HONDURAS ECONOMIC REFORM: DEPOSIT INSURANCE AGENCY

UNCLAS SECTION 01 OF 03 TEGUCIGALPA 002765

SIPDIS

SENSITIVE

STATE FOR WHA/CEN, WHA/EPSC, AND EB
STATE PASS AID FOR LAC/CAM
STATE PASS USTR
TREASURY FOR DDOUGLASS
COMMERCE FOR MSELIGMAN

E.O. 12958: N/A
TAGS: EFIN ECON PGOV HO IMF
SUBJECT: HONDURAS ECONOMIC REFORM: DEPOSIT INSURANCE AGENCY
STRENGTHENED

REF: A) 03 Tegucigalpa 2062

B) 04 Tegucigalpa 232
C) 04 Tegucigalpa 1984


1. (U) SUMMARY: In September 2004, at IMF insistence, the
GOH passed four banking reform laws aimed at strengthening
the nation's financial system. While the GOH missed the
IMF's target date by nearly three months, the laws passed in
late September do meet the terms of the IMF agreement and,
more importantly, should go a long way to strengthening the
country's fragile financial system. This cable focuses on
the deposit insurance agency reform law and is the first in
a series of four cables that will analyze each of the recent
laws, assess their impacts on the Honduran financial system,
and outline challenges of implementation or additional
needed reforms that remain.


2. (U) On September 22, the Honduran Congress passed a law
that reforms the Honduran deposit insurance agency, FOSEDE
(Fondo de Seguro de Depositos) in three major ways. First,
it simplifies FOSEDE's function, removing the responsibility
for resolving and recapitalizing stressed banks, so that
FOSEDE becomes strictly a deposit insurance fund. Second,
it leaves FOSEDE as the only deposit insurance agency
operating in the country, removing additional guarantees on
deposits that the GOH had provided since 1999. Third, the
law changes the way that FOSEDE is capitalized, adding some
sources of funding while removing others. These changes
should strengthen the financial system by giving FOSEDE a
clear mandate - to insure bank deposits - and by providing
it with sufficient capital to do that job, while greatly
reducing the financial costs and moral hazard implicit in
the earlier system. However, concerns remain that FOSEDE is
not sufficiently capitalized to handle a failure of one of
the country's major banks. END SUMMARY.

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BACKGROUND: THE NEED FOR REFORM
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3. (U) In May 2003, the IMF released its "Financial System
Stability Assessment" for Honduras, based on the work of a
joint IMF/World Bank Financial Sector Assessment Program
(FSAP). The report concluded that the Honduran banking
system is "highly fragile at a systemic level, impairing
sustainable economic growth," and outlined several reforms
needed to strengthen the system. (Ref A provides a summary
of this report and its recommendations.) The FOSEDE reform
law directly addresses two specific recommendations from
that report: "improve the framework for crisis management
and bank resolution" and "create the appropriate conditions
for a smooth transition towards a partial deposit
insurance." These recommendations were incorporated as
Structural Performance Criteria in the Letter of Intent
signed by the GOH and the IMF in February 2004 (ref B). The
Letter of Intent set a target date of June 30 for passage of
the four reform bills: the Deposit Insurance Law; the
Central Bank of Honduras Law; the Banking Commission Law;
and a new Financial Institutions Law. While the GOH missed
this deadline by nearly three months (ref C),the laws were
passed just in time for the IMF Board's six-month review of
Honduras' performance under the Poverty Reduction and Growth
Facility (PRGF) arrangement.


4. (U) The new FOSEDE law marks the third time in barely
five years that the GOH has overhauled its deposit insurance
scheme. However, this is the first time that the reforms
have been made pro-actively, as a result of deliberate
planning and technical analysis, rather than reactively, as
a sudden response to the political pressure generated by a
collapsing bank. The first deposit guarantee scheme in
Honduras was established 1999 when a major bank, Bancorp,
collapsed due to fraud and mismanagement. Regulators in the
National Commission for Banks and Insurance (Comision
Nacional de Bancos y Seguros, or CNBS) closed the bank, and
Congress created a temporary deposit insurance fund to
provide 100 percent compensation to depositors and preserve
the financial system's stability. The second overhaul came
in 2001, when the GOH created the current deposit insurance
agency, FOSEDE, to pay Banhcreser depositors following the
collapse of that bank (though depositors in uninsured
institutions associated with Banhcreser still lost their
savings).


5. (U) Even after FOSEDE was created, however, it still did
not bear sole responsibility for deposit insurance.
Instead, FOSEDE provided insurance for the first $9,633 per
depositor, per institution, and Congress continued to cover
the remaining amount, up to 100 percent of deposits. The
100 percent coverage was envisioned to be a temporary
arrangement, to give time for a sustainable restructuring of
the system. However, only limited restructuring and
consolidation took place. The first reduction in GOH
coverage, from 100 percent to 50 percent, was scheduled for
September 2002, but one week before the reduction was due to
take place, it was postponed for a year by Congressional
decree. GOH coverage was finally reduced to 50 percent in
September 2003 and on September 30, 2004, was removed
entirely, leaving in place only the guarantees provided by
FOSEDE.


6. (U) The financial and economic costs of 100 percent
coverage of deposits were substantial. Covering all
deposits is expensive and exposes the government to
insupportable financial liabilities. Nor could public
welfare be invoked to justify this added expense, since 98
percent of deposits in the Honduran banking system were
below $10,000 and hence were already covered by FOSEDE. In
other words, full coverage was a safety net that benefited
only the two percent of depositors who had bank deposits
over $10,000. (Comment: These politically influential
individuals were likely responsible for the government's
delay in removing 100 percent coverage. End comment.) Of
greatest concern, a 100 percent guarantee of deposits
creates moral hazard (that is, it establishes incentives for
increasingly irresponsible behavior) throughout the banking
system, as it undermines both bankers' and depositors'
incentives to manage the risks in their portfolios. The 100
percent guarantee provides depositors with an incentive to
place their savings in whatever bank pays the highest
interest rate, regardless of that bank's stability. To
attract these deposits, banks invest in increasingly risky
ventures to enable them to offer higher rates of return.


7. (U) FOSEDE also suffered from an overly-broad mandate
that did not allow it to focus on its core mission of
deposit insurance. Under its 2001 charter, FOSEDE was also
responsible for assisting stressed banks through
intervention and recapitalization. While there is no
inherent conflict in having these two functions reside in
the same institution, in practical terms the large costs
involved in taking over and recapitalizing stressed banks
detracted from FOSEDE's ability to act as a credible insurer
of deposits for the rest of the financial system.

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CHANGES UNDER THE NEW LAW
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8. (U) On October 29, EconOff met with President of FOSEDE
Rosa Lidia Montes de Oca to discuss the new law and the
changes that it would require. Unlike the President of the
Central Bank or the Banking Commission, who each serves four-
year terms, Montes was appointed in 2001 for a five-year
term, specifically designed not to correspond precisely with
the four-year electoral cycle, in the hope that the position
would be seen as more of a technical and less of a political
appointment.


9. (U) According to Montes, the September reform law
addresses all of the problems with FOSEDE described above.
By stripping FOSEDE of its function as a rescuer of ill
banks, the reform allows it to focus exclusively on its role
as a deposit insurance agency. The National Banking and
Insurance Commission, CNBS, now has responsibility for
resolving and recapitalizing stressed banks (septel).


10. (U) The new law also removes (as of September 30, 2004)
the additional deposit insurance that the GOH had provided
since 1999 and leaves FOSEDE as the only deposit insurance
agency operating in the country. Coverage for deposits in
insured institutions is therefore now capped at $9,633 per
depositor, per institution. This odd limit is an artifact
of the movement of the exchange rate between the drafting
and ratification of the original 2001 FOSEDE law. Depositor
protection was denominated in Lempira equivalent and is now
adjusted annually such that the dollar value does not vary.


11. (U) The reform law seeks to re-establish FOSEDE's
stability and reliability by modifying the way it is
capitalized. (Comment: This change is crucial. FOSEDE was
born with a negative net worth -- inherited from the
previous deposit scheme -- and went even further into debt
when it had to borrow from the Central Bank to rescue two
small banks in 2002. End Comment.) The new law provides
FOSEDE with a one-time grant of $25 million, of which $10
million is provided by the CNBS, and $15 million is made
available from the InterAmerican Development Bank's
Financial Sector Program (IDB loan number 1533/SF-HO). In
addition, all financial institutions covered by FOSEDE will
continue to make assessed contributions - presently 0.25 of
deposits annually -- but subject to future revision if
necessary. However, the law also states that once the
payment of $25 million is made, the Central Bank's
guaranteed line of credit to FOSEDE shall be removed,
meaning that FOSEDE will no longer be able to borrow from
the Central Bank as it has done in the past when it needed
funds.

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NEXT STEPS
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12. (U) FOSEDE is currently preparing the regulations for
the new law, with assistance from consultants paid for by
the World Bank and the IDB. Montes does not foresee this
implementation effort posing a major burden on FOSEDE, since
its function is being reduced, not expanded. However, she
said, it will take years to fully finance FOSEDE, even with
the $25 million infusion of cash that the new law provides
and a possible increase in assessments on member
institutions.

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COMMENT: FEARED JITTERS HAVE NOT MATERIALIZED...
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13. (U) Comment: The reform of FOSEDE, though technical and
circumscribed in scope, is an important example of a
Honduran economic policy success - one whose implementation
has gone better than some experts had expected. The
difficulty in achieving a smooth transition to a limited
deposit insurance system was one of the major concerns
raised by the 2003 IMF/World Bank FSAP report, which warned
that "the elimination of the blanket guarantee... by
September 2004 may produce market instability, given current
systemic weaknesses." In the event, there are no immediate
signs that this has been the case. CNBS officials have
expressed confidence that the successful passage of all four
financial reform laws before the September 30 elimination of
additional deposit insurance contributed to the stability of
the transition and boosted confidence across the financial
sector.

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...BUT THE REAL TEST LIES AHEAD
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14. (SBU) Comment (cont'd): However, two concerns remain.
The first, as mentioned above, is the fact that FOSEDE is
still not fully capitalized. FOSEDE President Montes made
it very clear that, now and for at least the next few years,
FOSEDE can only handle the failure of a small or medium-
sized bank. There remain, in other words, banks in the
system that are "too big to fail." Second, in the event of
another bank failure, would the Honduran Congress really
stand by and allow the wealthiest 2 percent of Honduran
account holders (including, of course, most members of
Congress) to lose their uninsured deposits? Post considers
it more likely that political pressures to intervene would
prove too strong to resist, as they did during the 2003
bailout of the agricultural sector that eventually cost the
GOH an estimated 1.7 percent of GDP. Despite these
concerns, however, Post believes that these financial
reforms, and the FOSEDE reform law in particular, constitute
a significant step forward toward stability of the Honduran
financial system.

Pierce