Document of The World Bank FOR OFFICIAL USE ONLY Repot No 13865-AR PROJECT COMPLETION REPORT ARGENTINA SMALL AND MEDIUM-SCALE INDUSTRY CREDIT PROJECT (LOAN 2793-AR) January 11, 1995 Public Sector Modernization/Private Sector Development Division Country Department I Latin America and the Caribbean RegionialOffice This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
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Document of
The World Bank
FOR OFFICIAL USE ONLY
Repot No 13865-AR
PROJECT COMPLETION REPORT
ARGENTINA
SMALL AND MEDIUM-SCALE INDUSTRY CREDIT PROJECT(LOAN 2793-AR)
January 11, 1995
Public Sector Modernization/Private Sector Development DivisionCountry Department ILatin America and the Caribbean Regionial Office
This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.
* Note: In mid-1985, the peso was changed to the Austral (eliminating threedigits); and in January 1992, the Austral was changed to the peso (eliminatinganother three digits).
ABBREVIATIONS AND ACRONYMS
BANADE National Development BankBCRA Central Bank of ArgentinaBHN National Housing BankBNA Banco de la Naci6n Argentina (National Savings Bank)FOPYME Fund for Small & Medium-Scale EnterprisesIFC International Finance CorporationINTI National Institute of Industrial TechnologyPB Participating BankPCR Project Completion ReportRTAC Regional Technical Assistance CenterSIGEP Comptroller of State CompaniesSMSE Small and Medium-Scale EnterpriseSSME Sub-Secretariat for Small and Medium-Scale EnterprisesTA Technical AssistanceUNDP United Nations Development Program
FOR OFFICIAL USE ONLYTHE WORLD BANK
Washington, D.C. 20433U.S.A.
Otfice of Director-GeneralOperations Evaluation
January 11, 1995
MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT
SUBJECT: Project Completion Report on ArgentinaSmall and Medium-Scale Industry Credit (Loan 2793-AR)
Attached is the Project Completion Report on Argentina - Small and Medium-ScaleIndustry Credit (Loan 2793-AR) prepared by the Latin America and Caribbean Regional Office. Nocontribution was received from the Borrower.
The main objectives of the Small and Medium-Scale Industry (SMI) Credit Project wereto encourage the modernization, expansion and productivity enhancement of Argentina's SMI sector.The project involved a loan amount of US$125 million to finance a line of credit, which was channelledthrough a second-tier fund within the national development bank, Banco Nacional de Desarrollo(BANADE); and a technical assistance component aimed at strengthening institutional support for SMIs.
The project was implemented during a particularly difficult period (1988-91) in Argentinamarked by hyper-inflation and severe financial hardship. The macroeconomic conditions, combinedwith weaknesses in project design and financial problems in BANADE, undermined the achievementof project objectives. Demand for the line of credit was weak and there was a lack of interest in thetechnical assistance component. However, the project did contribute to developing project appraisalcapabilities in a number of banks.
BANADE's mounting financial problems, which were the result of poor management, lackof operational autonomy and the impact of worsening macroeconomic conditions, eventually triggeredits liquidation and the cancellation of US$64.2 million of the IBRD loan. The disbursed loan fundsfinanced 338 subloans, over 70 percent of which were channelled through BANADE. There is no recordof subloan arrears or subloan performance.
The Bank's performance in project preparation and design was poor. Macroeconomic riskswere not carefully identified, the pre-existing weak financial condition of BANADE was never fullyanalyzed, and the loan pricing formula was faulty. However, supervision missions were effective inhandling BANADE's unfolding crisis and, following two attempted activations of loan suspensionprocedures, were instrumental in eventually convincing the Government to liquidate the bank.
The project outcome is rated as unsatisfactory. Institutional development is rated asmodest and sustainability as unlikely. The PCR is of very good quality. It provides a very candidassessment of the project's design weaknesses and implementation shortcomings. An audit is notplanned.
Attachment
This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contentsnmay not otherwise be disclosed without World Bank authorization. l
This document has a restricted distribution and may be used by recipients only in the performance of theirofficial duties. Its contents may not othervise be disclosed without World Bank authorization.
Table of Contents (Cont'd)Page
PART III: STATISTICAL INFORMATION ....... ............... 21
3.1 Related Bank Loans .213.2 Project Timetable .............................. 213.3 Loan Disbursements .223.4 Project Estimated (Appraisal) Cost .223.5 Project Estimated (Appraisal) Financing .223.6 Project Financing Planned and Actual .233.7 Project Results .233.8 Status of Covenants .243.9 Use of Bank Resources .283.10 M issions .................................... 29
ANNEXES
ANNEX I: SUMMARY OF TERMS AND CONDITIONS OF THE LOAN .. 30
SMALL AND MEDIUM-SCALE INDUSTRY CREDIT PROJECT(LOAN 2793-AR)
PREFACE
This is the Project Completion Report (PCR) for the Small and Medium-ScaleIndustry Credit Project in Argentina, for which Loan 2793-AR in the amount of US$125million equivalent was approved on April 14, 1987. The project was implemented duringa particularly difficult period marked by very high inflation and severe financial hardshipfor Argentina. The final disbursement was made in November 1991. At the request ofthe Borrower, the loan was cancelled in July 1993, about one year ahead of the originalplaned loan closing date. A total of US$64.2 million was cancelled over the life of theloan.
The PCR was prepared by the Public Sector Modernization/Private SectorDevelopment Division, Country Department I, of the Latin America and CaribbeanRegional Office (Preface, Evaluation Summary, Parts I and III). Submission of Part IIby the Borrower is still pending.
In preparation of this PCR, a mission visited Argentina in July 1993 and discussedthe effectiveness of the operation with Governmental officials, with representatives of theExecuting Agency, and with representatives of the participating financial intermediariesand industrial enterprises that received financing from this loan. The report is based,inter alia, on these discussions, the Staff Appraisal Report, the Loan and GuaranteeAgreements, supervision reports, correspondence between the Bank and the Borrower,and internal Bank memoranda.
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PROJECT COMPLETION REPORT
ARGENTINA
SMALL AND MEDIULM-SCALE INDUSTRY CREDIT PROJECT(LOAN 2793-AR)
EVALUATION SUMMARY
1. Project Objectives. The project objectives were to encourage modernization, tostrengthen productivity, and increase productive activity by small and medium scaleenterprises (SMSEs), with particular emphasis on employment generation and on greatereconomic diversification outside the major urban areas. These objectives were to beachieved by providing a line of medium- to long-term credit to overcome constraints oninvestment financing faced by SMSEs, complemented by a technical assistance programfor SMSEs. A unit, called the Fund for Medium and Small Scale Enterprises(FOPYME) was established within the National Development Bank (Banco Nacional deDesarrollo, BANADE), to operate as a second-tier financial intermediary to lend tocommercial banks and BANADE's own first-tier units, for onlending to private sectorenterprises. FOPYME was eventually to become the principal public sector institutionfor financing of SMSEs.
2. The credit line was structured to finance: (a) fixed assets and related permanentworking capital needs of SMSEs, including machinery and equipment (and theirinstallation costs); building construction, handling and storage facilities; civil works;quality and pollution control equipment; replacement of obsolete machinery andequipment; investments for improvement of product, quality and design; and acquisitionof new technologies; (b) free standing working capital needs; and (c) technical andmanagerial assistance needs of SMSEs.
3. The thrust of the technical assistance (TA) component was to: (i) strengthenBANADE's capabilities to provide assistance to SMSEs and participating banks; (ii)strengthen the National Institute of Industrial Technology's (INTI) capabilities to assistSMSEs; and (iii) support the creation of a system of Regional Technical AssistanceCenters (RTACs) for SMSEs by the Commerce Ministry's SMSE Division (SSME).These funds were to be applied towards training, preparation of studies and purchase ofequipment.
4. Design and Implementation Experience. The project addressed one of the weaklinks in the development of industrial enterprises in Argentina: the scarcity of medium-and long-term finance for investments by SMSEs. As a result of a long history ofinflation, lending by Argentina's banking system was constrained almost exclusively to
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short-term financing. This project, therefore, provided the only medium- and long-termcredit facility available to SMSEs at that time.
5. The most important design features that affected the outcome of the project werethe following:
* Creation of the second-tier mechanism within a major retail bankopened the possibility of connict of interests. One of the principaldesign elements of the project was the establishment of FOPYME as apermanent specialized wholesale banking unit within BANADE to lend toboth private banks and BANADE's own first-tier units, for onlending toSMSEs. It was expected that FOPYME would become the developmentfinance vehicle to manage similar future loans from bilateral andmultilateral agencies. The establishment of the second-tier unit within oneof the main retailers of the credit line posed serious conflict of interestsand created the perception of likely bias. Some participating banks (PBs)felt that BANADE's approval authority gave it an unfair advantage inprocessing its own loans.
* Oversight of BANADE's problems during appraisal undermined theloan. Weaknesses in loan preparation were noted in the appraisal'sevaluation of BANADE. Prior to appraisal, BANADE's financialproblems were widely known throughout the banking industry, althoughtheir magnitude was difficult to measure due to poor accounting andauditing standards and procedures. BANADE's financial problemsstemmed from inappropriate management decisions and policies that werefrequently influenced by political considerations. This should have raisedconcerns within the World Bank over BANADE's viability, or possiblyhave led to the consideration of a restructuring of that institution prior tomaking the loan.
* The use of debt/equity ratios to monitor BANADE's financialperformance was not effective. The project used a maximum debt/equityratio covenant to monitor BANADE's performance. Without credibleinformation on the value of BANADE's assets, such ratio gave amisleading picture of the bank's actual financial situation. Moreover, thecertification of covenant compliance was given by the Office ofComptroller of State Companies (SIGEP), which was not inclined, at thattime, to sound alarms about the fact that BANADE's net worth wasprobably negative.
* Loan pricing and interest rate policy discouraged usage of the loan.The rate charged on subloans was expressed in terms of a fixed real, or
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inflation adjusted, rate that was to be applied to an indexed amount ofprincipal, and which included a spread of 3.75 percentage points for thePBs. This spread, which seems to have been determined arbitrarily, wasmuch lower than the historically high spreads charged by Argentine banks.Participating banks were required to co-finance 10% of each subloan withtheir own funds. They had to source these funds in the money marketwhere they paid substantially higher rates in nominal terms. Thisrequirement discouraged banks from participating because, in addition toa sizeable negative interest rate spread on their 10% component of theloan, the spread earned on the remaining portion of the loan was notcommensurate with what banks would normally charge to cover credit riskand the cost of servicing the loan. In fact, most PBs interviewed for thisreport concluded that this facility generated a loss in terms of interest ratemargins, although these were partly compensated by other aspects of theoverall relationship with their customers. Eventually, of the 40commercial bank candidates identified at the time of appraisal, only 13banks participated.
* The Bank remedies did not allow the Bank to stop new commitmentsin response to worsening macroeconomic conditions. According to theLoan Agreement, the Bank could suspend disbursements whenever "anextraordinary situation shall have arisen which shall make it improbablethat BANADE will be able to perform its obligations under the ProjectAgreement." Although the macroeconomic crisis was such a situation, itwas too cumbersome for the Bank to exercise its rights with this clauseduring the initial stages of the crisis, when its impact on BANADE wasstill unclear. At this stage, the Bank was also unable to suspenddisbursements based on BANADE's failure to comply with the debt/equitycovenant, because SIGEP' s audit reports indicated that BANADE was stillin compliance. The Bank was able to protect the Borrower's interestsinitially through a slow down of subloan approvals, and later, through anagreement with the Borrower and BANADE to link subloan approvals toBANADE's successful reorganization. It would have been useful to havein the Loan Agreement a review clause that would have allowed the Bankofficially to suspend new commitments when the crisis started, whilegiving the Bank time to initiate suspension procedures.
6. The following issues in implementation of the loan were identified:
* Hyper-inflation undermined loan objectives. At the time of appraisal,Argentina was undergoing an economic revival that had begun in August1985, with the announcement of the Plan Austral. However, soon afterBoard approval of the loan, inflation began to accelerate as a result of an
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overly accommodative monetary policy and inability to maintain the fiscalsituation under control. During the hyper-inflationary spiral in 1989,commercial banks experienced an acute liquidity crisis, as depositorsrushed to withdraw their funds from account whose value were beingeroded through inflation. Hyper-inflation increased FOPYME's credit riskexposure to the participating banks, including BANADE. Also, highinflation and uncertainty discouraged SMSEs from embarking on newinvestments. In such a volatile environment, loan demand was bound tobe unpredictable, credit risk difficult to measure, and loan pricingunprofitable.
* BANADE's financial crisis triggered loan cancellation. One of thecritical variances between planned and actual implementation was thefinancial crisis which engulfed BANADE, an already weak bank.Persistent efforts by supervision missions to induce BANADE'smanagement to address the institution's problems proved unsuccessful.The Bank's negative assessment of BANADE's restructuring plans helpedto convince the Government to intervene and eventually liquidate thatinstitution. The process of loan cancellation was a long and complicatedone due to the many vested interests in preserving BANADE and the Bankloan.
* The TA componenit was reformulated several times. The loan'sappraisal had noted the absence of an active and coordinated TA programfor SMSEs. Despite a detailed description of the TA needs for thisproject, including the identification of the executing agencies (BANADE,SSME and INTI), the implementation process was stymied by the broadermacroeconomic and financial crises, BANADE's own problems,Government reorganizations that resulted in new views on TA needs orlack thereof, and inadequate follow up regarding additional resources thatwere needed to assure continuation of the programs. The TA programswere not given priority during loan implementation. The weakperformance was attributable to a lack of interest on the part of theimplementing agencies as well as to changes in the scope of the TAprograms which were not adequately evaluated in terms of linkages to theoverall loan objectives, and in terms of additional resource requirements.
7. Project Results. Despite its many weaknesses and premature cancellation, thisloan made some progress towards achieving its objectives. Specifically, this loanchanneled US$60.4 million to support investments in expansion of existing plants or inthe creation of new ones by SMSEs which would otherwise have had to rely on morelimited internally generated funds, or on very expensive and volatile short-term credits.Subloans concentrated in the following subsectors: food and beverages, 27% of the total;
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chemical products, 19%; and machinery and equipment, 17%. These loans helped todevelop expertise in medium and long-term financing in the banking system. To qualifyfor participation, a commercial bank had to establish a specialized medium- and long-term SMSE financing unit within its organization. By enhancing project appraisalcapabilities in a number of banks, this project may ultimately have been helpful instrengthening the institutional basis for the recent expansion of medium- and long-termfinancing in Argentina.
8. Project Sustainability. The sustainability of an operation of this type dependson the establishment of a viable and effective delivery mechanism to allocate funds in anefficient manner according to project objectives. In the event, BANADE's problemsaborted the operation, which in turn thwarted FOPYME's prospects for becoming aneffective wholesale development banking entity.
9. Lessons Learned. Several lessons can be extracted from the experience of thisproject including the following:
* The experience of this project suggests that Bank loans for creditoperations should not be provided in a situation of macroeconomicinstability. Loan appraisals should assess macroeconomic programs moreclosely and spell out the types of developments that would jeopardize theobjectives of the loan. Loan Agreements should provide adequateremedies for suspension of new commitments or disbursements if suchconditions arise.
* The experience of this loan also suggests that credit lines should not beprovided if the banking regulatory and supervisory framework isinadequate. The poor quality of bank supervision and regulation inArgentina rendered the available financial information highly unreliable,making it difficult for the Bank to evaluate the financial situation ofBANADE and for FOPYME to evaluate and monitor the financialsituation of the PBs, particularly as inflation accelerated.
* Second-tier lending facilities should not be administered by a publicbank that also acts as first-tier lender. In any event, public sectorbanks should limit their role to that of a wholesaler. Also, greatercoordination of public and private sector participation should beencouraged, possibly by incorporating private sector representation on theBoard of Directors of the public second-tier agency.
* Greater emphasis should be placed on loan information requirements.For example, the Bank might consider requiring periodic reports by PBswith the following information: (i) payment arrears on sub-loans by
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number of days in arrears; (ii) any refinancing of loan payments; and (iii)summary performance indicators of each investment enterprise. Thisinformation would be useful in assessing the impact of the loan. Inaddition, whenever the government assumes the exchange rate risk fromconversion of local currency into dollars, a quarterly report should besubmitted showing realized gains/losses, as well as translationgains/losses.
* Credit line operations should establish exposure limits to a single PBto avoid concentration of risks, particularly if public banks are allowed toparticipate.
* The pricing and termns of the sub-loans should be market determined.The currency denomination should be left as an option to the PB and thefinal borrower. In the case of local currency denomination, the interestrate charged on the loan should incorporate a margin to cover potentialexchange rate losses and should be based on the interest rate structure inthe country. PBs should be allowed to negotiate with their clients the sizeof the spreads charged on the subloans. In other words, pricingmechanism should rely as much as possible on market signals.
PROJECT COMPLETION REPORT
ARGENTINA
SMALL AND MEDIUM-SCALE INDUSTRY (SMI) CREDIT PROJECT(LOAN 2793-AR)
PART I. PROJECT REVIEW FROM THE BANK'S PERSPECTIVE
A. Project Identity
Project Name: Small- and Medium-Scale Industry Credit ProjectLoan Number: 2793-ARRVP Unit: LAICOCountry: ArgentinaSector: Finance and Industry
B. Background
1.1 Once among the world's most prosperous economies, Argentina has experiencedlow economic growth since the 1940s. By the mid-1970s, the country's long-termgrowth declined noticeably, and in the last half of the 1980s, the country suffered fromits longest period of stagnation in the century. Savings and investment rates fellprecipitously from the mid-1970s until 1989. This economic performance was traceableto chronic public sector deficits and endemic inflation. After the return to constitutionaldemocracy in 1983, public demands to control inflation were translated into foursuccessive stabilization programs. All failed to eradicate inflation, and each ended in amore virulent inflation than the one preceding it. The main reason for these failures wasthe inability of the stabilization programs to redress rapidly and permanently thestructural deficit of the public sector.
1.2 By the time of project preparation, the democratic Government, after severalunsuccessful attempts to stabilize the economy, had introduced a new program called thePlan Austral (in June 1985), which included the creation of a new currency known as theAustral as well as measures to freeze prices and the exchange rate. Shortly after theannouncement of the stabilization plan, the Government requested a Bank loan to supportthe development of small and medium industries. Like its predecessors, however, thisprogram was short-lived. At the time of loan effectiveness, in April 1988, monthlyinflation was fast approaching the 20% mark. In mid-1988, the Government introducedthe Primavera stabilization plan, which again used the nominal exchange rate as theanchor for inflation without sufficient fiscal restraint. The plan collapsed in early 1989in the middle of a hyper-inflationary spiral which lasted several months--July inflationalone was 200%. The inflationary crisis drove the economy into recession: commercialbanks experienced an acute liquidity crisis and the problem of bankruptcies intensified.In response to the crisis, the Menem administration, which took office in July 1989,
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undertook two stabilization plans in 1989 and 1990. Neither succeeded, principallybecause of the intractability of the fiscal deficit. Stabilization came with a new fiscalpackage introduced in February 1991, which was able to close the fiscal gap, and withthe Law of Convertibility, introduced in April 1991, which guaranteed the convertibilityof the peso into dollars at a one to one rate and effectively proscribed money creationother than to buy net foreign reserves.
1.3 The Industrial Sector. Argentina's import-substituting strategy of industrialdevelopment started showing its weaknesses during the 1960's. The military governmentthat took office in 1976, introduced some trade liberalization measures, but many non-tariff barriers remained that provided tailor-made protection to powerful domestic groupssuch as the auto industry and the petrochemical and steel companies, owned by themilitary. Unionized labor benefitted from high wages, guaranteed employment, and rigidrules governing hiring and dismissals. The strong protection granted to intermediateindustries and high labor costs, coupled with the overvaluation of the currency andgrowing inflation, resulted in decreased competitiveness of industrial producers, both inlocal and export markets. As a result of this strategy, during 1970-82, the industrialsector grew at a dismally low annual rate of 0.13%. The trade liberalization programwas reversed when the 1982 debt crisis emerged. The civilian government extendedsignificantly import tariffs and licenses, as well as export subsidies and subsidized creditfor some industries, while increasing export taxes for others.
1.4 Industrial policies discriminated against small and medium-scale enterprises(SMSEs) which had less access to subsidized credits and inputs, so that most SMSEs withplans for modernization or expansion were unable to carry them out. Many of themceased to produce, while others reduced their operations or moved into the informaleconomy. Between 1974 and 1984, the number of SMSEs productive facilities declinedby 13% to about 32,000 units with more than five employees each; physical productionfell 15%; and employment decreased 34%. A survey of industrial firms carried out in1984, showed that only 30% of the SMSEs made new investments during 1977-83.Another survey conducted by BANADE in mid-1986, complemented by the findings ofseveral Bank missions, showed that SMSEs had obsolete equipment, but were willing toinvest in modernization. However, scarcity of appropriate credit was viewed as abinding constraint for investment.
1.5 At the time or preparation of this loan, the Government had heightened its interestin the development of SMSEs. The Sub-secretariat for Small and Medium-scaleEnterprises (SSME) was established within the Secretariat of lndustry and Trade topromote SMSEs in the industrial sector. This loan was envisioned as an instrument tosupport the Government's newly developed interest in SMSEs.
1.6 The Financial Sector. At the time of loan appraisal, Argentina's financial systemconsisted of the Central Bank (BCRA), four specialized national banks: the country's
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largest commercial bank (Banco de la Nacion Argentina-BNA); BANADE, the industrialdevelopment bank; the national housing bank (BHN); and 189 banks, of which 31(including 24 provincial banks) were public and 158 were private (of which 31 wereforeign and 127 were nationally owned). The balance of the system included 68 financecompanies and 45 savings and loan associations and credit unions. The public banks,excluding BCRA, had about 57% of total deposits and were responsible for about 66%of the total volume of loans. Private banks controlled about 41% of total deposits andprovided about 32% of the credit. The equity base of the financial system, excludingBCRA, was relatively small, equivalent to US$3.7 billion by year-end 1985.
1.7 The growth of public banks had discouraged financial development in differentways. First, several of these banks hindered private sector banking development bylending at subsidized terms. Second, a large proportion of public banks' credit had beenchanneled to notoriously inefficient public enterprises. Third, despite the weak financialposition of public banks caused by mismanagement, strong political pressures, speciallyfrom the Provincial governments which relied heavily on financing from public sectorbanks, made it virtually impossible for the BCRA to deny funding as a last resort.Finally, public sector banks had set an undesirable example of not being subject toreview and being partially freed from regulatory restrictions.
1.8 The private banking system was oversized given its large number of branches(about 5,000) and institutions, its relatively low resource base, and its small portfoliosize. Between 1950 and 1985, bank employment tripled while real deposits did notexhibit any sustained growth. Thus, deposits per employee declined by about 66%.Inordinate physical expansion, including excessive branching per bank, was encouragedby subsidized central bank credit and controlled interest rates on deposits, which coupledwith inflation, provided opportunities for banks to benefit from the inflation tax.Furthermore, bank investors had been attracted to the banking business by the 100%deposit guarantee regime, which provided another opportunity of profiteering from theGovernment. These conditions encouraged excessive risk taking.
1.9 Since the 1960's, Argentina's financial sector performance had been underminedby macroeconomic and financial sector policies. The financial system's core structuralproblem was the peculiar BCRA intermediation arrangement that had evolved to channelsubsidies and to fund the public sector deficits. In effect, BCRA borrowed funds throughthe "forced-investment" mechanism from the private commercial banks, and passed theseon through "rediscounts" to public sector financial institutions--mainly to BHN,BANADE, and to the provincial banks, which in turn subsidized credit to public andprivate enterprises. The BCRA was called upon to provide credit to the public banksbecause the macroeconomic instability had made it impossible for them to raise sufficientfunds to finance their activities. This problem was compounded by the inefficiency ofthe public banks' operations. In the early 1980's this problem was further aggravatedbecause BCRA began to use the same mechanism to provide credit to the Treasury. An
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oversized banking system, weak capital adequacy rules and lack of prudential regulationand supervision, were strong incentives to corruption and contributed to the declininghealth of financial institutions. The Bank did not use this loan as a vehicle to addressany of the problems affecting the financial sector; these problems were expected to beaddressed by a US$400 million Banking Sector Loan under preparation at that time.
C. Project Objectives and Description
1.10 A Bank report on strategies toward industrial and export development, datedSeptember 1985, identified the need to assist SMSEs as a major component for anindustrial development strategy in Argentina. The appraisal mission was carried out inOctober 1986. Negotiations were held in Washington from February 24 to March 6,1987. The loan was approved by the Bank's Board on April 14, 1987 and was signedon December 21, 1987. The loan became effective on April 8, 1988. Subsequently, theloan was cancelled at the request of the Borrower in July 1, 1993.
1.11 The project objectives were to encourage modernization, strengthen productivity,and expand output by SMSEs, with particular emphasis on employment generation andon greater diversification outside of the major urban areas. The project objectivesaddressed one of the weak links in the development of industrial enterprises in Argentina:the scarcity of medium- and long-term lending to SMSEs. Due to a long history ofinflation, financial system lending in Argentina was limited almost exclusively to short-term financing. This project aimed to reactivate commercial banks interest in mediumand long-term project financing
1.12 The project was structured as follows: a credit line component of US$123.1million to finance: (i) fixed assets and related permanent working capital needs of SMSEs(including machinery and equipment and their installation costs; building construction,handling and storage facilities; civil works; quality and pollution control equipment;replacement of obsolete machinery and equipment; investments for improvement ofproduct, quality and design; and acquisition of new technologies); (ii) free standingworking capital needs; and (iii) technical services for SMSEs and for the establishmentand operations of trading companies related to SMSE activities. A technical assistancecomponent of US$1.9 million to strengthen the organizations providing technicalassistance to SMSEs. Specifically, the TA component would: (i) strengthen BANADE'scapabilities to provide assistance to SMSEs and to participating banks in the areas ofproject evaluation and sub-sectoral analysis; (ii) help INTI (the National Institute ofIndustrial Technology) to implement three types of technical training programs forSMSEs to: build management skills, develop in-plant managerial assistance, and addressdeficiencies in INTI's own training programs; and (iii) support the creation of a networkof Regional Technical Assistance Centers (RTACs) within the Sub-Secretariat for Smalland Medium-Scale Enterprises under the Ministry of Industry and Trade.
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1.13 A unit called the Fund for Medium and Small Scale Enterprises (FOPYME) wasestablished within BANADE to operate as a second-tier financial intermediary responsiblefor administering the project. FOPYME was eventually to become the principal publicsector institution for financing of SMSEs through BANADE and private commercialbanks as direct lenders. FOPYME was also responsible for coordination of a TAprogram for SMSE development. One of the conditions of loan effectiveness was thatBANADE's Board approve FOPYME's Statement of Policies and Operating Regulationsas well as the Statement of Policies and Procedures for subproject appraisal andsupervision.
1. 14 BANADE was selected to manage the second-tier mechanism because it was themain source of credit for industrial projects in the country. BANADE had been createdas an autonomous Government-owned industrial development bank in December 1970,out of the reorganized "Banco Industrial." In addition to its primary developmentobjectives, BANADE also provided commercial banking services, and had becomepractically the only domestic institution providing long-term lending for industry. Onlythose PBs that were pre-qualified by FOPYME/BANADE (estimated at 40 plusBANADE itself), in consultation with BCRA--based on creditworthiness analysis madeby FOPYME/BANADE--would be able to participate.
1.15 The cost of the investment projects financed under the loan was estimated atappraisal at US$250 million, of which 53% represented foreign exchange costs. TheBank loan of US$125 million was expected to cover 50% of the project costs, with theSMSEs contributing about 25 %, and the remaining portion to be financed withBANADE/FOPYME, BCRA, PB's funds. A summary of the Loan's terms andconditions is provided as an Annex.
D. Project Design and Organization
1.16 The most important design features that affected the outcome of the project werethe following:
Creation of a second-tier mechanism within a main retailer bank opened thepossibility of conflict of interests.
1.17 One of the principal design elements of the project was the creation of FOPYMEas a specialized wholesale banking unit within BANADE. It was expected that FOPYMEwould become the development finance vehicle to manage similar future bilateral andmultilateral agency lending facilities. It was felt that, if properly managed, FOPYMEcould perform the credit analysis of financial institutions, supervise financing operations,and provide technical assistance to financial intermediaries and SMSEs, either directlyor in conjunction with other local technical institutes. Through an entity such asFOPYME, the external financing agencies would then be able to achieve a more
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acceptable level of risk diversification, since FOPYME would spread the risks to asmany banks as possible. Previously, external agencies that dealt directly with local bankshad limited themselves to dealing with a few so-called "top-tier" institutions.
1.18 The Subsidiary Agreement gave loan approval authority to BANADE, which somePBs felt gave BANADE an unfair advantage in processing its own loans. To the extentthat BANADE approved its own loans faster than loans from other PBs, SMSEs wouldbe encouraged to seek a loan from BANADE. This perception may have been adeterrent to more active participation by PBs. Also, under the Loan Agreement, PBswere free to make sub-loans up to US$500,000 as long as they followed properprocedures (which were to be supervised by the Bank). However, under the SubsidiaryAgreements, free-limit loans above US$300,000 had to be approved by BANADE'sBoard of Directors, which should not have been necessary. The creation of FOPYMEwithin BANADE created the perception of likely bias and generated distrust from theother participating banks.
Oversight of BANADE's problems undermined the loan
1.19 Prior to appraisal, BANADE's financial problems were widely known within theArgentine banking industry, although the magnitude was difficult to measure due to pooraccounting and auditing standards and procedures. BANADE's financial problems wereassociated with inadequate management decisions and policies that were frequentlyinfluenced by political considerations. While the appraisal noted BANADE's weakfinancial situation and performance, it pointed to improvements since 1983. Theappraisal did not include detailed information on BANADE's loan portfolio showing theextent of arrears by age or the type of classification assigned to risk assets. Theappraisal concluded that BANADE's overall portfolio exposure/quality was relativelyacceptable (although it recognized problems associated with the 50 largest corporateborrowers) and that its provisioning policies and level of provisions as of June 30, 1986were satisfactory. Although one of the conditions of loan effectiveness was thatBANADE revise its policy on loan loss provisions, the Bank did not require that loanloss provisions actually be adjusted to conform with the new policy. The lack ofadequate credit policies and procedures should have raised concern over BANADE'sviability, or possibly have led to the consideration of a restructuring of the institutionprior to making the loan.
The use of debt/equity ratios to monitor BANADE's financial performance was noteffective.
1.20 The financial conditionality applied to BANADE consisted only of a maximumdebt to equity ratio. This ratio was highly misleading due to Argentina's accountingpractices: assets were not classified by risk, there were no provision standards, andincomes and expenditures we accounted on accrual basis. As a result, it was impossible
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to quantify BANADE's equity realistically. In addition, the certification of covenantcompliance was given by the Office of Comptroller of State Companies (SIGEP); onlywhen the Bank pressed for a special audit did SIGEP produce a qualified report. Inprinciple, the financial conditionality applied to BANADE as a wholesaler bank shouldhave focused more on portfolio quality, such as percent of arrears; on earnings, such asrate of return on assets; on liquidity, such as current assets to current liabilities; and onpolicies and procedures, such as requiring an update of certain policies and proceduresand manuals. Although the debt/equity ratio was inadequate to monitor BANADE'sfinancial performance, failure to comply with this covenant was one of the argumentsultimately used by the Bank to recommend loan cancellation.
Loan pricing and interest rate policy discouraged usage of the loan
1.21 According to the Loan Agreement, the rate charged on sub-loans was expressedin terms of a fixed real, or inflation adjusted, rate that was to be applied to an indexedamount of principal, and which included a spread of 3.75 percentage points for the PB.This spread seems to have been determined arbitrarily, and was much lower than averagespreads in Argentina. This in turn discouraged bank participation. The spread a bankearns on a loan should compensate for credit risk, administrative costs associated withloan servicing, and the opportunity cost of funds which reflects the degree of liquidityin the financial system. Clearly, the liquidity factor alone would have implied a muchhigher spread on the sub-loans. In this type of operations, PBs should be allowed tonegotiate the spreads directly with the borrower, and the real rate applied to the indexedportion of the loan should also be market determined.
1.22 BANADE was responsible for reviewing interest rates applicable to the subsidiaryloans and subloans at least twice a year, and for revising them according to the followingcriteria: a) that rates should be higher than the prevailing average rate on deposits; or b)that rates charged should cover BANADE's and PB's cost of funds. Both conditionswere vague with respect to reference rates. The requirement that rates on subloans wereto exceed rates on deposits proved difficult to apply due to the high inflationaryenvironment in Argentina. Since most deposits were short-term, their yields wereexpressed in terms of a nominal rate. Yet the interest rates specified for the subloanswere expressed in terms of a real rate on top of indexation. These two types of rateswere not comparable. The reference to the cost of funds rate was not practical in viewof the lack of available information on banks' cost of funds, and of PB's reluctance toprovide BANADE, a perceived competitor, with sensitive information regarding theircost of funds.
1.23 The subsidiary loans and subloans were denominated in Australes, instead ofdollars, because it was felt that the primary source of income for most of the industrialenterprises that would participate in this project was the domestic market. SMSEs thathad borrowed dollars in the past had incurred substantial losses as a result of maxi-
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devaluations. However, not all banks shared this view, which suggests that perhaps morecommercial banks should have been consulted during the initial stage of loan design.
1.24 Since the subloans were denominated in Australes, an indexation formula wasdevised to adjust the principal amount of the loan by inflation. According to the LoanAgreement, this adjustment was to be based on a special price index which combined theconsumer and wholesale price indices. This mechanism proved inadequate in dealingwith very high inflation rates. Since the price index was published with a delay of about30 days, the actual adjustment to the loan's principal value was based on the previousmonth's inflation. During periods of accelerating inflation, this formula benefitted theborrower, but during periods of declining inflation it resulted in an increasing value ofthe loan in real terms. As shown in Table 6, depending on when the loan was initiallycontracted, the adjustments produced dramatic differences in the outstanding balances.For example, a US$100 loan disbursed in June 1989, would show an outstanding amountof US$777 by March 1991; whereas the same loan disbursed in December 1990 wouldshow an outstanding amount of US$81 by March 1991. Distortions were also createdby drastic changes in the real exchange rate. The adjustment lag resulted in significantprepayments when the inflation rate dropped, since borrowers rushed to prepay in orderto avoid the adjustment for the very high inflation in the previous month. One SMSEclaimed that it had prepaid a US$250,000 line of credit with US$70,000. Thisopportunity could have arisen right after a maxi-devaluation, but before the local inflationrate reflected the impact of the devaluation, and thus before the loan's value had beenadjusted by the price index.
Loan limits and the subloan approval process further hindered PB's participation
1.25 Loan limits for each subproject may have resulted in a funding gap whichdiscouraged the financing of viable projects. The Bank's participation in the financingof each investment project was limited to 50% for the project, within which two sub-limits were established: first, a limit of 40% was to apply to the first US$62.5 millionof loan disbursements; and second, a 60% limit on the remaining portion of the loan.The Subsidiary Agreement required PBs to participate with another 10% of the subloanamount, even though this condition was not contained in the Loan Agreement. Thesubloans were in turn limited to 80% and 60% of the subproject costs respectively forexisting and for new SMSE's. In the case of an existing SMSE that would have qualifiedfor a subloan during the latter phase of the loan, the Bank's 60% plus the PB's 10%would have left a gap of as much as 30% of the subloan amount. The loan's financingstructure should have been simplified to only one or two types of operations, with acomplete accounting of each institution's participation within the total amount of eachsubloan spelled-out in the Loan Agreement.
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E. Project Implementation
Hyper-inflation undermined the loan's objectives
1.26 At the time of project appraisal, Argentina was undergoing an economic revivalthat had begun in August 1985, with the announcement of the Plan Austral. Monthlyinflation had been kept at single digit rates, and the economy was in a full blownexpansion. Soon after Board approval of the loan, inflation began to accelerate as aresult of an overly accommodative monetary policy. During the first half of 1989,commercial banks experienced an acute liquidity crisis as depositors rushed to withdrawtheir funds from indexed deposits whose value was being eroded through hyper-inflation.By providing emergency liquidity support to commercial banks, the Central Bankprevented a collapse of the financial system and thus safeguarded FOPYME's credit riskexposure to the PBs and BANADE. Private sector borrowers were not as fortunate, andthe incidence of bankruptcies was widespread.
1.27 Operating a medium and long-term lending facility is exceedingly difficult in suchan adverse economic environment. Typically, financial operations take on a very shorttime horizon, seven to 30 days, during periods of high inflation. Businesses focus oncash flow management, such as collections, and defer any investment plans until marketconditions stabilize. Any assessment of this project needs to recognize the highly unusualmacro-economic circumstances, which, when combined with the preexisting problems ofBANADE and the lack of experience with medium and long-term lending in Argentina,complicated practically every aspect of this operation.
1.28 While it was difficult to predict at the time of Board approval that the PlanAustral would collapse and thus trigger a hyper-inflationary spiral, when loaneffectiveness was declared inflation had already accelerated substantially. Althoughmacro-economic performance was not a condition of effectiveness, the fact that inflationwas getting out of hand should have been interpreted as a warning signal for potentialcredit risk problems and possibly have led to a stay in loan effectiveness. Whileeconomic conditions improved dramatically following the successful implementation ofthe Convertibility Law in 1991, by then it was too late to have prevented the loan'scancellation. If this loan had been made later in 1991 or in 1992, after the ConvertibilityLaw, perhaps the implementation and results would have been different.
1.29 The economic crisis that unfolded during the initial implementation of the loanworsened BANADE's financial problems, and subsequently led to the loan's earlycancellation. (A description of BANADE's financial problems is contained in Annex II).
1.30 Shortly before the loan was declared effective in April 1988, a Bank report had
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raised serious concerns about the weakness of BANADE's portfolio. The report showedthat loans to the 50 largest private borrowers in arrears represented 68% of total loanexposure. In addition, the Government had not complied with its guarantees attached toa sizeable portion of the affected portfolio. The report also pointed out that the loanportfolio was highly skewed towards heavy intermediate-goods industries, such as pulpand paper, petrochemicals and chemicals. The lack of an integral and coherent loanportfolio administration and supervision policy impeded the performance of basic duediligence of asset protection. In view of the deficiencies pointed out by the report, loaneffectiveness should have been postponed, or perhaps new understanding should havebeen reached that would have further limited the ability of BANADE to act as a first-tierlender under the project.
1.31 Immediately after loan effectiveness the Bank began to discuss the need for arestructuring of BANADE to avert further deterioration in its portfolio. Based on theBank's analysis, BANADE had technically lost its capital, although reliance on BCRAcredit had deferred a liquidity crisis. Nevertheless, since the official audit reports fromSIGEP did not show the extent of BANADE's equity problem, the Bank was limited interms of legal remedies to address this problem. Financial statements were found to bemisleading specially since loans with substantial payments arrears were still beingaccounted for as performing assets. A recommendation was made at that time towithhold any new Bank financing to BANADE until a satisfactory restructuring wasachieved. As a result of heavy losses incurred during the first half of 1988, BANADEhad failed to meet the loan's required debt to equity ratio. At this point, the Bank beganto stress the urgency of a thorough restructuring of that institution, while raising thepossibility of a freeze on new commitments under the loan. The restructuring optionsbeing considered included a major downsizing of BANADE into a wholesale bankingoperation, with the Government assuming a large portion of the non-performing loanportfolio. Opposition to any major cut in BANADE's 3,100 employee base was strong.
1.32 In October 1988 a Bank supervision mission for the Second Industrial CreditProject (Loan 2063-AR), administered by BANADE, found that only 48% of BANADE'sits portfolio could be classified as normal and that BANADE had a serious cash-flowproblem. This situation was further aggravated by the Ministry of Finance's decisionnot to meet its obligations regarding guarantees on loans extended by BANADE toseveral public and private enterprises which had defaulted. The mission also found thatBANADE's long term debt to equity ratio was above the agreed limit under Loan 2063-AR and above one of the three debt/equity covenants under Loan 2793-AR. The missionrecommended a prompt restructuring followed by recapitalization of BANADE.Although BANADE's management was lukewarm about the need for restructuring, theGovernment agreed to present by December 1988 a restructuring plan for BANADE asa condition of effectiveness of the Banking Sector Loan (approved in early 1988), whichwas eventually cancelled without ever becoming effective.
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1.33 A Bank mission visited Argentina in December 1988 to review the restructuringplans of BANADE and another state banks and to carry out a limited supervision of Loan2793-AR. The mission provided detailed advice for a restructuring to make BANADEa financially sound institution, without recourse to BCRA funding. To achieve thisobjective the Bank recommended: (i) strengthening the management of the loanportfolio;(ii) refraining from funding in the short-term money market; (iii) downsizingof staff and branch network; (iv) strengthening of lending policies and procedures; and(v) improving management and auditing procedures.
1.34 With the onslaught of hyper-inflation and the resulting financial system crisisduring the second quarter of 1989, the Bank began seriously to question the financialviability of BANADE. In June 1989, following the recommendations of the May 1989supervision mission, the Bank required the re-evaluation of participating banks and theupdating of sub-loans already presented for Bank approval to reflect current inflationaryconditions. The Bank also requested that BANADE provide audited mid-year financialstatements. The decision to suspend disbursements was deferred out of concern over thepotentially negative impact of such a freeze on BANADE's frail financial condition.
1.35 After President Menem assumed office in July 1989, a new administration wasappointed to BANADE. The new management supported the plan to restructureBANADE as a wholesale bank with limited retail operations. A September 1989supervision mission visited BANADE to assess the feasibility of continuing loancommitments. The mission made field visits to review a number of subprojectspreviously presented for Bank approval, which had been re-evaluated, and found themviable. However, the Bank did not approve further disbursements, awaiting the resultsof the mid-year audit review.
1.36 In October/ November 1989, a Bank mission carried out a review of Argentina'sfinancial sector including public banks. The mission confirmed the seriousness ofBANADE's solvency problems, and concluded that a recovery was not feasible. Themission found that BANADE's net worth was probably negative, its management veryweak and its restructuring plans inconsistent. With respect to the restructuring plan thathad been submitted by the new management, the Bank's analysis cast doubt onBANADE's ability to embark on new lines of activities such as fee-based services. Inview of its somber assessment, the Bank concluded that there were only three realisticoptions for managing Loan 2793-AR: (i) to continue lending through FOPYME, but stopBANADE's first-tier lending; (ii) to transfer FOPYME to BCRA; or (iii) to cancel theloan. In December 1989, the Bank advised BANADE that continuous non-compliancewith the financial covenants could lead to suspension. In view of the seriousness of thesituation, the Bank initiated internal processing for suspension of disbursements.
1.37 In March 1990, the Government intervened BANADE. An understanding wasreached with BANADE's new authorities to defer a decision on suspension of the loan
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pending BANADE's presentation, no later than June 30 of that year, of audited financialstatements confirming compliance with the financial covenants for 1989, and that it wasimplementing a viable restructuring plan. In May 1990, the Government orderedBANADE's restructuring into a second-tier bank. The bank's interventor hired PriceWaterhouse to assess the restructuring plan and to help during the transition period.Important restructuring steps were taken which included the closure of all branches,adoption of voluntary retirement plan and cessation of all commercial banking activities.
1.38 After BANADE submitted the requested audited statements in July 1990, adelegation of its top managers visited the Bank to seek endorsement of its restructuringplan and approval of a number of subprojects that BANADE had processed but whichhad been frozen since the Bank had stopped approving subprojects in May 1989. TheBank agreed to approve the pending subprojects subject to several safeguards. The Bankmade clear, however, that full normalization of the credit line would be subject to proofthat BANADE was still a going concern, and that it complied with the Bank'srequirements concerning risk management.
1.39 A Bank mission that visited BANADE in March 1991 to review its restructuringplans concluded that more work was needed to substantiate the viability of the bank, andto quantify its capital requirements. It was agreed that BANADE would not submitsubprojects for Bank approval or authorization for the time being. The Bank sent a letterto the Government indicating that given the uncertain outcome of the feasibility study forBANADE's reorganization, and the costs to the Government of maintaining the creditline unutilized for a year or more, the authorities should consider cancelling the loan.Soon after, the Bank informed the Borrower that if it failed to request cancellation of theloan, the Bank would consider suspension. The Bank reactivated suspension procedureswhich were stopped when the Government requested cancellation of US$39.5 million ofuncommitted funds. The cancellation was made effective as of November 1, 1991.
1.40 Cancellation of the remaining funds proved a long and arduous process.Following the Government's decision to close BANADE in May 1992, and to transferBANADE's industrial promotion functions to BNA, the Bank formally requested thecommitted funds be disbursed or cancelled as soon as possible. In July, at Government'srequest, the Bank cancelled--retroactive to April 1992--US$17.4 million of undisbursedfunds; another US$4.2 million were cancelled in November. By then all uncommittedfunds had been cancelled except the balance of US$3.8 million in the Special Account,for which BANADE had legal commitments with sub-borrowers who were payingcommitment fees. Between June 1992 and July 1993, the Bank made numerous attemptsto get the Government to return the remaining funds in the Special Account and to closethe loan. The authorities were advised of the consequences foreseen in Article VI of theGeneral Conditions of not reimbursing these funds. The loan was finally closed in July1993, following the reimbursement of the remaining funds in the Special Account.
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Other problems triggered by the rinancial crisis
1.41 During the hyper-inflationary period loan subborrowers encountered seriousliquidity problems that were exacerbated by the subloan's indexation formula.Subborrowers demanded dollarization since the adjustment applied to their loan inAustrales greatly exceeded the rate of devaluation. A number of subborrowers went tocourt to demand conversions by suing the PBs, which in turn sued FOPYME andBANADE. However, this issue was not resolved until 1991, when the passage of theConvertibility Law in effect made the option to convert a moot point. At BCRA'sproposal, the Subsidiary Agreement was amended in December 1991 to allow conversionof Austral denominated subloans into dollar subloans. Under this new scheme, SMSE'swould have the option of either maintaining their loan in Australes (pesos) or convertingit into dollars.
Response by PBs and SMSEs to the loan was mixed
1.42 PBs interviewed for this report, did not regard the Bank's loan as a profitableoperation. In addition to a sizeable negative interest rate spread on the 10% componentof the loan, the spread earned on the remaining portion of the loan was notcommensurate with what banks would normally charge to cover credit risk and the costof servicing the loan. However, most of those interviewed concluded that the loss interms of interest rate margins were compensated by other aspects of the overallrelationship with their customers. The problems of credit risk and of an inflexible loanpricing formula were exacerbated by the very high inflationary environment. Eventually,the 10% rule was relaxed allowing PBs to designate their participation as working capitalfinancing which had a shorter repayment period; eventually they were allowed to lendthe 10% for a term of less than a year.
1.43 Most of the sub-loans were made to well-established clients of the PBs.Typically, PBs offered this loan as a last resort, and only if the customer requested it.The lack of experience in medium- and long-term financing, coupled with the unattractiveterms on this facility, and the high degree of volatility in the economy, contributed to theunenthusiastic reception and promotion of this facility by PBs. In fact, of the 40commercial bank candidates identified at the time of appraisal, only 13 banksparticipated.
1.44 Initially, demand for the loan by SMSEs was strong due to the relatively favorableterms with respect to the maturity of the sub-loans. Later on, demand slackened as highinflation discouraged SMSEs from embarking on new investments. PBs became alsomore cautious in approving loans because in such a volatile environment projectevaluations became unpredictable, credit risk difficult to measure, and loan pricingunprofitable. Nevertheless, some demand for loan funds continued even during theheight of the hyper-inflation period.
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Reformulation of Technical Assistance
1.45 Despite a detailed description of the TA needs for this project in the appraisalreport, the implementation process was stymied by BANADE's own problems,Government reorganizations of the implementing agencies that resulted in new views onTA needs or lack thereof, and inadequate follow up regarding additional resources thatwere needed to assure continuation of the programs.
1.46 Of the initially envisaged three TA programs, only the development of thenetwork of RTACs was finally carried out with loan funds under the supervision of theUNDP. INTI did not participate in the project as originally expected, and thus thetraining seminars were excluded from the final program. Part of the reason for INTI'sexodus from the project was that its participation had originally been spearheaded by anofficial which subsequently left the organization, and his replacement could not come toterms with the Bank. The program to strengthen BANADE's capabilities to assistSMSEs was only partially implemented due to BANADE's financial problems. Withits own funds, BANADE created a computer program to do financial evaluations whichwas made available to the PBs. BANADE's plans to carry out sectoral studies and toupdate a 1985 study on shadow prices--used in calculating the economic return oninvestments--did not go ahead.
1.47 The RTACs project consisted of training seminars and development of data baseswhich would be offered to SMSEs through regional centers. Part of the funds financedthe purchase of computers to link each regional center with a central information center.The RTACs program experienced some setbacks when the Government changed thecoordinator and staff of the SSME in charge of this program. The Bank temporarilydelayed approval of new expenditures for the RTACs project due to unconvincingreformulations of the TA program by the new SSME coordinator. Although the programwas eventually completed, its sustainability is doubtful. While the equipment waspurchased and the network installed in several RTACs, the SSME did not assign thenecessary staff to the centers or allocated additional funds for their maintenance.Eventually, the network was utilized for electronic mail between government agenciesin the different facilities. The data base developed to assist SMSEs in obtaining strategicinformation on market opportunities contains valuable information on governmentagencies, regulations, contacts, as well as financing availability at commercial banks.However, without adequate maintenance, this information will soon become stale and oflimited use to SMSEs.
F. Proiect Results
1.48 Despite its many weaknesses and premature cancellation, this loan made someprogress towards achieving its objectives in terms of providing credit to SMSEs anddeveloping skills for medium and long- term financing among participating banks.
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Provided medium and long-term financing for SMSEs
1.49 At a time when medium- and long-term financing was scarce, this loan channeledUS$60.4 million (49% of the original credit line component) to support investments inexpansion of existing plants or in creation of new ones. These funds were applied toSMSEs which would otherwise have had to rely on limited internally generated funds,or on very expensive and volatile short-term credits. As shown in Table 1, totalfinancing was more or less evenly distributed between small and medium sizedenterprises.' About 71% of the loans were made to small scale enterprises accountingfor 54% of the total amount disbursed. As expected, the average loan size for mediumscale enterprises was slightly more than twice as large as for small scale companies.About two-thirds of the sub-loans were to the central region of the country, whichincludes the provinces of Buenos Aires and Cordoba, where most of the industrial sectoris situated, followed by the northwestern region with 18%.
1.50 This loan helped to finance investments by industrial enterprises withconcentration in the following sub-sectors: food and beverages, 27% of the total;chemical products, 19%; and machinery and equipment, 17%. These three industriesaccounted for 63 % of total disbursements. The remaining portion of the loan was spreadout over nine other industrial sub-sectors.
1.51 While the weak link in the project's structuring proved to be BANADE's financialproblems, FOPYME, as a self-contained financing unit within BANADE, was able toshield, the execution of the project from the financial difficulties of the host institution.In principle, FOPYME could have continued to operate as an independent second-tierfinancing agency, or have been transferred to another public sector bank. However, thistransfer was not a realistic option given the weak financial situation of public sectorbanks in Argentina.
1.52 This loan provided PBs with the opportunity to channel medium and long-termcredit to their clients at a time when these types of funds were scarce. About 28% ofthe funds were disbursed through PBs, which is moderately above the minimum of 25 %as per the loan Agreement (See Table 1). PBs role was more important in financingmid-sized enterprises--with about 38% of total financing to that sub-sector--whileBANADE was more active in lending to small companies--with 79% of the total. Thesize distribution between BANADE and the PBs may be due to BANADE's extensivenetwork of branches in small towns and rural areas, which was not the case for PBs.
1. The information on loan disbursements contained in this section is based oninformation as of 12/31/91. This was the most recent information available fromFOPYME at the time of this report. The reported amount of $58.5 millionrepresented 97% of total disbursements.
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1.53 The PBs emphasis on mid-sized enterprises could also be explained by theirdifferent approach in qualifying applicants. The customer profile of the corporatebanking department of commercial banks is typically dominated by mid- and large sizedcompanies. They prefer to deal with a mid-sized companies that have an establishedtrack record of performance, for which financial information is more readily available,and which also have greater amplitude for loan collateral. In addition, loans to mid-sizedcompanies are more attractive than to small-scale enterprises because of loweradministrative costs relative to the size of the loan. In this regard, a policy of freelydetermined spreads could have resulted in greater lending to small scale enterprises bythe commercial banking sector.
1.54 While no information was available on the quality of the sub-loan portfolio, at thetime of the PCR mission, FOPYME reported that no Participating Loans to PBs were inarrears. This would imply that FOPYME performed adequately in its evaluation of PBs,and that financial intermediaries were able to cope in Argentina's highly unstableeconomic environment. No information was available on the level of arrears on subloansmade by BANADE as a first-tier bank.
Helped to develop expertise in project financing among commercial banks.
1.55 This loan also helped to develop expertise in medium and long-term projectfinancing in the banking system. To qualify for participation, a commercial bank hadto establish a credit evaluation unit within its organization. Commercial banks had tobuild up their new units including the development of policies and procedures, thetraining of staff, and the promotion of these new products and services throughout theirorganization. Some of the PBs seized on their initial investments in these units to furtherexpand their activities through participation in other bilateral and multilateral facilities,such as the Spanish and Italian bilateral programs and the IFC's lines of credit.However, banks begun to consider financing as a viable activity only after theinflationary spiral had been eradicated, and the private sector was willing to consider alonger term investment horizon.
G. Project Sustainabilitv
1.56 The sustainability of any financing operation hinges on the design of a viable andeffective delivery mechanism to allocate funds in an efficient manner according to projectobjectives. In the event, BANADE's problems, exacerbated by the effects of hyper-inflation, aborted the operation, which in tum thwarted FOPYME's prospects forbecoming an effective wholesale development banking entity (See discussion ofBANADE's financial problems in Annex II). There is no information as to thesustainability of industrial operations financed by project subloans.
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H. Bank Performance
1.57 In the interest of launching this operation expeditiously, the Bank's staff may haveoverlooked, during preparation and appraisal, some pertinent questions regarding thecountry's macroeconomic conditions and the implementing agency's performancecapabilities. However, when the economic conditions deteriorated, Bank staff workeddiligently to protect the Bank's and the Borrower's interests and in pursuing remedialactions to work out the problems confronting BANADE.
1.58 During the time of appraisal, Argentina was experiencing the benefits of theAustral Plan in terms of strong growth and low inflation. The Bank's staff may havebeen led by good intentions in seizing on an opportunity to support that economicprogram. However, given Argentina's chronic inflationary problems, the appraisal wasoverly optimistic about the prospects of a stabilization plan that was just beingimplemented. With respect to the choice of implementing agency, a number of warningsignals were already evident at the time of appraisal such as BANADE's loan portfolioproblems, that should have alerted Bank staff to rethink the loan design. Furthermore,the mixed experiences from two previous Bank loans which used BANADE as projectadministrator should have put in question BANADE's role as implementing agency.Unfortunately, PCRs of the other operations came too late to provide lessons for thedesign of this loan.
1.59 Loan supervision flagged BANADE's problems almost immediately after loaneffectiveness. Successive Bank missions (including missions not directly involved in thesupervision of this loan) provided advice to BANADE's management and Governmentofficials on remedial actions to address BANADE's problems. The Bank consideredsuspension when the economic crisis jeopardized the objectives of the loan. The Bankcould suspend disbursements whenever "an extraordinary situation shall have arisenwhich shall make it improbable that BANADE will be able to perform its obligationsunder the Project Agreement." Although the macroeconomic crisis was such a situation,it was too cumbersome for the Bank to exercise its rights with this clause during theinitial stages of the crisis, when its impact on BANADE was still unclear. At this stage,the Bank was also unable to suspend disbursements based on BANADE's failure tocomply with the debt/equity covenant, because SIGEP's audit reports indicated thatBANADE was still in compliance. The Bank was able to protect the Borrower's interestsinitially through a slow down of subloan approvals, and later, through an agreement withthe Borrower and BANADE to link subloan approvals to BANADE's successfulreorganization. When it became evident that BANADE's restrLcturing efforts wereinadequate, the Bank was instrumental in convincing the Government of the need tocancel the loan and to close BANADE, a bank responsible for a large share ofArgentina's foreign debt.
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I. Borrower/Executing Agency Performance
1.60 On the macro-economic front, the Government was unable to maintain a suitableenvironment for medium- and long-term financing. Eventually, macro-economicperformance improved dramatically with the passage of the Convertibility Law and otherreforms by the Menem Administration, but it was too late to save the loan.
1.61 BANADE's downfall can be attributed to the inadequate response to its financialproblems which became critical as a result of the hyper-inflation. The Borrower'srepresentatives were not always willing to recognize BANADE's problems and takeactions to address them. BANADE's management was also unwilling to accept theBank's assessment of the financial and managerial problems affecting the institution.Only when the Government interventor took over the bank's management, seriousmeasures to solve the problems were adopted. However, attempts at restructuringBANADE were ultimately unsuccessful due to the difficulty of changing that bank'sentrenched culture. Eventually, it became evident to the Bank and the Borrower thatBANADE had to be closed. However, as discussed in the previous section onimplementation, the cancellation of the loan was a complicated process due to the manyvested interests in preserving the Bank loan which at the time was the only source offunds for BANADE.
1.62 One of the positive features of this loan was the development of FOPYME as awholesale development finance unit. Its staff implemented a methodology to qualify PBsdespite the lack of prudential banking regulations. Regular reports on financialconditions of these banks produced by FOPYME demonstrated good monitoringperformance. A selective review of subloan files showed that documentation procedureswere adequate. Some of the PBs expressed positive comments regarding theirrelationship with FOPYME. A number of PBs complained of inordinate delays in gettingBANADE's approval, although part of this problem may have been caused not byFOPYME, but by the Bank's decision to slow down its own approvals during the hyper-inflationary crisis in 1989. The Bank's decision was supposedly communicated to allPBs, so that they could in turn advise their customers and possibly have considered otheralternative sources of financing. When the hyper-inflation caused major distortions inthe indexing of the subloans, FOPYME pressed for the option to dollarize the subloans,and eventually succeeded in getting Bank approval.
1.63 Despite the good progress made by FOPYME in gaining acceptance as aneffective development finance unit, BANADE's crisis inevitably compromised its abilityto function adequately. FOPYME's staff had peaked at 15 persons during 1989, beforesignificant staff reductions were made as part of BANADE's restructuring efforts. Thecutback in human resources hindered FOPYME's ability to perform normal loansupervision activities. For example, in 1989 the unit developed a questionnaire tosupervise loan performance for BANADE and the PBs; however, subsequent staff
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reductions prevented further work on this initiative.
1.64 Prior to loan cancellation, the Bank staff had considered transferring FOPYMEto another entity such as BNA. However, BNA had similar problems as BANADE inthat it was also a first-tier bank. At that time, the Bank's agricultural loan was havingproblems with conflict of interest arising from BNA's dual role as project administratorof the agricultural loan and direct lender.
1.65 The performance of the TA implementing agencies--SSME and INTI--was weak;lack of institutional continuity caused the project's TA component to fail in meeting itsobjectives.
J. Project Relationship
1.66 Relationships between the Borrower and the Bank and between the ExecutingAgency and the Bank were mixed. Relations between the Bank and BANADE wereaffected by the Bank's insistence on measures to address the financial problems of thatinstitution. The Bank was in the difficult position of having to pressure the Governmentto take action to resolve BANADE's problems. Tensions between the Bank and theBorrower may have been caused in part by Government officials who consistently deniedthe seriousness of BANADE's financial problems. On the other hand, FOPYME staffworked closely with the Bank.
K. Project Documentation and Data
1.67 The project appraisal report contained extensive information that proved usefulin identifying the Borrower's needs and in structuring the loan. The description ofFOPYME's mission statement was appropriate and facilitated the development of thisunit. However, the appraisal was somewhat inaccurate in its analysis and conclusionsregarding BANADE. In effect, the report assigned a satisfactory rating to that institutiondespite serious loan portfolio problems.
1.68 The Loan Agreement provide for suspension of disbursements if BANADE failedto comply with the financial covenants or whenever an extraordinary situation shall havearisen which would make it improbable that BANADE would be able to pursue itsobligations under the Project Agreement. As explained before, it was cumbersome forthe Bank to use the suspension clauses to suspend disbursements during initial stages ofthe hyper-inflation crisis, when the effects of the crisis on BANADE were still unclear.It would have been useful if the Loan Agreement had a review clause that would haveallowed the Bank to stop new commitments when the crisis started, while giving theBank time to initiate suspension procedures if the situation worsened.
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1.69 The auditing arrangements of this loan were not fully satisfactory. As mentionedbefore, SIGEP the Government auditing agency, was not inclined to sound the alarmabout the fact that BANADE's net worth was probably negative. Only when the Bankpressed for a special audit of BANADE's compliance with the financial covenants, didSIGEP produced a qualified report.
1.70 Basic data and statistics on the results of this loan were deficient. Financial dataon BANADE was not complete, i.e. external assets and liabilities were not available,summary statistics of loan portfolio performance by aging were also not available.Statistics on investment projects regarding projected employment compared with actualresults, sales growth, and rates of return calculations were not available. It was thus notpossible to assess the economic impact of this loan. The lack of basic data on the loan,especially statistics, was due in large part to BANADE's institutional problems whichresulted in staff cutbacks. However, the Bank could have been more persistent inrequesting summary statistics on a regular basis as a means of monitoring sub-loanresults and performance.
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PART III: STATISTICAL INFORMATION
3.1 Related Bank Loans
Loan Title Purpose Year of Status CommentsApproval
Industrial Credit Credit Line 12/76 Closed PPAR 10/91Project I I
Second Industrial Credit Line 04/81 Closed PPAR 10/91Credit Project
1/ Includes: Bank proceeds plus BANADE/BCRA/FOPYME funds, plus PB's funds.
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3.8 Status of Covenants
Section Description Status of Compliance
Loan Agreement
2.02 (b) The Borrower to open and maintain Complied with.a Special Account in dollars in theCentral Bank.
2.03 The Closing Date to be June 30, Loan closed June 1, 1993.1994.
3.01 (c) The Borrower to transfer to INTI, as Part B 2 (i) was not carriedgrant, the amounts allocated from out.time to time to carry out Part B 2 (i)of the Project.
3.02 (a) The Borrower to transfer loan Amended 1/16/88 to makeproceeds to Banco Central under the the terms the same as thosesame terms and conditions applicable applicable to BANADE.to the Loan.
Banco Central to relend loan Complied with.proceeds to BANADE under thefollowing conditions:* loans made and repayable inAustrales.
* interest applicable on outstandingprincipal adjusted for inflation on thebasis of the Combined Index.
* interest rate initially of 7% p.a. onfunds to be used by BANADE forpurposes of Parts A (1) (ii) and 2and B (1) of the Project.
* interest rate initially of 4% p.a.for purposes of Part A (1) (i) and (3)of the Project.
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4.01 (a) Maintenance of separate records and Complied with concerningaccounts of SSME and INTI in respect of SSME but not INTI.Part B (2) of the Project
4.01 (b) Furnish to the Bank by April 30 audit Complied with audit ofreports on the accounts referred to in 4.01 the Special Account (last(a) including the Special Account. audit for period ending
31/1992). Not compliedwith audit of SSME.
4.01 (c) Audits of SOEs to be included in annual Not complied with respectaudits referred to in 4.01 (b). to SSME.
6.03 Effectiveness Date is: March 22, 1998. Effectiveness declared04/08/88.
Schedule 1 Bank resources to finance 60% of 60% was taken as aexpenditures for each subproject up to maximum with manyaggregate amount of US$62.5 million and subprojects below 60%40% of expenditures of each subproject Bank financing.financed thereafter.
Working capital subloans not to exceed the Complied with.accumulated amount of US$30.775 million.
The Borrower to present evidence that it has Not complied with.entered into a contractual agreement withINTI, and that INTI's Board of Directorshas approved plans for its center forresearch of methods and techniques forSMESs and its Management AdvisoryProgram.
Schedule 2 Project consists of two parts: Partially complied with.Only Part A and Part B
Part A financing of: (2) (ii) were implemented.* fixed assets and related permanent
working capital of SMSEs.* permanent incremental working capital of
SMSEs.* technical assistance to SMSEs.
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Part B financing of:(1) strengthening BANADE's capabilities to
provide TA to SMSEs.(2) (i) strengthening INTI's capabilities to
assist SMSEs.(2) (ii) strengthen SSME's capabilities to
provide technical assistance to SMSEs.
Schedule 4 Authorized allocation of US$8.0 million to be Complied with.deposited in the Special Account.
ProjectAgreement2.01 (a) BANADE to carry out Part A of the Project Complied with respect
through FOPYME and Part B (1) through to Part A only.FOPYME and other departments or units.
2.05 (a) BANADE to enter into Participation Complied with.Agreements with Participating banks.
2.8 BANADE to review at least every June 30 Partially compliedand December 31 the appropriateness of with. Reviews failedinterest rates on Participating Loans and sub- to expose increasingloans; exchange views with the Bank on the problems with pricingresults; and revise such interest rates as mechanism.required.
3.01 BANADE to carry out its operations and Not complied with.conduct its affairs in accordance with soundadministrative and financial practices.
4. 01 (a) BANADE to maintain procedures and Partially compliedseparate records and accounts to monitor with. Procedures andprogress of Part A and B (1) of the Project. record keeping
deteriorated withBANADE's crisis.
4. 01 (b) BANADE to furnish to the Bank by April 30 Partially compliedaudit reports of its records accounts and with. Last audit offinancial statements. financial statements
submitted was for yearending 12/1991.
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4.01 (c) Audits of SOEs to be included in annual Complied with. Lastaudits referred to in 4.01 (b). audit of SOEs submitted
was for year ending12/1992.
4.02 (a) BANADE to maintain the following ratios Not complied with.from December 1987 and thereafter:* Consolidated long-term unsecured debt
to capital: 8 to 1.* Consolidated unsecured debt to capital:
12 to 1.* Consolidated long-term debt to capital:
20 to 1.
Schedule 1 Subloans to be made in Australes and Pricing mechanismprincipal repayments thereunder to be amended in 12/23/1991 toadjusted for inflation on the basis of the allow for dollar lending.variations of the Combined Index.
Schedule 2 Maximum term on subloans: Complied with.* Financing of fixed assets: 10 years with
up to 3 years grace.* Working capital: 3 years with up to 6
months grace.* TA subloans: 5 years with up to 1 year
grace.
Schedule 3 Interests on subloans to be applied to a Pricing mechanismprincipal amount adjusted for inflation on amended in 12/23/1991.the basis of the Combined Index. Aninterest rate of 8% p.a. on the adjustedamount for subloans to finance fixed assetsand TA, and of 12% p.a. for subloans tofinance working capital.
Schedule 4 Interest rate spreads between Participating Complied with.Loans and the corresponding subloans tobe 3.75 percentage points.
Schedule 5 Participating banks to pay BANADE a Complied with.commitment charge not exceeding 1 % p.a.on the principal amount of eachParticipating Loan not withdrawn.
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Schedule 6 Subloan limits: Complied with.* Up to 80% of cost of subproject forexisting SMSE.
* Up to 60% of cost of subproject for newSMSE.
* Up to US$2.0 million in respect toinvestment subloans.
* Up to US$1.0 million in respect ofworking capital subloans.
* Up to US$0.2 million in respect of TAsubloans.
Subloans to an industrial enterprise not toexceed US$2.0 million.The permanent working capital componentnot to exceed 50% of a subloan.
Schedule 9 Free limit subloan: US$500,000 cumulative Complied with.of all subloans to a subborrower.
Schedule 10 Last date for presentation of subloan Extended to 12/31/1991.applications: December 31, 1990.
3.9 Use of Bank Resources
Staff Inputs
Stage of Project Cycle Period (FY) Staff Weeks
Through Appraisal 86-87 49.7Appraisal through Board Approval 87 37.2Supervision 87-92 61.0PCR 93-94 6.4
Total 86-94 154.3
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3.10 Missions
Month/ Number Number Staff Dates of OverallActivity Year of of Weeks Report Project
ANNEX I: SUMMARY OF TERMS AND CONDITIONS OF THE LOAN
Loan Amount: US$125 million equivalent.
Borrower Republic of Argentina.
Term and Rate: Repayable over 15 years with 3 years grace, at the Bank'sstandard variable rate.
Effectiveness: Upon satisfaction of the following conditions:* Signing of Subsidiary Loan Agreement.* that BANADE's Board has established FOPYME.* that FOPYME has approved sub-project appraisal
guidelines.* that BANADE has signed Participation Agreement with
at least four PBs.* that BANADE has revised policy on loan loss
provisions.Allocation:
Category 1: US$123.1 million to finance up to 60% of expenditures foreach sub-project financed under sub-loans up to US$62.5million; and 40% of expenditures thereafter, thus the Bankwould on average finance 50% of the project costs. Fundsto be applied towards the purchase of fixed assets, ofpermanent incremental working capital (up to a grand totalof U$30.775 million), and the financing of technicalassistance for SMSEs.
Category 2: US$1.9 million to finance technical assistance to: (i)strengthen BANADE's capabilities to provide assistance toSMSEs and to PBs and to carry out sub-sectoral analysis;(ii) help INTI to implement technical training programs forSMSEs and address deficiencies in INTI's own trainingprograms; and (iii) support the creation of a network ofRegional Technical Assistance Centers within the Sub-Secretariat for Small and Medium-Scale Enterprises.
Special Account: To be opened in the BCRA in dollars, with an authorizedamount of US$8.0 million to be replenished based onproper documents in evidence of expenses associated withsubloans.
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Subsidiary Loan:
Description: A loan from the Borrower, through BCRA, to BANADE,as project administrator, denominated in Australes [pesos].Loan to be governed by a Subsidiary Loan Agreement.
Term: Same as the Bank loan.
Interest Rate: To be applied to the principal amount adjusted for inflationon the basis of the Combined Index (the percentage rate ofvariations of the combined wholesale and consumer pricesas calculated by BCRA). An interest rate of 7% perannum on the adjusted amount for funds used by BANADEto finance permanent working capital requirements as wellas the technical assistance component dealing with thestrengthening of BANADE's capabilities; and an interestrate of 4% per annum for funds used by BANADE tofinance fixed assets and technical assistance directly toSMSEs. These rates to be reviewed semiannually.
Participating Loan:
Description: A loan made by BANADE to a PB, financed out of theproceeds of the Bank loan, governed by a ParticipatingAgreement between BANADE and the PB. The PB to actas subloan originator and servicing agent, and to assumefull commercial risk of the underlying subloan. PBs wereto relend at least 25 % of the total Loan amount; BANADEwas to relend the remaining portion as a first-tier bank.
Conditions: Same as those applicable to the corresponding subloan asexplained below.
Interest spread: BANADE to charge an interest rate to the PB equal to therate applicable to the subloan less a spread of 3.75percentage points to be earned by the PB. Theappropriateness of this rate is to be reviewed twice peryear.
Fee: A commitment charge of 1 % per annum on the un-withdrawn amount of the Participating Loan.
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Subloan:
Description: A loan from a PB to an SMSE denominated in Australes[as of 11/91: Australes, pesos or dollars].
Term: Maximum terms on subloans:_ Financing of fixed assets: 10 years, with up to 3 years
grace.- Working Capital sub-loans: 3 years, with up to 6
months grace.Technical Assistance sub-loans: 5 years, with up to 1year grace.
Interest: To be applied to a principal amount adjusted for inflationon the basis of the Combined Index (the percentage rate ofvariations of the combined wholesale and consumer pricesas calculated by BCRA). An interest rate of 8% perannum to be charged on the adjusted amount for subloansto finance fixed assets and technical assistance, and of 12%per annum for subloans to finance working capital. Theappropriateness of this rate is to be reviewed twice peryear.
Fee: A commitment fee of 1 % per annum on the un-withdrawnamount of the subloan.
Loan Limits: In terms of type of borrower:U Up to 80% of cost of subproject for existing SMSE.U Up to 60% of cost of subproject for new SMSE.
In terms of purpose of the loan:US$2.0 million in respect of an investment subloan.US$1.0 million in respect of a working capital subloan.US$0.2 million in respect of a technical assistancesubloan.
In terms of accumulated lending to one borrower:Accumulated amount of all subloans to one borrowernot to exceed US$2.0 million.
In the case of an investment subloan, the working capitalcomponent was not to exceed 50% of the sub-loan amount.
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Free Limits: A loan approval limit for a PB of US$0.5 millioncumulative of all subloans to one borrower. Any subloansbeyond this limit require prior Bank authorization.
Co-Participation: [No conditions were specified in the Agreement, althoughthey were incorporated in the Participation Agreement].
Supervision: BANADE was to maintain procedures, records andaccounts to monitor and record progress on eachinvestment project.
Documentation: For a free limit subloan the information to be provided bythe PB to BANADE, which in turn would submit it to theBank for final approval, included a summary description ofthe expenditures proposed to be finance out of the proceedsof the subloan and the terms and conditions of the subloan.
For a subloan above the free limit, the informationincluded: (i) a description of the borrower and appraisal ofthe project; and (ii) proposed terms and conditions of thesubloan.
Eligibility: To qualify for a subloan an investment enterprise had to beconsidered a SMSE with primary business activity in theindustrial sector. Definitions:
Small scale enterprises: fixed assets not exceeding theequivalent of US$350,000, excluding land andbuildings;Medium scale enterprises: fixed assets greater thanUS$350,000, but not exceeding US$3.0 millionexcluding land and buildings.
Conditionalitv:
BANADE' sFinancials: According to the Project Agreement, BANADE was to
maintain the following ratios from December 1987 andthereafter:
Consolidated long-term unsecured debt to capital: 8 to1.Consolidated unsecured debt to capital of 12 to 1.Consolidated long-term debt to capital of 20 to 1.
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Interest Rates: BANADE was to review interest rates applicable to theSubsidiary Loan and Subloans at least twice a year andrevise rates as required by the following criteria:_ Interest rates must: (i) be higher than prevailing average
interest rates on deposits--if such deposit rate is, in theopinion of the Bank, conducive to resourcemobilization; or (ii) cover BANADE's and PB's cost offunds as measured in a form satisfactory to the Bank.
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ANNEX II: BANADE'S FINANCIAL CRISIS
1. This section describes the evolution of BANADE's financial performance withspecial emphasis on the latter period, when the institution experienced a severe financialcrisis which eventually led to its liquidation and consequent cancellation of the Bank'sloan.
Background
2. Banco Nacional de Desarrollo (BANADE) was founded in 1944 as BancoIndustrial, to serve as an autonomous Government-owned industrial development bank.The name was subsequently changed to Banco Industrial de la Republica and then toBANADE in 1970. BANADE had been chronically troubled since its establishment,partly because macroeconomic instability made it difficult to secure finance and made itsassets excessively risky, but also because management had never succeeded instreamlining and modernizing its operations. In addition, successive governments hadused the institution to channel subsidized credit and to rescue failing industrialenterprises. During the mid-1980's it had come to rely on BCRA rediscounts for itsfunding due to insufficient funding (mostly comprised of external credits) and to a rapidlydeteriorating asset portfolio.
3. BANADE's role in resource mobilization had been focused on capturing specificlines of credit mostly from multilateral and bilateral lending agencies, such as the Bankand the Interamerican Development Bank. In this regard, it was the only domesticinstitution providing medium and long-term financing to the industrial sector.BANADE's local deposit base was negligible representing less than 5% of total financialliabilities.
4. At the time of appraisal, BANADE operated through its headquarters and 33provincial offices, with about 3,600 employees. Operating in a shrinking financialmarket during the 1980's, BANADE had managed to somewhat maintain its asset sizeand the level of its operations. Reflecting the events of the Argentine economy,BANADE's financial structure experienced significant deterioration during the 1980s.Nevertheless, the Bank's appraisal report evaluated BANADE's overall portfolioexposure/quality as relatively acceptable--although it pointed out that the 50 largestborrowers accounted for about 60% of the loan portfolio and these had been principallyresponsible for BANADE's high loan arrears ratio of 16% of total loans--and concludedthat BANADE's loan loss provisions policies and the level of provisions were relativelysatisfactory.
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Origins of the Crisis
5. Indications of BANADE's growing crisis appeared in the financial statements forthe first half of 1988. A loss was reported for the first half of that year of US$87.7million. The real situation was much more serious because the financial reports had beenprepared on an accruals basis of accounting, and thus did not adequately represent theactual cash gains and losses of the institution. More importantly, the initial lossesreported during the first half of 1988 were only the first signals of a severe portfolioimbalance that had accumulated over many years of inadequate policies. Loan approvalsto high risk borrowers had in many instances been instigated directly by the Board ofDirectors against the recommendations of the bank's staff. BANADE's situation becamemore precarious during the hyper-inflation period in 1989.
6. BANADE's problems resulted from the low quality of the loan portfolio whichresulted in a lack liquidity that was eventually exacerbated by a high degree of economicinstability. The key problem areas are outlined below.
BANADE: Summar of Key Financial Problems
7. Asset Quality: A large proportion of BANADE's loans were to moneylosing industrial enterprises that did not have the financialstrength to repay their loans.
BANADE's loan classification and loan loss provisionspolicies and procedures were inadequate, obscuring the fullextent of the portfolio problems.
Liquidity: Large maturity gap caused by increasing reliance on short-term funding. Historically BANADE had been overlydependent on external sources of funding. Whenavailability from these sources diminished, BANADE hadto access volatile short-term funds. Also, substantial loanarrears made its assets illiquid.
Interest rate risk was intensified by the high inflationaryenvironment and the mismatch between short-term nominalrates on liabilities and indexed real rates on assets.
Exchange rate risk was above acceptable levels due toreliance on foreign currency liabilities to finance localcurrency assets.
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Management: High degree of institutional inflexibility. Low staffturnover with limited management training anddevelopment. Information systems were not up tostandards of other banks, although some progress wasbeing made at the time of loan appraisal. Political factorshad dictated Board decisions on institutional policies.
Earnings: Earnings began to deteriorate in 1988; however, inadequaterecognition of asset quality problems had led to overstatingof operating income in prior years.
Capital: At the time of the financial crisis, BANADE's capital wasinsufficient to absorb the losses. Its precarious financialcondition prevented access to additional capital, althoughsome creative financial transactions were attempted in orderto buttress its equity position.
8. Asset Quality. BANADE's poor overall portfolio quality was the principal causeof its financial crisis. Inadequate policies and procedures on loan classification, loan lossprovisioning, and loan recovery precluded effective management action to remedy theloan quality problems. One of the principal shortcomings of the credit review processwas that only loans to firms in liquidation or under legal procedures were classified asnon-performing, while loans in arrears continued to accrue interest, even if thefundamentals of the borrower pointed to an inability to return to normal debt servicingcapacity. In April, 1988, BCRA Circular Al 171 established minimum criteria for loanloss provisions. Banks were required to begin provisioning for loans past due 24 monthson the basis of 1/12th the value of the loan per month until 100% reserves wereachieved. At that time, BANADE decided not to follow these criteria but to rely on theirown internal assessment of the quality of each individual loan, even though they couldbe more than 24 months overdue.
9. According to a previous Bank analysis (October 1988), portfolio quality wasaffected by: (i) portfolio concentration; (ii) inadequate portfolio recovery planning; and(iii) inadequate portfolio management and control. BANADE's credit to its 50 largestdebtors, of which 52 % were in arrears, represented nearly 75 % of its portfolio. Creditrelationships between BANADE and its largest debtors were marked by politicalfavoritism which held up the normal process of loan rescheduling and recovery. Thosecredit problems that originated during previous bank administrations were blamed on thepast, but little interest was shown in normalizing or resolving the problem up untilBANADE was intervened by the Government.
10. Another major complication arose from the refusal by the Ministry of Finance tocomply with its guarantees for loans BANADE had made to private as well as public
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sector enterprises. After the introduction of the Plan Austral in June 1985, the newlyappointed Minister of Finance announced that the Government would no longer cover anyclaims under previously issued guarantees to BANADE. This meant that whenever aborrower did not meet its debt obligations and the underlying guarantees wereuncollectible, BANADE had to resort to BCRA rediscounts, to the extent possible, inorder to continue normal servicing of its own liabilities.
11. According to the above mentioned Bank study of BANADE, due to theGovernment's refusal to comply with its guarantees, non-performing loans could easilyhave exceeded 50% of the loan portfolio. Yet the financial statements showed thatreserves to loans were a minimal 7.77% in 1988 (see ANNEX Table 3). Prudentbanking practices would have dictated a minimum reserve ratio of 30% of loans.Clearly, the bank was grossly understating its potential losses from loans.
12. Liquidity. Previous analyses of BANADE's financials refer to chronic cash flowproblems arising from asset illiquidity. This problem had its roots in the managementof the bank's assets and liabilities resulting in a huge maturity gap. To the extent thatloans were reported on an accruals basis, even though they were substantially in arrears,or had been restructured, the validity of the bank's financial statements were highlymisleading. The ballooning of loan arrears, combined with the refusal by the Ministryof Finance to make good on the guarantees, resulted in minimal cash flow from assets.On the other hand, the rigid liability base of the bank, mostly foreign loans with verylimited domestic deposit capability, greatly reduced BANADE's flexibility. Thus, theonly realistic option was to resort to BCRA's rediscount facility to remedy the lack ofliquidity. Eventually, accumulated arrears with BCRA contributed to BANADE'sfinancial problems.
13. BANADE's focus on providing medium- and long-term financing resulted in ahigh level of interest rate risk which commercial banks had traditionally avoided bymanaging their balance sheets on a purely short-term basis. While a major portion ofits liabilities were in the form of medium-term financing from multilateral and bilaterallending agencies, the acute liquidity problems described above led to increasing relianceon short-term funds whose costs were subject to dramatic swings. Another complicationarose from the method used in pricing assets and liabilities. For instance, someinstruments were indexed, with the principal amount adjusted by inflation, or thevariation in the exchange rate, while others were priced at a nominal interest rate whichreflected both the inflation and the real interest rate factors. The absence of a clearpolicy on the management of interest rate risk resulted in significant losses to the bank.
14. Foreign exchange risk contributed to BANADE's losses. However, at the timeof this PCR, no information was available on BANADE's net foreign exchange position.BANADE officials have commented that the foreign exchange position had varied fromyear to year. Thus, the net effect on profitability must have similarly fluctuated.
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BANADE did maintain a non-interest bearing claim on BCRA of approximately US$579million in 1988 as a result of foreign exchange guarantee contracts dating back to theearly 1980's, and for which BANADE had assumed the liability to the external creditor.
15. Management. BANADE's organization chart followed a classic developmentbank scheme. In 1989, total staff exceeded 3,000, with little turnover. Salaries werelower than those offered by the private sector, yet the bank offered attractive fringebenefits. Internal procedures were defined extensively in a huge Operations Manualwhich had not been updated for a long time. BANADE's Board of Directors wasultimately responsible for the management of the bank, although Senior Management hadthe responsibility for implementing day-to-day decisions, and advising the Board oncritical issues affecting the bank. Most analyses of BANADE performed by varioussupervision missions pointed to organizational rigidities, and to a lack of experience inmeeting the changing demands of the marketplace. In effect, BANADE's managementwas ill-equipped for dealing with the financial weakening of its loan portfolio. This wasdue in part to an unresponsive organizational structure and to outdated procedures incredit classification and administration.
16. More importantly, BANADE's demise was triggered by Senior Management'sfailure to anticipate critical problems; and perhaps more critically, by a lack of fiduciaryresponsibility exhibited by a politically appointed Board of Directors. While a finalassessment of BANADE's downfall may never be completed, this report recognizes thatthe bank counted with many well trained and loyal staff, including mid-levelmanagement, that performed their responsibilities in an exemplary manner, and that theirwell prepared recommendations may have often been ignored by higher levelmanagement.
17. Earnings. Historically, BANADE's reported earnings had presented a distortedview of the bank's financial situation. Interest income was accrued on a sizeable portionof the loan portfolio that was in fact non-performing. Insufficient provisioning for loanlosses combined with the over-accruing of interest income projected a much morefavorable outcome in terms of earnings. Inadequate treatment of "de facto" non-performing loans grossly overstated net interest margins, and under-stated non-interestexpenses as a proportion of adjusted income. While the first annual losses were reportedin 1990, the bank actually incurred a loss in the previous year that was hidden by theextraordinary gains from a number of debt swaps arranged by BANADE by which clientsin arrears repaid their loans with rescheduled external debt papers of the Republic ofArgentina (traded at the time at about 6% of their face value). The swaps resulted in anaccounting gain, but not an economic gain for the bank. Overall, it is difficult toseparate the bank's earnings performance from the underlying problem of asset quality.
18. Capital. According to the reported financial statements, BANADE's debt toequity ratio were in compliance with the Loan Agreement's covenant until 1991. This
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was an overstatement of BANADE's capital position. Clearly, if the bank had properlyrecognized the loan quality problems by provisioning a reasonable amount against non-performing loans, the consequent losses would have de-capitalized the institution.
Response to the Crisis
19. The hyper-inflationary period during 1989 further debilitated BANADE'sfinances. Despite efforts to restructure, it was too late to achieve a turn around of thesignificantly weakened institution. While the financial statements showed a modest profitin 1989, these were due to a one time swap transaction engineered to prevent furtherhemorrhaging. BANADE's staff had devised a debt swap operation that produced anaccounting gain. The swap transactions involved a number of large borrowers that werein substantial arrears, and for which the bank had already significantly reserved forlosses. The basic operation consisted of the borrower exchanging Republic of Argentinarescheduled external debt, which it obtained in the secondary market at a very deepdiscount, plus a certain amount in cash, for its own obligation to BANADE. BANADEtreated the transaction as a swap of equal nominal values, with the difference that thenew asset it received from the borrower had the guarantee of the Republic of Argentina.To the extent that the original loan had been partially written down, the swap produceda double gain: the higher nominal value of the Republic of Argentina debt paperpresented by the borrower plus cash, and the recovery of the loan amount which hadalready been written down. However, the gains produced by the swap operation wereactually accounting gains derived from the assumption that both types of loans wouldhave eventually been paid off. Normally, these swaps should have been recorded at thecorresponding market values of the debt instruments--as commercial bank creditors havetypically done in reserving against Argentina's external debt. In that case the gainsrealized from the swaps, if any, would have been much lower.
20. Once the financial media revealed BANADE's problems, a number of borrowerssaw this as an opportunity to stop making payments on their loans. They based theiractions on the expectation that if BANADE had to be intervened and eventuallyliquidated, the process of resolving all pending debts would drag on for years. Thus, anyborrower in arrears would be at an advantage in negotiating a final settlement during theliquidation phase.
21. The first definitive step towards resolving BANADE's crisis was taken in March1990, when the Government issued Decree 435 calling for an end to BCRA's rediscountfacility for BANADE and named the Ministry of the Economy as the Interventor of thebank. Subsequently, in May of that year, Decree 866 outlined additional steps that wouldbe taken as a result of the intervention. These included the following:
* The closure of all branches.* Sale of BANADE's portfolio.
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* Reorganization of the bank into a wholesale operation.* However, BANADE was still permitted to lend to medium scale industrial
enterprises until January 1994.* Government debts to BANADE would be settled with Government
Consolidation Bonds.* BANADE was to produce an action plan to implement the reorganization
within 60 days.
22. BANADE's attempts at a restructuring were not successful. As a result, theGovernment issued a new Decree (No. 1504) in August 1992, which called for themerger of BANADE into BNA. BNA was named administrator of BANADE andassigned 180 days to determine the appropriate allocation of BANADE's assets andliabilities in consultation with the Ministry of the Economy.
23. Finally, in May 1993, the Government decreed the dissolution and subsequentliquidation of BANADE and its remaining assets and liabilities.
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ANNEX II
ANNEX TABLE 1
BANADE: STATEMENT OF CONDITION(Thousand of US$'s)
1988 1989 1990 1991
Cash and due from Banks 131,016 34,358 56,385 42,605
Investments in Other Co.'s 68,380 46,806 80,146 95,790Less: Reserves for Losses 43,773 29,714 57,271 59,532
Government Securities 9,794 16,814 10,729 7,521Total Net Investments 34,401 33,906 33,604 43,779
Net Interest Income 894,921 503,659 1,838,396 558,619Less: Loan Loss Provisions 602,177 251,480 667,659 701,773Net Interest Income After P 292,745 252,179 1,170,736 (143,155)
