SUMMARY OF THE FINANCIAL SYSTEM ASSESSMENT OF

1. (SBU) SUMMARY. On April 28, 2003, the IMF staff submitted
to its Board of Directors the results of the Financial
System Stability Assessment (FSAP) performed by a joint
World Bank-IMF team between October 2002 and February 2003.
This cable contains a summary of their findings. In the
report, the Fund classified the financial system in Honduras
as "highly fragile" and "very vulnerable." The problems
within the financial sector merit immediate restructuring in
order to limit their adverse effects on sustainable economic
growth. The report contains five sections: (1) Monetary
Policy and Systemic Liquidity Management, (2) Financial
Structure and Regulation, (3) Money Laundering and Terrorism
Financing, (4) Financial System Soundness and Stability, and
(5) Crisis Management Framework and Recommendation. This
cable highlights the key findings of the report in order to
assist Washington policymakers in understanding the critical
problems in the Honduran financial sector and the key
objectives of the World Bank's new financial sector project
(approved in June 2003). This information, while
unclassified, is highly sensitive and should be kept close

SIPDIS
hold by policymakers. End Summary.



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Monetary Policy and Systemic Liquidity Management


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2. (SBU) Although generally favorable on the role of the
Central Bank of Honduras (CBH), the FSAP expressed concern
about its management of the foreign exchange market through
daily auctions. The authors noted that, although focusing
primarily on the stability of the exchange rate to maintain
price consistency, the program is directed at reducing
inflation by reducing liquidity in the market, a policy that
emphasizes control of the money base rather than the
exchange rate.



3. (SBU) Thanks to foreign investment and other inflows as a
result of Hurricane Mitch relief efforts, the level of
foreign currency has contributed to a relatively stable
foreign exchange market. However, this could change in the
future. The report urged that the restrictions on the
foreign exchange auction be modified and simplified. The
FSAP suggests using the marginal market-clearing price for
foreign currency (Dutch auction) rather than the individual
bidding price (American auction) to determine the winning
bids in the exchange auctions.



4. (SBU) Another monetary policy vulnerability noted is the
foreign exchange surrender requirement for banks and
exchange houses. These institutions are not allowed to
supply foreign exchange demands with their foreign exchange
purchases. As a part of this restriction, the CBH requires
them to surrender 100 percent of their foreign exchange
purchases on the next business day. However, it takes two
business days for the institutions to receive the purchased
foreign currency. The FSAP recommends lowering the
percentage surrender requirements as well as decreasing the
time between purchasing foreign currency and acquiring it.
This would then allow for greater efficiency in the banking
sector in the short run.



5. (SBU) To limit the growth of the monetary base
(countering the weekly foreign exchange auctions), the CBH
used central bank securities (Certificados de Absorcion
Monetaria, or CAMs) to stabilize the level of net foreign
assets. This resulted in large quasi-fiscal costs that have
created an increased deficit for the CBH and added to the
vulnerability of the CBH's financial position. To counter
these potential weaknesses, the FSAP suggests that Honduras
strengthen the money market to include liquidity management.



6. (SBU) The FSAP proposes increased transparency and
openness in the Central Bank's operations. The assessment
also warns against a dollarization policy in Honduras (a
view shared by the GOH). Dollarization in Honduras would
constrain the CBH's capacity to implement monetary policy
and would increase liquidity risks in the financial sector,
among other problems.



7. (SBU) Another important area of monetary policy falls in
the domain of debt management. The report's authors
recommend better strategy coordination between fiscal and
monetary authorities. Additionally, the authors suggest
development of a market-oriented government funding strategy
that would include development of a secondary bond market.



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Financial Structure and Regulation


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8. (SBU) While the FSAP recognizes the improvements in
National Banking and Insurance Commission's regulation of
the financial sector over the last few years, it mentions
five critical flaws that require immediate correction.
First, the FSAP authors suggest that the CNBS consolidate
its operations to ensure the widespread application of laws
and regulation monitored by a centralized, regulatory body.
Second, the capital requirements need to be addressed.
Reserves are insufficient to absorb expected losses, so
unexpected losses cannot be covered. Tightening of the
capital requirements would help to end the inflated
accounting of capital and provide sufficient reserves to
back any expected losses. Third, loan classification and
provisioning require improvement. The Honduran standards
for loan provisioning fall well below the norms of other
Central American countries. After Hurricane Mitch in late
1998, the government adopted a series of measures granting
debt forgiveness and tolerated a high number of non-
performing loans in the banking system. These policies need
to be restructured. Fourth, the report recommends that the
CNBS promote accountability for minimum corporate governance
requirements. For example, a written loan origination
manual for each bank would help create a sustainable risk
management system as well as enhance corporate governance in
the banking sector. Finally, the CNBS needs to transform
from a purely supervisory body to a "more risk-oriented,
forward-looking" agency. To achieve this transformation,
the CNBS should expand its actions to encompass more than
checking for compliance.



9. (SBU) The legal framework for the banking system is
another area addressed in the FSAP. The report notes the
severe problems in Honduran property registration. The
process is slow, obsolete, subjective, and risky.
Bankruptcy law is another distinctive problem area (almost
never used in Honduras). Companies tend to close their
business without concern for outstanding debt, partially
stemming from lack of faith in the judicial system. To
combat these inefficiencies and the problems they pose for
the financial sector, the GOH needs to encourage new
legislation to update property registration and bankruptcy.



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Money Laundering and Anti-Terrorism Financing


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10. (SBU) The FSAP recognized that the March 2002 law to
combat money laundering (ML) represented a significant step
for the country in this area. Under the new law, there are
now stiffened penalties for money laundering as well as
increased preventive measures. The law enhances the
capacity of law enforcement officials to combat this crime
and broadened classification of ML offenses (combined with
expanded mandates for confiscation of assets) will assist
officials in the investigation and prosecution of suspected
money launderers.



11. (SBU) The FSAP authors cautioned that the implementation
process remains riddled with potential setbacks. Limited
resources, both in funding and training, could hamper the
effectiveness of the legislation. Officials need training
and experience to combat money laundering. They also lack
useful technological resources, such as access to software
capable of detecting suspicious transactions. Without such
technology, employees are reduced to manual means of
detection, which creates opportunity for human error and
corruption. In addition, without strategic cooperation,
various governmental entities risk duplicating law
enforcement efforts. To eliminate this waste of scarce
resources, the roles and responsibilities of each
organization need to be clearly delineated.



12. (SBU) The authors emphasized the limited legal scope of
the Honduran money laundering law in the area of terrorism
financing. Terrorism financing is listed as potential
grounds for a money laundering charge but is not identified
as a crime in and of itself. The FSAP recommends that the
GOH identify a competent body to address this issue and to
have an explicit mandate to freeze assets of suspected
terrorists. Note: The CNBS has in fact issued a large
number of freeze orders of assets held by terrorists since
September 2001 and the financial system has complied with
these freeze orders in a prompt fashion. No terrorist
assets have been found in Honduras to date, however, so the
legal authority has not been tested. End Note.



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Financial System Soundness and Stability


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13. (SBU) The FSAP classifies the financial system in
Honduras as highly fragile, especially the banking sector.
Although the capital adequacy ratios and provision coverage
are improving, the tendency to overstate capital and hide
losses renders the system vulnerable and limits the
country's potential for economic growth. With the banks
earning close to zero profits, a cushion to absorb any
shocks to the financial sector does not exist.



14. (SBU) The combination of the repeated agricultural loan
forgiveness measures and the blanket deposit guarantee
contribute to severe moral hazard and fiscal contingency
problems. These programs, designed to assist struggling
farmers after the devastation of Hurricane Mitch, have
created large numbers of non-performing loans (NPLs) that
weaken the asset quality of the banks.



15. (SBU) Cooperatives, which are not regulated by the CNBS,
appear to have less liquidity than Honduran banks. Although
the figures for the cooperatives are not official, the
liquidity percentage of total assets (16 percent) is
reported at about half of Honduran banks (31.7 percent). A
high number of overdue loans have contributed to this lack
of liquidity in cooperatives.



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--
Crisis Management Framework and Recommendations


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16. (SBU) The 100 percent guarantee of deposits, enacted in
1999, stabilizes the banking sector through protection of
depositors. The temporary stabilization should have enabled
a sustainable restructuring of the system to occur in the
last three years. However, only limited restructuring has
occurred, and the fiscal costs are mounting. The blanket
coverage of deposits becomes an incentive to potential risk-
takers, which contributes to the instability of the banking
system. Additionally, the continual coverage of deposits by
the Deposit Insurance Fund, FOSEDE, has created a negative
net worth for this fund. This, in turn, undermines consumer
confidence in the value of FOSEDE as a true financial safety
net.



17. (SBU) The FSAP report suggests that the GOH move quickly
toward a limited deposit insurance system. The report
recommends additional transparency within FOSEDE.
Disclosure of goals and financial information in an annual
report would instill a higher level of confidence in the
FOSEDE, which now operates under a veil of confidentiality.



18. (SBU) The transition to a limited deposit insurance
system requires certain conditions to exist before
implementation. First, the report suggests that all
insolvent banks should close operations. Second, the CNBS
should monitor the finances of reporting institutions and
intervene at the first sign of problems. Third, FOSEDE must
have a positive net worth. Fourth, the financial system
must have a strong liquidity potential coupled with a stable
macroeconomic framework. These elements would help prevent
difficulties in the transition from a blanket coverage
policy to a limited deposit insurance guarantee.



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COMMENT


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19. (SBU) The FSAP report is a valuable diagnostic tool that
will help the GOH, the various multilateral institutions in
Honduras, and bilateral donors in efforts to head off a
future financial crisis. A careful reading of the report
also provides cautionary warnings. None of these problems,
which were years in the making, will disappear easily.
Many, such as cleaning up the bad loan portfolios and
rationalizing property registers, will require financial
resources far beyond the GOH's means. Others, the
transfer from a blanket deposit guarantee policy to a
limited deposit insurance guarantee, have been shied away
from in the past because of their potential to
unintentionally trigger the financial crisis that everyone
seeks to avoid. The Embassy, in particular USAID and the
Economic Section, are staying in close touch with the GOH,
the World Bank, and the IDB to ensure complementarity among
our respective assistance programs (including AID-funded
work with the Banking Commission and a Treasury money
laundering technical assistance project). End Comment.

PALMER