Document o f THE WORLD BANK

FOR OFFICIAL USE ONLY

Report No. 29666-CO

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED SECOND PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN

IN THE AMOUNT OF U S $100 MILLION

TO THE

REPUBLIC OF COLOMBIA

August 25,2004

Finance, Private Sector and Infrastructure Department Country Department for Colombia and Mexico Latin America and the Caribbean Regional Office

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY AND EXCHANGE RATES (As o f July 3 1,2004)

Currency Unit = Colombian Peso US$l.OO = COP$2,645.30

FISCAL YEAR January 1 - December 31

Vice President: David de Ferranti Country Director: Isabel Guerrero Sector Director: Danny Leipziger Task Team Leader: John Pollner

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AFP BANCAFE BANCOLDEX BECH BRC CAMEL CAS CAV CISA COP DTF FINDETER FIRST FNG FOGAFIN FRECH FSAP Granahorrar M I S IOSCO IF1 LIBOR M o F NPL REP0 RoR SARC SB SEARS SIMEV SME ssc sv TES UIAF UVR VAR VIS

ABBREVIATIONS AND ACRONYMS Administradora de Fondos de Pensiones (Pension Fund Firm) Banco Cafetero (A State commercial bank) Banco de Comercio Exterior de Colombia (the State Export Financing Bank) Bancos Especializados en Crkdito Hipotecario (Mortgage Banks) Banco de la Rep6blica de Colombia (Central Bank o f Colombia) Capital/Assets/Management/Eamings/liquidity Country Assistance Strategy Corporacidn de Ahorro y Vivienda (Savings & Loan Banks) Central de Inversiones, S.A. (Government Asset Management Agency) Colombian Pesos Depdsitos a TCrmino Fi jo (Interest rate on time deposits) Financiera de Desarrollo Territorial (Second Tier Municipal Financing Bank) Financial Sector Reform and Strengthening Initiative (Grant Program) Fondo Nacional de Garantias (National Guarantee Fund) Fondo de Garantias de Instituciones Financieras (Deposit Insurance Fund) Fondo de Reserva para la Estabilizacidn de la Cartera Hipotecaria Financial Sector Assessment Program A bank serving the mortgage sector, owned by the State International Association of Insurance Supervisors International Organization o f Securities Commissions Instituto de Foment0 Industrial (Industrial Development Bank) London Interbank Offer Rate Ministry of Finance Non Performing Loans Repurchase Market / Repurchase Operation Rate of Return Sistema de Administracidn Riesgos de Crkdito (Credit Risk Mgmt. System) Superintendencia Bancaria (Superintendency o f Banks) Sistema Especial de Adis is de Riesgos de Seguro (Insurance Risk Mgmt. Sys.) Securities Market Integrated Information System Small and Medium Enterprise Superintendencia de Sociedades de Colombia (Superintendency o f Companies) Superintendencia de Valores (Securities Superintendency) Treasury Securities Unidad de Inteligencia y Andlisis Financier0 (Financial Intelligence Unit) Unidad de Valor Real (Index based on real value of mortgages) Value at Risk Vivienda de Inter& Social (Social Priority Housing)

REPUBLIC OF COLOMBIA FOR om- USE ONLY SECOND PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN

TABLE OF CONTENTS

Loan and Program Summary .............................................................................................................. i PART I . Recent Economic Developments and Prospects ................................................................. 1

A . Recent Economic and Financial Developments ....................................................................... 1 B . Economic Prospects and Financing Requirements ................................................................... 3

PART I1 . Financial Sector Context and the Reform Program ........................................................... 4

A . Overview .................................................................................................................................. 4 B . The Financial System - Background 4 ........................................................................................ C . The Outcome o f the First Programmatic Financial Sector Adjustment Loan .......................... 9 D . The Government Reform Agenda under the Second Programmatic Operation ....................... 14

PART I11 . The Proposed Loan: Second Phase of the Programmatic Reform Program .................... 27

B . Program Conditionality ............................................................................................................ 35 C . Disbursement and Auditing ...................................................................................................... 37 D . Environmental Aspects ............................................................................................................. 37 E . Social and Poverty Impacts ....................................................................................................... 38

......................................... A . Loan Description: Objective and Rationale for Bank Involvement 27

F . Benefits and Risks ..................................................................................................................... 38

LIST OF ANNEXES Annex 1: Annex 2: Annex 3: Annex 4: Annex 5: Annex 6:

Policy Matrix .................................................................................................................... 41 Letter of Development Policy for the Financial Sector .................................................... 46 Timetable of Key Processing Events ................................................................................ 72 Colombia - Fund Relations Note ..................................................................................... 73 Colombia - Status o f World Bank and IFC Operations ................................................... 75 Colombia - Country at a Glance ...................................................................................... 77

LIST OF FIGURES AND TABLES Figure 1 : Bonds Spreads . Colombia vs . other L A C Countries ....................................................... 2 Table 1 : Table 2: Indicators of the Colombian Economy and Banking System ............................................ 6 Table 3: Banking Sector Performance Indicators ............................................................................ 9 Table 4: Indicators of Financial Credit Intermediaries .................................................................... 10 Table 5: Current Quantifiable Results Supported by the Program .................................................. 26 Table 6: Table 7:

Balance of Payment Financing Requirements ................................................................... 3

Summary o f Second Loan Triggers and Status of Actions Completed ............................. 28 External Financing Requirements ..................................................................................... 33

Bank staff who worked on the FSAL included John D . Pollner (Task Manager / Lead Financial Sector Specialist. LCSFF). Lo ic Chiquier (Lead Financial Officer. OPD). Joaquin Gutierrez (Lead Financial Sector Specialist. OPD). Thomas Glaessner (Lead Economist and Peer Reviewer. OPD). Jeppe Furbo Ladekarl (Sr . Financial Specialist. OPD). Claire Grose (Sr . Financial Specialist. OPD). Gabriella Ferencz (Lead Financial Sector Specialist and Peer Reviewer. OPD). Juan Carlos Mendoza (Sr . Financial Specialist. LCSFF). Eduardo Br i to (Sr . Legal Counsel. LEGLA). Cara Zappala (Operations Analyst). Helena Issa (Program Assistant. LCSFF) .

This document has a restricted distribution and may be used by recipients only in the performance of their official duties . I t s contents may not otherwise be disclosed without World Bank authorization .

REPUBLIC OF COLOMBIA

SECOND PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN PROGRAM AND LOAN SUMMARY

Borrower: The Republic of Colombia

Implementing Agency: Ministry of Finance

Objective: To contribute to a well capitalized, well regulated, supervised, stable, and efficient financial system that effectively intermediates savings and provides credit, capital, and other financial services and products to Colombian investors, consumers, and home- owners, including those currently underserved. In order to achieve this, the operation wi l l support the modernization of bank, non- bank and securities market norms on capital adequacy and strengthen the ability o f financial market participants to absorb market and credit risks, and macroeconomic shocks. The operation w i l l help implement alternatives for the provision of funding including the expansion of the housing finance market, through a diversified financial services industry which meets standardized and transparent reporting methods and harmonized asset valuation standards across sectors. I t w i l l support the disclosure of risks and volatility o f managed investments and credit portfolios, across the banking, mutual funds, insurance, and pension funds industries, applying uniform capital and provisioning standards for equivalent risks, thus engendering competition and rationalization in the system.

Description: The loan follows up on the reforms initiated in the first phase with respect to the implementation o f a stricter banking regulatory framework addressing the increased allocation of capital for credit and market r isks as well as the enforcement o f governance responsibilities, setting out new norms on related party exposure limits and corresponding capital allocations, and the regulatory implementation o f modernized asseaiability carve-out mechanisms for the orderly resolution o f troubled banks.

The loan operationalizes mechanisms to augment micro housing credit and new instruments for guaranteeing collateral to provide lending incentives to the banking sector. The mortgage banking market i s strengthened through new instruments to protect borrowers from inflation risk and lenders from interest rate risks. Mortgage funding i s increased through the securitization market which adopts capital adequacy rules consistent with new asset r isks generated from such instruments.

The non bank sector o f mutual funds, trusts and pension funds i s modernized with the implementation o f uniform capital adequacy rules and harmonization in reporting o f investment portfolio

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Beneficiaries:

returns, while insurance solvency norms are upgraded in line with similar banking practices.

The loan supports the implementation of the new capital markets law which raises standards for professional qualifications and governance in the securities business while improving and lowering the cost of the market’s operating infrastructure. The methodologies for determining the market value of private securities are set out, and the public short term debt market begins establishing benchmark rates as reference for other securities.

Colombian savers, consumers, borrowers, investors, households, SMEs and larger businesses -- by improving their access to credit, capital, insurance and other financial services. Taxpayers w i l l benefit from the reduced risks of financial institution failures that could generate fiscal costs.

Poverty Aspects: A key component of the reform program i s the implementation of a well structured program to enhance lending to the micro housing industry, mainly in less well of f sectors, in order to generate more wealth accumulation through home ownership. The follow up banking reforms w i l l put in place more efficient and cost effective mechanisms to ensure that the State can dispose o f sufficient funding to protect small depositors and return or replace their funds in the event o f bank failures. The overall reform should also attract greater foreign investment, reduce the cost of financing, facilitate higher domestic investment, and thus contribute to greater job creation, strengthened competitiveness and productivity .

Benefits:

Risks:

The main benefits would be the substantial strengthening of the financial system using norms aligned to international standards, and regulatory and risk management tools to withstand future market or credit shocks. Benefits to market participants such as institutions, individual investors, funds, and other players include more transparent and comparable market operating norms, thus promoting more entry into the capital markets and clearer valuation rules allowing improved arms length trading and issuing of securities. The additional instruments and mechanisms for protecting against r isks in the mortgage market should allow that market to become more sustainable and permit more access b y underserved groups to obtain financing for home construction and improvement. Savers w i l l benefit through greater security o f deposits, taxpayers w i l l be less likely to bear the cost o f financial institution failures, and small and medium enterprises should gain improved access to credit.

The risks o f an unexpected economic downturn would likely halt the progress in both the expansion o f the housing credit market as well as in the development of the securities market. The adverse

effects of a worsening fiscal and economic situation would put additional stresses on the banking system which could generate the need for the State to prevent new vulnerabilities from emerging. However, given the design of the banking resolution framework under the reform program, any outlays of the State would be minimized. The new inflation and interest rate hedging instruments for the banking system wi l l also mitigate economic and market risks. However, a prolonged period of economic weakness could result in a lack o f market absorption potential to redeploy bank assets under State divestment programs. The main factors driving such r isks pertain to the prudent macroeconomic management by the Govemment, particularly with regard to the fiscal and debt dynamics, as well as potential adverse regional developments which might affect or deteriorate Colombia’s already existing current account deficit. The program’s formation of an official debt management committee w i l l help reduce and detect early risks pertaining to debt exposure. Additional r isks include potential delays in the approval of the securities law, if the constitutional reform process i s unduly extended, displacing some of the legislative agenda. Since the Govemment conducted extensive consultations and obtained prior agreement with the industry on this law, the risk of opposition to i t s content i s substantially mitigated.

Loan Amount: US$ 100 million, for this second loan in the two-phase programmatic operation, to be disbursed fully upon effectiveness.

LIBOR-based U S Dollar Fixed Spread Loan with a grace period of 10 years and a final maturity o f 12 years on March 15, 201 6, with tailored repayments. All conversion options selected with variable rate option maintained and capkollar premium paid by the Borrower up front.

Terms:

Commitment Charge: 0.85% percent per annum on undisbursed loan balances.

Charge begins to accrue 60 days after signing. Four years following that date the charge reduces to 0.75%. During FY-2005, the annually approved 0.50% waiver o f the charge was in effect.

Front-end Fee: 1 percent o f the loan amount less any approved applicable waivers, paid up front by the Borrower through own proceeds.

Schedule of Disbursements: Loan to disburse upon Board Approval following effectiveness.

Conditionality to be met prior to Board presentation except for standard effectiveness conditions.

Economic R.O.R.: Not applicable.

Project ID No.: PE-P082597-LEN-BB

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT

ON A PROPOSED SECOND PROGRAMMATIC FINANCIAL SECTOR ADJUSTMENT LOAN TO

THE REPUBLIC OF COLOMBIA

1. Loan o f US$ 100 million as the second phase of a Programmatic Financial Sector Operation to the Republic of Colombia. The first phase was approved by the Board on April 24,2003 and was disbursed on June 5,2003. The outcome of the f i rs t operation was considered highly satisfactory in i t s contribution to the overall objectives of the Program by setting the stage for a sound and sustainable banking sector and initiating prudential operating reforms in the non-bank sector. This second operation wi l l consolidate the reforms in the banking sector and ensure the sector’s future stability, capitalization and capacity for savings and credit intermediation through the implementation of the new financial legal framework for mitigating banking risks. Simultaneously, and to augment competitiveness in financial intermediation in order to facilitate domestic and foreign investment, the operation w i l l strengthen the regulatory framework and soundness of non-bank financial institutions, modernizing the legal framework of the capital market, and upgrading the policy and operational strategy for the government securities market. The program wi l l be implemented by the Regulatory Department o f the Ministry of Finance with support from the Superintendency o f Banks (including the areas of banking, pensions, insurance and trusts), the Deposit Insurance Agency (FOGAFIN), the Superintendency of Securities, the Public Debt/Treasury Office of the Ministry of Finance, and the Central Bank.

This program document proposes a one-tranche Financial Sector Adjustment

PART I. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS

A. Recent Economic and Financial Developments

2. of GDP growth. Though this growth was initially concentrated in a few sectors (construction, manufacturing, mining), the expansion broadened to other sectors towards the end of the year. The initial shock caused by the Venezuelan crisis and the foreign exchange controls that were imposed there and that negatively affected Colombian exporters dissipated quickly as growth in the U.S. picked up and overall global economic performance improved. As the economic expansion continues, unemployment eased to i t s lowest level since the 1998-99 crisis and reached about 12 percent in December 2003 from a peak of 20 percent, though the non-seasonally adjusted spike usually seen in January was as strong as i t has been in recent years, bringing unemployment levels back to about 18%. This has translated in a moderate decrease in consumption and consumer confidence in the first quarter of 2004 which i s expected to be transitory. Investor confidence remains high and w i l l continue to be buoyed b y lower interest rates and a general sense of improvement of the security situation in the country.

The Colombian economy grew well above expectations in 2003 reaching 3.95%

3. the first two months of 2004 compared with an outflow o f US$80 mill ion during the same period a year ago, though current account deficits are s t i l l projected at above U S $ 2 billion The capital inflows though have led to an appreciation o f the peso in spite of the

Capital inflows have continued to grow with net inflows o f US$600 mill ion in

efforts b y the Central Bank, Banco de la Republica (BRC), to prevent this through the lowering o f interest rates and the accumulation o f reserves. The negative effects o f the peso appreciation in the export sector has been balanced b y the continued improvement of the global economy after export earnings in 2003 rose over 9 percent compared to 2002. In spite o f economic expansion, inflation has continued on a downward track. In 2003, inflation was 6.5 percent, down from 7 percent in 2002. However, i t overshot the BRC target of 5-6 percent. The current utilization level o f installed capacity remains l ow at 70 percent thus suggesting the current expansion i s s t i l l far f rom producing inflationary pressures.

4, During 2003 the government continued to make progress on fiscal adjustment and met the revised target under i t s two-year Stand-By Arrangement (SBA) signed with the International Monetary Fund (IMF) in January 2003. The combined public-sector deficit narrowed to 2.7 percent o f GDP, down from 3.7 percent o f GDP in 2002. Income tax receipts increased by 15.8 percent in nominal terms during 2003 both as a result o f the economic lift as wel l as the implementation o f the 2002 tax reform that eliminated some income tax exemptions and generally enlarged the tax base. The government exercised restraint in i t s expenditure policies with non-discretionary spending growing essentially at the rate of inflation. Financing o f this deficit was facilitated by improvements in the terms on which the government can access international financial markets thanks to the improved economic outlook. Coupon rates o f Colombian dollar denominated bonds have come down from a peak o f 11.75 percent in mid-2002 to 8.125 percent for an issue o f US$500 mi l l ion twenty-year bonds in early 2004. International bond issuance in 2003 totaled US$1.54 billion. Government bond spreads have thus improved and now rank roughly on par with Peru and Panama, relatively lower risk countries (Figure 1).

Figure 1: Bond Spreads - Colombia vs. Other LAC Countries

60 ,

Argentina Brazil Chile Colombia Dom. Rep. Ecuador Mexico Panama Peru Venezuela

Source: EMBI. Data as of July 20,2004.

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(Figures in US$ billions) Current Account Balance Debt Repayment Obligations Gross Financing Gap MediumLong Term Debt Inflows

o/w 2"d Programmatic FSAL

B. Economic Prospects and Financing Requirements

5. Growth i s expected to continue at least through 2005. The government economic policies and the perceived improvement of the security situation in the country continues to generate a sense o f confidence. This i s particularly the case in the business sector even though consumer confidence and spending decreased slightly in the first quarter of 2004 in response to the increase of unemployment in January. I f unemployment regains i t s overall downward trend, as i s expected given increases in private investment, GDP growth should remain in the 3.5-4.0 percent range both for 2004 and 2005 provided that global growth continues and prices of oil, still Colombia's main export in spite of decreasing production, do not tumble.

2004 (est.) 2005 (proj.) (1.9) (2.5) (3.6) (3.7) (5.5) (6.2) 6.1 6.2 0.1

6. in the U.S., the Colombian investment climate has improved and the appreciation expectation continues, i t i s likely that the strong inflows observed during the f i rs t quarter of 2004 w i l l continue. The adverse effect that this may have in the export sector due to the peso appreciation wi l l be balanced by the contribution that these flows w i l l make to investment activities. Furthermore, ongoing negotiations o f a free trade agreement with the U.S. should strengthen the position of the export sector.

Capital inflows are likely to continue. Given that interest rates remain higher than

7. government's agreement with the IMF calls for continuing to reduce the deficit to 2.4 percent o f GDP by 2005. However, further fiscal adjustments wi l l be difficult as the political environment needed to take these kind o f measures i s unlikely to be present. The legislative agenda during 2004. wi l l be driven by efforts to modify the constitution to permit reelection in consecutive periods. In spite of these difficulties, the government w i l l continue to show fiscal restraint and the current agreement with the International Monetary Fund (IMF) i s expected to be renewed after i t expires in January 2005.

The fiscal situation i s the main source o f potential economic vulnerability. The

Financing Requirements 8. The estimates on the balance of payments are for a current account deficit o f US$ 1.9 billion in 2004 and US$2.5 billion in 2005, representing 2.2 and 2.7 percent o f GDP, respectively. Coupled with the current account gap, the government has additional financing requirements from upcoming external debt repayments amounting to US$3.6 billion in 2004 and US$3.7 billion in 2005. Thus, before considering net capital inflows, the total financing requirements amount to US$5.5 bil l ion in 2004 and US$6.2 bil l ion in 2005. The medium and long term debt inflows from official and private sources, and which include multilateral financing and proceeds from this loan, are expected in total to amount to US$6.1 billion in 2004 and US$6.2 bi l l ion in 2005.

Table 1: Balance of Payments Financing Requirements

Source: World Bank, IMF, E N

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PART 11. FINANCIAL SECTOR CONTEXT AND THE REFORM AGENDA

A. Overview

9. to overcome the difficulties resulting from the banking crisis of the late nineties and develop solid foundations for the entire financial system extending beyond banking to other financial institutions, the insurance sector, the pension sector, the capital markets and the government’s issuance of debt securities. The overall objectives of these reforms and the Programmatic Loans through which the Bank has supported these efforts are:

The Colombian Government embarked on comprehensive financial sector reforms

(9

(ii)

(iii)

To strengthen the government’s capacity to manage and mitigate weaknesses in the financial system through an improved legal and regulatory framework which w i l l reduce costs to the State, as well as the implementation of modernized risk management approaches by the industry, to cushion future losses and strengthen institutional capital to support productive investment;

To complete the clean up of the banking system as a result o f the 1999-2001 crisis and provide mechanisms to dispose of assets which might represent contingent liabilities of the State and to taxpayers; and

To strengthen and diversify the participation of the housing mortgage market, the non-bank financial and insurance services, as well as the capital market in order to diversify the sources o f funding and risk while maintaining a prudential regulatory framework in all financial industries o f the system.

B. The Financial System

Background

10. The Colombian banking system had experienced rapid expansion during the f i rs t half o f the nineties, which was brought to a halt by a marked economic slowdown. The deteriorating quality of the loan portfolio and associated drop in the loss provisioning coverage ratio triggered liquidity problems. In spite of heavy intervention by the BRC in i t s capacity as lender of last resort, the magnitude of the problems eventually forced the Deposit Insurance Agency (FOGAFIN) to intervene in several credit institutions.

1 1. support, particularly given the concurrent pressure on government finances from a growing fiscal deficit and fast-closing access to international capital markets. New funds and mechanisms had to be established in order to stop the deteriorating condition of the banking system. Facing the risk o f a broader systemic crisis and a run on deposits, the authorities introduced a number o f economic emergency and support measures between 1999-2001 aiming at restoring the health o f the system and to provide relief to debtors (mortgage sector ‘reliefs’ and corporate restructurings). The measures, which attempted to bring a balance between the competing interests and problems of the involved parties, were mainly carried out by FOGAFIN and were supported b y innovations in the provision of well timed and monitored liquidity support by the BRC.

Available resources were clearly insufficient to provide the required financial

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12. recapitalizations. In the case o f private banks FOGAFIN provided a recapitalization credit l ine to institutions, under certain preconditions relating to portfolio clean-up, partial recapitalization by shareholders’ own funding (to ensure burden sharing and alignment o f incentives) and the successful adoption o f an adjustmenthmprovement plan and new performance contracts. As part o f the recapitalization l ine program, FOGAFIN lent funds to shareholders of some private banks so that they could participate in the required recapitalization wi th the matching 20 percent o f additional own equity. An innovative feature involved the use o f credit line funds to purchase Treasury bonds which were placed on the banks’ balance sheets to improve overall asset quality in contrast to the large stock of non performing loans. Additional measures included liquidity support operations in the form of credit portfolio repurchase agreements using government bonds, as well as the extension o f FOGAFIN’s recapitalization line subject to s im i la r conditions, to the mortgage financial institutions (BECHs).

Financial sector support consisted o f private and public sector bank cleanups and

13. concluded that, in spite o f inefficiencies, resource requirements, and moral hazard problems, the State should remain involved in the largely underserved rural communities where the private sector could not efficiently provide financial services. This would be achieved b y maintaining a sole public sector ‘f irst tier’ institution in relevant parts o f the country (Banco Agrario). In the case o f public banks, recapitalization was to be complemented by the disposal o f unproductive assets, followed by the liquidation or restructuring and (eventual) privatization or asset divestment o f most entities’.

The government undertook a detailed review o f the public sector banks, and

14. FOGAFIN assumed direct control o f public banks and o f those private ones deemed necessary to ‘officialize’ as part o f the recapitalization process. As a result o f the crisis, 35 entities were intervened for liquidation between 1998-2003, and another 20 were voluntarily liquidated by their shareholders. Liquidation and merger activity during that period contributed to the significant reduction (from 148 to‘64) in the number o f financial institutions enrolled in FOGAFIN for deposit insurance purposes.

15. Additional policy tools included promoting the use o f out-of-court debt restructuring agreements for viable enterprises which had trouble repaying bank loans, and debtor relief primarily focused on mortgage borrowers who were hard hit by rises in interest rates. Other support measures for mortgage debtors were also undertaken and included requiring credit institutions to accept ownership o f buildings as repayment-in- kind offered by mortgage debtors (“credit0 por daciones en pago”), where any losses incurred could be reclaimed from FOGAFIN. Subsequent support involved offering guarantees to the Social Housing (VIS) portions o f mortgage securitizations bonds in order to encourage growth in those securities and help to reduce the maturity mismatch between the deposits and loans o f the mortgage banks.

16. Credit classification rules were changed in order to strengthen the loan loss provisioning regime for both performing and foreclosed assets, with the a im of making them comparable to international ones. On-site supervision was strengthened and the SB initiated supervision on a consolidated group level. Moreover, minimum capital

The SB also undertook a host o f measures to strengthen the financial system.

Other forms o f support included the assumption o f future pension liabilities and the transfer of bad loans to CISA, a separate state-owned asset management and resolution company.

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standards were established and early warning indicators were introduced to detect capital problems and allow the adoption o f recuperation programs or other appropriate measures.

Recent Developments

17. the system i s wel l on i t s way to recovery, with the return on average assets and equity rising from -3.5% and -21% in 1999 to 1.9% and 17% respectively by end 2003. The total assets o f the banking system amounted to COP$97 trill ion in December 2003 (US$37 bi l l ion) or approximately 44% o f GDP. Other performance indicators (solvency, efficiency, loan quality) also reflect a recovery, though i t should be noted that the level o f financial intermediation has not yet returned to i t s pre-crisis levels. The improvement in performance i s primarily attributable to four factors:

Fol lowing a period o f contraction in both real terms and as a proportion o f GDP,

0

0

0

0

Partial resumption o f economic growth. A stable net interest margin in spite o f declining interest rates. The exit and/or restructuring o f a significant quantity of non-performing assets, cumulatively amounting to around a third o f the system’s current credit exposure. Significant recapitalizations of banks and credit institutions.

Table 2: Indicators of the Colombian Economy and Banking System (1998-2003) ( in COP$ Million)

Dec-98 Dec-99 Dec-00 Dec-01 Dee02 DN-03 Total Assets 79,394,592 80,045,786 80,389,697 84,244,205 89,185,456 97,305,151 Securities 9,387,825 12,065,639 17,165,071 22,163,053 25,069,639 28,946,227 Net Loans 51,040,036 48,469,259 44,300,768 44,097,631 46,436,319 49,614,965 Equity 8,402,017 8,822,892 9,100,524 9,416,882 9,824.156 11,159,517 Net Income After Tax (1,942,890) (2,810,748) (1,856,191) 102,306 919,047 1,788,329 Capital Adequacy Ratio (CAR) N/A 10.9% 13.2% 13.3% 12.5% 13.1% ROAA -2.5% -3.5% -2.3% 0.1% 1.1% 1.9% ROAE -21 .O% -32.6% -20.7% 1.1% 9.6% 17.0% Cost-Income Ratio 71% 81 % 80% 74% 71 % 58% NPWotal Loans N/A 16.3% 16.4% 15.4% 13.6% 10.5% Loan Loss Provisions/NPL N/A 25.3% 27.7% 37.5% 43.0% 47.6% Real GDP Growth 0.6% -4.2% 2.9% 1.4% 1.6% 3.7% Total Assets/Nominal GDP 57% 53% 46% 45% 44% 44% Gross Loans/Nominal GDP 38% 34% 27% 25% 25% 24% Annual Inflation Rate 16.7% 9.2% 8.8% 7.7% 7.0% 6.5% Average Annual COP/USD Exchange Rate 1,427 1,759 2,087 2,300 2,508 2,878 Source: Superintendencia Bancaria Note 1: Non-Perioming Loans (NPL) are defined as those loans that have stopped accruing interest (categories C, D and E) Note 2: ROAA is defined as the average retum on ail Balance Sheet assets (both eaming and non-eaming)

18. manage) the occurrence o f any financial crisis in the future, the authorities, as part of the Bank supported Programmatic Financial Sector Operations identified a number o f important policy measures and priorities in their reform agenda, including:

In order to further strengthen the banking system and to avoid (or appropriately

0 Improvements in financial system surveillance by the SB and upgrading o f prudential and capital adequacy norms.

0 Development o f suitable crisis management, early corrective actions (and sanctions), and bank resolution mechanisms to deal with financial sector weaknesses.

0 Divestment o f most remaining State owned banks and recovery o f previously invested fiscal funding.

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0 Upgrading o f the regulatory framework in the non bank sector (capital markets, insurance, pension, trusts) to avoid regulatory arbitrage among these sectors versus banking, and to solidify the capital base o f these financial industries. Development o f a prudentially sound and diversified financial sector so that financing and investment might be sourced from alternative market players while avoiding market concentration in any one sector or financial group.

0

19. The previous banking crisis had particularly affected the mortgage portfolio o f banks and the savings and housing banks as the recession forced borrowers into default and lowered real estate prices, the higher interest rates caused a mismatch on asset and l iabi l i ty yields on these institutions’ balance sheets. The Constitutional Court had also ruled against the use o f a variable mortgage rate index used by these banks as it was based on average interest rate levels rather than on an inflation based index that had originally been legislated. This forced the Government to reimburse borrowers for the excess interest already paid. N o n Performing Loans (NPLs) in the residential mortgage portfolio peaked at 35 percent in early 2000. Under the Programmatic Financial Sector Adjustment Operations, strong attention was dedicated to strengthening the mortgage institutions and revitalizing the market given the period o f turmoil i t had experienced.

20. The Programmatic Loans also took into consideration key “micro” institutional aspects to ensure that reforms were accompanied b y institutional strengthening efforts and use o f best practice tools and supervisory methods to monitor financial sector solvency, performance and fair competition. The Superintendency o f Banks (SB) i s responsible for the supervision o f various financial institutions including banks, financing corporations, large credit cooperatives, insurers, trust companies (fiduciarias), private pension management firms (AFPs) and other non-bank financial institutions, wi th the exception o f securities market players which are supervised b y the Securities Superintendency (SV), and small mutual cooperatives which are supervised by the Superintendency o f Cooperatives (Superintendencia de Economia Solidaria).

21. o f 1990 liberalizing the market. However, wi th the growth o f the industry, now constituting 30 general insurance and 26 l i f e insurance companies, more attention i s being paid to internal risk management procedures and solvency standards for existing and future market participants. The trust industry has grown into a significant player in the domestic financial market wi th 3 1 institutions currently operating. Trust companies are authorized to invest funds as trustees for third parties, to enter into contracts for the administration o f assets, to administer collateral guarantees and ensure financial obligations o f third parties, as wel l as to administer or oversee any assets underlying the execution o f any such collateral guarantees.

The insurance industry, until recently had been largely left untouched since a law

22. one of the lowest for the more developed economies o f the region. This presents serious obstacles to finance the real sector as alternatives to banks or credit institutions are l imited with 50 percent o f stock market capitalization concentrated on 10 companies and the total amount o f bonds or other commercial paper issued in 2003 amounting to a mere 2.2 percent of GDP.

Capitalization o f the Colombian stock market amounts to only 18 percent o f GDP,

23. with very few alternatives for diversifying their investments beyond government

On the demand side, institutional investors, particularly the AFPs, find themselves

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securities. Important steps are being taken to address this limitation through the recent consolidation of the three stock exchanges into a single nationwide exchange and under the second phase of the Programmatic reform program, via actions of the Government including the development of a new legal and regulatory framework of capital market activities consistent with the three objectives of securities regulation adopted by the International Organization of Securities Commissions (IOSCO), these being: (i) protecting investors, (ii) maintaining fair, efficient and transparent markets and (iii) preventing systemic risk.

24. debt (TES) and money markets are being implemented under the reforms supported by the Programmatic Operation, especially after important weaknesses were evident and were exposed b y the turmoil in Colombia’s debt markets that took place in 2002 involving a massive sell-off triggered by a temporary increase in interest rates. The vulnerabilities led to the discontinuation of TES auctions from mid-August until late November 2002, and highlighted the importance of implementing a mutually reinforcing set of reforms to ensure a transparent secondary pricing methodology and to improve the participation o f the market in the price formation of these securities.

Significant advances to the structure and functioning of the domestic government

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December 2002

C. The Outcome of First Programmatic Financial Sector Adjustment Loan

December 2003 May 2004

25. banking regulation and resolution component resulted in improved banking system performance, specifically as measured b y indicators on asset quality and on the real growth o f assets o f the banking system. The banking resolution sub-component was also predicated on the expectation that sound growth o f the financial system would result in minimal interventions; but should they occur, the deposit insurance agency would ensure that al l small depositors would be compensated fully and that prompt restructuring and liquidation o f the banks would minimize fiscal liabilities.

The first loan in the Program was designed with clearly defined outcomes. The

Net Return on Average Earning Assets

Net Return on Average Equity

Non Performing Loans / Total Loans

Solvency Margin / Capital Adequacy Ratio

Table 3 - Banking Sector Performance Indicators

1.1% 1.9% 2.7%

9.6% 17.0% 24.7%

13.6% 10.5% 9.3%

12.5% 13.1% 14.5%

26. With respect to the non-bank financial intermediaries, the housing finance component supported the continued expansion o f the mortgage-backed securities market including a mechanism for guaranteeing performance o f underlying social sector housing loan assets as an incentive for the market to supply additional funding for mortgage securitizations. The reforms in the non bank area upgraded insurance industry operating standards to bring them in line wi th international practices and an improvement in companies’ capitalization. The capital markets component encouraged the issuance o f securities and achievement o f better and more consistent market pricing on the secondary markets. Finally, the government debt component resulted in an increasingly liquid market for government securities with an efficient and transparent pricing methodology for the valuation o f investment portfolios.

27. engage in a stock-taking review o f the financial system as a pre-condition for this second Operation. As pointed out at the Board meeting o f the Bank’s Executive Directors, substantial Economic and Sector Work had preceded this Program, which was incorporated into the Program Document. The regulatory reforms called for by the f i rs t operation resulted in new standards of operation that would affect the future performance o f financial intermediaries. The stock-taking review, which was completed, played a fruitful role as a checkpoint o f the financial sector’s current financial condition and the

An innovative feature o f the first loan in the Program was the commitment to

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0.4% 1.3% 4.3%

2.3% 5.8% 18.4%

impact of these legislative and regulatory initiatives, as well as any pending systemic weaknesses that should be dealt with more rigorously during the implementation phase of the second operation. While mortgage bank portfolios remain weaker than those of other institutions, overall, the overall financial condition o f the system's various credit intermediaries has significantly improved.

3.5% 1.5% 3.1% 1.4% 3.2% 1.8%

16.8% 11.4% 15.6% 13.1% 19.4% 19.6%

Table 4: Indicators of Financial Credit Intermediaries

19.1% 15.6%

Net Return on Assets

2002 2003 2004"

Net Return on Ecluity

2002 2003 2004"

Non Performing Loans

2002 2003 2004"

Source: Superi * Through May

7.2% 4.3%

Private Commercial

Banks

1 .O% 1.9% 2.6%

9.2% 17.0% 25.3%

8.8% 6.6%

0.5% 1.4%

6.6% 16.6%

4.5% 3.2% 5.1%

19.0% 13.9% 23.6%

6.2% 14.2% I 5.2%

Finance Investment Leasing Companies I Banks 1 Companies

2.6% 5.9% 6.2% 1.9% 4.5% 4.1%

Total

1 .O% 2.9% 2.8%

9.5% 16.0% 24.7%

8.7% 6.8% 6.3%

28. The first operation also focused on the poverty component through the incorporation of legislative reforms promoting the increased supply o f micro housing credit to underserved sectors, as well as the innovation of housing leasing finance to promote eventual home ownership without the up front costs. While these programs are just being initiated and cannot be judged in terms of their long term impact, they have the intention of focusing priority on those sectors with traditionally little access to credit.

Banking System

29. The f i rst loan was primarily anchored in the approval of Law 795/2003 which implemented a number of key reforms in the financial system. This included various banking governance reforms to ensure Board independence and codes o f conduct for managers, as well as specifying that sanctions and penalties could also be applied to managers, Board members, directors and other bank administrative officers, for direct involvement in the breach o f prudential norms and risk management requirements mandated under the banking law. Governance issues also extended to defining conflict of interest breaches pertaining to operations with related parties. A significant change was also reflected in the law in i ts granting o f authority to the Banking Superintendency (SB) to inspect companies not directly under the SB's supervision mandate but which might have significant and adverse impacts on the financial condition o f banks (e.g.: companies in economic/financial conglomerates) as well as to inspect investments o f financial institutions' capital maintained abroad. In order to make these reforms more effective, the SB was granted autonomy in taking regulatory action and applying sanctions in such cases of breach, among other infractions.

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30. regime was substantially strengthened by requiring financial institutions to directly submit information on cash and other transactions exceeding certain minimum limits, to the Finance Ministry’s Financial Analysis and Intelligence Unit (UIAF) which has established commendable and regionally recognized systems and analytical infrastructure for tracking and correlating activity on suspicious financial flows. This AML Unit also receives data input from the National Revenue and Customs Department and processes information on the destination and composition o f offshore investments o f domestic financial institutions.

Prevention of Money Laundering. Under the first loan, the anti-money laundering

3 1. the tools, processes and skills necessary to supervise the banking sector under the new regulatory framework. This plan includes the design and implementation o f a risk-based supervisory strategy that adjusts the supervision efforts and remedial actions to the level o f risk in each institution thus making more effective use o f SB resources; and upgrading internal supervisory procedures, including assessing banks’ internal management controls, to make them consistent with the new risk-based approach.

The SB also began implementing a strategic plan which seeks to provide it wi th

32. Cooperatives Sector. The f i rst phase o f the program also included important legal changes in the regulation o f the credit cooperatives sector. Given the growing segment o f this portion o f the financial system, supervisory authority was given to the SB for overseeing and licensing cooperatives which effectively offered deposits to non member third parties or the general public, given that this activity implied putting deposits o f the public at risk, requiring oversight in line wi th banking norm standards.

33. resolve troubled banks, the f i rs t phase also supported the approval o f measures allowing additional guarantees to be provided b y FOGAFIN for asset transfer operations and with the possibility o f complementing these with deposit insurance funds and FOGAFIN bonds issued on the market while minimizing fiscal outlays. A new bank dissolution tool named ‘progressive carve-outs’ was authorized to permit the voluntary liquidation o f financial institutions in a phased and orderly fashion, while protecting or compensating depositor funds in the process. In addition, and in order to provide incentives for proper risk management, the deposit insurance premium scheme was structured so that banks would receive rebates at the end o f the year based on the maintenance or improvement in the soundness o f their institutional risk profile.

Framework of Bank Resolution and Dissolution. For improving the framework to

34. authorization to CISA, a state asset management company, to accelerate asset disposition through the use o f asset sales and asset securitization mechanisms, as wel l as to use trust instruments for transferring assets and liabilities f rom fai l ing institutions as well as to engage management contracts for the disposition o f specified assets requiring specialized skills. For other state financial institutions, namely key state-owned banks such as Banco Agrario and IF1 (the industrial development bank), the new legislation mandated that lending rates or other funding sources should fully cover al l such banks’ operational and financial costs to avoid future loss making institutions requiring State bai l outs. During the first phase o f the reform, the reduction o f I F I ’ s assets and merger with Bancoldex (the export financing bank) was initiated and the Government authorized the sale o f Bancafk, a State owned f i rs t tier bank.

In relation to bank dissolution, the first phase of the reform gave legal

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Housing Finance

35. The first loan under the program initiated major reforms in the housing finance and mortgage sector which was severely weakened from the previous crisis period. Given the backlog in the disposition of assets of already failed mortgage institutions, a key reform was the enactment of Law 794/2003 (a new Civi l Procedures Code) which effectively streamlined and accelerated procedures for the foreclosure of mortgage credit collateral in order to promptly resolve pending insolvencies and repay outstanding creditors. Previously this process took up to five years but under the new law this w i l l be reduced to a maximum of three years.

36. Expansion of Micro Housing Credit. In order to encourage new lending in the sector, the reform also permitted banks to provide outright micro housing credit (previously wrapped under general consumer credit) as well as to offer housing leases with the possibility of conversion to purchase. The new framework also allows smaller finance companies to borrow credit lines from commercial banks for the explicit only purpose of funding micro housing credit operations.

37. borrowers defaulted due to quickly rising rates, and in order to protect such mortgage loan borrowers from unhedged exposure to inflation (given the Constitutional Court’s pronunciation that such loans’ rates should remain linked to an inflation index) the first phase of the reform implemented an interest rate swap program managed by FOGAFIN. This program allowed mortgage finance borrowers to limit their inflation rate exposure (used as the index on their loans) at a rate cap of 6%, for a small premium. The swap program has been very successful to date with over 14,000 borrowers and U S $ 135 mill ion equivalent having been subscribed and these borrowers already benefited from inflation protection given that in 2003 the rate rose above the limit to 6.49%.

Hedging Inflation Exposure. Given the prior crisis periods when mortgage

38. Liquidity ofMortgage Securities. Simultaneously a related mechanism (the FRECH securities swap fund) was implemented to permit banks holding mortgage backed securities to swap them temporarily into treasury securities (for example, for use in short term rep0 transactions) and thus to increase the potential liquidity and fungibility of these new securities. Since to date, most banks still have a large stock of usable treasury securities, the facility has not yet had an opportunity to be deployed. However, another program being FOGAFIN’s guarantee o f social sector housing loans (VIS) that support the underlying assets in securitized instruments and which permit increased funding to that sector through the recycling o f such loans, has continued to be successful. These guarantees are being purchased by the market and FOGAFIN has ensured that the price of such guarantees are rigorously determined using an actuarial-based loss estimation methodology, to avoid losses to the State.

Non Bank Financial Institutions

39. Insurance Reform. The f i rs t operation in the program also overhauled the regulatory regime for the insurance sector. More flexible regulatory powers were provided for the oversight and establishment o f insurance companies’ solvency margins and technical reserves given the rapidly evolving norms and changing practices in the industry worldwide. An increase in the minimum capital requirement was mandated for both insurers and reinsurers alike operating in Colombia, more in l ine with international

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standards. At the same time, an insurance sector diagnostic which evaluated the regulatory framework o f the industry, was completed and used by the Insurance arm o f the SB to evaluate i t s own supervision practices in line with the core principles established by the International Association o f Insurance Supervisors (IAIS).

40. The reform also established the authorization and duty o f the SB to supervise the local representation offices o f foreign reinsurance companies and to limit the use o f ‘fronting’ operations, Le., the practice o f insurance companies to operate with practically no capital by reinsuring al l or most o f their r isks with associated reinsurance entities.

41. Trust Investment Companies. For the Trust industry which manages large investment portfolios for clients, the reform included transparency provisions to better reflect commission charge expenses applied by trust managers, so that the commissions represent a percentage discounted o f f managed assets, making industry charges more comparable. The reform however, also replaced previously mandated investment instrument l imi ts , with a procedure o f prior SB approval o f t rust managers’ own internal risk management systems showing how investment r isks were being mitigated.

Capital Markets and Government Debt Market

42. o f a collaborative inter-institutional agreement between the SB, the Securities Superintendency (SV) and the Central Bank to develop and issue a common securities and financial asset valuation methodologies for use across al l the financial industries and to unify mark-to-market regulations. For this purpose, a memorandum of understanding was signed between the SB and the SV to, inter alia, work on harmonizing the regulatory framework governing mutual funds subject to both banking and securities supervision, as wel l as prudential regulation and joint supervision activities involving both institutions.

A major accomplishment under the first phase o f the reform was the formalization

43. The result o f the above collaboration was the development, approval and issuance o f new regulations setting market valuation standards for domestic f ixed income treasury securities as well as external debt securities which represent key benchmark instruments for setting the prices in the local capital market. The SV was reorganized to create a new structure including: (a) a mutual funds division that wi l l oversee this growing segment o f institutions; (b) an intermediaries and markets division that focuses on the regulation o f entrants into the securities market and wel l as on institutions that are required to exit the market due to non compliance wi th norms; and (c) a supervision division to focus exclusively on surveillance o f the market and enforcement of regulations.

44. for securities brokers and dealers, particularly wi th respect to securities investments taken on their own behalf or as temporary holdings during the course o f transacting trades. The SV also issued new regulations for primary dealers, i.e., those dealers given f i rs t access to government securities prior to selling them on the secondary market.

Another major reform implemented was the specification o f capital requirements

45. securites, the reform also authorized the BRC to purchase and exchange treasury securities available in the current window o f issuance, known as ‘on-the-run’ securities.

In order to improve the liquidity and the market price formation of domestic

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D. The Government Reform Program Under the Second Programmatic Operation

46. elements o f the new regulatory framework established under the first phase, but also pushes the reform agenda into new sectors, mainly the securities market where a major legislative reform i s set forth, as well as eliminating the regulatory arbitrage previously present in non-bank sectors such as the mutual funds, pensions and trust industries. The Government’s strategy in this regard, i s to ensure that besides maintaining a sound banking system, other financial service industries are strengthened and can provide alternative channels for the funding o f investment. This involves promoting a general policy o f diversifying the sources o f capital providers in the economy while ensuring that al l financial industries operate under well established prudential standards and sound risk management practices.

The second phase o f the reform program builds upon and operationalizes various

Bank Regulation and Resolution

47. Key actions which the Government completed as part o f the second phase o f the reform, was the issuance o f operating regulations and decrees to implement the financial reform law approved in the first operation. In this context, the Ministry o f Finance and the Banking Superintendency have already issued over 65 such regulatory orders covering al l provisions o f the financial reform law, including the reform of bank resolution procedures using the asset and liability carve-out modality. This modality modernizes and reduces the cost o f bank closures b y attempting to maximize the transfer o f assets and matching deposits to existing sound banks, thus reducing the need for outlays o f deposit insurance funds.

48. These new approved procedures w i l l only be tested in the event o f future bank failures, something which has not occurred during the last year and half. The procedures provide the SB with tools to determine the optimal level o f assetAiability transfers as a preferred standard procedure without the need to seek prior authorization f rom client depositors. This is facilitated through the authority to use asset securitizations to enable a more effective transfer o f loan portfolios. The securitization method permitted as part o f this new resolution toolkit i s executed by transferring the viable loans with repayment potential, into a trust which subsequently issues securities whose interest rates are based on the projected cash flows o f the underlying loan portfolio.

49. of an immediate need since a greater value of loans normally ‘supports’ the face value o f the bond (that is, the bond i s overcollateralized to ensure that any loan default w i l l not affect the offered bond yield). The new regulations for implementing this also specify a limit o f complementary deposit insurance funds that may be used for non-matched deposits under this transaction - the limit to be used being whatever the deposit insurance fund would have had to pay if al l insured deposits o f the failed bank had to be redeemed.

Under this scheme, the loan portfolio valuation and audit therefore becomes less

50. implemented under the second phase o f the operation, i s the completion o f new norms for the supervision o f financial entities which comprise a part o f larger financial or economic conglomerates. This aspect o f financial system health i s crucial in order to ensure that the capital o f banks (which may be provided by members o f the larger economic group) reflects a true and unique value and i s not canceled-out for example, by that same bank’s

Supervision of Consolidated Financial/Economic Groups. Another key reform

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lending to a part o f the economic conglomerate, thus invalidating the net additional capital on the bank’s balance sheet. Under the new regulations now fully endorsed by the Superintendent of Banks, supervision processes would include the SB’s verification o f these financial, asset and liability flows among financial entities that belong to conglomerates, and eventually require for supervision purposes, that financial institutions report consolidated financial statements that make more transparent the sources of net capital of such financial institutions within larger groups. In order to obtain full ownership o f this comprehensive reform, the SB has subjected the new norm to a review by the general public, the private industry, the SV which i s responsible for oversight o f non financial corporations that issue securities, and the Superintendency of Companies (SSC).

5 1. Sanctions Regime. As part of the operational implementation of more structured supervision procedures under the second phase o f the program, the Government through the SB has implemented a comprehensive manual with directives for supervisors. This manual which i s to be used as an internal guide to standardize the SB’s own procedures, specifies the type and range of infractions applicable to the financial industry. These include, for example, those pertaining to lack of minimum capital or solvency ratios, lack of appropriate loan classification, surpassing regulated credit exposure to related parties, bad faith management of shareholder and depositor funds, failure to follow corrective orders by the SB and various others, and the range of sanctions and fines which the SB may apply in each case. The manual not only adapts the sanctions regime to the new provisions of the reformed legal framework, but also attempts to ensure consistency among bank examiners/supervisors in the application of sanctions and levels of monetary penalties.

52. Risk Based Supervision. Another key operational reform to support the implementation of the new regulatory framework, i s the SB’s development and documentation of criteria for assessing the level of riskiness of each subject financial institution, and prioritizing the SB’s inspection program towards those institutions. The new methodologies use a CAMEL2 based supervisory risk ranking model which allow banking supervisors to score and assign weights to a multitude of factors that make up the CAMEL components. The methodology includes an assessment of management aspects in each bank, such as how organized and timely financial monitoring and reporting is, and how advanced are a subject bank’s internal risk management procedures. These key aspects are frequently less developed in other country CAMEL models. The incorporation of them into the Colombian methodology provides additional information to allow assessing the overall level of risk judged to exist in particular bank, and thus rank i t s priority for inspection under the SB’s program.

53. version of the Basel I1 capital adequacy and risk management models, i t i s one of the few countries in the region which has pushed the envelope to a very advanced level in terms of requiring financial institutions to adopt internal credit risk management models for use in determining asset r isks and weighting factors for the calculation of required capital and solvency levels. This contrasts with the old Basel model which pre-assigned weights (for determination of solvency capital) to different types o f loan assets, irrespective of each individual bank’s estimation of those asset risks.

Basel II Oriented Risk Management. While Colombia has not adopted a full

Capital I Assets / Management I Earnings I Liquidity.

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54. for the insurance sector) to develop internal portfolio risk models involving the statistical estimation o f default probabilities and potential loss magnitudes. The SB’s review process for determining the viability and parametric accuracy o f each bank’s credit risk model w i l l be intensive and time consuming and may last a matter o f years rather than months. Besides the major reform o f shifting toward this internal based model system, and in order to ensure the adequacy o f human and technical resources to implement this reform, the SB has developed an action plan documenting the budgetary, personnel, and computing resources required, as well as the implied time lines to complete the review and approval process o f each bank’s statistical credit risk model. This logistical exercise is o f high priority in order for the SB to estimate wi th certainty when this reform process can be realistically completed so as to provide the market wi th a target date for having it fully implemented in every financial institution.

The SB has directed the banking system (and i s in the process o f doing the same

55. operation, the Government documented i t s commitment to undertake a comprehensive assessment o f latent and future r isks in the financial system. This has been ful ly completed as part o f the second operation’s triggers. The review concluded that, while the capital position and earning o f the financial sector had improved substantially since 2000, the mortgage banks (BECHs) remained the most vulnerable primarily due to their higher stock o f non performing loans s t i l l in their portfolio. Under assumed macroeconomic shocks such as a recurrence o f a recessionary environment, high inflation, or a sharp hike in interest rates, these banks could suffer potential insolvencies. As part o f the review, contingency strategies were identified to handle such cases if and when they occurred - among the strategies were the application o f the new resolution tools to transfer viable loan portfolios with depositor funds to new banks while liquidating the unrecoverable portfolios. Under the new law 794/2003 governing foreclosure proceedings, the liquidation o f collateral for these unrecoverable loans would also be processed faster, thus reimbursing the State for any unmatched insured deposits which would have been paid out in the interim.

Financial Sector Vulnerability Analysis (Stocktaking Report). Under the f i rs t

56. stock o f government securities f rom which a significant proportion of their income was generated. While the Government’s pol icy i s to plan its future debt management strategy to avoid a compromising situation wi th international or domestic creditors, the review nevertheless pointed out that this phenomenon might have also resulted in fewer incentives for banks to increase credit. The implications o f this observation are not fully evident given that the Government has issued securities to fund its short and medium term needs, and wil l l ikely continue to do so until i t substantially reduces i t s fiscal deficit. Nevertheless, this observation i s being discussed between the MOF and the SB to determine whether banks should be required to have capital r isk weighting if they are holding a certain threshold level o f government securities which constitute a significant share o f their balance sheets3. The assumption i s not that the securities (which are presumed to be risk free) have any imminent default probability but rather that any financial institution should provision against exposures i f they are concentrated in a specific sector or issuer.

Another observation o f the review was the banking sector’s holding o f a high

As at the end of December 2003, public sector exposure constituted 73% o f total securities and around 8% of gross loans o f the banking system. Sovereign bonds (mostly TES) accounted for the majority of securities exposure, while sub-national lending (municipal authorities and public sector entities) dominated other public sector loans.

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57. Government had committed to initiating the merger between IFI, the industrial development bank and BANCOLDEX, the export bank, both owned by the State. IF1 was already experiencing portfolio performance problems and it was not considered to be a long term viable concern. Likewise, the Government committed itself to improve the balance sheet o f BANCAFE in order to eventually bring i t to the point of sale. During the second phase of the program, the Government fully dissolved the IFI, transferred its viable assets to BANCOLDEX and began liquidating I F I ’ s remaining residual assets. From a legal standpoint, therefore, IF1 as an institution has been fully dissolved.

Dissolution of State Owned Banks. Under the f i rst phase of the program the

58. For BANCAFE, a state-owned bank that originally served the coffee growers sector, international investment advisors were contracted and as part of the reform commitment, the bank was advertised and publicly offered for privatization under an international bidding process. Unfortunately, despite the Government’s best and transparent efforts, no bid came forth although four investors showed up and examined the financial condition of the bank. The Government through FOGAFIN, has continued a process of improvement of the bank’s finances and loan recoveries while implementing a program for downsizing i t s operations and overheads in order to bring it out again for sale in the near future. An action plan to this effect has been approved by FOGAFIN as well as a parallel action plan to bring the other remaining State intervened bank, GRANAHORRAR up for sale. FOGAFIN i s working to continue to improve GRANAHORRAR’s loan recoveries as well as i t s internal information system which requires substantial upgrading to allow for adequate risk management. The Government’s plan i s to divest both banks through sale/privatization of the institutions or failing that, through a sale of their assets, an option which would be more costly to the Government in terms of absorbing residual assets and paying of f depositors.

Housing Finance

59. Under the second phase of the reforms, the Government has continued to support the recovery of housing finance through the implementation of measures to foster the improvement of lending to the sector. The lingering memories o f the last financial crisis have discouraged banks from extending residential mortgages in spite of the positive characteristics of this sector. Though the commercial and consumer portfolios non performing loans (NPLs) have returned to their pre-crisis levels, mortgage NPL ratios are at 14 percent, only a slight decrease from the 16 percent at end-2003 but an improvement from an earlier peak of 25 percent. This second Programmatic Loan focuses on supporting the implementation of new mechanisms to consolidate the environment necessary for housing financing to restart.

60. implemented legislative provisions so that micro housing credit might be more easily channeled through existing banking institutions. Under the second phase, the Government implemented a number of innovative reforms to promote this sector. The Government has obtained a voluntary agreement from commercial banks to allocate a small portion of their portfolio funding towards this sector. Alternatively banks can also participate in the purchase of bonds issued by FINDETER, a state-owned second tier financial intermediary. The proceeds of these bonds as well as FINDETER’s own funding are to be used to finance mortgage loans through various private credit intermediaries including banks, credit cooperatives and finance companies.

Micro Housing Credit. As discussed earlier, the f irst phase of the reforms

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61. The FINDETER program i s advantageous in that it provides loans to first tier credit intermediaries at longer than usual maturities, thus allowing such intermediaries to extend micro housing loans at those maturities without any repayment flow mismatch risk. Interest rates can be set competitively by participating banks provided that upper ranges remain within the usury limits for housing finance established in the law. The program i s geared towards all micro housing borrowers with emphasis on socially disadvantaged sectors which have home ownership or home enhancement potential. A separate housing subsidy program established b y the Government also provides incentives to expand the home ownership market using this program.

62. To complement the FINDETER program and increase private bank participation, the Government’s National Guarantee Fund (FNG) has also implemented an insurance program for loans given to lower income communities. This insurance provides needed collateral to housing credit borrowers whose lenders pay a fee (passed on to the borrower) which i s actuarially determined by the FNG, and which provides default protection for 70% of the statistically calculated expected loss4. Thus, in the absence of usable real estate collateral, this insurance/guarantee provides more comfort to participating financial institutions. The expectedaverage loss calculation not only computes loan principal and interest at risk but also the additional administrative costs of loan recovery once the loan enters into default. Thus, even though the indemnity provided by the guarantee i s only 70%, it i s actually higher as a percentage of the loan principal given the inclusion of these other default related expenses.

63. FRECH Interest Rate Option for Mortgage Banks. Another innovation implemented under the second phase o f the reform program i s the re-casting and reconversion of the prior FRECH interest swap into a more flexible interest rate options program. This FRECH program was established to provide an interest rate hedging instrument to those mortgage banks that were left with portfolio exposures after the Constitutional Court disallowed them from indexing their loans to deposit interest rates. Since these banks were lef t with loans indexed to inflation, they had a risk mismatch between the rate base on their assets versus liabilities. Since the banks had no other recourse, the Government first established the FRECH swap which converted banks’ asset returns to an interest rate base with a fixed interest rate upper l imi t in exchange for their inflation based rates. However, the swap was not successful since i t required, under a low interest rate environment, that banks continually pay money into the FRECH while the rate remained below the threshold limit. Only i f the rate rose above that limit would banks receive compensation.

64. Under the second phase of the reforms, the M O F and BRC agreed with the mortgage banking sector to implement a financial option instrument which i s now designed and agreed with the industry, and w i l l be enter into contracts in the third quarter o f 2004. This permits each bank to set the period o f protection needed, and the rate limit protection required according to institutional and financial needs. The pricing also varies according to the option chosen, and i s paid as an up-front premium. If the interest rate rises above the threshold l imit during the contract period, at the end o f that period, the program indemnifies the bank for the monetary difference between the actual higher rate and the limit rate. The program i s now in effect. Since the premiums are actuarially determined based on historical expected losses and values-at-risk, the Government does

Loss probabilities are calculated using historical default data for loans in this sector.

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not incur any funding risk beyond what the market would dictate commercially. In this regard, the instrument serves as a demonstration effect and should in the long run be able to be offered by private market players.

65, The Securitization Market. With the mortgage securitization market now developing, the SB has progressed in developing a sound regulatory framework for these instruments while preventing regulatory arbitrage in their usage. Securitization represents an innovative financing mechanism for credit institutions which can, by removing the assets and associated r isks f rom their balance sheets, effectively exchange loans for liquid capital wi th which to lend to new borrowers. The Colombian Securitization company (Titularizadora Colombiana) has helped drive this market by purchasing residential mortgages from originating entities and financing them by issuing mortgage-backed securities to investors, thereby providing a bridge between the housing and the capital markets. In order to satisfy investors’ diverse risk appetites and time horizons, the Titularizadora has issued mortgage-backed securities of different classes’ and maturities.

66. Four securitizations o f performing residential mortgage loans have already taken place through end 2003, corresponding to COP 1.8 trill ion (US$700 million) or about 15% o f the mortgage stock outstanding as o f December 2003. The securitizations have enabled originating banks to improve their liquidity, enhance after-tax profitability and reduce their capital adequacy requirements. The Titularizadora also completed in June 2004 the f i rs t securitization o f non-performing mortgages6 in Lat in America, for an amount o f COP 0.5 tr i l l ion (approx. US$200 million). This transaction has significantly improved the balance sheets o f the two participating mortgage banks since i t resulted in the replacement of a large portion o f their stock o f outstanding non-performing mortgages with cash and subordinated securities. The good credit performance o f mortgage-backed securities has increased investors’ confidence and appetite for this type o f instrument, as reflected in progressively declining yields and increased secondary market liquidity.

67. Capital Adequacyfor Securitized Assets. On the credit risk side, the most important change to the capital adequacy framework i s the recognition of the existence o f different levels o f credit risk in the different tranches o f a securitization. Under the reform, the SB has introduced new risk-sensitive capital adequacy rules for investments by credit institutions in such securities. The rules generally fo l low the Base1 II standardized approach for securitizations (Le. risk weights are mapped to external credit ratings). This i s important for mortgage securitizations since the overall capital requirement would increase for banks that sell their loan portfolios through

In this type o f structure, each class or tranche o f a security (e.g. subordinated, mezzanine and senior) i s given progressively higher repayment priority over the underlying mortgage cash flows. As a result, the subordinated (or ‘first loss’) tranche acts as a safety cushion for the other tranches and i s therefore given the lowest credit rating for investment purposes; this tranche i s typically bought back b y the issuing banks to discourage moral hazard in the selection o f mortgages to be securitized and in their administration. B y contrast, the senior tranche has very low repayment risks and i s consequently given the highest credit rating. In the case o f Colombia, the credit rating o f senior tranches i s enhanced by several mechanisms, including guarantees provided by the government (via Fogafin) for subsidized social housing loans (VIS) and by the IFC for non-VIS loans.

in the process o f foreclosure. Returns on these are gained through liquidation o f foreclosed assets and any residual debt service collected from the borrowers.

These are mortgages rated C, D and E, i.e. those that are delinquent for at least 9 months and are currently

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securitizations but retain subordinated tranches o f such bonds. Prior to this regulation, banks could easily buy back securitization instruments backed b y their own loans while reducing their capital/solvency requirements despite no change having occurred in the underlying r isk holdings.

68. Capital Requirements for Securitization Firms. The aforementioned capital rules apply to credit institutions and not to securitization companies such as the Titularizadora Colombiana that come under the jurisdiction o f the SV. However, these entities are also exposed to risks related to securitization, such as: (a) credit risk, to the extent that they offer credit enhancement facilities or credifliquidity support under securitization transactions; and (b) market risk, stemming from their underwriting function (the period between the purchase o f the mortgages and the sale o f the structured securities) or to the extent to which they invest in mortgage-backed securities or perform a market-making role to enhance liquidity in the secondary market.

69. finance market, the SV has introduced a risk-based capital adequacy regulation to cover the credit and market r isks incurred b y securitization companies. This follows closely the structure o f the SB rule, but also explicitly addresses capital requirements for bonds that bear the securitization company’s guarantee as a credit enhancement. Since it i s the f i rs t time that risk-based capital adequacy i s imposed on entities under the jurisdiction of the SV, the rule also defines the components o f the solvency formula including regulatory capital, and establishes concentration and related party exposure limits. Given the Titularizadora’s current range o f activities and capital base, the introduction o f the new rule i s not expected to affect i t s current operations but i s seen as ‘foresight’ for regulating potential future operation^.^

In order to ensure a level playing field and the on-going stability of the housing

70. exemption status o f interest income from mortgage-backed securities, which was originally introduced b y the Ministry o f Finance to support the development o f this market. A review o f tax incentive effects on this market as wel l as effects o f transaction taxes on the banking system, was completed under the second phase. The tax exemption on securitizations leads taxable entities to bid up the price o f mortgage-backed securities to a premium that i s uneconomical for non-taxable entities, and has among other factors, motivated the originating banks to retain securities corresponding to around 70% o f the securitized mortgage portfolio’. Although retention o f the subordinate tranche by issuers provides the right incentives for effective loan servicing, their purchase o f higher-rated tranches i s sub-optimal since it keeps the interest rate r isk o f the mortgage market in the banking system. This exemption, scheduled to expire in 2006, wil l be reevaluated in the context o f leveling the playing f ield to ensure that long-term institutional investors such as pension funds and insurance companies participate more actively in the securitization market.

One o f the remaining longer-term challenges that i s being addressed, i s the tax

’ On the credit risk side, the Titularizadora does not currently offer any guarantees itself but relies on the government and the IFC as investor to provide them. On the market risk side, although it has kept mezzanine tranches from the first four securitizations, i t has recently been selling some o f them in the secondary market.

investment in the secondary market. T h i s ratio has been reduced to around 50% as originating banks have been gradually selling parts o f their

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Insurance, Pension and Trust Industries

71. Based on an actuarial review o f all the branches o f the insurance business, the SB developed under the second phase reforms and the Banking Superintendent has endorsed, a new set o f regulations which w i l l fully implement Law 795/2003 and provide insurance companies guidelines on setting their solvency capital margins and technical underwriting reserves according in line with global standards.’ The regulations are currently undergoing a final audit by an expert actuary and being reviewed by the industry for f inal comments. This reform follows up on the implementation under the f i rs t phase, where the new minimum capital requirements for the insurance industry were implemented.

72. Simultaneously, the Insurance Arm o f the SB i s gradually implementing for the industry, a system for the analysis and reporting o f insurance risks (Sistema Especial de Analisis de Riesgo de Seguros -- SEARS). As with the banking sector and i t s move towards Basel I1 oriented models, this methodological system phases in new requirements for insurance companies to adopt formal procedures for the analysis and measurement o f a l l business r isks (underwriting, actuarial, market, credit, operational, reputational) in the insurance sector. Each insurer i s to produce i t s own version o f SEARS which must be approved by the SB as an internal risk management and capital adequacy tool. The SEARS modules must be comprehensive wi th the ultimate purpose o f addressing insurance companies’ calculation o f capital adequacy, technical and mathematical reserves, as wel l as market, operational, and reinsurance credit risks.

73. companies whose primary business is the management o f investment portfolios, and in order to prevent regulatory arbitrage and improve transparency in the comparative reporting o f returns o f these companies’ investments, a new regulation on value-at-risk adjusted returns has been implemented. Value-at-risk (VAR) is a statistically based calculation o f portfolio volatility and incorporates the computation o f potential portfolio losses based on a pre-specified confidence interval for worst case ‘tail’ events. Since such a loss, while extreme, cannot be ruled out, client investors should be aware o f their portfolio vulnerability to market movements. In this context, the SB in coordination with the SV have issued regulatory requirements for the above industries to report the rate o f return on their portfolios while disclosing the latent value-at-risk. In a sense, this normalizes returns for the degrees o f risk inherent in each subject portfolio, and provides the public with a more transparent understanding o f expected asset returns taking historically based market volatilities into account. Concurrent with the SEARS requirement for insurance companies, the insurance industry also incorporates VAR parameters to report their risk adjusted investment returns.

Investment Portfolio Risks. A key reform for the pension, trust, and mutual fund

74. for the AFPs pertains to l i m i t s on the quantity and diversity o f investment instruments permitted, in order to ensure that instruments o f good credit quality are purchased. Until this reform, investments in overseas securities were l imi ted at 10 percent o f AFP portfolios. In the second phase o f the reform, the Government has implemented regulations permitting AFPs to increase their foreign currency investments up to 20

Pension Znvestment Diversification. Another aspect o f investment management

’ While the overall calculation o f the solvency margin i s expected to deploy methodologies akin to Basel I1 for banks, the calculation o f technical reserves w i l l use E.U. insurance regulation methodologies until a sufficiently broad database to compute risks actuarially, i s available.

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percent of their portfolio holdings. This reform i s sound given that i t diversifies holdings into hard currency investments which can help protect and increase the value of pension affiliates’ benefits. As part of the reform and consistent with other reforms, the Government has removed many of the ‘floors’ placed on the credit ratings of instruments invested, and instead wi l l allow AFPs to present their own internal risk models, subject to SB approval, to demonstrate their prudent management of investment credit risks. In addition, the SB has issued regulations setting limits of up to 10 percent on AFP investments in securities of f i r m s which are related or part of conglomerated financial/economic groups which those AFPs make part of.

Capital Markets

75. Reform of the Capital Markets Framework. The new Securities Law i s a cornerstone o f the reform program under the second phase of the Programmatic Operation. The new law which sets the framework for the capital markets in Colombia was developed and approved by the Executive, and presented to Congress for i t s approval. As delineated in the Program Document for the First Colombia Programmatic FSAL Operation (Report No. 25472 CO, page 45, paragraph 171), “the completion of a draft new Securities Law and i t s presentation to Congress constitutes a key trigger for the second phase”. The new framework i s progressive in that i t establishes: (i) norms for corporate governance including the responsibilities of management and the Board, (ii) rationalized requirements to lower the cost o f issuance of securities while setting information disclosure standards, and (iii) entry qualification standards for industry professionals wishing to conduct securities business. Other key provisions of this law include:

76. all participants in the securities markets including: (a) issuers o f securities, (b) intermediaries that conduct securities transactions among other businesses, (c) stock exchanges, and (d) operators o f clearing and settlement facilities. The powers cover every aspect of the participants’ securities market activities and include powers to undertake investigations, obtain information and take enforcement action on supervised entities. Al l market participants are required to register with the Securities Markets Integral Information System (SIMEV). SIMEV i s to provide complete and timely information on supervised entities and w i l l comprise three registries: (i) the Securities and Issuers Registry which i s to contain information relating to securities and issuers, (ii) the Market Agents Registry which i s to cover persons that undertake securities market activities (other than issuers) and (iii) the Securities Market Professionals Registry which i s to cover individuals who are engaged by market agents to conduct market activities. The SV i s given greater powers to take administrative measures against those who contravene the law, allowing i t to impose a wide range o f administrative sanctions and penalties to deter securities violations.

Definition of Supervisory Powers. The new law gives the SV power to supervise

77. Custody, Clearance and Settlement Regulations. The Law establishes the principle of finality and makes clear the obligations o f parties in a concluded securities transaction, in accordance with the rules o f a clearing and settlement facility approved by the SV, whereby such contractual obligations are final and cannot be set aside in favor of a third party as a consequence of the occurrence of an event such as the insolvency of one of the parties. Similarly, assets of collective investment schemes are to be kept separate from the assets of the entity that manages those assets, and are not available to creditors

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o f such asset managers. The law also provides for the establishment o f central counterparty risk clearing houses which are intended to further reduce the r isks and costs to market participants since the central counterparty w i l l assume the obligations o f every buyer and seller for securities traded on the market.

78. intermediaries to self-regulate themselves under norms approved b y the SV. The law makes it compulsory for every brokerage firm to employ a compliance officer who has the responsibility for ensuring that the firm makes training programs available to its staff and puts in place compliance systems to meet its ongoing obligations under the law. The law also requires that al l intermediaries segregate third party funds received for administration, f rom the intermediaries’ own-account investments.

Regulation of Intermediaries. The law allows stock exchanges, brokers and other

79. governance standards that are designed to protect the rights o f minority shareholders o f securities. Twenty-five percent o f the Board Directors o f an issuing firm must be independent of the company as well as o f those who hold controlling interests in it. Minor i ty shareholder participation in the company’s general shareholder assemblies i s to be enhanced by obliging the Board o f Directors to put forward for consideration and providing responses to any requests or resolutions proposed by investors representing five percent or more o f al l shareholders.

Shareholder Protection Requirements: The law introduces a number o f corporate

80. the new Securities Law, a number o f complementary regulatory initiatives have also been implemented to improve the functioning o f the market. Since the mutual funds (collective investment schemes) industry had to-date been segmented across the brokerage, dealer, banking and trust industries with each having different prudential requirements, i t was deemed critical to harmonize such regulations to avoid certain funds having competitive advantages due to regulatory differences. In this context, the SV in coordination with the SB issued harmonized regulations specifying the minimum solvency ratios and capital requirements for the various types of funds under their respective jurisdictions (mutual, investment, securities and other funds). The regulation effectively permits funds to leverage the size of their portfolio up to a limit, as a multiple o f their capital base.

Harmonization of Mutual Funds Regulation. Besides the reforms established by

81. The SV has also issued new norms for mutual funds’ information disclosure reporting to the public (‘fact sheets’) so that financial, management, credit rating and market risk data are clearly summarized for the public’s evaluation and comparative review using uniform standards. Additionally, among the SV and the SB, new reporting requirements are under advanced design to be implemented for mutual funds and al l collective investment funds - these include the incorporation o f both credit risk and market risk ratings so that the public may assess the investment risk o f such funds both f rom a credit default perspective as well as a market volatility viewpoint.

82. Market Valuation of Securities. Under the f i rs t phase o f the reform program, uniform market valuation methodologies were established among the SV, SB, BRC and the market, to determine the daily price o f government securities. Under this second phase, regulations were issued for the same purpose but with respect to private sector fixed income securities. In terms o f daily market valuation for mutual funds, a new regulation requires a market value to be established on each trading day so as to avoid

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market arbitrage. Previously, the market value constituted the fund’s value on the close of the previous day and this generated opportunities for market manipulation and profi t taking based on outdated prices used for current day trades whose underlying securities’ prices already contained new information not reflected in the mutual fund’s lagged price.

Government Debt and Money Markets

83. reform agenda to further develop the domestic debt and money markets. The reform package included three carefully sequenced areas for action:

Under the second phase o f the reform, the authorities embarked on an ambitious

0

0

debt market development, focusing primarily on debt issuance strategy; money market development, as i t relates to the T-bi l l and repurchase markets; and improvement in risk management and measurement by market participants.

84. valuation o f treasury securities, and capital regulation for primary dealers in those securities, while the reforms supported by the second loan have focused on developing the short-end of the yield curve to improve market pricing and liquidity, and setting out a clear debt issuance strategy by an established high-level debt management committee. A number o f complementary measures are also included in the capital markets component of the loan and described in the preceding section o f this document.

The first loan under the programmatic operation emphasized improvements in the

85. historically suffered from a lack o f liquidity during periods o f high volatility, augmented by the previously light and non-enforced obligations of primary dealers that were required to ‘make the market’. T o establish the market valuation o f securities in the absence o f highly liquid markets, a high-level Valuation Committee was established by the SV and SB to periodically validate or revise the methodologies used to determine prices and reference rates. The guidelines for the valuation methodology have also been published on the web site o f the Colombian Stock Exchange.

Liquidity of Treasury Securities. The government securities market has

86. Short-term Yield Curve. An essential building block to support risk measurement is the development o f the money market via instruments such as the short-term T-bills. In the past, the authorities had been conducting l imited T-bill auctions, opting instead for the use o f forced debt issuance (“colocaciones forzosas y convenidas”) with public sector entities in order to satisfy their short-term funding needs. This practice hindered the development o f the short-term T-bill market and distorted interest rates, forcing money market mutual funds to purchase longer-term securities and thereby be exposed to higher interest rate risks.

87. In order to create a short-term government securities yield curve, the Government, under the second phase o f the program, established a new issuance program that relies on weekly T-bill auctions o f progressively greater size. The strategy has init ial ly focused exclusively on T-bills with a 3-month maturity in order to build l iquidity around that segment o f the yield curve, and has been supported by the Central Bank’s decision to abolish the issuance limit (“cupo”) for such securities. A s a result, weekly issuance has expanded from 5 bi l l ion pesos in January 2003 to 80 bi l l ion pesos (US$31 mi l l ion equivalent) by mid-2004, Le., a sixteenfold increase, while secondary market liquidity has picked up considerably allowing the market to price the securities at true market

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value and avoid excessive volatility. Following the success of the revolving T-bil l program to-date, the Government intends as part of the continuing reforms, to expand the issuance of T-bills to the 6-month maturity window.

88. Government Debt Issuance Strategy. Debt issuance had, until recently, been determined on a short-term basis, thereby sacrificing transparency and predictability. This tended to increase market uncertainty and adversely impact funding costs, particularly given the large amount of domestic debt that had to be rolled over frequently. In order to address this vulnerability, important steps have been undertaken to streamline and develop the policy and operational framework of debt issuance. First, as part of the second phase of the reform program, the functional fragmentation of, and duplication in many debt management responsibilities was eliminated via the merger of the Departments of Public Credit and of the Treasury within the Ministry of Finance. The consolidation of the cash and debt management functions allows important opportunities for gains in the form of operational savings, greater financing flexibility, strengthened accountability, and a more unified funding strategy and stance towards market participants.

89. Second, an “Internal Committee for Public Debt Policy”, formalized by Decree 921/2004 and comprised of Senior Ministry and Central Bank officials, w i l l advise the Finance Minister on the development of debt management policy. The Committee wi l l coordinate the different functions within the Ministry involved in debt management issues and provide the supporting analysis for high-level policy decisions, taking into account macroeconomic conditions and the state of financial markets. The Committee i s also tasked in setting the guidelines for risk management o f public debt, adopting reference benchmark portfolios, developing methods to assess public debt sustainability, coordinating debt issues with entities within and outside the Finance Ministry, and evaluating contingent debts in the form of State guarantees.

90. The Repurchase Market. Money market liquidity i s also expected to improve following the introduction o f new measures which strengthen the efficiency o f the repurchase market. This f i rs t covers the regulatory codification o f the three existing types of repurchase transactions (repos, simultaneous exchanges o f securities with cash loans, and temporary securities swaps). An inter-agency working group produced a report that identified some o f the regulatory gaps to be addressed, including the incorporation of provisions regarding the contracted legal finality o f repurchase transactions incorporated in the new Securities Law’’, and the implementation of a new collateral system for Central Bank rep0 operations as well as a securities lending and borrowing facility linked to the clearing and settlement system.

Results Attained to Date

91. based on results more fully reflected in the medium term, the Program has to-date helped generate measurable outputs which w i l l support the longer term impact and sustainability o f the reforms. These are summarized in the table below.

While the full impact o f the Programmatic Reform Program w i l l be measured

’” For example, under a repurchase contract involving the temporary borrowing of cash and the simultaneous provision of a market security as collateral, the new norm recognizes such an ‘open’ contract as a legally binding priority to both parties, avoiding third party legal loopholes or competing claims.

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Table 5: Current Quantifiable Results Supported by the Program

OBJECTIVE

BANK REGULATION Banking stability and

supporting financial and balance sheet strength indicators become evident. Enhanced banking supervision powers i s evidenced via prompt application o f sanctions and fines.

BANK RESOLUTION Reduction o f fiscal liabilities

and State interests in intervened financial institutions i s achieved via the sale of their assets and matching liabilities through the new securitizatiodtrust mechanisms.

HOUSING FINANCE Mortgage backed securities

develop. Public policy tools to augment the housing finance market (e.g.: interest rate hedge, inflation swap), improve the operation, risk management o f the markets.

INSURANCE / NON BANKS The solvency o f the insurance

industry i s confirmed with respect to international standards.

CAPITAL MARKETS

securities on the capital markets and purchases by securities are evident.

GOVERNMENT DEBT

government securities i s implemented.

Increased issuances o f

A regular issuance program for

RESULT / OUTPUT INDICATOR

(i) The net return on average earning assets o f the banking system increased from 1.1 % at end-2002 to 2.7% by May 2004. (ii) The non performing loans ratio decreased from 13.6% to 9.2% during the same period. (iii) The capital adequacy ratio (capital as a % of risk weighted assets) increased from 12.5% to 14.5% during a period in which stricter capital and loan classification standards were implemented. (iv) The Banking Superintendency, between May 2003 and June 2004, applies fifty three sanction actions and penalties to credit institutions that were not complying with legal and prudential norms.

(i) The Deposit Insurance Agency, FOGAFIN, has divested and sold banking assets previously in State hands. These include COP 9.8 billion (US$3.8 million) o f Granahorrar mortgage assets during 2003. (ii) The portfolio previously supported by State relief credits (‘alivios’) was sold in 2003 to 65,000 mortgage holders for COP 224 billion (US$ 86 million). Out o f 480 real estate assets at the start of the vear. 239 were sold.

(i) The FOGAFIN administered inflation hedge for mortgage borrowers, was implemented with over 14,000 subscribers covering loans up to US$135 mil l ion equivalent. (ii) Thirty issues o f mortgage backed securities were completed in 2003 for a total o f US$700 mil l ion equivalent. In June 2004, the f i rst issue o f non performing asset backed securities (US$64 million) took dace.

New regulations on insurance solvency margins and upgraded norms for determining technical reserves, were developed by the SB and published for industry comment and actuarial review.

Twenty-eight public offerings o f securities were made in 2003 for an amount o f US$1.8 bi l l ion equivalent, an increase of 19% with respect to the previous year.

A program o f weekly issuance of 90 days T-bills has been implemented with issuance authorization expanded from COP 5 billion (US$ 1.9 mn. equivalent) in January 2003 to COP 80 bi l l ion (US$3 1 mn equivalent). 90 day T-bills issued in 2003 amounted to US$238 mn. and 180 day T-bills were US$34 mn. In 2004 through July, 90 day T-bi l l issuance was US$661 mn.

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PART 111. THE PROPOSED LOAN: SECOND PHASE OF THE PROGRAMMATIC REFORM PROGRAM

A. Loan Description: Objective and Rationale for Bank Involvement

92. Loan Objective. The objective o f the loan i s to contribute to a wel l capitalized, regulated, supervised, and efficient financial system which i s less vulnerable to future shocks and efficiently intermediates savings, provides credit, capital, and other financial services to Colombian investors, consumers, and home-owners including the underserved sectors. I t also wi l l aim to facilitate greater domestic and foreign investment, reduce the cost of financing, and contribute to strengthened competitiveness, higher productivity and eventual j o b creation.

93. reforms set in motion under the f i rs t phase o f the program and implement a new legal and regulatory framework for the modernization o f the securities market and the upgrading o f risk management norms in the mutual funds, pension, insurance and trust industries. With the new banking framework approved under the f i rst phase, the loan supports the full implementation o f the institutional and regulatory mechanisms for applying the new standards for banking risk management, corporate governance, related party transactions, transparency to the public, bank exit procedures, sanctions and penalties regimes, assessment o f bank vulnerabilities, prioritization o f corrective actions, divestment procedures o f state owned financial institutions, and resolution tools to prevent the contagion caused by potential future financial disruptions.

Towards these ends, the loan w i l l support policy actions to operationalize the

94. economic growth through the implementation o f market oriented mechanisms to increase the supply o f securities and savings instruments to fund productive enterprises and to increase competitiveness in the form o f increasingly diverse investment channels, while enhancing the provision o f micro housing credit and augmenting financing for the overall mortgage market. This includes the establishment o f a level playing f ield in the valuation o f financial assets and capital requirements for mortgage backed securities, and encouraging expansion o f the mortgage industry through the implementation o f modern risk management and interesthnflation hedging instruments. In addition, the operating framework for the insurance, pensions, trusts and mutual fund industries i s strengthened and equalized to ensure transparency in the reporting o f asset performance and management, while disclosing inherent market and credit risks through standard reporting conventions across these industries.

This second phase pushes the envelope for the financial sector to further support

95. The key pillar o f the second phase, however, i s the implementation o f a new framework for the operation o f the capital markets to encourage that market’s growth and provide additional and alternative sources o f funding and investment for the economy. In this context, the framework for the securities market corrects many o f the costs, inefficiencies and latent risks existent under the earlier framework, so that securities market regulation and supervision are seen as rigorous and as wel l monitored as banking regulation, thus promoting additional participation by both issuers and investors alike. Related reforms in the government debt and money markets support the capital markets infrastructure through the formation o f reference interests rates on the yield curve and the implementation o f standardized method for the valuation o f market securities, both public and private.

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96. The detailed prior actions taken, referenced against the triggers for the operation, are shown in the table below. All triggers for this second operation have been completed and related prior actions taken under the loan have been met. Additional prior actions exceeded the trigger requirements as in the case of new investment regulations issued for pension funds, as well as the proactive launching of a new micro housing credit program. Other cases such as the issuance of final insurance regulations which are awaiting insurance industry review, or the offer for sale of a state bank which has not yet attracted final bidders, made progress but require further follow up. Overall, the key triggers were fully met and the relevant prior actions have been completed and implemented.

Table 6: Summary of Second LoanTriggers and Status of Actions Completed

Triggers for Second Operation

Banking Regulation

The Borrower through: (a) MoF has issued Decrees for implementing the financial system reform law and (b) SB has issued circulars and regulatory amendments to adapt existing regulations to the supervision o f financial conglomerates and related parties.

The Borrower through the SB has demonstrated: (a) the application and enforcement o f the Law 795-2003 via actions such as specifying and integrating in a sequenced manner, prompt corrective actions to be applied, and developing procedural handbooks specifying enforcement o f remedial actions under a graduated regime o f sanctions, and (b) the effectiveness and improvement o f supervision via progress on benchmarks established under it ’s Strategic Plan, including the improvement o f risk assessments made for financial institutions, the conducting o f consolidated financial group examinations, and the investment o f resources for SB’s institutional strengthening.

Status I Comments

The macroeconomic environment has continued to improve, supported primarily by increased growth which has helped reduce the pubic sector deficit.

Regulations and decrees related to the law, were issued. Regulations on conglomerates were approved by the Superintendent o f Banks and published for general public comment -- to be officially issued once the public and the Superintendencies o f Securities and o f Companies submit final comments.

As per prior actions above, the sanctions guidelines and procedures have been ful ly approved and implemented. Procedures for the risk based inspections were also documented and implemented, and a resource plan was approved to review and ro l l out the risk-based regulatory models o f al l banks. Additional budget could not be provided given the Government’s across-the- board budget freeze and reductions as part o f i t s fiscal adjustment.

Reforms Actions Completed

Macroeconomic Policv Environment

A stable macroeoconomic environment is maintained through the implementation o f sound fiscal, inflation and other policies including supplementary fiscal legislative/regulatory measures approved.

Bank Regulation

MoF and SB have issued 65 regulatory decrees, circulars to implement Law 795 for the resolution o f troubled banks, including regulations specifying procedures for the carve out and transfer o f assets and deposits from weak banks, the use o f asset securitization vehicles for the efficient transfer o f such assets to acquiring banks, and internal directives on sanctions to invoke for use in applying corrective actions and monetary fines, proportional to the level o f the regulatory/legal infraction.

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I

Triggers for Second Operation

The Borrower through MoF has undertaken a financial sector stability review to assess future banking system health using projections of: (a) the risks o f weak banking institutions under low growth scenarios; (b) the banking sector's actual cash flows; (c) the government debt securities held by commercial banks and i t s possible risks to said banks; and (d) contingency plans to resolve any potential negative effects within said sector.

The Borrower through FOGAFIN, has undertaken progressive actions in the divestmentldismantling o f insolvent State banks, and measures for selling off assets o f said banks to the private sector.

Housing Finance

The Borrower though FOGAFIN, SV and SB, has taken measures to increase the competitiveness, soundness, efficiency and transparency o f the mortgage industry, and to improve the institutional set-up to support housing micro finance.

The Borrower through SV and SB has taken measures to ensure that secondary mortgage market regulations and practices are adjusted, including improved securitization methodologies

Status I Comments

The Review was completed and approved by the Banking Superintendency and the Ministry o f Finance.

IF1 was merged and liquidated. BANCAFE was approved for privatization, and offered for sale. Interested investors did not bid but the Government continues with the bank improvement program under i t s action plan, so as to offer i t again for sale andlor divest its assets.

The Government ful ly implemented the inflation and interest rate hedging instruments to protect banks and borrowers against mortgage market risks and to protect the financial condition o f those banks, while encouraging new entrants. The institutional set up to support micro housing credit was implemented with combined support of state and private institutions. This was an alternative to up-front steep commissions for micro borrowers (allowed in the law) which was seen as socially unfeasible by the Executive.

All pertinent norms and regulations have been approved and issued.

Reforms Actions Completed

jOGAFIN has conducted an nternational bidding for BANCAFE, ind the Government has offered the lank to private investors for sale. The State development bank, IFI, has been :losed and remaining viable assets and issociated liabilities o f IF1 were nerged into BANCOLDEX. An 4ction Plan has been approved by 'OGAFIN for the continued financial Improvement and eventual sale or jivestment o f BANCAFE and SRANAHORRAR assets, as going :oncerns or via alternative mechanisms.

Housing Finance

(i) The Government, through a FINDETER program, has implemented a rediscounting program for banks and finance companies to offer mortgage and real estate micro-credits to lower income communities, (ii) the banking sector has entered into a voluntary agreement with the Government to offer credit to the micro-housing finance sector or fund FINDETER bonds for use in the same program, (iii) the National Guarantee Fund i s providing insurance products, based on actuarially based premiums, to cover financial institutions against losses from housing micro-credit and social mortgage loans.

The SB sets risk-adjusted capital adequacy rules for multi-tranche securitized instruments held by banks and raises prudential capital performing mortgage loans,

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and oversight functions between banks and securitization companies.

Non-Bank Financial Institutions

The Borrower through SB has demonstrated (a) significant progress in the implementation o f new insurance regulations addressing solvency margin standards and methodologies to upgrade the calculation o f technical and mathematical reserves, and (b) set forth regulatory methodologies for identifying Values-at-Risk in the pensions, trust and insurance industries' investment portfolios.

Capital Markets

The Borrower through SV, has implemented a new Securities regulatory and institutional framework covering, inter alia:

(a) Corporate governance norms including role o f the Board, management, auditors, and other industry officials; (b) Securities issuance norms and disclosure requirements including rationalized procedures for issuance; and (c) Qualification o f standards for industry professionals and entrants.

The Borrower through the coordination between SV and SB, has harmonized the regulatory and supervisory framework for the mutual and investment funds industry -- trust institutions, specialized investment funds and mutual funds under different supervisory authorities are placed within a consistent framework.

The Borrower through SV has implemented valuation guidelines for a range o f public securities and private fixed income instruments.

Government Debt Markets

The Borrower through MoF, has developed an issuance strategy for government debt developed through a coordinated effort comprising technical

Status I Comments

The SB progressed in completing a draft set o f regulations on solvency and technical reserves for various branches o f the insurance industry. The Banking Superintendent endorsed these and i s awaiting their issuance following the final review by an actuarial expert and receipt o f final comments from the industry. The value-at-risk methodologies and regulations for the pensions, trust and insurance industries were fully implemented. Additionally, the SB issued new regulations on the investment regime for the pension funds (AFPs).

A fully satisfactory version o f the Securities Law was presented to the Congress by the Executive, for approval.

A consistent regulatory framework regarding capital requirements and leveraging, was established among the mutual funds and other collective investment industries and agreed between the SB and the SV. The SV additionally, issued norms for information disclosure o f fund performance and risks, under summary public reports.

The Government conformed an official Debt Management "---:ttaa h., den+aa ..,:+h n

Reforms Actions Completed develops capital rules for market, credit and 'own position' risks o f securitization companies.

Non Bank Financial Institutions

The SB has issued (a) Value-at-risk methodologies and regulations requiring the reporting risk adjusted market returns o f Insurance Companies, AFPs, and Trusts, and(b) regulations expanding the limits o f investments by AFPs in foreign securities with adequate credit ratings, and limiting AFP investments in related party institutions.

Capital Markets

The reformed Securities Law has been presented by the Executive to the Congress for approval, and includes provisions for supervisory powers, custody/settlement systems, qualification o f intermediaries, shareholder protection, and corporate governance.

Regulations governing the operation and prudential capital requirements o f mutual funds or other collective investment schemes, daily market valuation o f such funds; have been harmonized across the banking, trust and securities sectors overseen b y the SB an the SV, and information disclosure reports for the public, covering the credit ratings, market risks, commission bases, and returns history for the mutual fund / collective investment scheme industry, have been implemented.

Government Debt Markets

As part o f the Government's debt management and debt markets strategy, the MoF has: (a) following the merger

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Triggers for Second Operation teams from the MoF regulatory units, the DGCP, and the Central Bank.

Status / Comments Committee by decree, with a mandate and terms o f reference to oversee the debt issuance strategy. A program o f significant short term T-bill issuance was implemented to start a market reference for interest rates on the short end o f the yield curve.

Reforms Actions Completed of its Treasury and Public Debt Departments, issued a Decree naming a formal Public Debt Management Committee and specifying the policy and risk management priorities for a debt management strategy, and (b) implemented an issuance program of 90 day T-bills, to establish a short term government securities (T-bill) zero risk yield curve based on increased liquidity and secondary market price formation in the short end o f the market.

97. Programmatic Operation, and reflects a one-tranche operation of US$ 100 million which follows the f i rs t loan of US$ 150 million under the program. All prior actions for this second operation have been implemented. The disbursement of the loan w i l l take place following compliance with all standard Bank effectiveness conditions and verification of met conditionality reflected in official and legal records. Medium term monitoring indicators o f the program wi l l continue as part of the Bank’s ongoing financial sector policy dialogue with the Government, with outcomes to be assessed as part of a two- phase evaluation of the results of the combined program.

Program Amount and Sequencing. This loan constitutes the second phase of a

Rationale for Bank Involvement and Strategy

98. Operation are a core element of the Bank’s Country Assistance Strategy (CAS) for Colombia, as reflected in the CAS report 25 129-CO dated December 24,2002 which was discussed and endorsed by the Board of Executive Directors on January 16,2003. Given the previous financial sector weaknesses which had for the most part been resolved by 2001, the financial sector strategy involves a major revamping o f the regulatory and operating framework of banks, non banks and capital market institutions, to identify all possible r isks which could impact the financial system and ensure a secure environment for saving. Addressing these issues as part of a preventive and strengthening strategy b y the Government, also dovetails with the Government’s economic program for resuming private sector led growth and providing an enabling and stable environment for financial institutions to participate in the funding of such growth.

Relation to Country Assistance Strategy. The two phases of this Programmatic

99. This i s to be accomplished both by direct funding (e.g.: credit, bonds) of enterprises through the banking and securities markets, and through the development of sound and prudentially managed investment vehicles (e.g.: mutual funds, trusts, pension funds, insurance companies) which can provide transparent saving vehicles with which to multiply and channel investment funding into the economy. Separately, additional vehicles for promoting growth through the financial system, include initiatives to promote the expansion of micro housing credit to allow underserved communities to accumulate wealth through real assets and encourage an expansion in home construction and retrofitting tailored to the characteristics o f each community.

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100. the Colombian financial sector, has benefited from extensive collaboration and supporting interventions between the Bank and F C . In the banking area, both institutions provided guidance and advice on the restructuring and eventual sale o f state- intervened or state-owned banks - this constituting a key element o f the Government strategy to transfer banking activity to the private sector. In the mortgage sector, a key driving component o f the reforms was the establishment and operation of a loan securitization company to which F C contributed start-up capital as a minority investor/shareholder. In the capital markets sector, both the technical inputs o f the Bank and IFC were instrumental in developing the new securities law and incorporating best practice elements. In terms o f developing the domestic bond market, while the Bank provided support for reforms to establish a benchmark yield curve in the government securities market, IFC provided technical assistance in the development o f the private domestic-currency bond market.

Bank/ZFC Coordination. The reform program plus complementary activities in

101. Timing and Level of Financial Support. In terms o f budgetary and balance o f payment financing requirements, the Government requires substantial support to meet projected financing gaps. While access to international capital markets has improved, the Government’s gross financing requirements w i l l continue to rely in the medium term on multilateral and official financing support. The Government’s funding needs are based on macroeconomic projections o f GDP growth o f 4 percent in 2004 and 3.5 percent in 2005. During this period, the consolidated public sector budget deficit i s projected at -2.8 percent o f GDP for 2004 and -2.9 percent for 2005 though under the IMF Agreement the Government w i l l target the deficit in 2005 at -2.4 percent. During the medium term adjustment period, the external debt/GDP ratio i s expected to remain stable wi th a slight rise from 45 percent in 2004 to 46 percent in 2005. The net debt ratio to GDP i s estimated at 32 percent for 2004 and 33 percent in 2005.

102. With a projected current account balance o f US$ -1.9 bi l lon and US$ -2.5 bi l l ion for 2004 and 2005, respectively, the Government requires external financing. Since debt repayment for those years are estimated at US$3.6 bi l l ion and US$3.7 bi l l ion for each year, the total financing requirement reaches US$5.5 bi l l ion for 2004 and US$6.2 bi l l ion for 2005. On a net basis, private direct investment and portfolio flows do not contribute any significant net additional financing and so the Government i s mainly dependent on official financing and medium term private debt flows (government bond issues, commercial credit). The combination o f official and private financing amounts to US$ 6.1 bi l l ion and US$6.2 bi l l ion for 2004 and 2005 respectively, out o f which the US$ 0.1 bi l l ion o f this loan constitutes part o f the official/multilateral financing share.

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Table 7 External Financing Requirements

(US$ millions)

2003 2004 2005 (est.) (proj.) (proj.)

Current Account Balance (1,417) (1,873) (2,485)

Debt Repayment Obligations (4,097) (3,621) (3,741)

Financing, net (gap = ( ) ) (5,514) (5,494) (6,226)

Official Flows & Public Issues 5,679 6,136 6,196 Direct Investment Flows 836 1,850 2,200 Portfolio Investment Flows (3,493) 33 139 Other Net Capital Flows 2,568 (1,721) (1,972)

Int. Reserves [ (-) = increase] (76) (804) (337)

103. Medium Term Objectives and Outcomes. For the banking system, the expected outcomes which are already evident as wel l as medium term objectives, include a more solid risk capital allocation in banking institutions setting the basis for additional investment and economic growth along with increased depositor safety. This w i l l be coupled with upgraded risk management procedures implemented at the institutional level and reflecting improved banking solvency. In terms o f the ownership composition of the sector, a steadily declining share of state ownership o f bank assets wil l help reduce government exposure to the sector. Additional reductions in government exposure and fiscal obligations would be evident in the medium term, fol lowing the use o f the deposit insurance fund and i t s deployment under modernized bank resolution procedures which would minimize fiscal outlays. In the housing finance area, the outcomes include a projected reemergence o f the mortgage loan market and expanding it to the underserved sectors to increase home ownership and eventual wealth - this being associated with the implementation o f market risk sharing mechanisms and special incentive programs.

104. The increased transparency in capital requirements and in practices for reporting on investment and risk management o f insurance companies, pension funds, and trusts, wi l l augment competitiveness in attracting savings for domestic investment purposes, as well as increase the comparability among s im i la r financial services thus increasing transparent disclosure in terms o f direct equivalence of pricing practices and fee ratios for asset management services. Similarly, wi th the implementation of the new securities law, a more transparent and risk conscious operation o f capital markets at lower costs and with clearer settlement rules, as wel l as with more technological automation - i s expected to increase the volume o f securities issuance and generate additional competitive financial services to channel funding for both domestic and foreign investment. A prudent debt management strategy and the creation o f a broader market reference rate wi l l generate increased issuances o f private securities thus providing alternative investments to government debt.

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105. through, inter alia, an FSAP update to be initiated in October 2004 and concluded with an issued report in early 2005 w i l l provide an additional opportunity for the Bank to review the implementation successes or shortfalls of the Programmatic Operation. In addition to th is program’s financial support for the implementation of policy reforms, the Bank wi l l maintain an active engagement through non lending technical assistance, special purpose grants (e.g.: FIRST fund) and other means, to ensure the operationalization o f the reforms including such aspects as the application, when warranted, o f the new bank resolution procedures and the dissemination of other evolving elements of the program (such as access to finance) and on lessons and successful applications in other countries.

Bank Role in the Medium Term Program. A planned ongoing policy dialogue

106. As follow up to this loan’s project preparation efforts with respect to state-of-the- art norms on consolidated financial group accounting and supervision norms, non-lending technical assistance wi l l continue, in order to test implementation o f the identification o f related party r isks and prevention of the duplication o f capital within financial conglomerates. While the program’s second phase developed comprehensive regulations for this purpose, given the need for review by the industry and other regulatory agencies involved in the corporate sector, the Bank w i l l continue follow up under the FSAP update on the progress in implementing these norms.

107. underway to provide technical assistance on global comparisons in this sector, and w i l l monitor the application of new housing finance market instruments in Colombia as well as the actuarial sustainability of risk hedging and loss insurance mechanisms to protect against market risks, while pushing the policy envelope to develop potential alternative indexation options for housing loan pricing. The insurance sector i s expected to receive ongoing policy advice on the quantification of underwriting risks including catastrophic r isks in the industry and the related establishment of solvency margins for comprehensive risks.

With respect to the housing finance area, initiatives by the Bank are already

108. For the capital markets sector, the Bank has a vested interest in the unrolling and full implementation of this reform and its resultant impact in this market. Through existing special purpose grant facilities, the Bank i s already providing follow up support for the implementation of sound market monitoring mechanisms, development of the mutual funds industry and implementation of capital adequacy norms for market players. Additional advice i s anticipated with respect to the application of state-of-the-art securities settlement systems and associated operating norms - with inputs and lessons garnered from the Western Hemisphere Payments Systems Initiative co-managed by the Bank. With respect to the government debt securities markets, the Bank, through the Treasurer’s Vice Presidency has recently agreed to a follow-up advisory program on institutionalizing a structured debt management and risk monitoring strategy which w i l l help support, inter alia, the continued efforts for a fiscally sustainable debt issuance program on the shorter segments of the yield curve and the establishment of a zero risk market pricing benchmark.

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B. Program Conditionality

Prior Actions for Board Presentation and Outcomes of the Second Loan

109. phase, particularly after the enactment on Law 795/2003, and i s based on supporting tangible implementation and enforcement actions. In particular with respect to the banking sector, prior actions center around the implementation of Law 795 through the issuance of the necessary regulations and implementation of concrete institutionally sustainable reforms. The upgrading o f the securities market legal and regulatory framework w i l l be the key legislative reform accomplished through the presentation to the Congress o f a new Securities Law, and the subsequent enactment o f regulations for implementing it.

The second part of the Program builds upon the reforms enacted during the first

110. available once the Government has: (i) continued to maintain a sound macroeconomic framework and meet its agreed program targets, (ii) confirmed that all legislative and related regulations under the f i rst operation remain in force, and (iii) carried out all the specified regulatory, institutional reform, market enhancement measures, and implementation actions. All prior actions have been completed at present. The full set of such actions, specified as legal conditions in the loan agreement, are listed in Annex 1 (Policy Matrix, fourth column in italics).

Prior to Board Presentation of the Second Loan. The Second Loan w i l l be made

1 1 1. Following the FSAP which i s expected to take place after the disbursement o f this loan, the Bank’s post-FSAP follow up work w i l l continue the monitoring, non lending technical assistance efforts, policy dialogue, and possible new project preparation to ensure sustainability of the reforms.

Expected Outcomes, Implementation Benchmarks and Results Monitoring.

112. In this context, implementation results to be monitored include banking balance sheet strengthening using measurements of solvency ratios, returns on assets, returns on equity, portfolio quality, and other indicators, under a regulatory environment demonstrating the application of tighter prudential norms. This w i l l be coupled with process results including evidence that the SB has taken action on conflict-of-interest and related party exposure regulatory breaches, and the application of sanctions and corrective actions demonstrating the reductions of such r isks and desisting o f such practices through the effective application o f dissuasive actions such as the application of fines. The Government through the SB has already instituted a system for tracking regulatory breaches by financial institutions so as to document and assure consistent application of the new sanctions and penalties regime. To address the potential capacity constraints in the SB’s implementation of the new SARC risk-model based approach to banking, a time line including human resource requirements to review bank draft models, wi l l take into account realistic analysis time and thus adjust the implementation program to such administrative parameters.

113. In the event o f future bank weaknesses, requiring resolution, the full application of new asset transfer procedures using securitization mechanisms and trust instruments w i l l be evaluated to determine how the least cost option involving, alternatively, paying or transferring depositor funds to new banks, has been carried out. At the same time, verification that coverage of the smallest depositors i s assured either through cash

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payments or transfers to other banks as part o f asset carve out procedures, wi l l be monitored. In parallel, the divestment o f state banks and/or sale o f assets w i l l be reported in terms of proceeds received by the Government and levels o f reduction in contingent liabilities, including obligations to depositors o f those institutions. The Government through FOGAFIN wil l be monitoring this process as i t s proceeds to pro-actively change strategies in the event that initial institutional sales do not materialize and alternative approaches such as asset sales need to be considered to achieve the same objective. In the case o f outright liquidations, implementation benchmarks wil l also include the recorded reduction in time for the foreclosure o f collateral assets (e.g.: real estate) underlying the loan portfolios being liquidated.

114. In the housing area, a key results indicator w i l l be the rate o f increase in the provision and demand for micro credit as well as the related increase in home ownership, particularly in the lower income segments o f the population. T o supplement information provided b y the formal financial sector, the Government w i l l also count on NGOs such as employer savings funds and cooperatives to report on increases in micro housing borrowing. As part o f the enabling environment in the mortgage market for increased funding to this sector, evidence o f increased liquidity and trading o f mortgage bonds w i l l provide turnover in the mortgage banking sector, which should allow new lending to take place. Similarly, the continued implementation o f new and alternative interest ratehnflation hedges as well as possible new loan indexing approaches, should begin reducing the market r isks inherent in the mortgage business and increase participation in that market. The continued implementation and subscription by banks to the new interest rate option instrument developed by the BRC would be evidence o f the success o f this hedge mechanism against interest rate increases. The taking up o f this product by the private sector would constitute a full market acceptance and internalization of the approach.

115. Under the insurance sector, the application o f stricter underwriting, capital and solvency norms including provisions for market and operational risks, should result in consolidation o f the industry towards fewer and more solid players with the incidence o f “fronting”” operations reduced and eventually eliminated. The Government w i l l supplement the analytical capacity o f the Insurance arm o f the SB by hiring private sector insurance experts and actuaries to test viability and realism of the new solvency and reserving norms. In the other non-bank sectors, a similar consolidation and standardization of operating norms with respect to investment management by industry players such as mutual funds, trusts and pension funds, should occur, given the increased competition that would be promoted within a framework of equivalent regulatory norms and standardized reporting on investment risks and returns.

116. The reform o f the capital markets regulatory framework wi l l set in motion significant cultural changes in the operation and transparency o f that market. With new investor protection safeguards, a focus on avoiding systemic market r isks, more cost effective and efficient technology mechanisms for trading, and more uni form asset valuation methodologies; increased issuance activity and secondary market trading

” Fronting operations refer to insurance companies which cede al l o f their underwriting risks to reinsurance companies. Hence they operate with little or no capital and rely on reinsurance protection for a premium. Such operations are discouraged since they can be established with little or no capital and they serve mainly to capture clientele for the benefit o f the reinsurance business which usually has no local presence.

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should constitute a major outcome which would increase the source o f investment funding for the real sector. This would l ikely be more evident in the medium term and beyond. The Government through the SV wil l particularly focus i t s program monitoring efforts on (i) due diligence and accuracy in disclosure, (ii) qualification o f market participants and new entrants, and (iii) detection o f conflict o f interest transactions. The Government’s plan to merge the SV with the SB may also generate synergies in providing additional monitoring and evaluation tools to detect irregularities in the securities sector.

117. Complementing the capital markets, the continued “filling in” o f the short term segments o f the yield curve through the organized issuance o f government securities o f significant volume while managing debt exposure, would establish a market benchmark evidenced by the increased issuance o f private sector securities whose pricing would be referenced to the government debt benchmark. The Government’s Public Credit and Treasury Directorate w i l l also carefully monitor the performance o f market makers, Le., private banks tasked with developing the secondary government securities market. This, coupled with the application o f fixed income securities valuation rules, should provide incentives to price such assets in a transparent manner and thus promote trading without previous uncertainties regarding market arbitrage or lack o f a collective price quotation mechanism. The implementation o f the Government’s Debt Management Committee w i l l also help to balance the market requirements wi th the fiscal sustainability issues implied by the generation o f government debt instruments, and provide additional oversight to foresee and prevent any potential market risks.

C. Disbursement and Auditing.

118. Procedures for disbursements w i l l fol low the simplified norms for Structural Adjustment and Sector Adjustment Loans. The Government wi l l utilize an account in the BRC for this purpose. After the Bank formally notifies the Government that a tranche i s available for disbursement, the Government may submit a withdrawal application so that the proceeds o f the tranche are deposited by the Bank, in accordance with the Loan Agreement. For the purposes o f loan disbursements and audits, the Government wi l l specify the deposit account prior to furnishing the Bank with the first request for withdrawal f rom the loan account, and maintain in the BRC, a dollar denominated account. All disbursements f rom the loan account wi l l be deposited by the Bank into the Government’s deposit account operating at the BRC, in a manner s imi lar to a commercial bank account without requiring the use o f intermediary commercial bank accounts. The Government i s committed for the proceeds o f the loan to be used only for eligible expenditures based on the negative l i s t specified for the loan. The Bank wil l reserve the right to request an audit o f the deposit account conducted in accordance with appropriate auditing principles consistently applied, by independent auditors acceptable to the Bank, and any other information concerning the deposit account and the audit.

D. Environmental Aspects

119. The loan has no direct impact on the environment. In terms o f Operational Directive 4.01, i t classified wi th an environmental category of C, and does not require an environmental assessment. Environmental considerations, nevertheless, are implicit in some o f the program’s policies being implemented. For example, in the process of assessing the value o f collateral used in the foreclosure o f loans, the government and the

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private industry, when taking part as creditors or liquidators of bank assets being disssolved or sold, consider as part of the prudential review of such underlying assets, whether they are attached to existing environmental liabilities (e.g.: real property in flood zones, industrial property in sensitive areas) to ensure an adequate market valuation of such assets and liabilities.

E. Social Aspects and Poverty Impact

120. While the loan i s not specifically geared toward poverty reduction initiatives, i t does contain certain social safety nets which would mitigate any losses imposed on lower income sectors, in the event of bank failures, as well as augment access to underserved communities to increase their wealth accumulation through housing market funding mechanisms. The prudent financial management of the deposit insurance fund and the ability of the Government to transfer assets with deposits under the new reforms, w i l l assure the long term sustainability of the deposit insurance system and in particular, i t s ability to protect insured depositors, most of which constitute the smallest deposits of individuals with modest assets. Savings w i l l be encouraged to rise as individuals perceive their savings to be more secure. The reform program also puts in place a number o f mechanisms to reach out to the lower income communities with bank funding instruments at reasonable costs in order for such communities to gain access to micro housing credits and purchase or improve their core homestead wealth. This should also generate increased micro, small and enterprise financing with the requisite collateral backing, thus creating jobs and expanding employment opportunities, including for the poor. The Bank w i l l give priority to monitoring this to ensure the success o f this component o f the program.

F. Benefits and Risks

121. Benefits. This operation, which builds and completes the reforms started in the first phase, w i l l result in a number of benefits aimed at strengthening the capital structure and solvency of the financial system. This w i l l result in more strongly capitalized and competitively diverse financial institutions which w i l l serve to increase private sector domestic investment, contribute to economic productivity, and augment financing to underserved groups to support home construction and improvement. Essentially, the reforms tackle multifaceted risks in the banking, non bank and capital market sectors (credit, market, governance, operational) and put in place measures to mitigate those risks and avoid future financial instability while preventing disruptive regulatory arbitrage among the sectors. The transparency, strengthening and stability measures, which w i l l benefit consumers and investors alike, are implemented with regulatory, supervisory and market mechanisms.

122. promoting a solid foundation for future sustainability, w i l l also have the reputational benefits of attracting foreign investment to a sector which should be seen as well managed with high standards, measured according to international comparators. On the supervision side, the strengthening of analytical tools (credit and market risk models and measurement of overall institutional risks) as well as enforcement mechanisms (structured schedules of sanctions and fines according to levels o f infractions) w i l l provide increased autonomy and direction to the supervisory agencies in order to assess and take early action against emerging r isks in the financial system. In this regard, the

On the regulatory side, the upgrading o f norms for the financial industry, besides

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operation also promotes policies which have an institutional strengthening impact and a knowledge impact in terms of advanced techniques to increase the quality o f supervision. In terms o f operational improvement, the new framework for the capital markets modernizes and provides more legal certainty to many infrastructure and liquidity making aspects o f securities trading.

123. Benefits in terms o f increasing access to credit in the micro housing sector have already been discussed and constitute a key socially oriented element o f the program. Other benefits include the implied results from harmonizing the regulations and capital requirements across the banking, mutual funds and non-bank (insurance, pensions) industries wi th respect to asset risk and valuation, as well as overall solvency standards. These reforms w i l l add much transparency to the investment risks and associated costs o f each financial services provider, and permit a better assessment o f investment choices and opportunities by the common investor. The result w i l l also be an improvement in capital market dynamics and greater incentives for competitiveness and cost reduction.

124. rationalization o f the State’s involvement in the financial system and the reduction o f contingent liabilities through the divestment and/or asset sale o f most remaining public financial institutions. The potential for future State involvement wi l l also be minimized through the application o f the new resolution framework in conjunction with deposit insurance support, so as to maximize the transfer o f balance sheets within the banking system while minimizing new future fiscal outlays during such instances.

A key benefit based on the legacy o f past financial crises w i l l be the

125. Risks. The key risks which could impact on the success o f the reform program pertain to the effect of an unexpected economic and fiscal downturn, legislative risk, the r isk o f an increase in guerrilla activity, and the risk of institutional fol low through and monitoring o f the reforms. The macroeconomic risk i s not trivial and could have several adverse implications particularly for the banking system where certain segments such as the mortgage lenders are s t i l l not ‘out o f the woods’ in terms o f long term financial sustainability. While the program has helped mitigate some of these institutions’ risks through the implementation o f appropriate interest rate and inflation hedging instruments, these cannot fully protect against an already existing stock o f non performing loans which are slowly recovering. A major reduction in economic growth could exacerbate these problems and generate additional instability in that sector which would be severely disruptive and possibly lead to systemic contagion if not managed immediately with the new bank resolution tools. A downturn scenario would also l ikely discourage much o f the financial services development and growth promoted by the reforms, such as in the securities, mutual funds and insurance markets.

126. Related to the macroeconomic risk would be a deterioration in the Government’s fiscal position. This might require additional domestic indebtedness by the Government with a large investor contingent being the commercial banking sector. An added accumulation o f government debt on banks’ balance sheets would imply a large stock o f bank assets in government securities which could signify a dif f icult to reverse concentration risk. The reform program to a modest extent mitigates some of this risk with the increased volume o f short term debt issuance where non bank investors such as mutual funds constitute a large clientele, as wel l as the formal establishment o f a debt management policy making committee which i s charged with overseeing the inherent r isks and sustainability o f the overall government debt program.

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127. Another potential risk i s the legislative process and uncertainty in the full implementation of the Securities Law. While this i s always a risk with regard to legislative initiatives, and could become more significant in terms of delays if the Government effort to modify the Constitution’s election term clause becomes too drawn out, this i s mitigated by the fact that the Government undertook extensive consultation with the financial industry to seek pre-agreement on the provisions in the draft law, before submitting i t to the Congress for approval. Therefore, opposition generated from potential industry lobbying efforts i s not seen as highly likely. In addition, the Bank has planned ongoing policy dialogue with the Government through mechanisms such as a FIRST Grant program, Analytical/Advisory work, and other interventions which relate to capital markets reforms, thus allowing follow up on the implementation of the law. Simultaneously, the Bank continues to work with the Government on the issuance of new regulations to ensure transparency in reporting on securities investment funds and other securities market disclosure issues, thus permitting the reform to be implemented and move forward in parallel with the the legislative front. Such work would expect to be accelerated in the event that the approval o f the securities law suffered unanticipated delays.

128. The risk of an increase in guerilla activity would likely have similar effects as the risk of economic downturn given this activity’s effect in reducing private investment and confidence in the economy. While the current Government’s policies would seem to render this less likely, this could always change due to factors not solely under Government control, a change in current policy, or a different Administration. This risk, therefore represents a conditional medium-term uncertainty.

129. reforms i s a risk factor in all sectoral adjustment reform programs, especially when legislation i s particularly complex and implementation actions are slow in crystallizing. Under the program, however, the Colombian Government has already demonstrated positive results through the regulatory operationalization o f the legislative changes to the banking law, the modest yet steady progress in the divestment of public banking institutions and the faster than expected harmonization o f regulatory norms in the capital market funds industries. In addition, as Colombia has demonstrated regional leadership in the official development o f latest risk management tools and supervisory procedures to be applied to the financial industry, i t i s deemed unlikely given this context o f technical expertise and institutional advancement, that the reforms would not be followed through and applied as projected.

Finally, the risk o f lack o f institutional follow through and enforcement of the

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I S c

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Letter of Development Policy for the Financial Sector

Bogotfi, August 18, 2004

Mr. James D. Wolfensohn President World Bank Washington, D.C.

Dear Mr. Wolfensohn,

The Colombian Government i s continuing to pursue policies to promote the country's recovery and economic growth, within the framework o f structural reforms anchored in fiscal discipline.

One aspect of these policies concems the financial sector and the ongoing commitment to stabilize and strengthen it. The support o f the World Bank, through the sectoral programs fo;r the development o f the financial, has been important in promoting the development o f the financial sector through stronger regulation, supervision and resolution mechanisms for institutions, creation o f new mechanisms for housing finance and support for development o f the securities market and the public debt market.

In this context we can state that, starting in 2002, the financial sector has recovered significantly compared with the difficult situation at the end o f the 1990s and now the various institutions that make up the financial sector have lower levels o f non performing loans, less capital exposure and better profitability indicators. In addition, the recovery o f the financial sector has helped to revive other sectors o f the economy, since the financial sector channels resources to the real sector and i s the core o f the payments system.

These actions are, in turn, supporting other structural reforms to which the Government attaches priority and which are ultimately aimed at creating a citizens' State. We know that many of these activities require considerable efforts on the part o f the Government, if the objectives are to be achieved, and that such efforts are justified because the quest for greater opportunities for all Colombians i s the guarantee o f a healthy economy.

With the aim of continuing to promote the strengthening o f the financial system and the development of the capital market, the National Govemment requested assistance and guidance from the World Bank for a second phase o f the adjustment program for the financial sector on which the Govemment i s working, and it i s grateful for the ongoing guidance and financial support from the World Bank and for the prompt consideration by the Board o f this new Programmatic Financial Sector Adjustment Loan.

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The Government of course stands ready to work with the Bank's technical teams to draw up future lending programs, as the reforms are consolidated and further action i s required in this sector.

Sincerely,

I original signed I

ALBERT0 CARRASQUILLA Minister o f Finance and Public Credit

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REPUBLIC OF COLOMBIA

MINISTRY OF FINANCE AND PUBLIC CREDIT

NATIONAL PLANNING DEPARTMENT

LETTER OF DEVELOPMENT POLICY FOR THE FINANCIAL SECTOR

BogotB, August 18,2004

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I. MACROECONOMIC SITUATION

CONTEXT

1. After experiencing a difficult period of recession in 1998-1999, the Colombian economy has been recovering rapidly, as witnessed by the higher GDP growth rate and the momentum in the private sector.

2. T h i s process was assisted by the considerable success achieved in the fiscal area. This resulted in an improvement o f financing terms and restored investor confidence.

MACROECONOMIC PERFORMANCE AND PROSPECTS

3. During 2003, economic growth accelerated to 3.95 percent, compared with 1.6 percent in 2002. This growth i s more consistent with the potential o f the economy in the long term.

4. T h i s level o f growth was fostered to a large extent by the momentum in the private sector. Private spending increased at a real rate of 5.83 percent, while investment and spending grew by 19.38 percent and 2.05 percent respectively in real terms. The upsurge in domestic investment and the favorable external circumstances benefited all sectors o f the economy, also promoting employment and thus reducing the unemployment rate (currently 14.8 percent). The investment momentum and unemployment reduction led to an increase in productive capacity.

5. The growth spurt did not exert excessive pressure either on the goods market or on external financing. In the case of the goods market, inflation was 6.5 percent (0.5 percent less than in 2002) and, as far as external financing i s concerned, the current account deficit was 1.8 percent o f GDP (the same as in the preceding year). This indicates that the recovery process can continue in a sustainable manner.

6. The fiscal deficit dropped from 3.7 percent of GDP in 2002 to 2.7 percent o f GDP in 2003 - in other words, a reduction o f one percentage point from one year to the next. These fiscal deficit improvements were the result o f the great effort made by al l public sector bodies and primarily the Central Government, which reduced i ts deficit by 0.7 percent. The fiscal adjustment made resulted in an increase in government revenue o f 6 percent in real terms, while spending over which the Government has more discretionary authority was reduced. For example, spending on personnel expenses and overheads grew by only 0.6 percent and 2.5 percent in real terms respectively, which was much less than the growth in revenue and GDP.

7. The positive results achieved by the fiscal policy adopted played a very important role in the improvement of macroeconomic equilibrium and the attainment o f fiscal goals. It was thus possible to honor the agreement with the IMF to reduce the consolidated public sector deficit to 2.7 percent o f GDP. The GDP growth, the dynamics o f the public sector primary balance and the positive interest rates resulting from the f irst two factors reduced net total debt from 54.6 percent in 2002 to 52.5 percent in 2003.

8. The results obtained so far in 2004 show that the favorable fiscal trends and economic advances are being maintained. In the f i rs t quarter, the economy grew by 4.1 percent and it i s expected that this trend wi l l continue, with growth of 4 percent by the end o f the year. I t i s also expected that inflation wi l l continue to drop, descending to 5.5 percent.

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9. Colombia's external position remains solid: the current account result i s being maintained and international reserves reached US$11,587.8 million.

10. The fiscal deficit target agreed with the IMF for the f i rst quarter of the year (0.5 percent) was achieved. The Combined Public Sector deficit was 0.3 percent o f GDP. This result reflects the ongoing adjustment policy o f the Central Govemment and the improvement in the decentralized public sector.

11. The 2004 fiscal deficit target o f 2.5 percent o f GDP may be revised upwards by 0.3 percent of GDP, if government spending on priority investments i s included. Such spending i s conditional on resources being procured from the disposition of public assets during the year, since these proceeds wi l l be used to finance additional investment.

12. For 2005, it i s planned to continue the public finance adjustment policy, keeping the fiscal deficit at 2.4 percent of GDP. However, the multi-year asset sale program wi l l continue and i s expected to finance additional investment totaling up to 0.5 percent of GDP. As in 2004, this investment i s contingent on obtaining resources from asset disposition.

STRUCTURAL REFORMS

13. The Government's program continues to be geared to guaranteeing fiscal sustainability and ultimately restoring security, stimulating economic growth and increasing social equity. The measures needed to achieve these objectives are therefore being pursued in an environment o f macroeconomic stability, supported by prudent monetary policies and strengthening o f the financial system. At the same time, social welfare programs are being strengthened, education and health coverage i s being extended and the impact o f public utilities rate increases on the poorest population groups i s being mitigated.

14. The Govemment i s thus aware o f the urgent need to press ahead with the plan o f structural reforms, designed to give continuity to the policy o f gradual fiscal adjustment and to guarantee the primary surpluses to make debt sustainable in the long term.

15. In this context, the legislative agenda i s s t i l l focused on the main fiscal risk, which i s closely related to the topic o f pensions. The activities to achieve this control are designed to:

J Generate income to cover pressures on pensions in the near future. With this objective, tax reform i s being promoted to increase income.

J Limit spending pressures. In this context, i t i s planned to introduce changes in the pension system to avoid future fiscal pressures.

STAND-BY ARRANGEMENT WITH THE INTERNATIONAL MONETARY FUND

16. In the context o f i t s macroeconomic policy, the Colombian Government signed a Stand-By Arrangement (SBA) with the IMF in January 2003, with the primary aim o f reducing the fiscal deficit. So far, the IMF has completed the third review o f the program and has noted that the specified performance criteria have been met. For 2004, the Government plans to maintain the impetus o f the economic reforms, which are designed to support 4 percent GDP growth, while the inflation target has been set at 5.5 percent. In addition, i t i s projected that the balance-of- payments current account deficit w i l l be 2.2 percent o f GDP and that net intemational reserves w i l l increase by US$700 million.

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11. THE FINANCIAL SECTOR SUPPORT PROGRAM

CONTEXT

17. Starting in 2002, the financial sector made a significant recovery from the difficult situation prevailing at the end of the 1990s. For example, during 2003 credit institutions continued to increase their loan portfolios, as they had been doing since 1nid-2002~; profitability levels were similar to those prior to the 1998-99 crisis; solvency remained at adequate levels; and in general the risks inherent in banking declined. This positive trend has intensified so far in 2004, showing that the system i s in a situation of stability.

18. However, efforts are s t i l l needed to consolidate the results obtained to date. Accordingly, in order to consolidate this performance and achieve greater asset and portfolio growth, the Government i s continuing to promote activities designed to achieve these objectives.

PROGRAM OBJECTIVES

19. The objective of the Second Phase o f the Financial Sector Adjustment Program i s to assist the Government o f Colombia in the financial sector adjustment process. Despite the sector's significant recovery of i ts health and sustainability, efforts are s t i l l needed to consolidate the results obtained so far. I t w i l l also be necessary to continue developing instruments designed to adapt Colombian financial legislation to market requirements and international standards, while taking into account the reality and special features of Colombia. The Government also remains committed to achieving appropriate integration of the intermediating banking sector and the securities market, in order to guarantee financial market stability.

20. In order to achieve this objective, the Government has initiated action in the areas of strengthening o f regulation, supervision and resolution procedures for institutions, creation o f mechanisms for financing housing programs and support for the development o f the securities market, the public debt market and the non-banking sector, the latter being related to the insurance industry, pensions and trusts. We are confident that these series o f reforms w i l l make it possible to consolidate the financial sector and to adapt regulations to international standards.

PROGRAM COMPONENTS

Imulementation o f the Financial Reform Law and effective banking resolution

21. The issuance o f enabling regulations for the implementation o f Law No. 795 o f January 14, 2003, sponsored by the National Government, w i l l enforce many of the Law's provisions. T h i s Law introduced important changes to modernize and strengthen the financial system, as well as a series of measures to make the rules more flexible and introduce new instruments to foster public confidence in financial institutions.

22. An important element o f Law No. 795 was the creation o f mechanisms for solving structural problems o f financial institutions and facilitating the voluntary exit of such institutions from the market, eliminating the risk o f contagion and strengthening confidence in the system. One such mechanism i s the carve-out o f assets and liabilities as a prerequisite for or consequence o f a take- over. This allows the rapid transfer of deposits from a troubled institution to other financial

' This trend was seen in all types of credit with the exception o f housing loans.

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institutions and of assets to a trust vehicle. The Government recently issued regulations to implement this mechanism, establishing general guidelines.

23. In addition, Law No. 795 of 2003 entrusted to the Deposit Insurance Agency (FOGAFIN) the responsibility for monitoring liquidators o f both public and private financial institutions, regardless o f the type o f liquidation arrangement involved. Accordingly and in the performance o f this duty, FOGAFIN concluded the liquidation process o f the ING Baring Financial Corporation and the Sociedad Administradora de Fondos de Pensiones y Cesantias Invertir S.A.

24. In addition, regulations have been issued for the take-over o f financial institutions and changes have been introduced in the regime governing the process o f forced administrative liquidation. With regard to take-overs, the regulations sought to clarify the effects o f that measure and to establish which take-overs are compulsory and which are optional, in order to facilitate fulfil lment o f the social objective o f the institution taken over and i t s reactivation. In addition, the regulations specified the powers o f the special agent appointed to conduct the take- over and the manner in which he can be assisted by an advisory board, whose membership and functions were described.

25. With regard to the arrangements applicable to the process o f forced liquidation, the main changes are designed to provide, firstly, tools to permit rapid and effective conversion o f the assets under liquidation, bearing in mind that they are the source o f funds to pay claims and, secondly, mechanisms for concluding liquidations as quickly as possible, through agreements with creditors and contracts for administration or compulsory tendering for assets, following clear and explicit rules.

26. The rationalization o f State institutions, including those in the financial sector, has also been promoted under the Public Administration Reform Program, encouraging the creation and consolidation o f an efficient State, which requires strict management o f the use of public resources in the service o f the citizens. Underlying this policy i s the divestment o f shares held in various public and private economic entities, keeping only those entities needed in order for the State to perform i t s social function.

27. In pursuance o f this policy o f rationalization o f public banking, the following measures were adopted:

J Industrial Development Institute (IFI): Under the public banking policy, the National Government ordered the liquidation o f IFI. At the same time, it transferred viable assets and liabilities to Bancoldex. In addition, through the Ministry o f Finance and Public Credit, the Nation took over foreign currency liabilities.

J Bancafk: FOGAFIN embarked on the strategy o f private capital involvement, opening a bidding process in October 2003, which consisted of two successive and independent stages.

The f i rs t stage involved capitalization o f the Bank by an investor or group o f investors, which would enable FOGAFIN to dismantle the guarantee capital provided to the institution, without endangering i t s financial standing. The second stage allowed the disposition o f FOGAFIN shares to Bancafk, under the procedure established for the purpose by Law No. 226 o f 1995 and other

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applicable rules, following adoption of the disposition program by the National Government.

During the capitalization process, three potential investors were identified as meeting the requirements established in the Regulations on Private Capital Involvement. The bidding process was held on February 18,2004 but no bids were submitted.

In this connection, it i s impossible to know precisely why no capitalization proposals were submitted. Possible causes identified are the institution's labor costs, the size o f the Bank and i t s large network of branches. In view o f this, it i s planned to close approximately fifty branches in the second half o f 2004, on the basis o f criteria of profitability, portfolio quality and commercial potential. In addition, between January and May 2004, the staffing level was reduced by approximately 218 persons, representing a cut of over 5 percent.

J Reduction o f State participation in public t rust companies: In the third quarter o f 2003, the merger of Fiduciaria de Desarrollo Agropecuario S .A. (Fiduagraria S.A.) and Fiduciaria Industrial S.A. (Fiduifi) was completed. On November 1, 2003, the public document on the absorption o f Fiduifi by Fiduagraria S.A. (by dissolution without liquidation) was executed.

The shares o f Fiduciaria FES S.A. owned by Fogafin were then offered for sale in mid-2003 in two stages: f i rs t to persons covered by article 3 of Law No. 226 of 1995 and then to the general public through an auction. The shares were not allocated at either o f the two stages, since there were no interested buyers. Fogafin i s studying other alternatives for disposing o f the shares.

J Banco Granahorrar: With support from Grant No. TF052531, a study has now been commissioned to review Banco Granahorrar in order to identify its needs and prospects in the event that i t were to be sold as a going concern. The conclusions o f this study w i l l be the basis for the bank sale strategy in the f i rst half o f 2005.

Strengthening of banking supervision

28. With regard to the focus o f banking supervision, Colombia's Superintendency o f Banks (SBC) i s making progress in establishing a risk management system for the universe o f supervised entities, Le. credit institutions, pension management firms, insurance companies, t rust companies, exchange banks, etc.

29. Progress has been made both with regard to maintenance and improvement o f a regulatory framework that, while taking into account the special features of the Colombian market and international trends, incorporates the relevant parameters for assessment, monitoring and management o f the sector's main risks, and with regard to gradual improvement o f the relevant supervision practices.

30. In the f i rs t case, the Colombian supervisor endorses the basic premises o f Base1 11. The SBC understands that measurement o f the risks in assets, liabilities and contingencies o f financial institutions i s a prerequisite for their business management and that constituting financial capital (i.e. capital consistent with such risks) represents an essential safeguard to preserve the sector's

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stability. Similarly, the supervisory authority i s very much aware o f the stricter technical requirements for supervision and of the institutional empowerment needed if supervised institutions are to be required to make timely and sufficient corrections to those situations in which financial capital tends to be inadequate to meet their exposures.

3 1. Because o f the special features o f the Colombian financial system, the natural considerations concerning the competitive conditions of local financial groups, the characteristics o f the regulatory framework governing risk management and the recognition o f institutional shortcomings with respect to some o f the basic principles o f effective banking supervision, it i s clear that the Basel I1 proposal must be carefully evaluated in the light of the other priorities for regulation and prudential supervision in Colombia.

32. The main way in which domestic prudential regulation i s developing along the lines o f Basel I1 relates to the introduction o f technical criteria for credit risk assessment and, on this basis, the design and implementation o f a system to manage such risk by the supervised institutions. However, there are no plans in the short term to translate changes in the value o f such r isks directly into changes in available capital (financial capital) in the same direction; credit r isks wi l l be covered by provisioning, reflected in changes in the solvency ratio. Preliminary estimates made by SBC indicate that implementation o f Pillar I in the Colombian financial system would mean increasing the current solvency ratio by a factor ranging from 1.3 to 10.3, depending on the portfolio rating (AA, A, BB, B and C) and on the confidence levels used in the estimate.

33. The Colombian authorities have decided to postpone the operational r i sk measures until further progress i s made in the drafting o f new guidelines for credit r i sk assessment and management.

34. Although they correspond only partially to Pillar I o f Basel 11, the changes in the Colombian regulatory framework are moving in that direction.

35. With regard to Pillar 111, i t i s noteworthy that the Colombian financial system produces and disseminates, via various media including the Web sites o f the supervisor and o f the main trade associations in the sector, regular and timely information on the main financial statements and indicators o f industry performance. I t i s planned to make the additional information derived from the new system o f credit risk management an integral part o f this reporting. However, the disclosure o f adequate and high-quality information, while necessary, i s not the only prerequisite for market discipline. The ability o f financial players - depositors and sector clients - to choose institutions on the basis o f quality does not apply to most users o f the Colombian financial system, partly because small depositors or users o f the payments system cannot be expected to make the same analysis and display the same behavior as professional investors.

36. Accordingly, the responsibility o f the supervisor assumes greater importance in terms o f protection of the system's clients and, of course, preservation o f the sector's stability. Implementation of Pillar 11, concerning the supervisor's ability to evaluate the suitability o f credit risk assessments and their management by financial institutions and to require a synchronized ratio of r isks to capital (in our case, portfolio provisions), represents a major challenge for the Colombian supervisor, given the limited training o f supervisory staff and the administrative and budgetary restrictions on human resources management.

37. With these provisos, SBC i s continuing efforts to train i t s staff in the areas needed for risk- based supervision. In addition, the supervision handbook of the Credit Risk Management System and rules for the evaluation o f risk forecasting models are being drafted; these tools w i l l facilitate

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the supervision performed by the institution. At the same time, SBC i s implementing a Guide to unify i t s sanctions policy in this area.

38. The supervision o f financial risks in economies with financial groups naturally involves the development o f specific agendas for comprehensive and consolidated supervision. T h i s approach not only involves the construction and adjustment o f mappings and matrices between shareholders and institutions as regards to assets, but also requires the consolidation o f their main financial statements, construction of aggregated indicators for financial analysis and assessment and aggregation o f the various risks concerned (solvency, market risks, liquidity risks, etc.). SBC has worked on the adjustment of regulatory parameters for these purposes and plans to form groups o f supervisors specializing in the subject, depending on availability o f resources.

Housing finance

39. In the area o f housing and housing finance, new mechanisms have been designed to counteract factors affecting demand for credit and the risk incurred by credit institutions. This was done within the framework of Law No. 546 of 1999, which introduced adjustments representing a far-reaching change in the housing finance structure and required reorganization o f the sector and i t s regulations.

40. One o f these adjustments concerns inflation hedging, introduced as a mechanism to enable homeowners to make future mortgage payments and the financial sector to accelerate the disbursement o f loans for housing finance in conditions o f security and manageable risk. At the end of May 2004, 14,058 o f the 40,000 mortgage holders identified under this program had the coverage, with disbursed loans amounting to COP$35 1,485.6 million.

41. In addition, work has continued on revision o f the operating procedures o f the Mortgage Stabilization Fund (FRECH), which was created to cover the risk to mortgage lending institutions caused by the discrepancy between the interest rate and inflation. In this connection, a study was made to determine the suitability of the mechanism for the needs o f the players concerned, in an attempt to guarantee the stability o f the mortgage financial sector in the light o f the existing volatility in their sources of funding. On the basis o f this study, the Government enacted a decree providing for a new procedure based on the use o f option contracts.

42. In order to promote rural and urban development, the National Government authorized the Municipal Financing Bank (FINDETER) to perform rediscounting operations for the financing o f housing credit or microcredit operations involving the construction, remodeling or purchase o f low-income housing. An important feature o f this type o f credit i s that the loans can be eligible for future portfolio securitization processes, provided that they meet certain uniformity criteria. Supplementing these initiatives, the rules on securitizations have been updated by the issuance o f new rules concerning capital consumption for the various tranches under securitizations and capital rules for proprietary positions o f securitization companies.

43. The National Government concluded an agreement with the financial sector whereby banking establishments and financial cooperatives undertake to place a percentage o f their gross portfolio in new loans andor in purchases o f low-income housing. In addition, in order to cover the r isks stemming from these operations, the National Government i s providing guarantees for these loans through the National Guarantee Fund, thus facilitating access to the resources o f the financial system by low-income segments o f the population.

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Insurance sector development

44. In the insurance sector, at the initiative o f the National Government, Law No. 795 o f 2003 introduced a series of changes in the legal structure governing insurance activity. For example, new regulatory powers were given to the National Government in matters such as technical reserves, adequate capital, investment arrangements, assets required for the operation o f the various types o f insurance and limits on indebtedness of insurance institutions and investment companies. In addition, it was clarified that solvency requirements w i l l be determined on the basis o f the amount o f the premiums or the average loss claims, whichever i s the highest, while the National Government has the power to determine the timing, form, r isks and technical elements o f the factors determining this solvency.

45. In exercise of this power, the Government established maximum rates chargeable for compulsory insurance for bodily harm caused to persons in traffic accidents and the amount o f the contribution to the Solidarity and Guarantee Fund (FOSYGA). Subsequently, a decree was enacted obliging companies authorized to operate in this branch o f insurance to issue policies requested and to have a compensation mechanism to prevent rejections based on vehicle category.

46. These reforms w i l l help to make the sector more solid and competitive. In the medium term, after review of the aspects incorporated in a draft decree concerning the implementation o f solvency rules for the various branches o f the insurance sector, the Government w i l l promulgate the relevant rules. The main aim o f these regulatory adjustments i s to harmonize the regulation and supervision o f the activity o f the institutions supervised by the Superintendency o f Banks, including those in the insurance sector. In this context, rules have also been put into effect requiring investment managers such as insurers, pension management f irms, trusts and mutual funds to report and disclose market r i sks in their portfolios. For the pensions sector, the requirements for investments in foreign securities have been broadened in order to promote the diversification of portfolios managed by these f i rms.

Capital market development

47. One o f the most important aspects o f this goal, to which the National Government has committed itself, i s the need to adapt the regulatory mechanism to new forms o f trading and the new risks involved, since the phenomenon o f market globalization requires market regulation to conform to international practices and trends and since information and communication sk i l ls and new technologies have resulted in a dizzying expansion o f securities markets al l over the world.

48. Accordingly, the Government resumed i t s analysis o f the draft legislation governing the handling, use and investment o f public resources through securities. Following joint efforts by the various institutions involved in the revision o f the draft, a new version was produced that w i l l give the Colombian securities market an appropriate and efficient regulatory framework to provide higher growth levels, alternatives to traditional sources o f corporate financing and, above all, clear guidelines for all market players, with the necessary legal security to win the support o f domestic and foreign investors and the necessary flexibility to permit adjustment to continual market innovations.

49. The above-mentioned draft was submitted for the consideration o f the Honorable Congress of the Republic in compliance with Colombian legal procedures. The Government w i l l give the necessary support to convert the draft into law so that the securities market w i l l have a new institutional framework that i s efficient, complete and appropriate.

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50. The Advisory Committee on Market Price Valuation i s continuing to review and adjust the regulations on this subject in order to achieve standards o f good governance in the unification of valuation methodologies for public debt securities, external public debt, other public securities instruments and private debt securities.

5 1. Capital rules for all collective investment schemes were also harmonized in order to avoid regulatory arbitrage between funds managed by institutions under the supervision o f SBC or the Securities Superintendency (SV). In order to avoid price arbitrage in securities funds, new rules were introduced to ensure that fund prices are adjusted to the value on the transaction date. In addition, reporting i s required on the faithful, uniform and comparable disclosure o f information and o f r isks o f the funds and collective investment schemes managed also by institutions supervised both by SV and by SBC.

Debt market development

52. The National Government's fiscal deficit reduction policy i s also designed to make the public debt sustainable in the long term. In this connection, the Ministry o f Finance, acting through the Office of Public Credit and the National Treasury, has devised a financing strategy supported by development o f the domestic capital market and an active presence both on international capital markets and in the multilateral banking system.

53. In recent years, the financing needs associated with an increase in the consolidated fiscal deficit resulted in a considerable increase in public debt as a percentage o f GDP, which was about 55 percent in 2002. However, fiscal adjustment policies halted this upward trend, reducing the figure to 52 percent in 2003. In this connection, in the medium-term fiscal framework established by the Government, this trend wi l l continue and the figure w i l l be less than 40 percent in 2015.

54. The debt strategy involves diversification o f financing sources and emphasizes the importance o f a solid and deep domestic market to avoid vulnerability to external shocks. In this regard, efforts are continuing to consolidate the domestic public debt market by strengthening the treasury bills market in the short-term segment, which has achieved considerable liquidity and depth.

55. Colombia w i l l maintain i ts presence on international capital markets by issuing bonds and taking syndicated loans. The goal i s also to strengthen relations with multilateral banks, which currently account for almost 20 percent o f the total debt.

56. As a result of this policy, the relative share o f the internal and external debt (currently 52 and 48 percent respectively) w i l l gradually shift so that the internal debt w i l l account for 60 percent and the external debt for 40 percent by 2010.

57. Lastly, the Government plans to continue an active policy o f debt management, conducting operations to improve the debt profile. For this purpose, it created an official Public Debt Committee with strategic responsibilities defined by decree.

111. CONCLUSIONS

58. Many o f the measures and policies described in this document have been developed within the framework of the Second Programmatic Financial Sector Adjustment Loan, to be financed with World Bank resources. Satisfactory progress has been made and economic and social

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conditions are ripe for continuation o f the reforms needed in order to give the intermediated and non-intermediated capital market, stability and clear rules, for the benefit of all market players.

59. Thus the Government i s committed to the program outlined in this document and welcomes the guidance and financial support o f the World Bank in these processes. The Government would be grateful for prompt consideration by the Board o f the new programmatic financial sector adjustment loan and stands ready to work with the Bank's technical teams to draw up future lending programs as the adjustments are consolidated and further action i s required in the financial sector.

/ Next Section - Original Letter Signed (Spanish version) /

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Carta de Politica de Desarrollo para el sector Financiero

Bogota, Agosto 18 de 2004

Seiior James D. Wolfensohn Presidente Banco Mundial Washington, DC

Estimado Seiior Wolfensohn:

El Gobierno colombiano continua desarrollando politicas que permitan la recuperacion y crecimiento economico del pais, en el marco de las reformas estructurales ancladas en la disciplina fiscal.

Uno de 10s aspectos de esta politica, esta relacionada con el sector financiero y el compromiso de continuar promoviendo su estabilidad y fortalecimiento. El apoyo del Banco Mundial a traves de 10s programas sectoriales de Desarrollo del Sistema Financiero ha sido importante para la promocion del desarrollo del sistema financiero a traves del fortalecimiento de la regulacion, supervision y esquemas de resolucion de entidades; a traves de la creacion de nuevos mecanismos para la financiacion de vivienda; y mediante el apoyo al desarrollo del mercado de valores y de deuda publica.

De esta manera, podemos mencionar que a partir del aiio 2002, el sector financiero ha presentado una recuperacion significativa frente a la dificil situacion presentada a finales de la decada del 90 y, hoy por hoy, las distintas entidades que conforman el sector financiero presentan menores niveles de cartera vencida, menor exposicion patrimonial y mejores indicadores de rentabilidad. Ademas, la recuperacion del sector financiero ha contribuido a la reactivacion de 10s diversos sectores de la economia por cuanto el sector financiero es canalizador de recursos hacia el sector productivo y eje del sistema de pagos

Estas acciones van en la direccion de apoyar otras reformas estructurales prioritarias para el Gobierno y cuyo fin ultimo es la construccion de un Estado Comunitario. Sabemos que la implementacion de muchas de estas acciones implica esfuerzos importantes por parte del Gobierno para el logro de sus objetivos que se justifican en la medida en que la busqueda de mejores oportunidades para todos 10s colombianos es la garantia de una economia sana.

Con el proposito de continuar promoviendo el fortalecimiento del sistema financiero y el desarrollo del mercado de capitales, el Gobierno Nacional solicit6 al Banco Mundial la estructuracion y el acompaiamiento para el desarrollo de una segunda fase del programa de ajuste para el sector financiero, en el cual el Gobierno esta trabajando y agradece el permanente acompaiamiento y apoyo financiero del Banco Mundial y la pronta consideracion por parte del Directorio del Banco de este Nuevo Credit0 Programatico de Ajuste al Sector Financiero.

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Sobra anotar que el Gobierno esta a disposicion de 10s equipos tecnicos del Banco para definir conjuntamente programas futuros de credit0 en la medida en que se consoliden 10s ajustes y se requieran nuevas acciones en este sector.

Cordialmente,

ivlinistro de Hacienda y Credit0 Publico

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REPUBLICA DE COLOMBIA

MlNlSTERlO DE HACIENDA Y CREDIT0 PUBLICO DEPARTAMENTO NACIONAL DE PLANEACION

CARTA DE POLlTlCA DE DESARROLLO PARA EL SECTOR FINANCIER0

Bogota, 18 de agosto de 2004.

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1. SITUACION MACROECON~MICA

CONTEXT0

1. Luego de atravesar un duro period0 de recesion en 10s aAos 1998-1 999, la economia colombiana ha venido experimentando un acelerado proceso de recuperacion que se refleja en el incremento de la tasa de crecimiento del producto interno bruto y en la dinamica del sector privado.

2. Este proceso ha estado retroalimentado por 10s importantes logros obtenidos en materia fiscal. Lo que ha redundado en el mejoramiento de las condiciones financieras y ha devuelto la confianza a 10s inversionistas.

DESEMPENO MACROECONOMIC0 Y PERSPECTIVAS

3. Durante el 2003 se presento una aceleracion en el crecimiento de la economia que paso de 1.6% en el 2002 a 3.95% en el 2003. Dicho crecimiento es mas consistente con el potencial de la economia en el largo plazo.

4. Este nivel de crecimiento estuvo jalonado en gran parte por la dinamica del sector privado. El gasto privado crecio a una tasa de 5.83% real, mientras que la inversion y el gasto crecieron 19.38% y 2.05% en terminos reales respectivamente. La creciente actividad que presento la inversion domestica y la buena coyuntura externa beneficiaron a todos 10s sectores de la economia, favoreciendo tambien la dinamica del empleo y por ende la reduccion de la tasa de desempleo que ya se ubica en el 14.8%. La dinamica de la inversion y la reduccion del desempleo influyeron en un aumento de la capacidad productiva.

5. La aceleracion en el crecimiento no ha representado presiones excesivas ni en el mercado de bienes ni en el financiamiento externo. En el cas0 del mercado de bienes la inflacion se ubico en 6.5% reduciendose 0.5% frente a12002 y por el lado del financiamiento externo el deficit de la cuenta corriente se ubico en 1.8% del PIB manteniendo el mismo nivel del aAo anterior. Estos factores hacen prever que el proceso de reactivacion puede continuar de manera sostenible.

6. El deficit fiscal paso de 3.7% del PIB en el 2002 a 2.7% del PIB en el 2003, es decir, que se redujo en un punto porcentual de un aAo a otro. Estos resultados en materia de deficit fiscal han sido producto del gran esfuerzo realizado por todos 10s entes del sector publico dentro de 10s cuales se destaca el Gobierno Nacional, el cual redujo su deficit en 0.7%. El ajuste fiscal implementado, logro que el Gobierno aumentara sus ingresos en 6 puntos reales, mientras reducia 10s gastos sobre 10s que tiene un mayor grado de discrecionalidad. Asi, 10s gastos de servicios personales y 10s gastos generales tan solo crecieron al 0.6% y al2.5% reales respectivamente, tasas muy inferiores al crecimiento de 10s ingresos y del PIB.

7. Los resultados positivos fruto de la politica fiscal aplicada, jugaron un papel muy importante en el logro de un mejor equilibrio macroeconomico y el cumplimiento de las metas fiscales. De este modo fue posible cumplir el acuerdo con el FMI de reducir el deficit del sector publico consolidado al alcanzar un nivel de 2.7% del PIB. El incremento del PIB, la dinamica del balance primario del sector publico y el positivo resultado de la tasas de interes como consecuencia de 10s dos factores anteriores, llevaron a la reduccion de la deuda total neta que paso de 54.6% en el 2002 a 52.5% en el 2003.

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8. Los resultados obtenidos en Io que va corrido del aRo 2004, muestran que se mantienen las buenas tendencias fiscales y de actividad economica. En el primer trimestre la economia alcanzo un crecimiento del 4.1% y se espera que esta tendencia se consolide, alcanzando un crecimiento del 4% al final del aiio. Asi mismo, se espera que la inflacion continue su tendencia decreciente alcanzando un nivel de 5.5%.

9. En el frente extern0 se sigue teniendo una posicion solida que ha permitido mantener el resultado de la cuenta corriente e incrementar el acewo de resewas internacionales que ha llegado a $ 11.587,8 millones de dolares.

10. Se cumplio la meta de deficit fiscal pactada con el FMI para el primer trimestre del aRo que era de 0.5%. El deficit del Sector Publico Consolidado fue del 0,3% del PIB. Este resultado refleja la continuacion de la politica de ajuste en el Gobierno Nacional Central y una mejoria en el sector publico descentralizado.

11, La meta de deficit fiscal que para el 2004 es de 2.5% del PIB, puede ser revisada al aka hasta en 0.3% del PIB si se incluye gasto en inversiones prioritarias del Gobierno. Dicho gasto es condicional a la obtencion de recursos por la enajenacion de activos publicos durante el aiio, dado que dichos recursos tienen como objeto financiar la inversion adicional.

12. Para 2005 se espera continuar con la politica de ajuste de las finanzas publicas, manteniendo el deficit fiscal en un nivel de 2.4% del PIB. Sin embargo, continuando el programa plurianual de venta de activos, se espera financiar inversion adicional por un monto de hasta 0.5% del PIB. AI igual que en el 2004, esta inversion es contingente a la obtencion de recursos por enajenacion de activos.

REFORMAS ESTRUCTURALES

13. El programa de Gobierno continua orientado a garantizar la sostenibilidad fiscal y en ultima instancia a recobrar la seguridad, recuperar el crecimiento economico y aumentar la equidad social. Por ello se continuan implementando las medidas requeridas para que estos objetivos Sean alcanzados dentro de un ambiente de estabilidad macroeconomica, apoyado por politicas monetarias prudentes y el fortalecimiento del sistema financiero, a la vez que se fortalecen 10s programas de asistencia social, se aumenta la cobertura en educacion y salud y se mitiga el impact0 de 10s aumentos en las tarifas de servicios publicos sobre 10s grupos mas pobres de la poblacion.

14. Asi, el Gobierno es consciente de la urgente necesidad de continuar con el plan de reformas estructurales, el cual pretende dar continuidad a la politica de ajuste fiscal gradual y garantizar que se obtengan 10s superavit primarios que hagan sostenible la deuda en el largo plazo.

15. En este contexto, la agenda legislativa persigue atacar el principal riesgo fiscal el cual esta estrechamente relacionado con el tema pensional. Las actividades tendientes a realizar este control estan dirigidas a:

J Generar ingresos que cubran las presiones sobre el rubro de pensiones en el futuro proximo. Para esto se impulsa una reforma tributaria que amplie 10s ingresos con dicho proposito.

J Acotar las presiones de gasto. En este contexto se pretende realizar modificaciones al regimen pensional para evitar presiones fiscales futuras.

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PROGRAMA STANDBY CON EL FOND0 MONETARIO INTERNACIONAL

16. Dentro del marco de la politica macroeconomica, el Gobierno colombiano firm6 en enero de 2003 un acuerdo Stand-By (SBA) con el FMI cuyo objetivo principal es la reduccion del deficit fiscal. A la fecha, el FMI ha completado la tercera revision del programa y se ha destacado el cumplimiento de 10s criterios de desempeiio previstos en el mismo. Para el aiio 2004 el Gobierno se propone mantener el impulso de las reformas economicas que estan orientadas a respaldar un crecimiento del PIB de 4%, en tanto la meta de inflacion se ha fijado en 5.5%. Ademas, se proyecta que el deficit de la cuenta corriente de la balanza de pagos llegue a 2.2% del PIB y que las reservas internacionales netas se incrementen en US$700 millones.

II. EL PROGRAMA DE APOYO AL SECTOR FINANCIER0

CONTEXT0

17. A partir del aiio 2002 el sector financiero ha presentado una recuperacion significativa frente a la dificil situacion presentada a finales de la decada del 90. Asi, durante el aAo 2003 las entidades de credito siguieron incrementando su cartera de credito, tal como Io venian haciendo desde medidos del 20021; 10s niveles de rentabilidad fueron acordes con periodos previos a la crisis de 1998-99; la relacion de solvencia se mantuvo en niveles adecuados; y, en general, 10s riesgos inherentes al negocio financiero han disminuido. Esta tendencia positiva se ha acentuado en Io que va corrido del aAo 2004, Io que pone de manifiesto que el sistema se encuentra en situacion de estabilidad.

18. Sin embargo, a h se requieren esfuerzos para consolidar 10s resultados hasta ahora obtenidos. Por ello, y con el fin de consolidar este desempeAo y alcanzar mejores niveles de crecimiento de 10s activos y la cartera, el Gobierno continua promoviendo acciones tendientes a alcanzar estos objetivos.

OBJETIVOS DEL PROGRAMA

19. La Segunda Fase del Programa de Ajuste al Sector Financier0 tiene como objetivo acompaiiar el Gobierno de Colombia en el proceso de ajuste del sector financiero. Si bien, el sector presenta una recuperacion significativa de su salud y sostenibilidad, aun se requieren esfuerzos para consolidar 10s resultados hasta ahora obtenidos. Igualmente, es necesario continuar con el desarrollo de 10s instrumentos que propenden por ajustar la legislacion financiera colombiana a las exigencias del mercado y a 10s estandares internacionales, sin desconocer la realidad y las particularidades del pais. El Gobierno sigue igualmente comprometido con la integracion adecuada entre el sector bancario intermediado y el mercado de valores, a fin de garantizar la estabilidad del mercado financiero.

20. Para cumplir con este objetivo, el Gobierno ha puesto en marcha acciones relacionadas con las areas de fortalecimiento de la regulacion, supervision y esquemas de resolucion de entidades, creacion de mecanismos para la financiacion de programas de vivienda y apoyo al desarrollo del mercado de valores, de deuda publica y del sector no bancario, estas ultimas relacionadas con la industria de seguros, pensiones y fideicomisos. Confiamos en que este conjunto de reformas permita consolidar el sector financiero y ajustar la normatividad a 10s estandares internacionales.

1 Este comportamiento se evidencio en todas las modalidades de credito, con excepcion del credito de vivienda.

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COMPONENTES DEL PROGRAMA

Implementacion de la Lev de Reforma Financiera v efectiva resolucion bancaria

21. La Ley 795 del 14 de enero de 2003, que promovio el Gobierno Nacional, ha surtido su proceso de reglamentacion para darle operatividad a muchos de 10s aspectos contenidos en la misma. Esta Ley incluyo cambios importantes para la modernizacion y fortalecimiento del sistema financiero asi como un conjunto de medidas para flexibilizar la normatividad e introducir nuevos instrumentos para proteger la confianza del publico en las entidades financieras.

22. Un tema importante que se desarrollo dentro de la Ley 795 fue la introduccion de mecanismos para resolver problemas estructurales de entidades financieras o facilitar la salida voluntaria del mercado de estas instituciones, evitando el riesgo de contagio y fortaleciendo la confianza en el sistema. Una de estas figuras fue la exclusion de activos y pasivos como medida previa a la toma de posesion o como consecuencia de la misma. Esta figura permite transferir rapidamente 10s depositos de una institucion en problemas a otras instituciones financieras asi como 10s activos a un patrimonio autonomo. Recientemente el Gobierno Nacional reglamento esta figura, determinando 10s lineamientos generales de la misma.

23. Por otro lado, la Ley 795 de 2003 centro en el Fondo de Garantias de lnstituciones Financieras la competencia para realizar el seguimiento a 10s liquidadores de las entidades financieras tanto publicas como privadas, independientemente del tipo de modalidad de liquidacion de que se trate. Conforme a Io anterior y en desarrollo de esta funcion, FOGAFIN ha concluido el proceso de liquidacion de la Corporacion Financiera ING Baring y de la Sociedad Administradora de Fondos de Pensiones y Cesantias lnvertir S.A.

24. De otra parte, se ha reglamentado el proceso de toma de posesion de entidades financieras y se ha modificado el regimen que regula el proceso de Iiquidacion forzosa administrativa. Con respecto a la reglamentacion de la toma de posesion, se busco precisar 10s efectos de dicha medida y establecer cuales son de caracter obligatorio y cuales facultativos, ello con el fin de facilitar el desarrollo del objeto social de la entidad intervenida y su reactivacion. Adicional a Io anterior, se dejaron establecidas las facultades propias del agente especial designado para desarrollar la medida y la forma como el mismo puede contar con la colaboracion de una junta asesora, respecto de la cual se definieron su conformacion y funciones.

25. En cuanto a la modificacion del regimen aplicable al proceso de liquidacion forzosa, 10s principales cambios estan dirigidos a brindar herramientas que permitan, de una parte, la realizacion rapida y efectiva de 10s activos de la liquidacion, si se tiene en cuenta que 10s mismos son la fuente de pago de las acreencias a cargo de la Iiquidacion y, de otra, a brindar mecanismos que permitan concluir 10s procesos liquidatorios en el menor tiempo posible, via la celebracion de acuerdos con 10s acreedores, la celebracion de contratos de administracion o la adjudicacion forzosa de activos, bajo reglas claras y expresamente seRaladas.

26. Por otro lado, y en desarrollo del programa de Renovacion de la Administracion Publica, a traves del cual se adelanta la creacion y consolidacion de un Estado gerencial, que presupone una gestion austera en el manejo de 10s recursos publicos y al servicio del ciudadano, se ha venido adelantando la racionalizacion de entidades estatales, incluidas las del sector financiero. El espiritu de esta politica es enajenar las participaciones accionarias que se tengan en diferentes entes economicos publicos y privados, conservando exclusivamente aquellas entidades necesarias para que el Estado cumpla con su funcion social.

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27. avances:

En cumplimiento de esta politica de racionalizacion de la banca publica, se realizaron 10s siguientes

J IFI: En el marco de la politica de banca publica, el Gobierno Nacional ordeno la liquidacion del IFI. A la par de realizo el proceso de cesion de activos y pasivos viables a Bancoldex. Ademas, la Nacion asumio a traves del Ministerio de Hacienda y Credit0 Publico las obligaciones en moneda extranjera.

Bancafe: FOGAFiN inicio la ejecucion de la estrategia de vinculacion de capital privado, con la apertura de la Sala de lnformacion en el mes de octubre de 2003, la cual comprendio dos procesos sucesivos e independientes entre si.

J

El primer0 tendiente a la capitalizacion en dinero del Banco por parte de un inversionista o grupo de ellos, que le permitiera a Fogafin desmontar el capital garantia proporcionado a dicha entidad, sin que se ponga en riesgo la solvencia patrimonial de este. El segundo, posibilitando la enajenacion de las acciones de FOGAFIN en Bancafe, siguiendo el procedimiento establecido para el efecto por la Ley 226 de 1995 y demas normas aplicables, previa la adopcion del programa de enajenacion por parte del Gobierno Nacional.

En desarrollo del proceso de capitalizacion, tres potenciales inversionistas accedieron a la Sala de lnformacion antes referida, previo cumplimiento de 10s requisitos establecidos en el Reglamento de Vinculacion de Capital Privado. El 18 de febrero de 2004 se llevo a cab0 la audiencia de adjudicacion per0 no se presentaron ofertas.

AI respecto, no es posible determinar con certeza las razones por las cuales no se presentaron propuestas de capitalizacion. Se han percibido como posibles causas, la carga laboral de la entidad, el tamaAo del Banco y su elevada red de oficinas. Trabajando bajo estos lineamientos, se tiene proyectado el cierre de aproximadamente cincuenta oficinas para el segundo semestre de 2004, fundamentado en criterios de rentabilidad, calidad de la cartera y potencial comercial. Ademas, entre enero y mayo de 2004 se redujo la planta de personal en aproximadamente 21 8 personas, Io cual representa una disminucion de mas del 5% de la planta.

J Reduccion de la participacion de Estado en sociedades fiduciarias publicas: En el tercer trimestre de 2003 se consolido la fusion de la sociedad Fiduciaria de Desarrollo Agropecuario S.A. Fiduagraria S.A. y de la sociedad Fiduciaria Industrial S.A. Fiduifi. El 1" de noviembre de 2003 fue protocolizada la escritura publica mediante la cual Fiduagraria S.A absorbio a Fiduifi, esta ultima mediante disolucion sin liquidacion.

Por su parte, las acciones de Fiduciaria FES S.A. de propiedad de Fogafin fueron ofrecidas en venta a mediados del aAo 2003 en dos fases: en una primera fase, a las personas de que trata el articulo 3" de la Ley 226 de 1995 y, en una segunda fase, al publico en general por conduct0 del martillo de bolsa. En ninguna de las dos fases se efectuaron adjudicaciones de las acciones, en la medida en que no se presentaron personas interesadas en adquirirlas. Fogafin viene adelantando el estudio de nuevas alternativas para lograr la enajenacion de dichas acciones.

J Banco Granahorrar: Actualmente y con el apoyo del Grant No. TF052531 se ha contratado un estudio que busca desarrollar un diagnostic0 del Banco Granahorrar, con el fin de estudiar sus necesidades y perspectivas frente a un proceso de venta como ente en marcha. Las

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conclusiones de este estudio serviran de lineamientos para iniciar la ejecucion de la estrategia de venta del Banco en el primer semestre de 2005.

Fortalecimiento de la supervision bancaria

28. En relacion con el enfoque de la supervision financiera, la Superintendencia Bancaria de Colombia (en adelante SBC) continlja avanzando sobre la puesta en marcha de un sistema de administracion de riesgos para el universo de entidades vigiladas, esto es, establecimientos de credito, entidades administradoras de fondos de pensiones y cesantias, compaiiias de seguros, sociedades fiduciarias, casas de cambio, etc.

29. Los avances al respecto involucran tanto el mantenimiento y adecuacion de un marco normativo que, teniendo en cuenta las particularidades del mercado colombiano y las tendencias internacionales, incorpora 10s parametros pertinentes de medicion, seguimiento y administracion de 10s principales riesgos del sector, como la adecuacion paulatina de las practicas de supervision correspondientes.

30. En el primer caso, el supervisor colombiano comparte las premisas basicas de Basilea II. La SBC entiende que la medicion de 10s riesgos incorporados en 10s activos, pasivos y contingencias de las entidades financieras son una condicion necesaria para la administracion de tal negocio y que la constitucion del capital economico, esto es, aquel consistente con dichos riesgos, representa una salvaguarda esencial frente a la preservacion de la estabilidad sectorial. De igual manera, la autoridad de supervision cuenta con un claro discernimiento sobre las mayores exigencias tecnicas para la supervision y sobre el empoderamiento institucional necesario para exigir de las entidades vigiladas una correccion oportuna y suficiente de aquellas situaciones en las que el capital economico tienda a ser deficitario frente a las exposiciones asumidas por las entidades vigiladas.

31, Las particularidades del sistema financiero colombiano, las naturales consideraciones sobre las condiciones competitivas de 10s grupos financieros locales, las caracteristicas del marco normativo vigente en materia de administracion del riesgo y el reconocimiento de deficiencias institucionales en relacion con algunos de 10s principios basicos para una supervision bancaria ef Efectiva, imponen, como es apenas Iogico, una evaluacion cuidadosa de dicha propuesta frente a las demas prioridades en materia de regulacion y supervision prudencial en el cas0 colombiano.

32. El principal desarrollo corriente de la regulacion prudencial domestica en la direccion de Basilea II tiene que ver con la introduccion de criterios tecnicos en la medicion del riesgo crediticio y, con base en ello, con el diseiio y puesta en marcha de un sistema de administracion del mismo por parte de las entidades vigiladas. Sin embargo, no esta previsto, en el corto plazo, que movimientos en el valor de estos riesgos se traduzcan directamente en movimientos, en igual sentido, del capital disponible (capital economico); 10s riesgos crediticios seran cubiertos mediante la constitucion de provisiones, Io que se traduce en movimientos de la relacion de solvencia . Las estimaciones preliminares realizadas por la SBC indican que la aplicacion del Pilar 1 en el sistema financiero colombiano implicaria una multiplicacion de la relacion de solvencia actual en un rango que va de 1.3 a 10.3 veces, dependiendo de la calificacion de la cartera ( AA, A, BB, B y C) y de 10s niveles de confianza empleados en la estimacion.

33. Por otra parte, las autoridades colombianas han decidido posponer las medidas en materia de riesgo operacional hasta tanto no se avance mas en la instrumentacion de las nuevas directrices para la medicion y administracion del riesgo crediticio.

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34. normativo colombiano, apuntan en esa direccion.

A pesar de su caracter parcial en relacion con el Pilar I de Basilea II, 10s cambios en el marco

35. En relacion con el Pilar Ill, es importante mencionar que el sistema financiero colombiano produce y difunde, a traves de diversos medios que incluyen las paginas web del supervisory de 10s principales gremios del sector, informacion periodica 'y oportuna sobre 10s principales estados financieros e indicadores del comportamiento de la industria. Esta previsto que la informacion adicional derivada del nuevo sistema de administracion del riesgo crediticio sea parte integral de ese conjunto de informes. Sin embargo, la revelacion de informacion suficiente y de calidad es condicion necesaria per0 no suficiente de la disciplina de mercado. La capacidad de 10s agentes economicos -ahorradores y clientes del sector- para seleccionar a las entidades en funcion de su calidad no se predica de la mayoria de 10s usuarios del sistema financiero colombiano, entre otras razones, porque a 10s pequefios ahorradores o usuarios del sistema de pagos no se les puede exigir el analisis y comportamiento propios de un inversionista profesional.

36. En este sentido, la responsabilidad del supervisor cobra una mayor importancia en terminos de la proteccion de 10s clientes del sistema y, por supuesto, de la preservacion de la estabilidad sectorial. El cumplimiento del Pilar 11, esto es, la adecuacion del supervisor para evaluar la idoneidad de las mediciones del riesgo crediticio y su administracion por parte de las entidades financieras y para exigir una relacion sincronizada entre el riesgo asumido y el capital (en nuestro caso, las provisiones de cartera), representa un reto de magnitudes importantes para el supervisor colombiano, dadas las limitaciones en la formacion del personal supervisor y sus restricciones administrativas y presupuestales para la gestion del recurso humano.

37. Con estas condiciones, la SBC continua en el esfuerzo de entrenar a sus funcionarios en aquellas materias necesarias para el desarrollo de una supervision basada en riesgos. Adicionalmente, se encuentra elaborando el manual de supervision SARC y la definicion del aplicativo para la evaluacion de 10s modelos de prediccion de riesgo, herramientas que facilitaran el trabajo de supervision adelantado por la institucion. Paralelamente, la SBC esta implementando una Guia sanctionatoria para unificar la politica en esta materia al interior de la SBC.

38. Como es natural, la supervision de 10s riesgos financieros en economias con grupos economicos implica el desarrollo de agendas de trabajo especificas para la supervision comprensiva y consolidada. Este enfoque no solo involucra la construccion y ajuste de las mallas y matrices entre accionistas y entidades relacionadas patrimonialmente, sin0 que requiere de la consolidacion de sus principales estados financieros, de la construccion de indicadores agregados para el analisis financiero y de la medicion y agregacion de 10s diversos riesgos correspondientes (solvencia, riesgos de mercado, riesgos de liquidez, etc.). La SBC se ha ocupado de la adecuacion de 10s parametros normativos para tales efectos y preve la conformacion de grupos de supervisores especializados en la materia, dependiendo de sus disponibilidades de recursos.

Financiacion de vivienda.

39. En el tema de vivienda y su financiacion, se han disefiado nuevos mecanismos para contrarrestar 10s factores que afectan la demanda de credit0 y el riesgo en que incurren las entidades crediticias. Lo anterior, en el marco de la Ley 546 de 1999 que introdujo ajustes que significaron una profunda modificacion a la estructura de financiacion de vivienda e implicaron el reordenamiento del negocio y de su regulacion.

40. Uno de estos esquemas es la cobertura contra la inflacion creado con la finalidad de implementar un mecanismo que le permita a 10s usuarios de vivienda asegurar 10s flujos futuros de sus creditos hipotecarios y al sector financiero'acelerar el proceso de desembolsos de creditos para financiacion de vivienda dentro de un

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marco de seguridad y riesgo manejable. AI cierre de mayo de 2004, 10s deudores hipotecarios beneficiados con la cobertura sumaron 14.058, de 10s 40.000 designados para este programa, con creditos desembolsados que ascienden a un monto de $351.485.6 millones

41. Igualmente, se ha continuado revisando el esquema de operacion del Fondo de Reserva para la Estabilizacion de la Cartera Hipotecaria - FRECH, mecanismo creado para cubrir el riesgo de 10s establecimientos de credito hipotecario del diferencial entre la tasa de interes y la inflacion. En este contexto, se adelanto un estudio para determinar la viabilidad del mecanismo a las necesidades de 10s agentes involucrados, buscando garantizar la estabilidad del sector financiero hipotecario dada la volatilidad existente en sus fuentes de fondeo. Con base en este estudio, el Gobierno expidio un decreto reglamentando un nuevo esquema que se basa en la utilizacion de contratos de opcion.

42. Por otro lado, y con el fin de promover el desarrollo regional y urbano, el Gobierno Nacional autorizo a la Financiera de Desarrollo Territorial, FINDETER, celebrar operaciones de redescuento dirigidas a la financiacion de operaciones de credito o microcredito inmobiliario cuyo fin sea la construccion, remodelacion o adquisicion de vivienda de interes social. Un componente importante de esta modalidad de credito es que 10s mismos pueden ser sujetos de procesos futuros de titularizacion de cartera, siempre que 10s mismos cumplan con condiciones de homogeneidad. Complementando estas iniciativas, la normativa sobre titularizaciones se ha actualizado con la emision de nuevas normas en relacion con consumos de capital para 10s diferentes tramos de valores en procesos de titularizacion, y normas de capital para posiciones propias de firmas titularizadoras.

43. Ademas, el Gobierno Nacional suscribio con el sector financiero un acuerdo mediante el cual 10s establecimientos bancarios y las cooperativas financieras se comprometen a colocar un porcentaje de su cartera bruta en nuevos creditos ylo en adquisicion de vivienda de interes social. Igualmente, y con el fin de cubrir 10s riesgos derivados de estas operaciones, el Gobierno Nacional otorga garantias a estos creditos a traves del Fondo Nacional de Garantias, facilitando de esta forma el acceso a recursos del sistema financiero a segmentos de la poblacion de bajos ingresos.

Desarrollo del sector aseaurador

44. En el sector asegurador y por iniciativa del Gobierno Nacional, la Ley 795 de 2003 previo una serie de modificaciones a la estructura legal que gobierna la actividad aseguradora. Es asi que el regimen del sector asegurador se ajusto en aspectos tales como la incorporacion de nuevas facultades de regulacion para el Gobierno Nacional en aspectos como- el patrimonio tecnico, el patrimonio adecuado, el regimen de inversiones, el patrimonio requerido para la operacion de 10s diferentes ramos de seguro y 10s limites al endeudamiento de las entidades aseguradoras y sociedades de capitalizacion. Ademas, se aclaro que el margen de solvencia se determinara en funcion del importe de las primas o de la carga media de siniestralidad, el que resulte mas elevado, quedando el Gobierno Nacional facultado para establecer la periodicidad, forma, riesgos y elementos tecnicos de 10s factores que determinan dicho margen de solvencia.

45. Con base en estas facultades, se establecieron las tarifas maximas que pueden cobrarse por el seguro obligatorio de daiios corporales causados a las personas en accidentes de transit0 y el valor de la contribucion al Fondo de Solidaridad y garantia, FOSYGA. Posteriormente, se expidio un decreto que obliga a las compaiiias autorizadas para explorar este ram0 de seguro a expedir las polizas solicitadas y a implementar un mecanismo de compensacion que impida la seleccion adversa por categoria de vehiculos.

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46. Estas reformas contribuiran a contar con un sector mas solido y competitivo. Hacia el mediano plazo, y posterior a un proceso de revision de 10s aspectos incorporados en un proyecto de decreto relacionado con la implementacion de normas de solvencia para el sector asegurador en 10s diferentes ramos de este sector, el Gobierno emitira normas relacionadas. El objetivo principal de estos ajustes normativos es propender por la armonizacion de la regulacion y supervision de la actividad de las entidades vigiladas por la Superintendencia Bancaria, incluidas las del sector asegurador. En este contexto, tambien se han implementado normas requiriendo que las inversiones gestionadas por aseguradoras, AFPs, fideicomisos y fondos mutuos, reporten y revelen sus riesgos de mercado en sus pottafolios. Para el sector de pensiones, el regimen de inversiones en titulos del exterior se ha ampliado para aumentar la diversificacion de 10s portafolios gestionados por las AFPs.

Desarrollo del mercado de capitales

47. Uno de 10s aspectos mas importantes dentro de este componente y en el cual el Gobierno Nacional esta comprometido, dado el fenomeno de la globalizacion de 10s mercados que exige que la regulacion de 10s mismos se ajuste a las practicas y tendencias internacionales y que la competencia y las nuevas tecnologias en informatica y comunicaciones han permitido un vertiginoso desarrollo de 10s mercados de valores alrededor del mundo, es la necesidad de ajustar el esquema regulatorio a las nuevas formas de negocios y a 10s nuevos riesgos involucrados.

48. Bajo la premisa anterior, el Gobierno retomo el analisis del anteproyecto de ley para regular las actividades de manejo, aprovechamiento e inversion de recursos del publico que se efectuen mediante valores. Del trabajo conjunto entre las distintas entidades involucradas en la revision proyecto, se obtuvo un nuevo proyecto que propende por dotar al mercado de valores colombiano de un marco regulatorio adecuado y eficiente que permita mayores niveles de crecimiento, alternativas frente a las fuentes tradicionales de financiacion empresarial y, principalmente, de un marco claro de actuacion para todos 10s participantes del mercado, con la seguridad juridica necesaria para que converjan inversionistas nacionales y extranjeros, y con la flexibilidad necesaria para facilitar la adecuacion normativa a las continuas innovaciones del mercado.

49. El proyecto en mencion fue sometido a consideracion del Honorable Congreso de la Republica a fin de que surta el tramite legal previsto en las normas colombianas. El Gobierno brindara el apoyo que se requiera para que el proyecto se convierta en Ley de forma que el mercado de valores cuente con un nuevo marco institucional eficiente, integro e idoneo.

50. Por otro lado, y en el marco del Comite Asesor de Valoracion a Precios de Mercado, se continuo revisando y ajustando la regulacion en esta materia con el fin de obtener estandares de buen gobierno en la unificacion de las metodologias de valoracion para titulos de deuda publica, deuda publica externa, otros titulos publicos y valores de deuda privada.

51. Las normas de capital para todos 10s esquemas de inversion colectiva tambien se armonizaron para evitar el arbitraje regulatorio entre fondos gestionados por entidades bajo la supervision de la SBC o la SV. Para evitar arbitraje de precios en 10s fondos de valores, se implemento nueva normativa para que 10s precios de 10s fondos se ajusten al valor en el dia de transaccion. Adicionalmente, se elaboro y se implemento una ficha tecnica para la revelacion fiel, uniforme y comparable, de informacion y riesgos de 10s fondos y esquemas de inversion colectiva gestionados igualmente por entidades supervisadas tanto por la SV como por la SBC.

- 7 1 -

Desarrollo del mercado de deuda

52 La politica del Gobierno Nacional encaminada a reducir el deficit fiscal tiene como proposito igualmente hacer sostenible la deuda pliblica en el largo plazo. En este sentido, el Ministerio de Hacienda a traves de la Direccion General de Credito Publico y Tesoro Nacional, ha diseiado una estrategia de financiamiento soportada en el desarrollo del mercado de capitales interno y en una activa presencia tanto en 10s mercados de capitales internacionales como con la banca multilateral.

53. Durante 10s ultimos aRos las necesidades de financiamiento asociadas con un incremento en el deficit fiscal consolidado representaron un importante crecimiento de la relacion deuda publica a PIB, alcanzando niveles cercanos al 55% en 2002. Sin embargo, las politicas de ajuste fiscal detuvieron esta tendencia ascendente, reduciendo este indicador a 52% en 2003. En este sentido, el marco fiscal de mediano plazo establecido por el Gobierno pretende mantener esta tendencia y converger hacia una relacion deuda a PIB inferior al 40% en 201 5.

54. La estrategia de endeudamiento se orienta hacia la diversificacibn de fuentes de financiamiento, resaltando la importancia de contar con un mercado domestic0 solido y profundo para evitar la vulnerabilidad frente a choques externos. En este sentido, se mantienen 10s esfuerzos por consolidar el mercado de deuda publica interna a traves del fortalecimiento del mercado de TES en el segment0 del corto plazo el cual ha alcanzado niveles importantes de liquidez y profundidad.

55. La Nacion mantendra su presencia en 10s mercados de capitales internacionales mediante la emision de bonos y la realizacion de creditos sindicados. Igualmente, el objetivo es fortalecer las relaciones con la banca multilateral que representa hoy cerca del 20% de la deuda total.

56. Como resultado de esta politica, la composicion de la deuda interna y externa que hoy representan el 52% y 48% respectivamente, se modificara gradualmente hasta alcanzar una participacion del componente interno del 60% y extern0 del 40% para el 201 0.

57 Finalmente, el Gobierno tiene previsto continuar con una activa politica de administracion de la deuda, realizando operaciones de manejo de deuda que permitan mejorar el perfil de la misma. Para esto, se establecio oficialmente un Comite de Deuda Publica con responsabilidades estrategicas definidas por decreto.

111. CONCLUSIONES

58. Muchas de la medidas y politicas descritas en este documento se han desarrollado en el marco del Segundo Credito Programatico del Programa de Ajuste al Sector Financiero, a ser financiado con recursos del Banco Mundial. Los avances alcanzados son satisfactorios y las condiciones economicas y sociales estan dadas para continuar con las reformas que se requieran en la direccion de dotar al mercado de capitales intermediado y no intermediado de estabilidad y claridad en las reglas que 10s regulan, en beneficio de todos 10s participantes del mercado.

59. Por Io anterior, el Gobierno esta comprometido con el programa que se presenta en este documento y ve con beneplacito el acompahamiento y el apoyo financiero del Banco Mundial a estos procesos. El Gobierno agradece la pronta consideracion por parte del Directorio del Banco del nuevo credito programatico de ajuste al Sector Financiero y esta a disposicion de 10s equipos tecnicos del Banco para definir conjuntamente programas futuros de credito en la medida en que se consoliden 10s ajustes y se requieran nuevas acciones en el sector financiero.

- 72 -

Annex 3

TIMETABLE OF KEY PROCESSING EVENTS

Time taken to Prepare: (Identification to Negotiations)

Prepared by:

Identification Mission Departure:

Preparation Missions

Management Review Meeting

Regional Operations Committee

Appraisal:

Negotiations:

Board Presentation:

Planned Date of Effectiveness:

Closing Date:

12 months

Government and World Bank Staf f

August 1 1 , 2003

December 8,2003 February 29,2004 June 21,2004

July 12,2004

August 2,2004

August 16,2004

August 20,2004

September 23,2004

September 30,2004

March 3 1,2005

- 73 -

Annex 4

FUND RELATIONS NOTE

Press Release No. 041134 June 30,2004

International Monetary Fund 700 19th Street, NW Washington, D.C. 2043 1 USA

IMF Executive Board Completes Third Review Under Stand-By Arrangement for Colombia and Approves US$284 Mill ion Disbursement

The Executive Board of the International Monetary Fund (IMF) today completed the third review of Colombia's performance under a two-year, SDR 1.5 bil l ion (about US$2.3 billion) Stand-By Arrangement approved on January 15,2003 (see Press Release No. 03/04). Completion of the review enables the release of SDR 193.5 million (about US$284 million), which would bring the total amount available under the arrangement to SDR 1.16 billion (about US$1.70 billion).

In completing the review, the Executive Board approved Colombia's request for a waiver of non-observance o f a performance criterion.

Following the Executive Board's discussion of Colombia's economic performance, Agustin Carstens, Deputy Managing Director and Acting Chair, said: "Colombia's strong policy track record i s bolstering confidence and contributing to the economic recovery. In 2004, real GDP growth i s projected to rise strongly, inflation to continue to decline, and the external sector to remain strong. Colombia i s well placed to adjust to a gradual rise in interest rates in the United States, provided that economic policies continue to be strong. The main policy challenge for 2004 i s to take advantage of the cyclical upturn in activity to press ahead with reforms that are crucial to sustain the economic recovery.

"Demand policies are set to remain prudent. The authorities are strongly committed to keeping fiscal policy on a path to reduce public debt over the medium term. The combined public sector deficit i s targeted to decline in 2004, with some room to accommodate additional investment financed by nondebt-creating flows. The government intends to submit to Congress a budget for 2005 that provides for a combined public sector deficit of 2.4 percent of GDP. Monetary policy w i l l remain directed at reducing inflation further, in the context of the inflation-targeting framework and a flexible exchange rate policy, while efforts w i l l continue to strengthen the financial system, and improve supervision.

"Structural reforms are also set to advance further. The government intends to secure congressional approval of the revised budget code during 2004, which would allow the 2006 budget to be prepared under the new code. Tax administration i s to be strengthened further, and a constitutional amendment on pension reform i s to be submitted to Congress in July 2004. B y September 2004, the economic policy cabinet

- 74 -

wi l l develop a plan to strengthen the current system of fiscal decentralization. Colombia has accepted the obligations of Article VIII, and the authorities plan to phase out the few remaining exchange restrictions in the next few years.

"These reforms, together with prudent macroeconomic policies, should lay a solid foundation for sustained growth and financial stability over the medium term, while also reducing poverty and improving social indicators," Mr. Carstens said.

July 2004 IMF Country Report No. 04/199

International Monetary Fund 700 19th Street, NW Washington, D.C. 20431 USA

Colombia: Third Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of Performance Criterion-Staff Report; Press Release on the

Executive Board Discussion; and Statement by the Executive Director for Colombia

In the context of the third review under the Stand-By Arrangement and request for a waiver o f nonobservance of a performance criterion with Colombia, the following documents have been released and are included in this package:

The staff report for the third review under the Stand-By Arrangement and request for waiver of nonobservance of a performance criterion, prepared by a staff team o f the IMF, following discussions that ended on April 25,2004, with the officials o f Colombia on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on June 15,2004. The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF.

A Press Release summarizing the views o f the Executive Board as expressed during i t s June 30, 2004 discussion of the staff report that completed the review and request.

A statement by the Executive Director for Colombia.

The documents listed below have been or w i l l be separately released.

Letter of Intent sent to the IMF by the authorities o f Colombia Memorandum o f Economic and Financial Policies by the authorities o f Colombia Technical Memorandum of Understanding

- 75 - Annex 5

Colombia: IBRD / IDA / Grants Portfolio As of August 10,2004

Active Projects (US$ Millions)

Project Name

Original Amount

FY IBRD IDA GRANT Cancel. Undisb. Disbursed

CO FIRST APL PEACE AND DEVELOPMENT CO CARTAGENA WTR SUPPLY & SEWERAGE ENV. CO INTEGRATED MASS TRANSIT CO JUDICIAL RESOLUTION IMPROVEMENT CO PRODUCTIVE PARTNERSHIPS CO PUBLIC FINANC. MANAGEMENT PROJECT I1 CO REGULATORY REFORM TA CO RURAL EDUCATION CO SANTAFE I (WATER SUPPLY) CO SIERRA NEVADA SUSTAINABLE DEVELOPMENT CO WATER SECTOR REFFORM PROJECT

LA OBRA)

CASH TRANSFERS

IMPROVING ACCESS CO: CUNDMARCA EDUCATION QUALITY IMPROVEMENT

PROJECT

MP/CO ODS PHASE OUT

CO- COMMUNITY WORKS (MANOS A

CO- HUMAN CAPITAL PROTECTION -

CO- HIGHER EDUCATION -

CO - BOGOTA URBAN SERVICES

GEF CO - HIGH ANDES

TOTAL

2004

2000 2004

2002 2002

200 1 1997 2000 1996

2000

2002

2000

200 1

2003

2004

2003 2001 1999

30.0

85.0 250.0

5.0 32.0

35.5 12.5 20.0

145.0

5.0

40.0

100.0

150.0

200.0

15.0

100.0 15.0 8.7

1225.0 23.7

30.0

54.4 250.0

1.1 2.4 10.0 16.7

26.3 0.8

12.1 23.7

1.7

34.0

67.0 6.0

45.5

179.4

13.8

92.3 9.7 6.1

78.1 804.8

0.0

30.6 0.0

2.6 15.3

9.1 11.7 7.9

121.3

3.3

6.0

94.0

104.5

20.6

1.2

7.7 5.3 2.5

443.8

- 76 -

Held

Colombia Statement of IFC's

Held and Disbursed Portfolio As of June 30,2004

Disbursed

(US$ Millions)

I

FY Company 2003 AAA 2002 BCSC 2002 Bavaria 2002 CF del Valle 2001 CHMC 2004 Cartones America 2001 Cementos Caribe 1999 Cofiinsura 2003 DAVIVIENDA 2002 Inversura 2002 Omimex Oil 1987 PRODESAL

1977/96 Promigas 1995 Promisan 2002 Proteccion 2002 SIC 1999 Surenting 2001 Tolcemento

Loan Equity Quasi Partic. 18.24 0 0 a

0 7 0 a

0 4.84 0 a 9.62 8.85 3.42 a

22 0 0 a

25 0 25 a 15.25 0 0 a

0 15 0 a 30 0 5 a 0 0.59 0 a

2.5 0 0 a 0 0.2 0 a 0 10 0 a

25 0 50.42 a 0 5.1 0 a

70 0 30 145

3.37 7.53 0 7.77

3.33 0 0 7.11

Loan Equity Quasi Partic 16.54 0 0 0

0 7 0 0 70 0 30 145 0 4.84 0 0

4.22 4.02 0.99 0 19 0 0 0

3.37 7.53 0 7.77 0 0 25 0

15.25 0 0 0 0 15 0 0

10.7 0 5 0 0 0.59 0 0

2.5 0 0 0 0 0.2 0 0 0 10 0 0

25 0 50.42 0 0 2.5 0 0 0 0 0 0

Total Portfolio 224.31 59.11 113.84 159.881 166.58 51.68 111.41 152.77

Approvals Pending Commitment Loan Equity Quasi Partic.

2004 Bancafe 0 20.25 0 0 2001 CHMC

2004 Caribbean Coal 2004 Carvajal S.A. 2003 DAVIVIENDA

2004 CHMC - NPL 0 19.38 0 0 0 0 0 0

25 0 0 0 35 0 35 0 0 0 10 0

Total Pending Commitment: 60 39.63 45 0

- 77 -

19e2 I9g2 2001 2002 (% of GDP) Agriculture 19.3 15.8 13.0 Industry 31.8 35.0 29.9

Services 48.9 49.3 57.1 Manufacturing 21.8 19.8 16.3 ..

Private consumption 72.8 71.6 63.6 .. General government consumption 10.9 9.5 21.1 Imports of goods and services 15.2 15.8 19.0

"

Annex 6

Growth of investment and GDP (%) 20

0

.zo -40

-60

-GDI -GDP

Colombia at a glance

1982-92 1992-02 2o01 2o02 (average annual growth) Agriculture 3.5 -1.4 0.1 Industry 5.0 0.7 -0.1

Manufacturing 4.2 -2.1 -0.8 .. Services 3.5 3.4 2.1 .. Private consumption 2.9 1.5 1.9 General government consumption 4.8 9.6 0.3 ..

Imports of goods and services 2.9 3.1 11.2 Gross domestic investment 1.0 -2.9 9.6

9/3/03

Growth of exports and imports (%) 20

10

0

-10 2

-30

-20

-Exports -Imports

POVERTY and SOCIAL

2002 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US5 billions)

Average annual growth, 1996-02

Population (%) Labor force 1%) Most recent estimate (latest year available, 1996-02) Poverty (?A of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live birfhs) Child malnutrition (% of children under5) Access to an improved water source (% of population) Illiteracy (% of population age 154 Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1982

GDP (US$ billions) 39.0 Gross domestic investmenffGDP 20.5

10.9 Gross domestic savingdGDP 16.3 Gross national savingdGDP 13.6

Interest paymentdGDP 1.8 Total debt/GDP 26.4 Total debt service/exports 27.8 Present value of debffGDP

Exports of goods and servicedGDP

Current account balance/GDP -8.4

Latin Lower- America middle-

Colombia & Carib. income

43.7 527 2,411 1,830 3,280 1,390 60.1 1,727 3,352

1.8 2.6

76 72 19 7

91 8

112 113 112

1.5 1 .o 2.2 1.2

76 49 71 69 27 30 9 11

86 61 11 13

130 111 131 111 128 110

1992 2001 2002

49.2 82.4 82.2 16.7 14.9 17.7 19.4 18.7 15.3 18.4 14.3

1.8 -2.2 -2.2 2.6 3.0 2.4

35.1 44.5 36.8 36.1

45.6

Development diamond*

Life expectancy

-

GNI Gross per primary capita nrollment

Access to improved water source

-Colombia Lower-middle-income group

Economic ratios'

Trade

-

Domestic savings

Investment

- 78 -

Co 1 om bia

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplus/deficit

TRADE

(US$ millions) Total exports (fob)

Coffee Petroleum Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and sewices Imports of goods and sewices Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, /oca//US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment Pottfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1982

24.6 24.8

1982

3,264 1,562

215 837

5,478 303 659

2,048

9 8

115

1982

4,785 7,052

-2,267

-1,184 171

-3,280

2,930 350

64.1

1982

10,306 1,346

20

1,491 187

1

12 403 856 366

0

738 277 93

185 95 90

1992

25.1 23.6

13.7 3.0

-1.9

1992

7,263 1,259 1,396 2,272 6,627

450 344

2,255

63 69 91

1992

9,257 8,262

994

-1,852 1,734

876

450 -1,326

681 .O

1992

17,277 3,195

13

4,008 959

1

89 -413 -12 729

0

466 262 681

278 -420

-698

2001

6.5 7.6

13.3 -5.0 -6.1

2001

12,309 764

3,083 5,606

12,834 1,578

189 4,468

243 209 116

2001

14,932 15,840

-908

-2,975 2,094

-1,789

2,956 -1,166

10,245 2,299.8

2001

36,699 2,006

7

6,297 365

1

86 1,083 1,312 2,328

-43

636 368 233 135 133

3

2002

6.0 7.0

13.6 -3.7 -4.6

2002

11,903 991

3,037 6,156

13,026 1,161

233 4,528

2002

14,439 16,077 -1,639

-2,525 2,335

-1,828

1,323 505

10,649 2,504.2

2002

1 2 5 - I

5 I -.

20

15

10

25 20

15

10

5 0

O2 I 97 98 99 00 01

-GDP deflator -CPI

I Export and import levels (US$ mill.)

20'ooo T 15 WO

10 000

5 . m

0

O Z I 96 97 98 99 00 01

Exports Imports

Current account balance to GDP (%)

' T

Composition of 2001 debt (US$ mill.)

A: 2,006 G: 3,738 6: 7

5,242

E 1337

F: 24.369

A - IBRD 6 . IDA D - Other multilateral F . Private C - IMF

E - Bilateral

G - Short-term

Note: This table was produced from the Development Economics central database. 9/3/03