US embassy cable - 05TEGUCIGALPA252

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