HONDURAS BANKING REFORM: FINANCIAL SYSTEM LAW MOVES

UNCLAS SECTION 01 OF 04 TEGUCIGALPA 000252

SIPDIS

SENSITIVE

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

E.O. 12958: N/A
TAGS: EFIN ECON PGOV HO IMF
SUBJECT: HONDURAS BANKING REFORM: FINANCIAL SYSTEM LAW MOVES
BANK SUPERVISION TOWARD GLOBAL STANDARDS

REF: A) 04 Tegucigalpa 2765

B) 04 Tegucigalpa 2826
C) 05 Tegucigalpa 8
D) 03 Tegucigalpa 2062
E) 04 Tegucigalpa 232


1. (U) SUMMARY: In September and October 2004, the GOH
passed four banking reform laws aimed at strengthening the
nation's financial system. This is the last in a series of
four cables that analyze each of these laws, assess their
impacts on the Honduran financial system, and outline
challenges of implementation and additional needed reforms
that remain. Previous cables analyzed the reforms of the
deposit insurance agency (ref A),the Central Bank (ref B),
and the Banking Commission (ref C); this cable focuses on
the Financial System Law.


2. (U) The Financial System law (Decree No. 129-2004)
delineates the responsibilities of the Banking Commission
and the Central Bank to supervise and regulate the country's
financial sector. The overriding objective of the law is to
bring Honduran financial sector regulation into compliance
with the internationally recognized Basel core principles
for effective banking supervision. The law also strengthens
the previously ineffective national credit bureau and
imposes new restrictions on bank ownership and management.
While the current leadership of the Banking Commission has
the respect of both government officials and the private
sector, full implementation of the new law will take time
and will require additional training of Banking Commission
officials. End summary.

--------------
Background: The Need for Reform
--------------


3. (SBU) As summarized in ref D, a 2003 joint IMF/World Bank
"Financial System Stability Assessment" for Honduras
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. These reforms were then incorporated into the
Letter of Intent signed by the GOH and the IMF in February
2004 (ref E),which required the passage of four financial
sector reform bills: the Deposit Insurance law; the Central
Bank of Honduras law; the Banking Commission law; and a new
Financial System law.


4. (SBU) Specifically, while the report acknowledged that
financial system regulation and supervision had improved in
recent years, it found that important areas remained weak
and required urgent action; the first of the report's four
key recommendations was in fact to "strengthen prudential
supervision and regulations." Until 1995, the supervision
of Honduran banks was the responsibility of the Central
Bank. The Banking Commission was created in 1995, but the
Central Bank continued to supervise the banking system until
1998, so the Commission has had only a limited number of
years of experience in supervising the Honduran banking
system. Furthermore, the Commission operated under a very
restrictive legal framework, which allowed corrective
actions in response to a crisis, but severely limited the
Commission's ability to proactively manage risk and avert
potential crises before they took place.

--------------
Changes in the New Law
--------------


5. (U) EconOff met on December 1 with Joaquin Alcerro, Chief
Legal Advisor at the Banking Commission and on December 8
with Maria Lydia Solano, Executive Director of the Honduran
Association of Banking and Insurance Organizations (AHIBA),
the private sector banking association, to discuss the
contents and implications of the new law.


6. (U) Of the four financial reform laws passed in
September, the Financial System law is by far the longest
and most important. Unlike the other three laws, which
simply listed amendments and additions to existing
legislation, the Financial System law is an entirely new
piece of legislation, as the changes envisioned were
considered substantial enough that an entirely new legal
framework was needed. As a result, this was the last and
the most difficult law of the four for Congress to pass in
September; Banking Commission President Ana Cristina Mejia
de Pereira spent many days in Congress going through the
law, article by article, and explaining its implications to
the congressional committee responsible.

7. (SBU) The law was also developed in close consultation
with the private sector, represented by AHIBA. Solano
stated that she was very pleased with the co-operation
between the Commission and the private sector as the law was
being drafted. While certain aspects of the law met with
resistance from some bankers (especially those in some of
the older, family-run banks),Solano says that there is
nothing in the law that the banking sector cannot accept and
that bankers are generally very happy with the clarity that
the law provides, unambiguously delineating the
responsibilities of Banking Commission versus the
responsibilities of the banks themselves. Solano also
praised the new law for providing banks with sufficient time
to adjust to the new, tighter regulatory structure. This
had been a fear of some bankers, who had previously
expressed concern that the IMF's recommendations for
financial sector reform would be imposed in a sudden and
severe way that would impose an unreasonable burden upon
Honduran banks.

--------------
Preventative Medicine
--------------


8. (U) According to Alcerro of the Banking Commission, the
single most important change created by the new law is the
granting to the Banking Commission of wider legal authority
to intervene in the affairs of troubled banks before they
are at the point of collapse. Speaking to the press after
the law was passed, Banking Commission President Mejia also
emphasized this change, summing up the law's key function as
"converting the Commission's role from one of curative
supervision to one of preventative supervision."


9. (U) Previous legislation gave the Banking Commission
virtually no authority to administer preventative medicine -
that is, the Commission could intervene in a troubled bank
only once the bank had reached a crisis point. The new law
gives the Commission the legal authority to intervene much
earlier, when the first signs of bank fragility appear,
demanding complete information from the bank on its
portfolio and imposing measures on the bank to minimize its
risk. As a result, the Commission will be able to play a
much more proactive role in investigating and maintaining
the health of troubled financial institutions. Note that
with this greater authority comes a greater responsibility
for the Commission to act impartially and apolitically,
since it now may impose stricter requirements upon some
banks than upon others, at its discretion.

--------------
A More Effective Credit Bureau
--------------


10. (U) The law should also greatly increase the
effectiveness of the national credit bureau. While a credit
bureau already existed in Honduras, it was of very limited
usefulness, as previous legislation required financial
institutions to report information only on their debtors who
owed at least 300,000 Lempiras (currently about $16,100).
As a result, the information that the credit bureau could
access was incomplete and gave only a partial picture to
other financial institutions of the true risk involved in
lending to certain individuals. The new legislation grants
the credit bureau access to a bank's entire portfolio of
loans.


11. (SBU) In addition, the new law explicitly resolves a
conflict that had earlier hampered the functioning of the
credit bureau. Previously, there had been some ambiguity in
Honduran law concerning the responsibility of banks to
report information to the regulating authorities and the
duty of banks to keep customer information confidential.
The Financial System law clarifies this ambiguity,
explicitly stating that provision of information demanded by
regulatory, judicial, or other legal authorities shall not
be regarded as an improper divulgence of confidential
information. (Note: The issue of bank secrecy is often
raised in conjunction with security concerns, since wealthy
Hondurans and their family members are often targets of
kidnapping. While kidnapping has decreased in recent years,
it is still a serious security concern on the part of
wealthy Honduran families. Many people express doubt that
customer information will truly remain confidential if all
such information is being reported to the credit bureau
under the aegis of the Commission. End note.)

--------------
Bank Management and Conflict of Interest
--------------


12. (SBU) The law also includes completely new regulations
on the permitted make-up and activities of a bank's board of
directors. Under the new law, no one may serve on the board
of more than one financial institution, no one with an
outstanding non-performing loan may serve on a bank's board,
and no more than one-third of a bank's board of directors
may be immediate relatives of one another. An article
entitled "conflict of interest" forbids a bank board member
or his family members to be present at a bank meeting when a
matter pertaining to their own economic interests is being
discussed. (Note: To Post's knowledge, this is the first
time that the phrase "conflict of interest" has ever
appeared in a piece of Honduran legislation. End note.)


13. (SBU) These provisions, if properly enforced, aim at a
key problem of the Honduran banking system, namely the close
family nature of many Honduran banks, and related-party
lending (the frequent granting of questionable loans to
friends, family members, or business partners). However,
some of these measures could well be watered down by weak
regulations - an article addressing nepotism, for example,
states only that the employment of relatives as "senior
officials" of a bank will be subject to a policy that the
Banking Commission has yet to establish.

--------------
Financial Crimes
--------------


14. (SBU) The first draft of the law that the Banking
Commission sent to Congress included articles on financial
crimes and the penalties for such crimes. However, at the
time, certain Congressmen protested that financial crimes
and their penalties should be described in the penal code,
not in a law about the structure of the regulatory system.
As a result, those articles were removed from the Financial
System law and prepared as a separate reform to the Penal
Code. This law was approved by Congress in December and
will be discussed in more detail septel.

--------------
Implementation and Next Steps
--------------


15. (SBU) The Banking Commission is currently preparing the
regulations for the new law, with assistance from
consultants paid for by the World Bank and the IDB.
However, the key question is whether or not the Banking
Commission has the capacity to carry out the more wide-
ranging and pro-active role established for it by the new
law. After all, the World Bank and IMF declared bluntly in
their 2003 assessment that "the Commission has limited
capacity to supervise banks on an ongoing basis," and the
new law only adds to the Commission's responsibilities,
without granting it any increased budget or resources to
meet these responsibilities.


16. (SBU) When asked about the Commission's capacity to
implement the new law, Alcerro (the Commission's legal
advisor) acknowledged the need for greater training and
increased staff but placed greater emphasis on the danger
that certain political interests will be opposed to the
complete implementation of the law's provisions. The
biggest problem of the Honduran banking system, according to
Alcerro, is the granting of loans to related parties. Many
political figures, including Congressmen, are also owners or
board members of Honduran banks. Just as there was some
resistance in Congress to the passage of the Financial
System law, Alcerro predicts that this pressure will persist
and manifest itself in a lack of co-operation on the part of
some banks that, because of their involvement in loans to
related parties, would not welcome closer investigation and
supervision from an independent commission.


17. (SBU) EconOff also asked Solano of AHIBA her opinion of
the Banking Commission's capacity to implement the new law
and to bring Honduran bank regulation up to Basel Standards.
Solano's answer focused almost entirely on the individuals
involved. She stated that the banking sector has tremendous
confidence in the current president of the Banking
Commission, Ana Cristina Mejia de Pereira, for two reasons.
First, Mejia is herself a former banker, so the private
sector respects her as one of their own. Second, she is
considered close to President Maduro and therefore, it is
hoped, would have the political support required to take
difficult actions if necessary. (Note: President Maduro is
himself a former President of the Honduran Central Bank and,
as a result, has a far better understanding of banking
issues than the average Honduran politician. End note.)
However, Solano cautioned, if Mejia and the current team of
Banking Commission leaders were replaced by a more political
group, the private sector would be very concerned.

--------------
Comment: A Greatly-Improved System
--------------


18. (SBU) Comment: The new Financial System law, along with
the other three financial sector reform laws passed at the
same time, unquestionably represent a major improvement in
the legal framework governing Honduras' historically-
fragile financial sector. The thorough and far-reaching
nature of these legal reforms testifies to the GOH's
commitment to implement the IMF program and to its
willingness to address long-standing structural impediments
to economic growth, even at the risk of offending certain
politically-influential individuals in the banking sector.
The GOH now faces the task of full and effective
implementation of this greatly-improved framework. While
bringing the legal framework for financial sector oversight
into compliance with international standards on paper is a
significant achievement, conducting financial supervision in
a manner consistent with these standards in practice is a
much more difficult process. End comment.

Palmer