCI) Honduras Honduras De Occidente Banco Panameño de la Vivienda PanamaDe Occidente Panama Honduras Panama Banco Universal PanamaPopular Bank Dominican Rep. Panama Banco del Pacifico EcuadorBCT Bank International Costa Rica Panama Metrobank PanamaCathay International Bank China Panama Blubank Panama

Mibanco Panama

Foreign banks Public banksScotiabank ES Canada El Salvador Nacional Costa RicaScotiabank CR Canada Costa Rica BICSA Costa RicaNova Scotia Canada Panama BICSA PanamaCitibank U.S. El Salvador Costa Rica Costa RicaCitibank U.S. Guatemala Popular y Desarrollo Comunal Costa RicaCitibank U.S. Costa Rica Hipotecario El SalvadorUnibanca R.B. de Venezuela Panama Hipotecario de Vivienda Costa RicaBanco del Centro R.B. de Venezuela Panama Banco Nacional de Panama PanamaBanco de Bogota (general license) Colombia Panama Caja de Ahorros PanamaHonduras U.S. Honduras Citibank De Fomento El Salvador

De los Trabajadores Guatemala

Sources: National superintendencies.1Country of origin is the one where the principal shareholders’ mind and management reside.


tral America (Table 2.2).30 They all hold an inter-national license to operate from Panama, wherethey consolidate operations. RFCs operate as agroup mostly within the region using holding com-panies. Nicaraguan and Panamanian groups havesignificant operations in Panama, while Salvadoranbanks have a more limited presence in Panama andhave established separate conglomerate structures invarious countries. RFCs actively pursue benefitsfrom economies of scale and risk diversification.RFCs exploit economic linkages among countries inthe region and generally conduct financial interme-diation in foreign currency, reflecting the fact thattheir countries of origin are dollarized or quasi-dollarized economies.

Three Nicaraguan groups are parallel-bank based.31

One group has been in contact with the Interna-tional Finance Corporation to pursue a capital injec-tion conditional on consolidation of operations oftheir different units. Another group perceives thatoperations by individual banks are sufficiently iso-lated, and that consolidation is not justified. Appar-ent concerns about political uncertainty in the homecountry of shareholders of parallel-bank-based re-gional groups partly explain their reluctance to con-solidate despite a relatively well-established reputa-tion as de facto financial groups in the region.Specifically, these groups argue that ongoing difficul-ties in the political arena and weaknesses in the insti-tutional and legal framework in Nicaragua entail risksthat are difficult to prevent under arrangements in-volving consolidation.

Seven banks have links with other financial insti-tutions in the region. Some of these institutions arecalled “offshore banks”—in practice, they are book-ing offices originally created to circumvent limita-tions to operate with sight deposits and/or foreigncurrency (Costa Rica and Guatemala). Other book-ing offices operate abroad to accommodate specificinterests of their customers. Supervisory authoritiesare in the process of gathering information fromthese institutions when they are part of regionalgroups.

Banks that do not consolidate can facilitate regu-latory arbitrage. Many booking offices are estab-lished outside of the region. Uncertainties about thepermanence of financial deregulation policies intheir home countries may explain why these struc-tures continue despite such deregulation. In CostaRica, the continued presence of banks with limitedphysical operations outside the country appears tobe related to the dominance in the domestic finan-cial system of public banks benefiting from preferen-tial treatment by the government relative to privatefinancial institutions.32

Few foreign banks have operations in CentralAmerica. Citibank and the Bank of Nova Scotia(United States and Canada, respectively) operate indifferent countries in the region. There are 30 otherforeign banks and several Panamanian banks oper-ating from Panama with an international licensegranted by Panama. Some of these Panamanianbanks have representation offices in the region(Table 2.2).

Regional Financial Indicators

Regional financial groups account for about one-third of assets and deposits of the regional bankingsystem, of which regional financial conglomerateshold about 22 percent of total loans and deposits.Parallel banks and regional financial institutionscombined hold about 10–13 percent of the systemin terms of assets, loans, deposits, and equity (Table2.3).33

Foreign banks, excluding banks operating fromPanama with an international license, representonly about 3 percent of the system. The share ofbanks with an international license not belongingto RFCs is between 10 and 15 percent for differentfinancial aggregates. Many of these banks’ opera-tions are with countries outside Central America.34

Domestic banks account for about half of the re-gional financial system. Private banks hold aboutone-third of different financial aggregates, similar tothe share of regional financial groups. Public banks

25


30Only financial institutions owned by shareholders domiciledin the region are analyzed in this section; subsidiaries of foreignbanks are not included.

31The Panamanian Primer Banco del Itsmo recently started toexpand operations in the region, and has already obtained a li-cense to operate in Nicaragua. This study does not deal withfraudulent parallel booking of the type uncovered during the2001–02 banking crisis in the Dominican Republic.

32Public banks benefit from a blanket government guarantee,monopoly in the attention of government agencies as cus-tomers, and exemption from a 17 percent required reserve onsight deposits.

33Financial information was aggregated using individual bankdata because consolidated financial statements are not availablefor all groups.

34As of September 2004, about 21 percent of assets in the in-ternational banking center were outside Latin America.


account for about 18 percent of the assets of the re-gional financial system, mostly reflecting the pre-dominance of public banks in Costa Rica.

Regional financial conglomerates have highercapitalization than parallel banks and regional fi-nancial institutions. Profitability, as measured by thereturn on assets, also appears higher for RFCs rela-tive to other groups. Higher capital and profitabilityof RFCs seems to reflect their success in servicingprime customers. Foreign banks show somewhatlower profitability, which may be partly related tomore strict accounting required by parent offices(for example, stricter provisioning) (Table 2.4).35

Foreign banks’ low share of the market is partly off-set by offshore operations. Lending by foreign banks,including entities located in financial hubs outsidethe region (Miami), has increased by 40–100 percentduring the period 1998–2003 in each individualcountry. Loans by foreign banks operating in financialhubs, mostly to prime customers, are equivalent tomore than twice the magnitude of loans from foreignbank offices in the region (Figure 2.6).36

26


TABLE 2.3Market Share by Bank Category, June 2004

Assets Loans Deposits Equity___________________ ___________________ ___________________ ___________________US$ billion Percent US$ billion Percent US$ billion Percent US$ billion Percent

Regional financial groups 22.6 33.0 11.4 32.1 15.3 31.9 2.3 32.2Regional financial conglomerates

(RFCs) 14.8 21.6 8.0 22.4 9.2 19.3 1.7 23.8Other 7.9 11.5 3.4 9.6 6.1 12.7 0.6 8.4

Banks with foreign ownership 12.1 17.7 6.1 17.2 9.3 19.4 1.2 16.7

Domestic banks 33.7 49.2 18.1 50.7 23.4 48.7 3.7 51.1Domestic private banks 21.7 31.6 12.6 35.3 14.5 30.2 2.2 30.8Public banks 12.1 17.6 5.5 15.4 8.9 18.5 1.5 20.2

Total 68.5 100.0 35.7 100.0 48.0 100.0 7.2 100.0


36“International players have found it better to serve the largerregional corporates from financial hubs in other latitudes, mainlyMiami. Some of the main foreign players providing cross-borderlending to Central American corporates are Citibank, Wa-chovia, International Bank of Miami, Scotiabank, DresdnerBank Latein Amerika and Barclays Bank” (Fitch Ratings, 2004),p. 5.

TABLE 2.4Selected Financial Ratios, June 2004(In percent)

Loan/ Loan/ Equity/Assets Deposits Assets ROE ROA

Regional financial groups 50.5 74.6 10.3 . . . . . .Regional financial conglomerates 54.0 86.5 11.6 19.2 2.2Parallel-bank-based groups 49.4 64.1 8.7 17.7 1.5Banks with links to other regional financial institutions 39.9 51.4 7.2 20.9 1.5

Foreign banks 51.8 75.3 12.4 11.1 1.4

Domestic banks 53.6 77.4 11.0 . . . . . .Domestic private banks 58.1 87.0 10.3 16.9 1.7Public banks 45.6 61.8 12.1 15.1 1.8

Sources: Individual banks; and IMF staff calculations.Note: ROE = return on equity. ROA = return on assets.

35Data processed using the format required for this study wasonly available for the period above indicated. To that extent,conclusions based on this information are tentative at this stage.


A trend toward consolidation is observed in the re-gional financial system. Between 1998 and 2003, 24banks were closed and 31 mergers took place, morethan offsetting the number of new banks (8 banksstarted operations in the region in the same period).37

Total bank assets expressed in U.S. dollars increasedby 38 percent between 1998 and 2002 for CentralAmerican countries (excluding Panama, which expe-rienced a slight decline). Concentration in the re-gion, as measured by the share of assets of the fivelargest banks increased to 73 percent in 2002. At thecountry level, this phenomenon is observed in allcountries except Costa Rica, with Nicaragua showingthe highest concentration (96 percent). Banks main-tain a dominant position in the region with 90 per-cent of financial sector assets.

Regional financial groups have increased theirshare in regional financial markets (see Figure1.3).38 In addition to the expansion of Salvadoranand Nicaraguan groups, Primer Banco del Istmo(Panama) has participation in Honduras and CostaRica, and Cuscatlán (El Salvador) acquired the re-gional banks formerly owned by the British bank,Lloyds. Banks belonging to regional groups acquiredselected assets of failed banks, including through

cross-border acquisitions: Banex (Panama) in CostaRica absorbed four banks between 1998 and 2001;Lafisse and Promérica (Nicaragua) absorbed assetsand liabilities from failed banks in Nicaragua and ElSalvador; and Cuscatlán and Agrícola (both El Sal-vador) from failed banks in Costa Rica andGuatemala. Banks belonging to regional financialgroups are dominant among private banks in CostaRica, El Salvador, and Nicaragua.

Regional Financial Groups: Risks and Regulatory Responses

Main Risks

Inflated Capital

Capital may be inflated for regional financialgroups, despite being apparently sufficient on a solobasis. For a financial conglomerate, capital must beadequate both on a group or consolidated level andon a single-entity solo level. Proper monitoring iscomplicated by differences in the definitions and cal-culations of both actual and required capital acrossborders, differences in accounting standards, and lackof proper financial and auditing consolidation. Also,capital adequacy requirements are not comparablebecause of differences in the measurement of both thenumerator (capital) and the denominator (risk-weighted assets) in individual countries. Minimumcapital adequacy requirements are set at 10 percent inall countries except El Salvador and Panama (12 per-cent and 8 percent, respectively), and compliance isgenerally good. Actual capital-to-asset ratios (i.e.,without risk weights) vary, with Guatemala showinga ratio below 8 percent; Costa Rica, Honduras, andNicaragua between 8 and 10 percent; and El Salvadorand Panama above 10 percent (Figure 2.7).

Inappropriate recording of intragroup transactionsmay also inflate capital. These transactions couldhide the overall risk exposure of individual entitiesand/or their corresponding groups. Problems associ-ated with intragroup transactions include (1) capitalor income may be inappropriately transferred from aregulated entity; (2) the terms of the transfer may bedisadvantageous to a regulated entity; (3) there maybe a negative impact on solvency, liquidity, and/orprofitability of individual entities; or (4) regulatoryrequirements may be circumvented.39 Transfers of de-

27


37Central American Monetary Council (2003).38Barraza (2003).

Figure 2.6.Total Loans, June 2004(In billions of U.S. dollars)


0

2

4

6

8

10

12

14

Foreign bankslending from abroad

Foreign banksin the region

Regional financialconglomerates

39Gruson (2004).


posits and loans (including asset dumping offshore)among banks belonging to the same group to boostcapital artificially have been particularly problematic.Other areas of concern have been the emergence ofoutsourcing contracts with related institutions whosepricing is difficult to test against the market, and theuse of credit by shareholders to inject capital into re-lated financial institutions, which facilitates doublegearing. Double (or multiple) gearing occurs whenone entity holds regulatory capital issued by anotherentity within the same group and the issuer is allowedto count the capital in its own balance sheet.

Contagion Risks

The intricate nature of cross-border operationsmakes the Central American financial system sus-ceptible to contagion (Table 2.5). Cross-bordertransfer of deposits may magnify liquidity risk.While the availability of intragroup financing mayhelp overcome temporary liquidity problems, even-tual solvency problems of a troubled institution maylead to intragroup contagion to liquidity providers.Contagion may take place within the group (if trou-bled members of a conglomerate “infect” healthymembers of a conglomerate in another jurisdiction),both within and across borders; and among unre-lated institutions within a country (if perception ofsystemic problems is augmented by cross-borderrisks).

Opportunities for Regulatory Arbitrage

Credit risk concentration, related in part to con-centration of wealth, has been a problem in the re-gion. Cross-border financial intermediation furthercomplicates adequate monitoring of credit risk. Cor-porate groups may become “too large” relative to do-mestic financial institutions, making it attractive forboth financial institutions and corporate groups touse different regional institutions to conduct busi-ness between them.40

Regulation of large credit exposures is uneven inCentral America. El Salvador imposes the moststringent regulations overall, with Guatemala andHonduras allowing wider room for lending to groups,presumably because their economies also show theleast diversification. On lending to related parties,demand for financing by groups operating as mixedconglomerates tends to be attended first by thegroup, because lack of capital market developmentencourages reinvestment as a source of financing.Regulations on related party lending also vary widelyacross the region—El Salvador and Panama havingfar more strict requirements than neighboring coun-tries. At the other end of the spectrum, Guatemalaand Honduras lack an aggregate limit for overalllending to related parties (Table 2.6).

Bad loans from a stricter jurisdiction could be soldto a less strict jurisdiction before recovery problemsare detected, increasing the underlying gap betweenreported and actual credit risk for the group. Risksmay be compounded as Central American countrieshave different requirements for the sale of loan port-folio bundles.

Differences in loan classification and provisioningcould also lead to regulatory arbitrage (Table 2.7). Afinancial group may take advantage of differences inthe treatment of collateral for loan classificationpurposes, and it may record loans in a locationwhere more favorable treatment is available. CostaRica, El Salvador, and Nicaragua link loan classifi-cation to the quality of collateral. Also, differencesin the minimum arrears period to reclassify a loanmay provide incentives for regulatory arbitrage. Pro-visioning requirements also vary: for example, ElSalvador and Nicaragua require more severe provi-sioning adjustments in the transition between the

28


Figure 2.7. Capital Ratios, December 2004


0

2

4

6

8

10

12

14

16

18

Capital-asset ratioCapital adequacy ratioCapital adequacy requirement


40 “Some of the hurdles that will have to be addressed . . . arethe existence of corporate/financial groups, where the corporatecomponent may be even more sizable than the financial portion”(Fitch Ratings, 2004, p. 8).


29

Reg

ional Financial G

roup

s: Risks and

Reg

ulatory R

espo

nses

TABLE 2.5Central America and Dominican Republic: Regional Financial Links, June 2004

Destination__________________________________________________________________________________________________________________________Dominican

Origin Costa Rica Republic El Salvador Guatemala Honduras Nicaragua Panama United States Other

Costa Rica BCT Improsa, InterfinInterfin (Bahamas), Banex

(Cayman Islands)

Dominican Republic 8 domestic banks Banco Popular

El Salvador Cuscatlán Agrícola, Cuscatlán Cuscatlán Caley Agrícola, Agrícola, Cuscatlán Cuscatlán, (Agrícola) Cuzcatlán Cuzcatlán (through Salvadoreño (international (remittances) Guatemala):

license) Montserrat,Western Indies

Guatemala 22 domestic GTC 8 offices in banks Bahamas, Puerto

Rico, Belize,Barbados

Honduras 10 domestic Banco de banks Occidente

Nicaragua BAC share in Promerica BAC, UNO, BAC, UNO BAC, UNO, BAC, UNO, BAC, UNO, BAC Florida BAC (Cayman Banco de San Promerica, Promerica Banpro, BDF, St. Georges Islands)José, UNO, Americano Bancentro (Promerica),Promerica, BDFLafise

Other Cathay Republic Bank Nova Scotia Internacional Procredit International (Taiwan), (Trinidad & from Canada (Spain) (ONG-owned) Financial Scotiabank Tobago) owns (acquiring Center, BLADEX(Canada) Banco Mercantil, Comercio), (shares from

Sabadel (Spain) Procredit BAC San Jose,and Popular (ONG-owned) Interfin, and BCT)(Puerto Rico) own shares of BHD

Sources: National superintendencies.


first and the second loan categories relative to othercountries in the region.

Unregulated Risks

Regional financial groups are exposed to sover-eign risk. In all jurisdictions within the region,

government bonds are subject to zero risk-weight,based on the argument that sovereign risk consti-tutes the benchmark for local securities (Figure2.8). Clearly, capital adequacy is overestimated be-cause not all countries are exposed to the same de-gree of government default risk. However, settingdifferential risk weights across countries would not

30


TABLE 2.6Regulations on Loan Concentration and Related Lending

Limits on Loan Concentration and Related Lending_______________________________________________________________________________________One borrower Groups Related lending

Costa Rica 20 percent of capital 20 percent of capital 20 percent of capital for financialgroups.Aggregate limit of up to 20 percent of capital

El Salvador 15 percent of capital (additional 15 percent of capital (additional Aggregate limit: 5 percent10 percent with real guarantees) 10 percent with real guarantees)

Guatemala 15 percent of capital 30 percent of capital Individual and group limit applies. Noaggregate limit

Honduras 20 percent of capital (50 percent 20 percent of capital (50 percent 30 percent of capitalwith real guarantees) with real guarantees)

Nicaragua 30 percent of capital 30 percent of capital 15 percent for individual, 25 percentfor group, 60 percent aggregate limit

Panama (regulations 25 percent of capital 25 percent of capital 5 percent of capital (10 percent with apply to banks with real guarantees). Aggregate limit:general license) 50 percent (25 percent in 2005)

Sources: Central American Monetary Council; and national superintendencies.

TABLE 2.7Regulations on Loan Classification and Provisioning

Length of Arrears for Provisioning for Second Best andIntermediate Loan Category Second Worst Loan Category Treatment of

(In days) (In percent) Collateral on Provisioning

Costa Rica 90–120 1, 60 (30 for Collateral helps classification in somemortgage loans) categories.

El Salvador 90–180 (60–90 for 6, 60 Collateral helps classification in consumer loans) some categories.

Guatemala 90–180 (60–120 for 5, 50 Provision net of collateral.microlending)

Honduras 61–90 (91–120 for 1.6, 36 (gradual Collateral not used for classification consumer loans) increase) or deducted for provisioning.

Nicaragua 60–90 (91–180 for 5, 50 Collateral helps classification inmortgage loans, some categories.31–60 for microlending)

Panama 60–90 (90–120 for 2, 50 Provision of loans net of “expected mortgage loans) recovery.”

Sources: National superintendencies.


be easy, because any official validation of a differ-ential risk may result in volatility in the market forgovernment bonds, especially for less-developedand illiquid markets. For groups that are not sub-ject to consolidated supervision, dependency of thegovernment budget on bank financing may createpressure to maintain the status quo not only in reg-ulation of sovereign risk but also in other areas (in-cluding consolidated supervision). For financialconglomerates that are subject to consolidated su-pervision, the question to be addressed is the ap-propriate valuation of a regional government bondportfolio.

Currency mismatches could be compounded bycross-border operations. Most loans in foreign cur-rency are to the nontradable sector, even ineconomies that are not fully dollarized (Figure2.9). In the case of regional financial groups, trans-fer of loans and deposits across borders may lead toimbalances in the foreign currency position of in-dividual banks. Financial groups may have an evenhigher incentive than domestic financial institu-tions to lend to unhedged borrowers to keep a bal-anced foreign exchange position. Competition toretain prime customers may also drive domestic financial institutions to offer similar alternatives to those offered by regional groups and foreignbanks.

Regulatory Responses

Supervisory authorities have put in practice regu-latory responses at the individual country and re-gional levels. They have attempted to combine thesupervision of domestic conglomerates and of cross-border financial intermediation, and in severalcountries financial legislation has been modified re-cently to that effect. For countries dealing with par-allel banks (notably, Nicaragua), ring fences arebeing used (more strict prudential regulation for en-tities belonging to a group and not submitting con-solidated financial statements to supervisory author-ities). At the regional level, memoranda ofunderstanding and regional plans within the Cen-tral American Council of Superintendents of Banks,Insurance, and Other Financial Institutions have

31


Figure 2.8. Share of Government Bonds inBank Assets, 2003(In percent)


0

5

10

15

20

25

30

35


Figure 2.9. Foreign Currency Lending toNontradable Sector(In percent)

Sources: Central American Monetary Council (2004); Alvarez (2003); and IMF staff calculations.

0

10

20

30

40

50

60

70

80

90

100

Foreign currency loans to nontradable sectorTotal Foreign currency loans

NicaraguaHondurasGuatemalaCosta Rica

Share of Foreign Currency Loans to Total Loans, 2002

0

10

20

30

40

50

60

70

20021998

NicaraguaHondurasGuatemalaCosta Rica

Share of Foreign Currency Loans to Nontradable Sector


been the main instruments utilized by country su-pervisory authorities in the region.

Individual Country Initiatives

Combining supervision of domestic financialconglomerates and of cross-border financialintermediation

Attempts to incorporate institutions operatingabroad into the same supervisory platform as domes-tic financial conglomerates have proven difficult.The first hurdle to overcome has been adapting thelegal framework for financial activities to allow forconsolidated supervision. Legislation in Costa Ricaand Panama includes long-standing provisions forconsolidated supervision, but only Panama has beenable to effectively implement to some extent supervi-sion of domestic financial conglomerates and of cross-border intermediation (Box 2.3). El Salvador ap-proved amendments to its banking law in 2002,defining “financial conglomerates” and providing fortheir supervision on a consolidated basis. However,the Salvadoran superintendency has not conductedsupervision of cross-border financial activities be-cause the two Salvadoran regional financial con-glomerates consolidate their international operationsin Panama. Guatemala and Honduras recently ap-proved modifications to the legal framework, and theprocess of implementation is under way. Changes inthe legal framework for financial activities are stillpending approval by congress in Nicaragua, wherethe supervisory authority has relied on miscellaneouslegal provisions and ring fences to control cross-bor-der transactions within financial groups (Box 2.4).41

The main problems with the legal framework foreffective consolidated supervision include the lackof a clear definition of a financial group in somecountries and the lack of enforcement of legal pow-ers to regulate financial groups to the extent neces-sary to ensure effective monitoring. Heterogeneousand unclear definitions across countries often lack astructure that would allow for clear parameters toconduct consolidated supervision. Weak legal pow-ers of supervisors to regulate financial groups pre-vent imposing effective limits on intragroup opera-tions or requiring corrective actions when dubious

transactions are observed. Implementation of legalrequirements is also made difficult by the limitedexchange of information, with critical sensitive in-formation not being shared among supervisors inthe region. In some cases, secrecy laws pose obsta-cles to effective exchange of information betweensupervisors.

El Salvador has attempted to incorporate non-bank financial institutions and cross-border activi-ties into the scope of consolidated supervision.However, as mentioned, Salvadoran conglomeratesconsolidate in Panama, and it was not possible totest the effectiveness of the legal framework pro-viding for consolidation of cross-border activities.Other difficulties faced by Salvadoran supervisorswere the evolving organization structures of cur-rent financial conglomerates and the exclusion ofcompanies such as instrumental companies andfiduciary trusts from the scope of supervision.

Ring fences

In light of the importance of cross-border opera-tions by parallel-bank-based groups of Nicaraguanorigin, the Nicaraguan superintendency has put inplace ring fences to limit opportunities to circum-vent regulation. This is consistent with Basel crite-ria. According to the Basel Committee on BankingSupervision, “where the supervisor of a parallel bankconcludes that there is inadequate access to infor-mation about material parts of the parallel-ownedbanking structure, and cooperation with the foreignsupervisor will not sufficiently mitigate the risk ofthe parallel bank structure, it should seek to ring-fence the operations of the domestic bank.”42 Con-sistent with this, the Nicaraguan superintendencyissued regulations including limits to investment infinancial institutions and special accounting rules;adaptation to the regulation on capital adequacy(for example, higher risk weights for some invest-ment categories); regulation on deposits and invest-ments; 100 percent provisioning on sales of loan-portfolio bundles; and restrictions in the use of acommon name. However, implementation of ring-fence-type measures has faced difficulties in practiceand does not provide an adequate alternative toconsolidated supervision, because it does not allowan overall assessment of vulnerabilities. Recent at-tempts to expand powers of the superintendency

32


41Although nonbank financial institutions are generally of nosystemic importance, there is experience in the region of crisisepisodes associated with them. In Costa Rica, inappropriaterecording of security transactions masked the failure of BancoAnglo in 1994. 42Basel Committee on Banking Supervision (2003a), p. 6.


based on ring fences have been subject to injunc-tions in the courts. While the efforts of the superin-tendency are commendable in the adverse circum-stances they face, prospects for further progress usingthis strategy appear limited. “It is not feasible orpractical to require any supervisor acting alone togather the necessary supervisory information on allrelated foreign parallel banks in the group, espe-cially if parts of the organization structure in foreigncountries are opaque.”43

Gradual absorption of booking offices into the scope of consolidated supervision

There has been some progress in the provision ofinformation from booking offices operating abroadthat are part of regional financial groups. In CostaRica, some information is available for the 7 (outof 14) private financial groups that have officesabroad. However, financial groups have been un-willing to allow full access to their subsidiaries’ ac-counts. The memoranda of understanding signedwith supervisory authorities where these sub-sidiaries operate have not allowed the verification

33


Box 2.3. Consolidated Supervision of Regional Financial Conglomerates in Panama

Several of Central America’s largest regional finan-cial groups have elected to consolidate their bankingactivities in Panama, and this has presented chal-lenges for implementation of consolidated supervi-sion. The attraction to consolidate operations inPanama largely results from the advantages of operat-ing in an international banking center and from mar-ket factors. The prospect of more favorable interna-tional recognition and Panama’s fully dollarizedeconomy and open capital account have attracted foreign-owned banks that offer integrated domesticand international financial services, which may beconvenient for cross-border transactions of regionalfinancial groups. Moreover, several of the domesticbanks are recognized as among the strongest in Cen-tral America; three banks have achieved an invest-ment grade rating from global rating agencies.

Legal and regulatory factors also explain consolida-tion of activities in Panama. New banking legisla-tion in 1998 established the Superintendency ofBanks as an autonomous regulator, independentfrom the government and with sufficient resources tofinance its activities. Key features of the legal andregulatory framework that support consolidated su-pervision are requirements for (1) consolidated supervision in law and regulation and (2) accountingand auditing standards and financial reporting. How-ever, it must be noted that according to Panamanianlegislation, banks with an international banking license are not subject to several prudential require-ments applicable to banks with a general banking license.

The Superintendent of Banks is able to superviseeconomic groups and their bank and nonbank affili-ates on a consolidated basis, though with some limita-tions. There is robust authority for the supervision ofdomestic banks and their subsidiaries (both domesticand foreign), which include the power to carry out di-

rect on-site inspections. However, for holding compa-nies and other nonbank entities, the Superintendent’spowers are limited to requiring audited financial state-ments and other reporting information from nonbankaffiliates of economic groups. The Superintendent hascarried out inspections of the domestic nonbankingsubsidiaries and some foreign subsidiaries of Panaman-ian banks.

Other powers of the Superintendent of Banks in-clude the ability to impose restrictions on the transac-tions between the domestic bank and the holdingcompany and other affiliates. To facilitate the cross-border supervision, the Superintendent of Banks hasin place numerous memoranda of understanding(MOUs) for cooperation with foreign supervisors, es-tablishing the working arrangements on the use ofshared information.

Accounting requirements apply to both the generaland international license banks and their economicgroups. For financial reporting purposes, the Superin-tendency of Banks requires that economic groups filefinancial information using International AccountingStandards (IAS) as issued by the International Ac-counting Standards Committee, or Generally Ac-cepted Accounting Principles (GAAP) as issued bythe U.S. Financial Accounting Standards Board. Fi-nancial statements are to be prepared on a consoli-dated basis requiring the combination of balancesheet and income statement accounts for subsidiariesand the holding company, with the elimination of in-tercompany balances and transactions. Consolidatedaccounting is necessary to provide a true and fair viewof risk concentrations, transactions with affiliates, andcapital adequacy. Most importantly, the IAS/GAAPaccounting requirement serves investors and othermarket participants, which is an important factor rec-ognized by regional financial groups for consolidatingtheir operations in Panama.

43Basel Committee on Banking Supervision (2003a), p. 2.


of consolidated information. Reluctance to reportcontinues despite higher capital adequacy require-ments (20 percent for nonreporting groups and 10percent for groups allowing full access). Private fi-

nancial groups allege that their behavior aims atmitigating the significant dominance of publicbanks, which results in the lack of a level playingfield. While public banks benefit from a blanket

34


Box 2.4. Comparison of Legislation on Consolidated Supervision in Central America

In Costa Rica, the National Council for FinancialSystem Supervision (CONASSIF) regulates the trans-fer, registration, and functioning of financial groups, in-cluding limits on lending or borrowing operations be-tween institutions belonging to the same group. TheCONASSIF oversees the General Superintendency ofFinancial Institutions (SUGEF), an arm of the centralbank that supervises banks, nonbank financial institu-tions, savings and loan mutual associations, savings andcredit cooperatives, and solidarity associations. Finan-cial groups are defined as entities subject to joint con-trol or joint management. They comprise holding com-panies and firms engaging in the provision of financialservices, such as banks, nonbank financial institutions,bonded warehouses, stockbrokers, investment compa-nies, financial leasing firms, and banks or financialcompanies domiciled abroad. The Superintendent maydetermine the existence of a de facto financial groupand must be notified of significant changes in “owner-ship interest.” While there is no explicit instruction forconsolidated supervision, provision is made for consoli-dated reporting by financial groups. For the purposes oflarge exposure and related-party lending limits, opera-tions of group members are consolidated. The require-ment for external audits includes audits on a consoli-dated basis. For banks or financial firms operatingabroad, SUGEF must assess whether there is sufficientsupervision exercised by the host country supervisor.There are no provisions for on-site inspections bySUGEF of entities domiciled abroad.

In El Salvador, financial conglomerates are expresslysubject to approval and consolidated supervision by theFinancial System Superintendency (SSF). Financialconglomerates consist of companies where more than50 percent of the respective stock is held by a holdingcompany. They must include one bank and may incor-porate insurance companies, pension fund manage-ment institutions, brokerage firms, companies special-ized in the deposit and custody of securities, credit cardissuers, foreign exchange houses, financial leasing com-panies, and bonded warehouses. Financial conglomer-ates can also include foreign banks, where at least 45percent of the stock the holding company owns and ex-ercises control of the bank. There is a presumption of afinancial conglomerate based on a determination ofcommon control, but this presumption can be con-tested. The SSF has access to all information of allmembers of the financial conglomerate needed to con-duct consolidated supervision. Financial conglomerates

must satisfy total capital requirements on a consoli-dated basis, but there is no explicit requirement toapply large exposure and related-party lending limits ona consolidated basis. For banks that are not part of a fi-nancial conglomerate, consolidated supervision is ap-plied to banking subsidiaries, including requiring con-solidated financial statements and adherence toprudential requirements. Banks may conduct financialoperations abroad through branches and subsidiaries,provided there is prudent regulation and supervision inthe host country and the SSF has given prior authoriza-tion. Foreign subsidiaries of a financial conglomerateare subject to the supervision of the SSF and examina-tion by independent auditors of the parent bank, with-out prejudice to the powers of foreign authorities.

In Guatemala, the Superintendency of Banks (SB) isgranted broad powers for the exercise of supervisionover banks and other financial service providers, in-cluding on a consolidated basis. A financial group is de-fined broadly as “two or more legal entities engaging inactivities of a financial nature, one of which shall be abank, when there is common control of such entitiesbased on ownership, management, or use of corporateimage.” A holding company or a bank may head the fi-nancial group. Only specified entities, such as banks, fi-nance companies, exchange brokerages, bonded ware-houses, insurance companies, surety companies, creditcard companies, financial leasing companies, factoringcompanies, securities brokerages, local or offshore enti-ties, and other entities determined by the MonetaryBoard as well as support service providers, such as auto-mated tellers or electronic data processing providers,are eligible to form part of a financial group. The SBmay presume common control, but its presumptionsmay be challenged. The financial statements of thecompanies comprising the financial group must be pre-pared on a consolidated basis. The law explicitly statesthat companies comprising the financial group shallmaintain required capital on a solo and consolidatedbasis, and prudential requirements may be applied tosuch entities on a solo and consolidated basis. The SBis empowered to request information from entities in afinancial group as needed and to carry out on-site ex-aminations while safeguarding the identity of deposi-tors. Banks may establish branches abroad, providedthat the host country exercises supervision in a mannerthat allows for the exercise of consolidated supervisionby the home country supervisor in line with interna-tional standards.


guarantee by the state, there is no deposit insur-ance for private banks. In Guatemala, the processof integrating information from booking offices isstill ongoing. Eleven out of 18 financial groups

have offices abroad (3 of which are foreign), andthe superintendency has completed a first round ofon-site inspections of all offshore entities. How-ever, reporting deficiencies result in unreliable fi-

35


In Honduras, the Financial System Law of September2004 introduces consolidated supervision, to be carriedout by the National Commission of Banks and Insur-ance (CNBS), an entity “in service” to the centralbank, reporting directly to the President of the Repub-lic. Financial groups consist of two or more companiesengaged in activities of a financial nature under com-mon control and may include banks, savings and loan associations, finance companies, subsidiaries, andbranches and offices of foreign financial institutions.The CNBS may determine that the relationships ortransactions with nonfinancial members of the samefinancial group may endanger the financial stabilityof the group, in which case it shall have the right toconduct all inspections necessary to evaluate risks andrequire the implementation of necessary measures.The CNBS may not authorize the existence of a fi-nancial group without being able to exercise consoli-dated supervision of the financial activities under-taken. Financial groups must provide the CNBS withconsolidated financial statements including its sub-sidiaries and branches abroad. Consolidated capital ofthe financial group must be at least equal to the sumof the capital requirements of the companies in thegroup, and intercompany investments among groupmembers are subtracted from the paid-in capital of theinvesting company. The CNBS authorizes the open-ing of branches or subsidiaries abroad of a Honduranfinancial system institution and may supervise themdirectly or through auditors hired abroad. For a for-eign financial institution to operate a branch in Hon-duras, the CNBS must have executed a memorandumof understanding with the home country supervisor.

In Nicaragua, the Superintendent of Banks is em-powered to exercise consolidated supervision over fi-nancial groups. A financial group is defined as banksand nonbank financial institutions (including domi-ciled abroad) and affiliates that are directly or indi-rectly controlled by a majority of shares. The Superin-tendent may specify cases where setting up holdingcompanies may be necessary. All banks or nonbank fi-nancial institutions must inform the Superintendentof whether they belong to a financial group. The coor-dinator of a financial group is the member establishedin Nicaragua with the largest asset value. The coordi-nator must consolidate the statements of the financialgroup and submit them together with individual fi-nancial statements of its members. The Superinten-dent may set general prudential standards as deemed

necessary to supervise financial groups on a consoli-dated basis. The Superintendent may apply a range ofpreventive measures “when the situation so warrantsit” to members of a financial group. Prior authoriza-tion from the Superintendent is required to openbranches abroad. However, there is no explicit au-thority to limit the range of activities a financialgroup may conduct in foreign locations, or for the Su-perintendency of Banks and Other Financial Institu-tions (SBOIF) to conduct onsite inspections, but theSuperintendent has broad authority to cooperate withforeign supervisors as necessary for consolidated su-pervision. Branches of foreign banks must apply forauthorization to operate in Nicaragua.

In Panama, the Superintendency of Banks (SBP) isauthorized to supervise Panamanian banks (both withgeneral and international banking licenses) on a con-solidated basis, and is responsible for the supervisionof economic groups that include Panamanian banks.An economic group is defined as a group of natural orjuridical persons whose interests are interrelated insuch a way that the SBP shall consider them as a single person. Descriptions of what constitutes aneconomic group, including ownership and controlcriteria, are specified in legislation. The financialconsolidation of subsidiaries for regulatory and finan-cial reporting purposes is required. An economicgroup of banks with a general banking license mustmaintain at all times a global index of capital ade-quacy equal to the sum of the capital requirements forall the companies comprising the group. The SBPmay set prudential requirements on banks and mem-bers of the economic group on an individual basis andon the entire economic group of which a bank is amember. However, powers of the SBP concerningcapital adequacy and other prudential requirementsappear more limited with regard to banks with an in-ternational banking license. The SBP has the powerto supervise operations, on a consolidated basis, ofbranches and subsidiaries of Panamanian banks estab-lished in foreign jurisdictions. For the opening ofbank branches and subsidiaries in Panama, the SBPmay require certification issued by the home countrysupervisor, indicating its assurance that consolidatedcross-border supervision of the applicant would occurand the frequency and extent of the on-site examina-tions in Panama. It appears that this requirement isapplied at the discretion of the SBP on a case-by-casebasis.


nancial statements of banks and groups. So far,only nine financial groups have completed theprocess of registration as financial groups.

Regional Initiatives

Cooperation through memoranda of understanding

The implementation of arrangements betweensupervisory authorities in the region shows limitedprogress. A general arrangement sponsored by the CCS was signed in 1998. Subsequently, spe-cific memoranda of understanding were signed be-tween 2000 and 2003 to motivate bilateral cooper-ation, especially on exchange of information.However, the lack of a central authority, legal re-strictions in some cases (in particular, secrecy pro-visions), unclear focus on what information is tobe exchanged, and reported reluctance of supervi-sors to provide timely and detailed inform-ation have conspired against a smooth exchange ofinformation. Sharing of findings of off-site analysisis incomplete, and joint inspections have beenrare.

Coordination in the Council of Superintendents of Banks, Insurance, and Other Financial Institutions

The CCS has been instrumental in promoting anexchange of views among regional supervisors onthe need for cross-border consolidated supervision.The CCS was founded in 1976 with the goal of en-couraging cooperation and exchange of informationamong regional superintendencies, and facilitatingthe implementation of regional agreements. Discus-sions on plans to harmonize regulation across coun-tries in the region have taken place with the Inter-American Development Bank, with the main goalof identifying the gaps in the application of interna-tional standards for banking supervision. The coor-dination needed to implement International Finan-cial Reporting System criteria was assisted by theCentral American Bank for Economic Integration.Steps to improve regional banking supervision in-clude the preparation of assessments and actionplans to be implemented in the second half of 2005.The CCS is at a crucial juncture in defining aroadmap and priorities to show effective progress inimproving consolidated supervision of regional fi-nancial institutions.

Conclusions and Elements of anAction Plan

Minimum Standards

International experience (e.g., the EuropeanUnion, the Nordic countries, the East CaribbeanCurrency Union, the West African Economic andMonetary Union (WAEMU), and the CentralAfrican Economic and Monetary Community(CEMAC)), can be used as a reference for consoli-dated supervision in Central America only to a lim-ited extent (Box 2.5). The experience of the Nordiccountries would seem most applicable to CentralAmerica, because both operate outside the frame-work of a currency union. In most cases, financialintegration has progressed in parallel with politicalintegration at least to the extent necessary to have acommon supervisory authority. Central Americanot only lacks the political integration to establish acommon supervisory authority but also it has lim-ited experience with minimum standards in the faceof enforcement difficulties. The exchange of infor-mation through a memorandum of understanding isless than what would be necessary to compensate forthe lack of a common authority. Moreover, thechoice of a home supervisor for a group is left to thegroup, providing for opportunities to seek out aweak supervisory regime in the context of a fairlyheterogeneous supervisory framework.

The minimum standards for the supervision ofinternational banking groups established by theBasel Committee on Banking Supervision stipulatethat (1) all international banks should be super-vised by a home country authority that capablyperforms consolidated supervision; (2) the creationof a cross-border banking establishment should re-ceive the prior consent of both the host countryand the home country authority; (3) home countryauthorities should possess the right to gather infor-mation from cross-border banking establishmentssubject to their supervision; and (4) if the hostcountry authority determines that any of thesethree standards is not being met, it could imposerestrictive measures or prohibit the establishmentof banking offices.

In Central America, the performance of consoli-dated supervision is most advanced in Panama. Anassessment of how capably supervision is performed isbeyond the scope of this book. Strengths of Panama’ssupervisory framework include experience in dealingwith financial groups, sufficient resources, and the

36



37

Conclusions and Elements of an Action Plan

Box 2.5. International Experience with Cross-Border Consolidated Supervision1

European Union

Regulation and supervision of cross-border bankinggroups in the European Union (EU) take place in thecontext of a regional market for financial services thathas to a significant extent been unified, but where—despite increasing harmonization—licensing, regula-tion, and supervision of financial institutions remainorganized essentially at the national level.

The single European market for banking services isbased on the principle of a single banking license or“passport.” This principle implies that any financialinstitution licensed to provide certain financial ser-vices in one EU country, and actually providing thoseservices in that country, can provide the same ser-vices throughout the EU, by means of cross-bordertransactions or foreign branches. To prevent regula-tory arbitrage, minimum licensing standards havebeen set at the European level, using the same proce-dures as those for minimum regulatory standards (seebelow). However, actual licensing is done by the rele-vant national authorities, which may opt to applystricter licensing criteria than the minimum stan-dards. Banking subsidiaries set up by EU banks inother EU countries need to be licensed separately bythe host country.

National authorities remain in charge of settingbank regulation, though this is subject to increasinglyspecific minimum standards agreed at the Europeanlevel. For banks that operate cross-border, the princi-ple of home country control applies, that is, banks aresubject to the regulations of their home country, evenwhen operating in other EU countries.

Until recently, EU-wide minimum regulatory stan-dards were established as regular EU legislation, onthe basis of proposals made by the European Com-mission that had to be approved by the Council and the European Parliament. In preparing such leg-islation, the Commission was advised by the Bank-ing Advisory Committee, which comprised represen-tatives of the national supervisory agencies andministries of finance of the different member states.In certain technical areas, the Committee was able to amend EU banking legislation without hav-ing to go through the above-described legislativeprocedure.

In part to avoid excessive delays in adapting the reg-ulatory framework to a rapidly changing financial en-vironment, and in order to further streamline and har-monize regulations, the EU decided in December2002 to extend the Lamfalussy approach to the area of

bank regulation.2 Under the Lamfalussy approach,regulatory framework principles are established in theform of formal directives or regulations (“primary leg-islation”) through the normal EU legislative proce-dures (Level 1). On the basis of these framework prin-ciples, more detailed technical implementing rules(“secondary legislation”) are prepared by the Euro-pean Commission, on the basis of consultations withsectoral committees consisting of the relevant author-ities, and subject to the approval of a regulatory com-mittee (the European Banking Committee—EBC)comprising representatives of the member states(Level 2). The consistent implementation of harmo-nized regulations throughout the EU is the objectiveof another committee (the Committee of EuropeanBanking Supervisors—CEBS), which brings togetherhigh-level representatives of European banking super-visory agencies and central banks (Level 3).

To ensure effective and harmonious supervision inthe context of an EU-wide single market in which re-sponsibility for supervision remains with nationalagencies, a number of basic principles have been es-tablished. These are (1) mutual recognition of theway supervision is conducted in the different memberstates, (2) an obligation for supervisors to cooperatewith each other, (3) harmonization of supervisorypractices, and (4) home country control as the basicapproach in consolidated supervision.

In this context, responsibilities for the supervision ofcross-border bank activities have been allocated asfollows: (1) the home country supervisor is responsi-ble for consolidated supervision of a banking group asa whole; (2) branches of EU banks in other EU coun-tries are supervised by the home country supervisor;and (3) subsidiaries of EU banks in other EU coun-tries are supervised by host country supervisors as sep-arate entities, and as part of the consolidated bankinggroup by the home country supervisor.

Cooperation between the different national supervi-sors is essential to make this framework functionsmoothly. Nevertheless, individual agencies have beenleft with a significant degree of freedom in organizingthis cooperation (in particular, the exchange of infor-mation), through the conclusion of bilateral memoran-dums of understanding (MOUs). Such MOUs specifythe modalities for information exchange (includingconfidentiality issues) and other forms of cooperationand outline the commitments agencies make vis-à-vis

1Prepared by Jens Clausen, Marco Espinosa, and WimFonteyne.

2The Lamfalussy approach was originally proposed in 2001for the regulation of securities markets, by a Committee ofWise Men led by Baron Alexandre Lamfalussy. A discussionof the Lamfalussy approach in bank regulation can be foundin the November 2004 issue of the ECB’s Monthly Bulletin.


requirement of international accounting standards.However, the presence of banks that do not consoli-date financial statements and the likely substantialmind and management in the home country of share-holders of RFCs are areas to be addressed within theframework of a regional approach.

Prior consent to authorize operations of banks indifferent jurisdictions was made without paying at-tention to the lack of consolidated supervision.Most institutions were established in different coun-

tries as domestic banks, and therefore they were pri-marily subject to supervision only of the individualentity.

Provision of information to the home countrysupervisor (Panama) seems to be generally ade-quate. However, supervisors in other countries feelthat the substantial presence of mind and manage-ment in their jurisdictions justifies the provision of information from the home to the host countrysupervisor.

38


Box 2.5 (concluded)

each other. These bilateral MOUs are supplemented by a number of multilateral MOUs, often dealing withspecific multinational banking institutions. Coopera-tion has been strengthened further with the establish-ment of the CEBS, which has among its objectives toserve as a forum for the exchange of information, arole that was previously fulfilled to a lesser extent bythe “Groupe de Contact” and the Banking Supervi-sion Committee of the European System of CentralBanks (ESCB).

Within the Lamfalussy framework, harmonization/ convergence of supervisory practices is a role allocatedto the CEBS and, to a lesser extent, to the EBC.

Nordic Region

There is a long-standing tradition of cooperationamong Nordic (i.e., Denmark, Finland, Iceland, Nor-way, and Sweden) central banks as well as amongNordic banking supervisory authorities.3 In 2003, theGovernors of the Nordic central banks agreed on anMOU that outlines the procedures followed in theevent of a banking crisis with cross-border implica-tions. It specifies the details of crisis management andpossible emergency liquidity support. They regarded anon-legally-binding MOU as the appropriate tool fororganizing cooperation among the central banks. AnMOU among the banking supervisory authorities wasfirst signed in 1989, and was renewed in 1994 and2000. The Swedish Financial Supervisory Authorityacts as the secretariat of the group. The memorandumspecifies the cooperation related to cross-border su-pervisory activities. It defines the home and hostcountry responsibilities, information sharing, and co-operation on conducting on-site examination, consol-idated supervision, and cross-border financial services.Special attention is given in a separate MOU to thesupervision of the Nordea Group, a financial con-

glomerate active in four of the five Nordic countries.The establishment of a joint supervisory group forNordea was a major step toward ensuring effectiveconsolidated supervision.

ECCU

The eight member countries and territories of theEastern Caribbean Currency Union (ECCU) are An-tigua and Barbuda, Dominica, Grenada, St. Kitts andNevis, St. Lucia, and St. Vincent and the Grenadines,which are all independent states and members of theIMF; and Anguilla and Montserrat, which are territo-ries of the United Kingdom. In 1983 they created theEastern Caribbean Central Bank (ECCB) andadopted the ECCB Agreement Act. The financial sys-tem in the ECCU comprises domestic banks, offshorebanks, credit unions, insurance companies, nationaldevelopment foundations, development finance insti-tutions, building and loan associations, and financecompanies.

The regulatory framework of the domestic bankingsystem includes the ECCB Agreement Act of 1983 andits amendments as well as the Banking Acts of the var-ious member states. The Agreement Act gives thebank the power to “regulate banking business on behalfof and in collaboration with participating Govern-ments.” Between 1988 and 1992, new banking legisla-tion, referred to as the Uniform Banking Act, was en-acted in each of the member states. This legislation setsthe stage for the harmonization of financial intermedi-aries within the ECCB area and the standardization ofthe ECCB’s supervisory and regulatory framework.

The Uniform Banking Act reaffirms the ECCB asthe region’s central bank with responsibility for thesupervision of the financial system. The ultimate au-thority in the application of the Act is vested in theminister of finance of each individual country, who isrequired to act in consultation with, and on the rec-ommendation of, the ECCB. All commercial banks and other banking business institutions are requiredto be licensed under the Uniform Banking Act. As 3See Majaha-Jartby and Olafsson (2005).


Standards do not call for a specific supervisorytechnique.44 In Central America, more than one ap-proach seems necessary because different problemsneed to be addressed: (1) regional financial conglom-erates with mind and management outside Panamaconsolidating in Panama; (2) parallel banks being su-pervised on a nonconsolidated basis taking advantage

of the absence of a common enforcement of consoli-dation; and (3) offshore activities of booking officesthat are not being reported to any supervisory author-ity are being phased out too slowly.

Regional Initiative to ImproveConsolidated Supervision

In the context of discussions within the CCS,Panama has prepared a regional initiative for con-

39


part of the continuing supervision, licensed financialinstitutions are required to submit monthly, quarterly,and annual reports to the ECCB.

The deficiencies of the Uniform Banking Act arebeing partly addressed, including weak central bankauthority to enforce banking regulations. This wouldbe particularly relevant where key supervisory deci-sions lie outside of the supervisory authorities, andwhere such decisions can be politically influenced.

The offshore financial services sector, regulated bythe Offshore Banking Acts in the respective coun-tries, is primarily the responsibility of the nationalregulators. In the cases of Dominica, St. Kitts andNevis, and St. Vincent and the Grenadines, the Off-shore Banking Acts have been amended to allow forvarying degrees of participation in the regulation andsupervision of the offshore sector by the ECCB. TheECCB provides support to the national regulators inthe other territories in supervising the sector.

WAEMU and CEMAC

The West African Economic and Monetary Union(WAEMU) and the Central African Economic andMonetary Union (CEMAC) are monetary unionswith a single currency, the CFA franc. The WAEMUtreaty established a single currency and a regionalcentral bank (Banque Centrale des États de l’Afriquede l’Ouest—BCEAO) in 1962. The eight membercountries of WAEMU are Benin, Burkina Faso, Côted’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, andTogo. The Governor of the BCEAO is the Presidentof the Banking Commission, which was created in1990 to strengthen regional banking supervision andauthorize uniform licensing. The Banking Commis-sion is responsible for the organization and supervi-sion of banks and financial institutions in the eightmember states. The 1995 law on savings and credit in-stitutions (Projet d’Appui à la Réglementation sur lesMutuelles d’Epargne et de Crédit) laid the basis for aregulatory framework for cooperative financial insti-

tutions in the region. Both government authoritiesand the BCEAO are responsible for supervising mi-crofinance institutions. Pensions funds, the stockmarket, and insurance companies are supervised byseparate regional institutions. There are reforms un-derway to expand the Banking Commission’s author-ity to also regulate these markets as well as to be ableto withdraw banking licenses, which until now hasbeen subject to the approval of the minister of financeof each country.

CEMAC encompasses six countries (Cameroon,Central African Republic, Chad, the Republic ofCongo, Equatorial Guinea, and Gabon). The Com-mission Bancaire de l’Afrique Centrale (COBAC)has been assigned nearly the full range of powers thatnational supervisory agencies have in individualcountries. It conducts off-site and on-site supervisionand issues prudential regulations. It shares responsi-bility with the national ministries of finance for thelicensing of new banks. It also has the authority tosanction credit institutions, to revoke banking licenses, and to decide on the liquidation of banks.Although legally independent, COBAC is closelyrelated to the Bank of Central African States(BEAC). The Governor of the BEAC is also theChairman of COBAC. COBAC depends on theBEAC for its financial and human resources. The 1992 Convention provides joint responsibilityfor issuing banking licenses between national au-thorities and COBAC. While the latter has de jureoverriding responsibility, in practice COBAC has torely on the respective national authorities’ coopera-tion to implement and enforce its decisions. The2000 FSAP for Cameroon found that through goodhandling of a number of crises, COBAC has becomea well-respected institution. Regional initiatives,such as the harmonization of the commercial codeand regional payment systems, are expected to pro-mote cross-border financial intermediation, trade,and investment, and thus generate higher economicgrowth.

44Basel Committee on Banking Supervision (1997).


solidated and cross-border supervision. The mainobjectives are to (1) eliminate opportunities toelude supervision; (2) use adequate prudential stan-dards; (3) define the structure, ownership, and man-agement of conglomerates; (4) establish adequatecapital requirements on a consolidated basis; (5) as-sess asset and liability management, including creditmanagement; (6) identify global risks of conglomer-ates; (7) ensure transparency of information; (8) es-tablish links to transmit risks; (9) determine conta-gion risks; and (10) verify compliance with the legalframework.

The proposed regulation would be implementedthrough a series of bilateral arrangements betweenthe supervisory authorities in Panama and other su-perintendencies. A model umbrella memorandum ofunderstanding would be developed. In addition, theproposal includes a standardized questionnaire to beused in inspections of a conglomerate. Moreover,the proposal discusses other elements that are perti-nent for improving the effectiveness of consolidatedsupervision, such as allowing for a major role for thehome country when the host country does not haveadequate resources, ensuring adequate flow of infor-mation, uniform criteria for on-site inspections, andadequacy of the legal framework. The proposedagreement has the following main features:

• the host supervisor would notify the home su-pervisor of requests to obtain licenses, and thehome country would report on compliance withlaws and regulations in the home country of therequesting financial group;

• information exchange would be open, with theexception of the identification of depositors;

• supervisors commit to provide assistance to on-site inspections of other country supervisors;and

• cooperation would be promoted, especially onAML/CFT issues.

Additional actions that could be considered tostrengthen Panama’s initiative are (1) a no-objectionletter from the home regulator be required prior tothe granting of licenses in another country in the re-gion; (2) information on depositors be made availableto the home supervisors on an exceptional basis, forexample, to identify group exposures and concentra-tion; (3) cooperation on AML/CFT issues be speci-fied to allow for specific gateways, such as for testingcompliance with the applicable group requirementsand in relation to suspicious activity reports.

Strategy to Improve ConsolidatedCross-Border Supervision

The strategy to be adopted should take as a start-ing point the endogenous response of financialgroups to consolidate in Panama. To be most effec-tive, the strategy should aim at maximizing the po-tential benefits that consolidating in a jurisdictionwithin the region may bring, while reinforcing themechanisms that would allow more effective identi-fication, monitoring, and mitigation of risks in eachcountry.

As a first step, all countries should commit to aplan to effectively integrate operations of parallelbanks and booking offices into their financial groupswith a common deadline to be enforced by regionalring fences. This will help enable supervisors to in-tegrate information from offices operating offshorewithout adequate supervision. More generally, forthe Basel Committee on Banking Supervision,“there is a presumption that in principle (parallelbanks) should not be permitted.”45 A reasonable pe-riod of regularization would be considered, afterwhich a lead supervisor might be appointed in thecontext of coordination within the CCS to actunder the presumption of the existence of a con-glomerate in the absence of a formal arrangement,which will be applicable in all jurisdictions. Accord-ing to the Basel Committee on Banking Supervi-sion, “if a bank exhibits one or more of these charac-teristics, the supervisors should conduct additionalinquiries to ascertain whether a parallel-ownedbanking structure is in fact in place:

• An individual or group of individuals acting inconcert who control a foreign bank also con-trols any class of voting shares of a domesticbank; or financing for persons owning or con-trolling the shares is received from, or arrangedby, a foreign bank, especially if the shares of thedomestic bank are collateral for the stock pur-chase loan.

• A domestic bank has adopted particular orunique policies or strategies similar to those of aforeign bank, such as common or joint market-ing strategies, sharing of customer information,cross-selling of products, or linked websites.

• An officer or director of a domestic bank eitherserves as an officer or director of a foreign bank,controls a foreign bank, or is a member of a

40


45Basel Committee on Banking Supervision (2003a), p. 1.


group of individuals acting in concert or withcommon ties that control a foreign bank.

• There is an unusually high level of reciprocalcorrespondent banking and other facilities be-tween a domestic bank and a foreign bank.

• The name of a domestic bank is the same as oris similar to that of a foreign bank.”46

The role of host supervisors in the process of con-solidated supervision should be strengthened. Thestrategy to be followed should be mindful of thestrong mind-and-management presence in thecountry of origin of RFC shareholders. Considera-tion should be given to a two-way exchange of in-formation, with the home country providing feed-back to host supervisors on selected risks thatrequire careful cross-border monitoring. A systembased on a principle of “host country conditionaldeference,” which would operate like the “homecountry rule” system in the European Union, couldbe put in place, but host country supervisors, whiledeferring to home country supervisors, would re-serve the right, when warranted by the circum-stances, to resume a more active role.47 In principle,there are three types of information to be providedby the home supervisor to the host authority. Theseare (1) information specific to the local office super-vised by the host supervisor; (2) information on theoverall framework of supervision in which its bank-ing group operates; and (3) significant problems thatarise in the head office of the group as a whole. Themost sensitive issue normally is material on adversechanges in the global condition of banking groupsoperating in the host supervisors’ jurisdictions.48

A minimum set of risks considered priority issuesshould be addressed in a first stage. Risks associatedwith related-party lending and loan concentrations,loan classification and provisioning, and capital re-quirements seem to be candidates to be addressed inthe first instance, establishing minimum standardsand a timetable to make them more stringent. Thiscould be accompanied by an effort to start promptlywork on the formation of a regional credit risk bu-reau. Risks associated with AML/CFT and countryrisk could also be targeted as priorities. There maybe a case to allow for differential limits for large ex-posures in countries where economic diversificationis limited (Box 2.6).

On unregulated risks, monitoring currency mis-matches and exposure to sovereign risk should beintensified. An effort should be made in gatheringinformation and promptly detecting cases where in-dividual institutions or groups take excessive riskrelative to the average. On lending to unhedgedborrowers, all countries could implement a policy ofincorporating information on foreign currencyhedging by borrowers as an element to decide onloan classification.

It is difficult to find alternative schemes for de-posit insurance protection that minimize the trans-fer of obligations in the event of a crisis. Alterna-tives such as differential protection or deposit

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46Basel Committee on Banking Supervision (2003a), p. 2.47Uhlick (1999).48Basel Committee on Banking Supervision (1996).

Box 2.6. Harmonization of Supervision ofAML/CFT Requirements

Supervisory systems and practices for anti–moneylaundering and countering the financing of terror-ism (AML/CFT) vary widely across the region. Asfor prudential supervision, such systems have notkept pace with the increasing development of fi-nancial groups operating across the region, particu-larly given the divergence in prudential require-ments applied to banks and nonbank financialinstitutions, resulting in an uneven application ofAML/CFT risk management practices and supervi-sion across countries and within financial groups.The evolving financial landscape therefore calls fora refocusing of AML/CFT risk supervision in a waythat (1) requires the application of AML/CFT poli-cies, procedures, and practices on a groupwidebasis. For banks, this would be consistent with theBasel paper on consolidated AML/CFT risk man-agement and supervision and with the applicableFinancial Action Task Force (FATF) recommenda-tions; (2) harmonizes the AML/CFT supervisoryprocedures across the region for both off- and on-site supervision; and (3) applies a risk-based ap-proach to AML/CFT supervision consistent withthe FATF recommendations. Development of en-hanced AML/CFT risk supervision should be con-sistent with the broader effort to implement re-gionwide consolidated supervision in other areas.

More stringent enforcement and implementationof AML/CFT requirements, in particular in theoffshore financial centers in the region, may con-tribute to encouraging regional financial groups toreorganize or conduct their offshore business in amanner that allows for effective supervision. Overtime, this may lead to a reduction in the number ofparallel banks as offshore operations are either dis-continued or converted to subsidiaries.


insurance premiums for financial institutions orgroups based on compliance with a schedule forconsolidation might be considered.

Cross-border cooperation needs enhancement.Central America has a history of formal MOUs thatlack effective follow-up. An assessment of compara-tive experiences would be useful to ensure thatMOUs could produce better results, noted in thecontext of the umbrella MOU proposed in the CCS.National authorities could consider making publicinformation on contacts and gateways to exchangeinformation. A clear sequencing and prioritizationshould start with the sharing of inspection and off-site reports. Thereafter, risks regarded as priorityshould be the focus of more intensive use of joint in-spections at the beginning, while joint global in-spections should only be considered once inspec-tions of specific risks have been successfullyconcluded. While the Basel Committee on BankingSupervision recommends to allow hosts the optionbut not the duty to accompany the home supervisorduring the inspections, the need to overcome defi-ciencies in Central America would appear to justifya more proactive approach.49

Transitional arrangements appear to be necessary.More stringent requirements for opening new officesin the region while consolidation of large groups iscompleted could be considered. Also, a commonunderstanding about the choices of organizationalstructures seems necessary. A clear common defini-tion of financial group should be a priority.

Finally, to promote the contribution of financialintegration to economic growth, fundamental im-provements of the institutional framework are re-quired. Political stability, enforcement of propertyrights, and effective legal protection of supervisorswhen performing their duties in good faith are allbasic requirements.

Addressing Systemic Risks in Central America

The growth of cross-border banking activitiesposes significant challenges for banking resolu-tion.50 In the event of failure, regional financialgroups may be split into their national legal entities,each subject to different bankruptcy proceedings.51

As a result, fair treatment of creditors may be ham-

pered if creditors in one jurisdiction receive highercompensation than similar creditors in other loca-tions. In addition, lack of harmonization in key res-olution procedures and poor communication be-tween regulators are obstacles to coordinatedintervention and resolution of different entitieswithin the same failed international group.

Ring fences can affect regulators’ ability to resolvecross-border banks in an manner that is fair to allcreditors. In jurisdictions where ring fencing is al-lowed, branches of foreign banks are treated as sepa-rate legal entities and, if necessary, are wound up assuch (separate-entity approach). The purpose of ringfencing is to ensure that local creditors receive prefer-ential treatment over foreign creditors, and underthis approach, the various parts of the financial insti-tution located in different jurisdictions will be subjectto separate legal proceedings. In contrast, in jurisdic-tions following a single-entity approach, there is onlyone set of insolvency proceedings in which the finan-cial institution is treated as one entity, and its assets,no matter where they are located, will be included ina single liquidation or reorganization process. Underthis approach, all creditors, no matter where situated,are entitled to lodge their claims in the single set ofproceedings and receive the same treatment as allother creditors within their class. There is no “bestpractice” as to which approach should be followed inthe legislation governing bank insolvencies.

While progress has been substantial in upgradingthe legal framework for banking resolution, differ-ences in approach remain that hamper coordinatedresolution of cross-border entities within the samefailed group. For instance, supervisors in differentjurisdictions may not be able to intervene branchesand subsidiaries of a failed group in a coordinatedfashion due to differences in the legal definition ofbank insolvency or in the legally mandated mini-mum period before liquidation. Different treatmentof shareholders also prevents consistency in dealingwith the same class of stakeholders across bordersand, in some cases, can prevent orderly resolution.

Continuous coordination and communication be-tween regulators is also critical to ensure orderly res-olution. A decision to intervene or close a domesticbank with operations abroad or a subsidiary of a for-eign bank could have unintended, but significant,consequences for other countries.52 Thus, bank su-

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49See Basel Committee on Banking Supervision (1996).50This section was prepared by Luis Cortavarría.51Lastra (2003).

52For instance, in certain circumstances, the intervention andclosure of a small subsidiary of a foreign bank by a host bank su-pervisor may have no major impact on the stability of the local


pervisors should coordinate their actions with aview to containing cross-border contagion as a re-sult of problems in an international financial group.

Regional Initiatives

Although the six Central American countries aresignatories on a regional convention on cross-borderbankruptcy proceedings, further efforts are needed.The 1928 Convention on International Private Law(the “Bustamante Code” or “Havana Convention”)only sets certain principles applicable to cross-borderbankruptcy proceedings as to the extraterritorialityof a bankruptcy order. In the absence of an interna-tional agreement specifically governing cross-borderbank insolvency, the authorities may want to con-sider entering into a regional treaty that would setspecific rules and procedures applicable to cross-border bank insolvency proceedings, particularlyaimed at dealing with regional banking problems tohelp ensure fair, timely, and transparent treatment ofclaims from depositors and other creditors.

Specifically, international experience on cross-border bank insolvency and the analysis of currentlegislation points to the following key areas requir-ing further strengthening:

• specific procedures applicable to cross-borderbank bankruptcy proceedings. The objective isto avoid the different approaches to, for in-stance, ring fencing, that result in inconsistentand unfair treatment of creditors of the same fi-nancial group based on their location. Suchprocedures would also need to address the issueof seniority of claims of deposit insurance agen-cies over foreign creditors and intercompanyaccounts, which is common in Central Ameri-can countries and may play against the fairtreatment of depositors in other locations;

• explicit agreement on coordination and infor-mation sharing between national regulators andliquidators to facilitate orderly cross-border res-olutions. For instance, agreement of regulatorsfrom a number of locations may be needed to fi-nalize the restructuring of an international fi-nancial conglomerate; and

• measures to reduce the risk that assets and lia-bilities be shifted across bank subsidiaries in the

event of problems. A particular concern in theregion relates to the possibility that, prior to abank failure, insider or other deposits might bemoved to locations with higher deposit insur-ance coverage.53 Harmonization of deposit in-surance regimes across the region would miti-gate this risk.

Upgrading National Legal Frameworks

In recent years, the legal framework for bankingresolution in most countries within the region hasbeen strengthened significantly (Table 2.8). Amongother measures, many countries have (1) introducedprompt corrective actions to address banking prob-lems at an early stage, including the requirementthat shareholders of weak, but viable, banks submitrehabilitation plans; (2) approved triggers to inducebank intervention in case of insolvency; (3) intro-duced bank resolution tools, including merger, andpurchase and assumption (P&A), schemes; and (4)enhanced and clarified the role of deposit insuranceagencies in bank resolution.

Further coordination and harmonization of treat-ment is needed in a number of areas, however, toensure equitable treatment of all parties in bankingresolution:

• Triggers for bank intervention. A uniform defini-tion of insolvency—currently ranging from 2 to8 percent of risk-weighted assets—would allowthe authorities to coordinate the timing of in-tervention of members of a financial groupacross countries, thereby minimizing the risk ofcontagion and asset stripping.54

• Duration of bank intervention. Consistency re-garding the length of time a bank may be sub-ject to official administration would facilitateorderly resolution of cross-border entities whena single-entity approach is followed. Interven-tion can vary in duration, however. It can rangefrom 30–90 days in Nicaragua and Panama toup to one year in Costa Rica. The time limit isnot well defined in Nicaragua, Honduras, andEl Salvador, and does not exist in Guatemala.

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banking system, but it may create severe consequences for theparent bank’s credibility and ultimately create a banking crisis inthat location.

53Except Panama, all Central American countries have ex-plicit deposit insurance, but the coverage varies.

54Generally, the banking authorities may put a bank under of-ficial administration in the event of insolvency, suspension ofpayments, and/or failure to submit or comply with a rehabilita-tion plan.


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TABLE 2.8Overview of Legal Framework for Banking Resolution in Central America

Triggers for Opening of Priority of Countries Official Administration Restructuring Powers Liquidation Proceedings Depositors’ Claims Deposit Insurance Scheme

Costa Rica Bank intervention is triggered During official administration, Judicially supervised proceedings. No priority for depositors’ Blanket guarantee for public by, among other causes, unmet the intervenor appointed by Liquidation proceedings initiated claims. Based on the general banks. None for private banks.regularization plans, the total or the National Council shall im- by the competent judge at the bankruptcy legislation the partial cessation or suspension plement the regularization plan. request of the National Council priority is as follows: (1) se-of payments, the detection of The National Council may or the appointed intervenor in cured creditors; (2) privilegedunsound or illegal banking (1) ban any new credit transac- case of failure of the restruc- creditors (labor and fiscal practices, or in cases where tion or extension of grace turing, including the lack of claims); (3) bankruptcy’s costs;more than half of the bank’s periods for the payment of approval or execution of the and (4) other unsecured credi-equity is lost. debts with past due dates; restructuring plan; at the request tors claims, including “deposi-

(2) call for a shareholders’ of the Superintendent when such tors’ claims.”meeting to recommend capital petition is “justified;” or by a increases; (3) suspend or limit petition filed by the bank itself orthe payment of bank’s liabilities; by one of its creditors in case of (4) ban or limit the distribution cessation of at least one payment.of dividends unless authorized by SUGEF; and (5) order the “reorganization of the bank.” The law does not specify the techniques that could be imple-mented by SUGEF or the inter-venors to restructure a failing bank, which may cause such actions to be challenged on legal or constitutional grounds.

El Salvador A bank may be restructured if The restructuring modalities Judicially supervised proceedings. Depositors are privileged The IGD guarantees the deposits the bank (1) fails to submit a are (1) a mandatory reduction Upon transfer of the excluded since they are guaranteed to of the general public in banks regularization plan when due; or increase of the bank’s estate’s assets or if the super- be paid with the proceeds of and participates in bank restruc-(2) does not correct its irregu- capital; (2) the exclusion of intendency determines that the the transfer of the excluded turings through the acquisition of larities within the regularization some of the bank’s assets and solvency or nonsolvency prob- estate’s assets, or directly assets of excluded estates, or by period; (3) fails to comply with liabilities (the “excluded lems that gave rise to bank irreg- from the deposit guarantee participating in the Fideicomiso any of its obligations arising estate”); (3) the judicial inter- ularity cannot be corrected scheme (IGD).The priority of established with such assets.The from the regularization pro- vention of the bank (official through a regularization plan.The claims is as follows: (1) liabil- deposit guarantee is currently ceedings; or (4) the super- intervention); or (4) the bank’s creditors are not in a posi- ities arising from labor, set in an amount equivalent tointendency finds that the regu- adoption of any other measure tion to petition for bankruptcy. pensions, and child support $7,060 per depositor per bank,larization plan would not be deemed technically necessary The law does not recognize the claims; (2) liabilities from and covers both sight and time sufficient to address the bank’s in accordance with the nature “cessation of payments” as one deposits up to the amount deposits.problems. of the problem (although the of the grounds for initiating a of the deposit guarantee;

law does not specify these bank’s liquidation. (3) claims of foreign banks other measures). arising from foreign trade

transactions duly registered before the central bank;(4) liabilities for deposits in excess of the deposit guar-antee; (5) other privileged claims; (6) claims represented


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Co

nclusions and

Elem

ents of an A

ction P

lanin credit instruments; (7) un-secured claims of the Multi-sectoral Investment Bank;(8) claims of the state and the local governments;(9) other unsecured claims;and (10) the balance of the time subordinated debt.

Guatemala The bank’s operations must be The restructuring powers are: Judicially supervised proceedings. No preference for depositors’ The deposit insurance scheme suspended when the bank (1) to determine losses and Bankruptcy proceedings are claims over other creditors in (FOPA) insures deposits under ceases the payment of its obliga- charge them against reserves or initiated by the competent judge the bankruptcy proceedings. the terms specified in the law tions or incurs a capital defi- capital; (2) to select assets and at the request of the super- Under the general bankruptcy but has no restructuring pow-ciency that exceeds 50 percent transfer them to a trust admin- intendency.The law provides that law, the liquidation proceeds ers (with some exceptions).of the required capital. In addi- istered by a bank appointed by the petition is made once the are paid in the following order The deposit insurance scheme tion, events that allow (but do the SB; (3) to select deposits procedures for the spin-off and of preference: (1) bankruptcy covers deposits of up to 20,000 not require) a suspension of for up to the amount covered transfer of assets and liabilities expenses; (2) alimony, funeral, quetzales or its equivalent in operations are the non- by the deposit insurance and are concluded but fails to and estate expenses; (3) ex- foreign currency (to be ad-presentation of a regulariza- employee liabilities and transfer explicitly state whether bank- penses documented in public justed as necessary to ensure tion plan, its rejection by the them to other banks; deposits ruptcy may be requested in the deeds, in the order they were that at least 90 percent of the superintendency or the non- exceeding the amounts guar- absence of such procedures. It documented; (4) other deposits are protected).compliance with such plan, or anteed by the deposit insurance in unclear whether the bank’s expenses.other grounds duly justified by can be transferred if it is esti- creditors may make such petitionthe superintendent. mated that there are sufficient to the courts upon verification

assets to transfer to the trust. of the grounds set forth under Banks assuming the payment of the general bankruptcy law.deposit and employee liabilities receive a participation in the trust for the same value of the liabilities they assume; (4) to request the deposit insurance fund to make grants to the trustformed with the assets of the failed bank.

Honduras The law emphasizes corrective The Commission may appoint a Mainly administrative process.The The priority of claims is as The FOSEDE is responsible for actions rather than providing delegate to the board of the Commission shall order the com- follows: (1) labor-related the payment of the deposits in for official administration of a financial institution with the aim pulsory liquidation of a financial claims; (2) all deposits; financial institutions that have bank in distress. In the event of of overseeing the operations institution for non-submission of (3) loans granted by the been liquidated and making deficiencies not yet triggering and safeguarding the interests the regularization plan, its contra- central bank due to liquidity nonreimbursable contributions compulsory liquidation, such as of the customers and the public vention, or the non-rectification problems and other banking or loans in relation to compul-liquidity and solvency problems, during the execution of the of the deficiencies at the origin obligations; (4) funds collected sory liquidation processes, as operational losses during three regularization plan.The of the plan. Other mandatory for payments to third parties; requested by the Commission.straight months, or capital inad- Commission is also authorized grounds for compulsory liquida- (5) payments to the deposit The maximum amount insured equacy for at least 60 days, to reverse any transaction in tion are, among others: (1) the insurance fund (FOSEDE); and is 150,000.00 lempiras per de-among others, financial institu- breach of the regularization capital is lower than the min- (6) the remaining claims in positor and financial tions are required to submit a plan. imum initial capital required; keeping with the priority institution.regularization plan to the (2) inability to pay outstanding established in the Commerce Commission. obligations with the public when Code.

due; and (3) the regularization plan is unworkable or cannot be implemented. Compulsory liqui-dation cannot be triggered by third-party creditors.


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TABLE 2.8(concluded)

Triggers for Opening of Priority of Countries Official Administration Restructuring Powers Liquidation Proceedings Depositors’ Claims Deposit Insurance Scheme

Nicaragua The bank must be placed under Under the Law on Banks, Finan- Mainly administrative, with some Depositors that are individuals FOGADE has broad powers official administration if the cial Institutions and Financial court involvement. Upon have a special preference on to undertake restructurings bank’s capital is less than one- Groups, the official administra- specified events, such as severe the liquidation proceeds over under the procedures for the fourth of the minimum required tor may: (1) terminate the illiquidity, insolvency, or an un- all other creditors for up to a restitution of deposits.capital or if the bank is in cessa- employment relationships and successful recovery of the bank specific amount.The priority FOGADE covers deposits of up tion of payments.There are reduce the bank’s expenses; in the context of an official of claims is as follows: (1) em- to US$20,000.several discretionary triggers, (2) sell any of the banks’ assets administration, the superintend- ployees’ claims; (2) all de- such as violations to the law in the interest of depositors; ent shall request the courts place posits, including for amounts and regulations, an evident non- and (3) sell or merge the bank a bank in forced liquidation.The not covered under the special compliance of the regularization with another bank. If the depos- role of the courts is limited to preference; (3) claims of theplan, losses that exceed one- it guarantee fund (FOGADE) is declaring the mandatory liquida- Central Bank of Nicaragua;third of capital, indications of a appointed as official administration, with the Superintendent in (4) taxes; (5) other claims inpossible cessation of payments, tor, in the process for the charge of appointing the liquida- accordance with their prefer-or illiquidity or insolvency restitution of deposits, it may tor and monitoring the liquida- ences and modalities establish-problems less severe than those transfer deposits and corre- tor’s performance.The declara- ed in the civil code.requiring the forced liquidation. sponding amounts of assets to tion of liquidation and any

acquiring banks. decisions adopted by the liquida-ator can be appealed before thecourts.

Panama Intervention is triggered on the In a reorganization, the super- Administrative proceedings with- The priority of claims is as None.following grounds: (1) a request intendency is authorized to out the involvement of the follows: (1) labor-related from a bank; (2) the reduction execute any of the following courts.The Superintendent has claims; (2) claims by the Social of capital by the bank so it actions: (1) amortize the losses discretionary powers to order Security agency concerning corresponds to less than 8 per- against the paid-in capital stock the compulsory liquidation of a contributions owed by the cent of its total assets and off- and reserves; (2) appoint new bank that has been intervened bank’s employees; (3) tax-balance sheet operations; managers; (3) authorize the or is in the process of reorga- related claims of the National (3) the decline of the capital issuance of new shares of the nization. Compulsory liquidation Treasury or the Municipalities,adequacy ratio below 8 percent; bank, as well as their sale to may also be decided by the super- as well as levies for public(4) business is conducted in an third parties at a price deter- intendency at the conclusion of services rendered by the state;illegal, negligent, or fraudulent mined by the superintendency; the reorganization, if the process (4) deposit accounts for manner; (5) payments are sus- (4) promote the merger or the has not been completed satisfac- US$5,000 or less belonging topended; (6) repeated infraction consolidation of the bank with torily, or at any other moment natural persons; and (5) all of the liquidity requirements; one or more banks, acquire before the conclusion of the re- other deposits and claims.(7) threat to the interest of the loans, the sale or partial organization because of in-depositors if the bank continues liquidation of its nonproduc- solvency or any other reason to operate; (8) assets are in- tive assets, or the imposition of that prevents the recovery of the sufficient to cover the sum of liens upon them; or (5) initiate bank. Insolvency proceedings its liabilities; (9) unjustified the process of liquidation. In an cannot be initiated at the requestdelay of the voluntary liquida- intervention, the intervenor is of third-party creditors.tion; and (10) failure to comply authorized to suspend or limit with the reorganization plan. the payment of the bank’s

obligations for the duration of the intervention.


• Rights of shareholders. Shareholders’ rightsshould be suspended as part of bank interven-tion. In Costa Rica, El Salvador, Honduras, andPanama, the law is ambiguous with respect tothe shareholders’ rights during a bank interven-tion, which could be a serious obstacle for bankresolution. In the case of Costa Rica, the law isnot only silent with respect to the status ofshareholders’ rights during bank intervention(suggesting that they maintain ownership rightsduring such period) but also specifically estab-lishes that the bank’s shareholders may be partof a bankruptcy committee together with theauthorities and creditors.

• Treatment of bank managers. If a single-entityapproach is followed, managers in all sub-sidiaries and branches of a failed group shouldbe prevented from participating in key bankresolutions decisions to ensure fairness. That isnot always the case in Central American coun-tries, however. In Guatemala and Nicaragua,bank managers are dismissed when the authori-ties declare a bank under official administra-tion. In the other Central American countries,it is unclear whether the authorities can keepincumbent bank managers from participating inkey decisions regarding bank resolution. For in-stance, in Honduras, the supervisor has onlylimited powers to reverse bank management de-cisions during the regularization phase.

• Asset valuation rules. If a single-entity approachis followed, different rules on the valuation ofassets could undermine the use of P&A transac-tions. Assets must usually be valued accordingto local rules before they are transferred to an-other institution or trust fund. The valuation ofclaims against nonresidents and assets abroadcould create difficulty in bank restructuring.

Weaknesses hampering quick bank resolutionsshould also be addressed because speed in the adop-tion of resolution measures is key to containing losses.Three major issues may play against the early identifi-cation of problem banks and proper implementationof the legal framework for banking resolution:

• lack of independence and discretionary powersof bank supervisors to act at an early stage. Insome jurisdictions, as a result of legal limita-tions or the political process, bank supervisorscannot act independently and may hesitate toimpose early remedial actions on weak banks;

• weak legal protection for bank supervisors. Therisk of legal challenges from former bank share-holders in court, together with weak protectionfrom recourse against individual bank supervi-sors, may discourage early bank resolution mea-sures by banking supervisors; and

• limitations in detecting bank insolvency. De-spite the progress made in strengthening banksupervision, in some cases, bank insolvencymay remain undetected as a result of: (1) lack ofeffective monitoring of credit to insiders (thebank’s capital may have already been dilutedthrough credit to related parties or affiliated en-tities); and (2) the use of inaccurate asset valua-tion rules. Failure to correctly assess the bor-rower’s future repayment capacity, over-relianceon loan collateral, and excessive regulatory for-bearance could, in some cases, postpone therecognition of bank losses.

References

Alvarez, Roberto, 2003, Dolarización Financiera en AméricaCentral, Serie de Estudios Económicos y SectorialesRE2–03–005 (Washington: Inter-American Devel-opment Bank).

Barraza, Rafael, 2003, “Integración Financiera Cen-troamericana,” presentation for the 40th Anniversaryof the Central American Monetary Council, Teguci-galpa, Honduras.

Basel Committee on Banking Supervision, 1997, CorePrinciples for Effective Banking Supervision, April(Basel: Bank for International Settlements).

———, 2003a, Parallel-Owned Banking Structures (Basel:Bank for International Settlements).

———, 2003b, Shell Banks and Booking Offices (Basel:Bank for International Settlements).

———, and the Offshore Group of Banking Supervisors,1996, The Supervision of Cross-Border Banking (Basel:Bank for International Settlements).

Central American Monetary Council, 2003, “Caracterís-ticas básicas y evolución reciente de los sistemas ban-carios de Centro América, Panamá y la RepúblicaDominicana,” Informe de Coyuntura (San José,Costa Rica).

———, 2004, “Un vistazo a la dolarización en CentroAmérica y la República Dominicana,” Informe deCoyuntura (Costa Rica).

De Nicoló, Gianni, Philip Bartholomew, Jahanara Zaman,and Mary Zephirin, 2003, “Bank Consolidation, In-ternationalization, and Conglomeration: Trends andImplications for Financial Risk,” IMF Working Paper03/158 (Washington: International MonetaryFund).

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References


Fitch Ratings, 2004, A Review of Central American BankingSystems, Special Report (New York).

Gruson, Michael, 2004, “Supervision of Financial Con-glomerates in the European Union,” Journal of Inter-national Banking Law and Regulation, Vol. 19 (Octo-ber), pp. 363–81.

International Monetary Fund, 2004a, Financial Sector Reg-ulation: Issues and Gaps (Washington). Available viathe Internet: http://www.imf.org/external/np/mfd/2004/eng/080404.htm

———, 2004b, Financial Sector Regulation: Issues andGaps—Background Paper (Washington). Availablevia the Internet: http://www.imf.org/external/np/mfd/2004/eng/081704.htm

Lastra, Rosa Maria, 2003, “Cross-Border Bank Insol-vency: Legal Implications in the Case of Banks Op-

erating in Different Jurisdictions in Latin America,”Journal of International Economic Law, Vol. 6 (1), pp. 79–110.

Majaha-Jartby, Julia, and Thordur Olafsson, 2005, “Regional Financial Conglomerates: A Case for Improved Supervision,” IMF Working Paper 05/124 (Washington: International MonetaryFund).

Standard & Poor’s, 2004, Industry Report Card: Caribbeanand Central American Banks (New York).

Uhlick, Lawrence, 1999, “Meeting the Challenges of Supervising Banking Organizations’ Cross-Border Activities,” paper presented at the 35th Annual Conference on Bank Structure and Compe-tition, Federal Reserve Bank of Chicago, Chicago,May.

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http://www.imf.org/external/np/mfd/2004/eng/080404.htm





Daniel Hardy and Miguel Palomino

The insurance sector remains small in most ofCentral America. The scarcity of insurance af-

fects welfare directly, because households and com-panies must bear most risks themselves, leading toundesired volatility of intertemporal consumption.Moreover, lack of insurance may reduce the avail-ability of financing or increase its costs, becauselenders are discouraged when they must bear boththe economic risks associated with a project to be fi-nanced and also insurable risks such as those forwork accidents or property damage. In addition, thelimited assets of insurance companies implies thatthey cannot be major players in domestic financialmarkets and in particular in securities markets, sothese markets are thinner than they would otherwisebe. Hence, measures to promote the insurance indus-try could yield multiple benefits if well targeted.

Many of these measures, such as those related tothe modernization of the regulatory framework, canbe undertaken by individual countries. In some cases,joint regional initiatives or coordination may makethe measures more effective, for example, by exploit-ing economies of scale or scope in the provision of in-formation or diversifying risks. Despite their differ-ences, the countries covered in this study—CostaRica, El Salvador, Guatemala, Honduras, Nicaragua,and Panama—are sufficiently similar that cross-coun-try comparisons are meaningful, and that worthwhilejoint action in certain areas might be identifiable.

These considerations motivate the material of thischapter. However, due account must be taken of thelimits of a regional study. Information is sometimesnot available for all countries, and data are often not

fully comparable.55 More fundamentally, the coun-tries differ in level of development, the structure oftheir economies, and other aspects of the frameworkwithin which insurance markets operate. Panamaand Costa Rica are substantially more well-to-dothan the other countries, and have generally dis-played greater economic and political stability in re-cent decades. Costa Rica is unique in having a state-owned monopoly provider of insurance. Guatemala,El Salvador, Honduras, and Nicaragua are more simi-lar to one another, although Nicaragua is still transi-tioning from a long period of state monopoly in thesector, which extended until 1996.

The prevalence of non-term life insurance, thatis, life insurance with an important savings element,depends on whether or not other savings vehiclesare available and whether or not public or privatepension schemes are in operation. Given the multi-tude of fiscal, distributional, and demographic fac-tors affecting non-term life insurance; their hetero-geneity across the region; and the fact thatimportant policy decisions are currently under de-bate in some countries, this study concentrates onnon–life insurance.

49

3

55The main sources of information include responses by na-tional supervisory authorities to a questionnaire; self-assessmentsof observance of the International Association of Insurance Su-pervisors’ Core Principles; the websites of supervisory authoritiesand the Association of Latin American Insurance Supervisors;Financial Sector Assessment Programs (FSAPs) for CentralAmerican countries; and discussions with the supervisory author-ities and market participants. The authors benefited from discus-sions with staff at the World Bank and the Inter-American De-velopment Bank.


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TABLE 3.1Financial Situation of the Insurance Sector

Costa Rica El Salvador Guatemala Honduras Nicaragua Panama_____________ _____________ _____________ _____________ _____________ _____________2000 2003 2000 2003 2000 2003 2000 2003 2000 2003 2000 2003

(In millions of U.S. dollars)

Gross premiums 314 318 230 350 274 344 157 185 50 57 368 393of which: non–life insurance premiums 277 290 182 303 233 295 125 151 . . . 50 254 267

Net retained premiums 235 . . . 96 140 129 163 69 65 34 33 258 251Gross damages payments 171 . . . 122 133 100 89 71 64 21 22 191 138Profits (after tax) . . . . . . 17 27 11 21 6 21 3 2 . . . 30

Total assets 776 . . . 249 347 228 306 203 263 67 77 689 704Investments . . . . . . 159 227 141 201 85 162 38 40 423 479Technical reserves 422 . . . 91 123 155 134 101 131 39 48 261 305Capital and general reserves 208 . . . 78 129 56 90 41 83 17 15 0 261Paid-in equity . . . . . . 54 70 24 32 . . . 40 9 10 . . . . . .

(In percent of GDP)

Gross premiums 2.0 1.9 1.8 2.3 1.4 1.4 2.7 2.7 1.3 1.4 3.2 3.1of which: non–life insurance premiums 1.8 1.7 1.4 2.0 1.2 1.2 2.1 2.2 . . . 1.3 2.2 2.1

Net retained premiums 1.5 . . . 0.7 0.9 0.7 0.7 1.2 1.0 0.9 0.8 2.2 1.9Gross damages payments 1.1 . . . 0.9 0.9 0.5 0.4 1.2 0.9 0.5 0.6 1.6 1.1Profits (after tax) . . . . . . 0.1 0.2 0.1 0.1 0.1 0.3 0.1 0.1 . . . 0.2

Total assets 5.0 . . . 1.9 2.3 1.2 1.3 3.4 3.9 1.8 1.9 5.9 5.5Investments . . . . . . 1.2 1.5 0.7 0.8 1.4 2.4 1.0 1.0 3.6 3.7Technical reserves 2.7 . . . 0.7 0.8 0.8 0.5 1.7 1.9 1.0 1.2 2.2 2.4Capital and general reserves 1.3 . . . 0.6 0.9 0.3 0.4 0.7 1.2 0.4 0.4 0.0 2.0Paid-in equity . . . . . . 0.4 0.5 0.1 0.1 . . . 0.6 0.2 0.2 . . . . . .

Assets/M2 (percent) 13.7 . . . 4.1 5.6 4.2 3.8 7.1 7.0 4.5 4.6 8.0 7.2

Sources: National authorities; and IMF staff estimates.


The next section describes the structure of the in-surance markets of these countries, the availabilityof insurance products, and the recent performanceof insurance companies. The subsequent sectionlooks at the legal, regulatory, and supervisory frame-work. The final section addresses a number of cross-country issues and recommendations.


Insurance Penetration

The market volume for insurance products inmost Central American countries is modest in ab-solute terms and relative to those countries’ GDP(Table 3.1 and Figures 3.1 and 3.2).56 However, thelevel of insurance penetration as measured by theratio of premium income to GDP is roughly in linewith the relationships that are seen around the

world: demand for insurance is strongly correlatedwith average income, and with the presence of asubstantial middle class, that is, with a relativelyeven distribution of wealth. Central America con-tains some of the poorest countries in the WesternHemisphere, and is characterized by uneven distrib-ution of wealth, so one would expected relativelylow demand for insurance. For many Central Amer-ican countries, their past history of macroeconomicinstability and at times severe political conflict mayhave hindered the supply of, and demand for, insur-ance products, as well as the creation of an insur-ance culture. Furthermore, most of Central Americaalso faces large risks, for example, of natural catas-trophes, that are not diversifiable domestically, andtherefore expensive to insure against.57

The insurance sector is small also relative tobanks and the market for government debt. Insur-ance company assets are just a small fraction ofbroad money, which can be taken as a metric for thesize of the banking system (Table 3.2). In addition,

51


56Available information pertains to companies operating inthe domestic market. The volume of insurance may be underesti-mated because much insurance for trade, international transport,and the activities of multinationals companies may be providedby insurance companies abroad.

57The same factors that constrain development of the formalinsurance sector also constrain the availability of informal insur-ance, which, moreover, is generally more difficult to organizethan informal credit.

Figure 3.1. Relative Insurance Indicators, 2003, by Indicator


Growth rate of gross premiums, 2000–03

Damages payments/premiums

Assets/M2 (percent)

Total assets/GDP

Gross non–life premiums/GDP

Gross premiums/GDP

Sources: National authorities; and IMF staff calculations.

0.0

10.0

7.5

5.0

2.5


many insurance companies tend to be relativelysmall affiliates of banks. Hence, insurance compa-nies cannot play a major role in counter-balancingbanks in the market for deposits or in the market forsecurities. Therefore, insurance companies are notgenerally of systemic importance.

The insurance sector in the region has showntrend growth in absolute terms in the past severalyears, but rather less when measured by gross premi-ums relative to GDP. However, growth in insuranceservices is sometimes underestimated by measuringthe service in terms of premiums paid when there isa reduction in unit prices; total premiums may falleven if the risks of being insured are growing. As canbe seen in Table 3.3, the number of policies is gener-ally increasing.

Nonetheless, insurance penetration is still low notonly in terms of value, but also in terms of the num-ber of policies. In addition to low income levels, thisis a reflection of the uneven distribution of income,because most households and production units can-not access insurance services. The available data onthe number of policies—because one policy can com-prise a large number of end users—complicate com-

parisons, but market participants agree that low pene-tration is a characteristic of all regional markets.

The poor are especially deprived of insurance ser-vices throughout the region. The relatively high ad-ministrative costs of offering small amounts of insur-ance coverage to low-income households and tosmall firms, where risk assessment, record keeping,and handling claims generate fixed costs, tends tomake the services either prohibitively expensive orunprofitable. Hence, the expansion of insurance ser-vices to the mass of the poor population is essentiallyan issue of developing a low-cost technology for theproduction of the service (Boxes 3.1 and 3.2). Pastadministrative control of insurance premiums andthe importation of insurance practices and modelsfrom more developed countries likely hindered thedevelopment of insurance schemes that would makethe service accessible to lower-income groups.

Product Range

Insurance companies receive most of theirnon–life insurance premiums for coverage of auto-mobile and other property risks; property insurance

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DEVELOPMENT OF THE INSURANCE SECTOR

Figure 3.2. Normalized Insurance Indicators, 2003, by Country

0.0

10.0

5.0

2.5

Growth rate of gross premiums, 2000–03Damages payments/premiumsAssets/M2 (percent)

Total assets/GDPGross non–life premiums/GDPGross premiums/GDP

Panama

Nicaragua

Honduras

Guatemala

El Salvador

Costa Rica

Sources: National authorities; and IMF staff calculations.

7.5


53

Structure and

Perfo

rmance

TABLE 3.2Insurance Sector Indicators(In percent)


Non–life premiums/total premiums 88.2 91.2 79.4 86.5 85.0 85.6 79.3 82.0 . . . 87.8 69.1 67.8Automobile/total non–life premiums . . . . . . 25.9 18.3 43.3 35.6 23.7 22.2 . . . 29.9 36.4 26.4Property/total non–life premiums 69.1 . . . 22.2 29.8 19.9 27.8 21.4 27.8 . . . 25.7 13.8 17.6Health/total non–life premiums . . . . . . 13.8 11.6 13.6 15.6 13.5 17.1 . . . 10.9 21.2 22.2

Retained premiums/gross premiums 74.7 . . . 41.8 39.9 47.0 47.3 44.0 35.0 67.7 56.9 70.0 63.8Damages payments/premiums 54.5 . . . 53.2 37.9 36.6 25.8 45.3 34.6 41.8 38.6 51.9 35.2Damages payments/reserves 40.5 . . . 134.0 107.4 64.8 66.2 70.5 48.6 53.6 46.0 73.2 45.3Reserves/retained premiums 179.9 . . . 94.8 88.4 120.1 82.5 146.1 203.3 115.0 147.6 101.3 121.7

Investments/reserves . . . . . . 174.5 183.9 91.1 150.0 84.0 123.6 98.6 83.6 162.0 156.9Share of investments

Claims on government . . . . . . 10.1 13.5 43.1 38.1 . . . . . . . . . . . . . . . 22.3Claims on banks . . . . . . 36.8 37.6 9.9 22.8 . . . . . . 40.0 47.8 . . . 32.7

Total capital/total assets 26.8 . . . 31.5 37.2 24.7 29.5 20.4 31.5 25.3 19.3 . . . 37.0Total capital/reserves 49.2 . . . 85.9 104.8 36.4 67.3 41.0 63.0 43.7 30.9 . . . 85.4Equity/total capital . . . . . . 68.9 53.9 42.9 34.9 . . . 48.4 53.7 66.5 . . . . . .

Profits/retained premiums . . . . . . 1.8 1.9 0.9 1.3 0.9 3.2 1.0 0.7 . . . 1.2Profits/assets . . . . . . 6.9 7.7 4.9 6.9 3.2 7.9 5.0 2.8 . . . 4.3Profits/capital . . . . . . 21.8 20.6 19.9 23.4 15.6 24.9 19.8 14.3 . . . 11.5Profits/equity . . . . . . 31.7 38.1 46.5 67.1 . . . 51.6 36.8 21.5 . . . . . .

Annual growth rates, 2000–03Gross premiums . . . 0.4 . . . 15.0 . . . 7.9 . . . 5.5 . . . 4.7 . . . 2.2Gross non–life premiums . . . 1.5 . . . 18.4 . . . 8.2 . . . 6.6 . . . . . . . . . 1.6



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TABLE 3.3Insurance Contracts1


(Number of policies)

Life . . . . . . . . . 81,231 . . . 174,688 117,826 134,678 . . . . . . 108,770 105,250Health and accidents . . . . . . . . . 5,842 . . . 106,026 . . . . . . . . . . . . 57,496 58,118Property . . . . . . . . . 60,981 . . . . . . 64,937 68,678 . . . . . . 78,857 105,501Automobile . . . . . . . . . 123,605 . . . . . . . . . . . . . . . . . . 129,095 104,175

(Value of coverage; in millions of U.S. dollars)

Life . . . . . . 8,082 . . . 41,195 . . . . . . 1,495 4,314 . . . . . .Health and accidents . . . . . . 4,579 8,364 . . . . . . . . . . . . 4,029 3,788 . . . . . .Property . . . . . . 11,666 13,129 . . . . . . 11,370 15,564 2,716 4,157 . . . . . .Automobile . . . . . . 1,764 2,853 . . . . . . 2,836 3,538 1,012 583 . . . . . .

Sources: National authorities; and IMF staff estimates.1Statistics cover the number of contracts outstanding and the value of coverage.The number of insured parties may differ because parties hold more than one policy each, or because policies

cover multiple parties.


typically covers damage from earthquake, fire,flooding, other natural catastrophes, and similarrisks. Health insurance is usually the third mostimportant category.58 Life insurance generates be-tween one-tenth and one-third of total premiumincome.

Mandatory insurance coverage exists in somecountries. This is the case of third-party liability(TPL) automobile insurance in Costa Rica andNicaragua and, for commercial vehicles, in Panama.Other coverage is sometimes also mandatory (e.g.,worker compensation insurance in Costa Rica).Mandatory insurance policies are the source of sig-nificant premium income and various schemes, es-

pecially automobile TPL, are being debated in somecountries. However, insurance requirements seemoften to go unenforced.59

In most countries, some type of coverage is avail-able for a wide range of risks. Larger firms and better-off households reportedly can obtain most standardforms of insurance at competitive rates. Insurers areable to tailor contracts to special needs when theclient is willing to pay a sufficiently high premium.However, total premium income from such businessis small. From the available statistics, it appears thatinsurance of plant and equipment as opposed tobuildings is still very limited. This reflects the weakindustrial base of the region.

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Box 3.1. Mass Insurance Products

To assure low costs, mass insurance product carriersrely on simple and standardized policies that requirelittle verification (and are therefore inexpensive andeasy to sell), and also on inexpensive collectionarrangements. One of the ways in which this has beenachieved in some countries in the region is through“bancassurance.” Bancassurance relies on the use ofbank’s branch network as a sales platform and thebank’s established payments system as a collectionmechanism with low marginal costs. Bancassurancehas been quite successful in several countries in theregion. In El Salvador, perhaps the most successfulcountry in this regard, a large insurance company ledthe effort to sell mass insurance products through abank with which it was affiliated. The first programwas one for traditional individual life insurance poli-cies (which can be made more simply than propertyinsurance policies): in the five years to 2004, close to300,000 individual life insurance policies were sold.Of these, some 120,000 were in existence at the endof 2004, compared to 3,000 policies in existence be-fore the program was launched. Reportedly, the num-ber of policies sold by this company in the five-yearperiod was more than the number of individual life in-surance policies sold in all of Central America in theprevious 20 years.

However, bank networks may not be entirely wellsuited to the distribution of mass insurance products.Banks may offer cost advantages mainly in collectingpredetermined amounts from established clients, ratherthan more generally. Alternative distribution networkwith low cost collection arrangements could be avail-

able to sell a product whose crucial ingredient is itssimplicity. Indeed, various insurance companies in theregion are developing mass insurance products thatneed not be distributed via bank branches. One inde-pendent insurance company that had successfully de-veloped a mass product reported technical difficultiesin using banks as a collection mechanism; it proveddifficult, for example, to keep track of payments frompolicyholders who were not depositors at the collectingbank. It appears that a major reason that mass insur-ance products are often sold through banks is thatbanks are often affiliated with insurance companies.

Bancassurance, as well as any mass insurance distrib-ution system, may raise regulatory concerns regardingthe appropriateness of the information and adviceprovided to end users. The absence of a qualifiedsalesperson (be it a broker or a trained insurance com-pany employee) in a bank sales point may reduce thescope for informed choice by consumers. Yet the suc-cess of mass insurance products depends on low costs,and if more expensive conditions are imposed on thepoint of sale, they may effectively block the product.(This issue has a parallel with the question of when toallow sale of over-the-counter medicines rather thanprescription drugs.) The question is whether the po-tential costs of “mistaken” choices by consumers areoffset by the gains from making the service morecheaply available to larger number of consumers. Inany case, regulations should consider new and futuredevelopments in order to determine the responsibili-ties and the scope for action of agents in activities re-lated to insurance.

58Most of the countries have some form of social security andalso a state-funded health service, but the provision of services islimited.

59For example, in Nicaragua, third-party motor insurance iscompulsory, yet as of 2004 there were only about 100,000 motorpolicies in force, while some 250,000 cars were registered.


Public sector institutions often take out insurancefor certain risks (e.g., affecting government cars),but rarely for health coverage for government work-ers. In all countries, substantial public sector assets,such as roads and bridges, are not insured. Coupledwith the lack of insurance of most of the private sec-tor capital stock, this exposes the country to signifi-cant macroeconomic risks from large-scale disasters,such as major hurricanes or earthquakes. The gov-ernment’s implicit liabilities regarding disaster reliefand reconstruction in the case of widespread de-struction can also have serious fiscal consequences.

Crop insurance and other forms of agricultural in-surance are rare and in most cases have been newlyintroduced, despite the importance of the agricul-tural sector in the region, in particular in El Sal-vador, Guatemala, Honduras, and Nicaragua (Box3.3). This deficiency has several causes. First, cropinsurance is relatively complex and expensive to ad-

minister (even in industrialized countries) because(1) policies must be tailored to specific products andto such factors as projected weather and local geo-graphical conditions; (2) high monitoring costs re-sult from such tailoring and from large exposure tomoral hazard;60 and (3) high loss rates are prevalentin the sector. These complications apply a fortiori indeveloping countries. Second, many farmers in theregion are poor and undercapitalized, so transactioncosts are high relative to potentially insuredamounts. Also, agricultural risk in undercapitalizedcountries tends to be higher because of the absenceof agricultural infrastructure (such as dams and irri-gation networks), which is largely aimed at reducingrisks to agricultural output. Finally, in small coun-

56


Box 3.2. Product Bundling

In addition to bancassurance (banks and insurance companies joining together forthe mass marketing of unbundled insurance products), banks throughout the regionalso sell bundled financial and insurance products. This is often the case of insurancetied to mortgage loans or automobile credits. The sale of bundled insurance productsthrough banks may generate concerns over consumer protection, as it may lead to con-fusion on the part of the public with regard to both product pricing and which entity isresponsible for the insurance liabilities. This is especially problematic in the sale of in-surance products tied to banking products offered by affiliated firms, which createsstronger incentives for uncompetitive practices that are difficult to regulate. However,these kinds of uncompetitive practices generally are caused by a preexisting lack ofcompetition in loan services, rather than on the offering of insurance services them-selves. Informing the public and requiring the unbundling of the prices for the differ-ent services offered would likely improve consumer choices. This appears to be an-other area for regulatory improvement in some countries, in addition to the issuesmentioned in Box 3.1.

Nonetheless, experience in the region suggests that it is not always easy to exploit“captive clients”: one insurance company reported that an attempt to integrate its cus-tomer base and that of an affiliated bank so as to sell both products to all clients wasabandoned because the preferred customers for each product line where rather differ-ent. Hence, attempting to force bundled products on them threatened to alienate thebetter clients of both product lines.

Another issue that may be associated with product bundling and bancassurance iscross-subsidization between affiliated firms of a financial/business group. There appearsto be evidence of this in some countries, with premiums for affiliated firms apparentlybeing higher than those for nonaffiliated firms (this may be motivated by tax arbi-trage). In one country, for example, an insurance company’s premiums for mortgage-related policies sold through an affiliated bank more than doubled when authoritiesdetermined that insurance taxes were being avoided by setting artificially low insur-ance premiums, which were compensated for by high (untaxed) insurance sales com-missions for the bank. However, the concern in these cases is not bancassurance itselfbut rather the broader issue of adequate regulation of business/financial groups.

60It is difficult to distinguish whether a low harvest is because ofexogenous growing conditions or because of the farmer’s neglect.


tries, premiums may have to be high because it is dif-ficult for companies to diversity risk (e.g., a droughtmay affect farming throughout the country).

Market Structure

Most insurance companies are locally owned, butsubsidiaries of foreign companies operate through-out the region with the exception of Costa Rica(Table 3.4). The foreign parents are typically lo-cated outside the region, in particular in the UnitedStates, but there also exist a few local insurancegroups active in several countries. Foreign entry isundertaken through subsidiaries rather thanbranches, with the latter forbidden in several coun-tries. In all countries of the region, cross-border sell-ing of insurance is prohibited under the insurancelaw, with exemptions only for products that are notoffered locally. Another reason for opening a local

subsidiary, as opposed to a branch, is that it can bedifficult to enforce insurance contracts and effectdispute resolution between entities in different juris-dictions.61

The insurance sector in most of the region ishighly fragmented and, therefore, the average com-pany is small. As of 2003, the average company in ElSalvador received the equivalent of just $17 millionper year in gross premiums. Costa Rica, with its mo-nopoly provider, is an exception. The insurance sec-tor in Nicaragua is also relatively concentrated be-cause a state monopoly existed there until 1997; the

57


Box 3.3. Crop Insurance Initiatives

Existing crop insurance schemes in almost all cases are derived from insurance re-quirements tied to bank loans, with the loan funding typically offered by state develop-ment banks. Hence, most crop insurance schemes are not wholly voluntary and appearto have some element of subsidy in the financing conditions, although no subsidy isprovided directly to the insurance premiums.

In El Salvador, the crop insurance scheme promoted by the Banco Multisectoral deInversiones (BMI), a state-owned bank, resulted in the insurance of 3,000 hectares ofcotton in 2004, with premiums of 5 to 6 percent of the loan amount. This appears af-fordable in the context of scarce and/or expensive agricultural credit, and the premi-ums appear roughly in line with the overall cost of subsidized crop insurance in Mex-ico. The program expects to increase coverage to 8,000 hectares of cotton in 2005,under similar conditions. Some farmers with other crops have begun to request the ser-vice directly, without being tied to a specific financing scheme. The insurance is calcu-lated to cover the equivalent of 70 percent of normal crop yields. Approximately 75percent of the risk is reinsured abroad. The program required extensive research andpreparatory work by the insurance company, which won the opportunity to managethe program in a contest among local insurers that was organized by the BMI. The pro-gram benefited from the experience in crop insurance in other countries, including ex-pert assistance for the supervisor for the approval of the novel policy, and the BMI par-tially financed the international consulting services needed for the preparation of theprogram. Note, however, that the insurance covers only weather-related losses in cropyields and not losses related to pests or other causes.

Other private sector crop insurance schemes are currently being pursued in mostcountries in the region, with varying degrees of success. The experience so far indi-cates that the service takes some time to be fully developed on a sound basis and to beunderstood by farmers: A crop insurance program that was admittedly rushed into op-eration two years ago in another country has had serious difficulties, with a substantialdecrease in the amount of crop land covered and with losses for the insurance com-pany that initiated the program. A number of private insurance companies (includingat least one with extensive related experience in a neighboring country) appear to beplanning to develop the product line.

61This chapter does not look further into differences amonglegal and judicial systems other than what is found in insurancelegislation. Analogous differences exist in other regions: report-edly, large European insurance groups generally find it easier tooperate through separate subsidiaries in European Union mem-ber countries rather than sell insurance products across borders orthrough branches abroad.


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TABLE 3.4Structure of the Insurance Sector


Number of companies 1 1 18 21 18 16 11 11 5 5 20 19of which: domestic 1 1 17 20 18 16 8 8 5 5 14 14

(Share in gross premiums; in percent)

Share of largest company 100.0 100.0 18.5 12.7 23.8 18.8 18.5 21.2 57.1 42.0 . . . 19.1Share of largest five companies 100.0 100.0 54.7 54.2 70.3 63.9 70.8 61.4 100.0 100.0 . . . 72.9

(Average per company; in millions of U.S. dollars)

Gross premiums 314.1 318.0 12.8 16.7 15.2 21.5 14.3 16.8 10.0 11.5 18.4 20.7Profits . . . . . . 0.9 1.3 0.6 1.3 0.6 1.9 0.7 0.4 . . . 1.6Assets 776.2 . . . 13.8 16.5 12.7 19.1 18.4 23.9 13.5 15.4 34.4 37.1



former monopolist has been slowly losing marketshare but still makes up about half of the sector.

The fragmentation is conducive to competition.It appears that most property product lines are of-fered under reasonably competitive conditions inmost of the region. This thesis is supported by dataon falling premiums and high loss-rates. Nonethe-less, premiums tend to be somewhat high in interna-tional comparisons, but this may be mainly becauseof higher nondiversifiable risks associated with theregion as well as the higher average costs of operat-ing on a smaller scale and with smaller insuredamounts. However, markets are sufficiently flexiblethat fire premiums (which include earthquake risks)are lower in Honduras, where there is no substantialearthquake risk, and auto premiums are lower inNicaragua, where auto theft risk is relatively low.

These numerous small companies almost cer-tainly operate at well below efficient size, especiallysince most, if not all, of them operate as a tradi-tional insurance company with traditional proce-dures.62 In many cases their revenues are insufficientto support the employment of their own actuary orthe development of a fully computerized system ofrecord keeping, data analysis, and claims processing.Their investment portfolios may also be too small toachieve full diversification.

The concentration ratio has remained fairly sta-ble in most countries over the past few years and, onaverage, the top six firms account for about 70 per-cent of the market. While high in absolute terms,this concentration ratio is not unusual in interna-tional comparisons. The number of insurance com-panies has been relatively stable (except for growthin Nicaragua since the market was opened to theprivate sector in 1996); some companies have ex-ited, but others have entered.

The available statistics may overstate the frag-mentation problem to an extent because, in mostcountries, many insurance companies form groupswith each other and perhaps with banks (for exam-ple, a bank might have one life insurance subsidiaryand one non–life insurance subsidiary), and thegroup as a whole might provide certain “back office”functions. Some companies, for example, inNicaragua, are subsidiaries of larger foreign insurersfrom the region or from industrialized countries.

Insofar as insurance companies are attached to fi-nancial groups that have a strategy of offering a fullrange of products, the lack of consolidation is notsurprising. Some insurance companies may belinked to broader industrial-financial conglomer-ates, which prefer to keep insurance in-house andwhich may be able to benefit from regulatory or fis-cal arbitrage.63 In addition, it is widely believed thatconsolidation is being held up also by the desire ofmanagers and major shareholders to preserve theirindependence. Industrial-financial groups will haveto decide to break up for there to be significant addi-tional consolidation in the insurance sector of sev-eral of the countries.64

The close, and in some cases growing, links be-tween insurance companies and banks present anumber of regulatory concerns. Chapter 2 in thisvolume addresses the regulation and supervision offinancial conglomerates. Nevertheless, it is worth-while to note that affiliated insurance companiesare generally smaller than their related banks, andthat often the insurance company has had signifi-cant exposure to the bank’s risk (largely from assetsplaced with the bank).65 The opposite is typicallynot true, as affiliated insurance companies typicallyaccount for only a small part of bank deposits. How-ever, the growth of bancassurance may lead to in-creased exposure of banks to the activities of theiraffiliated insurance companies, to the extent thattheir profitability may in time depend increasinglyon insurance.

Insurance companies use a variety of means todistribute their products. Besides using their ownoffices, a network of independent agents operatesin all countries. Independent agents take the formof both individual brokers and brokerage firms, andin all countries they intermediate a substantial per-

59


62Academic studies suggest that, for American insurance com-panies, economies of scale prevail in companies with premiumincome up to at least $500 million per year.

63For example, if marginal tax rates differ by sector and level ofprofits, a conglomerate can adjust transfer pricing in order tominimize taxation. Operating as a conglomerate might also beadvantageous because that structure might effectively loosenconstraints on connected lending.

64Possible obstacles to the breakup of industrial-financialgroups include (1) the lack of liquid capital markets that make ithard to price assets, and hence difficult to agree on terms of salefor companies (and may induce nonmarket diversification ofwealth); and (2) the relatively small scale (by international stan-dards) of the industrial-financial groups themselves, which al-lows economies of scale in top management to offset the costs ofcentralized control of disparate businesses.

65Regulations regarding insurance company portfolio diversifi-cation vary greatly within the region. Some countries havestrong diversification requirements, especially with respect to af-filiated firms, while others do not.


centage of policies. The importance of brokers indistribution varies significantly across countries,although exact figures are not available: in Panamabrokers reportedly generate over 90 percent of premiums, while in El Salvador they generate lessthan half of all premiums. Bancassurance is growing in importance in most countries (see Box3.1). In some countries, such as El Salvador andHonduras, a significant part of bank profits are reportedly derived from their sale of insuranceproducts.

Specialized reinsurance companies are found onlyin Panama. Companies in other countries are toosmall to achieve the risk diversification inherent inreinsurance. Instead, heavy use is made of reinsur-ance from the large international reinsurers, al-though the relatively small Panamanian reinsurers(both specialized reinsurance companies and insur-ance companies authorized to also perform reinsur-ance services) also accept risks in the region. Theincentive to cede premiums to reinsurers is greaterfor companies with low capitalization, and it is rein-forced by certain regulatory provisions (see the nextsection). Reinsurance is especially favored for prod-uct lines for which it is difficult to diversify risks do-mestically and for which monitoring costs are lower.Thus, companies retain a higher proportion of pre-miums for auto insurance, where the large numberof policies, their smaller value, and the nature of therisks ensure that loss rates are relatively stable andadministrative expenses high, than for other prop-erty insurance, especially catastrophe risk. At theother end of the spectrum are specialized high-valueproducts, such as airline insurance, where there isessentially no local retention and reinsurance ishandled through a small number of specialized for-eign companies.

Recent Performance

Most indicators for the soundness and perfor-mance of insurance companies in Central Americadisplay stability and do not raise immediate, sys-temic concerns. There have been no major failuresin recent years, despite the occasional failure ofsmall companies. In at least one case, the failure ofan insurance company was the direct result of sub-standard reinsurance contracts, and, in anothercase, an insurance company failed because of thecollapse of its affiliated bank. In cases of failures, in-surance policies have typically been transferred toother insurance companies along with associated as-

sets to constitute reserves.66 However, the lastdecade has witnessed a few cases of more disorderlyclosure in which policies have not been honored, forexample, because of delays in court resolution of dis-putes or because the affected company did not haveenough remaining assets.

Soundness indicators such as profitability rates,leverage, and liquidity ratios appear generally ade-quate for sectors as a whole, although in most coun-tries there are some firms that appear less healthy(Table 3.2). The absolute level of capitalization ofmost firms is low and tends to be proportional to thesize of the market. Average loss ratios (the ratio ofpayouts on claims to premium income) are in linewith, or sometimes above, those found in othercomparable markets. Since loss ratios are consideredto be indicative of the degree of market competi-tion, these indicators support the reported highlevel of competition in most product lines.

Recent experience with heavy losses from bothhurricane Mitch in several countries (especiallyHonduras) and two earthquakes in El Salvador in2001 indicates that, in the affected countries, theinsurance sector as a whole was prepared to cover itsliabilities, largely because it was extensively rein-sured.67 In the case of the Salvadoran earthquakes,some $300 million in losses were paid for by localinsurers, but the net cost for the local companieswas less than $5 million. All market participantsagreed that most claims were settled rapidly, whichhelped reduce the overall cost of the earthquakedamages. However, the low penetration of insuranceservices also resulted in substantial losses being ab-sorbed by producers and families, with some of thoselosses transferred to governments.

Companies’ investment portfolios are typically notvery diversified, at least by type of investment. Thisappears to be largely the result of underdevelopedcapital markets with few investment options; diversi-fication by asset type is greater in Panama, where thecapital market is most developed, although portfolioconcentration with related parties is in some casessignificant. Honduras applies stringent portfolio di-versification regulations with regard to both assettypes and private sector issuers (especially for relatedparties and for foreign investments), but there is no

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66Insurance legislation generally includes various provisionsfor intervening in and winding up companies in distress.

67Note, however, that, in Honduras, Hurricane Mitch led tothe failure of an insurance company that had substandard rein-surance contracts.


limit to portfolio concentration in government secu-rities. Most companies place most assets in bank ac-counts or, in some cases, in securities issued by theirrespective national governments. Real estate, directlending, and equity are also significant investmentsfor companies in some countries. Investment abroadis modest and in all countries is severely constrainedby regulations. Partly due to regulatory reasons, in-vestments related to non–life insurance business,which has a short time horizon, are held mostly inrelatively liquid assets to match companies’ liabilities(i.e., their reserves against potential insurance claimsand other risks). In this case, the available invest-ments may be broadly adequate, although real returnsmay be fairly low, especially for small companies thatlack the volume and sophistication to engage in ac-tive portfolio management or bargain with banks toobtain a good return on deposits. The latter is espe-cially true when dealing with banks that are affiliatedwith (smaller) insurance companies. For non–termlife insurance business, companies are often severelyconstrained by the lack of securities with a maturityapproaching that of liabilities to policyholders.

Until at least the 1990s, the majority of the insur-ance sector in all countries had antiquated back of-fices, which led to slow service both in issuing poli-cies and in paying claims. Information for adequatemanagement decisions was poor, leading to poorlymanaged risk taking. Administrative costs and issu-ing costs were high. Largely due to the deficienciesof insurance companies, brokers established a verystrong position in most insurance markets, oftentaking over some functions that are typically per-formed by the insurance companies.

In all countries, to varying degrees, the past fewyears have seen a significant improvement in theoperations of at least the leading companies, largelyas a result of the use of more modern informationsystems. In the case of Nicaragua, the elimination ofthe state monopoly in 1997 allowed private compa-nies to start from scratch and build up relativelymodern systems, despite operating in the smallestmarket in the region. Improved operations and in-formation should lower costs and improve products,allowing for greater market penetration. As an ex-ample, a company in El Salvador used its improvedinformation system to track and control costs insuch a way that it could introduce a new automobileinsurance product that attracted new clients by of-fering no deductible at no additional cost.

Several caveats must be made with relation tothese indicators of performance. On the one hand,

insurance companies have significant scope (per-haps more than banks) to smooth results from yearto year.68 On the other, the insurance business is in-herently vulnerable to rare but large risks; perfor-mance can be satisfactory for many years, but thetrue soundness of the system is often apparent onlywhen a major event such as an earthquake tests thecapital adequacy of the sector. Some, but not all,countries in the region have weathered “stress tests”rather successfully. As mentioned above, the stresstest of Hurricane Mitch in Honduras revealed thatregulatory standards for reinsurance contracts wereinadequate, and that it was the sound business prac-tices of most insurers (and not regulatory controls)that allowed them to cope with the event. It is alsointeresting to note that El Salvador and Honduras,the two countries that in the recent past have suf-fered the greatest losses from natural disasters, weremotivated to update their regulatory frameworks.These considerations reinforce the importance ofreviewing the regulatory framework.

The Legal and RegulatoryFramework

No detailed assessments of observance of the In-ternational Association of Insurance Supervisors’Core Principles were available, but several countriesin the region have performed self-assessments. Mostsupervisory institutions publish extensive materialon their activities and the regulations in force.These materials were the basis for the summary con-tained here (Table 3.5).

In El Salvador, Guatemala, Honduras, andNicaragua, supervision is carried out by a section ofthe financial sector supervisor. In some cases, insur-ance supervision is not integrated as a unit, andsome insurance-specific responsibilities (including,in one case, the review and approval of insurancepolicies) are assigned to non-specialized unitswithin the overall financial sector supervisor. Thismay lead to significant coordination issues. In addi-tion, in some cases, reorganization and reassignmentof responsibilities for insurance regulation and su-pervision have affected effectiveness. Panama has aseparate insurance superintendency that reports to

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The Legal and Regulatory Framework

68Insurance companies typically have some discretion in deter-mining the appropriate level of reserves against various risk fac-tors and allocating losses across reserves and capital.


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TABLE 3.5Summary of Main Insurance Sector Regulation

Costa Rica El Salvador Guatemala Honduras Nicaragua Panama

Location of Self regulating. Integrated supervisor. Integrated supervisor. Integrated supervisor. Integrated supervisor. Separate; bureau of the supervisor Ministry of Commerce

and Industry.

Licensing Company established by Yes. Life and non–life insur- Life and non–life insur- Life and non–life licensing Life and non–life licensing Separate authorization requirements law. ance must be separate ance activities must each not separated. not separated. for life and non-life.

companies. be licensed.

Ownership forms State monopoly. Joint stock company. Share company. Anonymous company or No restriction. No restriction.mutual.

Foreign entry Forbidden. Foreign subsidiaries and Foreign subsidiaries and Foreign subsidiaries and Foreign subsidiaries, joint No restriction.joint ventures but not joint ventures but not joint ventures but not ventures, and branches branches. branches. branches. with own capital.

Minimum capital None. US$0.67 million for non-life Equivalent to about Equivalent to about Minimum equivalent to Equivalent to US$2companies and US$1 million US$0.5 million for either US$1.3 million for person- US$0.7 million for life or million.for life companies. Updated life or non–life insurance al or property companies, property companies,periodically. companies, and US$1 mil- and US$2.6 million for US$1.4 million for mixed

lion for mixed companies. mixed companies. companies.

Technical Required to hold Technical reserves on non- Technical reserves on Technical reserves on Technical reserves on Technical reserves on provisions and reserves on premi- life products proportional non-life products propor- non-life products pro- non-life products propor- non-life products propor-reserves ums, claims, and to retained premiums. tional to retained premi- portional to retained tional to retained premi- tional to retained premi-

contingencies. Mathematical reserves for ums (10 percent to 25 premiums and to loss ums (40 percent to ums (35 percent). Mathe-life products on actuarial percent). Mathematical history. Mathematical 50 percent). Mathematical matical reserves for life basis.Also reserves for un- reserves for life prod- reserves for life products reserves for life products products on actuarial earned premiums, statisti- ucts on actuarial basis. on actuarial basis.Also on actuarial basis.Also re- basis.Also reserves for cal risk, unpaid claims, and Also reserves for un- reserves for unearned serves for unearned pre- unearned premiums, sta-unreported claims. Catas- earned premiums and premiums, statistical risk, miums, statistical risk, tistical risk, catastrophe,trophe reserve based on unpaid claims. Catastro- unpaid claims, and unre- unpaid claims, and unre- unpaid claims, and unre-probable maximum loss phe reserves from accu- ported claims. Catastro- ported claims. Catastro- ported claims.(PML) of highest risk con- mulated earthquake phe reserve based on phe reserve based on centration area. policy reserves. PML of highest risk PML of highest risk con-

concentration area. centration area.

Solvency None. Determined by law on the Determined by regula- Determined by regula- Determined by regula- Determined by regula-requirements basis of product-specific tion on the basis of tion on the basis of prod- tion on the basis of tion on the basis of

premiums and losses as product-specific premi- uct-specific premiums product-specific premi- product-specific premi-well as fixed parameters. ums and losses as well and losses as well as ums and losses as well ums and losses as well as

as fixed parameters. fixed parameters. as fixed parameters. fixed parameters. Gen-eral reserve accumulatedfrom 10 percent to 20percent of net earnings.


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The Leg

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Restrictions on Only government se- Direct lending limited. At least 40 percent in Ceilings on share in Supervisor sets limits on Admissible investments investment curities, real estate, Maximum limits on various government securities; banks, government bonds, categories of investment. specified for 75 percent portfolio and mortgages. categories of investment. at least 1 percent in de- corporate bonds, shares, No limit on exposure to of technical reserves:

mand deposits; at most loans, real estate. government. Equity lim- government and private 59 percent in other Exposure to one risk ited to 10 percent of securities, real estate. No investments. less than 10 percent of portfolio. large exposure limits.

capital.

Restriction on Forbidden, although Maximum of 20 percent Forbidden for required Maximum 20 percent of Maximum of 20 percent Maximum of 25 percent investment abroad local U.S. dollar assets of technical reserves and reserves and capital. capital and reserves from of technical reserves and of required capital and

are available. required capital. Excess Excess capital freely local-currency-denomi- required capital. Excess reserves; at most 50 per-capital freely investable. investable. nated policies can be in- capital freely investable. cent of excess capital.

vested abroad. Reserves from dollar-denominatedpolicies can be freely in-vested abroad.

Pricing restrictions None. Policies denomi- Supervisor reviews premi- Supervisor reviews and Supervisor reviews and Supervisor reviews and Supervisor reviews pre-nated in local currency ums so that they cover can enforce premiums can enforce premiums can enforce premiums miums so that they coverand U.S. dollars. future claims but enforce- so that they cover so that they cover future so that they cover future future claims but en-

ment only through suspen- future claims. claims. claims. Supervisor may forcement only through sion of product. set ceiling on rates for suspension of product.

compulsory insurance.

Compulsory Auto third-party liabil- None. None. Government demands Auto TPL. TPL for commercial insurance ity (TPL), civil liability, bond from contractors. vehicles.

and labor risks.

Reinsurance Law exists. No compa- No companies operate. No companies operate. No companies operate. No companies operate. Reinsurance specialists regulations nies operate. Reinsur- Companies specify maxi- Companies specify max- Companies specify maxi- Companies specify maxi- have to be licensed.

ance abroad available. mum and minimum reten- imum and minimum re- mum and minimum re- mum and minimum re-tion limits. Reinsurers must tention limits. Reinsur- tention limits. Reinsurers tention limits. Reinsurersregister and meet minimum ers must register and must register and meet must register and meet qualifications from rating meet minimum qualifica- minimum qualifications minimum qualifications agencies. Retention and ces- tions from rating agen- from rating agencies. from rating agencies.sion requirement for catas- cies. Maximum retention Maximum retention lim-trophe insurance. limits specified. its specified.

Regulation of Various agents, includ- Brokers must be licensed. Brokers and agents must Brokers and agents must Brokers and agents must Only licensed brokers brokers and ing bancassurance, are be licensed. be licensed. be licensed. can offer insurance agents used. products.

Tax treatment Premiums on life, Life products over 10 years (Term) life premiums Payments exempt from Premiums on life, health, Special levy (2 to 5 per-worker safety, and a exempt from sales tax. Life deductible from income income tax. accident, and mandatory cent of net premiums) tofew other products premiums deductible from tax. insurance products ex- pay for supervisor. No exempt from sales tax. income tax and payments empt from sales tax, and tax on earnings from life-Property and catastro- exempt. payouts tax exempt. savings products.phe premiums de-ductible from incometax.


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TABLE 3.5(concluded)


Accounting Generally Accepted Set by supervisor: Inter- Set by supervisor: IAS Set by supervisor: IAS Set by supervisor: IAS GAAPconventions Accounting Principles national Accounting Stan- with insurance adjust- with insurance adjust- with insurance adjust-

(GAAP). dards (IAS) with insurance ments. Life and non-life ments. Life and non-life ments. Life and non-life adjustments. income statement. income statement. income statement.

Auditing Auditor General, in- Internal and external audi- Annual external audit of Internal and external au- Internal and external au- Internal and external au-ternal, and external tors mandatory.Annual financial statements. ditors mandatory.Annual ditors mandatory.Annual ditors mandatory.Annual firm. external audit of financial external audit of financial external audit of financial external audit of financial

statements. statements and actuarial statements. statements.audit of reserves.

Actuarial report Not obligatory. All new products. Quarterly All new products. Super- All new products.Annual All new products.Annual All new products. Super-actuarial review of technical visor does actuarial audit. external actuarial audit actuarial financial state- visor does actuarialreserves.Annual external of technical reserves. ments audit. audit.actuarial audit of technical reserves.

Centralization of Yes, but not publicly Yes No Yes Yes Yesclaims data available.

Remarks State monopoly will Revisions to law under New law in preparation. New law 2001. Imple- New law in early stages New law in preparation.end under CAFTA-DR. consideration. mentation not fully of preparation.

completed.

Sources: National authorities.


the Ministry of Commerce and Industry. In CostaRica, the state monopoly insurance company reportsdirectly to the executive and is not subject to for-malized prudential or other regulation and supervi-sion beyond provisions of the insurance law andgeneral legal principles.

The supervisors generally monitor the conditionof their insurance industries closely and are aware ofregulatory developments elsewhere. However, inseveral countries the supervisors acknowledge thatthey lack the budgetary resources to retain as manywell-trained staff as they would prefer. In addition,in some countries, detailed and inflexible laws thatmay be outdated limit the supervisor’s ability to re-spond to perceived problems. Insurance supervisorshave available several venues for international co-operation, such as bilateral contacts with other na-tional supervisors, the Central American Council ofFinancial Sector Supervisors, and the Latin Ameri-can Association of Insurance Supervisors. In somecountries, international cooperation is a very impor-tant source of resources for training.

All countries have a law on insurance. The Hon-duran law was substantially amended in 2001 andthe supervisor is currently working on some minorlegislative revisions. The supervisor in El Salvador isplanning changes aimed at establishing risk-basedreserve regulations and some other modest revisionsto the 1997 law. Panama and Guatemala are prepar-ing substantially new insurance laws that are ex-pected to be discussed in their respective congressesduring the course of 2005. It appears that the pro-posed legislation would only partially move in thedirection of risk-based regulation. In Nicaragua, theregulator expects significant revisions to the 1997legislation, also aimed at establishing risk based re-serve regulations, but only in the medium term.

Existing laws sometimes specify prudential andother provisions in detail, which can be problematicwhen they have not been amended to keep up withdevelopments in insurance practice. Supervisors andmarket participants are generally aware that certainlegal provisions are inappropriate, but enacting thenecessary amendments is not high on the legislativeagenda.69 Many firms choose to establish internal fi-nancial policies that are much stricter than those re-quired by regulations.

Largely because of the provisions in insurancelaws, certain common features can be identified inthe regulations of many (if not always all) of thecountries of the region:

• Minimum required technical reserves (alsocalled provisions) for non–life insurance poli-cies are defined as a proportion of premiums netof the amount ceded to reinsurers, rather thanrelated to the actuarial value of expected losses.This approach may be administratively conve-nient and would not be problematic if premi-ums were always set as a known proportion ofrisks borne. Indeed, in most countries, a com-pany must receive approval from the supervisorfor the terms attached to any new product; ap-proval is contingent on proof that (initial) pre-miums are set at or above an actuarially appro-priate level. However, this condition need notobtain over time because required reserves arerelated to a company’s pricing policy, whichmay vary depending on such factors as the de-gree of competition in various product lines, ad-ministrative expenses, the current return on as-sets, and level of the company’s capitalization.Furthermore, the factor of proportionality link-ing net premiums to minimum reserves is de-fined in law and is often the same across a broadrange of products, yet the risk characteristics ofproducts may differ. Thorough studies are notavailable on the determinants of appropriateproportionality factors; the various countriesuse different factors for no apparent reason. Fur-thermore, this specification of minimum re-serves may create an incentive for companies toincrease risk by competing via lower premiums,because that way they both gain market shareand reduce the expense of holding reserves.70 Ifthe proportionality factor is too high, the af-fected products will be needlessly expensive.

• On a related point, the treatment of insurancepremiums ceded to reinsurers does not differ-

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69The legislatures in some Central American countries arecharacterized by weak party discipline, so on occasion it hasproven difficult to pass even technical laws without delay or sub-stantial amendment.

70To illustrate the issues, suppose that a company underwrites arisk on a project; losses are normally distributed with mean 100and a standard deviation of 10. If the authorities wish to ensurethat the company can meet payouts without resorting to its capi-tal 95 percent of the time, the company should be required tohold premiums and reserves of 120. If required reserves are set at20 percent of premiums and premiums are 100, the objective isachieved. However, the company would underprovision if it setthe premium at 90 (when reserves would be only 18), or if theminimum-reserve-to-premium ratio is fixed at 10 percent.


entiate sufficiently depending on the specificsof the reinsurance contract. Reinsurancemight be ceded on more or less tight condi-tions, so that the reinsurer has more or lessscope to limit or contest reinsurance payoutsto the primary insurer in case of loss. If theregulations do not allow for this possibility yetrequired reserves are related to net premiumsor retained risks, primary insurers have a short-term incentive to reinsure as cheaply as possi-ble while also reducing the expense of holdingreserves. Hence, the effective level of reservesagainst true retained risk might be less thanthe supervisor intended. The regulation ofreinsurance risk (i.e., the risk that, for what-ever reason, the reinsurer will not cover all theceded risk) is especially important given com-panies’ heavy reliance on reinsurance.

• Most countries also require companies to estab-lish reserves against a standard range of risk fac-tors, such as those connected with nonaccruedpremiums, unpaid or unreported claims, uncer-tainty over the actuarial model used in settingpolicy rates, and the possibility of unusuallylarge correlated losses (“outliers” in statisticalparlance or “catastrophe risk” in insurance par-lance). Some countries have slightly less com-prehensive regulations in these areas and, as inthe case of technical provisions, the reserve re-quirements vary across countries, often withoutthorough studies to establish the appropriatelevel of required reserves.

• All countries establish solvency requirements(“solvency margins”) that set a minimum levelof overall reserves and capital, based on complexcalculations that depend on, among otherthings, gross and retained premiums, currentand past gross and retained claims, and the com-position of the insurance portfolio. Numericalparameters, presumably based on internationaland historical experience with event risks, arealso part of the calculations and were uniform insome countries. No supervisor had a study thatsupported the parameters used or the specificcalculations, although they indicated that simi-lar practices appear to exist in other countriesoutside of the region. A few supervisors indi-cated that the minimum solvency requirementsappeared to be too low. In some countries, (pri-vate) insurance firms have capital and reservelevels that are a multiple of regulatory require-

ments. In Panama and Guatemala, the insur-ance sectors have five times and three times therequired level of capital and reserves, respec-tively. This would indicate that required capitaland reserves are too low.

• Insurance laws also set an absolute minimumcapital requirement, which is somewhat low insome countries and for some business lines.71

The requirement is set in local currency, whicherodes in real terms over time due to inflation,although some countries have a mechanism forregularly revising and maintaining the capitalrequirement level in real terms. A low mini-mum capital requirement permits very smallfirms to survive, though it also facilitates entry.It can be argued that higher capital require-ments would help consolidation of the insur-ance sector, but it is not clear what the costswould be in terms of barriers to entry, especiallyif one considers the potential for the develop-ment of small-scale insurance schemes aimed atthe lower-income population.

• Investment by insurance companies is restrictedin various ways. While many of these restric-tions are motivated mainly by concern to pre-serve the solvency and liquidity of the compa-nies, some may be counterproductive orinefficient. Certain restrictions strongly favorinvestment in securities issued by the nationalgovernment, rather than a full range of domes-tic investments. In all countries, regulationsspecify authorized investments, and most coun-tries establish maximum exposure limits to spe-cific issuers and to specific securities, while oth-ers have no such requirements. Typically, whenspecifying exposure limits to issuers, no differ-entiation is made on grounds of the varyingriskiness of issuers or of investments within onecategory. In some countries, this can result inmeasures aimed at diversification forcing insur-ers into poor quality investments. Given theprevalence of insurance companies affiliatedwith financial-business groups, most (but notall) countries also have regulations on exposureto related parties.

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71In the United States, where insurance is regulated by thestates, the typical minimum absolute capital requirements forproperty insurance companies are about the same as in CentralAmerica, but minimum requirements for certain products and inparticular for life business tend to be somewhat higher.


• Additionally, in all countries, investment abroadis severely limited and in some countries returnson foreign investment are taxed much moreheavily than returns on domestic investments. Inat least one country, limits on exposure to a sin-gle issuer are applied separately to domestic andforeign investments, creating a further restric-tion for foreign investment.72 Given the limitedsize and development of regional capital markets,restrictions on foreign investment seriously limitinvestment choices and significantly increaserisk by limiting diversification. While develop-mental/nationalistic arguments are made to sup-port restrictions on foreign investment by insur-ance firms, all the countries in the region havereasonably open capital accounts. Hence, any re-striction on insurance sector investment hasscant macroeconomic impact since the local re-cipients of said investment can normally investthe funds abroad with few if any restrictions. Theonly result is that policyholders bear additionalrisk and potentially lower returns.

• Investments related to non–life insurance re-serves typically have significant liquidity re-quirements in order to assure that funds areavailable to pay claims without insurers havingto resort to potentially high costs of selling illiq-uid assets. However, an adequately capitalizedand solvent insurer should be able to access li-quidity in the market without incurring theseliquidation costs. Since liquidity requirementscan significantly erode returns on investments,regulators should be careful not to overempha-size the importance of liquidity when setting in-vestment regulations.

• The interaction of underdeveloped capital mar-kets and investment regulations limits the in-vestment options available to insurance firms.Hence, it may be expensive for companies todiversify their portfolios, obtain adequate riskadjusted returns, and match their portfolios totheir underwriting risks to the degree thatwould be desirable.

• Entry by foreign firms is generally permitted,subject to standard licensing procedures (except

in Costa Rica). However, there are restrictionson the form in which a company can be incor-porated. In particular, in several countries, aforeign entrant must establish a locally incorpo-rated subsidiary, rather than open a branch. Allcountries prohibit the purchase of insurancefrom abroad, with some countries making ex-ceptions for the products that cannot be offeredby local insurers. The requirement to insurethrough domestic authorized firms leads to thewidespread practice of “fronting,” whereby localfirms will nominally carry insurance that is inreality offered by a foreign insurer. This is mostcommon in the case of multinational firms.73

• Premiums and other contract conditions aregenerally free of restrictions, except that theymust be approved by the supervisor when a newproduct is introduced. Some regulators may en-force compliance with minimum premium lev-els determined on an actuarial basis when poli-cies are originally authorized, but otherregulators have no mechanism to assure compli-ance once policies are authorized. Laws relatingto free competition and pricing may limit anyattempts to enforce actuarially sound premiumlevels. In most countries, minimum (or mini-mum average) premium levels are often im-posed by reinsurers as part of proportional rein-surance contracts. To the extent thatproportional reinsurance is replaced by excessloss contracts, reinsurers do not impose mini-mum premiums. In some cases this has led toincreased price competition among insurers.

• In most countries, presumably because of therecent nature of the service, specific regulationsregarding bancassurance are weak. As discussedabove, when banks sell insurance productsthrough their branches, the scope for bundlingfinancial products—such as a loan with an in-surance requirement—gives rise to potential is-sues of consumer protection and the definitionof fiduciary responsibilities.74

• Regulations in all countries cover the licensingand authorized activities of insurance agents

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72 Suppose that regulations state that at most 25 percent of thetotal portfolio can be invested abroad, and at most 10 percent ofinvestments can be placed with any one issuer. If the large expo-sure limit is applied just to the foreign component, effectivelyonly 2.5 percent of investments can be placed with any one for-eign issuer.

73The countries of the region have subscribed to the CentralAmerican Free Trade Agreement with the United States. Whenthis comes into force, entry and the availability of insurance fromabroad will be liberalized.

74Chapter 2 in this book addresses the regulation and supervi-sion of financial conglomerates.


and brokers, although the specific regulationsvary significantly. In some countries, regulatorshave encountered significant problems whentrying to impose mandatory qualifications forbroker licenses.

• Few countries have extensive requirements forcompanies to prepare and publish regular reportson their actuarial situation (Nicaragua is an ex-ception), although some countries require an ac-tuarial review of reserves as part of an annual ex-ternal audit of financial statements. Regulationsrelated to and supervision of information man-agement systems, computer systems, and otherforms of operational risk are very limited. Thelack of requirements in these areas, where effec-tive systems are characterized by high fixed cost,helps smaller companies to survive.

• Domestic reinsurers exist only in Panama, whichhas a reinsurance law, but throughout the regioncompanies are heavy users of foreign reinsurance.In most countries, reinsurance contracts can beestablished only with reinsurers that meet mini-mum ratings set by international ratings agen-cies, and, in some cases, reinsurers must also pro-vide the supervisor with basic and updatedinformation to be authorized to sell reinsuranceto local companies. Supervisors often establishcontact with the regulators of the home coun-tries of the reinsurers to assure their good stand-ing. In most countries, reinsurance plans must bepresented to and approved by the supervisor.

• The tax treatment of insurance differs acrosscountries. In some, but not all, countries, premi-ums for life insurance and certain other cate-gories of insurance are deductible from incometax. Sometimes certain insurance expenses areexempt from sales tax or value-added taxes. Thetax treatment of insurance payouts also varies.

Insurance Sector Developmentand Regional Issues

The insurance sector in Central America is devel-oping, and the private sector is taking the lead.Some important initiatives are under way, for exam-ple, in the mass marketing of products and the pro-vision of crop insurance. Nonetheless, the authori-ties, in individual countries and in the region as awhole, have scope to accelerate the process.

Fostering Insurance SectorDevelopment

Modernizing the regulatory framework and super-visory practices will contribute to the sound devel-opment of the insurance sector. The authoritieshope to move toward a more risk-based approach toregulation and supervision, with a greater roleplayed by actuarial calculation of risks. In particular,technical reserves need to be related to expectedvalue of losses, their variance and covariances, andother risks (such as reinsurance risk and catastropherisk). Also, companies need more scope to managetheir portfolios to match underwriting risks. Manymeasures needed for prudential purposes, such as in-troducing more risk-based reserve requirements,mandating the production of actuarial reports, andintroducing modern information management sys-tems, would likely have a greater effect on smallercompanies, and could spur consolidation.

While the regulatory and supervisory frameworkcan be improved, it will be important to allow roomfor less sophisticated products aimed at providingbasic coverage at low cost. Regulatory principlesthat by and large have been developed for more so-phisticated markets may limit some potential av-enues for growth in countries where insurance mar-kets are at an early stage of development.

Besides these regulatory issues, the authoritiesmay have a role in providing other supporting ser-vices. For example, direct subsidies or administra-tive support for crop insurance could be worth-while.75 Any subsidy would have to be madetransparent in the budget and consistent with fiscalsustainability, perhaps by being offset by a reductionin other agricultural subsidies. Furthermore, thecost-benefit ratio would probably be most advanta-geous if any subsidies were temporary and directedat covering start-up costs. Administrative supportmight take the form of some type of centralized in-formation processing and provision, possibly gov-ernment organized, to reduce the substantial start-up costs of crop insurance services.76 Financing thedissemination of international experience in agri-cultural insurance can also help reduce the costs of

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75Mexico, among other countries, has a program of direct sub-sidy for agricultural insurance that pays between 30 and 45 per-cent of insurance premiums for a wide number of crops.

76The firm in El Salvador that launched agricultural insurancereported that collecting existing but unpublished data mostly frompublic sector institutions constituted one of the more complicatedand time-consuming tasks in the preparation of its program.


developing agricultural insurance schemes. Insofaras farmers are poor, there may be distributional rea-sons for these types of support. Moreover, the avail-ability of crop insurance may yield a payoff in termsof greater provision of credit to the agricultural sec-tor (helping to break the vicious cycle that limitsthe capitalization of the sector), yet be held back byfixed costs that are high relative to the capitaliza-tion of the sector. Government action may beneeded to overcome this threshold to establishing amarket and achieving critical mass.77

Governments could also contribute to the devel-opment of the insurance sector by insuring more oftheir own risks instead of relying on implicit self-insurance.78 Greater insurance volumes by thegovernment could help in creating critical massand economies of scale for the sector. Note that in-creased demand for insurance by the government isneither unlikely to pressure prices (in part becausethe products would be specialized) nor would itnecessarily lead to crowding out. Adequately insur-ing important assets such as roads and bridges,among other infrastructure, could add to explicitplanned expenses but would also allow for an im-proved budgetary process and less need for costlylast minute reallocations of budget revenues to at-tend to unforeseen reconstruction expenses andother losses.

Another potential area for government action iscatastrophe insurance; action in this area could belinked to efforts to stabilize government expenses asdescribed in the previous paragraph. A large numberof private sector assets are uninsured and the poten-tial losses from a large event, such as an earthquake,can create a negative macroeconomic shock thatsignificantly disrupts economic activity and multi-plies the direct losses from the event. To the extentthat governments typically assume some responsibil-ity for disaster recovery and reconstruction in thecase of catastrophes, there exists an implicit publicsector liability. Recognizing these potential liabili-ties and dealing with them through appropriate in-

surance contracts is likely to reduce the associatedcosts.79 In the light of international experience andthe size of the Central America economies relativeto the world insurance and reinsurance industry, avariety of approaches seem feasible. Hence, a num-ber of issues must be considered when designingthese insurance contracts.

• Given that social desirability of providing forcatastrophes through insurance, should thecosts of the insurance be financed throughmandatory insurance, as is the case with similarprograms such as pension schemes, or should fi-nancing come out of general government rev-enue?80 In this connection, should operationsbe managed by one or more private companies,with the government acting as regulator, orshould the government play a more direct role?

• Since high administrative costs constitute amajor reason why insurance coverage is cur-rently low, any insurance scheme (mandatory ornot) must focus on minimizing the costs of im-plementation.81 This would likely entail the useof existing mechanisms and non-insurance dis-tribution systems for identification of potentialprogram clients as well as for access, collection(if necessary), and potential payments.

• The insurance scheme should aim to providefor rapid relief, to minimize both the directmacroeconomic shock occasioned by a catastro-phe as well as the added costs of delaying reliefand reconstruction. There will generally be atrade-off between precise targeting of the reliefand the speed and administrative expense ofproviding the relief; assessing and verifying in-dividuals’ losses is time consuming and oftenrelatively expensive.

• The insurance scheme should aim to create in-centives for economic agents to reduce risk

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Insurance Sector Development and Regional Issues

77Many factors, including land titling and a history of politicalinterference, contribute to agricultural under-capitalization andthe scarcity of agricultural credit. However, crop insurance ser-vices themselves are relatively simple contracts in terms of legalprinciples and ownership, as they apply to a single crop cycle andtend to be paid in advance.

78Governments in other some countries take out insurance onmajor installations. In Bahrain, for example, premiums on gov-ernment-owned infrastructure such as petroleum facilities ac-counts for about half of all non–motor property insurance.

79Initiatives to develop catastrophe insurance are under way inseveral individual countries of the region, with the assistance ofthe World Bank, the Inter-American Development Bank, andthe International Finance Corporation.

80Turkey has introduced mandatory earthquake insurancewhere premiums are paid by homeowners. Iceland imposes a spe-cial levy to pay for a reserve fund dedicated to meeting costs asso-ciated with natural disasters.

81Traditional insurance services typically cost several times theunderlying “technical” cost of the risk because of the costs associ-ated with marketing, identifying, and valuing the insured asset;processing the policy; monitoring the risk; placing the reinsur-ance; identifying and valuing losses; processing claims; and pay-ing out the proceeds.


through individual decision making, for exam-ple, on where and how to build housing. Again,there will generally be a trade-off between howsophisticated the insurance scheme is and theexpense of administering it.

Governments could also reduce the losses fromvarious risks, including catastrophes, by enactingand/or and enforcing appropriate regulations, suchas building codes or zoning restrictions. Reducinglosses would lead to lower insurance and reinsurancecosts, and hence help expand insurance services. Inaddition, existing insurance schemes, in some coun-tries such as those for automobile TPLs, could bebetter enforced to further expand the market.

Regional Issues

It is likely that economies of scale in insurance ac-tivity could be better exploited on a regional basis,and that the countries could learn from each other’sexperience. One set of measures available to the au-thorities would be directed at the harmonization andmutual recognition of regulations, in line with inter-national best practice. The authorities could coordi-nate the introduction of risk-based regulations, andeventually there could be a presumption that a com-pany satisfying the regulatory requirements of one ju-risdiction would be free to offer insurance productsand to open a branch or subsidiary in another countryof the region.82 In this way, competition could be pre-served even as the sector consolidates within individ-ual countries. This type of effort appears particularlyrelevant given the expected results of the CAFTA-DR with the United States and other possible tradeliberalization negotiations.83

Regional efforts could be worthwhile in otherareas, including (1) the collection and dissemina-tion of demographic, meteorological, agronomic,

and other statistics needed for actuarial calculationsthat underlie insurance pricing, notably, but not ex-clusively, in relation to crop insurance; and (2) jointdevelopment of catastrophe insurance programs, es-pecially where geographic or climatic regions withsimilar risk characteristics extend across the border.

Conclusions

The insurance sector is small and fragmented inmost of Central America, and much of the popula-tion has scarcely any insurance cover despite their ex-posure to a range of natural and other risks. Yet, thesector has the potential to contribute much more tofinancial deepening and economic development.Some recent initiatives, for example, in the areas ofcrop insurance and the mass marketing of certainproducts, are promising. The financial situation ofthe insurance companies is generally satisfactory, themacroeconomic environment is relatively benign,and countries of the region have committed them-selves to intensified regional integration, for example,through free trade agreements. Hence, conditions arefavorable for measures to promote the sector.

The regulatory and supervisory regime governingthe insurance sector needs to be modernized, pri-marily by moving toward a risk-based approach. Forexample, the provisions that a company must makeneed to be related to a fair valuation of the risks thatit retains, and companies need to improve risk man-agement techniques by developing the requisite sys-tems for information collection and analysis. Therelaxation of nonprudential limitations on the allo-cation of companies’ investments could enhanceboth the functioning of regional capital markets andthe soundness of the companies. Liberalization oftrade in insurance products could ensure that com-petition remains effective even if national industriesconsolidate.

Governments can play a more direct role in ex-panding the availability of insurance coverage. Cropinsurance schemes may yield a range of benefits, in-cluding improved access to credit for the agricul-tural sector. Governments could insure more of theirown assets, which would not increase the scale ofthe insurance market but also contribute to fiscalmanagement. In recognition of the region’s vulnera-bility to natural disasters, consideration could alsobe given to introducing compulsory catastrophe in-surance, with premiums paid by private parties.

70


82Foreign (extra-regional) reinsurers currently operate undersimilar conditions to those proposed here for regional insurers. Ineffect, regulation by their home country supervisor, plus somesimple registration and information requirements (and minimumrisk classification), are deemed sufficient for them to offer (re)in-surance services in the region.

83CAFTA-DR contains provisions requiring home countrytreatment of insurers from all signatory countries, so that entrywill be restricted only by nondiscriminatory prudential require-ments. Therefore, the insurance monopoly in Costa Rica will bedismantled after a phase-in period. Insurance companies in all countries may face more competition from larger U.S. companies.


Payment and Securities Settlement Systems

Massimo Cirasino and Mario Guadamillas84

There is a growing interest in Central Americaand elsewhere in the possible efficiency gains

to be achieved from the adoption of integratedframeworks for regional payment and securities set-tlement. Individual Central American countries arealready undertaking payment system reform with as-sistance from the international financial institutions(IFIs). In addition, projects on regional clearanceand settlement of large-value financial transactionsand on integrated regional large-value real-timegross settlement (RTGS) payment system have beenlaunched by Central American governments, theCentral American Monetary Council, and theInter-American Development Bank.

This chapter draws from country assessments un-dertaken as part of ongoing efforts to upgrade thepayment and securities settlement systems in severalcountries in Central America.85 Assessment datesfor each of the countries are reported in Table 4.1.

This chapter is organized by topic, covering (1)issues related to the legal framework; (2) interbankexchange settlement circuits, including proposalsfor the reform of these systems; (3) retail paymentsystems; (4) government payments; (5) foreign ex-

change and cross-border settlement mechanisms;(6) interbank money market; (7) securities marketsand settlement, including clearing and settlementprocesses, settlement risks, custody risk, regulatoryand oversight issues, central securities depositories’(CSDs) organizational arrangements, and cross-border settlement; and (8) payment system over-sight and cooperation. Each of these sections include a brief context that generally identifies in-ternational standards and best practices, a statustable in the Appendix describing the current statusof the specific issue covered, and observations sum-marizing the overall findings. A section on proposalsfor reform concludes the chapter.

Legal Framework

Context

An appropriate legal framework is needed to un-derpin a sound and efficient payment system. Thelegal environment should include the following: (1) laws and regulations of broad applicability thataddress issues such as insolvency and contractual re-lations between parties; (2) laws and regulationsthat have specific applicability to payment systems(such as legislation on electronic signature, valida-tion of netting, and settlement finality); and (3) therules, standards, and procedures agreed to by theparticipants of a payment system. The legal infra-structure should also cover other activities carriedout by both public and private sector entities. Forexample, the legislative framework may establish

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4

84The authors work at the World Bank. They would like tothank Joaquín Bernal (Banco de la República, Colombia) for con-tributing to the analysis of the Panamanian payment systems.

85The IFIs have helped to conduct these assessments as part ofthe joint IMF–World Bank Financial Sector Assessment Program(FSAP) or as part of the Western Hemisphere Payments and Se-curities Settlement Forum (WHF), a joint effort by the Centerfor Latin American Monetary Studies (CEMLA) and the WorldBank. For more information on the WHF, see http://www.forodepagos.org.


http://www.forodepagos.org

http://www.forodepagos.org

clear responsibilities for the central bank or otherregulatory bodies, such as oversight of the paymentsystems or the provision of liquidity to participantsin these systems. Finally, relevant pieces of legisla-tion that have an impact on the soundness of thelegal framework on the payment system include alaw on transparency and security of payment instru-ments, terms, and conditions; antitrust legislationfor the supply of payment services; and legislationon privacy. Although laws are normally the appro-priate means to enforce a general objective in thepayments field, in some cases, regulations by theoverseers may be an efficient way to react to arapidly changing environment. In other cases, spe-cific agreements among participants may be ade-quate. In such cases, a professional assessment of theenforceability of these arrangements is usually re-quired. Finally, because the payment system typi-cally includes participants incorporated in foreignjurisdictions or it might operate with multiple cur-rencies or across borders, it may be necessary to ad-dress issues associated with foreign jurisdictions.

The operation of a securities settlement system(SSS) must be reliable and predictable. This de-pends on the laws, rules, and procedures that sup-port the holding, transfer, pledging, and lending ofsecurities and related payments, and how these workin practice—that is, whether system operators, par-ticipants, and their customers can enforce theirrights. If the legal framework is inadequate or its ap-plication is uncertain, it can give rise to credit orliquidity risks for system participants and their cus-tomers or to systemic risks for financial markets as awhole.

A variety of laws and legal concepts can affect theperformance of clearing and settlement systems.Weaknesses in contract laws, company laws, bank-ruptcy and insolvency laws, custody laws, and prop-erty laws may impede the performance of a clearingsystem. There is a need for an adequate legal basisthat is able to accommodate technological advances.Key aspects of the settlement process that the legalframework should support include enforceability oftransactions, protection of customer assets (particu-larly against insolvency of custodians), immobiliza-tion or dematerialization of securities, nettingarrangements, securities lending (including reposand other economically equivalent transactions), fi-nality of settlement, arrangements for achieving de-livery versus payment, default rules, liquidation of as-sets pledged or transferred as collateral, andprotection of the interests of beneficial owners. Therules and contracts related to the operation of theSSS should be enforceable in the event of insolvencyof a system participant, irrespective of whether theparticipant is located in the jurisdiction whose lawsgovern the SSS or is in another jurisdiction.

An important emerging issue is the legal status ofdigital signatures. If digital signatures are to substi-tute for handwritten signatures, they must be legallybinding. A critical need is to ensure that laws areboth enforced and are enforceable in all relevant ju-risdictions. In addition, disputes should become thesubject of court proceedings only as a last resort.This can be achieved through the specification andacceptance of clear, comprehensive, and fair arbitra-tion processes.

For further details on the legal framework’s statusin the region, see Appendix Table A4.1.

Observations

There is no regulation in the six countries specify-ing how oversight is to be conducted, although cen-tral bank laws usually recognize that payment sys-tems’ oversight is among the central bank’sfunctions (the exceptions being El Salvador andPanama).

There is a lack of provisions regarding accep-tance, irrevocability, or settlement finality of anorder to be processed by the system. These conceptsare especially important in the event of an insol-vency. In netting systems, the legal definition ofthese concepts would reduce uncertainties and limitsystemic liquidity risk from unwinding procedures.Similarly, although in general there are no explicit

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PAYMENT AND SECURITIES SETTLEMENT SYSTEMS

TABLE 4.1Assessments of Payment and SecuritiesSettlement Systems

Date of WHF Date of FSAPCountry Assessment Assessment

Costa Rica June 2001 October 2001El Salvador February 2000 February 2000Guatemala February 2004 September 2000Honduras October 2002 October 2002Nicaragua December 2003 December 2003Panama — January 20051

Sources:Western Hemisphere Payments and Securities Settle-ment Forum (WHF); and IMF–World Bank Financial Sector As-sessment Program (FSAP).

1A payments expert visited Panama for the purpose of the Fi-nancial Sector Research Project (FSRP) in January 2005.


zero hour rules, it is not clear if the countries’ courtscould revoke pending or already executed opera-tions made by the defaulting institution. Many legalframeworks fail to define specific triggers for the in-tervention of a financial institution, creating uncer-tainty about the system’s or central bank’s credit riskexposure (the latter in the case the central bank ex-tends credit to the system’s participants).

In some of the Central American countries, thecentral bank law provisions have not translated intoa specific regulation dealing with the operation ofsettlement systems. Not all the systems have de-tailed rules. Thus, participants may not be aware ofthe risks they incur. There is also a lack of clarity re-garding penalties and the conditions and proceduresfor removing a participant from the system.

There is no explicit legal recognition in the sixcountries of multilateral netting arrangements, cre-ating legal uncertainty in the event of an insol-vency. Since netting is used on a broad scale for thesettlement of stock exchange transactions andcheck and retail payments, this constitutes a seriouslegal risk. It might also hamper further developmentof financial instruments such as derivatives. It is im-portant to protect netting schemes from potentiallydisruptive insolvency laws so that, even if a systemparticipant fails during the day, a liquidator cannotunwind settlement occurring on a net basis at a latertime in the day (see, for instance, the Finality Direc-tive of the European Commission).

Most Central American countries have recentlyapproved laws for electronic documents and signa-tures. These need to be complemented by changesin relevant rules and regulations to ensure that thelegal basis is effective and clarify that the laws alsoapply to the electronic exchange of messages withinthe payment systems operated by the central bank.

In general, there is no public or private body re-sponsible for the resolution of potential conflictsarising from the operation of the systems. There isno provision regarding the responsibility of the op-erator in case of malfunctioning of the system and,therefore, there is no rule dealing with a possiblecompensation in those cases.

The judiciary in the six countries lacks familiaritywith the specific legal needs of the financial sectorand the systemic implications of the application ofcertain laws. Focused training programs should be putin place as soon as an overall assessment of the legalframework for the payment system is completed.

Although securities markets legislation usually in-cludes the legal basis for immobilization and dema-

terialization, in some cases (e.g., Guatemala) thislaw only applies to private securities. The legalframework for public debt securities is separate anddoes not include a definition of dematerializationand immobilization.

A sound legal basis requires the legal definition ofthe depository function that the central bank oftenundertakes for public debt securities. However, thedepository function is normally defined in securitiesmarkets legislation for joint stock companies, whilecentral bank laws only cover the custody function:that is, central banks maintain the registry of theprimary market but have not developed the owner-ship transfer functionality for the secondary market,even when another depository does not exist. This isa clear impediment to the development of the sec-ondary market because its settlement rests on theexchange of physical certificates.

Transactions linked to securities settlement sys-tems are not legally final, creating a potential forcounterparty risk. Finality must be integrated intothe legal framework. This is an important issue in allexisting net settlement systems, especially thosethat have longer settlement cycles. Without thislegal basis, it is uncertain whether in case of bank-ruptcy the transfer of securities to the counterpartyor his custodian could take place, even if the coun-terparty has already paid for the securities (in somesystems there is a time lag between the settlement ofthe cash leg and the settlement of the securities leg).Due to this uncertainty, an unwinding of the netsettlement might be the only solution if the cashsettlement process did not take place. If the cashsettlement already took place, it might bring for-ward principal risk if the court did not grant the re-quest to transfer the securities.

Even systems with more advanced legal frame-works are vulnerable to settlement finality risk be-cause of bankruptcy procedures that cancel fraudu-lent transactions effective several days before theparticipant is declared failed. However, the impact incase of RTGS systems is likely to be negligible be-cause of the gross nature of the system. Problems ofinterpretation might also arise since settlement final-ity is subject to regulations that have a lower hierar-chy than the bankruptcy law. Initiatives to engagethe judicial system in this debate are worth pursuing.

In general, protection of customer assets undercustodian arrangements is not clearly established.Therefore, assets pledged as collateral by clearingmembers are not adequately covered by the law,thereby compromising the capacity to execute col-

73

Legal Framework


lateral. Sometimes, the protection of custodyarrangements is provided for the depository and broker-dealers but not for other custodians, or viceversa. This limitation could bar potential settlementarrangements from taking place.86 In the case ofpublic securities, this could limit retail market de-velopment because beneficial owners are usually notidentified in the accounts of the depository.

Custodian arrangements for government securi-ties (which are often issued in physical form) do nothave secure legal support because primary dealerskeep the ownership in the registry of the ministry offinance or central bank. Thus, it is uncertainwhether the certificate endorsements in subsequentrepo operations can be legally considered a proof ofownership. In some cases, participants agree thatthe transferred certificate will be kept but not usedto transfer ownership in the ministry of finance orcentral bank registry.

Although repo operations are legally defined, thereis uncertainty about their use as guarantees for trans-actions to be processed in a system. The legal basis forthe pledge is typically included in the civil code butthe pledge, as a tool for collateralized operations, isnot regulated. Furthermore, there are no rules on theexecution of those guarantees in case of a default.This creates an important impediment in the grant-ing of collateralized intraday credit by the centralbank for the purpose of payment settlement.

The definition of repos covers only sell and buy-back transactions, although the scope of a repo ismuch wider internationally. Repos are much used tocollateralize cash or securities loans. If, during thecollateralization period, due to market develop-ments, the collateral offered no longer covers in fullthe obligation to pay back the loan or the value ofthe securities borrowed, additional collateral cannormally be requested through a margin call. Thedefinition used in the six countries leaves no roomfor this market practice and makes it difficult to useinternational standard contracts. Margin calls dur-ing the contract period might also give rise to legalrisk if the court recharacterizes a repo agreementwith interim margin calls as an improper pledge. Itmight be worth studying if there should be an ex-plicit distinction between a repo in the form of a

collateralized cash or securities loan and an explicitsell and buy-back transaction.

Laws are clear in terms of the segregation of ac-counts by the depository but not by the custodians(e.g., banks, broker-dealers), although this is oftendone in practice. This makes it unclear whether thecustomer assets will be protected against the insol-vency of custodians. This issue is relevant in cir-cumstances when the bulk of the market is repre-sented by government securities (a commonsituation in Central America) that are issued inphysical form and largely held by custodians.

The legal basis for securities lending does notexist in many cases or detailed regulations have notbeen developed. The current low volume of markettrading is an opportunity to develop the legal andregulatory framework in preparation for an eventualrecovery of past market volumes.

The fragmentation of laws and regulations relatedto securities and capital markets is common in theregion. This creates uncertainty and confusion inthe legal framework and may ultimately influenceboth the functioning of the markets and the activi-ties of market participants. A unified payment sys-tems law might help in resolving the potential con-flicts of interpretation on issues such as finality andoversight.

Legal frameworks often do not contain explicitconflict of law rules. This could hamper the devel-opment of intraregional financial markets and inter-national cooperation in the area of trading, custody,and clearing and settlement.

The lack of enforceability of the legal frameworkis hampering the development of securities settle-ment systems. Many countries have introduced anadequate legal and regulatory framework for the pro-cessing of electronic operations but poor enforce-ment is preventing the further development of fi-nancial markets.

To sum up, country authorities need to review thelegal framework with particular attention to irrevo-cability of final settlement, adequate protectionagainst bankruptcy effects, the legal basis for custodyarrangements, legal definition of a repo operation,legal recognition of multilateral netting arrange-ments, legal definition of immobilization and dema-terialization of securities (especially public securi-ties), and legal definition and regulation ofoversight powers of the central bank. Other legal is-sues considered from a developmental point of viewinclude the legal basis for collateral pledge and secu-rities lending. Due to the variety and importance of

74


86For example, markets with a high volume of transactionssometimes do not maintain subaccounts with beneficial ownerinformation but only accounts at the participant level. Such set-tlement systems should be accompanied by a strong legal protec-tion of custody arrangements and supervisory framework.


these legal aspects, some of the countries should de-termine whether the level of legal changes requiredjustify a payment systems law.

Interbank Exchange andSettlement Circuits

Context

Large-value systems are the most significant com-ponent of the national payment system. This is be-cause they can generate and transmit systemic dis-turbances to the financial sector. Several measurescan be adopted to minimize these systemic risks. Ifthe system is characterized by a deferred net settle-ment of payment transactions, risk control measuresinclude the introduction of bilateral and multilat-eral caps, the implementation of loss-sharing agree-ments, and the pledging of collateral. The develop-ment of RTGS systems is one response to thegrowing awareness of the need for sound risk man-agement in large-value funds transfer systems.RTGS systems can offer a powerful mechanism forlimiting settlement and systemic risks in the inter-bank settlement process, because they can effectfinal settlement of individual fund transfers on acontinuous basis during the processing day. In addi-tion, RTGS systems can contribute to the reductionof settlement risk in securities and foreign exchangetransactions by facilitating delivery versus paymentand payment versus payment mechanisms. Variantsof the basic RTGS system—the so-called hybrid sys-tems—that take into account liquidity saving fea-tures in net settlement systems are being introducedin some countries.

Appendix Table A4.2 presents some data aboutthe amount of cash and transferable (sight) depositsas a proxy for the use of cash and cashless paymentinstruments. Appendix Table A4.3 presents themain characteristics of the interbank settlement sys-tems identified as systematically important paymentsystems (SIPS). Clearinghouses are included as theyare systemically important, although there are alsorelevant retail payments (see next section).

Observations

Large-value and systemically important paymentsystems in Central America do not fully observe sev-eral of the Committee on Payment and SettlementSystem’s Core Principles for Systematically Important

Payment Systems (CPSS-CPSIPS).87 A number ofcentral banks in Central American countries (El Sal-vador, Guatemala, Honduras) have initiated paymentsystem reforms to improve the safety and efficiency oflarge-value systems, launch RTGS systems, and re-duce the use of checks for large-value settlement.These efforts should be carried out as part of the over-all strategy to reform the national payment system, ofwhich large systems represent the backbone.

The high value of checks settled in the checkclearinghouses throughout the region and their usein interbank payments confirm that these systemsshould be viewed as SIPS. Strengthening paymentsystem stability requires that the discharge of obliga-tions among financial intermediaries be executedthrough electronic payments settled in the RTGSsystem (when this is operational). The movementfrom checks to electronic payments is crucial to in-crease the efficiency of the payment system as awhole. Consequently, central banks should evaluateways to provide intermediaries with incentives touse the RTGS system instead of checks for inter-bank transfers. Pricing policy should be used as anincentive for this transition.

There has been progress in launching RTGS sys-tems in the region. Costa Rica already has a safeand efficient RTGS system, and new systems in linewith the CPSIPS are being launched in El Sal-vador, Honduras, and Guatemala. In Nicaragua, anoverhaul of the gross settlement system (Transfer-encia Telefónica Segura de Fondos, TTS) is underway. All countries in the region should count withan appropriately designed RTGS system. To thisend, central banks should evaluate and discuss withmarket participants all aspects of the new system.In particular, central banks should prepare rules andprocedures related to the use of the system, includ-ing tools for managing legal, financial, and opera-tional risks. Tools to handle liquidity risks shouldinclude queuing and optimization mechanisms; effi-cient throughput mechanisms and adequate inter-connections among the systems; routines for chan-neling government payments early in the operatingday; the flexible use of reserve requirements; andintraday liquidity provision through repos with ap-plication of haircuts. Moreover, the design of thesystem should include (1) a robust and efficientcommunications network between the bank andsystem participants, which should reduce and even-

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Interbank Exchange and Settlement Circuits

87Bank for International Settlements (2001a).


tually eliminate the use of manual and paper-basedprocedures; (2) strict security measures for physicaland electronic access to the system; (3) contin-gency plans and disaster recovery mechanisms, in-cluding the setting-up of a secondary site; and (4)measures for business continuity and resilience.The design should include elements that could af-fect the system’s efficiency and practicality such asfull integration of available systems, strictly en-forced operating hours, and reduction and elimina-tion of manual procedures. Pricing policies shouldbe consistent with the overall objectives. Someform of cost recovery should be evaluated vis-à-visother externalities stemming from a robust and effi-cient payment system. Access criteria (includingexit and exclusion) should be defined more clearlyand tiered arrangements should be reviewed andeventually favored to allow the reduction of manualprocedures. In some cases, certain institutions (suchas the stock exchange and retail system operators)might be allowed to hold settlement-only accountswithin the system. The governance of the systeminside the central bank should be streamlined andrationalized. User groups (i.e., groups of system par-ticipants to discuss system development issues)should be introduced.

The smooth functioning of the RTGS system re-quires sufficient reserves and the efficient distribu-tion of liquidity among intermediaries during the op-erational hours of the day. To facilitate the optimumuse of available liquidity, intermediaries should havecomplete and timely information on incoming andoutgoing payments. It is the central bank’s responsi-bility to remove obstacles to the efficient use of liq-uidity and to facilitate cash management by interme-diaries. To this end, the central bank should collectreliable statistics to be used to analyze the function-ing of the RTGS system. This supports the decisionto improve the functionality of the system. In deter-mining how to improve the efficiency of the system,it is important that open discussion takes placeamong all parties involved. In particular, some cen-tral banks have found it useful to review the timeschedule of settlement of payments in the RTGS sys-tem during the day and the critical times at whichrelevant sources of liquidity are injected into the sys-tem. In this regard, the evaluation of the treasurytime schedule for settling its payments—one of themost important sources of liquidity for the financialsystem—is critical in order to avoid unforeseen in-jections or withdrawals of reserves that increasevolatility in the availability of intraday liquidity.

The implementation of RTGS systems in CentralAmerica will not only serve the needs of domesticpayment systems but also create conditions for fu-ture regional integration. The integration of pay-ment systems should be based on the existence ofcommon features in all relevant areas (includinglegal, risk control mechanisms, liquidity provision,access policies, governance, organizational arrange-ments, operational aspects, reliability, and businesscontinuity).

Retail Settlement Systems

Context

A wide range of payment instruments is essentialfor supporting customer needs. A less than optimalsupply of payment instruments may ultimately havean impact on economic development and growth.The safe and efficient use of money as a medium ofexchange in retail transactions is particularly impor-tant for the stability of the currency and a founda-tion of the trust people have in it. As CPSS publica-tions have shown, the use of retail paymentinstruments differs both within and among devel-oped countries.88 This is because of a variety of rea-sons, including cultural, historical, economic, andlegal factors. Common trends can be observed, how-ever, namely, the continued primacy of cash (in vol-ume terms) for face-to-face payments; growth inpayment cards use; increased use of direct fundstransfers, especially debit transfers, for remote pay-ments; and changes in market arrangements for pro-viding and pricing the retail payment instrumentsand services delivered to end-users. This evolutionis likely to continue in the future and is expected toinfluence traditional (especially paper-based) instru-ments. Over the long term, some of the observedmarket developments may well alter traditional pay-ment practices and contribute to increased effi-ciency of and convenience in using retail paymentsystems. In an increasing number of countries, moreand more attention is devoted by authorities andmarket participants to the efficiency and efficacy ofproduction and distribution of payment instruments(including cash).

Central banks are involved in retail payments inan operational capacity, as payment system over-

76


88See Bank for International Settlements (1999, 2000).


seers and/or as facilitators of market and regulatoryevolution. Even though the involvement of centralbanks in retail payments varies from country tocountry, a 2003 CPSS report argues that each cen-tral bank should examine market developments pe-riodically with a focus on clearly identified policy is-sues (Box 4.1).89 Where such issues are judged toarise, relevant public authorities (including centralbanks) may decide to take action aimed at establish-ing or re-establishing an acceptable balance of thevarious aspects of safety and efficiency. The publicpolicy goals, central bank minimum actions, and therange of possible additional actions identified in theCPSS report are summarized in Box 4.1. The CPSSreport has been prepared in light of the trends in re-tail payment markets in the G-10 countries andAustralia. It is likely that, in developing countries,central banks and other private and public entitiesneed to take a proactive role and carefully explorethe possibility of taking the additional action.

Appendix Table A4.4 includes data on the use ofcashless instruments for retail payments. However,many countries still use checks as means of paymentfor large-value transactions, though it is a diminish-ing trend. The main features of the clearinghouseswere presented in the previous section.

Observations

In many cases, new applications to process retailelectronic credit and debit instruments have been amajor element of efforts to modernize national pay-ment systems. ACHs have been launched in somecountries—Costa Rica, El Salvador, Guatemala, andHonduras. In most Central American countries,however, ACH projects are either too slow to keeppace with costumer needs or too limited in scope(e.g., the project focuses only on improving checkclearing procedures). Central banks should activelysupport the full deployment of efficient applicationsto process electronic retail payment instruments.Specifically, central banks should take a leadershiprole to ensure that banks and other participantsreach the necessary agreements. They should alsocoordinate efforts to achieve a single system encom-passing all banks and other major participants, andprocessing as many payment and collection servicesas possible (see next section on government pay-

ments), so as to avoid duplications and misuse of infrastructure.

Central banks and commercial banks shouldconsider extending payment instruments and ser-vices offered by the ACHs. The introduction ofnew means of payments (such as electronic trans-fers and direct debits) has good potential for costreduction. Strategies for modernizing the paymentsystem based solely on improvements in the checkclearing system are inadequate and counterproduc-tive. Improvements in checks clearing produces ef-ficiency gains in the short term because checks arethe main cashless payments media used in allcountries. However, a strategy that includes thedevelopment of other means of payments couldhave a major impact in the medium and long term.New instruments such as electronic transfers anddirect debits will directly benefit the urban andmajor rural areas, and indirectly benefit remoterural areas through the reduction of operationalcosts in financial institutions and, therefore, lessexpensive financing.

The region relies heavily on use of checks, whichis far from optimal from the point of view of effi-ciency and risk control. Central American centralbanks and all stakeholders in the retail arena mustwork together in a clear strategy to promote the in-tensive use of retail electronic payment instrumentsand reduce the importance of checks. Customerschange their choice of payment service as a re-sponse to the price and convenience of the servicesprovided. Thus, central banks might use moral sua-sion to persuade participants to make alternativeretail payment instruments relatively more attrac-tive at the end-user level, including a relativehigher cost for checks than that for electronic pay-ment services. It should be noted that such a pric-ing strategy must be agreed on and applied at thesystem level (e.g., binding interbank agreements),because individual competitive strategies may de-rail efforts in this direction. To avoid oligopolisticpractices, the interbank agreements would be basedon an analysis of processing costs for the differentpayment instruments. Also, a minimum fee struc-ture could be set in such a way that there will stillbe incentives for banks to reduce costs and promoteefficiency, for instance, by basing the minimum feefor the different payment instruments on the pro-cessing costs of the bank that has the lowest inter-nal processing costs.

In all countries, checks are used for large-valuepayments and check clearinghouses are systemically

77

Retail Settlement Systems

89See Bank for International Settlements (2003), Policy Issuesfor Central Banks in Retail Payments (CPSS publication No. 52,March 2003).


78


Box 4.1. Public Policy Goals, Central Bank Minimum Actions, and Range of Possible Additional Actions for Retail Payment Systems

Legal and Regulatory FrameworkPublic Policy Goal A. Policies relating to the effi-ciency and safety of retail payments should be designed,where appropriate, to address legal and regulatory im-pediments to market development and innovation.

The central bank should, at a minimum:• review the legal and regulatory framework to iden-

tify any barriers to improvements in efficiencyand/or safety; and

• cooperate with relevant public and private entitiesso that the legal and regulatory framework keepspace with the changing circumstances and barriersto improvements in efficiency and/or safety are re-moved, where appropriate.

The range of possible additional actions could in-clude, depending on the individual central bank’s re-sponsibilities, powers, and priorities:

• altering regulations that currently present barriersto improving efficiency and safety, where this iswithin the central bank’s remit and where otherpublic interest arguments do not militate againstsuch action;

• introducing or proposing new regulations, as thecentral bank’s remit allows, where the legal or reg-ulatory framework is insufficient to support in-creased efficiency and/or safety; and

• offering expert advice to other responsible author-ities; for example, in the preparation of relevantlegislation.

Market Structure and PerformancePublic Policy Goal B. Policies relating to the effi-ciency and safety of the retail payments should be de-signed, where appropriate, to foster market conditionsand behaviors.

The central bank should, at a minimum:• monitor developments in market conditions and

behaviors relating to retail payment instrumentsand services and assess their significance; and

• cooperate with other public or private entities, as appropriate, to foster competitive market con-ditions and to address any significant public policy issues arising from market structures and performance.


• promoting appropriate standards or guidelines fortransparency, in cooperation with relevant publicand private sector entities;

• reviewing conditions in the market for cross-border retail payments, with a view to promotingimprovements, if such action is warranted; and

• considering and, if appropriate, performing regula-tory and/or operational intervention in caseswhere market forces are judged not to haveachieved or not to be likely to achieve an efficientand safe solution.

Standards and InfrastructurePublic Policy Goal C. Polices relating to the effi-ciency and safety of retail payments should be designed, where appropriate, to support the develop-ment of effective standards and infrastructurearrangements.

The central bank should, at a minimum:• monitor developments in security standards, oper-

ating standards, and infrastructure arrangementsfor retail payments that the central bank judges tobe important for the public interest, and assesstheir significance; and

• cooperate with relevant public and private entitiesto encourage market improvements in such stan-dards and infrastructure arrangements, where appropriate.


• participating actively in reviewing and developingappropriate standards and arrangements, in coop-eration with relevant public and private entities,where the central bank judges its more intensiveinvolvement to be necessary to furthering thegoal; and

• considering and, if appropriate, performing regula-tory and/or operational intervention in caseswhere market forces are judged not to haveachieved or not to be likely to achieve an efficientand safe solution.

Central Bank ServicesPublic Policy Goal D. Policies relating to the effi-ciency and safety of retail payments should be de-signed, where appropriate, to provide central bankservices in the manner most effective for the particu-lar market.

The central bank should, at a minimum:• review and, if appropriate, adapt its provisions of

settlement services to contribute to efficient andsafe outcomes; and

• be transparent in its provision of services.The range of possible additional actions could in-

clude, depending on the individual central bank’s re-sponsibilities, powers, and priorities:

• reviewing the relevant non-settlement services itprovides and considering their adaptation tochanging market conditions; and

• reviewing policies on access to central bank ser-vices and on pricing.Source: Bank for International Settlements (2003).


important payment systems. Central banks shouldbe proactively pursuing the removal of all large-value items from the check clearinghouse. In paral-lel, the introduction of some risk control measures(such as guarantee funds and loss-sharing agree-ments) should be considered.

Some efficiency gains could also be implementedin the check clearing system, such as full or partialtruncation (for checks under a given value). Invest-ments required for these efficiency gains should notcreate an obstacle for the development of modernpayment instruments (e.g., electronic transfers, di-rect debits), by giving system participants the illu-sion that check processing can be less costly thanprocessing of other instruments.

Retail circuits are characterized by very low in-teroperability (e.g., automated teller machines(ATMs) and electronic funds transfers at point ofsale (EFTPOS)), resulting in the inefficient use ofthe current infrastructure. Many of the positive ef-fects of a payment cards system for increased effi-ciency are not being captured because of the lackof electronic payment instruments for retail trans-actions. For example, ATMs of any network can beused only by the customers of the banks belongingto that network. As a result, the volume of transac-tions needed to amortize the investment in theATM is slow to be achieved, creating disincentivesfor the deployment of more ATMs. AlthoughATMs are not payment instruments on their own,they are an effective means to reduce the use of“on us” checks and are a useful infrastructurethrough which electronic payments and other ser-vices may be channeled. In the case of EFTPOS,lack of interoperability translates into merchantshaving three terminals (one for each card proces-sor) on their premises, which increases overallcosts and may translate into merchants giving cus-tomers incentives to pay in cash or by checks. Fi-nally, the lack of retail electronic payment instru-ments makes the card system more cumbersomeand costly as card processors pay merchants withchecks, or merchants need to have an account atmany banks in order to receive credits from everycard processor they work with.

Some banks are starting to offer retail paymentinstruments and services in multiple countries inthe region. These efforts should be monitored andsupported by central banks and banking supervi-sors. However, there is no project to develop a com-mon regional infrastructure in the retail sector.Consideration should be given to fostering the

standardization and harmonization in this area toallow for the creation of some form of regionalACH in the future.

In sum, central banks and commercial bankshave a role to play to ensure that retail circuitssupport customer needs and that such arrange-ments are safe, convenient, and efficient for theeconomy as a whole. The central bank, as the en-tity leading the efforts to improve the country’s fi-nancial infrastructure, should promote agreementsamong banks to facilitate increased interoperabil-ity. Central banks should examine developmentsin the market periodically in the light of publicpolicy goals and take action as necessary. In partic-ular, the central bank should (1) review the legaland regulatory framework to identify barriers to ef-ficiency and/or safety, and cooperate with relevantpublic and private entities to ensure that such aframework keeps pace with market developments;(2) monitor market conditions and behaviors, andensure they are competitive; and (3) support thedevelopment of effective standards and infrastruc-ture arrangements. Central banks could engageparticipants in a dialogue on national payment sys-tems with a view to agreeing on necessary im-provements. Once conditions are ready (e.g., whenagreements on interoperability are reached and/orwhen an ACH is deployed that would produce in-terbank obligations that need to be cleared andsettled somewhere), central banks could adapttheir provision of settlement services for systemsoperated by other entities to contribute to efficientand safe outcomes, allowing all such systems to set-tle in central bank money.

Government Payments

Context

The public sector is a heavy user of payment sys-tems. The government receives and remits manypayments (tax collection, salaries, purchase of goodsand services, and so on). In several countries, thepublic sector has lagged behind the private sector interms of efficient use of payment instruments andhas failed to make effective use of the banking sec-tor. In recent years, increasing attention has beendevoted to this issue and, in some countries, thegovernment has been able to use efficiently the op-tions offered by new technologies, such as ACHs,smart cards, and so on, significantly reducing its pro-cessing costs.

79

Government Payments


For the status of government payments in the re-gion, see Appendix Table A4.5.

Observations

Costa Rica, Guatemala, and Panama have imple-mented or are in the process of implementing proj-ects to integrate the public sector in the nationalpayment system. In one case (Costa Rica), the inte-gration has been particularly successful. In others,these projects are stand-alone and are not fully con-sistent with a long-term strategic vision of the pay-ment system.

Central banks and relevant government agenciesshould foster coordination and communication toensure that collections and disbursements of publicinstitutions that are major players in the paymentsystem be processed electronically and timelythrough an appropriate system, such as an ACH forretail electronic payment instruments. In manycases, gains in efficiency and cost reduction for gov-ernment payments have resulted from the reform ef-fort. Such a strategy can also ensure that all sectorscan benefit from new payment alternatives, for ex-ample, by increasing the banking services used bythe public. Moreover, government payments pro-vide an opportunity to channel a high volume oftransactions, thereby making the ACH project forelectronic payment instruments more attractive forpotential investors.

Government payments are also a major source ofliquidity for the banking system. If coordinated ef-fectively, they can facilitate the smooth functioningof the RTGS system being implemented in the re-gion and increase its appeal to participants.

Foreign Exchange and Cross-Border Settlement Mechanisms

Context

Foreign exchange markets present relevant risks.The foreign exchange settlement risk clearly has acredit risk dimension. If a bank cannot make thepayment of the currency it sold conditional upon itsfinal receipt of the currency it bought (as is usuallythe case under current market practices), it faces thepossibility of losing the full principal value of thetransaction. Foreign exchange settlement risk alsohas an important liquidity risk dimension. Eventemporary delays in settlement can expose a receiv-

ing bank to liquidity pressures if unsettled funds areneeded to meet obligations to other parties. Foreignexchange settlement risk has other dimensions aswell, for example, legal risk. In the case of foreignexchange deals, legal risk can be complicated by thefact that settlement normally takes place in morethan one jurisdiction. In a 1996 CPSS report, theG-10 central banks agreed to a three-track strategyproviding for90

• action by individual banks to control foreignexchange settlement exposures;

• action by industry groups to provide risk-reducing multicurrency services; and

• action by central banks to induce rapid privatesector progress.

The report also states that “the G-10 central banksencourage existing and prospective industry groups todevelop and offer services that would contribute tothe risk-reducing efforts of individual banks.”91

Also as a result of the recommendations includedin the 1996 CPSS report, the continuous linked set-tlement (CLS) service was launched in September2002. The CLS, provided by CLS Bank Interna-tional, settles foreign exchange transactions in fif-teen currencies—U.S. dollar, euro, British pound,Japanese yen, Swiss franc, Canadian dollar, Australian dollar, Swedish krona, Danish krone,Norwegian krone, Singapore dollar, Hong Kong dol-lar, New Zealand dollar, Korean won, and SouthAfrican rand—on a payment-versus-payment (PvP)basis on the books of the respective central banks.The CLS Bank is supported by over 70 of the world’slargest financial institutions, accounting for a largeshare of cross-currency transactions across theworld. Transactions in other currencies are likely tobe settled by the CLS Bank in the future. The CLSBank is subject to the cooperative oversight of thecentral banks that are involved and it is under thedirect oversight of the U.S. Federal Reserve.

For the status of foreign exchange and cross-border settlements in the region, see AppendixTable A4.6.

Observations

Foreign exchange transactions are not settled ona PvP basis. Central banks should investigate the

80


90See Bank for International Settlements (1996), p. 40.91See also Basel Committee on Banking Supervision (2000).


possibility of introducing measures to mitigate therisks associated with these operations when PvP isnot possible. Risks in this market can be evaluatedby taking as a reference the reports and question-naires published by the CPSS. For domestic foreignexchange transactions, that is, those that involveonly domestic counterparties, the central banks thatallow holding reserve accounts both in local cur-rency and in U.S. dollars need to ensure, as matterof urgency, that wholesale foreign exchange tradesare settled in central bank money on a PvP basis(not necessarily RTGS, but always maintainingPvP). In this direction, these central banks couldeventually consider the provision of a settlement-only account to other major players in the foreignexchange market such as the casas de cambio.

Central banks and banking supervisors should in-troduce measures to mitigate the associated risks.Attention should also be given to correspondentarrangements abroad of domestic banks to ensurethat risk profiles and operating procedures of corre-spondents are constantly reviewed and do not gen-erate any relevant risks in the country.

Proprietary mechanisms of commercial banks forcross-border payments can turn into a less costly andconvenient alternative for customers. Another possi-ble benefit is that remittances from other CentralAmerican countries can now be channeled all theway through banks instead of unregulated specializedcompanies, so that, among other things, remittancesneed not be paid in cash. Central banks, in coopera-tion with banking supervisors and among themselves,should carefully monitor these mechanisms and otherdevelopments in this area and decide whether regula-tions are necessary to ensure that they do not increaserisks for the domestic banks that are involved.

On the other hand, a large share of remittancesare still channeled through unregulated specializedinstitutions, for which there are no standards for as-pects such as transparency of fees and other chargesor the timing of accreditation of funds to end bene-ficiaries. In the latter cases, the regulatory perspec-tive should be widened from the traditional areas ofbalance of payments and money laundering to in-clude payment system issues, in particular issues re-lated to efficiency, transparency, and risks.

In sum, Central American central banks shouldcarefully monitor trading and settlement platformsand procedures for foreign exchange and cross-border transactions, especially remittances, to en-sure that they can apply the principles of safety andefficiency to the clearance and settlement.

Interbank Money Market

Context

The adequate functioning of an interbank moneymarket goes beyond clearance and settlement consid-erations. An efficient mechanism for trading and set-tlement of these transactions will allow for improvedliquidity management and, thus, for increased safetyand stability of the financial system. In addition itwill help securities settlement through lower interestrates that will benefit the broker-dealers in the creditlines they negotiate with banks. Another importantconcern for the authorities is the smooth and effec-tive functioning of the monetary policy because cen-tral banks normally use the interbank money marketto give a clear signal to banks, which then is ex-tended to the rest of the financial sector. If the opera-tional procedures or the organizational and regulatoryarrangements do not provide for an efficient system,the central bank can have difficulties in providingclear monetary policy signals.

Two key elements for the development of inter-bank money markets are a special purpose system forlarge-value payments to provide secure electronicinterbank transfers with immediate settlement thatcan be interconnected to an electronic book-entrysecurities system to register and record changes in ownership of securities.

For the status of interbank money markets in theregion, see Appendix Table A4.7.

Observations

The future evolution of securities markets needsto be discussed among responsible authorities andmarket participants. An adequate strategy that takesinto account the national interest, leaving aside pri-vate interest, should be defined. Once the strategyhas been agreed, a neutral securities clearance andsettlement system can be implemented to allow faircompetition in the financial sector. Authorities andmarket participants should openly discuss the likelyfuture of securities markets and agree on organiza-tional and regulatory arrangements that allow foradequately developing the interbank money market,on the one hand, and the securities market, on theother. This will be a difficult process because severalprivate interests will be affected, but the only alter-native is to develop safe and efficient securities mar-kets that can take a lead in a potential regionaliza-tion process.

81

Interbank Money Market


In sum, the adequate functioning of an interbankmoney market is crucial for the smooth functioningof payments and securities settlement. An efficientmechanism for trading and settlement will improvethe system’s liquidity management. Another impor-tant concern for the authorities is the smooth andeffective functioning of monetary policy because theinterbank money market is the backbone of mone-tary transmission. Two key elements for the devel-opment of interbank money markets are a specialpurpose system for large-value payments to providesecure electronic interbank transfers with immedi-ate settlement that can be interconnected to anelectronic book-entry securities system to registerand record changes in ownership of securities.

Securities Settlement Systems

This section covers issues related to securities set-tlement other than legal issues, which have beencovered earlier in the chapter. Included in this sec-tion are issues related to clearing and settlementprocesses, settlement risk, operational issues, cus-tody risk, regulatory and oversight issues, deposito-ries organizational arrangements, and cross-bordersettlement.

Clearing and Settlement Processes

Context

The clearance and settlement process includescapturing trade information, trade matching, con-firming and affirming institutional investor’s trades,clearing, and settlement. Various international orga-nizations have attempted to set standards forprompt, efficient, and effective trade processing, in-cluding its cost-effectiveness (in terms of both sys-tem operation and fees paid by participants) andease and convenience of use. One of the mostwidely recognized concepts is that the longer ittakes to settle a securities trade, the greater the riskthat settlement may not take place. In this regard,the CPSS and the International Organization of Se-curities Commissions (IOSCO) recommend thattrade settlement occur by T+3 or less. However,T+3 often is no longer regarded as best practice.The shortest possible elapsed time between tradedate and settlement date reduces settlement risks(especially market risk) and promotes liquidity inthe maturity. Nevertheless, the practical impact ofshortening this time must be assessed, especially if it

affects the number of trades that fail to settle.92

Same-day settlement could be considered as thefinal goal, although it is generally recognized thatthis may not be achievable in the short or mediumterm, particularly for cross-border transactions. Themagnitude of the changes required to achieve a par-ticular standard must also be carefully considered.For example, whereas it might be relatively easy tomove from T+5 to T+3 by simply imposing morediscipline on system participants, more fundamentalchanges (i.e., process re-engineering) in all aspectsof the system are likely to be necessary to move toT+2 or T+1. Regardless of the settlement cycle, thefrequency and duration of settlement failures shouldbe monitored closely.

The profile of market investors (retail versuswholesale, domestic versus foreign) and their inter-mediaries should be taken into account because thiscan influence the practicality of the targeted clear-ing and settlement cycle. Appropriate trade-off be-tween risk, cost, and convenience must be made, orelse the system will not satisfy user requirements atan affordable and acceptable cost, and thus mightconstrain market development.

Another widely recognized concept is that tradematching should occur as soon after the trade aspossible so that errors and discrepancies can be dis-covered early in the settlement process. The CPSSand IOSCO recommend that trade comparison beaccomplished by T+0 and in any case no later thanT+1. In addition, indirect market participants—institutional investors and custodians—should bemembers of a trade comparison system that achievespositive affirmation of trade details. Moreover, thereshould be an integration system for trade matching,comparison, and book-entry settlement of securitiesand funds. An automated link between the exchange/over the counter (OTC) and the centralsecurities depository (CSD) is generally consideredto be desirable and is a prerequisite for broker-dealerstraight-through processing (STP) from executionto settlement. Likewise, when clearing and deposi-tory services are provided by different entities, it isrecommended that these two functions be closelytied together, otherwise finality of settlement is dif-ficult to achieve. Fortunately, the cost of imple-

82


92Currently, there is a debate about the adequacy of movingthe settlement cycle to T+2 or even T+1. Given globalization offinancial markets, there is an increasing necessity to standardizethis process at an international level, even if this implies increas-ing the settlement cycle for some countries.


menting automated systems is decreasing. However,care should be taken to ensure that sufficient trans-action volume exists and that users are willing topay for the automated services based on tangiblebenefits in terms of efficiency or risk reduction.

Mature and liquid securities lending markets, in-cluding markets for repos and economically equiva-lent transactions, generally improve the functioningof securities markets by allowing sellers ready accessto securities needed to settle transactions wherethose securities are not held in inventory; by offeringan efficient means of financing securities portfolios;and by supporting participants’ trading strategies.The existence of liquid markets for securities lendingreduces the risk of failed settlements because marketparticipants with an obligation to deliver securitiesthat they have failed to receive and do not hold ininventory can borrow these securities and completedelivery. Securities lending markets also enable mar-ket participants to cover transactions that have al-ready failed, thereby curing the failure sooner. Intra-day finality is crucial for these operations. Incross-border transactions, particularly back-to-backtransactions, it is often more efficient and cost-effective for a market participant to borrow a securityfor the delivery rather than to deal with the risk andcosts associated with a settlement failure.

Because of increased automation and globaliza-tion of securities markets, it is beneficial for domes-tic systems to use internationally recognized securi-ties identification numbering standards. With thisin mind, the G-30 recommended that all marketsshould adopt a numbering system that meets the in-ternational securities identification number (ISIN)standards. The CPSS-IOSCO “Recommendationsfor Securities Settlement Systems” insist on thispoint in recommendation 16.93

For further details on the status of securities set-tlement systems in the region, see Appendix TableA4.8.

Observations

There is significant manual handling in the con-firmation process, which increases the probability oferrors and, thus, settlement failures. Manual han-dling of securities results in inefficiencies and risksthat limit the development of the markets. Indeed,the bulk of the market is sometimes settled in-houseto minimize these risks.

Some systems (e.g., in Costa Rica and Panama)have close links between trading and settlementsuch as blocking of transactions prior to matching.This procedure ensures the availability of securitiesbut hampers back-to-back transactions and the ef-fective arbitrage between trading and settlementplatforms. To arbitrate, an investor might wish tosell in one system securities that were bought in an-other during the same day. This is not possible if se-curities have to be blocked in advance. This block-age also makes the rollover of repos difficult. Moreorthodox risk management tools should be used toavoid the rigidity introduced by this mechanism.The development of a new system that allows forthe separation of trading and settlement is crucialfor the efficient operation of stock exchanges as wellas observance of international standards for settle-ment risk. In addition, as long as no robust risk man-agement procedures are implemented, cash settle-ment on a multilateral net basis should be doneseparately for each trading system in order to mini-mize systemic risk even if it raises costs throughhigher liquidity needs of broker-dealers.

The standardized settlement cycle must be fixedand identified for all the trades executed in the se-curities markets. This is particularly relevant in thestock exchanges where a T+3 settlement cyclewould be appropriate. Shorter settlement cycles forsecurities traded in the stock exchanges should betaken into consideration, especially those related tobilateral trades between market participants.

Some stock exchanges (e.g., Costa Rica) play acrucial role in money markets and have difficultiesin accommodating different settlement needs.Should these stock exchanges evolve to have a moretraditional role of secondary market transactions,the introduction in a standardized settlement cyclewill be needed.

Shorter settlement cycles can reduce risk in linewith international standards. However, the costsand benefits of a shorter settlement cycle should beassessed, in particular the impact on retail cus-tomers. Retail customers may be required to keepfunds with broker-dealers or deposit funds with abroker before a broker can execute a buy order. Ingeneral, STP will help the reduction of settlementcycles without increasing settlement risks.

Some SSSs allow for the extension of the stan-dardized settlement cycle should a failure occur inthe settlement process. It is essential to count withappropriate risk management tools to guarantee set-tlement in the case of failures on settlement date.

83


93Bank for International Settlements (2001b).


Settlement procedures on a delivery versus pay-ment (DvP) basis help to avoid settlement exten-sions. Given a failure in the delivery of securities onsettlement date (and counting on a guaranteeregime and a settlement system on a DvP basis), it isrecommended that SSSs can execute buy-in proce-dures in the securities markets to reduce the risk inthe system.

Automatic securities lending and borrowing facil-ities are not available in Central American markets,mainly because of the low level of activity. Suchmechanisms provide the SSS with an effective riskmanagement tool for the securities leg of markettransactions. Prior to its establishment, securitieslending must be recognized and encouraged by law.The finalization of the standardization process is es-sential for this mechanism to be effective. All legal,tax, and other barriers, including lack of standard-ization, should be removed. Securities lending couldbe implemented in two different ways:

• bilaterally between market participants: in thiscase the CSD will act as loan register; and

• multilaterally or centralized: this implies thecreation of a group of entities, mostly bankingand financial institutions, capable of lendingsecurities against an interest rate. The adminis-tration of the pool of potential available securi-ties and the allocation process normally is dele-gated to the securities depository or anotherentity acting on a policy of no risk-taking. Theefficiency of existing ways to cope with securi-ties shortages should be evaluated vis-à-visstandardized forms of securities lending.

In addition,

• all securities lending operations must be collat-eralized and backed by private contracts subjectto international standards;

• fiscal treatment of securities lending contractsmust be neutral and objective; and

• if short-selling is permitted, for example, as a wayto increase the liquidity of the markets, it shouldbe linked to securities lending operations inorder to cover the oversold positions. Regardless,securities regulators must be alert against un-healthy market practices relating to short-sellingthat could lead to market manipulation.

With the exception of Costa Rica, communica-tion networks do not follow international standards.Although the local communication networks work

correctly, for cross-border transactions to be rele-vant, the networks should also be consistent withinternational communication procedures. Securitiesdepositories and investment firms with a relevantforeign business share should adopt in the shortterm international standardized communicationprocedures to facilitate cross-border transactionsboth free or against payments. Local firms shouldadapt their communication procedures to the inter-national communication networks using the samestandards.

In sum, improved clearing and settlementprocesses in SSSs are necessary to reduce marketfragmentation, increase standardization of settle-ment cycles, accommodate different settlementneeds, operate with shorter settlement cycles, avoidextension of settlement cycles due to inadequaterisk management tools, improve market liquiditythrough automatic securities lending, and intro-duce international communication standards.

Settlement Risks

Context

The settlement process exposes market partici-pants to different risks. The system should be de-signed to minimize these risks. The immobilizationor dematerialization of securities reduces or elimi-nates certain risks, such as destruction or theft ofcertificates. The transfer of securities by book entryis a precondition for the shortening of the settle-ment cycle for securities trades, which reduces re-placement cost risks.

The main settlement risk is counterparty—creditor principal—risk. DvP is one of the primary meansby which a market can reduce the risk inherent insecurities transactions. The DvP concept seeks toeliminate principal risk from securities transactionsby ensuring that sellers give up their securities if,and only if, they receive full payment and viceversa. There are three essential elements in a DvPtransaction: (1) good and irrevocable delivery of se-curities, (2) final and irrevocable funds, and (3) si-multaneous exchange. The CPSS has identifiedthree different models of DvP.94 Although thesemodels vary in their approach to achieving DvP,they all meet the concept of real DvP.

The use of a central counterparty that interposesitself between the counterparties to securities trades

84


94See Bank for International Settlements (1992).


is becoming more common. It is an especially effec-tive tool for reducing risks vis-à-vis active marketparticipants. The use of a central counterparty con-centrates risk and reallocates it among participants.The ability of the system as a whole to withstandthe default of individual participants depends cru-cially on the risk management procedures of thecentral counterparty and its access to resources toabsorb financial losses.

Risk management procedures to reduce marketrisk and strengthen a DvP mechanism include (1) establishing admission standards, participationfunds, collateral, margins, buy-ins and sell-outs, netdebit caps, bilateral credit limits, and loss-sharingarrangements; and (2) monitoring members’ credit-worthiness. Most settlement systems use more thanone procedure to minimize market risk. In addition,there are a number of mechanisms designed to im-prove the settlement process. Among them are cen-tral lending facilities, pledge recording facilities, andprompt re-registration procedures. Lending and bor-rowing of properly regulated securities lending andborrowing can bring significant benefits to a marketand its users, leading to more liquid markets. Short-selling could be a useful mechanism to add liquidity,but regulation must be in place against manipulativepractices, including those associated with significantshort positions.

Systems that are considering whether to imple-ment RTGS or a netting scheme should examinemarket volume and participation to determine ifthese mechanisms are appropriate. Historically, net-ting was introduced to reduce the amount of physi-cal documents passing between market members.Later, with the introduction of early computer sys-tems, it was used to reduce the number of electronicsettlements. Today efficiency advantages are less im-portant because of the high speed introduced bypowerful computers and RTGS systems. Thus, thedebate is focused on the trade-off between liquidityrequirements and risk mitigation, as discussed earlierin this book.

Settling in same-day funds is essential when oper-ating in an RTGS environment and is useful inachieving real intraday DvP.95 To achieve timelyand risk-free settlement in same-day funds, efficientbanking arrangements will need to be developed

that enable funds to be moved quickly and relativelyinexpensively.

The finality of the ownership transfer of both pay-ments and securities is a crucial factor in the devel-opment of a securities market. Otherwise, only localinvestors will operate in the market based on well-established client relationships and the confidencethat these provide. In emerging markets, this factoris critical if there is a desire to attract foreign invest-ment. Foreign investors will be reluctant to partici-pate in a market that is not considered to be safeand sound. Payments finality is equally important.

The failure of a bank providing cash accounts tosettle payment obligations for CSD members coulddisrupt settlement and result in significant lossesand liquidity pressures. The use of the central bankas the single settlement bank may not always be pos-sible, however. In such cases, a private bank some-times is used as the single settlement bank, and stepsmust be taken to protect CSD members from poten-tial losses and liquidity pressures that would arisefrom its failure.

For the status of settlement risk management inthe region, see Appendix Table A4.9.

Observations

A modern securities market needs to have a secu-rities depository and fungible securities. All physicalsecurities kept in custody by participants of the se-curities depositories should be immobilized or dema-terialized in a securities depository.

Additional efforts are necessary to achieve full de-materialization and immobilization of securities.Central banks and ministries of finance are makingefforts to achieve the complete dematerialization ofgovernment securities. Similar efforts are being un-dertaken by the private sector. Lack of securitiesstandardization is an important obstacle, mainly inthe case of public securities. Regular meetings withissuers and both institutional and noninstitutionalinvestors are practical measures to promote demate-rialization and immobilization and the movement ofsecurities on a book-entry basis.

Some systems—those in El Salvador, Guatemala,Honduras, and Nicaragua—still do not settle on aDvP basis. Consequently, payments are not neces-sarily linked to securities transfers and vice versa.Therefore, principal risk exists. No measures havebeen taken to eliminate principal risk and to reduceand mitigate replacement risk (i.e., a guaranteeregime). Coordination and links between securities

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95A payment is made in same-day funds when it is made on anirrevocable basis to the counterparty on the day of settlementsuch that they are available for use on the day of settlement.


and monetary flow transfers on a DvP basis modelare essential. Replacement risk must be reduced ormitigated with the implementation of a strict guar-antee regime.

Most systems have imperfect DvP procedures.Due to the time differences between the clearing ofthe cash leg and that of the securities leg, principalrisk could occur if a broker goes bankrupt in this pe-riod. In that case it might be difficult to transfer thesecurities from the account of the depository inwhich they are blocked at the beginning of the trad-ing day to the defaulter’s counterparty, even if thecounterparty has already paid for these securities. Inaddition, principal risk in these systems is sometimessubstantially enlarged by the decision to release se-curities in the second leg of a repo transaction be-fore cash settlement to allow for rollover. The secu-rities might already be transferred to a third party bythe original owner while no money might be avail-able to fulfill the obligation to its counterparty. Onereason behind this kind of a settlement arrangementis lack of standardization.

In general, there is an absence of risk manage-ment tools for covering settlement failures. Somesystems do not offer any tools, while others offersome clearly insufficient ones. Authorities shouldanalyze if current risk management tools are suffi-cient to cover potential failures, especially takinginto account that existing guarantee funds can beused for failures other than those associated withsettlement. A specific guarantee fund for settlementfailures could be separated from a more general guar-antee fund. In some cases, operations are unwoundprior to the use of the guarantee funds and no riskmanagement tool is established for failures on thesettlement side, except to compensate the broker-dealer for the fee. To avoid potential systemic risk,the guarantee funds should be used prior to the un-winding, and a buy-in or similar mechanism couldbe established to cover securities failures. In somecases, the total value of the guarantees seems insuffi-cient to cover failures for both securities and funds,at the current levels of market volume and value.

Related to the funds side, the common use ofchecks in the settlement process implies that thesame-day-fund principle could not be fulfilled. Cen-tral bank money is often used in transactions. How-ever, settlement in central bank money is not nor-mally mandatory and payments by checks arecommonly used in many systems. The use of centralbank money to settle transactions relating to securi-ties markets should be encouraged (this is especially

important for developing markets although not re-quired by the standards). Existing fund settlementsystems in the region already allow for the use of theother type of fund transfer that would eliminate thisrisk. Due to the nature of securities transaction, fundsettlement should take place with an instrument thatallows for finality at the end of settlement day.

Normally, nonbank clearing members and broker-dealers do not have access to central bank money,which imposes a liquidity constraint on their opera-tions. If there is a lack of liquidity in the financial sys-tem or inefficient liquidity management and marketpractices of broker-dealer and their clients, the short-age of liquidity could be exacerbated by settlementwithout DvP. In some cases, broker-dealers have diffi-culties accessing intraday liquidity facilities fromcommercial banks. Banking innovation in paymentmechanisms might bring some reduction of liquiditypressures at the broker and customer levels. Provisionof funds from the final investor to the broker-dealerto execute the transactions would also ease liquiditypressures. The reliability of the system as a whole, andof clearing and settlement procedures on a DvP basis,are essential to bringing confidence to the systemand, thus, allowing final investors to provide broker-dealers with liquidity for operations carried out ontheir behalf.

In the case of settlement of funds being made at aprivate settlement bank (not common but presentin the region), assets used to settle the cash leg of se-curities transactions between SSS members shouldcarry little or no credit or liquidity risk. If centralbank money is not used, steps must be taken to pro-tect participants from potential losses and liquiditypressures arising from the failure of a settlementbank. Often, when a private settlement bank isused, there is no supervision of its settlement func-tion. Lack of coordination between regulators onthis raises additional concerns. Authorities shouldexplore alternatives in terms of the assets used tosettle the cash leg of securities transactions and, if aprivate settlement bank is used, adequate regulatoryand supervisory mechanisms should be put in place.

Plans for the development of new securities de-positories in the region are not always realistic interms of timing and are driven by a specific techno-logical solution, not by a strategy agreed by all stake-holders. Some stock exchanges are developing tech-nological solutions based on other countries’experiences in the region. The launch of a securitiesdepository is a desirable and necessary element, butit implies much more than the establishment of an

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operational system. The launch of the securities de-pository should be considered in the context of acomprehensive reform of the payment and securitiessettlement systems. Some of the following crucial el-ements should be agreed by regulators and otherstakeholders before any implementation takes place:

• What should be the role of the central bank?

• What kind of securities will the securities de-pository immobilize or dematerialize?

• Which settlement bank will it be and what im-plications does the legal framework have in thisregard?

• What are the most appropriate settlement cycles?

• Should the depository identify the beneficialowner or should this be done only at the custo-dian level (this decision depending on thestrength of the supervisory function)?

• What model of DvP will be implemented?

• Which risk management tools will be in placeto mitigate settlement risks in case of a multi-lateral net system?

• What should be the operational security re-quirements and supervision?

• What ownership structure should the deposi-tory have?

• Will the system allow for fair and open access toall participants? and

• What will the governance arrangements be?

It is important that the reform focuses on all ele-ments of SSSs and not only on the operational sys-tem for a securities depository. It is also importantthat the new SSS observes the “Recommendationsfor Securities Settlement Systems” issued by CPSSand IOSCO in November 2001, which include legaland custody issues, clearance and settlement proce-dures, settlement risk, cash settlement asset, opera-tional risk, regulation and oversight, transparency,efficiency, access, and governance. Finally, formalcoordination among regulators and cooperationwith the private sector are crucial in developing thispiece of financial infrastructure.

Where public authorities have not taken a leader-ship role in the development of securities settlementarrangements, private institutions have introducedsolutions that are not integrated into a comprehen-sive payments and securities settlement reform. Due

to public interest in the development of an SSS in-frastructure (implications for fiscal and monetarypolicy, liquidity management, and development ofthe capital markets), public authorities (centralbank, securities regulator, pension funds regulator,and ministry of finance) should take the lead indefining how such a system should be designed andimplemented, and cooperating with the private sec-tor in doing so. The public nature and neutral posi-tion of regulators can help overcome the conflictamong private interests.

Some markets are exposed to concentration riskin settlement activity. Broker-dealers have a centralfunction in some trading and securities settlementsystems. In some cases, they have the monopoly ontrading in the stock exchange. They are also theonly participants in the depository with operationalrights (pension funds and banks have nonopera-tional custody accounts) and for that reason have amonopoly on custody services for immobilized secu-rities. In some cases, all money market transactionshave to be done via broker-dealers. Broker-dealersalso provide services to the public by attracting de-posits and by investing in capital or money marketinstruments. This full range of services includes sub-stantial liabilities of the broker-dealers to banks,other financial institutions, and the public. How-ever, capital requirements for broker-dealer housesare relatively low.

The settlement of securities and funds should belinked to stock exchange transactions settled on aDvP basis in order to eliminate principal risk. Themain improvements needed are achievement of fulldematerialization and immobilization of securities,establishment and completion of DvP procedures,upgrade of current risk management tools, mitiga-tion of credit and liquidity risk in the cash leg settle-ment (including elimination of checks as a cashasset), better access to liquidity for SSS participants,and comprehensive strategic approach for the re-form of SSSs as opposed to technology-driven andexclusively operational reform projects.

Operational Issues

Context

Operational risk is the risk of deficiencies in in-formation systems or internal controls, human er-rors, or management failures resulting in unexpectedlosses. As clearing and settlement systems becomeincreasingly dependent on information technologysystems, the reliability of these systems becomes a

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key element of operational risk. Operational riskcan arise from inadequate (1) control of systems andprocesses; (2) management more generally such aslack of expertise, poor supervision or training, andinadequate resources; (3) identification or under-standing of risks and the controls and proceduresneeded to limit them; and (4) attention paid to en-sure that procedures are understood and compliedwith.

To minimize operational risk, system operatorsshould identify the sources of this risk. All key sys-tems should be secure (i.e., have access controls, ad-equate safeguards to prevent external intrusions,and provide audit trails), reliable, scalable, able tohandle stress volume, and with contingency plans incase of a system interruption. The system shouldmaintain an adequate capacity to process currentand anticipated future transaction volume, includ-ing projected peak day and peak hour volume de-mands. To achieve this, the operator must (1) estab-lish formal current and future capacity estimates fortheir automated trade comparison systems; (2) con-duct periodic capacity stress tests to determine thebehavior of systems under a variety of simulatedconditions; and (3) conduct independent annual re-views to assess whether these systems can ade-quately perform at their current and estimated fu-ture capacity levels.

Operational capacity must also be demonstratedto exist at the mandatory disaster recovery site. Op-erators must have in place a well-designed and ade-quately tested mechanism for transferring systemcontrol to the backup site in an acceptable timeframe without loss of data or unacceptable reductionin service levels.

In assessing the efficiency of settlement systems,the needs of users and the costs imposed on themmust be carefully balanced with the requirementthat the system meet appropriate standards of safetyand security.

For more details on the operational reliability ofsecurities settlement systems in the region, see Ap-pendix Table A4.10.

Observations

The physical handling of securities is still commonin many SSSs. The clearing and settlement of securi-ties transactions with physical certificates instead of atransfer via a book-entry system is not only risky butalso cumbersome and costly, and hampers the devel-opment of capital markets. It is not in line with inter-

national standards. Thus, an important target shouldbe to eliminate physical handling of securities. Gen-eral laws on securities or capital markets must recog-nize the immobilization, dematerialization, and thetransfer of securities on a book-entry basis. Deposito-ries should encourage the dematerialization and im-mobilization of all securities as a matter of urgency.

Straight-through processing is not the rule inSSSs in the region. Many procedures imply physicalhandling of securities. This makes some clearanceand settlement procedures cumbersome, for exam-ple, dividends payments and corporate actions ingeneral that require a substantial amount of manualintervention. Gradual implementation of STP pro-cedures would be desirable for all kinds of securitiesin order to reduce operational risk. STP for securi-ties transactions will mean a fully automated trans-actional link for trade matching, comparison, andbook-entry settlement of securities and funds. Suchan integrated system would not only reduce the pos-sibility of errors but also make the clearing and set-tlement process more efficient by, for example, elim-inating duplicate processes and giving theparticipants immediate information for effective liq-uidity management.

In many cases, backup facilities are missing or arein the process of being implemented. They shouldbe in place as early as possible to cover any contin-gency in the system. Alternate sites and disaster re-covery facilities must enable operations to be recov-ered in a manner that does not disrupt settlement.

External auditing of operational systems should beconsidered to assess the security and cost efficiency ofall systems. The authorities and the private sectorhave made very important efforts in developing tech-nological platforms for the operation of the SSSs. Insome cases, an in-house solution has been adoptedversus the acquisition of standard systems. In thesecases, an external audit of the systems should be con-ducted to ensure that all required features (i.e., secu-rity, contingency, backups, capacity) are in place forsafely and efficiently operating the new systems. Thisis even more important when the supervision of oper-ational risk is not well developed.

In sum, there is room for important efficiencygains in the securities settlement infrastructure. Inparticular, physical handling of securities should beeliminated to increase the safety and efficiency ofSSSs. In addition, there is room for improvement inthe clearing and settlement process as STP is notthe common rule. Various plans for backup sites anddisaster recovery facilities should be accelerated or

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established when nonexistent. Finally, externalaudit of the systems should be undertaken, espe-cially when systems have been developed in-house.The latter is especially important when the supervi-sion of operational risk is weak.

Custody Risk

Context

Custody risk is the risk of losses on securities heldin custody because of the custodian’s (or subcusto-dian’s) insolvency, negligence, misuse of assets,committing of fraud, poor administration, or inade-quate record keeping. A custodian should employprocedures ensuring that all customer assets are ap-propriately accounted for and kept safe. Customersecurities must also be protected against claims ofthe custodian’s creditors (typically client assets aregiven preferential treatment under insolvency law).

Custodians must have a demonstrated capacity tosafeguard securities and funds in their custody orcontrol, or for which they are responsible, and toprotect against reasonably anticipated internal orexternal threats to the integrity of their operations.In many markets, settlement is carried out and con-trolled through automatic data processing systems.In these cases, the system should have appropriateprocedures to backup data and a contingency planto minimize disruptions.

The use of electronic technologies such as the In-ternet for initiating financial transactions increaseconsumer choices but at the same time has the poten-tial for abuse and illegal activity. Safeguards shouldanticipate, and be designed to provide protectionagainst, the possibility of theft, accidental or mali-cious destruction or loss of securities or funds, and ac-cidental or intentional but unauthorized modifica-tion, disclosure, or destruction of data.

Custodians should have an adequately staffed in-ternal audit department, which has the authority toreview, monitor, and evaluate the organization’s sys-tem of internal controls and the integrity of opera-tional procedures.

In summary, special attention must be paid to re-ducing incidence of fraud. Some of the issues to beaddressed are (1) the operational security of systems,including identification systems, message authenti-cation, and protection measures in safeguarding ac-cess to the system; (2) protection against insiderfraud; (3) a regular independent audit of the systemsto ensure continued integrity; and (4) the determi-nation of liability for loss or technical failure.

For details on custody arrangements in the region,see Appendix Table A4.11.

Observations

There is a need for additional legal developmentsto guarantee the protection of customer assets in theevent of bankruptcy of the depository or insolvencyof the custodian. Country authorities should makesure that the segregation of accounts for securitiesand funds under custody have a clear legal basis. Theymust also ensure that all customer assets are appropri-ately accounted for under the beneficial owners inthe depository or in the custodian’s omnibus ac-counts. Specifically, they must ensure that customerassets are protected against the insolvency of custodi-ans, whatever the nature of the custodian.

Regulatory and Oversight Issues

Context

A specific allocation of responsibilities for securi-ties clearance and settlement supervision is impor-tant. In most cases, this function is performed to-gether with the general supervision function ofparticipant entities without any special attentionbeing given to clearance and settlement issues.There is a trend toward regulatory oversight policybeing implemented at two levels, substituting fortraditional direct supervisory activity. The regulatorconducts oversight of the activities of self-regulatoryorganizations (SROs) such as CSDs and exchanges,while the SROs conduct oversight of the activitiesof participants.

A securities regulator should have the authority tolicense central clearinghouses and CSDs (i.e., the sys-tem operators) as SROs, and to review and approvetheir rules. As an SRO, a system operator should havethe authority to make rules and enforce them on itsparticipants. The securities regulator should have thepower to issue guidelines for system operators. In ad-dition, the securities regulator should ensure thatrules and procedures issued by SROs permit a soundand effective operation of the system and provide fairaccess to all market participants. The securities regu-lator should also have the authority to conduct peri-odic inspections, require the production of periodicreports, and enforce securities laws and regulations.

Mutual cooperation between the securities regu-lator and the central bank as well as their coopera-tion with other relevant authorities is important inachieving their respective policy goals.

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For more details on the regulatory and oversightissues in the region, see Appendix Table A4.12.

Observations

Most countries do not have an oversight role oversecurities settlement other than the SRO role of thestock exchange. This undermines trust in the sys-tem, especially from a foreign investor perspective,and is an obstacle to the development of securitiesmarkets. This will become a clear bottleneck as en-visaged reforms in the payment systems will makeliquidity management important through the collat-eralized money market.

In general, the capacity of securities regulators inthe area of securities settlement should be strength-ened. Some securities regulators have only recentlycome into existence and, therefore, their capacity forsecurities settlement is yet to be developed. The secu-rities regulator must have the appropriate human andmaterial resources to supervise participating institu-tions and the SSS as a whole. If the skills cannot befound in-house, external assistance should be sought.

The oversight empowerment for securities settle-ment systems is missing in some cases. The securitiessupervisor’s oversight responsibilities for SSSs mustbe strengthened by law. This law must regulate thepowers of the securities regulator and authorize it, incooperation with the central bank, to issue regula-tions relating to securities clearing and settlement ac-tivities. Since the oversight of an SSS and its partici-pants is normally shared among regulators (centralbank, securities regulator, and pension funds regula-tor), cooperation is crucial. Potential conflicts be-tween the roles of the central bank as operator andoverseer of SSSs should be addressed by appropriateinternal organizational arrangements. Cooperationcould be achieved through formal agreement amongthe parties (e.g., a memorandum of understanding).

In sum, oversight of securities settlement shouldbe institutionally strengthened by devoting ade-quate resources and establishing an effective cooper-ative framework with other regulators, SROs, andthe private sector.

Organizational Arrangements of Central Securities Depositories

Context

It is widely accepted that a securities marketshould be supported by the CSD with the broadest

possible industry participation. Admission should beopen to all qualified market participants needing ac-cess to the CSD.96

Membership standards for system operators shouldbe established to minimize risk. Certain minimumstandards of financial responsibility, operational ca-pacity (including system security and integrity), ex-perience, and competence should be required forparticipation in the systems. Mandatory capital re-quirements for participants are the first safety netagainst a participant’s failure. However, these re-quirements are frequently established for reasonsother than clearance and settlement, and a systemoperator should have the authority to impose higherfinancial standards on its members/participants if thegeneral requirements do not adequately cover theperceived risks.

The rules for clearing and depository organiza-tions should avoid discrimination among potentialand actual participants. The rules should providefair procedures for review of decisions concerningdenials of access. In addition, the system should pro-vide participants with a meaningful opportunity toparticipate in the administration of the organiza-tion’s affairs.

The above applies to CSDs and central counterpar-ties, which are at the heart of the settlement process.Many are sole providers of services to the marketsthey serve, and their performance is a critical deter-minant of the safety and efficiency of those markets.Therefore, their performance is a matter of public aswell as private interest. In addition, there may beother providers of services (e.g., trade comparison ormessaging services) whose performance is also criticalto the functioning of some markets. The governancearrangements of any critical service providers shouldalso be consistent with the above recommendation.

No single set of governance arrangements is ap-propriate for all institutions in the securities mar-kets. However, an effectively governed institutionshould meet certain basic requirements. Gover-nance arrangements should be clearly articulated,coherent, comprehensible, and fully transparent.Governance arrangements should therefore seek tominimize the conflicts between the objectives ofowners, users, and other interested parties, and as faras possible to resolve any remaining conflicts.

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96The cost is an important element to consider in order toavoid an unfair situation for the minority investor. In any case,transaction costs per unit should be clearly identified.


Financial markets operate most efficiently whenparticipants have access to information on the risksto which they are exposed and can take action tomanage those risks. The need for transparency ap-plies to the entities that form the clearing, settle-ment, and custodial infrastructure of the securitiesmarkets. Informed market participants are betterable to evaluate the costs and risks to which they areexposed as a result of participation in the system.Relevant information should be accessible to mar-ket participants. Information should be current andavailable in formats that meet the needs of users.

For further details on the status of the organiza-tional arrangements of the CSDs in the region, seeAppendix Table A4.13.

Observations

Although, in general governance arrangementsare adequate, it is unclear whether they preventconflicts of interest. These aspects should be care-fully evaluated by the overseers, especially in light ofpossible expansion of the stock exchanges in theclearing and settlement industry. Also, the stock ex-changes might want to form a user group to ensurethat the needs of all participants are represented andall parties have the opportunity to participate in thedecision-making process.

Some legal and governance arrangements intro-duce monopolistic situations that impede the ade-quate development of some markets (e.g., themoney market). This could lead to the developmentof settlement infrastructures that are not adequatefor market needs. These include high entrance fees,inadequate facilities, and lack of facilities to processintraday repos used by the central bank to provideintraday liquidity.

Unsolved conflicts of interest are the main reasonfor the underdevelopment of basic SSS infrastruc-tures such as depositories. In these cases, under theleadership of the securities regulator and the centralbank, in coordination with the ministry of finance,a legally sound solution should be agreed with stake-holders to establish the depository function as soonas possible. Depending on the solution adopted forthe immobilization/dematerialization of securitiesand establishment of the depository function, care-ful attention should be given to the ownershipstructure of the depository to make sure that the sys-tem is efficient and fair in terms of access, and thatit has appropriate governance arrangements. Thedepository should provide participants with a mean-

ingful opportunity to participate in the organiza-tion’s decision-making process for system design andsettlement procedures, among others.

A strong, capitalized, and autonomous securitiesdepository, with reliable and flexible systems to ex-pedite settlement of transactions and accessoryrights, is crucial for the development of the securi-ties markets. When important conflicts of interestemerge, the authorities should take the lead in theirresolution.

Cross-Border Settlement

The settlement of cross-border securities transac-tions is more complicated and involves more riskthan that of domestic transactions. Links amongCSDs permit participants from multiple jurisdic-tions to settle trades in securities through a simplegateway operated by either the domestic or an inter-national CSD. However, CSDs need to design linkscarefully to ensure that risks are reduced. They mustaddress legal and operational complexities. If linksare not properly designed, risks can be exacerbated.Inefficiencies may arise because of variations in op-erating hours. Links may create significant creditand liquidity interdependencies between systems. ACSD should evaluate the financial integrity and op-erational reliability of any CSD with which it in-tends to establish a link. Any credit extensions be-tween CSDs should be fully secured by securities,letters of credit, or other high-quality collateral, andshould be subject to limits.

For more details on the status of cross-broker set-tlement in the region, see Appendix Table A4.14.

Observations

Most securities depositories include cross-borderlinks. Authorities should analyze in detail the risksassociated with these links as settlement of cross-border transactions typically involves more riskthan settlement of domestic transactions. Particularattention should be paid to the multiple jurisdictionprofile of these transactions, especially from a legaland operational perspective. At the internationallevel, the main improvement in this area is relatedto the international law governing the cross-borderpledge of securities as collateral. Some depositorieshave been participating in the Hague Conventionefforts to build an internationally accepted principleon this issue, but they believe that market partici-pants and clearing and settlement systems were not

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sufficiently involved. Some securities regulators arealready involved in this discussion.

Transparency, Oversight, andCooperation in Payment Systems

Context

Smooth and reliable money transfer mechanismsaffect the efficiency of financial markets and the realeconomy; they also have an impact on the centralbank’s lender-of-last-resort function, the conduct ofmonetary policy, and liquidity management. Marketforces alone may not be able to achieve the objectivesof efficiency and reliability of the payments systembecause participants and operators may not have ade-quate incentives to minimize the risk of their ownfailure, or the costs their failure may impose on otherparticipants. In addition, the institutional structure ofthe payment system may not provide incentives ormechanisms for efficient design and operation.

For these reasons, central banks’ involvement inthe payments system is an integral component oftheir overall mandate to ensure financial system stability and maintain confidence in the domesticcurrency. In this context, central banks perform anumber of functions in their national clearing, set-tlement, and payment arrangements. These func-tions may include direct involvement in managingclearing and settlement systems and in overseeingthe payments system by developing rules, principles,and best practices under which private paymentarrangements operate. The oversight role of the cen-tral bank is at the heart of the current internationaldebate and the function is emerging as a key facet ofcentral bank activity.97

The role of the central bank is particularly impor-tant when the country is engaged in a comprehensivereform of its payments system. In this case, the cen-tral bank has a leading role to play in developing a vi-sion for the reformed system, in coordinating with allstakeholders, and in carrying out the reform plan. Di-rect involvement of the central bank in managingclearing and settlement systems has been the first steptoward governing the overall structure and operation

of a country’s payments system and ensuring that thedesire to limit systemic risk, especially in the area oflarge-value payment systems, is adequately taken intoaccount. In many cases, this role stems from the needto ensure a widespread adoption of more advancedtechnology in the fund transfer mechanisms and toavoid possible discriminations in access to paymentservices. In all cases, to pursue the public interest inthe payments system, central banks should ensurethat the systems that they operate comply with theprinciples and guidelines they establish and, as over-seers, ensure the (financial and operational) reliabil-ity and efficiency of the clearing and settlement sys-tems they do not operate. The central bank’soversight role is more prominent when payments re-form is complete and the central bank is called uponto ensure the ongoing monitoring of the reliabilityand efficiency of the domestic system.

In an increasing number of countries, paymentssystem oversight is entrusted to the central bank bylaw. Specifying objectives in the law may be themost direct way of providing a well-founded legalbasis for the central bank to implement its policiesand make it accountable in pursuing its goal andmandate in the payment system. For countries thatare reforming their payment systems, it is important

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97See Bank for International Settlements (2005) for a frame-work for payment system oversight. Other examples are the focuson central bank’s responsibilities in the CPSS Core Principles,the CPSS-IOSCO recommendations for securities settlementsystems, and the Payments System Oversight reports of the Bank ofEngland. See also Bossone and Cirasino (2001).

Box 4.2. Oversight Role of the Central Bank

Central banks have the following responsibilitiesin applying the Core Principles:

Responsibility A. The central bank should defineclearly its payment system objectives and shoulddisclose publicly its role and major policies withrespect to systemically important payment sys-tems.

Responsibility B. The central bank should en-sure that the systems it operates comply with theCore Principles.

Responsibility C. The central bank should over-see compliance with the Core Principles by sys-tems it does not operate and it should have theability to carry out this oversight.

Responsibility D. The central bank, in promot-ing payment system safety and efficiency throughthe Core Principles, should cooperate with othercentral banks and with any other relevant domes-tic or foreign authorities.

Source: Bank for International Settlements (2001a).


for the central bank to have a well-founded legalframework that clearly defines its payment systemrole and objectives.

As for the scope of the oversight function, at theinternational level there is consensus that systemsposing systemic risks should fall under the directcontrol of the overseer. Typical examples of thesesystems are those that handle transactions of a highvalue at both the individual and aggregate level. Forexample, the CPSS Task Force on Core Principlesidentified four responsibilities of the central bank inapplying the CPSIPS (Box 4.2).

Increasing attention is being paid to securitiesclearance and settlement systems as relevant com-ponents of the overall payments system. The over-sight of these systems might well be a cooperativeeffort of two or more regulatory agencies. In somecountries, retail (low-value) systems also fall undercontrol of the oversight agency because of their im-portance in the overall efficiency of the paymentssystem, their potential impact on the public trust ofmoney, and their relevance to the ultimate objec-tive of economic growth.98

The evolution toward a new central bank role inpayment systems calls for a careful consideration ofat least three issues:

• The adequacy of legal enforcement of centralbank actions in the payments system should beevaluated. The central bank role in paymentsystems stems from its responsibility for finan-cial market stability and monetary policy. Inmany countries, a clearly stated legal enforce-ment for the central bank’s activity as overseerof the payments system has facilitated the ful-fillment of the central bank’s objectives.

• The internal organization of the central bankmay also be worth evaluating. Experience inmany central banks indicates that significantimprovements can be derived by setting up aunit specifically devoted to payments policy is-sues. Typically, such a unit could develop a pol-icy framework and tools (e.g., data collectionand periodical inspections) for use in assessingthe appropriateness of individual payment sys-tems. This function could be undertaken inclose coordination with the banking supervisor.The staff of this unit should have adequate

skills. Typical aspects to be analyzed in adminis-tering the oversight functions include, interalia, potential risks emerging from the clearing-houses, the adequacy of risk control measures,the potential implications of unwinding proce-dures, and efficiency issues.

• Effective cooperation must be achieved betweenthe overseer and market players, among domesticregulators, and among international oversightagencies. In particular, central banks withoutbank supervisory powers may face considerableinformation limitations, especially in crisis man-agement situations.99 An effective way to over-come this problem is to stipulate formal rules forgranting the overseer adequate access to supervi-sory information. The institutionalization of in-formation-sharing arrangements may reduce therisk that the exchange of information might behampered by frictions in cooperation betweendifferent institutions. Various solutions can beadopted for this purpose, from signing a memo-randum of understanding that specifies theframework for cooperation, to assuring contactsbetween institutions through joint board mem-bership, or the establishment of a comprehensivemarket regulatory/supervisory body where all theinstitutions with oversight responsibilities arerepresented and mandated to cooperate.100 Co-operation must also be pursued between theoverseer and the securities market regulators, assecurities settlement is an integral part of thepayments system, and problems in securities mar-ket clearing and settlement may easily spill overto the payments system and vice versa.

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Transparency, Oversight, and Cooperation in Payment Systems

98There are many examples of how an inefficient retail systemcan affect economic activity, for example, by failing to accommo-date the needs of customers and merchants in a transaction that,as a result, cannot take place.

99The overseer would have to rely on information from the su-pervisory authorities, or should develop its own independent ac-cess to information on payment system participants. While thefirst option de facto transfers the responsibility for triggeringoversight action to the supervisory authority, the second oneraises risks of duplication in information collection, inconsistentpublic action, and additional costs to participants.

100See Banca d’Italia (1999) for a description of institutionalarrangements adopted in some industrial countries. In theUnited Kingdom, the Bank of England and the Financial Ser-vices Authority (FSA) signed a memorandum of understandingrequiring that “the FSA and the Bank [of England] will establishinformation sharing arrangements, to ensure that all informationwhich is or may be relevant to the discharge of their respectiveresponsibilities will be shared fully and freely. Each will seek toprovide the other with relevant information as requested” (Bankof England, 2000). In the European Union, the European Cen-tral Bank (ECB) issued a protocol for payment system oversightto be adopted by the euro-area national central banks and theECB.


Effective cooperation among market participants,between regulators and market participants, andamong regulators is essential for the development ofa sound and efficient payments system. In particular,the systemic nature of the underlying operating pro-cedures for the transfer of money makes the pay-ments system an “institution” whose existence andsmooth functioning requires effective cooperationbetween all participants. On the one hand, the useof payment instruments generates significant exter-nalities on the demand side, because the usefulnessof an instrument is strictly linked to the degree of itsacceptance and use for transactions purposes. Con-sequently, widespread use of new payment instru-ments and services relies heavily on public confi-dence in them. On the other hand, within thepayments system, the supply of services can be af-fected by coordination failures because of the exis-tence of conflicts of interest (and information costs)as well as the intermediaries’ unwillingness to coop-erate. This can lead to suboptimal equilibria in theorganizational arrangements in terms of reliabilityand efficiency. The payments system overseer istherefore entrusted with making up for coordinationfailure in the market for payment services. Coopera-tion problems may be especially relevant within in-terbank clearing and settlement systems. In thesesystems, risk profiles—both at the system level andat the level of the individual intermediary—maynot be fully assessed by participants. In addition, theconcern with having to support less reliable inter-mediaries may lead larger participants to discrimi-nate against smaller ones, even when the smallerones are technically eligible to participate in thesystem. Finally, the payment system industry also de-pends on agreements between producers to ensurethat different components of the system are compat-ible. Most recently, the emergence of new types ofnonbank intermediaries and payment instrumentshas strengthened the need for a comprehensivelevel of cooperation in payment systems.

The safety and efficiency objectives of paymentand securities settlement systems may be pursued byother public sector authorities in addition to thecentral bank and the securities commission. Exam-ples include legislative authorities, ministries of fi-nance, and competition authorities. There are alsocomplementary relationships between oversight,banking supervision, and market surveillance. Ap-propriate cooperation among supervisors can beachieved in a variety of ways, for example, ex-changes of views and information between relevant

authorities may be conducted by holding regular orad hoc meetings. Agreements on the sharing of in-formation may be useful for such exchanges.

For further details on the status of transparency,oversight, and cooperation in payment systems inthe region, see Appendix Table A4.15.

Observations

In most Central American countries, except ElSalvador and Panama, the law gives some authorityto the central bank over the payment system. How-ever, the legal foundation of oversight of clearanceand settlement systems is not always solid. For ex-ample, the law is often not clear about the scope ofapplication of the function and the relative roles ofthe central bank and other authorities. To overcomethese problems, it is important that central banksprepare and encourage approval of primary or sec-ondary legislation to complete the legal frameworkand ensure the secure foundation of payment mech-anisms that effectively contributes to the integrity,efficiency, and safety of all financial markets and theoperation of monetary policy, especially in the areaof securities settlement systems. Legislation shouldclarify in detail the empowerment and enforcementof the central bank as the payment system overseer.

In the context of establishing the oversight func-tion, central banks should disclose publicly their ob-jectives and implementation strategies relating topayment system matters. To this end, central banksshould develop a comprehensive policy statementproviding guidance to the private sector on mattersrelating to payment system governance, day-to-daymanagement, risk mitigation, and on the policiesthat must be satisfied by all transactions that are ul-timately settled on its books.

Central banks should broaden the set of policy ob-jectives from efficiency and reliability of paymentsystems to including competition in the payment ser-vices market and consumer protection. These objec-tives might be pursued by central banks, especiallywhere they are not included in other regulators’mandates. With regard to their oversight role, cen-tral banks should apply their authority over all pay-ment and securities settlement systems in the coun-try, both the systemically important ones and retailsystems, since the latter have a role in supportingeconomic activity and the public trust in money.

Central American central banks should be able tocarry out their oversight role effectively. To this end,central banks should (1) establish appropriate orga-

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nizational arrangements and staffing;101 (2) ensurethat an adequate degree of participant cooperationexists and is sufficient to promote and realize the de-sired organizational and operational arrangements;(3) verify that individual payment systems satisfyuser needs as well as risk and efficiency requirementsthrough appropriate interventions both at the de-velopment stage and during the ongoing system im-plementation and operational phases; (4) define andimplement appropriate actions should participantsnot comply with published rules and regulations(e.g., the application of predetermined penalties andsanctions for compliance failures); and (5) collectand distribute relevant statistical information todemonstrate how each system is being used and theextent to which the systems are satisfying end-userand other market needs. Information on substantialpayment system matters should be disclosed in amanner that assures wide dissemination among pay-ment system stakeholders and the general public.

Central American central banks should move to-ward compliance of their systemically importantpayment systems with international standards. Inparticular, central banks will continue to be directproviders—owners and operators—of clearing andsettlement services. In this regard, care should betaken to ensure that appropriate service and perfor-mance levels are routinely achieved and adequatelycover all critical safety and efficiency requirements.To this end, central banks should continuously re-view and seek to improve the design and operationof the systems they operate (e.g., along the lines thatthe CPSS Core Principles envisage for payment sys-tems operated by private entities).

In performing the oversight function, centralbanks should ensure that policies and conditions forpayment services offered are transparent. In eachcountry, the central bank, banks, and other finan-cial institutions should be encouraged to provide in-formation to the public on the services they offer inthe payment system. Moreover, arrangements forthe resolution of conflicts should be disclosed andunderstood by providers, users, and regulators ofpayment systems and services. The general publicshould be able to resort to consumer protection

agencies (e.g., a bank ombudsman) for resolution ofconflicts related to payment services. The centralbank should cooperate with the banking supervisorand other relevant authorities to ensure that pay-ment services and instruments are appropriatelycovered by the new arrangements.

Cooperation among regulators is weak in CentralAmerica. The payment system overseer (centralbank), the ministry of finance, the banking supervi-sor, the securities commission, and other relevantauthorities should identify and implement proce-dure and process changes to address any weaknessesor inconsistencies in the regulatory arrangementsand assure a high level of cooperation in the waythat policies are implemented. Considerationshould be given to establishing joint task forces toaddress problems of common interest and/or thepreparation of appropriate memoranda of under-standing. At the international level, central banksshould get involved in the efforts of harmonizationat the subregional level in Central America and inthe activities of the WHF Working Group on Pay-ment System Issues of Latin America and theCaribbean.

Cooperation among regulators and stakeholdersshould also be strengthened. No formal cooperativearrangement for the payment system as a whole ex-ists in Central America. In each country, the centralbank should establish a formal national paymentsystem council. The new body should include repre-sentatives from all major stakeholders with an inter-est in improving payment and securities clearanceand settlement systems and should also be used asthe main tool to secure a constructive dialogue be-tween regulators and market participants. The cen-tral bank should provide strong leadership and thesecretariat. Payment system councils in CentralAmerican countries could establish forms of interac-tion with a view to moving forward the harmoniza-tion and integration agenda.

Binding interbank agreements are equally impor-tant to enhance cooperation within the bankingsector. Cooperation at the interbank level has notalways been satisfactory in Central America. Evi-dence can be seen in the area of retail payment cir-cuits, the development of the interbank market, andthe slowness to reduce dependency on checks. Inlight of possible market concerns about the poten-tial loss of competitive advantages, which are how-ever lower than the social benefit of taking these ac-tions, the central bank and the banks are urged towork together toward the implementation of some

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Transparency, Oversight, and Cooperation in Payment Systems

101This includes forming a small unit in charge of payment sys-tem oversight to be separated to the extent possible from the unitsin charge of operating the systems offered by the central bank.Skills of the staff involved in the function should be as wide aspossible and include operational, technical, and policy expertiseas well as proficiency in the areas of law and economics.


agreements in the area of payment systems, whichcould enhance efficiency for the banking sector as awhole.

In sum, there is a need to establish the oversightfunction over the payments system. Regarding theoversight function and its transparency, CentralAmerican central banks should strive to fully ob-serve the key responsibilities assigned to them bythe CPSIPS (see Box 4.2). Cooperative arrange-ments in payment systems among all stakeholdersshould also be enhanced.

Conclusions

In recent years, Central American central bankshave played a very active role in the reform of na-tional payment systems. Important efforts have beencompleted and others are ongoing. Reform programshave allowed for a better integration between thecentral bank and the banks and have given thebanks a means to send and reduce settlement lagsand settle their payments more efficiently on the ac-counts they hold at the central bank. In some coun-tries, these results have been achieved despite insta-bility in the financial sector. Acknowledging theseimportant achievements, central banks need to un-dertake an exercise to finalize the reform effort. Ele-ments such as improvements in the legal framework,compliance with international standards, full inte-gration of all systems, introduction of new and effi-cient payment instruments, and establishment ofthe oversight function for payment and securitiessettlement systems have not been fully included inthe reform projects. The degree of coordination andcommunication with other stakeholders and gov-ernment treasurers has been on some occasions in-formal and asymmetrical, resulting in a technology-driven approach with strong emphasis on somecomponents of the operational aspects of the pay-ment system (e.g., the automation of the checkclearinghouse), and less emphasis on others. In gen-eral, this has not permitted Central American coun-tries to catch up rapidly with the systems found inother Latin American countries.

As a result, Central American central banksshould broaden the scope of reform to include addi-tional elements (e.g., electronic retail payment andsecurities settlement) and incorporate improve-ments not only in the systems but also in the legal,regulatory, and oversight environments. In doing so,central banks should follow the guidelines defined

in the 2006 Report on General Guidance for Na-tional Payment System Development (Bank for In-ternational Settlements, 2006).

Central banks should develop a long-term, com-prehensive strategy for the payments system as awhole, and discuss it with stakeholders. In conduct-ing a reform, the logical sequencing process wouldbe as follows: (1) diagnostic, stocktaking, and situa-tional analysis; (2) vision development; (3) concep-tual design and implementation planning; (4) userrequirement specifications; and (5) acquisition, pro-curement, development, testing, and implementa-tion. Furthermore, important issues to be decidedwhen launching a payment and securities settle-ment reform are scope (holistic versus specific); ap-proach (gradualist versus leap-frogging); degree ofsophistication (e.g., innovative products); numberof systems; system operator (central bank, externalprovider, private provider); ownership of the system(central bank, private, joint); and time frame.

In some countries, important projects, such as anRTGS system, have already been launched or are inthe pipeline. Indeed, the definition of formal coop-erative arrangements with all stakeholders is veryimportant to avoid different positions and opinionsof participants once the reform has been launched.

Countries should reform their payment systemsas a matter of urgency. By adopting a broad ap-proach based on international standards and bestpractices, and with support from international orga-nizations, other central banks, and payment systemexperts, each Central American country will counton a set of payment arrangements, services, and cir-cuits able to serve the needs of all users in the econ-omy. Appropriately reforming each national pay-ments system in the region will also create theconditions for further harmonization and integra-tion among the different payment systems. Centralbanks should, therefore, work in parallel in reform-ing, as a first priority, their national payments sys-tems and, at the same time, work toward closer in-tegration within the region by discussing andpreparing minimum common features and a realis-tic timetable.

Specifically, assessments of national payment andsecurities settlement systems in Central Americapoint to the following key findings:

• There is a need to improve the legal framework,notably as regards the irrevocability of final set-tlement, adequate protection of the systemsagainst the effects of bankruptcy procedures,

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legal basis for custody arrangements, legal defi-nition of a repurchase (repo) operation, legalrecognition of multilateral netting arrange-ments, legal definition of immobilization anddematerialization of securities (especially publicsecurities), and legal definition and regulationof central bank oversight powers. From a devel-opmental viewpoint, improvements are alsoneeded on the legal basis for collateral pledgeand securities lending in all countries except ElSalvador and Costa Rica where the laws con-tain specific provisions for the creation, regula-tion, and enforcement of pledges. Due to thevariety and importance of these legal issues,passage of a separate payments system lawmight be advisable in some countries.

• Upgrading RTGS systems as recommended willmodernize the national payment systems andcreate the conditions for future regional integra-tion through the interlinking of the differentsystems. Such recommendations would createcommon features in all relevant areas of the pay-ment systems (such as legal, risk control mecha-nisms, liquidity provision, access policies, gover-nance, organizational arrangements, operationalaspects, reliability, and business continuity),which would facilitate their integration.

• Central and commercial banks have roles toplay in ensuring that the existing retail circuitssupport customers’ needs and are safe, conve-nient, and efficient for the economy as a whole.Central banks should monitor market develop-ments and take action as appropriate, in consul-tation with other relevant authorities (e.g.,consumer protection agencies), to restore safetyand efficiency. In particular, the central bankshould (1) ensure that the legal and regulatoryframework keeps pace with market develop-ments;102 (2) monitor competitive market con-ditions and behaviors and take appropriate ac-tions to foster such conditions; (3) support thedevelopment of effective standards and infra-structure arrangements;103 and (4) adapt as nec-

essary its provisions of settlement services forsystems operated by other entities to contributeto efficient and safe outcomes, allowing all suchsystems to settle in central bank money.104

• Central banks and relevant government agen-cies should coordinate to ensure that collectionand disbursements of public sector institutionsthat are major players in the payment systemare processed electronically through an appro-priate system, such as an ACH for retail elec-tronic payment instruments. Government pay-ments are also a major source of liquidity for thebanking system and, if coordinated effectively,can facilitate the smooth functioning of theRTGS system being implemented by CentralAmerican central banks and increase its appealto participants.

• Central banks should monitor trading and set-tlement platforms and procedures for foreigncurrency and cross-border transactions, notablyremittances, to ensure that the principles ofsafety and efficiency can be applied to clearanceand settlement.

• An adequate interbank money market is key tothe smooth functioning of a country’s paymentsand securities settlement system. An efficientmechanism for trading and settling these trans-actions will improve systemic liquidity manage-ment. A key element for the development ofinterbank money markets is a special purposesystem for large-value payments providing se-cure electronic interbank transfers with imme-diate settlement that is interconnected to anelectronic book-entry securities system, whichis registering and recording changes in securi-ties’ ownership.

• Improved clearing and settlement processes insecurities settlement systems are necessary toreduce market fragmentation, increase stan-dardization of settlement cycles, accommodatedifferent settlement needs, operate with shortersettlement cycles, avoid extension of settle-ment cycles because of inadequate risk manage-ment tools, improve markets’ liquidity through

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Conclusions

102Particular issues in this regard would be for central banks toassess whether the current legal framework effectively supportsthe use of modern (i.e., electronic) payments and relatedarrangements.

103The central bank could engage participants in a dialogue toanalyze all payment systems in the country and come to agree-ments on necessary improvements, possibly building on the already

existing groups that in most countries are engaged in the discussionto improve the check clearinghouse or other retail systems.

104This would become necessary when agreements on interop-erability are reached and/or when an automated clearinghouse isdeployed producing interbank obligations that need to be clearedand settled.


automatic securities lending, and introduce in-ternational communication standards.

• Linking the settlement of securities and fundswould allow stock exchange transactions to besettled on a DvP basis so as to eliminate prin-cipal risk. The following aspects need to beimproved: achieving full dematerializationand immobilization of securities; establishingDvP procedures; upgrading risk managementtools; mitigating credit and liquidity risk inthe cash leg settlement (including eliminatingthe use of checks as a cash asset); providingbetter access to liquidity for SSS participants;and developing a comprehensive strategic ap-proach to the reform of SSSs, as opposed totechnology-driven and purely operational re-form projects.

• There is room for efficiency gains in the secu-rities settlement infrastructure. Physical han-dling of securities should be eliminated to in-crease the safety and efficiency of SSSs. Inaddition, clearing and settlement should aimat achieving STP. The various plans forbackup sites and disaster recovery facilitiesshould be accelerated or established whennonexistent. External audits of the systemsshould be undertaken, especially when the sys-tems have been developed in-house and/or theoversight framework is weak.

• The legal framework needs to be strengthenedto reduce custody risk—that is, to guarantee theprotection of customers’ assets in the event ofbankruptcy of the depositary holding their titlesor insolvency of the custodian. The country au-thorities should ensure that the segregation ofaccounts for securities and funds under custodyhas a clear legal basis; that all customer assetsare appropriately accounted for as beneficialowners in the depository or in the custodian’somnibus accounts; and that customer assets areprotected against the insolvency of custodians,whatever the nature of the custodian.

• The securities depository should be well capital-ized, autonomous, and capable of expeditingsettlement of transactions and accessory rights.This would be crucial for the development ofthe securities markets. The authorities should

take the lead in the resolution of conflicts of in-terest in the event they emerge.

• The authorities should analyze the risks associ-ated with cross-border links among securitiesdepositories, as settlement of cross-bordertransactions typically involves more risk thansettlement of domestic transactions. Particularattention should be devoted to the multiple-jurisdiction profile of these transactions, espe-cially from a legal and operational perspective.At the international level, the legal frame-work governing the cross-border pledge of se-curities as collateral should be improved. Inthis respect, some depositories and securitiesregulators participate in the Hague Conven-tion efforts to develop internationally ac-cepted principles in this area, but believe thatmarket participants have not been sufficientlyinvolved.

• There is scope for improving the oversight ofpayment and securities settlement systems.Central American central banks do not fullyobserve Responsibilities A, B, C, and D of theCPSIPS regarding payment system oversight.In addition, securities settlement oversightshould be strengthened by devoting adequateresources to regulators and establishing an ef-fective cooperative framework with otheragencies, SROs, and the private sector. In per-forming the oversight function and as systemoperators, central banks and securities regula-tors should ensure transparency in their poli-cies and conditions for payment services of-fered. The general public should be able toresort to a bank’s ombudsperson and to thecentral bank or another appropriate supervisorand the consumers’ protection agencies forresolution of conflicts related to payment ser-vices. Cooperative arrangements in paymentsystems should be enhanced in Central Amer-ica as a matter of urgency.

• Central American central banks should work inparallel in reforming, as a first priority, their na-tional payment systems and, at the same time,work toward closer harmonization and integra-tion within the region by discussing and prepar-ing minimum common features and a realistictimetable to achieve this objective.

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Appendix

99

Appendix

TABLE A4.1Legal Frameworks for Payment and Securities Settlement Systems

Finality and Oversight Custody Country Legal Basis Irrevocability Netting Empowerment Arrangements

Costa Rica Organic Law of Banco No explicit zero hour No explicit legal Article 2 of the BCCR Adequate.Central de Costa Rica rule but no complete recognition of netting Law, but no clarity on (BCCR) (Law 7558 of certainty and finality. arrangements. power to regulate and 1995) and Securities oversee payment sys-Market Law (SML) tems provided outside (Law 7732 of 1998). the central bank.

El Salvador Ley de Integración No provision regard- No explicit legal No legal clarity on the No protection of custody Monetaria (LIM) intro- ing acceptance and recognition of netting authority empowered arrangements.duced dollarization in irrevocability. arrangements. to regulate and over-January 2001. see payment systems.

For securities, Legisla-tive Decrees 806 (Organic Law of the Securities Superinten-dency) and 809 (Stock Exchange Law).

Guatemala Organic Law of No provision re- No explicit legal rec- Article 4 of Protection of custody Banco de Guatemala garding acceptance ognition of netting BANGUAT Law, but arrangements only (BANGUAT) of May and irrevocability. arrangements. no regulation develop- included for the securi-2002 and Securities ing the oversight ties depository but not Markets Law (Ley del function. for other custodians.Mercado de Valores y Mercancías) of 1996.

Honduras Banco Central de No provision regard- No explicit legal Article 2 of BCH No clear legal basis for Honduras (BCH) Law ing acceptance and recognition of net- Law; recent reform of ownership transfer of de-2001 SML; its regula- irrevocability. ting arrangements. the BCH Law (in materialized securities.tion is under develop- 2004),Article 54.ment.

Nicaragua Organic Law of Banco No provision regard- No explicit legal Article 3 of the BCN None due to lack of spe-Central de Nicaragua ing acceptance and recognition of net- Law. cific legal framework for (BCN); no legal frame- irrevocability. ting arrangements. securities.work for the securities market.

Panama Banking Law (Decree- No provision regard- No explicit legal No central bank. Adequate.Law 9 of 1998) and ing acceptance and recognition of net-SML (Decree-Law 1 irrevocability. ting arrangements.of 1999).

Sources: National authorities;Western Hemisphere Payments and Securities Settlement Forum; and IMF–World Bank Financial Sector Assess-ment Program reports.


100

PAY

ME

NT

AN

D S

EC

UR

ITIE

S S

ET

TLE

ME

NT

SY

ST

EM

S

TABLE A4.2Use of Cash and Transferable Deposits, 20041

Transferable Transferable Population Bank Notes and Deposits in Deposits in

(in millions)/ Coins in Circulation Domestic Currency Foreign Currency Systemically Yearly Value GDP Per Capita (in millions of (in millions of (in millions of Important Payment Settled to GDP

Country (in U.S. dollars)1 U.S. dollars) U.S. dollars) U.S. dollars) Systems (SIPS) (in percent)

Costa Rica 4.0/4,280 449 1,074 898 SINPE2 312Check system (CLC)3 125

El Salvador 6.5/2,200 36 1,167 1,167 Check system . . .

Guatemala 12.3/1,910 1,266 1,903 406 Check system 187MIT4 31

Honduras 7.0/970 408 531 . . . Check system (CEPROBAN)5 173Funds transfer 125

Nicaragua 5.5/730 190 147 279 Check system 135Phone transfer system (TTS)6 32

Panama 3.0/4,250 . . . . . . . . . Check system 220BNP-CIASA7 984

Source: National authorities.1Population and GDP per capita are 2003 data.2SINPE = Sistema Interbancario de Negociación y Pagos Electrónicos.3CLC = Cámara de Compensación y Liquidación de Cheques.4MIT = Mecanismo Interbancario de Dinero.5CEPROBAN = Centro de Procesamiento Bancario.6TTS = Transferencia Telefónica Segura de Fondos.7BNP-CIASA = Banco Nacional de Panamá—Centro de Intercambio Automatizado, S.A.


101

Appendix

TABLE A4.3Systemically Important Settlement Systems

Owner/ Type of Settlement, Credit and Liquidity Country System Operator Closing Time Settlement Asset Risk Mechanisms

Costa Rica SINPE Central bank Real-time. Central bank money. Use of reserve requirements forsettlement; no intraday credit; noqueuing mechanism.

CLC Central bank Multilateral net basis Central bank money. Guarantee scheme based on next day 2:00 p.m. defaulter’s pay principle (amount

of guarantee recalculated basedon net debit position).

El Salvador Check clearinghouse Central bank Multilateral net basis Central bank money. None.next day 5:00 p.m.

Guatemala SICOF Central bank Deferred gross basis Central bank money Use of reserve requirements (manual procedures). for settlement.

Check clearinghouse Private banks Multilateral net basis Central bank money. None.next day 3:00 p.m.

Honduras Funds transfer Central bank Deferred gross basis Central bank money Use of reserve requirements system. (manual procedures). for settlement.

CEPROBAN Private banks Multilateral net basis Central bank money. None.same day 7:00 p.m.

Nicaragua TTS Central bank Deferred gross basis Central bank money. Use of reserve requirements for (manual procedures). settlement.

Check clearinghouse Central bank Multilateral net basis Central bank money. None.same day 4:30 p.m.

Panama Corresponding banks Network of Gross through Asset of the foreign None.in the U.S. correspondent SWIFT network. correspondent

banks banks.

Clearinghouse BNP Multilateral net basis Asset of BNP. None.next day 12:00 p.m.


Notes: SINPE = Sistema Interbancario de Negociación y Pagos Electrónicos; CLC = Cámara de Compensación y Liquidación de Cheques;SICOF = Sistema Contable Financiero; CEPROBAN = Centro de Procesamiento Bancario;TTS = Transferencia Telefónica Segura de Fon-dos; BNP = Banco Nacional de Panamá.

TABLE A4.4Use of Cashless Instruments for Retail Payments, 20011

(In millions of U.S. dollars, unless otherwise noted)

Number/Payments by Cards

Checks in Checks in (in millions/millions ATMCountry Domestic Currency Foreign Currency of U.S. dollars) Credit Transfers Direct Debits Operations

Costa Rica 14,045 6,464 1.5/740 39,662 37 1,900

El Salvador . . . 24,591 . . . /202 6,818 . . . . . .

Guatemala 45,108 1,211 4.3/125 10,318 . . . 564

Honduras 11,179 . . . . . . . . . . . . . . .

Nicaragua 5,300 1,882 4.3/32 1,114 . . . . . .

Panama . . . 28,800 120 . . . . . . . . .

Sources: National authorities; and Western Hemisphere Payments and Securities Settlement Forum.1Data for checks are for 2003. Data related to cards, credit transfers, direct debits, and ATM operations are for 2001.


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TABLE A4.5Government Payments

Country

Costa Rica Significant progress has been achieved in recent years in government payments.The launch of SINPE and the extensionof its services to the treasury has generated a remarkable result in terms of efficiency and cost reduction for treasuryoperations. Payments of the central treasury are channeled exclusively through SINPE.They include payment of pay-rolls and public sector providers.Tax collection is done through the banking sector, which transfers funds to the trea-sury the day after receiving the payments.The reform has introduced important savings for the treasury in fees and re-duction of costs (in the order of about six million dollars since its introduction) and is perceived as highly successfulby the treasury. Currently a relatively high fee is charged by the banks for tax collection (0.25 percent of the value).Anintended and beneficial side effect of government use of direct credit was the increase in bank customers.The same ef-fects were and will be reached through the implementation of direct credit payments for social services.

Several projects are under way to further improve the efficiency of public sector payments.They include the introduc-tion of a centralized account, the connection of all local treasuries to the central account, and the reform of proceduresfor the collection of customs duties.These reforms will be key in reducing the public deficit since the current practiceof assigning budget to local treasuries in advance, and the consequent investment of positive balances by local treasuriesin government securities, generates the paradox of having a relatively high portion of the public debt in the hands of thepublic sector.The reform of customs procedures should, on the other hand, reduce corruption and guarantee a smoothfunctioning of import-export operations.These projects have a high level of support from the government.

El Salvador The BCR serves as the government bank, issuing and receiving payments on behalf of the government. By law, over-drafts of government accounts at BCR are not permitted.

Guatemala The central government treasury and the Social Security Institute have made some progress to reduce the use of cashor checks in their payments. Until recently, the treasury was using the ACH-like system offered by Bancared, but it decided to develop an alternative system for cost and efficiency reasons, as the system of Bancared entailed a relativelyhigh use of paper and several manual procedures.At present, both institutions use credit transfers through the “Oficios”system of the BANGUAT. Paper instructions (oficios) are received by the BANGUAT from 8:00 a.m. to 2:00 p.m.The lat-ter distributes the funds among commercial banks on the same day according to what is established in the oficios. Oncethe banks have received the funds and a fax confirmation of the transfer, which happens on T+1, they can access thewebsite of the paying institutions to download the payment details.The final beneficiaries are credited on T+3.

Nearly 70 percent of the total volume of payments of these institutions is channeled through the system explained inthe previous paragraph.The rest is made by checks. In the case of local governments, payments are made mainly bycash or checks drawn on commercial banks. On the other hand, central government collections are managed by a dif-ferent institution, the SAT.Taxes and other payments to the government are collected through the commercial bankingnetwork.The banks gather the amounts collected in a single account each of them hold for the treasury.Then, in T+1,through an oficio they request the BANGUAT to make a transfer from their reserve account to the single account thetreasury holds at the BANGUAT. Finally, banks access the SAT system to send the details of payments they received.

Honduras Currently the Secretaría de Finanzas makes payments to suppliers and government staff by means of checks.Tax col-lection takes place through the banking system through an electronic system (FENIX) or through manual procedures.The BCH makes payments associated to government securities through its accounts.

Nicaragua At present, the ministry of finance and the Social Security Institute, two of the major users of the country’s paymentssystem, handle collections and make payments mainly with cash or checks. Every month, the ministry of finance drawsnearly 50,000 checks on its BCN account that are paid to the final beneficiaries through the commercial bank networkon behalf of the BCN. It also makes recurrent payments through the TTS system of the BCN to other government en-tities, particularly autonomous schools. However, this system does not handle third-party information and paymentsmay take from several days to some weeks to arrive in the beneficiary’s account. Recently, the ministry of finance hasalso been using direct credits to the account of the beneficiaries, basically for payments associated with its payroll, butthese represent only 2 percent of the total volume of payments it made.

Collections related to income taxes are operated mainly through the ministry’s own premises, while customs taxesand other collections are operated basically through the banking network. For this latter purpose, the ministry of fi-nance holds approximately 300 different current accounts at commercial banks.

Panama Government payments and receipts follow a complex and lengthy process characterized by manual procedures, andlacking automation.The BNP serves as the government bank, collecting taxes through the banking network and placingthem in government accounts at BNP, receiving payments on behalf of the government and acting as its paying agent.Overdrafts of government accounts at BNP are not permitted.The national treasury (part of the MEF) instructs BNPto execute payments to providers on its behalf. For payroll (wage) payments, the national treasury authorizes and pre-pares checks with a facsimile of the minister’s signature, while these checks are handed physically to recipients by theOffice of the Comptroller.


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TABLE A4.5(concluded)

Country

For servicing the domestic public debt, MEF-General Directorate of Public Credit authorizes the gross budgetary allo-cation and informs Latinclear and MEF-General Directorate for the treasury. Latinclear is the CSD in charge of thecustody of public debt securities and in such capacity has detailed information on the custodians of the securities whoare the beneficiaries of the payments. In order to fund Latinclear accounts for it to serve the debt, MEF-treasury in-structs BNP (which acts as paying agent) to credit Latinclear’s account (currently a CIASA account acting on behalf ofLatinclear).When the CSD has confirmed reception of funds in its accounts, it credits custodians’ accounts through anACH order (using the services of CIASA for this purpose).

The treasury has been working on alternatives to streamline procedures.Two projects developed with the financialsupport of the Inter-American Development Bank are particularly worth mentioning:

• The “revenues module of the CUT project,” which will make possible an automatic register (financial, budgetary,and for accounting posting) of all current and public debt revenue at a single treasury account (cuenta única delTesoro, CUT), by interacting with other currently existing systems and in close coordination with BNP; the Direc-torates of Income, Customs, and Public Debt; the “institutional treasuries;” the Office of the General Comptrol-ler; and banks that collect taxes; and

• The centralization and concentration of revenues and expenditures at the CUT with a view to improving the effi-ciency of public finances management and reducing the fragmentation of public sector liquidity in different ac-counts of public entities. For this purpose, a secure electronic link between BNP and the treasury is expected tobe developed to allow remote access on balance status, posting of recent transactions, sending electronic orders,and so on. In addition, to make it possible to execute electronic transfers, that is., direct credits (initially toproviders, later on the payroll) through the ACH, the BNP has installed an electronic system at the Directorate ofTreasury. Operations are expected to commence in 2005 (pending approval of a Manual of Operations).


Notes: SINPE = Sistema Interbancario de Negociación y Pagos Electrónicos; BCR = Banco Central de Reserva de El Salvador; ACH = auto-mated clearinghouse; BANGUAT = Banco de Guatemala; SAT = Superintendencia de Administración Tributaria; BCN = Banco Central de Nicaragua; TTS = Transferencia Telefónica Segura de Fondos; BNP = Banco Nacional de Panamá; MEF = Ministry of Economy and Finance;CSD = central securities depository; CIASA = Centro de Intercambio Automatizado, S.A.


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TABLE A4.6Foreign Exchange and Cross-Border Mechanisms

Country

Costa Rica Since 1992, residents in Costa Rica are allowed to hold deposits in the financial sector in U.S. dollars and make payments in dollars. Nowadays around half of the deposits held by residents in the financial sector are U.S.-dollar-denominated but only about a fourth of checks cleared at the clearinghouse are denominated in foreign currency.Au-thorized financial institutions can hold deposits denominated in foreign currency at the central bank for the settlementof their foreign exchange operations. However, the BCCR does not remunerate them.These accounts have the samecharacteristics as the reserve accounts in colones, and the clearing and settlement of domestic transactions in foreigncurrency are concomitant with those in colones.The value of interbank transfer of funds through TEF in dollars isaround two-thirds of transfer in colones.

The foreign exchange market is predominantly in U.S. dollars and the value of interbank transactions is around US$90million a month, without considering BCCR interventions.The central bank conducts a crawling peg policy and intervenesaccordingly.The domestic foreign exchange market trades in MONED, which is administered by the stock exchange.Themarket operates on an anonymous basis.All operations are settled gross on a real-time PvP basis on the reserve ac-counts of the central bank. Since only a few large banks (around five) are connected to the international SWIFT network,the BCCR performs a correspondent function for domestic financial institutions that have to settle trade and foreign ex-change obligations or that are receiving payments from abroad. Orders are received and sent via TEF. BCCR is connectedto SWIFT.

El Salvador BCR and six large banks are members of SWIFT, which is used to process cross-border payments.As such, they haveaccess to SWIFT hardware and software that permits the electronic transmission of payment instructions on a world-wide basis.These payment instructions can then be settled through the use of correspondent bank balances in thecountry of settlement. SWIFT access in El Salvador occurred in recent years and replaced the telex for internationaltransfers. Banks that do not have SWIFT still resort to the telex for their payment instructions.

The central bank has three types of clients for international payments.These are the government, commercial banks,and near-government agencies.The BCR serves as the government bank, issuing and receiving payments on behalf ofthe government. In order to facilitate international payments, the BCR will also provide international payment servicesfor commercial banks in El Salvador. Banks continue to use the central bank to move their funds abroad, especially totransfer their excess reserves.As with government agencies, transfers will be made to and from the commercial bank’sU.S. dollar holdings in their reserve account.The BCR will effect such transfers via SWIFT. Finally, there are a numberof government or near-government agencies that receive funds from foreign donor institutions. Such agencies may re-ceive the payments via SWIFT through the BCR.

Guatemala The foreign exchange market in Guatemala is very active when compared to the overall size of the financial system,trading an average of US$70 million a day.There are two formal trading platforms in the country, the SINEDI, which ismanaged by the stock exchange, and the SPID. However, both systems combined account for less than 6 percent of thetotal traded value, as most of the trades are made bilaterally in the OTC market. For settlement, participants in theSINEDI and the SPID, which include banks, finance companies, and casas de cambio, may choose from three settlementalternatives (check vs. check, reserve account transfer vs. checks, international transfer vs. check), none of which guar-antees that the two legs of a foreign exchange transaction are settled on a PvP basis. Furthermore, participants knowwho their trading counterparties are only in the case of the SPID.These problems have apparently led to the currentfragmentation of the market. Participants have largely used bilateral OTC transactions as a less costly and apparentlysafer alternative, because they are based on mutual trust. However, not even in this latter case are PvP conditions met,since payments are also made with checks.

Cross-border retail payments are relevant for Guatemala because there is increasing commercial and financial integra-tion among Central American countries and because of the importance of remittances.A total of 13 commercial banks(nearly half of the country’s total) and the BANGUAT are connected to the global SWIFT network.The BANGUATonly makes cross-border payments on behalf of the government, mainly those associated with servicing the externaldebt and the diplomatic service. In recent years, several commercial banks in the country are developing proprietarymechanisms to facilitate wholesale as well as retail cross-border payments through their banking subsidiaries in Cen-tral American countries or through joint ventures with other banks in this region.

Honduras Accounts at the central bank are in domestic currency (lempiras) and foreign currency (U.S. dollars).The reserve re-quirement is 12 percent for domestic currency and 50 percent for foreign currency.The entities that have current ac-counts at the central bank are banks, savings and loans associations, finance companies, foreign exchange dealers (casasde cambio), stock exchanges, and the government.The 12 percent reserve ratio for domestic currency is calculated asan average every 14 days and balances can be used for making daily payments. Furthermore, the BCH Law specificallymentions that they should be used as the base for the functioning of the check clearinghouse (see Article 54). In thecase of foreign currency, 12 percent has to be maintained in the accounts at the central bank and the remaining 38percent can be held in a foreign bank in liquid assets. However, in this case, 12 percent has to be maintained as a mini-mum at all times and account holders can only make a transfer in U.S. dollars if after the transaction they still havemore than 12 percent in the account. Foreign currency transactions can only be operated through the funds transfer“system” as the check clearinghouse only operates in domestic currency.


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Country

The foreign exchange market is intervened by the central bank, which operates a crawling peg system. Only banks andcasas de cambio can trade in foreign currency in Honduras (BCH Law Article 29).They must convert foreign currencycoming into the country to domestic currency at the central bank (see BCH Law Article 29).1 They have to make atransfer to one of the central bank’s accounts in a foreign correspondent bank.Then, the central bank credits theequivalent amount in domestic currency in the accounts of these institutions at the central bank.2 The purchase of for-eign currency is done through the central bank auction.The central bank has to receive the funds payment by meansof bank check or funds transfer in order for an intermediary to participate in the auction two days in advance.Thecentral bank debits the domestic currency account two days before the auction, and once the auction is finished, cred-its the foreign currency account of the buyer.

Nicaragua Regarding foreign exchange trading and settlement, the BCN operates a wholesale foreign exchange market (localcurrency into U.S. dollars and vice versa) for banks, the financieras, and the government. In this market, the BCN is theseller for every buyer and the buyer for every seller, and PvP is achieved through the use of the current accounts inboth currencies at the central bank. However, this is not necessarily the case for other important participants in thismarket, such as foreign exchange dealers (e.g., casas de cambio) or for trades among the banks and financierasthemselves.

Cross-border retail payments are very relevant for Nicaragua as there is increasing commercial and financialintegration among Central American countries, particularly because of remittances, which are a major source ofexternal income for the country. Only two commercial banks in the country are connected to the global SWIFTnetwork. Furthermore, several commercial banks in the country are developing proprietary mechanisms to facilitatewholesale as well as retail cross-border payments, mainly throughout Central America.

Panama Since the U.S. dollar is legal tender in Panama and bank assets and interbank operations are in U.S. dollars, foreignexchange transactions are very occasional and limited to transactions between the U.S. dollar and other currencies,especially the euro.At least 20 large banks are connected to the international SWIFT network, and Panama is animportant hub for SWIFT services in the region. In 2003, BNP entered into an agreement with the U.S. FederalReserve to receive international ACH direct credits from the United States, which are directed to American residents.BNP cannot send ACH payments to the United States.

Cross-border retail payments and remittances with Central American countries are small.


Notes: BCCR = Banco Central de Costa Rica;TEF = Transferencia Electrónica de Fondos; MONED = Mercado Organizado para la NegociaciónElectrónica de Divisas; PvP = payment versus payment; SWIFT = Society for Worldwide Interbank Financial Telecommunications; BCR = Banco Cen-tral de Reserva de El Salvador; SINEDI = Sistema de Negociación Electrónico de Divisas; SPID = Sistema Interbancario de Divisas; OTC = over the counter; BANGUAT = Banco de Guatemala; BCH = Banco Central de Honduras; BCN = Banco Central de Nicaragua; ACH = automatedclearinghouse.

1The public can hold foreign currency but can only trade it with the central bank or authorized institutions.2Other institutions operating with foreign currencies (such as remittances companies) must convert incoming foreign exchange into domestic

currency in one of the authorized intermediaries (banks and foreign exchange dealers).


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TABLE A4.7Interbank Money Market

Country

Costa Rica For historical reasons, in Costa Rica brokerage houses are the main players in the money markets, and trading systemsare operated by the stock exchange.The current trading and settlement systems, in order to avoid defaults on thesecurities leg of a settlement transaction, have introduced fragmentation in the liquidity market due to operationaldifficulties to arbitrate between different trading systems.This is basically a consequence of the need to blocksecurities before trading to assure the security delivery in a nonstandardized securities market.However, as the banking system has evolved and banks have been more active in the money markets, new tradingmechanisms have been required to attend to the need for an interbank money market. In this sense, the MIB waslaunched in 1997 by the stock exchange in order to facilitate interbank trading in this market.The current organizational and regulatory arrangements are not conducive to the development of an efficientinterbank market. Legal impediments to directly executing a pledge in a bankruptcy case (without the intervention of ajudge), unless the ownership is transferred to a trust, has led to the practice of collateralized interbank loans by meansof repos.1 However, the SML (Article 23) states that any repo transaction is considered a “securities transaction” and,thus, subject to trading by brokerage houses in the stock exchange.This situation could force banks to trade and settlein the systems operated by the stock exchange even if it is not the best solution in terms of cost and efficiency.

El Salvador The treasury of El Salvador plays a relatively minor role in securities issuance.The secondary market is dominated byrepo trading on the stock exchange (70 percent of stock exchange operations were repos in 2000). It is basically amoney market as the bulk of repo transactions have a maturity of less than seven days (91 percent of repos in 2000).

Guatemala The interbank money market is not very active. Banks exchange liquidity among themselves through the MIT and thechecks system, but the central bank does not have the information to differentiate between interbank money marketoperations and other types of transactions carried out through this system. Interbank money market operations arenormally outright loans, as collateralized interbank loans would require the exchange of physical certificates.Interbank money market transactions take place by means of an interbank check or a transfer through the fundstransfer system, but the central bank does not capture the reason for the operation.This market is mostlyuncollateralized as there is not an effective way to collateralize securities and, thus, it would mean the exchange ofphysical certificates.The other active money market is repos through the stock exchange but it is not a bankingmarket but a broker-dealer one.

Honduras The interbank money market is not very active. Banks exchange liquidity among themselves through the funds transferand the checks system, but the central bank does not have the information to differentiate between interbank moneymarket operations and other type of transactions carried out through this system.

Nicaragua The interbank money market is almost nonexistent at the moment. Participants with liquidity shortages may resort tosome facilities.They can (1) arrange an uncollateralized loan bilaterally, and since there is not an effective way tocollateralize interbank loans it would mean the exchange of physical certificates; (2) get liquidity through a repotransaction at the stock exchange; and (3) obtain liquidity from the BCN.The combination of relatively high reserve requirements (16.25 percent) and the abundance of liquidity under normalcircumstances ensures that the system does not experience liquidity shortages as a whole. However, the managementof the liquidity in the system is far from efficient in part due to deficiencies in the financial infrastructure and theinterbank market.This contributes substantially to the high levels of interest rates in the country.The market is very narrow at present for several reasons. First, there is a lack of confidence among financialinstitutions stemming from the period of financial distress. Furthermore, investors face a lack of investmentalternatives as there are not enough instruments in the market.The public debt market is not yet very well organizedand the government of Nicaragua does not issue securities on a regular basis. In addition, banks, the financieras, andbrokerage houses (the latter are currently regulated by the banking law since there is no designated law for thesecurities market) are not allowed to invest freely in private sector securities, but only after the SBOIF gives themspecific authorization, which occurs on a case-by-case basis and may take several days.However, an additional contributing factor is the lack of an adequate financial infrastructure. For example, in Nicaragua,securities settlement systems are risky owing to the lack in many cases of DvP. In this context, the emergence of acollateralized interbank money market, an important alternative in situations where the level of confidence is low, willface substantial difficulties.

Panama There is not much information on the interbank money market in Panama since no public or private institutionreceives and collects systemwide statistics. It is noteworthy that most interbank money market operations in Panamaare executed through correspondent banks in the United States (either Fedwire or CHIPS) and are non-collateralized.It is not possible to perform same-day domestic operations in BNP funds.When trading securities, banks recur mostlyto their own broker-dealers (for tax reasons) and rarely perform OTC transactions.


Note: MIB = Mecanismo Interbancario de Dinero; SML = Securities Market Law; MIT = Mecanismo Interbancario de Transferencias; BCN =Banco Central de Nicaragua; SBOIF = Superintendencia de Bancos y Otras Instituciones Financieras; DvP = delivery versus payment; CHIPS =clearinghouse interbank payments system; BNP = Banco Nacional de Panamá.

1This is not the case for dematerialized securities (see Article 123 of the SML). However, for the time being, there are no dematerialized securi-ties in Costa Rica.


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TABLE A4.8Securities Settlement Systems

Securities Trade Securities International Country Settlement System Confirmation Settlement Cycles Lending Numbering

Costa Rica Stock exchange, Lock-in (securities T (Mercado de Liquidez) No A standardization process CEVAL. blocked before T+1 (TEBEL) is under way for both

matching). T+1 (SITE international private and public securities) securities and all issues in T+2 (Primary auction) CEVAL have been T+3 (SITE equities). assigned an ISIN number.For all the systems only one multilateral net debit position is calculated every day for the cash settlement.

El Salvador Stock exchange, T T No NoCEDEVAL.

Guatemala Stock exchange. T T No No

Honduras Stock exchanges. No confirmation. No standardized No No settlement cycle.

Nicaragua Stock exchange, T T (market practice, no No NoCENIVAL. official settlement cycle).

Panama Stock exchange, T T+3 No NoLatinclear.


Notes: CEVAL = Central de Valores;TEBEL = Transacciones Electrónicas Bursátiles en Línea; SITE = Sistema Integrado de Transacciones Elec-trónicas; ISIN = international securities identification number; CEDEBAL = Central de Depósito de Valores; CENIVAL = Central Nicaragüensede Valores.

TABLE A4.9Management of Settlement Risk

Securities Risk Cash Country Settlement System Management Tools Delivery vs Payment Settlement Asset

Costa Rica Stock exchange, CEVAL. Securities block prior Model 2 (1.5 hours Central bank.to trading; credit line; difference between cash guarantee fund settlement and securities (defaulters pay). leg).

El Salvador Stock exchange, None. No Central bank.CEDEVAL.

Guatemala Stock exchange. None. No Central bank or checks.

Honduras Stock exchanges. None. No Cash or checks.

Nicaragua Stock exchange, None. No Checks.CENIVAL.

Panama Stock exchange, Securities blocking Model 2. Private Settlement Agent Latinclear. prior to selling; (CIASA).

guarantee scheme (a defaulter pays).


Notes: CEVAL = Central de Valores; CEDEVAL = Central de Depósito de Valores; CENIVAL = Central Nicaragüense de Valores; CIASA =Centro de Intercambio Automatizado, S.A.


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TABLE A4.10Operational Reliability of Securities Settlement Systems

SecuritiesCountry Settlement System Operational Reliability

Costa Rica CEVAL. In the present systems for clearing and settlement and for central custody services, attention ispaid to operational reliability. Every year an analysis of potential threats is made and the existingemergency plan is adapted accordingly.A contingency committee is installed. Protectionmeasures against unauthorized access are tested periodically by an external expert.There is anown power supply in case of an electricity cutoff. Communication with the brokers is based ona client-server infrastructure. Every participant is connected with the server via two dedicatedfiber-optic lines. Capacity of the systems can handle two times the peak hours’ demand.Procedures are in place concerning procurement, development, and modification of the systems;and modifications are adequately tested before becoming operational.The systems haveseparate environments for production, developing, and testing.A changeover committee isinstalled with participants of the IT department who designed and implemented themodification, the internal audit department, and the person responsible for testing.Thecommittee is chaired by the CEO. However disaster recovery facilities are not up to standard.There is no back-up server in standby mode and there is no second contingency site.

Efficiency of the systems needs to be improved.There are too many systems for differentsegments, which leads to fragmentation. Integration of trading and settlement and the blockingof securities at the moment the participants enter the trading platforms are inefficient andcostly.

El Salvador Stock exchange, Contingency plans are based on manual procedures.CEDEVAL.

Guatemala Stock exchange. The BVN reports that all their systems, including the securities depository, have safe operationalfeatures, back-up sites, and contingency plans. However, there is no regulation or supervision ofthese issues by any regulatory authority, as the stock exchange operates as a full SRO.

Honduras Stock exchange. Manual procedures.

Nicaragua CENIVAL. Neither the BVDN nor the CENIVAL have contingency facilities and/or back-up sites.The onlycontingency plan at present is the possibility to hold outcry floor sessions for trading purposesin case the electronic trading system malfunctions.

Panama Latinclear. Periodical analyses of potential threats are made. Communications with brokers are madethrough dedicated lines.There is no back-up server in standby mode, but there is a contingencysite located in Panama City, about six kilometers away from the primary site.A tape containing aback-up copy of operations is sent daily to the back-up site.


Notes: CEVAL = Central de Valores; CEO = chief executive officer; CEDEVAL = Central de Depósito de Valores; SRO = self-regulatory organi-zation; CENIVAL = Central Nicaragüense de Valores; BVDN = Bolsa de Valores de Nicaragua.


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TABLE A4.11Management of Custody Risk

Country Depository Custody Arrangements

Costa Rica CEVAL Segregation of accounts in CEVAL exists at the client level. Investor/ownership rights are clearlydefined.An investor who has given securities in custody is protected by law against the claims ofthe creditor or custodians (Article 142). Independent of form and location, securities of clientsare no part of custodian assets, stay outside the available assets after bankruptcy, and cannot beclaimed by its creditors.This is also the case for securities deposited by third parties.This articleprotects securities issued in Costa Rica and foreign securities kept in custody by a localcustodian.The law protects Costa Ricans, foreign investors, and foreign custodians using a CostaRican local agent.

El Salvador CEDEVAL Securities settlement occurs through CEDEVAL, which is the nation’s security depository.Securities settlement occurs by transferring the ownership records at CEDEVAL. Since not allsecurities are immobilized, sellers must deliver physical securities to CEDEVAL 24 hours beforethe sale is made.A draft law for the dematerialization of securities has been presented for Parliament approval.The draft law makes it possible for the BCR to be the depository and maintain the registry forpublic securities. Considering that 80 percent of all transactions in the securities market are ofofficial securities (treasury and BCR paper), mainly in the form of short-term repos, theproposed dematerialization will have an important impact on securities settlement.

Guatemala Stock exchange In principle, all public securities are issued in physical form; however, if the investor decides tokeep them under the custody of the central bank, they are issued as book-entry notes at thecentral bank Registry.The central bank performs only the custody function, not the ownershiptransfer, that is, it only registers the ownership of the investor in the primary market.Subsequent ownership transfers are done by means of delivery (if bearer securities), orendorsement (if order securities), or book-entry note in the stock exchange’s securitiesdepository, once deposited.For stock exchange transactions, securities must be deposited in the correspondent securitiesdepository (Caja de Valores).The securities depository of the BVN started operating in 1994.Physical custody of securities deposited in the Caja de Valores has been outsourced to a privatebank, owner of broker-dealer members of the stock exchange. Custody of securities isformalized by means of a deposit contract, regulated in the SML (Article 79). Each participant inthe depository must open an own account and an account on behalf of final beneficiaries, ofwhich the depository keeps a record. Broker-dealers must send periodic information to theircustomers about their accounts statements.The depository also administers economic rightsassociated with the securities deposited.

Honduras Stock exchange Public securities are issued in dematerialized form and can be under the custody of the BCH orthe stock exchange. On the rare occasion that those securities are traded in the secondarymarket, it is done through the physical exchange of custody certificates or at the custodianservice of the stock exchange. In any case, there is no legal basis for this custody arrangementsince the Commercial Law only recognizes securities issued in physical form.The SML providesthe legal support for a CSD and ownership transfer of securities by book-entry notes throughit, but it has not yet been established.

Nicaragua CENIVAL All public securities are issued in physical form. Subsequent ownership transfers are done bymeans of delivery (if bearer securities) or endorsement (if order securities) or book-entry notein the CENIVAL.To be traded at the stock exchange in a secondary market, securities must be deposited in theCENIVAL. Physical custody of securities is formalized by means of a deposit contract.Participants endorse their securities to CENIVAL in order for the latter to make the necessarysecurities transfers through book entries.The depository also offers the services ofadministering economic rights associated with the securities deposited.Regarding the protection of customer assets in the event of bankruptcy or insolvency of thecustodian, each participant in the depository must open an own account and an account onbehalf of final beneficiaries, of which the depository keeps a record. In turn, the CENIVAL keepsthe deposited securities in so-called memorandum accounts. However, there is no specific legalprotection for assets under custody for the securities market.

Panama Latinclear The SML mandates segregation of accounts of clients.The ownership rights of an investor areclearly defined.An investor who has given securities in custody is protected by law against theclaims of creditors. Independent of form and location, the securities of the clients are no part ofthe assets of the custodian, stay outside the available assets after bankruptcy, and cannot beclaimed by its creditors (SML, articles 27, 37, 122, 177, and 179). Ninety-nine percent of securitiesare either dematerialized or immobilized, so that 100 percent of transfers are book-entry.


Notes: CEVAL = Central de Valores; CEDEVAL = Central de Depósito de Valores; BCR = Banco Central de Reserva de El Salvador; SML = Se-curities Market Law; CSD = central securities depository; CENIVAL = Central Nicaragüense de Valores.


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TABLE A4.12Regulatory and Oversight Issues

Country Regulatory and Oversight Issues

Costa Rica CONASSIF is responsible for issuing all regulations for the financial system as well as the overall policiesthat govern the three supervisory agencies of the financial system. In this regard,Article 169 of the SMLstates that the SUGEF, the SUGEVAL, and the SUPEN will all function under the direction of CONASSIF.The members of CONASSIF are the minister of finance, the president or general manager of the BCCR,and five representatives not holding public sector positions.The SUGEVAL was created by the SML (Law7732 of 1998) and replaced the former National Securities Commission, which had been created by theprevious SML (Law 7201 of 1990).The SUGEVAL is responsible for supervising broker-dealers, investmentfunds managing companies, financial groups, and financial and nonfinancial securities issuers. SUGEVAL ischarged with the regulation, supervision, and control of the securities markets. However, its powers arelimited by the SML, which confers to the CONASSIF the power to dictate the rules for authorization,regulation, supervision, control, and surveillance that SUGEVAL and the other supervisory agencies mustexecute.

Regarding securities clearance and settlement, the SUGEVAL sets and supervises the rules regarding thefunctioning of CSDs, clearance systems, and centralized transaction and information systems for securitiestransactions.Article 6 of the SML specifically entitles SUGEVAL to regulate the organization andfunctioning of the RNVI, including the necessary information and updates, to which all individuals and firmsparticipating either directly or indirectly in the securities market (except for investors) must subscribe.Allactions and contracts associated with this market as well as all public offerings of securities must also beregistered in the RNVI.

Depositories must be authorized by SUGEVAL.Article 134 of the SML gives them also the possibility,together with broker-dealers and entities subject to SUGEF control, to offer custody services, including theadministration of economic rights associated with the securities under custody.Articles 119 and 134 to143 regulate different aspects of the central depository and custody functions, such as the constitution of adeposit; proof issuance; restitution of securities, bonds, or documents; and depositor protection in case ofbankruptcy or insolvency of a custodian.

El Salvador The SV is the entity in charge of supervising and overseeing the stock market and its participants.Thisinstitution began its operations on January 1, 1997, with the stock exchange, brokerage firms, deposit andsecurities custody firms, and risk rating firms falling within its supervision. Securities depositories must beapproved by the SV, but apart from this, there is no specific oversight function of securities settlement.

Guatemala According to the SML, the stock exchanges are SROs with regulatory and supervisory power over theirmembers.There is neither a securities regulator nor any other public agency that performs this role.Thisfunction is completely assumed by the stock exchanges in their SRO capacity.Article 18e of the SMLspecifies that the stock exchange oversees and ensures that the activity of the broker-dealers and issuerscomplies with the regulation.Title V of the Internal Rules of the Stock Exchange develops the supervisoryrole of the stock exchange over the registered entities and broker-dealers. Penalties are included inChapter III of Title II.

Honduras The CNBS Law (Ley de la Comisión Nacional de Bancos y Seguros, 1995) states the institutions under thesupervision of the CNBS (see Article 6) including entities involved in securities markets.There is no formaloversight of the securities settlement.

Nicaragua The stock exchange, the depository(ies), and broker-dealers are all regulated by the SBOIF but only on thebasis of the banking law.The SML draft gives self-regulatory powers to the stock exchange (Articles 39 and123). In this draft, depository(ies) are to be authorized by the SBOIF according to some of therequirements set forth in the banking law. Depository(ies) are not considered SROs in the SML draft.

Panama CNV is an autonomous entity, responsible for issuing all regulations for the securities market based on theprinciples of the Decree-Law 1, 1999. BVP and Latinclear are SROs with capacity to issue regulations andenforce them on their participants. CNV is responsible for supervising market participants (broker-dealers,investment societies, securities issuers, and SROs). Broker-dealers, investment societies, and SROs must beauthorized by SUGEVAL.Articles 27, 56, and 122 of the SML regulate the conditions for the provision ofcustody services, including the administration of economic rights associated with the securities undercustody.Title XI, Chapters I, II, and III, regulate different aspects of the central depository and custodyfunctions, such as the constitution of a deposit; proof issuance; restitution of securities, bonds, ordocuments; and depositor protection in case of bankruptcy or insolvency of a custodian.


Notes: CONASSIF = Consejo Nacional de Supervisión del Sistema Financiero; SUGEF = Superintendencia General de Entidades Financieras;SUGEVAL = Superintendencia General de Valores; BCCR = Banco Central de Costa Rica; CSD = central securities depository; RNVI = RegistroNacional de Valores Inmobiliarios; SV = Superintendencia de Valores; SRO = self-regulatory organization; SBOIF = Superintendendia de Bancos yOtras Instituciones Financieras; CNV = Comisión Nacional de Valores.


111

Appendix

TABLE A4.13Organizational Arrangements for Central Securities Depositories

Country CSD Organizational Arrangements

Costa Rica CEVAL Currently, only brokerage houses, with the exception indicated below, can open anaccount in CEVAL and have for this reason a monopoly on custodial services.Also,banks and pension funds have their own accounts at CEVAL; however, securities inthese accounts can only be traded if they are transferred to a broker’s account or tothe MIB account in the case of the interbank market. In the present governancestructure, brokers, as owners of the stock exchange, dominate the policy withrespect to trading, custody, clearing, and settlement. It is sometimes difficult tochange the situation separating the money market and capital markets.The CEVAL isa private institution fully owned by the exchange and governed by the members ofthe Exchange Board of Directors (brokerage houses and the stock exchange).

El Salvador CEDEVAL Currently, the CEDEVAL—an association specialized in the deposit and custody ofsecurities that began operations in 1998—is the central securities depository.Companies specialized in the deposit and custody of securities are constituted ascorporations and are subject to the commercial laws.The deposit and custodyservices can only be offered through stock exchanges, banks, or financial orspecialized institutions.The principal shareholders of CEDEVAL are the stockexchange and brokerage firms. Presently, the stock market has 80 percent ofCEDEVAL’s capital and shares five directors, and the stock exchange’s generalmanager is proprietary director of CEDEVAL.

Institutions holding an account at CEDEVAL are the pension funds, the stockexchange, and foreign trustees.At present, brokerage firms are not connected onlinewith CEDEVAL; nevertheless, this institution works so that the pension funds and thebrokerage firms can directly access the trustee’s information from their terminals.

Guatemala Stock exchange The creation of the Cajas de Valores is regulated in the SML (Article 79).They werecreated as a department of the respective stock exchanges.Thus, governancearrangements of the securities depositories in Guatemala are the same as those forthe stock exchanges.The stock exchanges are equally owned by each member.As ofDecember 2003, there were 33 registered broker-dealers of which 20 remain active,14 of the latter being linked to a banking group. Some banking groups own morethan one broker-dealer. In order to use the services of the Cajas de Valores, an entitymust be an agent or broker-dealer of the respective stock exchange.The Cajas deValores also allow for institutional participants to use the services of the depositoryfor its own operations but not on behalf of others.

Honduras N/A There is no CSD.

Nicaragua CENIVAL The CENIVAL is a subsidiary of the stock exchange, which owns 90 percent of theformer’s equity.The CENIVAL started operating in December 1997, and currentarrangements and practices are based on bilateral agreements and contract lawbecause in Nicaragua there is no legal basis for the operation of a CSD. Governancearrangements of the securities depository are, in general, the same as those of thestock exchange; the two institutions share the Board of Directors and somemanaging directors.Access to the CENIVAL is broad.According to Article 8 of itsInternal Regulation, all types of financial institutions duly authorized by the SBOIF,foreign banks, and other nonfinancial institutional investors may open a depositaccount.

Panama Latinclear Brokerage house accounts are segregated into own accounts and client accounts.Also, banks and corporations have their own accounts at BVP but securities can onlybe traded if they are transferred to a broker’s account. Acuerdo 7, 2003, of CNVexplicitly encourages SROs’ internal regulation to create conditions for fair and openaccess and prevents any discriminatory practice.


Notes: CSD = central securities depository; CEVAL = Central de Valores; CEDEVAL = Central de Depósito de Valores; SML = Securities MarketLaw; CENIVAL = Central Nicaragüense de Valores; BVP = Bolsa de Valores de Panamá; SRO = self-regulatory organization.


112


TABLE A4.14Cross-Border Settlement of Securities

Country CSD Links Among CSDs

Costa Rica CEVAL Regional links (see information for Guatemala and Nicaragua).

El Salvador CEDEVAL Regional links (see information for Guatemala and Nicaragua).

Guatemala Stock exchange The securities depository (Caja de Valores) also offers the custody of securities, inboth physical or book-entry form, for securities issued outside Guatemala. For thispurpose, the depository has links with Clearstream Banking; Central de Depósito deValores, S.A. (El Salvador); Bolsa Hondureña de Valores, S.A.; Central Nicaragüense deValores, S.A.; Central para el Depósito de Valores en la Bolsa Nacional de Valores,S.A. (Costa Rica); and Central Latinoamericana de Valores, S.A. (Panama).Theseoperations are settled through an omnibus account open in the name of Bolsa deValores Nacional, S.A.; in each of these entities.The BVN keeps a detailed registry ofthe securities deposited in each of the omnibus accounts.

Honduras Stock exchange Regional links (see information for Guatemala and Nicaragua).

Nicaragua CENIVAL Currently, the CENIVAL holds accounts for other CSDs in the Central Americaregion: CEDEVAL (El Salvador); Caja de Valores (Guatemala); Bolsa Hondureña deValores; CEVAL (Costa Rica); and Latinclear (Panama). Foreign investors may buysecurities deposited in CENIVAL through the omnibus account these other CSDshold with CENIVAL.

The CENIVAL also offers the custody of securities, both in physical or book-entryform, for securities issued outside Nicaragua through the same group of CentralAmerican securities depositories.These operations are settled through an omnibusaccount open at the name of the CENIVAL in each of these entities.

Panama Latinclear Latinclear also offers custody services for securities issued outside Panama. It hasdepository links with Clearstream, CEDEVAL (El Salvador), and CEVAL (Costa Rica).These operations are settled through omnibus accounts.


Notes: CSD = central securities depository; CEVAL = Central de Valores; CEDEVAL = Central de Depósito de Valores; CENIVAL = CentralNicaragüense de Valores.


113

Appendix

TABLE A4.15Transparency, Oversight, and Cooperation in Payment Systems

Transparency of the Oversight and Objectives, Scope, Organizational

Legal Foundations of Dissemination of Instruments, Arrangements and Country the Function Information Pricing, and Access Cooperation

Costa Rica Law 7558 of 1995 (Organic The operation of system- The BCCR has a significant Several departments underLaw of the Banco Central ically important payment role in payment system the Dirección de Servicios de Costa Rica—BCCR), systems detailed in a set of reform. Financieros deal with pay-Article 2. documents known as the ments system issues. Some

“Blue Book.” The BCCR’s objectives in aspects related to foreign the payment system have exchange and cross-border

The BCCR does not have not been publicly disclosed. payments are dealt with by any regular publications another department.covering payment system Instruments of oversight developments. can be summarized as the No formal unit is in charge

operational involvement, of monitoring the payment Statistical information on its specific regulations, and system.the payment system is not moral suasion.available on a regular and At the top level, coordina-structured basis. Explicit provision exists to tion exists through

regulate the pricing of pay- CONASSIF.At the working ment services in both the level, no formal framework central bank law and the exists to enhance coopera-SINPE regulation. tion on a continuous basis.

The BCCR determines No Payment System access requirements for the Council.systems it manages.As of yet, there is no general provision to regulate access to payment systems managed by the private sector.

El Salvador No legal clarity on the Oversight function not Oversight function not Oversight function not authority empowered to formally performed. formally performed. formally performed.regulate and oversee pay-ment systems. No Payment System

Council.

Guatemala The Statute of the The BANGUAT does not The BANGUAT plays a Oversight function not BANGUAT (Ley Orgánica have any regular publications leading role in the reform formally performed.del Banco de Guatemala) of covering payment system of payment arrangements May 2002,Article 4. developments. in the country, in particular, No formal cooperation

through the launch of the exists between the Statistical information on new RTGS system. BANGUAT and other regu-the payment system is not lators on payment systemavailable on a regular and The objectives and scope issues. Only recently, the structured basis. of the oversight function BANGUAT has become

are not clearly defined. more active in international and regional forums on pay-

In absence of secondary ment and securities settle-legislation and/or any ment issues.central bank document on payment system oversight, No Payment System the available instruments Council.are regulation and moral suasion in the context of central bank’s activities.

The BANGUAT has not yet defined a coherent pricing policy for the payment systems it operates and/or guidelines for the payment systems it does not operate.


References

Banca d’Italia, 1999, White Paper on Payment System Over-sight. Objectives, Methods, Areas of Interest, November(Rome).

Bank of England, 2000, Oversight of Payment Systems, No-vember (London).

Bank for International Settlements, 1992, Delivery VersusPayment in Securities Settlement Systems, CPSS Publi-cation No. 6, September (Basel).

———, 1996, Settlement Risk in Foreign Exchange Transac-tions, CPSS Publication No. 17, March (Basel).

———, 1999, Retail Payments in Selected Countries: AComparative Study, CPSS Publication No. 33, Sep-tember (Basel).

———, 2000, Clearing and Settlement Arrangements for Re-tail Payments in Selected Countries, CPSS PublicationNo. 40, September (Basel).

———, 2001a, Core Principles for Systemically ImportantPayment Systems, Committee on Payment and Settle-ment Systems, January (Basel).

———, 2001b, Recommendations for Securities SettlementSystems, Committee on Payment and Settlement Sys-tems and Technical Committee of International Organization of Securities Commissions, November(Basel).

———, 2003, Policy Issues for Central Banks in Retail Pay-ments, CPSS publication No. 52, March.

———, 2005, Central Bank Oversight of Payment and Set-tlement Systems, Committee on Payment and Settle-ment Systems, May (Basel).

114



Transparency of the Oversight and Objectives, Scope, Organizational

Legal Foundations of Dissemination of Instruments, Arrangements and Country the Function Information Pricing, and Access Cooperation

There is no statement that clarifies BANGUAT objectives and policies related to access.

Honduras Banco Central de Honduras Oversight function not The BCH plays a leading Oversight function not (BCH) Law,Article 2. formally performed. role in the reform of pay- formally performed.

ment arrangements in the country, in particular, Payments System Council re-through the launch of the cently established.new RTGS system.

Only recently, the BCH has Oversight function not become more active in inter-formally performed. national and regional forums

on payments and securitiessettlement issues.

Nicaragua Banco Central de Nicaragua Oversight function not Oversight function not Oversight function not (BCN) Organic law, formally performed. formally performed. formally performed.Article 3.

No Payments System Council.

Panama No central bank. Oversight function not BNP performs some regula- Oversight function not formally performed. tory and administrative formally performed.

responsibilities related to checks and other payments No formal cooperative instruments and settlement. arrangements are in place,

but banks have reached im-portant agreements in rele-vant areas.


Notes: BCCR = Banco Central de Costa Rica; CONASSIF = Consejo Nacional de Supervisión del Sistema Financiero; SINPE = Sistema Inter-bancario de Negociación y Pagos Electrónicos; BANGUAT = Banco de Guatemala; RTGS = real-time gross settlement; BCH = Banco de Honduras.


———, 2006, General Guidance for National Payment Sys-tem Development, Committee on Payment and Settle-ment Systems, January (Basel).

Basel Committee on Banking Supervision, 2000, Supervi-sory Guidance for Managing Settlement Risk in ForeignExchange Transactions, September (Basel).

Bossone, Biagio, and Massimo Cirasino, 2001, “The Over-sight of the Payment Systems: A Framework for theDevelopment and Governance of Payment Systemsin Emerging Economies,” Payments and SecuritiesClearance and Settlement Systems Research SeriesNo. 1 (Mexico City: CEMLA-World Bank).

115

References


Migrant Remittances in Central America

Dilip Ratha105

This chapter highlights the importance of inter-national migrant remittances in six Central

American countries—Costa Rica, El Salvador,Guatemala, Honduras, Nicaragua, and Panama.106

Migrant remittances are the largest source of exter-nal financing in four out of these six countries. Froma financial sector point of view, these large remit-tance flows raise two sets of issues:107

• The cost of sending remittances is very high, es-pecially for small transfers undertaken by poormigrants. High remittance fees are a reflectionof market failure and inefficiencies in the retailpayment system. Remittance costs can be re-duced by strengthening the financial infrastruc-ture supporting remittances. But these efforts toreduce costs would also have to be carefully bal-anced with efforts to fight money launderingand the financing of terrorism.

• The second issue relates to increasing the im-pact of these remittances on financial develop-ment without directly affecting these personalflows. This would require encouraging more

flows through formal channels, and linking re-mittances to consumer and housing loans andinsurance products for remittance recipients. Fi-nancial institutions can also use remittances ascollateral for raising external bond financing.

The next section describes the size of remittancesand their importance in the retail payment systemsof each of these six countries. Section III discussespossible measures to reform the retail payment sys-tem and reduce high remittance fees. Section IVbriefly describes the complementarities between fi-nancial institutions and remittances. Section V isdevoted to securitization of remittances as a tool forraising private external bond finance. The last sec-tion contains a summary of recommendations.

Remittances and Retail Payment Systems

A retail payment transaction may be defined as atransaction originated by or payable to an individual,the counterparty being an individual, a firm, or agovernment agency. Retail payments may be definedto include frequent, small-value business-to-businesspayments.108 Thus, retail payments would includepure transfers such as migrant remittances or trans-fers from public and private institutions to individualbeneficiaries. They would also include small-valuepayments in exchange for goods and services, for ac-

116

5

105The author works at the World Bank.106Migrant remittances are defined as the sum of workers’ re-

mittances and compensation of employees—see Ratha (2003).107This chapter does not discuss the development impact of re-

mittances in the receiving countries. At the household level,these impacts could be to reduce poverty, act as an insuranceagainst adverse shocks, and increase household spending. At themacroeconomic level, remittances could increase financial deep-ening and lead to exchange rate appreciation. See Mishra(2005); Yang (2004); Adams (2004); and Edwards and Ureta(2003) for discussion of some of these issues. 108Bank for International Settlements (1999).


quisition of assets, or for debt servicing. In more de-veloped countries, migrant remittances would formonly a small share of retail payments, which, in turn,are only a tiny fraction of wholesale payments. Butin developing countries, especially in Central Amer-ica, remittances form a significant source of fundingin relation to the size of the economy and, therefore,of the retail payment system. Furthermore, any eval-uation or reform of the retail payment system fromthe point of view of facilitating remittances isequally likely to benefit other (not easily quantifi-able) components of retail payments as well.

In 2003, officially recorded international remit-tance receipts by Costa Rica, El Salvador, Guatemala,Honduras, Nicaragua, and Panama amounted to $6billion, or about 7.4 percent of their combined GDP(Table 5.1 and Figure 5.1). Remittance receiptsranged from $85 million in Panama to over $2.1 bil-lion each in El Salvador and Guatemala. While largercountries in general received larger amounts of remit-tance flows, the poorer countries (Nicaragua, Hon-duras, Guatemala, and El Salvador) received rela-tively larger amounts than the richer countries(Panama and Costa Rica).109 In El Salvador, remit-

tance receipts in 2003 were 14.7 percent of GDP,over 30 percent of imports of goods and services,nearly 12 times the size of net official inflows, andnearly 24 times the size of foreign direct investment(FDI). In general, in the poorer Central Americancountries, remittances are larger than earnings fromthe single largest export item, and larger than officialand private capital flows.110

These data are likely to be underestimated.111 Of-ficial data do not include remittance flows throughinformal (unregulated) channels. They do not evenfully capture flows through the formal channels.Most countries do not require reporting of “small”remittance transactions.112 Also, remittances paidby post offices, exchange bureaus, and other agentsof money transfer companies in Central Americaare often not reflected in the official statistics. Fi-

117


109Remittances tended to be more stable than export receiptsor private capital flows in El Salvador, Guatemala, Honduras,and Nicaragua (Figure 5.1). The cyclical stability of remittancesowes in part to the fact that they are largely altruistic transfers bythe existing migrant stock. Indeed, remittances may also behavecountercyclically as existing migrants may increase remittances,

and new migration may take place, during a period of economicslowdown in the remittance recipient economy (Ratha, 2003).

110In contrast, the richer neighbors, Costa Rica and Panama,have significant remittance outflows to the region. The exactamount of flows from various source countries is not available asbilateral flow data do not exist for most countries.

111The 2004 estimates of remittance flows produced by theMultilateral Investment Fund of the Inter-American Develop-ment Bank, for example, exceed the figures presented in Table5.1 by 20 percent in El Salvador, 25 percent in Guatemala, and31 percent in Honduras.

112For example, the reporting threshold is $10,000 in theUnited States, 12,500 euros in Western Europe, and 3 millionyen in Japan. Data on remittances rely on reports from recipientcountries.

TABLE 5.1Remittance Flows, 2003


Remittance receipts (US$ millions) 321.0 2,122 2,147 867 439 85As a share of (in percent)

GDP 1.8 14.7 8.7 12.4 10.0 l0.7Trade deficit 37.0 284 153 224 40 15Imports of goods and services 3.4 30.4 27.5 21.9 21.0 0.9FDI 56 2,384 1,851 438 204 11Official flows1 272 1,172 2,440 387 101 266

Outward remittances (US$ millions) 192 25 82 1 . . . 53

Memorandum items:Per capita GNI (US$) 4,280 2,200 1,910 970 730 4,250Number of migrants (in thousands)2 109 1074 591 354 302 178As share of own population (in percent) 2.9 17.0 5.2 5.5 6.0 6.2

Sources: IMF, Global Development Finance (2005), and Balance of Payments Statistics Yearbook (2004).Note: Remittances defined as the sum of workers’ remittances and compensation of employees. FDI = foreign direct investment; GNI = gross

national income.1Data for Nicaragua are for 2002.22001 round of U.S. Census 2000 Supplementary Survey as calculated in Yang (2004).


nally, a large amount of remittances are misclassifiedunder export revenue, tourism receipts, nonresidentdeposits, or even foreign direct investment (FDI).113

The United States is by far the largest source ofremittances to the Central American countries. Theremittance pattern is closely linked with the migra-tion pattern. It is worth noting, however, that the

Central American countries also have significantintraregional migration and remittance flows.Nicaragua, for example, has nearly half as many mi-grants in Costa Rica as it has in the United States; italso has a significant number of migrants in Canada,El Salvador, and Guatemala. Honduras has a sizablemigrant stock in Mexico, besides the United States.Costa Rican migrants have a significant presence inEl Salvador and Honduras, besides the UnitedStates and Canada. The sizable intraregional remit-tance flows are a factor worth including in discus-sions about regional retail payment systems.

Formal remittances to these Central Americancountries are largely originated by money transfer

118

MIGRANT REMITTANCES IN CENTRAL AMERICA

Figure 5.1. Cyclical Stability of Remittances, 1990–2003

-2

0

2

4

6

8GDP growth (right scale)

Sources: IMF, Global Development Finance (2005) and Balance of Payments Statistics Yearbook (2004).

1

3

5

7

9

11

13Remittances/GDP (left scale)

2002200019981996199419921990

Honduras

-2

0

2

4

6

8

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9

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13

15

2002200019981996199419921990

El Salvador

2

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5

1

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9

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2002200019981996199419921990

Guatemala

-2

0

2

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14

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2002200019981996199419921990

Nicaragua

113An International Working Group to Improve RemittanceStatistics was set up in 2004 at the behest of the G-8, and in-cludes the World Bank, the IMF, the European Central Bank, theInter-American Development Bank, the Organization for Eco-nomic Cooperation and Development (OECD), and the UnitedNations.


operators (MTOs) and banks in the source coun-tries, and are channeled using mostly private propri-etary payment systems and distributed throughbanks and agents of the MTOs (Box 5.1). Most re-mittances from the United States to these countriesare in the form of electronic transfers, but some arein the form of money orders and drafts, especially inHonduras.114 Nicaraguan migrants seem to relyheavily on the MTOs, which often have partner-ships with local bank and postal networks. Hon-duras and Nicaragua also have partnerships betweentheir post offices to provide remittance services. In

El Salvador and Guatemala, banks are the dominantremittance service provider. Except for a small pres-ence in Guatemala, credit unions and microfinanceinstitutions do not play any significant role in dis-tributing remittances.

A significant part of flows also goes through infor-mal channels, especially traveling friends and rela-tives.115 The choice of the channel is affected by,

119


Box 5.1. Remittance Transaction Structure

A typical remittance transaction takes place in threesteps: (1) initiation of remittances by a migrant senderusing a sending agent, (2) exchange of informationand settlement of funds, and (3) delivery of remit-tances to the beneficiary. In step 1, the migrant senderpays the principal amount of remittance to the send-ing agent using cash, check, money order, credit card,debit card, or a debit instruction sent through e-mail, telephone, or Internet banking. In step 2, thesending agency—a money transfer operator (MTO),bank or other financial institution, money changer, or

merchant (e.g., gas station, grocery store) then in-structs its agent in the recipient country to deliver theremittance to the beneficiary. In step 3, the payingagent makes the payment to the beneficiary. In mostcases, there is no real-time fund transfer; instead, thebalance owed by the sending agent to the payingagent is settled periodically according to a mutuallyagreed schedule. The settlement is mostly carried outusing commercial banks through the national clearingand settlement systems. Informal remittances aresometimes settled through goods trade.

Step 1 Step 2 Step 3

SenderInformation by phone

or mail Beneficiary

Cash, check, money order,bank transfer, credit, debit,prepaid card, transfer orderin person, by phone, or by Internet

Cash, check, money order,bank transfer, credit, debitcard, Internet goods

Sending agentMTOs, banks, credit unions,microfinance institutions,merchants, money ex-changes, friends, relatives,missionaries, cell phonecompanies

Information forwardedby e-mail, SWIFT, proprietarynetworks, fax, phone,ACH

Settlement in cash, viabank transfers, netting byother trade

Paying agentMTOs, banks, credit unions,microfinance institutions,merchants, money ex-changes, friends, relatives,missionaries, cell phonecompanies

114De Luna-Martínez (2005).

115For instance, the results of the 2004 survey on State-By-StateData on Remittances Sent by Migrants in United States to LatinAmerica, conducted by the Multilateral Investment Fund of theInter-American Development Bank, indicate that approximately12 percent of remittances are sent through people traveling or by mail (available via the Internet: http://www.iadb.org/exr/remittances).


http://www.iadb.org/exr/remittances

http://www.iadb.org/exr/remittances

among other things, remittance costs, trust in theintermediary, and convenience factors such as loca-tion, hours of operation, language, and identifica-tion requirements. Among these factors, high remit-tance costs stand out as the most important factoraffecting the channel, the instrument (check,money order, electronic wire, prepaid card, debitcard, and hand carry), the frequency, and possiblythe amount of remittance flows.

Remittance Costs

The fee structure for sending cross-border remit-tances is rarely transparent. Remittance fees, typi-cally paid by senders to the remittance agent at thetime of sending, range from a fixed $3–$5 per trans-action to as high as 20 percent in the case of someMTOs. The average remittance fee (excluding for-eign exchange commission), according to some re-ports, is around 4–6 percent in Honduras, 5–7 per-cent in El Salvador, 6–8 percent in Guatemala, and6–9 percent in Nicaragua for money transfers of lessthan $300, which is the average amount that mi-grants send home every month. In the case of West-ern Union and MoneyGram, the fee for sending$300 from New York to any of these Central Ameri-can countries was 9.7 percent and 8.3 percent, re-spectively, in 2005 (Figure 5.2). All remittanceagencies charge an additional foreign exchangecommission when the remittance is delivered inlocal currency. In El Salvador, Nicaragua, andPanama, major remittance agencies deliver remit-tances in U.S. dollars. On top of the remittance feeand foreign exchange commission, remittanceagents (especially banks) often take advantage ofthe “float” by delaying remittance delivery and in-vesting the funds in the overnight money market.

Remittance costs are significantly higher forsmaller remittance transactions used by poorer mi-grants. In the case of Western Union and Money-Gram, for example, sending $100 costs 15 percent;however, sending $500 costs 8.6 percent and 8 per-cent, respectively. The remittance cost structure,thus, represents a greater burden for small transac-tions. It is very likely that remittance flows wouldincrease, especially through formal recorded chan-nels, if remittance costs were lowered.

Conservative estimates based on market analysissuggest that the true cost of transactions—labor,technology, setting up networks, and rent—add upto only about $5 (or less) per transaction, signifi-

cantly below the fees charged to customers.116 Themarginal cost of effecting transfers using sophisti-cated payment system infrastructure can be verylow. The FedACH International service, offered bythe Federal Reserve Banks to process cross-bordertransactions, for example, charges only 67 cents perremittance transaction, irrespective of the principalamount.117 However, this service may enjoy cost ad-vantages in terms of volume and infrastructure.

Further analysis is necessary to determine variouscomponents of remittance costs. Recent researchpoints to absence of competition in this market as amajor contributor to high transaction costs. Remit-tance costs are low, and have fallen in recent years,in corridors (the United States–Mexico corridor, forexample) where competition has increased.118 Entryof new remittance service providers, however, hasbeen sluggish in most corridors. High fixed costs re-quired to build extensive agent networks is a majorentry barrier.

Improving transparency in remittance transactionswould raise consumer awareness, reduce unfair remit-tance practices, and may have a significant effect oncosts. The World Bank and the BIS Committee onPayment and Settlement Systems have set up a taskforce, with IMF participation, to develop voluntaryprinciples for remittance service providers, regulators,and supervisors for improving transparency in themarket. It is also possible that simply publicizing in-formation on costs, as Mexican authorities dothrough the consumer protection agency (Procu-raduría Federal del Consumidor, PROFECO) initia-tive, will contribute to strengthening competition.119

Other measures to reduce remittance costs includeintroducing new remittance instruments that takeadvantage of new technology, especially Internet-based technology. Card-based instruments, such asstored value cards (similar to phone cards), creditcards, and debit cards, are frequently used for sendingremittances to urban locations that have access tocard processing machines.120 These instruments,

120


116Ratha and Riedberg (2005).117FedACH International services are currently available to

Canada, Mexico, Austria, Germany, the Netherlands, Switzer-land, and the United Kingdom.

118Hernandez-Coss (2005).119The International Remittance Protection Act proposed by

Senator Paul Sarbanes of Maryland in September 2004 marks aneffort to improve disclosure of fees and exchange rate commis-sions in remittance transactions.

120Cellular phone–based technologies, such as the SmartPadala system in the Philippines, are not yet popular in the re-gion, but it is a matter of time before such instruments become


however, represent a challenge from an anti-money-laundering/combating the financing of terrorismstandpoint to properly identify the customer behind atransaction.

Regulatory and policy decisions also affect thelevel of transaction costs. Since the terrorist attacksof September 11, 2001, authorities in many coun-tries have adopted more stringent regulations andstepped up enforcement of existing rules governingthe transfer of foreign exchange. In particular, theintroduction of the Patriot Act in the United Statesin late 2001 tightened know-your-client require-ments for fund transfers.121 In addition, financial in-stitutions are also required to comply with theAML/CFT recommendations of the Financial Ac-tion Task Force (FATF), which are transposed in na-tional regulations, as well as with the Office of For-

eign Assets Control (OFAC) sanctions list.122 Anincreasing number of countries are requiring MTOsto register and report transactions on a regular basis.These regulatory requirements have raised the costof fund transfers to the remittance service providerswho tend to pass on the cost increase to customers.

The regulatory regime governing remittances hasto strike a balance between curbing money launder-ing, terrorist financing, and general financial abuse,and facilitating the flow of funds through formalchannels. While, for instance, documentation re-quirements can add to the cost of remittances andrestrict access to formal channels, they are necessaryto prevent the abuse of remittance services formoney laundering or terrorist financing purposes.Strengthening the formal remittance infrastructureby offering the advantages of low cost, flexiblehours, expanded reach, and language, and increas-ing efforts to identify and regulate the unregulatedsector, would be effective ways to facilitate remit-tance flows while preserving their integrity.

Harmonizing electronic fund transfer systemscould reduce the cost of remittances. Currently,major transfer agents use their own (costly) propri-

121

Remittance Costs

Figure 5.2. Remittance Costs, April 2005

Sources: www.westernunion.com and www.moneygram.com. Note: Fees shown are for remittances from New York to Central America. The same fee structure applies to all six Central American countries.

0

4

8

12

16

MoneyGram Western Union

5004003002001000

10

20

30

40

50

MoneyGram Western Union

500400300200100

Remittance costs are high . . . . . . and regressive

Fee

(in U

.S. d

olla

rs)

Fee

(in %

of p

rinc

ipal

)Principal (in U.S. dollars) Principal (in U.S. dollars)

available. These systems combine the advantages of phone bank-ing with the unique ID and security features of cellular technol-ogy. See Ratha and Riedberg (2005); and Department for Inter-national Development (2005).

121Section 326 of the Patriot Act requires banks to verify theidentity of customers. The law does not bar non-U.S. citizensfrom opening bank accounts in the United States. A non-U.S.customer who does not already have a social security numbercould use a government-issued identity document (e.g., the na-tional passport) to open a non-interest-bearing checking ac-count, and apply for an income taxpayer identification number(ITIN) to open an interest-bearing savings account.

122The FATF has issued special AML/CFT recommendationsfor registering/licensing remittance service providers. See IMF(2005).


www.westernunion.com

www.moneygram.com

etary systems for effecting cross-border remittances.Also, domestic payment systems have evolved inde-pendently, although efforts are under way for theirharmonization.

Even with the prevailing cost structure, there maybe scope to reduce average remittance costs by“bundling,” that is, by enabling senders to remitmore money but less frequently, perhaps by improv-ing access to savings accounts or credit. Banks andother financial institutions could play a role in facil-itating this. In addition, improving migrant workers’access to banking in the remittance-source coun-tries could reduce transactions costs as well as en-courage financial deepening in the countries receiv-ing remittances.

Remittances and FinancialInstitutions

Financial institutions, including smaller onessuch as credit unions and microfinance institutions(MFIs), can play a major role in delivering low-costand convenient remittance services.123 If remit-tances are channeled through financial institutions,they might encourage more savings and also enablebetter matching of savings and investment in theeconomy.124 Among the products that financial in-stitutions are starting to offer to families receivingremittances are consumer loans, mortgages, and lifeinsurance. Banks from countries in the region havebeen active in this market for some time, includingthrough branch networks in sender countries. Largerinternational banks have more recently shown someinterest in tapping this market.125

Credit unions in El Salvador, Guatemala, Hon-duras, Nicaragua, Mexico, and Jamaica that are mem-bers of the World Council of Credit Unions(WOCCU) encouraged WOCCU to establish theInternational Remittance Network (IRnet) in July1999, to facilitate remittance flows from the UnitedStates to Latin America. This initiative has success-

fully lowered remittance costs by raising customerawareness of remittance fees and by generating, tosome extent, competition in the remittance market.The remittance fee through IRnet is a flat $10 forsending up to $1,000, much lower than the feescharged by major MTOs (see Figure 5.2). Besides feeincome, these institutions are interested in using re-mittances for relationship building with existing andnew customers. It is reported that 14–28 percent ofnonmembers who came to WOCCU-affiliated creditunions to transfer funds eventually opened an ac-count, and 37 percent of credit union members savedsome part of their remittance receipts.126

Financial institutions are exploring new productssuch as car and housing loans to remittance recipi-ents. The idea of using remittance receipts as a way toevaluate credit history for lending to microenterprisesis also being explored. Some institutions are also ex-ploring ways to target remittances to specific usessuch as paying school fees or medical bills. Others areexploring insurance products, for example, to ensurea stable flow of income to the remittance beneficiaryin the event that the sender suffers an income shock.

In entering the remittance market, smaller non-bank financial institutions such as the MFIs haveoften entered into corresponding banking relation-ships with local commercial banks and with interna-tional remittance providers (such as the IRnet orthe major MTOs).127 Such tie-ups may be a reasonbehind high remittance fees charged by some MFIsin Central America, although their services maystill be considered convenient by customers.128

Securitization of Remittances

Taking advantage of the large size and stability ofremittance flows, financial institutions in El Sal-vador followed the example of Mexican banks andraised $650 million from the international capitalmarkets between 1998 and 2004 by securitizing fu-ture flows of remittances and, more recently, other

122


126Grace (2005) based on data from the FEDECACES in ElSalvador and the FENACOAC in Guatemala.

127In Guatemala, Bancafe, Banrural, and FENACOAC havepartnerships with MoneyGram, Western Union, and Vigo, re-spectively. In El Salvador, FEDECACES has partnered withVigo, and Procredit with Western Union, and several others withMiPueblo (see Orozco, 2004).

128See Orozco and Hamilton (2005); Isern, Deshpande, andvan Doorn (2005); and Sander (2004).

123Microfinance can be particularly important for channelingremittances to rural areas, where nearly 40 percent of recipientsreportedly live—see Yang (2004) based on the 2002 round of theEncuesta de Hogares Propósitos Multiples.

124A bank account offers security and convenience for saving.Thus, a remittance recipient with a bank account is more likely tosave a part of the remittance income than an unbanked person.

125For instance, in 2004, Banco Bilbao Vizcaya Argentaria(BBVA) of Spain reached an agreement to acquire Laredo Na-tional Bancshares of the United States with a view to tapping theHispanic market in the Texas-Mexico border area.


diversified payment rights (DPRs), such as exportrevenue and FDI (Table 5.2).

Securitization of future remittances (as well astourism receipts and export receipts) can enable de-veloping country borrowers (typically, financial in-stitutions) to access international capital marketsduring hard times. By mitigating currency convert-ibility risk, a key component of sovereign risk, thesecuritization of future remittances allows securitiesto be better rated than the sovereign. These securi-ties are typically structured to obtain an investmentgrade rating. In the case of El Salvador, for example,the remittance-backed securities were rated invest-ment grade, two to four notches above the subin-vestment grade sovereign rating. Investment graderating makes these transactions attractive to a widerrange of “buy-and-hold” investors (e.g., insurancecompanies that face limitations on buying subin-vestment grade securities). As a result, the issuercan access international capital markets at a lowerinterest rate and longer maturity.

Perhaps the most important incentive for govern-ments to promote this asset class lies in the externali-ties associated with it. Securitized transactions, as op-posed to unsecuritized ones, involve a much closerscrutiny of the legal and institutional environment—the existence as well as the implementation of lawsrelating to property rights and bankruptcy proce-dures. A remittance securitization transaction backedby the government can also help usher in reforms ofthe legal and institutional environment.

Remittance securitization typically involves theborrowing entity such as a bank pledging its future

remittance receivables to an offshore special purposevehicle (SPV) that issues the debt (for an example,see Box 5.2). Designated correspondent banks are directed to channel all remittance flows of the bor-rowing bank directly to an offshore collection ac-count managed by a trustee. The collection agentmakes principal and interest payments to the in-vestors and sends excess collections to the borrowingbank. Since remittances do not enter the issuer’shome country, the rating agencies believe that thestructure mitigates the usual sovereign transfer andconvertibility risks. Such transactions also often re-sort to excess coverage to mitigate the risk of volatil-ity and seasonality in remittances.

The first major securitization deal involving in-ternational migrant remittances occurred in 1994 inMexico. Since then, the volume of remittance secu-ritization has grown rapidly. Using this instrument,Mexico, Turkey, and El Salvador raised about $2.3billion during 1994–2000. As electronic transfersbecame more prevalent and made it easier to trackcomplex transactions, remittance securitizationgave way to securitization of DPRs including mainlymigrant remittances, but also payments related toexports and FDI. Between 2000 and 2004, a total of$10.4 billion was raised through securitization ofDPRs by Brazil ($5.3 billion),129 Turkey ($4.1 bil-lion), El Salvador, Kazakhstan, Mexico, and Peru(although remittances remain dominant).

123


TABLE 5.2Securitization of Future Remittances in El Salvador

Amount(in millions of Transaction Sovereign

Year Issuer U.S. dollars) Flow Type Rating Rating

1998 Banco Cuscatlán 50 Remittances BBB BB1999 Banco Cuscatlán 25 Remittances BBB BB+2002 Banco Cuscatlán 100 DPR AAA BB+2002 Banco Agrícola 100 DPR AAA BB+2002 Banco Agrícola 40 DPR AAA BB+2003 Banco Cuscatlán 125 DPR AAA BB+2003 Banco Agrícola 60 DPR AAA BB+2004 Banco Salvadoreño 25 DPR BBB BB+2004 Banco Salvadoreño 75 DPR BBB BB+2004 Banco Cuscatlán 50 DPR BBB BB+

Total 650

Sources: Ketkar and Ratha (2004); Fitch Ratings; and Standard & Poor’s.

129These bonds resulted in a spread saving of over 700 basispoints compared with Brazil’s sovereign spread.


As experience with this instrument broadens andinvestors become more comfortable with its charac-teristics, it is possible that it could be used by a widerrange of countries (including poor countries) andfor a broader range of external flows (remittances,tourism receipts, commodity earnings). Financialinstitutions in the Central American countries thatreceive significant amounts of remittances can po-tentially raise financing from international capitalmarkets using the future remittance-backed securiti-zation structure. However, to the extent remittances

finance consumption and imports, they will not beavailable as collateral.

One of the main problems with future flow securi-tization is that it increases the level of inflexibledebt of the issuer, usually private financial institu-tions.130 Although the current level of debt pledgedto future flows is not alarming, such debt reduces theflexibility and ability to service other nonpreferreddebt. Securitization of future remittances (and other

124


Box 5.2. Banco do Brasil’s Nikkei Remittance Trust Securitization1

Amount: $250 million.Collateral: U.S. dollar– or Japanese yen–denominated

worker remittances.Transaction BBB+ versus Banco do Brasil’s and

rating: Republic of Brazil’s foreign currency ratingof BB–Stable.

This deal involved Banco do Brasil (BdB) selling itsfuture remittance receivables from Brazilian workersin Japan directly or indirectly to a CaymanIsland–based offshore special purpose vehicle (SPV)named Nikkei Remittance Rights Finance Company(see the figure). A New York city–based SPV issuedand sold the debt instrument to investors, receiving$250 million. BdB Japan was directed to transfer re-mittances directly to the collection account managedby the New York–based trust. The collection agentwas to make principal and interest payments to theinvestors. Excess collections were to be directed to theoriginator BdB via the SPV.

Since remittances did not enter Brazil, the ratingagencies believed that the structure mitigated theusual sovereign transfer and convertibility risks. Thestructure also mitigated the bankruptcy risk becausethe SPV had no other creditors, and risk of bank-ruptcy was minimal given the government-ownedBdB’s dominant position in Brazil. Furthermore, legalopinion held that creditors would continue to haveaccess to the pledged security (i.e., remittances) evenif BdB were to file for bankruptcy.

A number of residual risks remained that were diffi-cult to structure away. These included performancerisk—the ability and willingness of BdB to garner re-mittances and deliver them to the collection accountmanaged by the New York–based trustee; productrisk—the ability and willingness of Japan to generateremittances; and diversion risk—the possibility of BdB

selling the remittance rights to another party. The per-formance risk is generally captured in the issuer’s localcurrency rating. For entities such as banks, Fitch usesthe going concern and Standard & Poor’s (S&P) the“survival” assessment of the originating entity in ratingan asset-backed transaction higher than the issuer’slocal currency rating. This was the case for the BdB’sNikkei Remittance Trust transaction, which was ratedBBB+ versus BdB’s BB+ local rating. In reaching thisdecision, S&P took into account BdB’s position as thelargest financial institution in Brazil (with a 2,900-strong branch network) that makes it a natural con-duit for funds transfers, the long-established presenceof BdB in Japan since 1972, and the importance ofworker remittances in generating foreign exchange forthe Brazilian government. The product risk fromvolatility and seasonal fluctuations in remittances wasmitigated via over-collateralization or excess coverage,with a debt service coverage ratio of 7.64.2 Another el-ement of product risk was partially mitigated by recog-nizing Japan’s need for workers to supplement the na-tive workforce, and the availability of Brazilians ofJapanese descent to fill this demand. S&P, however,recognized as constraints on the rating the possibilitiesof Japan obtaining workers from countries other thanBrazil and BdB selling remittance rights to anotherparty. It expressly identified the latter as an event ofdefault, triggering early amortization.

Some elements of sovereign risk cannot be totallyeliminated. For example, the Central Bank of Brazilcan compel BdB to pay remittances directly to thecentral bank instead of the trust. A degree of protec-tion against this risk is provided by the fact that BdBis majority owned by the government of Brazil. Inother instances, remittance securitized transactionshave made designated correspondent banks sign a

2While excess coverage helps to mitigate elements of prod-uct risk, it also reduces the total amount of funds that can beraised with future flow receivables.1This box draws on Ketkar and Ratha (2004).

130See IMF (2003); and Chalk (2002).


future flows) can potentially conflict with the nega-tive pledge provision included in the World Bankloan and guarantee agreements. While this clausedoes not prevent a borrower from pledging assets toother lenders, it prohibits establishing a priority forother lenders over the World Bank.131

Several policy hurdles need to be surmounted be-fore securitization deals can proceed. High fixedcosts of legal, investment banking, and credit ratingservices as well as long lead times can pose difficul-ties for developing countries with few large entitiesand high borrowing needs. A master trust arrange-ment can permit issuers to structure a large deal buttap the market in several tranches. Pooling receiv-ables of several branches (or even several borrowers)could also help to increase the deal size to justifylarge fixed costs. Absence of an appropriate legal in-

125


Notice and Acknowledgement, binding under theU.S. law (or the law of a highly rated country), thatthey will make payments to the offshore trust. Thatwould make the sovereign reluctant to take the drasticstep of requiring payments into the central bank. Cur-

rency devaluation is yet another element of sovereignrisk that cannot be totally eliminated even in struc-tured transactions. For instance, currency devaluationmay impact the size and timing of remittances, particu-larly through formal channels.

Structure of Banco do Brasil’s Remittance Securitization

Remittance paymentsBanco do Brasil,

Japan via consent agreement

New York City–based trust

Proceeds of $250 million

Cayman Island–based SPV:Nikkei remittance rights

finance companyExcess collection

$250 million +excess

collateral

Collectionrights

Processed$250 million

P&I

InvestorsBanco do

Brasil

Source: Standard & Poor’s.

131The IMF does not have any formal negative pledge provi-sion, but it could take into account collateralized future receiptagreements in making financing decisions under Article V. SeeIMF (2003), p. 14.


frastructure is yet another constraint on issuance.Overcoming this constraint need not call for agrand overhaul of the entire legal system—a morefocused approach that concentrates on bankruptcylaw may suffice, by making sure that pledged assetsremain pledged in the event of default.132

Conclusions

Migrant remittances are the largest source of ex-ternal financing and a large source of funding in re-lation to the size of the Central American economy.Remittances are, therefore, a significant part of theretail payment system covering small-value transfersor transactions where one of the counterparty is anindividual.

From a financial sector point of view, large remit-tance flows raise two sets of issues: how to reducecross-border remittance costs, and how to leverageremittances for improving financial deepening inthe recipient countries. A related and somewhatunder-researched issue is the use of remittances ascollateral for raising external financing.

Measures to reduce remittance costs andstrengthen the financial infrastructure include en-couraging competition among remittance serviceproviders, harmonizing regulation, introducing elec-tronic remittance instruments, harmonizing pay-ment systems, and extending banking access of re-mittance recipients at home and migrants overseas.

Improving data on remittances, especially bilat-eral flows and corridor-specific data, would help toencourage competition in the larger corridors. Offi-cially recorded remittance data are believed to sig-nificantly underestimate the true size of remittanceflows. An international working group comprisingthe World Bank, the IMF, the European CentralBank, the Inter-American Development Bank, theOECD, and the United Nations, is currently look-ing into improving data on remittances. Anothertask force jointly set up by the World Bank and theCPSS, in which the IMF is also participating, is cur-rently developing voluntary principles for remit-tance service providers and regulators to improvetransparency in the remittance market.

Many of these efforts to facilitate cross-border re-mittances would require bilateral cooperation be-tween the Central American countries and the U.S.government, since the United States is the most im-portant source of remittance flows to Central Amer-ica. These efforts would also require regional coop-eration as intraregional remittance flows are sizable.

Efforts to reduce costs have to be carefully bal-anced with efforts to fight money laundering andthe financing of terrorism. While, for instance, doc-umentation requirements can add to the cost of re-mittances and restrict access to formal channels,they are necessary to prevent the abuse of remit-tance services for money laundering or terrorist fi-nancing purposes. Strengthening the formal remit-tance infrastructure by offering the advantages oflow cost, flexible hours, expanded reach, and knowl-edge of foreign languages, and increasing efforts toidentify and regulate the unregulated sector, wouldbe effective ways to facilitate remittance flows whilepreserving their integrity.

Banks and smaller financial institutions, such ascredit unions and microfinance institutions, canplay a role in delivering low-cost and convenient re-mittance services. Remittances, in turn, may bringnew customers and business, such as consumerloans, mortgages, and life insurance, to these institu-tions. Banks in Central American countries havebeen active in this market for some time, includingthrough branch networks in sender countries. Largerinternational banks have more recently shown in-terest in tapping this market.

There is potential for mobilizing financing frominternational bond markets by securitizing future re-mittance flows in Central America, especially dur-ing times of low liquidity and heightened perceptionof country risk. Future flow securitization, however,increases the level of inflexible debt of the issuer(usually, financial institutions). This activity mayalso be constrained because remittances tend to feeddirectly into consumption and imports and thus donot constitute increased financial savings.

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Bank for International Settlements, 1999, Retail Paymentsin Selected Countries: A Comparative Study, CPSSPublications No. 33, October (Basel).

126


132Tran and Roldos (2003) outline a broader set of policy ac-tions and reforms for securitization. Although these recommen-dations are for securitization of existing (and local currency) as-sets such as mortgage loans, they also apply for securitization offuture flow (and hard currency) assets.


———, 2003, Policy Issues for Central Banks in Retail Pay-ments (CPSS publication No. 52, March).

———, 2006, Report on General Guidance for NationalPayment System Development.

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_____, 2004, “Recent Advances in Future-Flow Securiti-zation,” paper presented at the Annual Finance &Accounting International Conference on “ManagingSecuritization for Lebanon and the MENA Region,”Lebanese American University, School of Business,Beirut, December.

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———, and Eve Hamilton, 2005, “Remittances and MFIIntermediation: Issues and Lessons,” ResearchClearinghouse, The Center for Financial ServicesInnovation.

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———, and Jan Riedberg, 2005, “On Reducing Remit-tance Costs” (Washington: World Bank).

Sander, Cerstin, 2004, “Capturing a Market Share? Mi-grant Remittance and Money Transfers as a Microfi-nance Service in Sub-Saharan Africa,” Small Enter-prise Development, Vol. 15 (March), pp. 20–34.

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