US embassy cable - 04TEGUCIGALPA2765

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 
------------------------- 
 
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... 
--------------------------------------------- --- 
 
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