"rLEiCOPY4 Report No. 4274-CO Colombia TheColombian Investment Banking System and Related Financial Sector Issues August 1, 1983 Projects Department Latin Americaand the CaribbeanRegional Office FOR OFFICIAL USE ONLY Documentof the World Bank Thisdocument has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosedwithout World Bankauthorization. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
Projects DepartmentLatin America and the Caribbean Regional Office
FOR OFFICIAL USE ONLY
Document of the World Bank
This document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.
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CURRENCY EQUIVALENTS 1/
Currency Unit = Colombian Peso (Col$)
US$1.0 = Col$70.11Col$1.0 = US$.0143Col$1.0 million = US$14,164
LIST OF ABBREVIATIONS
BR Banco de la Republica (The Central Bank)
Caja Caja de Credito Agrario, Industrial y Minero(The Official Agrarian Bank)
CAT Certificado de Abono Tributario(Tax Rebate Certificate For Non-traditional Reports)
CAUFs Companias de Autofinanciamiento('Auto-financing' Companies)
CAVIs Companias de Ahorro y Vivienda(Savings and Loan Associations)
CDTs Certificados de Deposito al Termino(Certificates of Deposit)
CFs Corporaciones Financieras(Investment Banks)
CFCs Companias de Financiamiento Comercial(Trade Finance Companies)
FFI Fondo Financiero Industrial(Industrial Financing Fund)
FIP Fondo de Inversiones Privadas(Private Investment Fund)
WFI Instituto de Fomento Industrial(Official Industrial Development Bank)
INCOMEX Instituto Colombiano de Comercio Exterior(Colombian Foreign Trade Institute)
PROEXPO Fondo de Promocion de Exportaciones(Export Promotion Fund)
'Superintendencia Bancaria'(Superintendency of Banks)
'Superintendencia de Sociedades'(Superintendency of Companies)
I/ December 31. 1982
FOR OFFICIAL USF ONLY
COLOMBIA
THE COLOMBIAN INVESTMENT BANKING SYSTEMAND RELATED FINANCIAL SECTOR ISSUES
TABLE OF CONTENTS
Page No.
PREFACE AND ACKNOWLEDGEMENTS
SUMMARY AND RECOMMENDATIONS ........................... i-x
I. PAST TRENDS AND POLICIES IN THE COLOMBIANFINANCIAL SECTOR .................. 1
Developments Through the 1960s .1The Creation of the UPAC System (1972)............ 2The Financial and Tax Reforms of 1974/75. .. 3Creation of New Financial Intermediaries For Trade
and Consumer Financing. 4CFs and CDTs ........................................... 4Equity Investments by CFs .............................. 5The 1977-79 Stabilization Measures. 5Recent Developments .......... .......................... 6The Formation of Financial and Industrial Groups 7Conclusion .......... .. . 7
II. ISSUES FACING THE CORPORACIONS FINANCIERAS. 8
Nature of the Main Issues. 8The Share of Medium and Long Term Credits in the CFs'Portfolios .10
Dynamism of Growth of CFs .12
Equity Investments by the CFs .14The Overall Profitability of CFs' Operations .......... 18
III. INTEREST RATE AND OTHER FINANCIAL SECTOR POLICIES 21
This report is based on the findings of a World Bank mission comprisingMessrs. K. Challa (mission chief), M. Hinds (both of LCP), J. Silva Lopes,F. Veneroso and J. Villarzu (consultants). The mission visited Colombiaduring July/August 1982. IFC (CCMD) collaborated by supporting part of theconsultant assistance.
This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.
TABLE OF CONTENTS (Continued)Page No.
IV. INSTITUTIONAL ASPECTS OF THE FINANCIAL SYSTEM ... ...... 29
Recent Developments ................................... 29Evolution of Financial/Industrial Groups andConcentration of Financial Sector Assets ............. 29
Multi-banking vs. Specialized Banking ............... 31Recommendations for Institutional Restructuring ...... 33Specific Institutional Proposals for CFs .............. 35
V. RESOURCES FOR MEDIUM AND LONG TERM LENDING BY THECORPORACIONES FINANCIERAS ............................ 38
A. Introduction ........ ............................. 38B. Creating Conditions for Term Transformation
and Deposit Resources ........ .................. 38
a. Floating Interest Rate Loans as a Solutionto Avoid Interest Rate Risks .... ........... 38
b. The Liquidity Problem in Terms Transformation. 40c. Summary of the Features of the Proposed Term
Transformation Mechanism .... ............... 41d. Capitalization of Interest Payments .... ...... 42e. Tax Treatment of Floating Interest Rate Loans. 43f. Transparency of Effective Lending Rates ...... 44g. Advantages of the Proposed Modifications ..... 44
C. Improving Conditions for Issue of Longer TermSavings Instruments ............................ 45
D. Access to Official Financing Funds .... ........... 4i7E. Role of the Instituto de Fomento Industrial (IFI). 49F. Increasing Foreign Currency Resources for
VI. RISK CAPITAL INVESTMENTS ............................. 51
Increasing Use of Hybrid Instruments ................. 51Fiscal Measures to Improve Incentives for RiskCapital Investments ................................ 52
Stock Market Development ............................. 53
TABLE OF CONTENTS (Continued)
Page No.
STATISTICAL APPENDIX
Table I: Effective Interest Rates - Principal FinancialAssets ....................................... 57
Table II: Colombia: Central Government Cash DeficitAdjusted For Cuenta Especial de Cambio (C.E.C.)and its Effect on The Money Base .... ......... 58
Table IV: Percentual Composition of Deposits in Colombia -1970-81 ....... ................. 60
Table V: Colombia: Nominal and Real Interest Rates on3-Month Certificates of Deposit (CDs) .... ..... 61
Table VI: Legal Reserve Requirements and Forced InvestmentsImposed on the Colombian Financial System ..... 62
ANNEXES
1. Colombia: Alternative Long-Term Interest Rate Regimes ...... 63
2. Illustrative Example of a System of Floating InterestRate Medium and Long Term Loans with PartialCapitalization of Interest ............................... 73
3. Hybrid Risk Capital Investments ............................ 80
PREFACE AND ACKNOWLEDGEMENTS
This report is based on the findings of a World Bank financialsector mission which visited Colombia in July 1982 at the Government'sinvitation. The single most important focus of the study was to review theperformance of the Corporaciones Financieras (investment banks) system andsuggest ways to improve it in the future. It was recognized, however, thatbroadei institutional, capital markets and financial sector policy questionsdirectly or indirectly related to the above would also have to be addressedas part of the mission's work.
In view of the nature of the problems addressed and theinter-relationships among different issues, several relatively detailedrecommendations concerning the implementation of the required changes areincluded in the report, in addition to the recommendations on sector policydirections. In many instances, qualitative analysis and judgments regardingthe relative weights to be placed on different factors played a complementaryrole to quantitative analysis in arriving at the recommendations. Manyofficials of the Colombian Government, Banco de la Republica,Superintendencia Bancaria, Comission Nacional de Valores and other publicagencies, representatives of the Colombian banking and industrial sectorsincluding in particular the Asociacion Bancaria, Asociacion Nacional deInstituciones Financieras, Asociacion Nacional de Industriales, as well asthe IFC and IMF, have provided valuable help and advice during the course ofthis work, particularly in arriving at judgments regarding the balance offactors.
The report is organized as follows. Chapter I traces the evolutionof the institutional structure of the Colombian financial system andfinancial sector policies over the last two decades. The specific issuesthat face the Corporaciones Financieras today, which follow to a large extentfrom the above evolution, are identified and analyzed in Chapter II. ChapterIII examines in more detail the impact of interest rate and other financialsector policies and recommends directions for future policy evolution. Thelast three chapters analyze and provide recommendations in three specificareas concerning the future development of the Corporaciones Financieras,namely, the institutional structure of the financial system (Chapter IV),resources for medium and long-term lending (Chapter V) and risk capitalinvestments (Chapter VI).
Several actions relevant to the issues discussed in this reportwhich were taken subsequent to the visit of the financial sector missionwhich have not been incorporated herein. These are summarized here brieflywith the relevant paragraphs in the main report indicated in parentheses:
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(a) Through Junta Monetaria Resolutions 1 and 27 of Jauary 1983 andMarch 1983 respectively, marginal reserve requirements on demandand sight deposits (with maturities of up to 30 days), which hadbeen in effect since 1977, were removed unconditionally. Thisde-links the liberation of such reserve requirements from the useof Official Financing Fund resources (paras. 4.13 and 5.22 of thereport).
(b) Through Junta Monetaria Resolution 10 of February, 1983, theeffective spreads to the participating intermediaries underoperations of the Official Financing Funds were improved slightlyto provide somewhat better incentives for the intermediaries toparticipate in them (para. 5.22).
(c) Through Junta Monetaria actions, including Resolution 72 ofDecember 1982, the conditions for the use of the last resortfacility ('cupo extraordinario') by the Corporaciones Financieras(CFs) were improved and supplemented by a new facility to providefor a more adequate protection in case of liquidity problems (e.g.,as a result of term transformation) and to make treatment of CFsmore comparable to that of commercial banks (para. 5410).
(d) Through Junta Monetaria Resolutions 16, 41, 56, 72 and 75 of 1983(all issued between February and July 1983), a sepcial 'EnterpriseCapitalization Fund' has been established in Banco de la Republica(BR) to facilitate the purchase of minority-shareholdings byColombian investors, particularly in widely-held Colombiancompanies (although closely-held Colombian companies and foreign ormixed ownership companies are also eligible for support withincertain limits). The Capitalization Fund would stimulate suchpurchases of shares by making available loans via CFs to investorsto finance the purchases and/or by providing financing to CFs tosupport their 'under-writing' operations (para. 6.09).
(e) Legislation to exempt or alleviate the effect of double-taxation ofdividends and increase incentives for capitalization in widely-heldcompanies (Law 9 of 1983) was proposed by the Government andapproved by the Congress in the second quarter of 1983 (paras. 607to 6.09).
(f) Authorization for the creation or operation of the Companias deAuto Financiamiento (CAUFs) has been withdrawn, except for alimited transient period over which the operations of existingCAUFs would have to be phased out (para. 4.10).
(g) Through Decree 1914 of July 1983, the Government also clarified theregulations governing the public issue of bonds by Colombiancompanies and strengthened the oversight and regulatory functionsof the National Securities Commission in this respect (para. 5.19).
(h) The high level National Commission for Financial System Reformsubmitted to the President of the Republic its summary report and
main conclusions. The commission's report endorses measures to:
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(i) regulate more closely the activities of 'financial groups' andinterlocking ownership of financial institutions;
(ii) define more clearly and enforce strictly the rights,responsibilities and obligations of the different categoriesof financial institutions;
(iii) reinforce the specialization of functions among the differentcategories of financial institutions through appropriateinstitutional regulations;
(iv) enforce stricter controls over portfolio concentration,minimum capitalization and lending to other financialinstitutions;
(v) regulate more closely the activities of the majorityshareholders and directors of financial institutions; and
(vi) strengthen faculties of the Superintendency of Banks andimprove coordination of its control activities with those ofthe National Securities Commission and other concernedagencies (paras. 4.10 to 4.14).
(j) A special Sub-Commission chaired by the Vice-Minister of Financewith participation of senior representatives of BR, Junta Monetariaand Superintendency of Banks has been created to study further thespecial issues related to the operations of CFs and neededreforms.
SUMMARY AND RECOMMENDATIONS
Background
i. The Colombian financial sector enjoyed a prolonged period ofstability and was characterized by a relatively simple institutional systemcomprising mainly commercial banks and investment banks (CorporacionesFinancieras -- CFs) until the late 1960s. A series of developments in thesubsequent period led to numerous changes in the institutional structure ofthe system as well as financial instruments. Most importanit among these are:(a) periodic movements towards financial sector liberalization as a means toincrease the volume of resources intermediated by the institutionalized(formal) system; (b) development of a flourishing extra-bank (informal)market as a response to strong financial sector repression which prevailedover a major part of the decade and prevented the institutionalized financialsystem from meeting fully the demand for intermediation; some of the informalmarket was later regulated under the name of Companias de FinanciamientoComercial (CFCs); (c) the creation of new categories of financialintermediaries (Corporaciones de Ahorro y Vivienda (CAVIS) and CFCs) and ofnew instrur ts such as Certificates of Deposits (CDTs) and indexedinstruments (1UPAC) to mobilize resources to fill specific evolving needs inthe economy; (d) domestic and international economic developments, includingthe coffee and illegal exports boom during 1975-80 and the subsequentworldwide recession; and (e) perceived conflicts between stabilization andfinancial sector liberalization policies in the face of high inflation ratesduring the 1970s and early 1980s.
ii. The complexity of these developments has put strains on thetraditional framework of financial institutions. By the end of the 1970s,several inconsistencies were visible in the institutional framework and inthe body of financial regulations. The liberalizing measures introduced overparts of the last decade have not succeeded in reducing the fragmentation ofthe financial markets, but instead, have tended to increase it. They led toa complex system in which the institutionalized free market coexists with acompartamentalized system of subsidized credit and a large and growinginformal market. The structure of market incentives in recent years made itmore profitable even for intermediaries traditionally oriented towards termfinancing to move increasingly towards short term operations. A de factomultibanking system has resulted from the formation of groups of entitiesworking in the different specialized markets and linked by common ownership,and linkages between financial and non-financial groups have becomewidespread, in the absence of adequate regulation of such groups.
iii. The sources of the above can be traced in part to the conflicting,or at least competing, objectives which the Government tried to pursue withits financial policies. Among the competing objectives were: (a) to supplysubsidized credit to priority sectors; (b) to increase the intermediation ofresources through the institutional financial system; and (c) to useregulation of the financial sector as an instrument to control inflation.The relative weight given to these aims differed at various periods duringthe seventies.
Interest Rate Policies and Prospects forFinancial Sector Liberalization
iv. Observed real lending interest rates have been high over the last1-2 years in Colombia due to: (a) the high real international interestrates; (b) varying expectations of savers regarding future exchange rate ofthe peso; (c) the growing cash deficits and/or credit needs of the Govern-ment, the high marginal reserve requirements used in part to finance themand neutralize their inflationary impact; (d) the use of forced investmentsto finance subsidized credits; and (e) the imperfect competition in financialsector arising from the existing oligopolistic market structure and theprotection afforded by the regulatory framework through restricted access toexternal credit and absence of free entry for new financial intermediaries.
v. The high real interest rates coexist with relatively large creditsubsidies. The latter have several undesirable effects on resource alloca-tion. They tend to discriminate against labor intensive techniques,discourage efficient use of capital and create incentives for industrialfirms to become exceesively leveraged. Moreover, based on field interviewswith industries and financial institutions, there is reason to believe thatthe subsidies are contributing to a worsening of ownership concentration inthe Colombian industrial sector, because the larger industrial groups inColombia tend to have close linkages with the major financial institutionsand are typically able to obtain privileged access to the subsidizedcredits. Finally, under the current system of fixed interest rates forsubsidized credits, the amount of subsidy automatically increases wheneverthe market nominal interest rates increase, as may result from rising infla-tion rates. The forced investment requirements in effect operate as a wedgebetween free market and subsidized rates, causing increasing segmentationbetween the two segments as inflation rates rise.
vi. In general, the continued process of financial sectorliberalization appears to offer the best prospect of helping to solve theproblems identified. A relatively free financial system would be aprerequisite for financial intermediaries (including the CFs) to be able toperform the desired role in promoting industrial investment and development.Any attempts to bring the current interest rates down by administrativemeans, without addressing the underlying causes, are likely to be frustratedby large and destabilizing shifts of funds from the controlled segments toless restricted segments of the sector offering better yields, from formal toinformal markets, and from domestic financial instruments to domestic real(tangible) assets or foreign (real or financial) assets. The liberalizationstrategy would, however, have to be chosen cautiously and should reflect agradual approach. Among the early measures should be a significant butgradual reduction in the credit subsidies and forced investments, and stepsto promote freer entry of institutions and more effective competition in theformal financial system. At a later stage, a gradual reduction of the legalreserves requirements and/or interest rate ceilings on current and savingsaccounts, could also be considered to help increase price competition andresource mobilization in the financial system. However, the beneficial
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effects of such liberalization would be achieved only if the Governmentsucceeds in bringing its budget deficits and inflationary pressures undercontrol.
The Corporaciones Financieras (CFs) System
vii. The system of CFs was created in Colombia as the investment bankingcomponent within a specialized banking model, to provide term credit and riskcapital to the productive sector and to help in the process of Colombiancapital markets development. While these objectives have been partiallyrealized, several concerns have emerged in recent years regarding theperformance of the CFs system. Among the important concerns are: (a) thetendency of the private CFs to operate increasingly in the short term market;(b) relatively less dynamic resource mobilization by the CFs in comparisonwith other types of Cinancial institutions; and (c) the observed limitedimpact of the CFs in stimulating risk capital investments in the productivesector. These concerns have led to a dilution of the identity of the CFs asgenuine investment banks.
viii. The lack of a proper identity for CFs is reflected by the fact thatthere are in Colombia at least three types of CFs with diverse objectives.These are: (a) private CFs which have attempted to fulfill their originalobjectives of providing term financing and risk capital to productiveenterprises; (b) private CFs which were established mainly to take advantageof certain regulatory and other benefits and which focus almost entirely onshort term operations; and (c) special purpose official CFs created by theGovernment to fulfill specific sectoral functions.
ix. The causes for the above situation can be traced to themacro-economic climate, the regulatory and incentives framework, officialintervention, the evolving structure of the financial/industrial groups andthe early stage of development of the Colombian capital markets. These havecontributed to the relatively low profitability and high risk of medium- andlong-term financing (including equity investments) in comparison with shorterterm lending operations and have weakened the competitive position of the CFsvis-a-vis other types of financial institutions.
x. Specific factors that currently impair the working of the CFssystem as originally conceived include:
- the strong liquidity preference among domestic savers, stemmingfrom the uncertainties regarding future inflation rates, frequentchanges in the relative yields of savings instruments and the lackof suitable longer term savings instruments;
- the lack of adequate mechanisms to facilitate using short termdeposit resources for medium- and long-term lending, particularlyin the presence, in effect, of an "inverted" yield curve caused byavailablity of highly subsidized medium- and long-term loansthrough the official system;
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- competitive disadvantages faced by the CFs vis-a-vis other types offinancial institutions with respect to the type of depositaccounts permitted, size of branch network, etc.;
- a relatively high degree of concentration of financial powercharacterized over the last decade by the emergence of "de facto"financial/industrial groups, some of which control directly orindirectly institutions covering the whole spectrum of financialactivities as well as a wide range of industrial firms;
- the absence of a comprehensive regulatory framework to controlactivities of 'groups' to define clearly the mutualresponsibilities and obligations of the constituents (and owners)of a group and to protect the interests of minority shareholders;and
a tax system that favors heavy debt financing by industrial firmsin preference to adequate capitalization and acts against asatisfactory development of the stock market and wide distributionof share ownership.
xi. To address the above problems and issues, a series of actions isrecommended to improve the CFs system, investment financing mechanisms andthe related policy framework. Some of these actions can be takenimmediately, but some will require further study and elaboration before theycan be implemented.
IMMEDIATE MEASURES
A. Interest Rate Policies
xii. Any new administrative controls of interest rates should beavoided. Likewise regulatory policies and official interventions which leadto frequent variations in the relative yields of alternative savingsinstruments should be resisted. Avoiding arbitrary changes in the yields ofsavings instruments would help reduce the uncertainties facing the savers,the consequent large liquidity preference among them, and potentially largedestabilizing flows of resources among instruments and among institutions(para. 3.15 of the main report).
xiii. The existing forced investment requirements applicable to resourcesof financial institutions should be reduced gradually but substantially inorder to reduce the segmentation between the free and subsidized creditmarkets (paras. 3.14 and 3.16).
B. Facilitating Floating Interest Rates and a Term TransformationMechanism.
xiv. A floating interest rate scheme which links the CFs' lending ratesto an index representing the average cost of raising deposit resources should
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be introduced to facilitate term lending to the productive sectors. Thefloating rate feature would allow the use of the short term deposit resourcesby the CFs to make medium- and long-term loans. The satisfactory working ofsuch a system would critically depend on a stable and liberal interest ratepolicy applicable to CDTs and competing market instruments (paras. 5.03 to5.11).
xv. The term transformation scheme should preferably also provide theoption to borrowing enterprises to capitalize automatically part of theinterest payments due on the loans. This would help alleviate the cash flowproblems of borrowing enterprises in the initial years of investment underconditions of high nominal interest rates (paras. 5.12 to 5.14).
xvi. Several specific actions should be taken to facilitate theimplementation of the term transformation scheme along the above lines:
(a) BR should calculate and publish periodically (say once a month) asuitable index of the average cost of new CDT (Certificates ofDeposit) resources e.g., the average effective interest rate on 3-6month CDTs issued by Colombian financial institutions over the most>ecent period; the index would be based on information gathered byBR on the borrowing costs of financial institutions, with suitablecross-checks to ensure its accuracy and reliability; theavailability of similar supplementary indices should be facilitatedthrough requirement of publication by banks and CFs of theireffective CDT (and lending) interest rates (para. 5.07).
(b) Reasonable access, subject to appropriate restrictions, should beallowed for the CFs to BR's 'cupo extraordinario' and/or othersupplemental schemes (e.g., those involving a short term sell andbuy-back of term loans) to help address liquidity problems thatmight arise from term transformation in case of a demonstrated dropin CDT deposit resources (para. 5.09).
(c) In order to correct the artificially low ceiling on final interestrates applicable to arrearages, which also acts as a de factoceiling on the lending rates themselves, the 'tasa de interes enoperaciones crediticias ordinarias', which is to be determined bythe Superintendencia Bancaria under the 'Codigo de Comercio' forfixing maximum interest rates on loan arrearages, should be revisedat least once a year, and more frequently if conditions so demand,to set it equal to a representative market rate, say, the averageCDT interest rate in the month immediately preceding such revision(para. 5.05).
(d) Information on the lending rates of financial institutions, whichis required to be published periodically under a current JuntaMonetaria Resolution (and is published through the AsociacionBancaria under current practice), should be required to stateclearly the effective lending interest rates which take account ofall loan charges, advance payments and commissions, in order toallow greater transparency in lending rates and help improve
competition in the financial markets (para. 5.17).
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C. Access to Official Financing Funds and Levels of Subsidies
xvii. (a) BR's rediscounting funds ('Official Financing Funds') should alsoreplace their current fixed interest rates system by a floatingrate system along the lines described in item B (using the samebase index). This would imply that any interest rate subsidiesprovided under the credits would stay essentially at a constantlevel over the period of the loan. The floating rate system wouldavoid arbitrary increases in the margin of subsidization wheninflation and nominal interest rates rise. The level of subsidiesshould be substantially lowered from their current levels, using agradual approach to allow the necessary time for adjustment(para. 5.22).
(b) The proportion of the loans refinanced by the Official FinancialFunds should be reduced significantly over time and the financialintermediary required to contribute a larger share from depositresources mobilized from savers in financing term loans. Thespreads to the intermediaries should be modified in order to allowthem to cover their full operating costs, costs of depositresources raised on their own and default risks, and to provide areasonable incentive in the form of a fair profit (paras. 5.22 and5.23).
(c) Domestic currency loans financed by IBRD and other officialinternational organizations should, as far as possible, also bebased on the floating interest rate system described above (para.5.23).
(d) The 5-year maximum limit on terms of lending under the FFI schemeshould be eliminated because it creates a bias against investmentwhose cash flows imply a need for longer term financing.
(e) The CFs should be assured of at least an equal access to theresources of the Official Financing Funds by securing the specialprivileges enjoyed by commercial banks in the rediscountingoperations (paras. 4.13 and 5.22).
D. Institutional Development
xviii.(a) The CFs should in the near term be encouraged to reestablish theiridentity as specialized institutions devoted to term financing andequity investments in productive enterprises. In view of thehigher risks involved in long-term lending and equity investments,the maximum limit on the debt to equity ratio for CFs should bereduced from its current level of 15:1 to about 10:1. To ensuresoundness of portfolios and adequate diversification, total loansand equity investments outstanding to the constituents of a singlegroup of affiliated financial and industrial enterprises (definedcomprehensively to include all enterprises with significant
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ownership linkages), their owners and managers should be limitedto, say, 50% of the CFs' own networth; separate maximum limits onthe total equity investment by a CF in a single firm are also inorder, say a maximum of 40% of the firms' networth or 10% of theCFs' own networth, whichever is higher. Similar restrictions onportfolio concentration and strict public disclosure requirementsshould also apply to other kinds of financial institutions such ascommercial banks and CFCs (paras. 4.09 and 4.11).
(b) In general, free entry should be allowed for financialintermediaries, and Government authorization granted to new CFs aslong as certain well specified criteria, including the minimumcapital requirement, are met. In the case of CFs, the minimumcapital requirement should be reduced from the currently high levelof Col$ 1.0 billion to, say, Col$ 500 million, but this requirementshould apply to existing as well as ntewly created CFs. The CFsshould also be required to maintain a substantial proportion(60%-70%) of their portfolios in medium- and long-term loans orequity investments. Existing CFs should be given a transitionperiod (of say 2-3 years) to comply with the new requirements.Smaller, marginally competitive CFs,which were originally createdwhen the minimum capital requirement was extremely low (Col$ 50-100million), but are still operating, should be allowed, during thetransition period, to merge as necessary to comply with the newminimum capital requirement (para. 4.11).
(c) In order to ensure sufficient financial incentive for CFs in tnelight of the institutional requirements proposed above, the CFsshould be provided incentives in the form of a waiver of the 10%forced investment requirements on CDTs and allowing a largerpercentage and/or a higher spread on BR's rediscounting funds(para. 4.13). The Government may also wish to examine whether itwould be desirable to provide privileged access by CFs to thoseOfficial Financing Funds which require particular technicalcapacity and skills in evaluation and supervision of investmentprojects (e.g., FIP and medium- and long-term financing operationsof PROEXPO) (para. 5.22).
E. Risk Capital Investments by CFs
xix. In addition to their normal equity holdings, CFs should beencouraged to make use of quasi-equity instruments such as subordinatedconvertible debentures, preferred shares and equity instruments with an
obligation to repurchase. These would provide CFs with a wider range ofinstruments falling somewhere between pure debt and pure equity, and wouldenable them to match the instruments better with the borrowing firms' cashflow characteristics and needs. At the same time they would provide greatermarketability and a better assurance of a fair return on the CFs' riskcapital investments. More work is needed, however, to analyze the legal, taxand other aspects of these instruments and decide on their specificapplication in the Colombian system (paras. 6.01 to 6.06). Steps tostimulate stock under-writing activities of CFs should also be considered
(para. 6.09).
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F. Access to Borrowings from Foreign Commercial Sources
xx. Limitations on external borrowings by CFs and industries inconnection with expansions in productive capacity could be relaxed, e.g.through removal of the maximum term limitations for such borrowings, which nolonger appear appropriate, and allowing some external borrowings forfinancing local investment costs. The increased access should help promoteinvestment financing and could also put a downward pressure on bank spreadsand lending rates through increased competition. Such relaxation should,however, be compatible with other macro-economic developments (such as importliberalization) and total external debt capacity (paras. 5.27 and 5.28).
LONGER TERM MEASURES
A. Institutional Structure and Regulation
xxi. (a) More comprehensive regulations covering the activities of finan-cial/industrial groups should be developed and implemented. Suchregulations should specify permissible ownership, funds flow andother linkages among different types of financial institutions andbetween financial and industrial groups, the rights as well asobligations of the owners and constituents of a group (ensuring anappropriate balance between such rights and obligations), andrequirements to provide consolidated financial statements forgroups of related enterprises (paras. 4.04 and 4.10).
(b) The supervisory functions of the Superintendencia Bancaria and thelegal information requirements from financial institutions shouldbe strengthened by: (i) placing under the authority of Super-intendencia Bancaria all financial intermediaries raising resourcesfrom the public; and (ii) improving the quality and timeliness ofthe information available from the financial institutions to theSuperintendencia Bancaria and the public at large (para. 4.10;).
(c) Any borrowings from the public by majority owned financial subsi-diaries of large industrial firms or groups should be secured bythe assets of the parent company, be within prudent limits commen-surate with such security, and preferably be in the name of theparent company (para. 4.10).
(d) In the long term, once adequate regulation of financial groups hasbeen achieved and the required expertise for investment financinginternalized within the banking system, the authorities couldconsider whether a move towards a 'multi-banking' system might bejustified. Such a move, if chosen for the longer term, wouldstill have to build on the expertise developed in the specializedinstitutions in the near term. In view of the potentialologopolistic effects, such a move should be undertaken cautiously,and only after confirming that competitive financial markets can beensured (para. 4.08).
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B. Longer Term Instruments for Resource Mobilization
xxii. (a) CFs should be encouraged to raise longer term resources in thedomestic markets. This should be facilitated through issuance ofmedium and long-term floating rate notes and bonds whose interestrate would be linked with the average CDT rate prevailing in themarket to be published periodically by BR (paras. 5.20 and 5.21).
(b) To avoid possible destabilizing flows affecting the Corporacionesde Ahorro y Vivienda (Savings and Loan Associations - CAVI), theyshould also be permitted to issue CDT-based bonds as well as longterm UPAC indexed bonds with a gradually liberalized ceiling on themonetary correction to ensure equilibrium between UPAC rates andmarket interest rates, taking into account the Government policy ofproviding suitable financing to stimulate housing construction.
C. Capital markets development
xxiii.(a) Fiscal and legislative measures should be taken to strengthen theoperation of the securities markets and thus achieve greaterattractiveness for equities and other long-term savings instru-ments. Needed reforms include measures to improve protection ofthe rights of minority shareholders and removal of existing fiscalbiases against investments in risk capital e.g., those stemmingfrom the double taxation of dividends, full interest rate deductionon debt financing for purposes of tax computation, and the muchlarger withholding taxes on dividend income (up to 40%) compared tointerest income (only 5%). Both the difficulty of equitablyenforcing taxes on interest and dividend income and theirpotentially negative effect on personal savings suggest that thesetaxes should be reduced if not eliminated. Consideration shouldalso be given to introducing a full inflation accounting system inthe accounts and tax systems of corporations and financialinstitutions. These reforms are best undertaken in the context ofa wider ranging reform of the tax system and administration(paras. 6.07 to 6.09).
(b) Efforts should be made to strengthen the secondary market for theCDTs, including through the creation and administration of aspecial facility to help secondary market liquidity (but withoutany associated price guarantee). It would also be desirable forthe Government to consider homogenizing the characteristics of theseveral short term official papers being issued under differentnames and with different characteristics ('titulos departicipacion', 'certificados de cambio', etc.). This wouldfacilitate a secondary market of the required depth and breadth forthese instruments, and could provide an excellent index of shortterm interest rates which can be used as the reference for futurefloating rate instruments (para. 5.07).
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D. Further financial sector liberalization
xxiv. Further liberalization of the financial sector should be consideredfor the longer run through a gradual reduction of the reserves requirementsas inflation is brought under control. This should be accompanied by agradual removal or relaxation of the ceilings on checking and savingsaccounts interest rates. In order to achieve the desired longer-termbenefits of such liberalization, these measures would have to be accompaniedby other measures related to macro-economic management such as a substantialreduction or elimination of fiscal deficits and improvement of public sectorsavings. The possible liberalization measures should therefore be consideredcarefully to ensure full compatibility with macro-economic conditions andmonetary management (paras. 3.16 to 3.18).
I. PAST TRENDS AND POLICIES IN THE COLOMBIAN FINANCIAL SECTOR
Institutional Structure
1.01 Colombia has a relatively well-developed and diversified financialsector comprising the Central Bank (Banco de la Republica - BR), about 25each of commercial banks and corporaciones financieras (CFs--investmentbanks), a central mortgage bank (Banco Central Hipotecario--BCH), 10 savingsand loan associations (Corporaciones de Ahorro y Vivienda--CAVIs), nearly 40trade finance companies (Companias de Financiamiento Comercial--CFCs), morethan 70 insurance companies, several mutual funds and two stock exchanges (atBogota and Medellin). The commercial banks have the largest branch network,with more than 1,800 offices distributed throughout Colombia, followed by theCAVIs (400 branch offices in total), BCH (75 offices) and CFs (over 100branch offices). Commercial banks represent the dominant segment, accountingfor more than one-third of the total outstanding credit of the institu-tionalized financial system in recent years. As described below, to a sig-nificant extent this institutional structure represents the result of anevolution of the system over the last few decades in response to the changingfinancial sector policies, regulations, the macro-economic situation, andrelated stabilization measures.
1.02 Direct lending by banks is supplemented by rediscounting funds ofBR funded in part out of the legal reserves of the banking system. Forindustry, the most important of these are the Industrial Financing Fund(FFI), which rediscounts loans made by commercial banks and financieras tosmall- and medium-size industrial firms (those with total assets of up toCol$60 million), the Private Investment Fund (FIP), which mainly financesfirms larger than those covered by the FFI, and PROEXPO, which providescredit to non-traditional export activites (typically industry), using mostlyfunds from a 5% import tax.
Developments Through the 1960s
1.03 The Colombian financial sector enjoyed a prolonged period ofstability up until the late 1960s. However, by that time the financialsystem was a relatively repressed one, characterized by depressed financialsavings due to low ceilings on interest rates, high reserves requirements,and substantial credit rationing. The regulations obliged private inter-mediaries to pay negative real interest rates on savings deposits, in part toreduce competitive pressures on official banks and government borrowings. Bythe end of the 1960s, an increasingly flurishing informal (extra-banking)market developed to circumvent the regulations of the formal institu-tionalized financial system.
1.04 The main institutional innovation during the 1950s and 1960s wasthe creation of the Corporaciones Financieras(CFs), through Decrees 336 of1957 and 2369 of 1960. The stated objective of the CFs was "to promote thecreation, reorganization, and transformation of firms (in the manufacturing,mining, and agricultural sectors), to participate in their capital or facili-tate the participation of others, and to provide them credit". The onlyother major financial intermediaries operating were the Caja Agraria (Caja deCredito Agrario Industrial y Minero), an official credit institution created
in 1931 primarily to provide credit to small scale farmers (later broadened
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to include provision of credit to small industry and small scale mining), andthe Central Mortgage Bank (BCH), an official bank created in 1932 to fulfillthe full range of moirtgage banking functions. By the end of the 1960s therewere 23 commercial banks, 9 CFs, and 2 specialized official credit institu-tions (Caja Agraria and BCH). The financial system remained relativelysimple until the late 1960s and the functions of the different categories ofcredit institutions were delineated clearly. Apart from the specializedfunctions assigned to the two official banks, commercial banks were raisingresources through checking and savings accounts and lending mainly throughshort-term operations as conceived originally under Law 45 of 1923 (althoughin the early 1960s the banks began to participate in term lending operationsthrough the rediscounting funds of BR), while the CFs focussed their effortsprimarily on provision of medium and longer term credit to the productivesectors and to a limited extent participation in the share capital ofproductive enterprises.
1.05 The prolonged period of stabilization ended in the late 1960s andearly 1970s, when a major liberalization of the financial sector was under-taken. The liberalization was made possible in part by the establishment ofa crawling peg exchange rate system in 1967 which reduced the risks ofcapital flight in anticipation of major devaluations. In 1969 interest rateceilings on term deposits with banks, BCH certificates and publicly-heldgovernment debt were increased. To further increase the intermediation ofresources through the institutionalized financial system, and to enable thesystem to compete with the secondary market yields of the Certificados deAhorro Tributarios (CATs - negotiable tax rebate certificates created in 1967to stimulate non-traditional exports), commercial banks were allowed,starting in 1971, to issue CDTs at interest rates substantially higher thanthose on savings accounts (see Table I of the Statistical Appendix). T'hesemeasures facilitated an increase in the total assets of the institutionalizedfinancial system from about 15% of GDP in 1967 to 17% during 1970-72.
The Creation of the UPAC System (1972)
1.06 The creation of the savings and loans institutions (CAVIs) in 1972represented a major innovation in the Colombian financial market, not onlybecause it represented a further specialization within the institutionalsystem, but also because they were allowed to index both their credits andliabilities to the public through the use of a "constant purchasing powerunit" (UPAC) linked to the consumer price index. Interest rates (bothlending and borrowing rates) were subject to ceilings, but were expressed asmargins additional to the monetary adjustment of the UPACs. Thus, the UPACsystem represented a further liberalization of the financial system, but forthe specific purpose of stimulating the housing and construction sector,which was an important vehicle to spur economic development under thePastrana administration's "Four Strategies."
1.07 The effective interest rate on UPAC savings accounts in 1973 was26.2% compared to 13.6% and 8.8% in commercial banks' CDTs and savingsaccounts respectively. This yield differential in favor of a quasi-liquidinstrument made for a steep growth of CAVIs. Their share of total depositswith the financial system went up from nothing in 1972 to 12.1% in 1973 and16.7% in 1974. The housing industry boomed as a result, reflected as a. sharpincrease in housing starts. However, the UPAC investments posed a danger tothe rest of the financial system, which by 1973/74 began to experience asignificant disintermediation.
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The Financial and Tax Reforms of 1974/75
1.08 The solution to the above problem was provided by the comprehen-sive reform of the financial system which was undertaken by the LopezMichelsen administration upon taking office in August 1974. The generalphilosophy of the reform was to liberalize the financial sector in order topermit higher financial savings, improve efficiency in credit allocation andtherefore a higher productivity. The reform had the following major ele-ments:
- Interest rates on deposits with financial intermediaries stillremained under control, but the ceilings were raised substantially. Interestrates on savings accounts were raised to 12% on minimum quarterly balances(up from 8% previously) and those on CDTs were doubled in nominal terms from12% to 24% to make them approximately equal to those offered by UPAC instru-ments (Table I).
- Interest rates on loans by financial intermediaries were freed,eliminating the previous 14% limit.
- The Government intervention on the allocation of resources wasreduced through the reduction of reserve requirements and forcedinvestments and the abandonment of policies attempting to fix theamount and destiny of loans other than rediscounts.
1.09 The above liberalizing measures were, however, accompanied byimposition of a ceiling on the monetary correction allowed under UPAC instru-ments, in order to put them on an approximately equal footing with CDTs.Moreover, the 1974 financial reform was accompanied by a tax reform enactedin the same year to strengthen the fiscal base and make taxation more pro-gressive, which had a somewhat unintended effect of neutralizing some of thebenefits offered by the financial sector liberalization. Specifically, thetax law changes reduced the attractiveness of financial savings, sinceinterest income from savings accounts and certain other instruments such asCATs became subject to taxation (after deducting a minimum tax fee allow-ance). Also, realized capital gains were made subject to the same tax rateas ordinary income except for a deduction of 8% allowed as compensation forinflation (which averaged about 16% per year during 1970-74 and 25% during1974-81). UPAC's monetary correction was also made taxable except for a 8%deduction.
1.10 The net effect of the financial and tax reforms was an increase inthe ratio of deposits mobilized by the institutional financial system to GDPfrom an average of 19.7% in 1970-74, to 24.6% in 1975-79. However, this wasnot adequate to fill the intermediation needs of the economy and the informal(extra-bank) market remained strong. During the mid and late-1970s, it isestimated that as much as one-quarter to one-third of total industrial creditwas being channeled through the extra-bank market, which comprised operationsof unregistered entities as well as complex innovations such as sales ofportfolios and trust accounts developed by the formal banking institutions tocircumvent the regulations.
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Creation of New Financial Intermediaries For Trade and Consumer Financing
1.11 In an effort to bring into the institutionalized system part ofthe resources which were being siphoned off by the informal market, theGovernment created, through Decrees 1773 of 1973 and 971 of 1974, a newformal category of financial institutions, simply called "financial inter-mediaries," which were subject to less supervision and regulation by theauthorities than commercial banks, CFs an CAVIs, although some amount ofcontrol was exercised through the Superintendencia de Sociedades. The typesof credit operations and deposits which could be undertaken by the new"financial intermediaries" were defined only in vague terms, giving the newinstitutions a large amount of flexibility in managing their operations. Thebulk of the resources of the new intermediaries were raised through 3-6 monthpapers and their credit was oriented mainly to trade and consumer financing.The minimum capital and other requirements for establishing the new type ofintermediaries were less demanding than for other categories of financialinstitutions. The response from the market was overwhelming: 16 such new"financial intermediaries" were created between 1974-76 and an additional 18were created during 1977-78, to take adavantage of the looser regulations andescape the more restrictive regime applicable to other intermediaries. Thesenew "financial intermediaries," which were renamed in 1979 as 'Companias deFinanciamiento Comercial' (CFCs), remained the most rapidly growing segmentof the organized financial system through the end of 1981. Their share ofthe total liabilities of financial intermediaries in Colombia increased fromabout 2% in 1975 to 3.9% by the end of 1977 and 4.9% by year-end 1980.
CFs and CDTs
1.12 In 1975 (through Decree 399/75), the operations of CFs werebroadened to permit them to issue CDTs of 90, 180 and 270 days to mobilizeshort-term resources, and to finance the working capital needs of productiveenterprises through short-term lending operations using the CDT resources.This measure had a profound impact on the operations of the CFs. Previously,CFs had been heavily dependent on BR and BR-administered external lines ofdevelopment credit to finance their credit operations. Decree 399 had thepositive impact of liberating the CFs from excessive dependence on BR's andother rediscounting lines of credit of their resources. However, at the sametime, it also freed the CFs from the need to lend on medium or long term. Infact, the prevailing market conditions were such that short-term lendingoperations using CDT resources were much more profitable than longer-termoperations, partly as a result of the inverted yield curve which effectivelyprevailed in Colombia since firms had access to subsidized longer-termcredit. This created strong incentives for the CFs to move increasinglytowards shorter-term lending operations in preference to medium and long-termcredit operations or equity investments. By 1978, resources utilized by theprivate CFs through CDTs as a percentage of the total resources of CFsaccounted for more than one-third of their total resources.
1.13 The above liberalization measures together with the prevailingmarket incentives and higher leverage ratios permitted for CFs compared tocommercial banks resulted in the creation of a large number of new CFs in theensuing years. As many as 12 new CFs were established between 1974 and 1978most of which had the primary objective of operating in the short-termmarkets. The existing CFs also tended to shift their emphasis in the same
direction, but those CFs which attempted to maintain their initial objectiveswere less aggressive in mobilizing short-term resources. The largest singleCF with a short-term orientation mobilized more resources through CDTs thanall the six major traditional ones in every single year during the 1976-81period. I/
Equity Investments by CFs
1.14 Responding to increasing concerns that CFs have not been able tostimulate significantly the capitalization of productive enterprises (thoseoperating in the industrial, agricultural or mining activities), which wasone of the originally stated objectives of the CFs system, the Monetary Boardimposed, through its Resolution 65 of 1977, requirements for CFs to hold atleast 10% of their total assets in the form of equity investments. Theconcerns were well jLstified, although the real reasons for the lack ofinterest in equity invstments were the absence of adequate market incentivesand lack of a developed secondary market for venture capital type investments(see Sections II and VI for a detailed discussion). The period for complyingwith the above requirement was later extended until mid-1979, and the Resolu-tion itself was amended subsequently to require minimum equity investments inthe portfolio of any CF equal to 80% of its networth instead of 10% of totalassets. The latter change was made to take into account the diverse leverageratios of the CFs and that for reasons of financial prudence the CFs shouldlimit their risk capital investments to an amount somewhat less than thevalue of their own equity. The CFs have generally complied with the minimumsspecified. The above requirements had an effect of increasing equity invest-ments of CFs from about Col$ 800 million in 1976 to more than Col$ 3,000million by year-end 1978. In the case of several industrial companies inwhose share capital they participated, the CFs have played a significantdevelopmental role, although this observation should be tempered with thequalifications expressed in Section It (para. 2.13). 2/
The 1977-79 Stabilization Measures
1.15 In 1977 a series of stabilization measures were implemented tocounter the strong inflationary pressures brought about by the sharp rise inforeign exchange earnings due to the coffee bonanza and the substantialillegal exports as well as the shortage of basic food supplies. The measureseffectively reversed most of the financial market liberalization undertakenduring 1974/75. Since the increased foreign exchange flows were viewed as atemporary phenomenon and conspicuous consumption of non-essential imports wasconsidered undesirable, the Government was unwilling to liberalize importssignificantly. Instead, strict monetary controls were imposed in the form of100% marginal reserve requirements on increases in checking accounts, termdeposits and foreign currency deposits above their January 1977 levels andsome increases in the average reserve requirements on checking accounts
1/ Significantly, CFs which retained a longer-term orientation tended to bemainly those that were forced to do so under contracts signed for World Banklines of credit which specify maximum limits on short term lending by the par-ticipating CFs.
2/ Through an earlier measure in mid-1979, the Government created a NationalSecurities Commission with the objective of stimulating and regulating the
securities markets.
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and foreign currency obligations. Concurrently, in an attempt to avoid aslowdown of investment in key sectors, renewed emphasis was placed on trhesystem of selective credit allocation through BR's industrial financingfunds, the forced investment regime was restored through requirements for theacquisition of agroindustrial and IFI bonds, and more restrictive ceilingswere reimposed on interest rates which therefore could not rise withinflation. Additional restrictive measures included the institution offorced investment requirements (initially of 15% and later 25%) on CDsinssued by the CFs, the issue by BR of 90-day "certificates of exchange"denominated in dollars for the purpose of "mopping up" the liquidityoriginating from the external sector, and, starting in September 1979, openmarket operations through the issue of 'certificates of participation' i(akinto treasury bills in the U.S.) offering effective yields of up to 37% p.a.(for maturities ranging from 15 to 90 days) which exceeded the yield allowedfor the institutionalized financial system. A withholding tax of 5%, whichwas instituted through Law 20 of 1979 for income on interest earnings, had afurther dampening effect on resource mobilization by banks and CFs. Theimmediate effect of these measures was a virtual stagnation of financingsavings channeled through the formal financial system in 1977. This"counter-reform" of the financial sector was maintained through the years1978 and 1979, while the extra bank (informal) market continued to grow.
1.16 In order to ensure more effecte vigilance of at least part of theextra bank market, the Government took measures in August 1979 (throughDecree 1970) to make the "financial intermediaries" referred to above (whichwere earlier on the fringe of the institutionalized banking system) a formalpart of the institutionalized system with clearly specified rules and objec-tives and direct supervision of these entities by the SuperintendenciaBancaria. Renamed as "Companias de Financiamiento Comercial" (CFCs--tradefinance companies), they were made subject to higher minimum capitalrequirements of Col$ 100 million (up from Col$ 10 million earlier). The CFCswere allowed to issue CDTs and other term deposit instruments and authorizedto use those resources for making short and medium-term loans (of up to threeyears in maturity) for financing durable consumer goods, services and otheraspects of trade. The term deposits mobilized by CFCs were made subject toforced investment requirements comparable to those of CDTs issued bycommercial banks and CFs. Also, CFCs have been precluded from rediscountingloans with BR's Official Financing Funds and contracting external loans.
Recent Developments
1.17 Starting in 1980, restrictions on the financial sector have beeneased. In January 1980, the Monetary Board put in effect a series of majorreforms to remove or relax a wide range of regulations affecting banks andCFs. Most importantly, it removed ceilings on interest rates on CDTs and onloans made with funds raised through CDTs. The Monetary Board also abo:Lishedthe 100% marginal reserve requirements on current accounts and foreigncurrency deposits as of January 1980 and substituted this by a gradualincrease of the regular (average) reserve requirements from 45% to 50%.Regular reserve requirements for CDTs of banks and CFs were reduced from 25%to 15%, and later to 10%. Yields provided on the forced investments wereincreased. Finally, the Monetary Board lifted the 3-5 year mandatory ceil-ings on the terms for external financing contracted directly by the privatesector for equipment purchases and delegated to the External Trade Council(Consejo Directivo de Comercio Exterior) and INCOMEX, the authority to
approve terms for each external financing operation compatible with the
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investaent's gestation period and cash flow projections. In September 1980,and again during 1982, interest rate ceilings on savings accounts and UPACinst.-uments were liberated slightly and reserve requirements further lowered(see Section III).
1l18 The expansion of reserve money continued into the 1980s, evenafter the end of the above boom, as the Government started to use the "CuentaEspecial de Cambio" to finance its increasing cash deficit (estimated atabout 2% of GDP for 1981 (see Table II of the Statistical Appendix). Tocounteract this, the Government continued to maintain relatively highmarginal reserves requirements, although substantially lower than the 100%marginal requirement used during the coffee boom. At the same time, in orderto provide subsidies in the form of low cost credits to some sectors andactivities which were considered to be of high priority (e.g. agriculture,small-scale industry, long-term industrial investments) the Governmentretained substantial forced investment requirements on financialintermediaries.
The Formation of Financial and Industrial Groups
1.19 seen from the above discussion, the Colombian financial system,which consis-ed primarily of commercial banks and two official creditinstitutions in the 1950s was gradually widened to include CFs, CAVIs andCFCs. This growth of specialized institutions was accompanied by a trendtow;ards formation of financial conglomerates (groups), which was to asignificant extent a natural consequence of the specialization itself. Mostof the important CFs and CAVIs and to a lesser extent, CFCs, were created bycommercial banks or their shareholders as a way to expand services to theircustomers.
1.20 What distinguished the 1970s from earlier times was the emergenceof a trend of groups to grow through acquisition rather than through creationof new enterprises, the key role played by financial institutions in theprocess, and the formation of large conglomerates that include industrial aswell as financial companies. Since access to funds from public depositsprovides powerful opportunities for takeover in a market characterized by lowshare values (see Section II), control of financial institutions themselvesbecame an attractive proposition to large groups. Not infrequently, theincentive to control a financial institution arose from the possibility ofchanneling its credit to the new shareholders to finance other acquisitions,in a dangerous process that led two Colombian groups into receivership in1982.
Conclusion
1.21 The institutional structure and the relative growth rates ofdifferent instruments and institutional categories can for the most part beexplained as rational responses of the system to changing government policiesand macro-economic prospects. For example, the variations in the strength ofthe extra-bank market, the rapid growth rate of CDTs in the mid-1970s andchanges in the relative growth rates of CFCs, CAVIs, CFs and commercialbanks, etc. over the last decade can all be explained by the changes in theregulatory policies and official intervention. However, once certainpatterns (e.g., formation of groups or means to circumvent normal regulatorypractice) set in, they have tended to perpetuate themselves unless deliberate
official action is taken to reverse them.
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II. ISSUES FACING THE CORPORACIONES FINANCIERAS
Nature of the Main Issues
2.01 As explained in Section I, the system of Corporaciones Financieras(CFs) was created in Colombia starting in the 1960s, as the investmentbanking component of a specialized banking system. The specific objective ofCFs was to support the creation and expansion of the productive capacity inthe industrial, mining, tourism and related sectors through the provision ofthe medium- and long-term credits and risk capital. A related objective wasto help promote the Colombian capital markets through the development ofsuitable instruments and channels for term credit and equity investments.Although the CFs have had significant success in achieving some of theseobjectives (see para. 1.14), recent trends have become causes of concern:
(a) The CFs have been driven by the prevailing market conditions andincentives to operate increasingly in the short-term lendingmarket. At the end of March 1982, 74% of the total CFs' lendingportfolio was short term and only 8% in medium- or long-term loans.
(b) Total credit granted by the CFs to the manufacturing sector has notkept pace with the growth in manufacturing value added over thelast decade (see para. 2.12). In terms of total assets, the CFs asa group have grown less rapidly over the last decade than othertypes of financial institutions such as CFCs and CAVIs (SeeStatistical Appendix Table III). The share of CFs' deposits in thetotal deposits market stood at a modest 5% as of December 1981.
(c) As a group, the CFs have had only a limited impact in stimuliatingthe creation or expansion of productive enterprises through riskcapital investments.
2.02 The above average trends mask the substantial heterogeneity amongthe CFs, which can be classified into three distinct groups according to theterm composition of their loan portfolio:
(i) Private CFs which have attempted to fulfill their originalobjectives of providing term financing and risk capital toproductive enterprises. As seen from the table below, these CFshave a lower than average proportion of short-term credit in theirportfolios (47% in March 1982, as compared to an overall average of74%).
(ii) Private CFs which have little commitment to the stated objectivesof the CFs system, per se. Many of them were created to takeadvantage of certain regulatory benefits and the relatively easyentry of new CFs to financial intermediation at a time whenauthorization of new commercial banks was virtually suspended(since early 1970s -- see para. 4.01). As the following tableshows, their portfolios are almost entirely short term oriented(94% as of March 1982).
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(iii) Special purpose official CFs created by the Government to fulfillspecific sectoral functions (six of them, the largest one being theInstituto de Fomento Industrial -- IFI), which lie in between theformer two groups, with 65% of their average portfolio being shortterm.
TM( COMPOSITION OF THE CFs' LOAN PORTFOLIOS, BY GROUP 1/(As of April 30, 1982)
ed:-Tcn.hTer Crit Total Cr2aitShare of Mc:-~T r-- dit re orE tShort-term Share of 1!.cium- % of _e`umn- Long-term Z of Long-
Credlit in 7 of Total SF.ort- Term Credit in Terr. Crcdit Credit in Term Credit ° of TotalTotal Credit Ter- Credit by CFs Total Cr-dit by Cas Total Credit by CFs Credit by CFs
1 (6 UEs) 46.5 19.1 34.0 56.9 19.5 73.2 30.3
IT (1S T-FS) 94.1 63.5 5.0 13.9 .9 5.5 49.9
31 Of l 64.7 77.4 26.6 29.2 8.7 21.3 19.9
total 73.8 lCO.O 18.1 100.0 8.1 100.0 100.0
1/ Follocing tre officially prevaiLing aefinivion in Cbiomcia, shorr term loans are defined as those with original maturityof up to 3 years, medium term loans as those with 3-5 year maturities and long term loans as those with longer maturities.
Source: 'Corporaciones Financiera Privadas" by Helena Villamizar, Banco de la Republica - Bogota, Junio de 1982.
The heterogeneity of the system is illustrated by the fact that while Group Iprovided only 30% of total credit granted by the CFs system, it accounted for73% of total long-term credit. On the other hand, Group II had a 50% shareof total credit, but accounted for less than 6% of total long-term credit.
2.03 Inclusion within the formal CF category of qualitatively differentinstitutions can lead to misleading conclusions. In particular, the lendingoperations of CFs of Group II bear a greater resemblance to those ofcommercial banks and trade financing companies (CFCs) than to Group I CFs.While some of these were established as bonafide CFs but were driven to theshort-term market for market reasons discussed below, a substantial numberhad been predominantly short-term oriented since their inception, having beencreated mainly to take advantage of the regulatory framework (e.g., certainadvantages offered from time to time to CFs with respect to reservesrequirements, debt-equity limitations, etc). Their investment and lendingstrategies are therefore probably better understood under the label of CFCs.The above heterogeneity has undermined the functioning CFs as conceivedoriginally. This report focusses particularly on addressing the issues facedby Group I and III CFs, and possible ways of transforming Group II CFs tobring them more in line with the original objectives of the CFs system orallow their formal transition into other kinds of financial institutions(e.g., CFCs).
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The Share of Medium and Long Term Credits in the CFs' Portfolios
2.04 The share of medium- and long-term credits in the CFs' portfoliocurrently stands at about 26%, a relatively low figure when it is consideredthat CFs' primary objective is to finance the creation or expansion ofproductive capacity. What is more, the existing medium- and long-termportfolio corresponds almost entirely to investments supported through Bancode la Republica's (BR) rediscounting funds (the 'Official Financing Funds')and other official sources. The reluctance of the CFs to use their ownresources for term lending stems from the predominantly short-term characterof these resources, and the difficulties and risks of using short-termresources for medium- and long-term lending.
2.05 In recent years the CFs have not issued many medium- and long-termbonds in the domestic market due to the strong preference of savers forshort-term instruments, many of which offered liquidity without the risk ofcapital losses. Bonds issued recently by some CFs have relatively shorteffective maturities (often 1 year or 18 months) and/or are supported bycommitments of repurchase at par by the issuing corporations after an initialperiod of 1 year. The strong preference of savers for liquidity is due touncertainties regarding future levels of inflation and interest rates, thefrequent changes that have taken place in the relative yields of differentsavings instruments as a result of changes in regulations and officialintervention in the financial market and the artificially large differencesamong yields of comparable instruments which have been maintained through taxand other regulations. 1/ Unforeseen changes in the interest rate levelsand relative yields of longer-term savings instruments could result insubstantial capital losses to the savers in the event that they wish toliquidate their investment in the secondary market.
2.06 Utilization of short-term deposit resources by CFs to make medium-and long-term loans is hindered by the absence of a suitable mechanism toaddress interest rate and liquidity risks associated with such 'termtransformation.' Specifically, a system providing for floating interest rateswith an objective base index and a suitable last resort liquidity facil-ity isneeded. In addition, perceived or real limitations caused by theimplementation of 'Codigo de Comercio' rule (Article 884) which under thecurrent guidelines of the Junta Monetaria and Superintendencia Bancaria implya 36% ceiling on penal interest rates on arrearages (and hence effectively onall nominal lending rates), have been an important obstacle to term lending(whether under a fixed or a variable rate scheme) because the effectivelending rates in the market for short-term loans have been considerably above
1/ Thus, for instance, in December 1981 the effective nominal yields onsavings instruments were 18.8% in Titulos de Abono cafetero, 19% inbonds issued by Corporaciones Financieras, 22.7% in savings deposits ofthe commercial banks, 21.7% in UPAC savings deposits with Corporacionesde Ahorro y Vivienda, 33.7% in Titulos Financieros Agroindustriales and38.6%, on average, in 90 day CDTs of commercial banks and CorporacionesFinancieras.
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that ceiling (currently 45-50%). 2/ Effective rates above the 36% limit onshort-term instruments can easily be (and are) obtained through discounts andcommissions, but it is more difficult to raise them on long term instruments,both because those discounts would have to be huge 3/ and because thediscount or commission fixes a portion of the interest rate for the entirelife of the loan.
2.07 In view of the difficulties mentioned in the previous paragraphs,practically all of the medium and long-term credits channelled by the CFscorrespond to those rediscounted by the Fondos Financiero Oficiales (OfficialFinancing Funds 4/ or to term resources obtained from internationalagencies. Even the shares of these operations channeled by the CFs havestagnated in recent years, and have actually been declining in the mostrecent months, as a result of weak aggregate demand and the dwindlingprofitability of the rediscounting operations to the CFs. Final aggregatedemand for industrial products has been low during 1981/82 in both domesticand exports markets, reflecting the domestic and international recessionaryconditions. Manufacturing value added decreased by about 1% in real termsduring 1981. Some growth has, however, been observed in the demand forshort-term credit, mainly as a consequence of the unexpected sales declinesand consequent inventories build up.
2.08 The CFs' incentives to participate in term lending involvingrediscounting have also declined sharply since 1981, when the margins ofrediscount of FIP and FFI were lowered from 100% to 65-80% in the midst ofrising interest rates. Since the CFs have to provide the balance of theresources required from funds they mobilize at market rates, which areconsiderably higher than the prescribed lending rates on Official FinancingFund operations, the CFs obtain very low or negative average spreads onthem. As shown by a computation of the current spreads earned by the CFson these operations, the spread on CFs' own resources are in the range of-5% to -16%, while the overall gross spread on these operations variesfrom -0.4% to 1.6% depending on the particular fund, location of theenterprise, etc. (see table below). Understandably such lending is weak.
2/ See Section V, para. 5.05 for a more detailed discussion of thisproblem.
3/ For example, the price discount would be about 26% to get a 50%effective rate on a 10-year loan with equal annual loan service paymentand a normal interest rate of 36%.
4/ The Official Financial Funds include Fondo de Inversiones Privadas(FIP), Fondo Financiero Industrial (FFI), Fondo Financiero Agropecuario(FFAP), Fondo de Desarrollo Electrico, and Fondo de Promocion deExportaciones (PROEXPO). Data from 1981 indicate that about 40% of theCFs' rediscounts correspond to the refinancing of short-term credits byPROEXPO, with the remaining 60% consisting mainly of rediscounts ofmedium- and long-term credits by FIP and FFI.
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EFFECTIVE SPREADS TO CFs OF LOANS REDISCOUNTED BY OFFICIAL FUNDS(As of mid-1982)
Effective Cost of Spreae oninstitution Line of Lending Rediscounted Rediscointed Cost of Own Spread cn Z of Overall
Credit Rate 1/ Resources Resou: ces Resources Own Resources Redi_count Spread
1/ Taking account of quarterly prepayment of interest due.2/Market rate div_ded by 0.90 to take account of a 10% forced investment requirement on resources mobilized through CATs
minus yield ot forced investments.
Source: Banco de la Re'iiblica and mission estimates.
The percentage of the total resources of the CFs provided by rediscounts; ofthe Official Financing Funds fell gradually from 17% at the beginning of 1977to 10.6% by the third quarter of 1982. 5/
Dynamism of Growth of CFs
2.09 The shares of different institutions in total financial savingshave been influenced by the policies that have regulated the Colombian finan-cial market during the last ten years. These policies have differentiatedinstitutions by the kind of instruments they are allowed to use to mobilizeresources, and imposed different interest rates ceilings, reserverequirements and forced investments on them. Consequently, institutionswhich have been allowed to use more competitive and profitable instrumentshave grown faster than the others. However, as seen from the discussion inSection I, frequent changes in policy have resulted in uneven rates of growthfor different institutions and instruments.
2.10 The CFs operate at a competitive disadvantage vis-a-vis thecommercial banks in mobilizing domestic savings, since the latter have accessto low financial cost current and savings accounts which provide them largeinterest rate spreads. This is demonstrated by the tables on the next page
5/ Since February 1982, the CFs have been facing a further disadvantagevis-a-vis the commercial banks in making use of the resources of therediscounting funds, because the Junta Monetaria passed a resolutionallowing commercial banks to use part of their frozen monetary reserverequirements to meet the required contribution of counterpart resourcesunder the rediscounting funds (see paras. 4.13 and 5.22).
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MARGINAL SPREADS OF COMMERCIAL BANKSFOR RESOURCES AT THE MARGIN, AS OF MID-1982 1/
IesourcesCurrent fro. Port- Trust OtherAccounts Savings CLTe folio Sale. Accounto Deposits Total
Spread Pinancial Costo/Depo-it. 0.0 14.7 38.1 38.1 38.1 a.-.Spr.ad/Deposits 20.1 23.0 9.4 -16.1 -4.1 D.-. 14.2Sbere of Each Instru-ent in I00.0
lncremental Depositr 5/ 27.1 13.9 59.0 - U- .S.
Incidence of Each lnstrunton lot-1 Spreod (2. at thesssg~in) 38.4 22.5 39.1 100.0
j Fonds free quity capital ar not raken into account.2/ Includ s ret q-r e. ts rel ted tc depoaits as well a thos. based oe building portfolio.
y IWeight.d average.
j alis ion eastimate of rarket lending rate in June 1982, equival-nt to 361 -Inual rate, paid quarterly in advance.pIos cor=i-sins.
5/ Shacas of each instrunent in 1980-81 i.crese.t Of total deposit..
MARGINAL SPREADS OF CORPORACIONES FINANCIERAS (CFs)(For resources at margin, as of mid-1982) I/
Short Term Long Torr Orionted CF.oriented CFs (Crnup 1) 2)
MHnetary Reserv Require-ento
Worced Iov-st-ents 10.0 10.0
Sub-Total 10.0 10.0
Availahle for VoluntaryOperations 90.0 90.0
Yields Average Forced lvestmnets 25.0 25.0
Weighted Avnragr RediaeO=nts - 26.6
Other Volustsry Operationo 50.0 50.0
Veighted Averag VoluntaryOperations 50.0 37.1
Overall Weighted Average/Deposits 47.5 35.9
Fi-ntcial Ctsts CDTs 38.1 38.1
Veighted Avrage of Redins.outs - 22.9
Overall Wtight.d Average 38.1 31.0
Spread 9.4 4.9
Fonda fron eq,ity capital ece not taken into _ccount. The averages for yields, Coots*nd nargins of red-ssounted ccedits were weighted by the proportions in chuch the mainFunds -erc used at tho end of Dece=ber 1941 (PROEXPO, FYI, FIP, FFAi). CDTs woretaken as the source of funds fur all short ter= credit and for 15.4Z of theredi-count (the -ve-age margin of r-d-sco.nt was 84.6%X./Crop I CF. cannot exp-nd e-clu--lpy i, snorn-rcrm ope-ar- osp , due te contractoalobligations with the Wec1 ldSa, they cannot lcnd more thu- 45.0% of their portfoliois the short tern -arkht (.ppro-ira-tlyl. Thc root is assumrd te he r discountedbocassa prcsently them in no long tern -redit dnmand at fre- -arkct rate..
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which provide an analysis of the gross spreads on different instrumentsavailable for commercial banks and CFs taking into account effective interestrates, forced investment requirements, rediscounting percentages and otherapplicable conditions. As indicated by them, the weighted average grossspread for resources at the margin of CFs is estimated to be about 4.9% forCFs oriented towards term lending (Group I CFs), 9.4% for short-term orientedCFs and 14.2% for commercial banks. Using their privilege to offer currentand savings accounts and the associated large gross spreads, the commercialbanks have been offering an increasingly wide range of services and havedeveloped extensive branch networks, which also help them to market their ownCertificates of Deposit (CDTs). Such economies of scale are not available tothe CFs. As a result, the share of commercial bank CDTs as a percentage oftotal deposit resources in the institutional financial sector more thandoubled over the last five years, while that of CFs remained relativelystagnant (see Tables III and IV of the Statistical Appendix). The share ofthe CDTs issued by CFs also exhibited considerable variability from year toyear, as a result of changes in the regulatory environment (e.g., forcedinvestment requirements).
2.11 CFs have also grown less rapidly than CAVIs. Using their facilityto offer the above mentioned UPAC instruments and savings accounts with asight withdrawal feature (both of which also provide a favorable taxtreatment to the savers by exempting up to 8% of the monetary correction fromtaxable income), CAVIs have competed aggresively for the small saver marketand liquid quasi-money balances carried by enterprises, and have been able toestablish large branch networks. On the other hand, the trade financingcompanies (CFCs) have been competing increasingly successfully for theshort-term deposits by offering interest rates on CDTs, reflecting theprevailing higher demand and lending rates for trade financing than forindustrial investments.
2.12 Total credit generated by CFs to the manufacturing sector has not,on the average, kept pace with the growth of manufacturing value added inrecent years, dropping from about 9.6% of the value added in 1978 to lessthan 9% in 1980/81. It is also worth noting that, among the CFs as a group,the longer-term oriented CFs (Group I cited in para. 2.02) have tended to beless dynamic in growth than the others. In part this may have been because,as participants under the World Bank loans, most of the Group I CFs have hadto subject themselves to more restrictive leverage and portfolio limits thanwould otherwise have been required under existing banking regulations (seealso para. 4.11).
Equity Investments by the CFs
2.13 Reflecting the Government's intention that the CFs provide riskcapital as well as long-term credit to industry, CFs have, since 1979, beenrequired to invest at :east 80% of their own networth in equity instruments(para. 1.14). 6/ Currently, equity investments of CFs exceed this level:for all CFs in the aggregate equity investments currently stand at about 90%of their networth. As discussed in Section I, some CFs, particularly thosebelonging to Group I, have made some equity investments with a high
6/ 'Networth' is defined for this purpose as total share capital, retainedearnings and reserves.
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development impact. Even the Group I CFs have tended to invest only part oftheir equity holdings in venture capital type investments (e.g., investmentsin newly formed or transformed companies), with a significant proportion inshares of established companies, which are typically not firms facing marketconstraints in new capitalization. Among some of the Group II CFs, thelatter type of holdings are quite concentrated, since they have been acquiredfor control purposes by large financial groups. The institutionalregulations and incentives proposed in Sections IV and VI of this reportshould help to encourage a reduction of such shares and increases in thevolume of true risk or venture equity investments.
2.14 The current market structure and incentives in Colombia are at theroot of the tendency of CFs to hold a large portion of their equity invest-ment portfolios in shares of well established companies. Since the desir-ability of, and therefore, the demand for, risk investments is ultimately afunction of the ease with which the holders can realize or encash theircapital gains and obtain a fair premium for the risks assumed, the CFs preferto hold shares which are actively traded in the stock market. However, giventhe underdeveloped stage of the stock market in Colombia, only shares of afew, very well established, companies are actively traded. The value ofshare tran-actions per year has grown less rapidly than GDP in recent years;this trend is exhibited even more prominently if the growing transactionsinvolving corporate take-over activities by large groups are excluded. 7/The chart below also indicates that the level of stock market activity inColombia relative to GNP is considerably behind that for most comparabledeveloping or developed countries.
7/ The value of all share transactions on the Bolsa de Bogota, theprincipal stock exchange, has in recent years been only a fraction of 1%of GDP, varying in the range 0.2-0.6% of GDP during 1970-81; this is alow ratio for a developing country, at the level of GDP per capita ofColombia and far lower than the 3%-4% ratios found in LDCs with activestock markets. There have been a few new actively traded issues and afew old issues which have been, from time to time, much more active, butthese have been more than offset by companies which have become lessactively traded due to corporate takeovers and slack investorinterest.
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Comparison of Outstanding Sbares as Per=entae of GNP
For Different Countries
AW -ARGENTINA30 -41L00.A US
Nt -4RA.ZIL61 -CANADA __.
CO -.COLOMBIA-ECUADOR
F -FRANCEG-GERMANY.
I1-iV OY COASTJ -JPAN
40 J -- JORDANZ C - KENYA
mo -o JDa9 K0 _:DR£JS ~ ~ ~ 0
K 0I -NETHERLANDS O CAS * Itr2PWILNESe
00 7 T-TKATLANDa u -ERU;;VAYz t- 3lt -uS_AlitDSTATS ._ _ .__ _ __ _ _ _2 V1 -_V'EZUE! A
ri 3CLSHtD OtSiAOGQREGATEO DATAtoA0 ESTIATED FROM GGREGATEO OATA
0
I0 _.
KO
00
*PER CAPITA INOME
SOURCE: International Finance Corpoiration
The majority of the shares in the stock market sell at very low price earning
ratios (P/Es) and at discounts to book value. Only the most actively traded
stocks display healthy share price relationships. ' / Use of full inflation
accounting, which would be required to eliminate some of the distortions in
corporate and tax accounting, would probably reveal even much lower share
valuations relative -to book values than currently observed. These factors
militate against the making of genuine venture capital type investments with
a high development impact.
8/ Average P/E for the 12 most actively traded stocks in 1981 at the Bogota
stock exchange was 11.8, and the average share price was 1.6 times theaverage book value.
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2.15 The above problems are accentuated in Colombia due to the increas-ing dominance of the large industrial/financial groups, which are increas-ingly acquiring controlling interests in industrial companies because onlycontrolling positions tend to command high prices in imperfect markets.Minority share holdings, which would be the most suitable form of participa-tion for CFs, cannot be assured of a fair price under such conditions. More-over, Colombian legislation does not appear to provide for an adequate pro-tection of the rights and interests of minority shareholders, e.g., an equalselling opportunity for minority shareholders in the case of large blocktransactions and a voice in the financial administration of the companies.As a result, CFs have at times found it difficult to sell even very success-ful venture capital investments at a reasonable price.
2.16 There are also several fiscal and administrative factors which alsoact to impede investor interest in equity investments in general and sharesof publicly held companies in particular. Among the problems identified onthe basis of a qualitative analysis and field interviews with industries arethe following:
(i) Various fiscal provisions, including the much higher withholdingtaxes on dividends (which could be as high as 40%) than on interestincome (which is subject to a flat withholding tax of 5%) and thedouble taxation of dividend income (first over corporate profitsand later on dividends distributed to individual shareholders whichare taxed as part of personal income), as well as the possibilitiesof tax avoidance available to savers on debt instruments sold on adiscount basis, discriminate against investments in equityvis-a-vis debt instruments. These problems are accentuated in thecase of publicly held companies ('sociedades anonimas') because theapplicable corporate tax rate for them is higher than for closelyheld companies ('sociedades limitadas') and because the former arealso subject to a minimum income tax ('presumptive tax') computedas a percentage of net worth regardless of their profitability.
(ii) It is generally considered easier for closely held corporations toevade taxes and other governmental regulations since they aresubject to less public scrutiny -- in part because the relativelysmall number of tax and other auditors tend to focus theirattention on other areas which offer higher returns fromsurveillance.
(iii) Existing corporate law and regulations do not assure minorityinvestors that they will act in a market characterized by rules offair play. Although a Securities Commission and a Superintendencyof Companies have been operating, regulatory control remains weak.
(iv) The evolution of saver portfolio preferences over past decadesappears to have had negative implications for stock marketdevelopment. Aside from the very wealthy, risk appetites appear tobe low and liquidity preference high; moreover, the emergence ofliquid deposit instruments with positive real returns is takingaway portfolio demands from higher risk, direct instruments such asshares.
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(v) Partly as a consequence of the foregoing, the Colombian stockmarket does not have the depth, breadth and anonymity to achievegood secondary market liquidity, and the absence of such liquidityimpedes further development. Until the market is able to break outof this vicious circle, proper share valuations necessary to expandthe market will not be achieved.
The Overall Profitability of CFs' Operations
2.17 The following table presents an analysis of the evolution of theprofitability of Group I CFs over the last six years:
DETERMINANTS OF THE PROFITABILITY OF LONG-TERM ORIENTED CFs - 1976-81 ("GROUP I" CFs)
(i) Except in 1979 and 1980, the gross spread as a percentageof total assets shows a declining trend caused by financialcosts growing faster than gross income, reflecting theincreasing importance of CDTs as a source of CF's loanablefunds.
(ii) Because of this and the growing administrative costs, grossprofits as a percentage of total assets went down steeply(again excepting 1979 and 1980) (see rows c, d and e).
(iii) To counteract this trend, CFs increased their sales of shareinvestments to realize capital gains, especially during 1979and 1980, and substantially increased their leverage (see rowf = debt-to-equity ratio + 1). These two actions together
helped to maintain and even increase the net profits/networth ratio during the period.
Source: Financial Statements of the "Group I" CFs.
- 19 -
As indicated by the analysis in the table, at least for the longer-termoriented CFs, the profitability of lending operations has been decliningsharply, with gross profits from lending operations dropping steadily from4.5% to 1.6% of average total assets excluding equity investments over the1976-81 period. 9/ This reflected the increase in the proportion of highercost resources raised from the public (mainly in the form of CDTs -- seepara. 1.12), the increasing requirements for CFs to contribute a higherproportion of the resources for medium and longer term lending operationsusing the Official Financing Funds (para. 2.08), as well as the higheradministrative costs implied by the need to open new branch offices andcompete with other institutions for resource mobilization (para. 2.10). 10/Thus the basic reason for the dwindling profitability of lending operationshas been the CFs' inability to cope with the changes which took place in theColombian financial markets over the last several years, stemming from legallimitations on the types of their deposit resources and lending operationsand the competitive disadvantages vis-a-vis other institutions discussedearlier.
2.18 The CFs were able to avoid an equally sharp drop in their overallafter tax profitability only because they were able to increase theirleverage s:Lgnificantly (up from an average of 4.7 in 1976 to 7.1 in 1981) andbecause their income from equity investments in the form of dividends andrealized capital gains (from selling shares) grew substantially. Equityinvestments grew from 42% of the CFs' net worth in 1975-76 to 83% in1980-81. Profits from equity investments went up from 22% of total grossprofits in 1976 to 58% in 1981, although these are subject to greater vari-ation and uncertainty than those from lending operations (see table below).
9/ Available data also indicates that the profitability of the longer-termoriented CFs ("Group I" CFs) as measured by net profits as proportion oftotal assets has been lower than those of the shorter-term orientedCFs.
10/ As explained earlier, the gross spread of CFs on lending operations hasbeen much lower than that for commercial banks (even without takingaccount of 'reciprocities' obtained by commercial banks from clients inother areas of bank services), which are in effect the CFs' maincompetition in industrial lending, since they finance some industrialinvestments through roll-over of short-term loans.
- 20 -
SOURCES OF GROSS PROFITS OF "GROUP I" CFs - 1976-1901 (%)
Realized Capital Gains (-1.3) (5.0) (1.0) (19.8) (27.9) (17.3)
Total Gross Profits 100.0 100.0 100.0 100.0 100.0 100.0
Memo Item: Gross profits from lending operations aspercentage of total assets net of equityinvestments: 4.5 4.5 3.9 3.0 2.8 1.6
Source: Financial Statements of the "Group I" CFs.
Realized capital gains grew from a negative value in 1976 to a weightedaverage of 21.9% of gross profits during 1979-81. 11/ The increase in therelative contribution of equity investments to income helped even more to
moderate declines in the after tax profitability, since the tax rate on
profits from dividend income of CFs is only 4% (provided that the CFdistributes at least 60% of its own dividends to its shareholders), whileprofits from normal operations of CFs are subject to a 40% tax.
2.19 The after tax profitability cannot be preserved any longer by these
methods, because neither the leverage nor the ratio of equity investments to
capital can be further increased without endangering the financial health oflong-term oriented institutions. In any case, excessive reliance on equity
investments for maintaining short-term profitability is not a prudent option,because returns from equities are subject to potentially very large swingsand could irreversibly damage the liquidity and solvancy of a CF underadverse circumstances. If the incentives for genuine CFs to stay in business
are to be maintained, the profitability of their term financing operationsmust be restored by allowing CFs to have a reasonably effective spreadwithout undue risks in long-term operations. Some recommendations towardsachieving this objective are included in Section V.
11/ CFs' overall profit figures also include some unrealized capital gains(losses) corresponding to the revaluation of the book value of sharesheld by them as approved by the Superintendencia Bancaria on the basisof the latest stock market valuations or the most recent balance sheetof the respective industrial company. The exact value of unrealized
capital gains (losses) on shares can only be considered speculativeuntil the shares are actually offered for sale.
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III. INTEREST RATE AND OTHER FINANCIAL SECTOR POLICIES
Background
3.01 As is clear from the previous discussion, the performance of theCFs system has been influenced to an important degree by the evolvingfinancial sector policy framework, and particularly the policies concerninginterest rates, credit allocation and the regulation of the banking system.The impact of the policies is reviewed in more detail in this section toprovide a basis on which to identify appropriate directions for future policyevolution.
3.02 During the Sixties and most of the Seventies, when interest ratesin the institutionalized credit markets were subject to artificial ceilings(paras. 1.03 and 1.15), a low ratio of M2 (savings and term deposits pluscurrency with the public) to GDP persisted. For example in 1977, this ratiostood at 0.25, a low level when compared with other developing and developedcountries. 1/ In response to the freeing of interest rates on term depositsand lending rates in 1980 (although ceilings remained on checking and savingsaccounts which together accounted for more than 40% of total deposits in theorganized financial system), M2/GDP increased from 0.25 in 1979 to 0.31 byyear-end 1981 (see Table IV of the Statistical Appendix). 2/ However,continuing interest rate ceilings on the most important types of bankdeposits (savings and current accounts) and a substantial body of otherregulations have limited the size and efficiency of intermediation andincrease the spread between deposit and lending rates.
3.03 Since their liberalization in 1980, the observed free market CDTrates and lending rates in the formal (institutionalized) financial sectorhave gradually increased to 11% and 18% in real terms respectively. Theavailable evidence indicates, however, that the liberalization per se has notbeen the cause of the higher borrowing and lending rates. The real causescan instead be traced to changes in the level of international interestrates, domestic regulatory policies and imperfect competition in the domesticfinancial system. Average borrowing and lending rates in the economy,including both formal and informal markets, would probably have risen tocommprable or possibly even higher levels, regardless of the liberalizationof the formal sector. This point is important to recognize, because as
1/ Some comparable ratios for other countries were: US:0.99; West Germany:1.00; Japan: 1.30; Argentina: 0.31; Brazil: 0.42; Uruguay: 0.58;Venezuela: 0.58; South Korea: 1.02; Kenya: 0.28; and the Philippines:0.48 (1977 data and IFC estimates). See also "Financial Repressionwithin less Developed Countries" by R.I. McKinnon in The World EconomicOrder: Past and Prospects (edited by S. Grassman and E. Lundberg,McMillan 1981).
2/ For a more detailed discussion of the effects of the financialliberalization attempts and tax reforms undertaken during the 1970s onfinancial deepening of the system and on household savings, seeCOLOMBIA: Manufacturing Sector Developments and changes in ForeignTrade and Financial Policies, World Bank, Report No. 4093-Co datedJanuary 21, 1983.
- 22 -
experience in many other countries shows, the efficiency of intermediation ispositively correlated to financial deepening. A continuing liberalizationeffort mDving towards market-determined interest rates, would be essentialfor mobilizing larger amounts of resources and inducing a better allocationof them. These points and the implications to future policies are elaboratedin the discussion below.
Deposit Interest Rates
3.04 The available evidence strongly suggests that most of the increasesin the borrowing rates in the recent period in Colombia can be explained bythe cumulative effect of the changes in international interest rates, andthe relative rates of inflation and devaluation expectations. The equivalentin Colombian pesos of short-term interest rate on US dollar denominatedCDs (adjusted by the ex-post peso devaluation rate) increased from 23.3% inMay 1980 to 31.0% in January 1982, while the Colombian CDT rates increasedfrom 32.0% to 39.6% in the same period (Table V of the StatisticalAppendix). The somewhat higher Colombian CDT rates, with effective ratedifferentials averaging 4.7% during that period, can be explained by marketimperfections and varying expectations among savers about the future rates ofdevaluation (which at times included speculation about a possible majordevaluation).
Interest Rate Spreads and Lending Rates
3.05 Observed free market lending rates, on the other hand, areconsiderably higher than the corresponding international rates, reflectinglarge gross spreads between the lending and borrowing interest rates (ineffective terms) of Colombian financial institutions. As of mid 1982, theeffective spread in real terms between CDT rates and lending rates is esti-mated at 10-12% compared to spreads of 2-4% between bank CD rates and lendingrates in dollar-denominated operations in the U.S. The high spread is mainlythe result of two kinds of factors: (a) imperfect competition in theColombian financial market combined with restrictions on the access of inter-national banks to the Colombian market; and (b) regulations deliberate:Lyaimed at restricting the volume of credit going to the private sector throughthe free market, including the high marginal reserve requirements on currentaccounts and their close substitutes and forced investments imposed ondifferent types of financial intermediaries.
3.06 The imperfect competition in the financial market probably has itsorigin in the substantial protection which the financial sector enjoys.Commercial banks and CFs have enjoyed substantial protection against newdomestic entrants in recent years; no new commercial banks have beenpermitted to start operations during the last ten years and the author:izationof operations for new CFs has been effectively stopped since 1980. Moreover,competition from foreign banks has been restricted by mandate. With theexception of investments in a few priority sectors (e.g., energy and agro-industry) for which policy has been relaxed since 1980/81, lending operationsof foreign banks are limited to financing of imported goods; moreover theyare subject to maximum terms of five years unless explicitly relaxed byINCOMEX in the context of a global import license (see paras. 1.17 and5.26). The restricted competition together with inadequate regulation of
- 23 -
grOU}L; and inter-company linkages has contributed to the evolution of largefinancial/industrial groups which tended to dominate the financial market.(para. 4.03).
3.07 The acquisition of significant market power by individual groupsfurther excacerbated the negative consequences of imperfect competition,leading to an adverse cycle of eroding commpetition. Consequently, there hasbeen insufficient incentive in the banking sector to look for ways to improveadministrative efficiency. The existence of large administrative ineffi-ciencies in the operation of commercial banks is evidenced by the high levelof operational expenditures. These stood at 8.6% of the average loan port-folio in 1980, compared to less than 1% in the U.S. and 2-6% range forcomparable operations in most LDCs, Thus, while the large banks failed totake advantage of scale efficiencies, undersized, "marginal" competitors havebeen able to continue operations by squeezing profit margins. Section Vincludes some specific proposals to correct these negative trends.
3.08 The large legal reserves and forced investment requirements whichhave been in effect since 1977 (although liberalized somewhat since early1980) (para. 1.15), have also significantly restricted credit allocationthrough the institutionalized free market. This is illustrated by Table XI,which presents a summary of the currently prevailing legal reserves andforced invec'i-ment requirements. For example, at present, for each additionalCol$ 100 million mobilized by commercial banks in the form of demanddeposits, less than Col$ 40 million can be freely used for commerciallending. The effective cost of intermediation has been raised by thesepolicies leading to high spreads between marginal borrowing and lending ratesof the banking system. Since the forced investments are used to financesubsidized credit, they also lead to the development of an increasinglysegmented credit market,
3.09 To the extent that legal reserve requirements are a mechanism forthe imposition of an "inflation tax" 3/ on the private sector to financeGovernment deficits (which would have-to be financed either through this orother means such as government borrowings from the public or tax increases,the resultant increase in the real interest rate is ultimately attributableto the government deficits, rather than the reserve requirements themselves.It is therefore difficult to isolate the impact of reserve requirements onthe real free market interest rates. However, the effect of the forcedinvestments on the free market rates can be more readily estimated, sincethese are used exclusively to finance subsidized credit through BR's OfficialFinancing Funds (FFI, FIP, FFAP, etc.). In effect, the forced investmentrequirements operate as a wedge between free market and subsidized interestrates. Thus, excluding PROEXPO resources (which derive not from forcedinvestments but from import taxes), the weighted average real interest ratepaid by entrepreneurs on funds obtained from the institutionalized domesticfinancing system (in mid-1982) was about 11.7%, made up of 17.1% paid by the
3/ The term "inflation tax" is used throughout this report to refer to theimplicit "tax" paid by savers and/or the banking system to the extentthat they are forced to hold liabilities yielding zero or low return ontheir resources in an inflationary environment.
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borrowers working in the free market, about 2% paid by the users of FIP and
FFI (see table below), and intermediate rates for external credits. 4/
AVERAGE MARGINAL INTEREST RATES PAID BY THE MANJFACTVRING SECTOR
Share of Estir3a- Niominal _siaa
Source of Credit ted Total Credit Interest Real RatesOutstardinR Rates (Jure398-
Memo Item: Total FIP, FF1, and PROEXPO 11.4 . 26.3% -1.4%
I/ Estimated on the basis of LIBOR (15.77%, everage January-March 1982 for
one year loans) plus 3%, adjusted by devaluation rate of 16.8%.
2/ Exclu6es Caja Aeraria
3/ Based on the 1981 change in the CFI for blue collar workers (28.1%).
Source: Banco de la Republica, International Finance Statistics and mission estimates.
The net impact of the fixed investment requirements was therefore to raise
the free market real lending rate from 11.7% to 17.1%. In nominal terms, the
lending rate in the institutionalized free market as of mid-1982 wouLd have
been about 43% in the absence of forced investments, instead of the observed
50%, and the corresponding spread would have been 7.5% instead of the
observed 12%.
4/ The corresponding weighted average real lending rate on credit by the
formal sector to the manufacturing sector including PROEXPO credit was
10.2%, made up of -1.4% for subsidized credits (including PROEXPO
credit), 17.1% in the formal (institutionalized) free market and 8.3%
for external credit. Adding to this the cost of credit obtained from
the unregulated ("informal") market, the weighted average real lending
rate on all credit to the manufacturing sector is estimated at 13.9%.
Thus the average real interest rates on credit are significantly lower
than the free market real rate observed in the formal sector (see table
above).
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3.10 In summary, the observed real lending interest rates are high inColombia due to: (a) the high real international interest rates; (b) varyingexpectations of savers regarding future exchange rate of the peso; (c) thegrowing cash deficits and/or credit needs of the Government, and the highmarginal reserve requirements which are used in part to finance the above andneutralize their inflationary impact; (d) the use of forced investments tofinance subsidized credits; and (e) the imperfect competition in thefinancial sector arising from the existing oligopolistic market structure andthe protection afforded by the regulatory framework through restricted accessto external credit and absence of free entry to the financial intermediationbusiness.
The Level of Credit Subsidies
3.11 While the preferred credits account for only a small proportion oftotal credits, the rate of subsidization on them is high. For example,assuming a subsidized interest rate of 22% and a domestic market rate of 45%,which probably typifies the situation at the end of 1982 although this ishigher than the equilibrium rate because of distortions caused by the factorsdiscussed in para. 3.05),5/ the net present value of loan service paymentsunder the subsidized loan would be 65% of the value of the principal,implying a subsidy equivalent to 35% of the principal. Moreover, under thecurrent system of fixed interest rates for subsidized loans, the amount ofsubsidy automatically increases whenever the market nominal interest ratesincrease, as may be triggered by higher inflation rates. The result is afurther increase in the fiscal or financial burden of the subsidies, whichmay in turn fuel further inflation. Not only does this process imply adestabilizing feedback, but it prevents the Government from ensuring that thesubsidy remains close to a prespecified 'target' (desired) level.
3.12 The high rates of credit subsidies can have several undesirableeffects on resource allocation. They discriminate against labor intensivetechniques, discourage efficient use of the capital and create incentives forindustrial firms to become excessively leveraged. Since most of the subsi-dized financing through the Official Financing Funds is oriented towardsfinancing of fixed investments, they also encourage acquisition of fixedassets in preference to working capital which appears to be currently morescarce. Moreover, based on field interviews with industries and financialinstitutions, there is reason to believe that the subsidies are contributingto a worsening of ownership concentration in the Colombian industrialsector. This stems from the fact that the larger industrial groups inColombia tend to have close linkages with the major financial institutions(para. 4.03) and are typically able to obtain privileged access to thesubsidized credits.
5/ Based on a U.S. prime lending rate of 11.5% at the end of 1982, adjustedby the devaluation rate of about 19% in 1982 and a small premium tocover exchange rate uncertainties, an equilibrium domestic marketlending rate of 30-35% could have been feasible in the absence of themarket distortions.
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3.13 In the near future, any subsidization of interest rates is likelyto continue to be financed by the inflation tax, in view of the existingdeficit of the public sector. However, there are limits to this processwhich has been used intensively in Colombia.6 / First, the inflation taxtends to be an inefficient and inequitable instrument for mobilizingresources from the private sector. Second, there are limits to the -revenuesfrom that tax that can be collected in the financial sector: if the realrates of interest in demand and savings deposits remain at highly negativelevels for long periods, the proportion of such deposits in relation to GDPwould tend to fall, as has been happening in Colombia; also, as theexperience of the late 1970s shows, persistently very high legal reserves andforced investment requirements on the banking system tend to induce evasionof reserves and forced investments requirements, by means of financialinnovations, movements from the formal sector to the extra-bank market,and/or financial disintermediation. Third, there are many other competingdemands for the use of the resources provided by the inflation tax, e.g., thefinancing of the public sector deficit, agricultural subsidies, etc., whichwould all be difficult to pursue simultaneously. Finally, a reliance on theinflation tax for financing expenditures and subsidies implies the need toperpetuate inflation itself, thus acting as a negative factor in achievingstabilization.
3.14 In view of the above, close consideration should be given toreducing the credit subsidies substantially from their current levels. Tothe extent that continuation of some credit subsidies to priority sectors/activities is considered desirable by the Government, such subsidies shouldbe moderate and be kept constant over the period of the respective loans. Agradual reduction in subsidies would allow a lowering of forced investmentrequirements and/or an increase in the,yields provided to financial interme-diaries on such forced investments. The resulting smaller dispersion ofinterest rates around the average would facilitate more efficient resourceallocation throughout the financial system.
General Financial Sector Liberalization
3.15 At a more general level, the above analysis indicates that acontinued process of financial sector liberalization would probably offer thebest prospect of helping to solve the problems identified. A relatively freefinancial system would be a prerequisite for financial intermediaries(including the CFs) to be able to perform the desired role in promotingindustrial investment and development. Any attempts to bring the current
6/ Although between 1973 and 1980 the inflation tax was used by BR and theGovernment for purposes other than the financing of government deficits-- primarily for building up international reserves. During 1973 and1974 the Government increased its total debt but reduced its debt tocitizens and BR by increasing foreign borrowings. in 1976 and again in1978 the Government actually achieved fiscal surpluses by slowing downits investment. During 1979 and 1980 the Government did run smalldeficits but showed an accounting surplus because BR's accountingprofits on foreign exchange sales (through the 'Cuenta Especial delCambio') were treated as government revenues.
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interest rates down by administrative means, without addressing theunderlying causes, are likely to be frustrated by large and destabilizingshifts of funds from the controlled segments to less restricted segments ofthe sector offering better yields, from formal to informal markets, and fromdomestic financial instruments to domestic real (tangible) assets or foreign(real or financial) assets. This would result in a decrease in the share(and probably also the amounts in real terms) of financial resourceschanneled through the domestic formal market. Although the administeredinterest rates in the formal market would be lower, the aggregate averageinterest rate in the formal plus informal markets (including any incrementalforeign borrowing made necessary by capital flight) would probably increase.These developments would impair the overall efficiency of domesticintermediation and resource allocation. Similarly, to the extent that forcedinvestment requirements are maintained in order to provide substantial creditsubsidies, interest rate spreads in the formal market would tend to remainhigh and savers and investors would be increasingly tempted to move to theinformal market.
3.16 The liberalization strategy would, however, have to be chosencarefully. A gradual approach appears advisable. Among the early measuresshould be a substantial (although gradual) reduction in the credit subsidiesand forced investments, and steps to promote freer entry of institutions andmore effective competition in formal financial system. Sections IV and Vinclude specific recommendations towards achieving these goals.
3.17 In the longer term as inflation is brought under control, thefinancial system would probably be better served by a gradual reduction ofthe legal reserves requirements on current and savings accounts, which wouldincrease price competition in the financial system. These measures couldalso help increase total financial savings in the system and permit anaccelerated liberalization of borrowings from foreign banks by ensuring aregulatory system which does not put domestic banks at a competitivedisadvantage. However, for reasons explained in para. 3.13, the beneficialeffects of such liberalization on the financial system would be achieved onlyif the Government deficits and inflationary pressures are brought undercontrol. Otherwise, to compensate for the foregone inflation tax infinancing the deficits, the Government would have to resort to other meanssuch as increases in base money or open market borrowings, whch in themselvescould fuel further inflation and/or increases in interest rates and furtherdeficits. Thus the desirable pace of liberalization would depend criticallyon other macro-economic developments.
3.18 Another step which could be considered for the longer term is thegradual elimination of all remaining interest rate ceilings, including thoseon checking and savings accounts. Such a measure would probably beconsidered in the context of a reduction in legal reserve requirements,although not necessarily so. The move offers the advantage of helping toreduce commercial bank spreads and probably increasing the total financialresources mobilized by the system; however, since it reduces the total amountof inflation tax which can be appropriated from savers, several of the samecaveats as discussed in paras. 3.13 and 3.17 would apply. In any case, sucha decision is closely linked to monetary management issues beyond the scopeof this report.
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3.19 Finally, in considering possible removal of the remaining interestrate ceilings on CDTs and savings accounts, the case of CAVIs should receiveparticularly close attention, since these are expected to play a key role inthe Government strategy of stimulating housing construction as an engine ofdevelopment. The yields on the UPAC savings accounts and CDTs, which are themain instruments used by CAVIs (para. 1.06), are subject to administeredceilings, and have been significantly lower than those of other CDTs in themarket. Currently, the CAVIs are having no problems in competing with otherinstitutions for mobilizing funds, even with the large rate differentials,because of their ability to offer small saver deposits withdrawable on sight,their large branch networks and advertising efforts, tax advantages of UPACinstruments (basically a partial tax shield offered against inflation), andthe attachment of small savers to the notion of a 'monetary correction'.However, saver perceptions and the performance of UPAC instruments in thefinancial markets could change in the future, if the interest ratedifferentials become excessively large. One way to avoid this potentialproblem would be to make automatic adjustments by linking the monetarycorrection to movements in the market short-term interest rates. Somedifferential could, of course, continue to be allowed between the marketshort-term rates (e.g., rates on CDTs issued by banks), and UPAC savingsinterest rates, but the differential would be fixed at a nearly constantlevel which can be sustained in the market by the product differentiation(e.g., on-sight withdrawal feature, branch services, tax features, etc.). Analternative solution may be to adjust the monetary correction periodically onan ad hoc basis to gradually reflect changes in the market rates, a movewhich should become easier as market interest rates decrease (as is hoped).In addition, the CAVIs could issue medium- and long-term bonds denominated inUPACs or CDT-based bonds akin to those proposed for CFs (para. 5.21), as ameans of reducing liquidity risks from potential disintermediation from theCAVI system.
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IV. INSTITUTIONAL ASPECTS OF THE FINANCIAL SYSTEM
Recent Developments
4.01 The Colombian financial system experienced a considerablebroadening over the decade of the 1970s (particularly the second half of thedecade) characterized by the emergence of new kinds of institutions (CAVIs,CFCs, and more recently, Companias de Autofinanciamiento (CAUFs)), and arelated substantial increase in the total number of intermediaries. Threetypes of factors contributed to this development:
(a) the desire to avoid regulation --most of the first CFCs (earliercalled "irtermediarios financieros") were created with thispurpose, and remained on the fringe of the formal market until1979, when they were brought under s'tricter regulation and becamean integral part of the formal market (paras. 1.11 .nd 1.16);
(b) the de-facto suspension of the entry of new institutions into thecommercial banking business since the early 1970s, which createdincentives for establishing other types of institutions such as CFsand CFCs with the essential aim of competing with the commercialbanks in the short-term lending market 1/; and
(c) the financial sector liberalization of the mid 1970s including themajor reform of 1974, which allowed many of the intermediariesrormeriy operating in the informai marKet to snirt to the rormalmarket.
Evolution of Financial/Industrial Groups and Concentration of FinancialSector Assets
4.02 At the same time, a strong trend developed towards the formation offinancial groups which control, directly or indirectly, many different typesof financial institutions, including commercial banks, CFs, CFCs, CAVIs andlife insurance companies. Some of these groups have also grown intonon-financial areas, such as industry and real estate. On the other hand,others which started primarily as industrial groups expanded into thefinancial areas as a means of facilitating easy access to credit. Forexample, several financial institutions were created primarily to secureaccess to artificially low cost deposits or subsidized credits to finance thenon-financial enterprises belonging to the same group.
1/ Entry of new CFs has also effectively stopped since 1980 by impositionof very high minimum capital and other requirements.
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4.03 The trend towards the formation of large, dominantfinancial/industrial groups was facilitated by three types of factors:
(i) the limited price competition permitted in banking because ofinterest rate ceilings and restrictions on external financing(para. 3.06);
(ii) the lack of adequate regulation of the operation of financial andindustrial 'groups'; and
(iii) the increasingly easy take-over activities made possibly by lowmarket valuations of traded shares and the 'cash squeeze'experienced by many companies due to tight credit and high interestrates. (paras. 1.20 and 2.14).
As a result, ownership and, more importantly, effective control of financialinstitutions became increasingly concentrated. It is difficult to estimatethe degree of concentration in terms of effective control, because a clear,commonly accepted definition of 'effective control' is not available andbecause at present there are not sufficient public disclosure requiremientsregarding operations of groups (e.g., on ownership linkages, interlockingdirectorates, transfer of funds among related companies, etc.). However,rough estimates are that at present the two largest financial groups control,directly or indirectly, 30-40% of the total assets of the financial system,and the largest six financial/industrial groups have effective control of atleast two-thirds of the assets. Since the groups tend to have similarrelative weights in the different specialized markets, the above figures arelikely to be representative of their competitive position in each of themarkets. More precise data available on direct ownership (rather thancontrol) of financial assets at year-end 1980 by individual institutions(rather than groups), which is presented in the table below, lends credenceto this observation.
FINANCIAL INSTITUTIONS AND THEIR ASSETS(As of Year-end 1980)
CommercialBanks CFs CAVIs CFCs Total
Number of Institutions 25 30 10 39 104
Total Assets (Col$m) 423,631.4 116,044.1 98,558.5 29,559.6 667,793.6
Z of Total Assets 63.4% 17.4% 14.8% 4.4% 100.0%
Z of Total Assets in the hands ofthe largest institutions:
Largest 20%: 58.1% 63.4% 33.2% 60.0% 55.3%
Largest 50%: 86.3% 87.6% 56.6% 88.8% 82.3%
Source: Revista de la Superintendencia Bancaria.
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As seen from the table, with the exception of CAVIs, half the number offinancial institutions in each category (commercial banks, CFCs, CFs andCAVIs) owned 80-90% of the total assets in the respective category.Commercial banks as a whole (which tend to be the leaders of the financialgroups) controlled roughly two-thirds of the total assets of the financialsystem at the end of 1980 (see also para. 2.10).
4.04 The above observations as well as field interviews lend reason tobelieve that the formal financial markets in Colombia are not sufficientlycompetitive. The market structure appears to be characterized by a degree ofoligopoly, with the largest finacial/industrial groups wielding a significantamount of market power. The events which shook the Colombian banking sectorin the second half of 1982, culminating in the intervention of the Super-intendency of Banks in a major commercial bank (Banco Nacional) and otherfinancial intermediaries associated with the same group (iacluding a CFC anda "Group II" CF) and the nationalization of another commercial bank (Bancodel Estado), highlight the gravity of the problems that can arise frominadequate control of and insufficient public information on the activitiesof financial groups, particularly those involving insider transactions.Paras. 4.10 - -12 outline several principles and recommendations whichcould help mdtigate the adverse effects of the concentration of ownership andcontrol of f §ancial sector assets; they basically involve a more adequateregulation of groups, a clearer definition of the responsibilities andobligations of the constituent members of a group, and strengthenedinformation disclosure requirements at the level of groups as well asindividual financial institutions.
Multi-banking vs. Specialized Banking
4.05 Another important structural issue of the Colombian financialsystem concerns the question of whether 'multi-banking' or 'specializedbanking' is more suitable for the Colombian context. The debate over thisquestion has been becoming increasingly sharp in Colombia in recent years.
4.06 The term 'multi-banking' has been used at least at two levels ofgenerality in literature. In the narrower sense, the term refers to generalpurpose banks which engage in all deposit and credit activities, includingconventional short-term borrowing and lending operations, investment banking,general mortgage loans and housing finance, but not securities marketactivities per se. Under the broader definition, 'multi-banking' alsoincludes securities brokerage and dealership activities and the role of aninstitutional investor. The following discussion concerns mainly therelative merits of specialized banking vis-a-vis multi-banking under thenarrower definition. A detailed discussion of the broader version ofmulti-banking, which essentially involves merging of banking and securitiesmarkets, is excluded because in the mission's judgment there is no case atthe present time to consider moving towards this alternative; the potentialconflicts of interest between banking and a healthy securities marketdevelopment, possible worsening of the ownership concentration problem, andthe consequent further damage to securities markets development which appearsprobable, essentially rule this out as a viable option for the foreseeablefuture.
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4.07 Although the Colombian financial system is formally structuredalong the lines of specialized banking, multi-banking in the narrower sensealready exists de facto to some extent in Colombia, since in many instances,operations of different specialized institutions are effectively controlledby the same parent company or group. Without ruling out the possibility ofmoving towards more formal multi-banking at some time in the future, at thepresent stage of development of the Colombian financial markets it wouldprobably be easier to improve the overall functioning of the system by firsttrying to build on the specialization model: in the immediate term, theColombian financial system can and should be strengthened taking advantage ofseveral benefits that a well administered specialized banking system couldprovide. In general, specialized institutions can be expected to be moreefficient and show more innovation and entrepreneurship in delivering itheirspeciality of financial services than multi-purpose institutions. This maybe extremely important in the case of the CFs, given the mre sophisticatednature of their investment and lending operations, and the special demandsplaced on them as mobilizers and providers of medium- and long-term financialresources. Particular skills and technical -capacity are needed for fu:Lfill-ing investment banking functions (e.g., evaluation and supervision of invest-ment projects and, more generally, lending based on project appraisals),which are typically not available among staff of other types of financiialinstitutions. 2/ Also, since short-term operations tend to be dominant inmulti-banking institutions, the commitment of managers to long-termoperations tends to be diluted. In contrast, specialized investment bankscan better preserve their independence and role as development orientedinstitutions.
4.08 Multi-banking does indeed offer some potential advantages whichcould offset the above considerations. Most important among the possiblebenefits are economies of scale in administration, diversification of lendingrisks and liquidity risks among a larger number of borrowers and types ofoperations, and greater flexibility in designing the most suitable financialservices package for an individual borrowing enterprise. These advantages,if realized, can be passed on to borrowers and savers in the form of betterservices and improved efficiency. However, a good multi-banking system wouldhave to embody measures to ensure, among other things, that each type ofbanking activity is carried out on a sound basis and that funds formalLyallocated for one purpose are not surreptiously utilized for another. In theabsence of adequate control of information on the operations offinancial/industrial groups, compliance with these principles would be verydifficult to ensure, and moving towards formal multi-banking could aggravatethe problems of concentration of financial power cited above (para. 4.03).On balance, it is the mission's judgment that in the near future, thispotential risk taken together with the advantages of specialization citedabove would considerably outweigh the potential advantages of multi-banking.In the longer term, once adequate regulation and mechanisms for monitoringand control of group activities are achieved, a possible move towards formalmulti-banking, building on the strengthened institutional capacities of
2/ For example, prior experience under the operation of BR's rediscountingfunds suggests that there is a very substantial difference between thequality of project appraisals carried out by the best CFs ("Group I"CFs) and those of participating commercial banks.
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constituent specialized institutions, could be considered. Such a futuredecision would have to depend on a careful reassessment of its relativeadvantages vis--a-vis retaining a specialized banking system.
4.09 Thus in any case, in the near term it appears advisable forColombia to reinforce its specialized banking system through appropriatereforms. Specifically, the realms of action and operations allowed for eachtype of financial intermediary should be carefully delineated, and measuresshould be taken to make the institutions stronger and more effective indelivering the particular type of financial service in which theyspecialize. While some formal overlap of functions among institutions mayhave to be allowed in view of the nature of their respective operations, thisshould be kept to the minimum necessary. Strict sanctions should beapplicable against informal transgressions of functions beyond these limits.
Recommendations for Institutional Restructuring
4.10 The major objective of institutional restructuring at the presenttime should be to translate the principles elaborated in paras. 4.04 and4.09 above into a set of operational rules. In particular, the restructuringshould aim to help transform the market from its present form of a few verypowerful institutions (or groups) surrounded by a large number of weak,marginal competitors, into one in which a smaller number of more competentand comparable institutions (or groups) compete effectively. At the sametime it should reinforce and help build up the specialized functions of thedifferent categories of financial institutions. The system should also bedesigned to achieve a fair balance of regulations/requirements versusprivileges/incentives among the different categories of financial inter-mediaries. In addition to the financial sector liberalization measuresdiscussed in Section III which would allow increased price competition amongfinancial institutions, the following specific institutional measures aresuggested to help achieve the above objective:
(a) Relatively free entry should be allowed for all types of financialintermediaries subject to compliance with certain prespecifiedcriteria such as debt/equity limits, limits on portfolio exposureand composition and minimum capital requirements, definedseparately for each intermediary category. These criteria would bechosen to ensure that financial structure of differentinstitutional categories is suitable to undertake their respectivespecialties and nature of business, while avoiding excessiveobstacles to free entry and competition. They would thus reinforcethe specialization of functions among the institutional categories.
(b) The same criteria should also be binding on institutions which arealready operating, so as to provide equal treatment for existinginstitutions and new entrants. If an existing institution is notin compliance with one or more conditions, a transition period of2-3 years should be allowed over which the institution would haveto achieve compliance, or transform itself into anotherinstitutional category.
(c) Since the focus of this report is on the CFs system, specificrecommendations on the limits applicable to financial structure areincluded only for the case of CFs (see para. 4.11 below).However, it is worthwhile stating three general principles whichreflect the mission's judgment in this connection.
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(i) Appropriate portfolio exposure restrictions (loans to asingle firm or group, loans to managers, directors andshareholders, etc.) similar to those suggested for CFsin para. 4.11 should be applied for all types of financialinstitutions.
(ii) In verifying compliance with the maximum debt/equity limitsspecified for each institutional category, liabilities of therespective intermediary to the Central Bank resulting fromrediscounting operations with the Official Financing Funds(FIP, FFAP, PROEXPO, etc.) should be included in thecomputation of total debt (it is gathered that this is not sounder current practice), since these represent seriousrepayment obligations unrelated to legal reserves maintainedwith the Central Bank. Likewise all guarantees granted bythe intermediaries should be included as part of thedefinition of total 'debt.'
(iii) In general, the maximum debt/equity limits should be lowerfor institutional categories which hold higher riskportfolios of assets (e.g., those with higher proportion oflong-term loans and equity investments) or whose deposits canbe expected to exhibit considerably higher volatilitycompared to their assets.
(d) Regulations on linkages between financial institutions through flowof funds and transfer of liabilities should be streamlined andstrictly enforced so as to avoid chain reactions within the groupswhen one of their members has financial problems; public disclosureof any such significant linkages should be required;
(e) At a more general level, comprehensive regulation of financial/industrial groups should be implemented, incorporating among otherthings: clearly defined limits on ownership linkages among finan-cial institutions and between financial and industrial companies(since excessive amounts of such linkages can disrupt the structureof the financial system); 3/ a clear statement of the rights andobligations of the owners and constituents of the group with anappropriate balance between such rights and obligations; andrequirements of periodic submission of consolidated financia:Lstatements for the group, as well as separate financial statementsfor each constituent entity; and
(f) The supervisory functions of the Superintendencia Bancaria shouldbe strengthened. Special importance should be given to:
3/ Excessive ownership linkages between financial and non-financial insti-tutions create incentives for the banks and other financial institutionswhich mobilize funds from the public to take greater lending and liqui-dity risks and pay higher interest rates for the resources mobilizedthan would otherwise be prudent. Some evidence of this can be foundin the operations of some of the financial/industrial groups. Suchphenomena would increase the risks of failure of the financial institu-tions and may also contribute to increases in market interest rates.
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(i) Placing under its authority all financial intermediariesraising resources from the public; and
(ii) Improving the quality and timeliness of the informationavailable to the public at large by periodically publishing,for example, each institution's balance sheets and incomestatements, the effective interest rates charged by differentinstitutions, the amounts of bad loans, the composition offinancial groups, etc.
(g) Any resource mobilization operations from the public of majority-owned financial subsidiaries of large industrial firms or groups(such as the CAUFs whose abolition has been announced recently)should be restricted to the issuance of long-term bonds orcommercial paper approved by the Comision Nacional de Valores andthe Superintendencia Bancaria. Such borrowings from the publicshould be secured by the assets of the parent company, limited tobe within prudent limits commensurate with such security, andpreferably be made in the name of the parent company.
Specific L_'~stitutional Proposals for CFs
4.11 ia the case of the CFs, the following specific actions andfinancial limits are recommended:
(a) Maintain the required minimum ratio of e uity investments tonet-worth at 80%-100% (see para. 1.14), / but provide themincentives to increase the proportion of genuine venture capitalinvestments in the equity portfolio, and the use of hybridrisk-capital instruments, along the lines suggested in Section VI.
(b) Reduce the limit on CFs' debt-equity ratio from 1:15 to, say about1:10, in view of the relatively high risk profile of their assetsstructure (which includes close to 100% of their networth in equityinvestments and a high proportion of medium- and long-term loans)and the significant degree of term transformation the CFs may haveto undertake. 4/
(c) Introduce additional restrictions on the maximum amount ofresources a CF can allocate to its customers. For example:
(i) limit equity investment in a given firm to 40% of the firm'snet worth or 10% of the CF's own net worth, whichever ishigher; and
4/ The above proposed limits are based on a definition of networth orequity which includes share capital, legal and other reserves andretained earnings, but not revaluation of the book value of assets.Other capital adequacy measures may also be used (e.g., debt-service orincome-related ratios) as alternatives to the simple leverage ratio,although these tend to be more difficult to monitor and control.
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(ii) limit total equity investment and credit allocated andguarantees provided directly or indirectly to the controllingshareholders or their affiliates, managers of the CF andrelated persons and enterprises to, say, 25% of the CF's ownnet worth.
(d) Reduce minimum capital requirements for CFs from its current levelof Col$1.0 billion (to say Col$500 million) in order to facilitateeasier entry of new CFs; such minimum capital requirement should bemade binding on those currently in operation as well as newCFs 5/;
(e) Reinforce the CFs' role and identity as term financinginstitutions, through suitable portfolio requirements, for example,to maintain a minimum proportion (say 60% or 70%) of their totalassets in medium- and long-term loans and equity investments.
4.12 Any existing CFs which are not in compliance with one or more ofthe above requirements should be allowed a transition period of, say, 2-3years to adjust and achieve compliance. During that period, a liberal policyshould be followed to allow any existing CFs to reorganize themselves as CFCs(or as some other type of financial institution which may suit better theirbusiness objectives) under agreed conversion procedures. Similarly, mergersof small CFs in order to meet the minimum capital requiremento suggested aboveshould be allowed.
4.13 Finallv, in order to retain sufficient financial incentive for theCFs in the light of the institutional restrictions proposed as part of thespecialization model and to enable them to compete on a near equal basis withother financial institutions, it would be necessary to provide the CFscertain special previleges and incentives. Specifically, it is recommendedthat:
(a) The CFs be exempted from the 10% forced investments requiremtents ontheir CDT resources (which would be well justified since these arerevised at market rates and since CFs have no access to other zeroor low cost resources from the market);
(b) Steps be taken to remove the perverse effects of the JuntaMonetaria Resolution of 1982 allowing commercial banks to use theirfrozen marginal reserve requirements as counterpart resources for
5/ The minimum capital requirements were revised upwards in 1981 fromCol$ 100 million to a very high Col$ 1.0 billion, in order to avoid thecreation of an excessive number of new CFs in a volatile financialclimate; the concerns which led to this previous action would bemitigated by the various other measures being proposed for theinstitutional restructuring of CFs.
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the Official Financing Funds, which creates much strongerincentives for commercial banks than CFs to participate in therediscounting operations with the Official Financing Funds; theresolution in effect allows the commercial banks to earn returns ofup ti 29% on their own resources used as complement to therediscounting operations, which, as part of the frozen marginalreserve requirements, would otherwise yield a zero return. 6/
(c) In operations of other Official Financing Funds such as FFI, FIP,PROEXPO and FFAP, the CFs be allowed a higher percentage ofrediscounting (say 60% instead of 40% for other institutions -- seepara. 5.22) or a higher interest rate spread, or a combination ofboth; 7/ and
(d) Some privileged access be also considered for CFs to medium- andlong--term external loans (para. 5.28).
4.14 The implementation of these measures should provide a soundinstitutional basis for the operations of the CFs by reinforcing theirposition as institutions specializing in investment financing, weeding outmarginal CFs whose main business interests diverge from the objectives setfor the CFs system, improving the capital base of the remaining CFs, andproviding incentives for them to channel a substantial share of theirresources to equity investments and long-term credit.
6/ One way of correcting this would be to implement the desired gradualliberalization of the marginal reserve requirements following a scheduleindependent of the use of the rediscounting operations by the OfficialFinancing Funds--say by pre-announced targets every month subject tominimum amounts of total incremental lending to the productive sectors.
7/ The Government may also wish to examine whether it would be desirable toprovide the CFs privileged access to the resources of those OfficialFinancing Funds which require special technical capacity for evaluationand supervision of investment projects (e.g., FIP and medium-termoperations of PROEXPO), in order to ensure a satisfactory balancebetween the institutional requirements and privilege of CFs -- seepara. 5.22.
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V. RESOURCES FOR MEDIUM AND LONG TERM LENDINGBY THE CORPORACIONES FINANCIERAS
A. Introduction
5.01 The growth of medium and long-term financing provided by the CFsis governed, among other things, by the amounts, costs and stability of thefinancial resources which can be raised by the CFs. Apart from the CFs'equity, such resources are basically made up of: (i) domestic savingsmobilized through the issue of CDTs and bonds; (ii) loan rediscounts by theOfficial Financial Funds (FIP, FFI, FFAP, PROEXPO, etc.); and (iii) externalloans provided by international financial organizations, other officialsources and foreign commercial banks.
5.02 Medium- and long-term lending by the CFs can therefore bestimulated by: (i) term transformation of the resources provided by CDTs andother short-term instruments; (ii) improving conditions for issuance oflonger term savings instruments by the CFs; (iii) improving the conditions ofaccess of the CFs to the rediscounts of the Official Financing Funds; and(iv) increasing the possibilities of utilization by the CFs of medium- andlong-term external loans from foreign commercial sources. These four mainavenues of action are examined in the following subsections.
B. Creating Conditions for Term Transformation of Deposit Resources
5.03 In principle the CFs could actively engage in medium- and long-termlending by term transforming resources which they mobilize by means of 90-dayCDTs and the relatively short-term (typically less than one year) 'bonds'.However, such term transformation by the CFs is not taking place at presentbecause of interest rate and liquidity risks. These two types of risks andthe solutions which may be adopted to overcome them are analyzed separatelybelow.
(a) Floating Interest Rate Loans as a Solutionto Avoid Interest Rate Risks
5.04 In the present conditions of high and variable inflation ratesthere is the fear that nominal interest rates may fluctuate substantially inthe medium and long run. This could impose substantial losses on thefinancial intermediary if it extends long-term loans at fixed interestrates. Moreover, the extent of such losses remains uncertain until thematurity of the respective long-term loan is reached, creating an open-endedlong term income risk, with potential losses increasing as future nominalinterest rates go up. The only way to avoid the risks of such losses wouldbe to introduce a system of floating interest rates in medium- and long-termloans tied to the cost of the short-term resources used. For example, theinterest rate of a 5-year credit could be changed every quarter and set equalto the average CDT rate at the beginning of each quarter plus a margin of,say, 4%. Under such a system, the financial intermediary would not beexposed to significant interest rate risks and its margin of intermediationwould remain roughly constant.
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5 .05 In principle the CFs are free at present to make medium- andlong-term floating interest rate loans. 1/ An important element which hashitherto hindered the use of a floating interest rate system lies in theregulation governing the penalty interest rate on overdue credits (arrears).In view of Article 884 of the Commercial Code and of the interpretation ofthe Supreme Court of May 29, 1981, the penalty interest rates for creditwhich have not been paid on maturity ("moratorios") cannot exceed twice the"interes corriente bancario" (the "current bank interest") fixed by theSuperintendent of Banks, which has remained at 18%. In theory, the normalinterest rates on types of loans for which there are no ceilings can exceed36%, but this would create situations in which the "moratorios" would belower than the normal interest rates. Besides being illogical, such situa-tions would make it profitable for the debtors not to pay their credits onthe maturity dates. As explained in Section II, in short-term credits thereare no difficulties in charging effective interest rates substantially inexcess of 36% in the form of discounting or prior payments, or large'commissions" collected at the beginning. In medium- and long-term creditsthis is much less feasible (para. 2.06). Thus, in order to create condi-tions for medium- and long-term loans with floating interest rates, it wouldbe essential to relax the constraint on the maximum level of the"moratorios." This can be easily achieved by a decision of the appropriateauthority (Junta Monetaria or the Superintendent of Banks) to adjust periodi-cally the "interes corriente bancario" to make it equal to a suitable marketreference interest rate such as the interest rate on the most recent issuesof CDTs in the market.
5.06 Another major factor which has prevented the development of afloating rate system is the lack of a reliable and widely accepted referenceindex of deposit costs to be used as the base for the system. The indexshould represent the estimated weighted average of the costs of raising shortterm resources in the market. Given the relatively thin secondary market andthe concentration in financial power in Colombia, it has been difficult inthe past to have an index which commands wide confidence among borrowers andlenders. Moreover, a spontaneous interest in developing such an index hasbeen lacking in the past among the banks and CFs, since medium- and long-termlending is not part of the normal business of commercial banks and CFCs (withthe exception of some rediscounting operations by the banks) and has recentlynot been profitable for the CFs (para. 2.08).
5.07 To address this problem, it is recommended that Banco de laRepublica (BR) provide a suitable reference index by computing and publishingperiodically (say once a month) the weighted average effective interest rateon 90-day CDTs issued by commercial banks and CFs (and possibly also CFCsalthough their inclusion could distort the index to some extent) in the imme-diately preceeding 1-month period. The data on CDT rates would be gatheredthrough information submitted weekly to BR by all financial institutions. Inorder for the index to be used as an objective indicator of average marketCDT rates, it would be very important to ensure that the methodology of its
1/ This has not always been true in the past. In particular, floatinginterest rate loans with interest rates linked to movements of CDT ratescould not have been made prior to the removal of administered ceilingson lending interest rates in January 1980.
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computation enjoys the widest possible confidence amo-g the >biic in generaland borrowers and financial intermediaries in particular 0 To this end, thefull cooperation of the local banks and CFs providing the basic informationwould have to be obtained, and suitable cross-checks to verify datareliability should be incorporated in the methodology. Moreover, fullinformation on the methodology used to compute the index sho_ld be publiclyavailable. 2/ Despite these measures, which should assure a satisfactoryreliability of the data, the above proposed index should nevertheless beconsidered a second best solution pending the development of an activesecondary market for CDTs, since the index would be based on rates on primaryissues, on which information is harder to compile. Once a strong secondarymarket for CDTs and (or other suitable short-term paper) de-.elops, the aboveindex could be replaced by an index of the appropriate effec--ive interestrate in the secondary market which could provide a better reference in thelonger run. One could also envisage the development of a secondary marketfor a short-term government instrument which could provide an alternativereference for linking interest rates, or at least would exert enough compe-tition in the market to force CDT rates to be more responsive to marketforces. To facilitate this, the Government should consider homogenizing thecharacteristics of the various short-term official papers ("titulos de parti-cipacion" certificados de cambio, etc.) which together can provide a suffi-ciently large consolidated secondary market for the new instrument.
(b) The Liquidity Problem in Term Transformation
5.08 Even if the interest rate risk is minimized by a system of floatinginterest rates, it is probable that the CFs would be wary of undertaking termtransformation on a large scale from CDTs into medium- and long-term loans.This is because, as indicated in Section I, the recent years have witnessedfrequent changes in the relative yields of instruments and consequent abruptshifts of saver preferences among instruments. The CFs therefore face thepotential risk that the amount of their total CDT liabilities used in finan-cing medium- and long-term credits may fall abruptly, putting them in seriousliquidity difficulties.
5.09 A large part of the solution for this problem is to maintain astable financial sector policy which avoids frequent changes in the relativeyields of different financial instruments and artificially large differencesamong yields of comparable instruments (e.g., through changes in tax treat-
2/ In order to provide for alternative base indices (other than theBR-computed index), which may also be agreed upon between the borrowerand lender for adjusting lending rates, it would also be advisable torequire all Colombian financial institutions to publicly announce, say,once every week, the effective interest rates (taking account ofcommissions and interest pre-payments) on their new issues of CDTs. Inorder to ensure the authenticity of these rates, the Superintendency ofBanks should have the authority to make spot checks of the aboveinformation vis-a-vis information obtained directly from depositors.Individual borrowers and lenders may then enter into loan contracts inwhich the lending rate is linked explicitly to an average of pub:Liclyannounced CDT rates of a mutually agreed sub-set of leading banks andCFs.
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ment, official intervention or other regulations). If more homogeneity ismaintained in those yields, with differences among them reflecting onlydifferences of liquidity, transaction size and risk, there would be nocompelling reasons for the financial institutions to fear that the amounts oftheir resources obtained from CDTs could fall abruptly. However, even withmore stability of the relative yields of the different savings instruments,it would be important to provide the CFs with satisfactory assurances thatthey would be supported in overcoming potential liquidity problems which theymight face in the event of unexpected declines of their short-term resourcesused in medium- and long-term loans. These assurances can in part beprovided through the extraordinary rediscounting facility ('cupo extra-ordinario') in the Central Bank (BR) available to CFs. However, the CFs atpresent receive a less favorable treatment than commercial banks: while thereis no defined limit to the 'cupo extraordinario" of commercial banks, the"cupo" for the CFs cannot exceed 50 % of their capital and reserves. Also,the interest rates charged by BR on credits granted under the same cupohave in the recent past been lower for commercial banks than for the CFs. 3/Both of these rates are low in the present -conditions of the market, but inprinciple the conditions of access for CFs and the commercial banks should beequal.
5.10 BR should maintain the restrictive conditions that are usuallyimposed on the users of the resources of that "cupo," including penalinterest rates. However, in circumstances of a decline in the amount of CDTsor other short-term liabilities of an individual CF due to reasons beyond its,control, these conditions should be substantially eased to the extent thatthe CF's short-term resources were used to provide medium-and long-termloans. As a supplement to the 'cupo extraordinario', the Government shouldalso explore the possibility of a facility to which CFs can sell their termloans at a discount with a buy-back provision (akin to the system used byFNMA of the United States). This would help to minimize the need of CFs toresort to the 'cupo extraordinario'. For administrative convenience and tofacilitate risk diversification, the liquidity fund proposed above could becombined with FAVI, the stabilization fund being administered for CAVIs.
(c) Summary of the Features of the Proposed TermTransformation Mechanism
5.11 The proposed term transformation would have the following features:
(a) Banco de la Republica would announce every month (or week) theaverage effective rate on CDTs issued by commercial banks and CFsin the preceeding week;
3/ Until recently the interest rates on 'cupo' advances were 30% forcommercial banks and 36% for CFs. A Junta Monetaria Resolution (No. 59)of November 1982 changed these percentages to 28%, presumably equal forthe banks and CFs.
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(b) The interest rate for the loans for every 90-day period would bethe latest average CDT rate announced by BR 4/ plus a margin tocover the intermediation costs of the CF; that margin would beagreed between the CF and the borrower based on the marketconditions at the time of the loan contract and would stay constantduring the entire period of the loan;
(c) The amortization of the loan would be determined by a scheduleannounced at the beginning that would specify the proportion of theoutstanding loan at the end of each period which would have to beamortized; and
(d) The interest would be paid at the end of each quarter; in caseswhere the option of capitalizing part of the interest payments onan automatic basis is provided, the method for capitalizationshould be chosen in advance (see paras. 5.12 and 5413).
(d) Capitalization of Interest Payments
5.12 With a system of floating interest rates along the above lines, ifthe CFs would be able to extend loans with medium- and long-term maturitieswithout the interest rate risks which would arise in fixed interest rateloans. From the borrower's point of view the system would ensure that thereal (and nominal) rate of interest applicable on medium- and long-terrm loansis not out of line with that on short-term loans. This helps to remove animportant source of uncretainty facing borrowers in making their short--termvs. longer-term financing decisions and reduce the potential variabilily inthe long-term real interest rates paid by them. Also, it would tend toreduce the dangerous practice of rolling over short-term loans to financelong term assets.
5.13 While the above features would in themselves make it fullyworthwhile to implement the proposed term transformation scheme based onfloating interest rates, the system could be designed to incorporate anadditional attractive feature. This relates to the special problems faced byborrowers of investment loans during periods of high nominal interest rateswhich are associated with situations of high inflation. Loan servicing inthese instances typically places excessively burdensome cash flow demands onthe borrowers during the early years of the loan, since a large part of thenominal rates in these cases represent compensation for the erosion of theprincipal outstanding. The high nominal interest rates effectively imply ashortening of the weighted average real maturity of the loan. In the case oftypical investment projects whose revenues build slowly, this can causeserious cash flow problems in the initial phase of the project, creating theneed to resort to additional shorter term borrowings during that phase. Theproblem can be solved by providing for indexation of the prinrcipal or bysystems of floating interest rates which allow partial capitalization ofinterest payments. As discussed in Annex 1, the latter alternative appears
4/ Or, alternatively, a simple average of the publicly announced effectiveinterest rates of CDTs issued by a subset of leading banks and CFsmutually agreed upon between the borrower and the lender (see footnoteto para. 5.07).
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preferable and can be easily combined with the features of the floatinginterest rate system described above. It would, therefore, be desirable toprovide for a partial capitalization of interest as an option on which theborrower and lending institution could agree under contracts for floatingrate loans. Capitalization of part of the interest payments would effec-tively increase the term transformation undertaken and hence the potentialliquidity risks to CFs. Specifically, if the CFs' resources do not grow asrapidly as the capitalization of interest payments less repayments, liquidityproblems could arise. These rises are, however, considered low, provided anational and stable interest rate policy is followed as suggested earlier.
5.14 Several alternative systems of partial capitalization of interestcan be considered, depending on the criteria used to determine which portionof the interest payments are capitalized. The relative merits of the alter-native schemes are presented in Annex 2, together with an illustrativeexample. Based on that analysis, the most advisable method appears to be onein which the portion of interest payments to be met in a cash basis is fixedat a predetermined level (roughly corresponding to an appropriate -real-interest rate level or possibly slightly higher) and the remaining interestpayable is automatically capitalized, say, every quarter.
(e) Tax Treatment of Floating Interest Rate Loans
5.15 At present, borrowing enterprises are allowed to deduct fromtaxable income the entire interest charges on their debts. This proceduretends to overcorrect the taxable income of companies in the sense that, underconditions of high inflation a large part of the nominal interest rate onlycompensates for the erosion of the real value of the principal and hence isnot a cost in real terms. The practice also makes debt financingexcessively attractive compared to equity financing (para. 2.16). Both thedifficulty of equitably enforcing taxes on interest income and theirpotentially negative effect on personal savings suggest that these taxesshould be reduced (e.g. by limiting the taxable income as well as interestdeductions to the amount corresponding to the effective real interest rate)if not eliminated. Consideration should also have to be given to the broaderimplementation of 'inflation accounting' and exempting from capital gains orother taxes any increases in the nominal value of fixed assets and equityinvestments attributable to increases in general price level (para. 2.14).
5.16 These statements are, however, not intended to suggest definitivesolutions but to illustrate the nature of the problems in respect oftaxation. There are many other ways of addressing these problems, someinvolving a simple 'inflation shield' as suggested above. Any solution tothe problem would have to be an integral part of a comprehensive reform inthe tax system and its administration applicable to the entire economy,covering not only the treatment of interest payments and capital gains butalso methods of computing capital consumption (depreciation) allowances,possible investment write-offs, amounts of withholding taxes, ways to reducetax evasion, etc. The discussion of these issues is beyond the scope of thisreport and is expected to be covered more extensively in the Bank'sforthcoming Economic Report.
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(f) Transparency of Effective Lending Rates
5.17 As a complement to the introduction of the floating interest ratesystem, steps should be taken to improve the transparency of the effectivelending rates charged by different types of financial institutions for loansof different maturities. A Junta Monetaria Resolution which has been ineffect since 1981 requires financial institutions to provide regularinformation on their average lending rates to the public. However, undercurrent practice, banks and CFs have been announcing only their averagenominal lending rates. These are not very informative about the true cost ofloans in view of the widespread use of prior payments, comi=Jssions, etc., toboost up the effective lending rates. In the future, all .financialinstitutions should be required to provide information on thaeir effectivelending rates for each type of loans, taking into account all prior paymentsand other loan charges. The improved information would help the authoritiesin monitoring the levels of lending rates and spreads of financialinstitutions for loans of different maturities. The information would alsohelp in assessing the competitiveness of the financial system and the needfor further regulatory reforms in the system (para. 4.03). In addition, itwould provide financial institutions useful guidance in fixing appropriatespreads in new contracts for floating interest loans.
(g) Advantages of the Proposed Modifications
5.18 A system incorporating the modifications proposed above would offerthe following important advantages:
(a) Since it is linked to the cost of 90-day CDTs which the CFs aremobilizing already, the resulting long-term rate would be in linewith the overall structure of market rates, and would not introduceany additional fragmentation or distortions in the Colombianfinancial market.
(b) The rate compatibility helps the term transforming institutionsminimize their interest rate and liquidity risks; any remainingliquidity risks would be mainly those related to distortions in thefinancial markets which could result from official intervention orregulation of CDT rates.
(c) From the borrowers' viewpoint, the system ensures that adequateinformation about market interest rates is available and that theinterest rate on longer-term loans is not out of line with that onshort term loans, thus helping to reduce an important source ofuncertainty regarding long-term real rates. Moreover, the optionof partial capitalization of interest, if provided, would reduceconsiderably the cash flow problems often faced by borrowersundertaking investment projects during periods of high nominalinterest rates.
(d) Experience in other countries as well as field interviews inColombia indicate that a system such as the proposed one would bemuch more attractive to borrowing industries than a system ofCPI-indexed loans. This is mainly because they are reluctant toassume the risk of changing relative prices for their output and
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principal inputs (vis-a-vis the general price level) over the termof the loan. They generally prefer to accept instead theuncertainties related to the volatility of market short-terminterest rates, with which they are familiar and which probably putthem on a par with their competition.
(e) The system would be consistent with the eventual use by CFs offloating interest rate bonds proposed below to mobilize longer-termresources from the market. 5/
C. Improving Conditions for Issue of Longer Term Savings Instruments
5.19 The term transformation scheme proposed above would permit CFs tomake medium- and long-term loans even with their predominantly short-termnature of market mobilized resources. In the longer run, steps should betaken to facilitate mobilization of resources from the market by CFs throughlonger term savings instruments (medium- and long-term bonds), to allowadditional increases in term lending by CFs, without increasing the need forterm transformation and the associated liquidity risks for the CFs.
5.20 Given the high liquidity preference among savers induced by thehigh and variable inflation and sharp fluctuations in market-determined nomi-nal and real interest rates, medium- and long-term savings instruments bear-ing fixed interest rates have virtually been impossible to issue in theColombian market in recent years (para. 2.05), The only practical way toovercome the savers' resistance to longer-term instruments under the currentcircumstances appear to be to issue bonds with floating interest rates linkedto a reference short-term rate, or indexed bonds whose principal is adjustedto reflect changes in a general price index such as the CPI. A discussion ofthe relative merits of these two alternatives is included in Annex 1. Onbalance, it appears that floating interest rate bonds linked to a base indexof average CDT rates would clearly be preferable. They would offer many ofthe same advantages as those cited earlier for floating rate loans (para.5.18). In summary: (i) being linked to already existing market instruments(CDTs), they would introduce no additional fragmentation or distortions inthe Colombian financial markets; (ii) since most industrial borrowers preferfloating rate loans over CPI-indexed loans, floating rate bonds would enablebetter matching of the CFs' structure of assets and liabilities; savers mayalso prefer them over CPI-indexed bonds in view of the prior experience ofadministrative ceilings on monetary correction; and (iii) the holders of thebonds would benefit from a yield somewhat higher than the CDT rate combinedwith a reasonable liquidity without the risk of significant capitallosses--since the interest rate would reflect movements in the market CDTrate, the price of the bonds should not depart very much from their nominalvalue, except as a result of possible administrative action to control CDTrates.
5/ Implementation of a floating interest rate system would have someoperational implications to the way in which loans to borrowing enter-prises would have to be documented. Since there are many alternativeways of documenting these loans, it would be useful for the Governmentto issue official guidelines on acceptable form(s) of such documenta-tion, after consultation with the private sector. This would help makethe new types of loans more readily acceptable in the market.
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5.21 It should be emphasized that the CFs (and other financialintermediaries) would have incentives to issue longer-term bonds in thfsmarket only to the extent that availability of subsidized term lending isconstrained and the amounts of subsidies are reduced as proposed earliger(para. 3.14). Otherwise the inverted yield curve implied by the availabilityof officially subsidized credit to fully meet the demand of term loans wouldpreclude the issue of longer-term instruments in the markete Assuming thatthis basic condition of their issue is satisfied, the following specificfeatures are suggested for the proposed floating rate bonds:
(a) Their interest rate would be adjusted at the beginning of each90-day period to equal the average rate of CDTs published by BRplus a small premium to compensate for longer maturities; thesinterest rate premium would be determined at the time of the issueon the basis of market conditions and would stay constant throughthe life of the loan.
(b) Given the marked liquidity preference of savers, the first issuesof these new bonds should probably have comparatively shortmaturities (for instance 3 years) and annual repayments ofprincipal (for instance, one-third at the end of each year forthree-year bonds).
(c) The bonds should be traded in the stock exchange.
(d) In the case of fixed interest rate bonds which were issued in thepast, the CFs found it necessary to create special support fundswhich in effect guarantee bondholders the option to repurchase thebonds at par value in order to gain the acceptance of the savers.No such support fund is considered necessary for the proposedfloating rate bonds, because the yields on the floating rate bondsshould move in line with the market thus minimizing any potentialcapital losses for the bondholders. However, it may be desirableto create a 'liquidity fund' which would help the development of asecondary market by maintaining a limited inventory of the bondsand helping to smooth out price fluctuations.
(e) Savers should be offered a choice between two types of floatingrate bonds: (i) those for which the interest earned in a givenquarter is paid in its entirety to the bondholder at the end of thequarter; and (ii) bonds which provide for partial capitalization of
the interest payments along the lines described for floatinginterest rate loans (paras. 5.12 and 5.13). CFs are likely toprefer the latter type since they would increase the effectivematurity of the bonds and, to the extent that the CFs offerindustrial borrowers the option of capitalizing interest on theirown bonds, would match better their resource requirements (para.5.18). Given the lack of prior experience, however, savers mayinitially prefer bonds of the first type;
(f) The resources raised through the bonds should not be subject to anycash reserves or forced investment requirements, since they wouldbe mobilized at market interest rates and somewhat adversecircumstances;
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(g) In addition to CFs, companies undertaking large investment projectsin manufacturing, mining, construction, transportation, tourism,etc., should also be allowed to issue the above type of bonds,subject to the authorization of the National Securities Commission(Comision Nacional de Valores).
D. Access to Official Financing Funds
5.22 The system of refinancing development credits by the OfficialFinancing Funds (FIP, FFI, FFAP, etc.) can continue to serve its originalpurpose. However, in order to reduce some of the existing distortions,several modifications should be considered:
(a) The Official Financing Funds should be changed from the currentsystem of fixed interest rates on their rediscounts to a floatinginterest rates system linked to CDT rates. This would a-,oid thearbitrary increases in the margin of subsidization which resultunder the present system when inflation goes up. Credit subsidiesprovided by the Official Funds would have to be ultimately financedby monetary creation, the imposition of an 'inflation tax' on thebanking system or additional borrowings in the market by theGovernment, or a combination of these. An exogenous increase innominal interest rates, by increasing such credit subsidies, could
therefore lead to further increases in inflationary pressuresand/or increases in real interest rates and crowding out in creditmarkets (para. 3.11). To the extent that they are financed byforced investments by financial intermediaries, observed interestrate spreads of the intermediaries would also increase. Each ofthese factors could further add to the segmentation of the free andsubsidized credit markets, leading to misallocation of resourcesand inefficient investments.
(b) Although the present situation of depressed investment and the highlevel of market interest rates put strong pressures on theColombian authorities to provide somewhat preferential interestrates on investment loans financed through the Official FinancingFunds, the margin of subsidization of such loans should begradually (but substantially) reduced for the reasons discussed inSection III. In the medium-term, final lending rates on such loansshould be only a few percentage points below the short-term lendingrates in the market (for instance, they could be set at the CDTrate plus two or three percentage points) and the differentialshould stay constant through the life of the loan.
(c) The margin of intermediation received by the CFs on term loansrediscounted with the Official Financing Funds should be sufficientto cover a reasonable level of operating costs and default risksand provide for a fair profit. As mentioned earlier that margin iscurrently extremely small or even negative (see para. 2.08 andTable IV).
(d) The proportion of the loans refinanced by the Official Funds should
be reduced significantly (for instance to 40%-60%) in order to
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stimulate the CFs to contribute larger shares of !-'eir Ownresources and to be more active in mobilizing domestic savings; theproportions refinanced would, of course, have to be set consistentwith the intermediation margins referred to in (b) aboveto ensure adequate overall spread in the respective lendingoperations. 6/
(e) Financial institutions which are devoting special attention tomedium- and long-term lending as evidenced by their willingness tohold a certain minimum percentage of their portfolio (say 60% or70%) in medium- and long-term loans and equity investments, whichin the medium-term should include all CFs by mandate (para. 4.11),be provided additional incentives in the form of a higherpercentage of refinancing from the Official Funds (say 60%vis-a-vis 40% for other financial institutions), higher interestrate spreads, or a combination of both. 7/
(f) As suggested in Section IV, the special privileges enjoyed by thecommercial banks in the rediscounting operations which cause aperverse incentive system, should be removed by delinking theliberation of marginal reserve requirements from use of OfficialFinancing Funds. On the other hand, the Government may wish toexamine the desirability of providing privileged (or exclusive)access to CFs in the case of Official Financing Funds which requirelending based on comprehensive project appraisals to achievedesired selectivity (and hence a certain minimum technical capacityand Dersonnel to evaluate and supervise investment Drojects) -
e.g., in the case of FIP and the medium- and long-term operationsof PROEXPO.
(g) The 5-year maximum limit on terms of lending under the FFI schemeshould be eliminated because it creates a bias against soundinvestment projects whose cash flows may imply a need for longerterm financing.
6/ The gross spread as a proportion of the total loan amount in a lendingoperation refinanced by an Official Fund is given by:
g= p (rb-ri) + (l-p) (rb-rc)where p= proportion refinanced by the Official Fund; rb = onlending
interest rate to the final beneficiary; ri = lending ratefrom the Official Fund to the intermediary; rc = effectiveinterest rate on CDTs; and (rb-ri) = prespecified marginfor the intermediary in the refinancing operation. Thecorresponding net profit would be obtained by deducting fromtg' the CF's administrative and other expenses and anallowance for credit risks.
7/ As suggested in para. 4.13 for CFs, such institutions should also bewaived from the 10% forced investment requirements applicable for CDTresources.
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5.23 For reasons of uniformity, the interest rate system and otherconditions applicable to domestic currency loans financed by IBRD and otherofficial international organizations should be basically the same as thosesuggested for the Official Financirg Funds. 8/ Some modifications may,however, be in order. For instance, in the case of financing from officialinternational organizations, a major part of which is directed towardsfinancing of imported equipment, it may be logical to leave the CFs theoption of raising the required complementary resources in the form ofdomestic or external cofinancing resources for the project (instead of solelyas CDTs). The spreads allowed for the intermediaries in these cases Fhouldbe determined on the basis of the same criteria as discuseed in para. 5.22above, although their absolute levels may have to be different depending onthe type of complementary resource requirements.
E. Role of the Instituto de Fomento Industrial (IFI)
5.24 It has been suggested that the Inst-tuto de Fomento Industrial(IFI) should play a refinancing role similar-to that of FIP and FFI. This byitself would not necessarily increase the amount of medium- and long-termfinancing available. However, to the extent that the IFI resources representnet additions to the rediscounting operations of the Official FinancingFunds, e.g., if IFI is willing to allocate for rediscounting operations partof its resources which it would otherwise have channeled into direct credits,this would be a favorable development for medium- and long-term financingthrough CFs. The main factor affecting a decision about a refinancing rolefor IFI would therefore have to be the judgment of the Colombian authoritiesas to the relative prioritv of Droiects which require direct financiig by iFIvis-a-vis those that can be financed through private CFs. Any additionalrefinancing provided through the CFs would, of course, offer the advantage ofautomatically securing some additional medium- and long-term financing fromthe CFs' own resources.
5.25 If IFI were to assume any refinancing functions, it should act onthe basis of the same rules as the Official Financing Funds with respect tothe proportion of refinancing, the interest rates charged, etc. as discussedabove. Moreover, direct credits provided by IFI should, as far as possible,bear the same conditions as those of the private CFs, and should offer thesame system of floating interest rates.
F. Increasing Foreign Currency Resources for Productive Sector Financing
5.26 In recent years, restrictions on foreign borrowings were imposed tohelp combat the inflationary pressures caused by rising internationalreserves and the Government budget deficits. In particular, maturities offoreign borrowings were not to exceed 3 years for financing normal importsand 5 years in case of imports under a "global license" (which can be grantedfor "integral" investment projects). Although the latter ceilings weresubsequently relaxed through a Junta Monetaria Resolution in1981 by providing INCOMEX (the agency authorizing import licenses) the
8/ At present these lending schemes mostly use fixed interest rate systems,although the latest IBRD loan (1857-CO) provides for a review of thelevel of interest rates at least once every six months.
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authority to approve longer terms in connection with granting of globallicenses, this procedure continues to represent a significant adminislrativehindrance, particularly since approval of financing is not a primary functionof INCOMEX. Also, no external borrowing is permitted to finance locaLinvestment costs, except in the case of priority sectors like mining andenergy (para. 1.17).
5.27 Given the more recent developments of less rapid build-up ofinternational reserves and a current account balance of payments deficit, therestrictions on borrowings from abroad can probably be eased in the future,
subject to satisfactory total debt servicing capacity in the economy andcompatibility with the proposed public sector borrowing program abroad. Evenif some restriction on total amounts of external borrowing is deemednecessary, it would appear advisable not to use maximum limits on maturitiesof external borrowings as the rationing device; such ceilings should beremoved and foreign loans with longer maturities should, in fact, beencouraged in preference to shorter maturities. Also, allowing foreigncommercial borrowings to finance local investment costs on a more generalbasis, rather than just for a few selected priority activities, wouldprobably help increase financial sector competition and could contribute tolowering of interest rate spreads of financial intermediaries. The aboverelaxation of the rules governing external borrowings could nevertheless besubject to target levels of total external borrowings which can be monitoredby the Central Bank, and, if necessary, controlled from time to time throughappropriate measures (e.g., restrictions on short-term external borrowings,financing of letter of credit operations with BR's accumulated reservesinstead of resources of foreign banks, etc.).
5.28 Financial institutions acting as intermediaries, alone or inconsortia, as well as industrial enterprises undertaking major investmentprojects should in principle be allowed to contract external borrowingswithin the same guidelines. In this connection the Government could considergiving some privileged access to CFs in the negotiation of medium- andllong-term external loans, which would be justified in view of their specialrole in fixed investment financing and their earlier experience incofinancing under loans from multilateral institutions.
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VI. RISK CAPITAL INVESTMENTS
Increasing Use of Hybrid Instruments
6.01 As mentioned in Section II, the desirability of risk capitalinvestments to CFs is ultimately a function of the ease with which they canobtain a fair return commensurate with the risks involved in suchinvestments. In the absence of a developed stock market, incentives for theCFs to make risk capital investments can be improved through the use ofinstruments which assure the CFs of more stable (and less risky) returnsand/or help them encash their capital gains with greater ease. Suchinstruments would help increase the willingness of the CFs to make anincreasing proportion of venture capital type instruments rather thanfocusing mainly on exchange-traded shares of very established companies(para. 2.13). Moreover, since most of the CFs already have equityinvestments approaching or exceeding their net worth, they cannot prudentlyincrease their risk capital investments if they were to be only in the formof pure equity holdings. Based on these considerations, it appears advisablefor the CFs to make increasing use of hybrid quasi-equity instruments whoserisk-reward characteristics lie somewhere in between straight debt andstraight equity.
6.02 Some of the hybrid instruments which have traditionally been usedby investment banks in other countries could be quite suitable for the needsand objectives of the CFs and the industrial enterprises being financed.Among these instruments are: straight preferred shares, convertible andparticipating preferreds, convertible subordinated debt, and straight debtwith an attached equity feature. Except for straight preferred, theseinstruments carry a lower interest (or predetermined dividend) rate, which iscompensated for with some probability of additional gain. The gain can takethe form of a future participation in profits or a capital appreciation, andcan become very substantial, if the company proves to be very successful.
6.03 Hybrid instruments such as the above could increase the demand forrisk capital by evolving companies by more satisfactorily meeting the capitalneeds of entrepreneurs who want to retain complete ownership control duringthe company's initial growth phase. They may also increase the CFs'propensity for true risk capital investments because they provide greatermarketability, assurance of a minimum cash flow and return on their riskinvestments, and hence a better overall liquidity position for the CFs. Inexchange for foregoing a high current spread, the CF would have a highprobability of earning higher returns over the long run than with straightdebt. At the same time they would represent a somewhat less onerous cashflow obligation on the borrower than a straight loan, which would be anattractive feature for emerging rapidly growing companies.
6.04 Another type of hybrid instrument that could also be appropriatefor use by the CFs is a special type of equity investment in a new venture,with a possible attached contractual agreement for the CF to sell the sharesto the other shareholders (typically controlling shareholders) once thecompany matures (similar to a put option). Thus, initially, when the newventure has large investment needs and little cash flow, the CF makes theequity investment; later, when the company is mature and is able to pay large
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cash dividends, the CF can sell its equity holding at some prezdeterminedvaluation to the controlling shareholders. To facilitate s-uch a sale, the CFcould also agree to provide a term loan to the purchasing shareholders tofinance the purchase; the loan can later be serviced by the purchaser in partwith the dividend income. As this loan is basically a personal loan, itshould be secured with the shares sold to the controlling shareholders. TheCF should finance only a part of this purchase and the loan should not besubsidized. The maturity of the loan should be of medium-term --long enoughto facilitate the needs of the purchasing shareholders but short enough toallow the CF to recycle the funds to new productive investments.
6.05 Annex 3 includes a more detailed discussion of the features andrelative merits of the various possible hybrid instruments. While several ofthe proposed instruments hold promise, a more detailed study is needed toexamine the legal, tax and other practical aspects of using each of theseinstruments, before definitive conclusions can be arrived at on theirapplicability and relative desirability within the Colombian system. It isrecommended that such a study be undertaken in the very near future.
6.06 If one or more of the above quasi-equity instruments is foundsuitable, the CFs should be encouraged to make increasing use of them. Oneway of providing such encouragement would be to replace the existingstipulation of the minimuim amounts of equity investments to be held by theCEs (paras. 1.14 and 2.13) by one that specifies minimum amounts of totalrisk capital investments (including both equity and quasi-equity holdings)required to be held by the CFs. Once adequate experience is gained in theuse of the new instruments, using this broader definition, total requirementof risk capital investment could be increased to, say, wlUW70 ot the Uksnet-worth from the currently specified level of 80% counting equityinvestments alone.
Fiscal Measures to Improve Incentives for Risk Capital Investments
6.07 The Government should consider appropriate reforms in the taxsystem, which at present encourages debt financing by industries inpreference to equity (or quasi-equity) financing and discriminates againstrisk capital investments, because:
(a) firms can deduct their full interest payments on their borrowings(including the inflation related part of such interest payments);
(b) the withholding taxes on income from share dividends are muchhigher (going up to 40% in some cases) than the withholding taxeson interest income (which is a constant 5%); interest incomes fromsome savings instruments such as UPACs are also protected through atax shield to compensate partially for the erosion of the realvalue of principal through inflation;
(c) dividends received by the shareholders are subject to adouble-taxation -- once on the corporate income and again on thedistributed dividends as part of the individual's personal income.
The existence of several market instruments which are traded on a discountbasis with no 'coupont or nominal interest payment, thus offering ampleopportunities for tax evasion for the holders, also contributes to lower
investor interest in equity shares.
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6.08 To address the above issues, the Government should consider reformsin the tax system to remove the existing asymetry between the tax treatmentof interest income and interest expenses (with respect to the deductibilityof the inflation related part of the interest payments), equalize withholdingtaxes for dividend and interest income and remove or reduce the double taxa-tion of dividend income. A reform in the tax administration to reduce taxevasion would also help substantially by removing the existing inequalitiesamong alternative instruments with respect to opportunities for income taxevasion. However, these measures are best contemplated within the frameworkof and consistent with a wider reform which considers the broader issues ofincome tax policies, as suggested in para. 5.16. Such a wider framework isexpected to be discussed with the Colombian authorities in connection withthe forthcoming Economic Report of the Bank.
Stock Market Development
6.09 In the longer run, stimulation of risk capital investments in theeconomy will also depend to an important degree on the development of anactive stock market, as discussed in Section II. The fiscal measures out-lined above should have a particularly favorable impact on investor interestin shares of widely held companies, and thus help remove one of thedepressant factors on stock market development. Regulations to strengthenthe protection of the interests of the minority shareholders (e.g., toprovide them a reasonable selling opportunity in block sale transactions) andto control adequately the operations of large industrial/financial groups asoutlined in Section IV (para. 4.10) should also facilitate the development ofthe stock market. Alternative courses of action to address these would needto be examined closely for their legal, financial and other practical impli-cations, but an early beginning is advisable since the type of reformsrequired typically involve a long implementation time (see paras. 2.14 and2.15). Stimulation of stock under-writing activities by CFs could also havea beneficial effect on the development of stock market and growth of widelyheld companies. Finally, a development of the stock market would be helpedby a reduction in the uncertainties facing the capital markets with respectto the absolute and relative yields of alternative market instruments, whichin turn would depend on the stability of the macro-economic environment andthe applicable regulatory regime in the financial sector (para. 5.09).
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STATISTICAL APPENDIX
Table I: Effective Interest Rates - Principal Financial Assets
Central Bank (-29) . (802) (106) (-915) (936) (3,032) (-2,969) -t-756) (-1,696) (100) (7.614) (34.490)
Privato Sector and other (-129) (-371) (320) (717) (1,811) (-1,006) (-206) (-2.337) (-2,427) (-3.2i0) (-5.500) (-13,521)(Pen.)
A!/ Monetery croation - (Tranwter from Banco de la Republica to Covernruent from C.E.C. - C.L.C. other thon coapraventa.BI Buyinr-Sulling Account in negattvo; Govornrent contributed to Coritral !$ank.
°! Surplus hodn as na&dtiVe,
Source: Economic Mission estimates, using data provi.ded by aanco de la Republica.
HA
'-1
Table III : Estimated Outstanding Credit to Manufacturing by SourcePercentual Composition
Sources: Rows (1), (2), from Revista del Banco de la Repuiblica, various issues. l
Row (3) from Revista de la Superintendencia Bancaria, various issues.
Row (5) from "Colombia - Manufacturing Sector Develcpments and Changes in Foreign Trade and FinancialPolicies", August 20, 1982 Report No. 4093-Co.
Row (7) 1971-77 - Basic data from and R.Junguito and Y. Castro "La Financiacion de la IndustriaManufacturera Colombiana." FEDESARROLLO. Bcgota, Febrero 1979. The figures presented in thosepapers refer only to sociedades Anoni'mas and Sociedades Limitadas, that accounted for 82-84%of the manufacturing output during the decade. Those figures were adjusted to take account ofother kinds of firms, using for them the informal credit to output ratio of manufacturingsociedades Limitadas. The new estimates are 24% higher than the sources in the average.
Row (7) (1978-80) - Same source of row (5).
Row (7) (1970) Mission estimate.
Table IV Percentual CCmDOSition o: Denosits in Colombia - 1970-1981
(Figures in parentheses are % of tttal commercial banks' deposits) if
Depcsits as % of GDP 13.3 12.8 13.5 15.9 15.4 16.6 18.3 19.3 21.0 19.8 23.5 26.2
M2 (Deposits and Currency 0
with the Public) as % o
of GDP 19.3 18.5 19.3 21.1 2).3 21.6 24.3 24.9 26.8 25.4 28.9 31.2
Deposits to currency ratio 2.2 2.3 2.3 3.0 3 2 3.3 3.5 3.4 3.6 3.5 4.4 5.3
1/ Year-end figures.
Scurce: Revista del Banco de la Republica.
Table V COLOMBIA: NOMINAL AND REAL INTE.REST RATES ON 3 NONW1 C.:RTXFrCATES OF DEPOSIT (CD'S)(Anntialzod rercentage Rates)
Effective CPI for workers Real ex-post Actual Interest RateRate on over period of Interest Rate'' Devaluation on 90 day Excesa of Rate onColS CD's a/ Col$ CDos Col$ b/ Col$/US$ USS CD's Coloubian CD's c/
a/ Effective rates estimated on the basis of prepayment of interest.bJ Real rate - ((I + C1))/(1 + (2))J - I expressed as a percentagc.c/ Excess - [(1 + (1))/(l + (4)) (1 + (5))] - 1 expressed as a percentage.d/ End of month figulre.
Source: Banco de la Republica data and Economic mission estimates for Colums 3 and 5.
TABLE VI
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Table VI :Legal Reserve Requirements and Forced Investments imposed on
the Colombian Financial System(as of July 1982)
Legal Reserve ForcedRequirements Investments
I. On Deposits (Percent of deposits)
A) Commercial BanksOn sight
- First C$130 million 17.00 1.0- Increase over the reservesrequired as of 1/31/80 44.0 1.0
Sold Portfolio 45.0 -Some specified Liabilities at30 days or more 15.0 14.0Deposits of Public Enterprises- Balance excepting the variationbetween Jan. 1977 and Jan. 1980: 80.0 -
- Variation Jan. 1977 to Jan. 1980: 100.0 -CDTs - 10.0Fiduciary Deposits 21.0 -Savings Deposits 19.5 .5Special deposits in foreign Exchange tC$1.00 per dollar)
B) CFsCDTs - 10.0Public Enterprises Deposits destinedto social benefits 80.0 -Sold Portfolio 45.0Foreign Exchange Deposits C$2.00 per dollar
Voluntary investments+ Loans and discounts+ Other Loans in local and foreign currency+ Bad debts not yet written off- Development Credit- Resources mobilized through CDTs- Voluntary investments in BR's paper (Titulos deParticipacion and Bonos de Prenda).
Source: Banco de la Republica
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ANNEX 1
COLOMI,61A: ALTERNATIVE LONG-TERM INTEREST RATE REGIMES
I. INTRODUCTION
1. Currently the corporaciones financieras (CFs) are engaged chieflyin short-term financi.g; funds mobilized on domestic markets withcertificates of deposit (CDTs) have been relent at short term, and medium-and long-term lending has been restricted to special funds at below marketrates from the Banco de Republica or foreign sources. The failure of theseinstitutions to fulfill their initially envisaged developmental roles stemsin part from the lack of an adequate instrument for lending domestic currencyresources at long term.
2. To date the CFs have employed only fixed rate credit instruments.The question arises whether such long-term lending at market rates ispossible given Colombia's chronically high inflation rate (approximately25%), and whether medium- and long-term lending would be more feasible if adifferent financial instrument were employed. This annex provides a reviewof the different possible instruments or combination of instruments which canbe used in this respect, discussing their relative merits.
3. Choosing a long-term rate regime will depend upon very generalconsiderations that are more or less applicable in any country, as well asspecial factors peculiar to the country under consideration. This annex willattend first to the most general considerations in order to establish apolicy framework, and then proceed to some of the particular aspects ofapplying this framework to the situation in Colombia.
II. THE LONG-TERM CREDIT INSTRUMENTS
4. There are basically four alternative long-term rate regimes whichthe Colombian financieras might employ: fixed rates, indexed rates, floatingrates, and floating rates with capitalized interest. For chronicallyinflationary countries such as Colombia, only indexed rate and floating rateswith capitalized interest hold much promise for achieving truly long loanmaturities.
5. (a) Fixed rate loans. The fixed rate loan is the standard long-termdebt instrument in price stable economies. In all economies, fixed ratecredit markets experience a progressive shortening of maximum maturities asinflation increases. Due to dispersions of expectations of inflation underconditions of high inflation, savers and borrowers cannot agree on a nominalinterest rate that they would both find acceptable over a long and uncertaintime horizon. Therefore, only special "low" fixed rate loans exist.Financieras in Colombia have employed only fixed rate loans to date, which inlarge part explains their inability to intermediate between savers andborrowers at long term.
6. (b) Indexed loans. By linking the money value of the principal of adebt to a general price index (usually the Consumer Price Index), borrowersand savers should be able to eliminate the need for deciding in advance on anominal rate of interest adequate to compensate for inflation over anuncertain time horizon. In practice, it is not clear that such general priceindexation succeeds in getting all types of savers and borrowers to agree onmutually acceptable long-term financial contracts.
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7. The experience of almost all countries which have experimented withfinancial market indexation has shown that the success of fully indexedlong-term instruments is quite sector specific: households appear to bewilling to borrow indexed debt, while corporations appear to be reluctant todo so. In almost all countries where it has been tried, indexed savings andloan institutions have flourished despite high inflation. Savers have beenwilling to purchase indexed deposits with immediate liquidity under mostconditions and borrowers have been willing to take on fully indexed debt withmaturities of 15 years and more.
8. By contrast, in no country where it has been tried have industrialcompanies issued large quantities of fully indexed debt at truly longmaturities on a sustained basis. In Brazil, corporate opposition persuadedthe state development bank to put a "cap" on long-term debt indexation andfully indexed long-term bonds proved to be unsuccessful. Recently, underconditions characterized by severe bank credit controls and extremely highreal short-term interest rates, firms began to issue indexed bonds but theeffective maturities of these instruments have been quite short (on the orderof one to three years). In Chile indexed corporate credit grew only during abrief period when indexed deposit rates proved to be too low to maintain apositive inflow of such funds. Most bankers and corporate managers inColombia believe that companies will shun fully indexed debt. However, Linderpressure from current high interest rates, some Colombian industrialists areasking for authorization of fully indexed bonds. It is unclear how deeplyrooted this demand is, and whether it is possible to mobilize such funds atrates acceptable to these prospective borrowers with non-indexed short-termdeposit rates at current high real levels.
9. In summary, there are some conditions when industrial firms willborrow fully indexed debt, but these occur infrequently. When real interestrates are very high and credit is very scarce, corporations appear willing totake on such debt. However, under these conditions such fully indexedlong-term funds are difficult to mobilize; savers tend to prefer high returnshort-term instruments that are not indexed and banks tend to refrain fromborrowing short on such terms and relending at long term on an indexedbasis. Though fully indexed long-term corporate loans are one rate regimewhich should be considered, their feasibility is subject to question.
10. (c) Floating rate loans. Rates on medium- and long-term credit can belinked to a short rate, with some risk premium to compensate for the longermaturity. This type of credit is utilized worldwide where inflation ismoderate; it is the standard medium-term credit instrument in internationalbanking. In high inflation environments, however, floating rate instrumentsare less prevalent. For example, Mexico has had only limited success withfloating rate corporate bonds at inflation rates comparable to those ofColombia.
11. Under conditions of high inflation, the high nominal interest ratecontains a large inflation premium which is basically a repayment ofprincipal due in the current payment period. Such large current interestpayments reduce the effective real maturity of the floating rate debt con-tract relative to its stated maturity, and impose large cash flow obligationson borrowers. It is probably for this reason that floating rate instrumentsare not widely employed in highly inflationary economies, since in realitythey provide few advantages over roll-over, short-term credit.
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12. (d) Floating rate loans with partial capitalization of interest. It ispossible to capitalize a portion of the interest payment on a floating rateloan and thereby reduce current cash flow obligations and lengthen effectivereal maturities. The capitalized portion of the interest payment cancorrespond with the inflation premium in the interest rate, though it neednot. If it does, the real maturity of the loan becomes equal to its statedmaturity, and the cash flow profile of the loan in real terms becomes thesame as that of a floating rate loan under conditions of price stability.
13. We have little experience with this type of floating rate loan; ithas been employed in housing finance in Portugal and government finance inArgentina, and is currently being introduced for all sectors in Peru. Todate, there has been no case in which a corporate sector has issued suchfloating rate debt. Yet, logical considerations alone indicate it shouldprove to be a feasible long-term corporate loan instrument. In mostinflationary countries, firms rely on roll-over, short-term credits.Floating rate loans with capitalized interest have roughly the same costsover time as such short-term credits, since the liquidity premium for suchlong-term loans should be modest. At the same time, such loans will havemuch longer maturities and less onerous cash flow obligations. Therefore,firms willing to finance with short-term roll-overs should be even moreinclined to borrow such floating rate credit with capitalized interest.
III. CHOOSING A LONG-TERM RATE REGIME
14. Inflation in Colombia has been on the order of 25% per annum forapproximately a decade. At this inflation rate, fixed rate long-term instru-ments are not feasible, and standard floating rate instruments are likely tomeet with only limited success, owing to their short real maturities. There-fore, there are only two serious alternative rate regimes facing the finan-cieras which might significantly alter their role as long-term lending insti-tutions: indexed instruments and floating rate instruments with interest cap-italization. Each of these types of instruments can be employed in threeways:
- As long-term bonds issued by non-financial units(direct finance);
- As long-term credits granted by financial institutions andfunded with long-term bonds of similar maturity and character(indirect finance without term transformation).
- As long-term credits granted by financial institutions andfunded with short-term deposits (indirect finance with termtransformation).
This provides us with six different long-term interest rate modalities:
(a) Term transforming institutions with indexed long-term loanassets and indexed short-term liabilities;
(b) Term transforming institutions with floating rate long-term loanassets with interest partially capitalized and short-term fixedrate liabilities;
(c) Indexed bonds issued by financial institutions to fund long-termloan assets;
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(d) Floating rate bonds with interest partially capitalized issuedby financial institutions to fund similar long-term loan assets.
(e) Indexed bonds issued by non-financial units such as industrialfirms;
The policy problem of choosing a long-term rate regime is to determine whichalternative or combination of alternatives should be adopted.
15. It is often argued that all of the above modalities should beauthorized and market forces should determine which combination shouldprevail. However, market forces can give rise over the short run tofinancial market structures which can involve significant social costs.Therefore, the social benefits and costs of each modality and allcombinations thereof should be envisaged, and policy should allow only thatset which optimizes social welfare.
16. In weighing such social costs and benefits there are four importantfactors to consider:
(i) The unique social benefit provided by the above interest rateregimes is truly long maturities. The reason why these linkedor indexed instruments could be socially useful is not because'Iey keep interest rates at positive real levels, since that can
be achieved with both market determined and administeredshort-term instruments; again, they are not socially usefulbecause they neutralize inflation, because even indexing of allcontracts, financial and otherwise, probably does not succeed indoing so. The special feature of these instruments is thatthey spread cash flow obligations on debts over time in a mannerthat corresponds to the cash flow generation of productive fixedcapital, even under conditions of high inflation.
(ii) Some interest rate regimes result in the "right" rate -- therate that clears the market for loanable funds. This ratemaximizes financial intermediation for any given monetary policyregime. Basically, the right or adequate interest rate is theone that is determined by market forces in a well organizedmarket environment. Administered rates can sometimes be corrector adequate, but they can just as well not be, no matter howmuch the administrating authority tries to set rates equal tomarket rates. Interest rates embody a real rate component andan inflation premium; real rates are highly variable and theinflation premium, which reflects expectations of inflation, isinherently not measurable, making it impossible to determine the"right" interest rate short of market pricing itself. Anylong-term rate regime is adequate only if it can reflect themarket clearing interest rate.
(iii) Some financial market structures are inherently unstable, inthat they lead to large and volatile fund flows and financialcrises. In social terms these financial market' disequilibriacan be very socially costly. Some financial market structures
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can lead to unwanted flows of funds that result in aninefficient allocation of real resources. In Colombia in themid-1970s indexation of the savings and loan institutions led tolarge inflows of funds into these institutions; though thehousing stock in Colombia was very deficient and increasedhousing investment was warranted, the resultant reallocation ofresources to this sector was excessive. Such sudden shiftscould lead to liquidity crises which impair the function offinancial markets and shift spending and investment propensitiesin undesirable ways. Such liquidity crises can shift moneydemand, thereby complicating monetary policy, and can bring thedual roles of the Central Bank as lender of last resort andmonetary authority into conflict, thereby compromising theconduct of monetary policy. The Colombian Central Mortgage Bankunderwent a severe disintermediation crisis when it operatedwith fixed interest rates; the Banco de la Republica'sdifficulties with this institution at that time are an exampleof this latter type of social cost.
(iv) It is the contention of some that widespread indexation to ageneral price index can introduce rigidities in the rates ofchange of prices and wages and thereby increase the social costsof stabilization. Indexation of financial instruments tends totie inflationary expectations to past inflation embodied in theindexing formula, and this may tend to perpetuate past priceinflation. Politically, indexation of capital assets tends tobeset indexation of wages, and the consequent regidity in wageinflation may increase the costs of stabilization. The degreeto which indexation of financial assets affects the social costsof stabilization is very situation specific, as it depends uponbehavioral and institutional factors peculiar to the economy.In some countries, such as Brazil, many observers believe thatindexation has acted to perpetuate inflation; in othercountries, where trade union power is great and costly wagesettlements are a problem, many believe that indexation wouldincrease labor price flexibility.
IV. EVALUATING ALTERNATIVE RATE REGIMES
17. Evaluating alternative rate regimes comes down to choosing that setof rate regimes that optimizes social benefit/costs; in other words, one mustdecide on that set of instruments and institutions that provides longmaturities at the "right" rate of interest without risking financialinstability or volatile changes in sectoral pattern of fund flows and withoutexacerbating inflation pressures. In conducting this evaluation, we need notconsider the most important potential benefit provided by these alternativerate regimes, as that already has been done: as explained earlier, fixed andstandard floating rate instruments do not provide truly long maturities,whereas both indexed instruments and floating rate notes with capitalizedinterest do, and we have narrowed our evaluation to the latter. We canfurther reduce the scope of this evaluation by not treating direct andindirect bond instruments separately. Though they are different in importantways, from the point of view of these key benefits and costs they areequivalent. Also, our interest is in a rate regime for the corporacionesfinancieras, which are engaged specifically in indirect finance.
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18. On the other hand, there are two ways in which indexed institutionscan operate: with fixed real rates or with variable real rates. The overallsocial costs and benefits associated with these alternatives are quitedifferent, and they should be evaluated separately. Therefore, it isnecessary to consider five different options: term transforming indexedinstitutions with fixed real rates, similar institutions with variable rates,term transforming institutions with floating rates with capitalized interest,indexed bonds (presumably of CFs), and bonds (again of CFs) with floatingrates and capitalized interest. Each alternative will be looked at from thepoint of view of system stability, rate adequacy, and its impact oninflation. A fourth criterion, ease of understanding and simplicity inoperation, is also quite important to consider because it would influence theacceptance of the savers and borrowers for the particular instrument. Th,epoint should be kept in mind though not discussed explicitly below.
19. (a) Term transforming indexed institutions with fixed real rates. Iheseinstitutions have short-term deposit liabilities and long-term loan assets,and the principal of both instruments is linked to a general price index.The real rate of interest applied to the principal is fixed over the life ofthe debt contract. Prior to the imposition of a "cap" on the indexation ofprincipal, the deposits and loans of the UPAC system in Colombia were anexample of this type.
20. Indexed instruments with fixed real rates constitute a special typeof administered rate regime; rates are set according to a predeterminedformula rather than at a predetermined level. Consequently, indexed regimessuffer from some of the same defects as administered rate regimes. Mostimportantly, indexed rates can depart widely from market clearing rates.This occurs for two reasons: expected inflation can depart from the pastinflation which enters into the indexing formula, and the real rate can varywidely. In the first case, the inflation premium in the market rate can bevery different from the adjustment of the principal of indexed instruments.In some countries, expected inflation will depart widely from past inflationif a major event influencing the course of inflation occurs. For example, achange in government will often reduce inflation expectations dramaticalLy,and with them the market clearing nominal interest rate. Again, abruptdevaluations will often raise inflation in a discreet fashion; however, thisinflation tends to be tranitory and expectations of inflation will often berational and view it as such. Under these conditions interest rates wil:Loften be far below past inflation. In the second case, the real rate, whichtends to vary over the business cycle, will depart from the real rateestablished for indexed instruments. In this latter case, the divergencebetween indexed rates and market clearing rates is likely to be smaller thanin the former case, though in recent years real rates have appeared to bemuch more variable than was heretofore thought.
21. Because market rates and indexed rates can diverge, termtransforming institutions with fixed real rates are prone to destabilizingfunds flows. When free market short rates are higher than indexed depositrates, funds flow out of these institutions. Such disintermediation lealds toliquidity problems for the institution--liquidity problems which can erodedepositor confidence and develop into panic deposit runoffs. Of course, theCentral Bank as lender of last resort tends to act to avert such liquiditycrises, but in doing so it must often increase the supply of money in waysthat are inconsistent with its overall monetary policy objectives.
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22. On the other hand, when free market rates fall below indexeddeposit rates, these institutions receive destabilizing inflows. If properlymanaged, these institutions would simply relend to sectors where returns werehighest. However, sectoral specialization and less than perfect foresight onthe part of institutional managers leads to excessive lending to certainsectors. This in turn leads to excessive investment or spending by thatsector and a misallocation of overall resources. Sometimes, the pressure ofsuch inflows of funds lead institutions to make bad loans, which caneventually lead to institutional failures and financial crisis. At the sametime, excessive inflows of funds into indexed institutions tends to subjectother institutions to disintermediation pressures and liquidity problems.
23. Depositary institutions are basically banks, whether they arecalled by that name or another. Indexing the deposits of one institutiontends to engender indexation of other quasi-monies, including those issued bythe commercial banks. When banks deposits are indexed, indexation has becomequite deeply rooted in the economy and can be expected to influence thebehavior of various economic actors. If it is believed that indexation canperpetuate inflation and increase the costs of stabilziation, then indexationof bank deposits can be expected to contribute to the inflation problem andthe costs of overcoming it.
24. (b) Term transforming indexed institutions with variable real rates. Ifreal rates on indexed instruments are allowed to vary in response to marketforces, additional flexibility is provided to the term transforming indexedinstitution. This reduces the social costs associated with this type ofregime, but it does not eliminate them. However, there is an importanttrade-off involved: variable real rates make indexed long-term loans lessattractive to corporate borrowers. It was noted earlier that corporationshave not been willing borrowers of indexed debt in other countries and thatthe feasibility of indexed corporate debt is questionable due to demandconsiderations. Allowing real rates on long-term indexed debt contracts tofluctuate makes the cost of indexed debt open ended, which will surely makecorporations less likely to borrow indexed debt.
25. If real rates on indexed contracts can fluctuate, indexed rateswill not diverge from market rates as long as market rates are higher thantotal returns to indexed instruments. However, market rates and indexedrates will diverge whenever market rates fall significantly below indexedreturns. This is because it is not administratively easy to issue short termdeposits with a negative real rate. When market rates fall sharply relativetx past inflation, because of a change in economic policy, a sharpdevaluation, or a sharp economic contraction, indexed rates may prove to betoo high, even if the real rate component of the total return goes to zero.
26. The flexibility provided by variable real rates reduces the risksof disintermediation and liquidity crisis of term transforming institutions,but does not eliminate them entirely. Indexed deposit rates will always becompetitive with other rates, and rate differentials will not develop whichwill disintermediate these institutions. Shocks of various sorts, such aspolitical change, large loan defaults, or an expected devaluation can causeprecipitous deposit withdrawals that may not be managed by paying higherrates to maintain deposit funds. However, these are very rare and can leadto liquidity problems in any term transforming insitutiton, regardless of therate regime employed.
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27. When market rates fall relative to past inflation andc u1ierefore toindexed rates, indexed term transforming institutions will experiencedestabilziing inflows of funds. Allowing the real rate on indexed depositsto vary will not prevent the misallocation of resources associated withindexed institutions with fixed real rates. Also, allowing real rates tovary will not avoid the potential impact that indexation of deposits may haveon inflationary expectations and the cost of stabilization.
28. (c) Term transforming floating rate institutions with interestcapitalization. The deposit and loan rates of these institutions are alwaysconsistent with short-term market rates, since they are directly linked toone of them. For this reason, they always mobilize and relend at the "right"rate. Further, only a small liquidity premium is required for longmaturities in this rate regime, since term transformation imposes littleliquidity risk on the term transforming institution, as will be discussedbelow.
29. Because deposit and loan rates in these institutions move with freemarket rates, no rate differentials between these institutions and otherfinancial market subsectors tend to develop. Disintermediation can stilloccur, but it is limited to relatively infrequent shocks that can precipitatedeposit withdrawals. Also, because of the result system-wide rateconsistency, no large and volatile flows of funds which can lead tomisallocation of resources can develop.
30. The portion of the interest rate on such floating rate loans thatis not capitalized should roughly correspond to the real rate that isexpected to prevail over the long term; therefore, the capitalized portionwill tend to be equal to the inflation premium in the market rate. However,this relation need only be an approximate one; as the real rate varies, thecapitalized portion of the floating rate will diverge somewhat fromprevailing inflation expectations. Also, policy makers or financialinstitutions will have some flexibility in dividing the total return on suchinstruments into a portion that is currently paid and one that iscapitalized. Since there is no one obviously appropriate real interest ratein the economy, the link between the capitalized portion or the "ajuste" canonly be approximate. If the authorities and the institutions use a lanaguagethat reflects this very loose link between the ajuste and expectations ofinflation, the capitalized portion of the interest rate will not be linked inthe minds of assetholders to inflation and should not influence expectationsand price adjustments. More importantly, when the policy makers bent onstabilization have the good fortune to have expectations of inflation fallrelative to past inflation, nominal interest rates and the ajuste willreflect this, whereas with indexation, nominal rates remail: stubbornly tiedto past inflation and act as a reminder to all assetholders of how highinflation has been. To the extent that indexation does feed inflation, thisfloating rate regime avoids this social cost of indexation while retainingall of its positive maturity characteristics.
31. (d) Indexed bonds. Unlike indexed deposits, indexed bonds will alwaysbear the "right" interest rate, even if they have fixed real rates. This isbecause bonds can sell at discounts or premiums above par value; when reatesrise, bond prices fall to equate bond rates and other rates, and when theyfall bond rise to a premium over par. The fact that bonds can be issued a,t apremium above par allows the issuing institution to sell bonds at a"negative" real rate when market rates fall significantly below past
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inflation. However, if market rates fluctuate widely relative to pastinflation, as they often do in highly inflationary economies, wide swings inindexed bond prices around par will be needed to equate indexed long-termrates and market clearing short-term rates. Under such conditions, indexedlong-term bond rates may require a significant liquidity premium. Long-termindexed bond finance will always occur at the "right" rate, but that rate mayprove to be quite high relative to short-term rates; as corporations shunindexed debt, even when it has a modest real rate, this factor is likely totip the scales and make this rate regime of limited use.
32. For institutions which match maturities by financing theirlong-term loan position with long-term bonds, there is no risk of liquiditycrisis. Also, since indexed bond rates and free market short-term rates willmove together, there is no risk of destabilizing fund flows between marketsubsectors and no possibility of sectoral resource,misallocations. To theextent that bonds are indexed to a general price index they may engender moreindexation and influence the course of inflation. However, the bonds of aclass of long-term lending institution are not nearly so visible as thedeposits of the banks, and indexation of these instruments alone is lesslikely to have an impact on expectations and price behavior than indexingbank deposits.
33. (e) Floating rate bonds with capitalized interest. Because rates onthese bonds are linked to the market clearing short rate, their rate isalways "right" and is always consistent with rates in other financial marketsubsectors. Furthermore, adjustments to changes in short ratres are made bvchanges in the floating rate and not in the bond price; therefore, there isminimal risk of capital loss, and the liquidity premium associated with suchbond rates will be very small.
34. As with any institution which matches the maturities of its assetsand liabilities, institutions which issue bonds of this type will not beexposed to liquidity risks. Also, as long as the capitalized portion of theinterest rate is not linked to past inflation, introducing such instrumentsshould have no effect on inflationary expectations or on the costs ofstabilzation. This regime, if it proves to be feasible, provides trulylong-term finance without any of the disadvantages of the other regimesdiscussed above.
35. Conclusion. Option (e), namely floating rate bonds withcapitalized interest, would be the most desirable alternative if savers areinclined to purchase such floating rate bonds. This regime provides the"right" rate, long real maturities, and only a small liquidity premium forsuch long maturities. At the same time it does not expose the institution toany liquidity risk, nor does it propagate inflationary expectations and wageand price behavior that is linked to past inflation. Floating rate bondsshould always sell quite close to par, even if nominal and real rates varywidely; consequently, they should be acceptable to Colombian savers.
36. However, since in the past Colombian savers have exhibited a veryhigh liquidity preference it is possible that they would, at least in theimmediate term, strongly prefer liquid deposits to bonds, whatever theircharacteristics. To address this, it would be advisable to start with option(b). namely, term transformation with floating rates and interestcapitalization, leaving open the possibility of gradually attempting option(e) in the longer run. There is little risk of institutional illiquidity
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with such institutions, and the decision to go this route simply depends uponthe tradeoff between additional savings mobilization provided by issuingdeposits versus the risk of some institutional illiquidity that might beprecipitated by "shocks." Another approach could be to make floating rate'loans with capitalized interest and fund these loans with CDTs which haveincreasingly long maturities. It would be preferable if a secondary marketin such CDTs were established.
37. One might also consider the authorization of indexed bonds. Thisregime has few drawbacks: it operates at rates consistent with otherfinancial market subsectors and is immune to institutional liquidity prob-lems. It may propagate indexation in the economy and influence indirectlythe recalcitrance of inflation, but the risks of this should be limited ifindexation is restricted to bonds alone. The existence of indexed UPACdeposits constitutes a more serious precedent, and indexing CF bonds shouldnot change matters much.
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ANNEX 2
ILLUSTRATIVE EXAMPLE OF A SYSTEM OF FLOATING INTEREST RATE MEDIUM AND LONG
TERM LOANS WITH PARTIAL CAPITALIZATION OF INTEREST
The Floating Interest Rate
In a system of floating interest rate loans, the interest rate canbe linked to the average market rate of the Certificado de Deposito a Termino(CDTs) at 90 days. The characteristics of the system can be fixed asfollows:
(a) the interest payments corresponding to each quarter are made at theend of that period;
(b) the interest rate for each quarter is determined at beginning ofthat period and will correspond to the last average interest ratefor 90-day CDTs announced by the Banco de la Republica, plus aspread to cover the costs of intermediation of the CorporacionFinanciera;
(c) the average interest rate for 90 day CDTs will be announced by theCentral Bank at the beginning of each week, on the basis of itssurvey of the effective interest rate paid by commercial banks andcorporaciones financieras during the preceding week;
(d) the spread to cover the costs of financial intermediation will bedetermined according to market conditions and will be establishedin the loan agreement between the borrower and the lender.
Example 1/
Periods (quarters) 0 1 2 3Latest average 90-day CDT effective interestrate announced by the BR before thebeginning of the period (annual basis)l/ 38% 36% 40% 35%
1.2 Spread 4% 4% 4% 4%1.3 Floating interest rate used in the
calculation of the interest paymentat the end of the period (annual basis)
(Total) 42% 40% 44% 39%
1/ The effective interest rate figures for 90-days CDTs in this illustrationhave been chosen to correspond to the typical range of market interestrates actually experienced in Colombia during 1981-82.
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The Capitalization of Interest
It is possible to conceive many alternative schemes for determiningthe portion of the interest to be capitalized. The following three methodsdeserve special consideration.
Method I - Fix in the loan agreement the porition of the interest ratechargeable which would be payable in that period (10% in this example), andcapitalize the remaining interest accrued.
(annual basis)1.2 Rate of interest payment which will
be made (annual basis) 10% 10% 10% 10%1.3 Rate of interest capitalization 32% 30% 34% 29%
(annual basis) (1.1) - (1.2)
Method II - Fix at the beginning of each period the portion of the interestpayment which will be capitalized at the end of that period, (fixed in theexample at 25%, 25%, 28% and 26% for the four quarters), and pay theremainder.
Example 2
Periods (quarters) 0 1 2 32.1 Floating interest rate (annual basis) 42% 40% 44% 39%2.2 Rate of interest capitalization
Lixed at the beginning of eachperiod (annual basis) 25% 26% 28% 26%
2.3 Rate of interest payments to bemade (annual basis) (2.1) - (2.2) 17% 14% 16% 13%
Method III - Fix in the loan agreement the proportion of the total interestpayment which will be capitalized (80% in the example).
Example 3
Periods (quarters) 0 1 2 33.1 Floating interest rate (annual basis) 42% 40% 44% 39%3.2 Capitalization of 80 %
of the interest accrued:0.8 x (3.1) 33.6% 32% 35.2% 31.2%
3.3 Rate of interest paymentto be made (annual basis) (3.1) - (3.2) 8.4% 8% 8.8% 7.8%
Method I is probably the one which should be preferred. It issimple and automatic. One simple criteria to fix the portion of the interestrate which is payable each quarter (10% in Example 1) would be to choose itto approximately equal the average real interest rate predicted for theperiod of the loan. No great difficultires will however necessarily arise
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if the real interest rate is not accurately predicted. If the actual realrate turns out to be lower than the rate of interest payments, the realamortization of the loan will be slightly faster than expected. If,conversely, the actual real interest rate is higher than projected the realamortization will be slower than it was intended. In these cases, there maybe some minor problems of liquidity either for the borrower or for thelender, but they will be far less serious than if no capitalization ofinterest was made. Such problems will be easily manageable, except if thedifferences between the actual and the projected average real lendinginterest rates became excessive. Of course, the system could also be usedwith the agreed portion of the interest rate payable in the quarter setdeliberately to exceed the expected average real interest rate, if suchhigher figure is mutually agreed between the borrower and lender. Such adecision would have to take into account the particular cash flowcharacteristics of the investment project.
Method II could be theoretically a good solution if thecapitalization of interest at the beginning of each period correspondedexactly to the inflation rate. In that case, the rate of interest paymentsto be made would be equal to the real rate of interest. However, inpractice, there is no indisputable way of determining the expected inflationrate. Moreover, the announcement of an official expected inflation rate bythe authorities might have negative consequences: it might produceundesirable effects on inflationary expectations; and the authorities mightbe tempted to tinker with the expected inflation rate (as to a certain extenthas happened with the element of monetary correction in UPAC savings depositsand loans), thus affecting the confidence in the system.
Method III should also be excluded. In that method the rate ofcapitalization of interest would be much less closely related to the averageinflation rate than in either Methods I or II. Besides, if the nominalinterest rates were to increase substantially, the rate of interest paymentsto be made might also increase to levels which would create excessiveliquidity problems for the borrowers.
The Refinancing of Floating Interest Rate Loans by the Official FinancialFunds
The refinancing of floating interest rate loans by the officialFinancial Funds (FIP, FFI, FFAP) should also be made on the basis of floatinginterest rates.
If the proportion of the loan to be financed by FIP is 5C%, if themargin of intermediation for the Corporacion Financiera in the entire loan is3.5% and if the spread over CDT rates to be paid by the borrower is 1%, thenthe spread charged in the rediscounts by FIP is 1-3.5 = - 5%
0.5
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Example 4
Periods (quarters) 0 1 2 34.1 CDT average interest rate
(annual basis) 38% 36% 40% 35%4.2 Spread on FIP rediscounts
(annual basis) 33% 31% 35% 30%4.4 Cost for the C.F. of the resources
used 0.5 x (4.1) + 0.5 x 4.3 35.5% 33.5% 37.5% 32.5%4.5 Margin of the C. Financiera
(annual basis) 3.5% 3.5% 3.5% :3.5%4.6 Interest rate paid by the borrower
(annual basis) 4.4 + 4.5 39% 37% 41% 36%4.7 Spread over CDT rates paid by the
borrower (4.6 - 4.1) 1% 1% 1% 1%
The Amortization of the Loan
In order to determine the amortization schedule of a loan withpartial capitalization of interest, it is first of all necessary to decidewhat is the intended amortization schedule in real terms.
If the maturity of the loan is n quarters, if the first k quarterscorresponds to a grace period, and if the proportion of the initial realvalue of the loan to be amortized at the end of quarter i is a al, theproportion of the outstanding loan to be amortized at the end of quarter i is
aiAi= i= k + 1, k + 2,...n
ai + ai+l+. r*+an
The amortization payments of a loan with partial capitalization ofinterest can be determine by applying the proportions Ai to the amounts ofthe outstanding loan at the end of each period.
Numerical Illustration of the Computation of the Capitalization of Interestand Loan Amortization Payments
A 3 year loan of 120 million pesos with floating interest ratesand capitalization of interest following the illustration in Example 1. Ithas a grace period of 1 year and its initial real value will be amortizedl inequal quarterly instalments in the two remaining years. The rates ofinterest and the inflation rates are assumed to follow the pattern shownbelow:
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TABLE A
CDT annual Floating interest Rate of Rate of Price
Quarter effective rate rate of the loan capitalization inflation indexat the beginning at the beginning of interest from the at theof each quarter of each quarter on a quarterly beginning end ofAnnual Basis Annual Quarterly basis (2) to the each
basis basis (I) end of quartereach (3)quarterAnnualBasis
(1) If ia is the interest rate on an annual basis and iq is theinterest rate on a quarterly basis
1 + iq = (1 + ia) 1/4
(2) The rate of capitalization of interest on a quarterly basis isgiven by iq - 2.41%, where iq is determined as in the preceding note and2.41% is the quarterly rate corresponding to the 10% interest capitalizationrate of Example 1.
(3) If the price index at the end of quarter i is Pi and if therate of inflation from the beginning to the end of quarter i on an annualbasis is Pi, then
Pi= Pi_i(lp)/
According to the data of the example, there will be no amortizationduring the first 4 quarters, and each of the amortization payments of theremaining 8 quarters will correspond to 1/8 of the initial real value of theloan. Consequently:
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ao= aj=a 2 =a 3 =O
a4=a5=... =all=0.125
AO=A1 =A2=A3 =0
A4= 0.125= 0.1251
A5= 0.125= 0.1429
A6= 0°125= 0.1667
A7= 0.125= 0.2
The interest payments, the capitalization of interest and the
amortization will be as follows.
TABLE B
Debt at the tnd or esch quarter
beginning Atort± zation De tQuarter f each Interest Interestt pets d o th--t
qate acrd pai citl:d is proport4or. In sillion o Itstsr.ding Of the Z1ttqu r er accrue I ai I capitalized of outstar.din. Fe,so mlillion pesor outrtan4-ng
million pesos loan rilio- ,0o0
.~~~~~~~~~6 _ llo eo
(1) .- (23 (3) (4) (5) 17) tt!
0 100 9.16 2.41 6.75 0 0 106.75 101.:
1 106.75 9.37 2.57 6.8o 0 0 113.55 lOl.f
2 113.55 10.83 2.74 8.10 0 0 121.65 102.:
3 121.65 10.44 2.93 7.50 0 0 129.15 103.!
4 129.15 9.80 3.11 6.69 12.51 16.98 118.86 90.-
5 118.86 8.05 2.86 5.19 14.29% 17.73 106.32 77.-
6 106.32 5.88 2.56 3.32 16.671 1.2% 91.36 64.3
7 91.36 4.66 2.20 2.46 20.00S 18.76 75.06 51.:
S1 75.06 4.78 1.81 2.97 25.00% 13.51 5'.52 38.:
9 58.52 4.21 1.41 2.80 33.33% 20. .L £0.88 25.!
10 40.88 3.59 0.99 2.60 50.00% Z1.74 21.7£ 12.f
11 21.74 2.07 0.52 1.55 100.00S 23.29 0 0
(1) Debt at the and of the preceding quarter. in million pesos
(2) Colu-n (1) xColutn IV of Table A
(3) Column (I) r O.0241 See footnote (2.) of Table A
(4) Column (1) x Column V of Table A
(5) Values or Ai
(6) Column (1) * Coluan (4jxcoluan (5)
7) C.t-.., (1) 4 Cn.,.a, (4) . -..i.n (t5)CS) Column (7) : Coluan Vill o Table A
Since the interest rate paid (2.4% per quarter) does not coincide
exactly with the real rate of interest (which is, for instance, 3.25% in the
first quarter, 3.08% in the second, etc.), the amortization path will notcoincide exactly with the amortization schedule.
In real terms that path remains however quite close to the real intendedamortization schedule as shown by the following figures.
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TABLE C
Debt outstanding in real terms:million pesos prices of the beginning of year 0
According to According to the In a floatingEnd of the intended amortization interest rate loanQuarter amortization schedule in without nartial
(a) Intended amortization schedule corresponding to a grace period
of 4 quarters and amortization in equal payments in real terms in the
following 8 quarters
(b) Column (8) of Table B
(c) Real value of the debt outstanding in a floating iterest rate
loan in which (i) there is no interest capitalization; (ii) no amortization
payment is made in the first 4 quarters: (iii) amortizations of 12.5
million pesos at current prices are made at the end of each of the
following 8 quarter3. Thua for in3tance In pertod 0: 100 : 105.7 - 94.6:
in period V:. 87.5 : 131.1 - 66.7; in period 7: 50 : 147.2 = 34.0
(a) Intended amortization schedule corresponding to a grace period of 4quarters and amortization in equal payments in real terms in the following 8quarters;
(b) Colum (8) of Table B
(c) Real value of the debt outstanding in a floating interest rate loanin which (i) there is no interest capitalization; (ii) no amortizationpayment is made in the first 4 quarters; (iii) amortization of 12.5 millionpesos at current prices are made at the end of each of the following 8quarters. Thus for instance in period 0: 100: 105.7 = 94.6; in period 4:87.5 : 131.1 = 66.7; in period 7: 50: 147.2 = 34.0
The difference between columns (a) and (b) would be larger if thedifferences between the real rates of interest and the rate of interestpayments (2.41% per quarter) was higher. The real amortization of a loanwithout capitalization of interest (shown in column c) is much faster becausethe proportion of the nominal interest rates which represents the monetarycorrection, corresponds in fact to an antL-cipated amortization of the loan.It is for that reason that loans with partial capitalization of interest willcreate much less liquidity difficulties for the borrowers than loans in whichsuch capitalization does not take place.
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ANNEX 3
Hybrid Risk Capital Investments
There are several instruments with risk/reward characteristics thatlie somewhere between straight debt and equity. Recourse to theseinstruments might increase the risk capacity of the Corporaciones Financieras(CFs).
I. Traditional Quasi-equity Instruments
(a) Convertible and participating preferred shares. Straight preferredshares pay a fixed divided and have a prior claim on earnings over commonshares. They resemble stright debt except that, if a firm earns no profit,it is not obliged to pay preferred dividends. They provide the institutionwith a high and stable cash flow, though one that is not as reliable as thatderived from debt, while providing the firm with a liability that is not asonerous as straight debt. Preferred shares may be voting or non-voting incharacter, allowing some latitude or flexibility in designing theseinstruments to meet the desires for corporate control or determination ofboth the borrowing and lending parties.
Convertible and participating preferreds are preferred shares,either voting or non-voting, which carry a lower preferred dividend rate butprovide the investor with some contingent claim on future profits.Convertible preferreds can be converted into common stock at some agreed uponconversion rate; presumably, if the company's equity increases rapidly invalue, it is to the advantage of the lender to convert the preferred intocommon and realize a capital gain.
(b) Convertible debt. Convertible debt is usually subordinated toother debt; i.e. other debt has a prior claim on assets in case of corporateliquidation. In addition, it can be converted into common stock at someagreed upon conversion rate, and, again, if the common stock appreciatessubstantially in value, the lender will convert his debt into common equityand realize a capital gain. Convertible debt imposes a more onerous cashflow burden upon the borrower than preferred stock, since interest paymentsmust be made even if there are no profits. In exchange for the convertiblefeature, the lender usually receives a lower interest rate than that paid onstraight debt.
(c) Straight debt with an attached equity feature. The equity"sweetner" or "kicker" can take the form of attached warrants, an option topurchase shares at a predetermined price, or attached shares purchased at alow price at the time the loan is granted. Again, such debt usually carriesa lower interest rate than would be warranted if there were no attachedequity feature, thereby easing the cash flow obligation of the borrower atthe expense of some future dilution of his shareholder's equity.
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II. Contracts with Other Shareholders Involving Repurchasable Equity("Equity Repo")
This would be a new type of instrument which, to the mission'sknowledge, has not been used in the past to any significant extent inColombia or other countries. However, it offers certain characteristics thatmay be particularly suitable to the needs of Colombian venture capitalcompanies and shareholders, and is worth exploring.
The instrument is designed to create incentives for the CFs to takean equity position in new ventures with large investment needs and low cashflows in the early years, in the absence of a market for the equityinvestments. Essentially it would offer the CF a possibility to sell itsinvestments at a predetermined price to the other shareholders of the venture(presumably the controlling shareholders in most cases); at the same time, tofacilitate such a sale, it would offer the purchaser of the shares thepossibility to finance the purchase with a loan from the CF. The purchaseprice would have to be determined at the time of the initial equityinvestment, and should be set relative to future earnings or book value orsome other suitable index. At this later date, the mature company should beable to pay cash dividends large enough to allow the purchasing shareholderto service the loan obtained from the CF. An equivalent arrangement canalso be achieved by using combination of an option/right for the CF to sellits shares at a predetermined price together with a loan contract between theCF and the other shareholder(s).
Caution should be exercised in designing such a scheme so as not toprovide excessively favorable terms to the controlling (purchasing)shareholders. The CFs should not finance all of the shares purchased by thecontrolling shareholders; a portion should be purchased from the CF withcash. Further, the loan should be secured with the purchased shares.Lastly, the loan should carry a market rate of interest; special attentionmust be given to avoiding subsidies for loans of this type.
It should be mentioned that the legal, administrative and otherpractical aspects of a scheme along the above lines would need to be examinedin detail before its use can be considered seriously, e.g., the legalacceptability of the repurchase contract, implications of the CFs eventuallyholding a loan to another shareholder (who may be an individual, anindustrial company, or another type of enterprise), etc.
Rationale for Introducing Hybrid Instruments
Hybrid instruments impose somewhat less onerous cash flowobligations on the borrower, yet provide a basically stable fixed incomestream to the lender. This provides new rapidly expanding companies whichhave fixed investment needs far in excess of their internal funds generationwith a more desirable source of finance than straight debt. At the sametime, the lender is compensated with the probability of a future capitalgain. This may increase the volume of risk finance provided by theCFs in two respects:
(a) The stable cash flow associated with hybrid instruments may allowthe CFs to make "risk" or "venture" capital investments with debtrather than capital funds. For example, with convertibles and
