## _pdp03

## Source details

**Canonical URL:** [_pdp03](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2003/_pdp03.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2003/_pdp03.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2003/_pdp03.pdf.json)

---

### Banking Market Access Restrictions in Central America — country provisions
- Costa Rica
  - Foreign banks are allowed to establish wholly owned subsidiaries of foreign banks, but not branches.
- Dominican Republic
  - Foreign banks may establish subsidiaries, branches, or agencies when authorized by the Monetary Board.
  - Foreign branches are subject to capital requirements.
  - They must submit a feasibility study justifying the economic need.
  - In its commitments under the 1997 Financial Service Agreement (FSA), the Dominican Republic indicated that the equity participation of foreign investors in banks is restricted to 49 per cent of the subscribed and paid-up capital.
- El Salvador
  - Foreign banks may establish subsidiaries, branches, or representative offices.
  - Foreign branches are subject to capital requirements.
  - At least 75 percent of ownership of shares in banks or finance companies must be maintained for the following persons:
    - (a) Salvadorian or Central American natural persons;
    - (b) Salvadorian legal persons whose shareholders or majority members are the natural persons referred to in the preceding subparagraph;
    - (c) Central American banks in whose country of origin there is supervision in accordance with relevant international practices and which meet the legal and regulatory provisions in force in their country of origin;
    - (d) Foreign banks and other financial institutions in whose country of origin there are prudential regulations and supervision in accordance with relevant international practices and which are classified as first grade financial institutions by internationally recognized risk rating companies; as well as companies controlling first grade foreign banks and other financial institutions subject to consolidated supervision in accordance with relevant international practices.
- Guatemala
  - Foreign banks may establish subsidiaries, branches, and representative offices.
  - Foreign branches are subject to capital requirements.
  - In its commitments under the 1997 Financial Service Agreement (FSA), Guatemala indicated that employees must consist of 90 percent Guatemalan workers who must receive 85 percent of total wages.
  - Training of Guatemalan personnel is required in specialized fields.
- Honduras
  - Foreign banks may establish subsidiaries, branches, and representative offices, subject to authorization from the Central Bank of Honduras (BCH) and a National Commission.
  - The BCH can refuse such authorization when the home country does not grant reciprocity.
  - The types of entry restrictions on foreign banks depend on how they deliver financial services (through branches, subsidiaries, representative offices, etc.).
  - Subsidiaries and branches can undertake the same operations permitted for domestic banks.
  - The legally-established branch offices are subject to the same laws, regulations and resolutions as national entities, including capital requirements, except where international treaties to which Honduras is a party stipulate otherwise.
  - Foreign bank representative offices can only conduct asset operations (granting credit or making investments) not liability operations in the country.
- Nicaragua
  - Foreign banks may establish subsidiaries, branches, and representative offices.
  - Before opening, the foreign branch has to meet all the prerequisites established for banks to operate in Nicaragua.
  - The branch will be considered a resident of the state for any legal purpose and must abide by all the laws in Nicaragua, including capital adequacy requirements.
  - Representative offices can issue credits and invest in the country but can not accept deposits from the public.

### Notable quantitative restrictions and operational constraints
- Quantitative restrictions and requirements
  - Dominican Republic: equity participation of foreign investors in banks restricted to 49 per cent of the subscribed and paid-up capital.
  - El Salvador: at least 75 percent of ownership of shares in banks or finance companies must be maintained for specified domestic or qualifying regional/foreign entities.
  - Guatemala (FSA commitment): employees must consist of 90 percent Guatemalan workers who must receive 85 percent of total wages.
- Operational and supervisory constraints
  - Capital requirements apply to foreign branches in Dominican Republic, El Salvador, Guatemala, and Nicaragua.
  - Honduras: authorization by BCH and National Commission required; refusal possible when home country does not grant reciprocity.
  - Nicaragua: foreign branches are treated as residents and must abide by all Nicaraguan laws, including capital adequacy.
  - Representative office limits:
    - Honduras: representative offices limited to asset operations, not liability operations.
    - Nicaragua: representative offices can issue credits and invest but cannot accept deposits from the public.

### Prudential measures, trade agreements, and transfers
- Prudential measures and dispute settlement
  - U.S.-Singapore prudential language: “maintenance of the safety, soundness, integrity or financial responsibility of individual financial institutions or cross-border financial service suppliers” (emphasis added).
  - U.S. bilateral agreements: parties may not stipulate targets for the nationality of senior managerial personnel; investors may initiate state-to-state or investor-to-state dispute settlement before panels which will reach final and binding arbitration.
  - NAFTA and U.S. bilateral agreements use negative list approach; FSA uses positive list approach.
  - Example: Mexico removed foreign provider market share limits ahead of 2000 transition after 1994 crisis; NAFTA credited with substantial increase in foreign presence in Mexican financial system since mid-1990s.
- Implications for capital account restrictions
  - Effects depend on service and mode of supply: liberalizing cross-border deposit taking essentially requires liberalization of corresponding capital account flows; financial advisory services should not have important implications for the capital account.
  - GATS provisions: capital inflows permitted only if “essential” for cross border supply and “related” to establishment; safeguards allow reimposition of capital account restrictions for balance of payments problems or to safeguard financial stability.
  - U.S. bilateral agreements (example U.S.-Chile): “Transfers” include transactions in capital account and current account (dividends, interest, royalty); investors may effect transfers immediately, in a freely usable currency, and at the market rate of exchange.
  - Under U.S. agreements parties may restrict transfers, but measures subject to compensation after dispute settlement following a “cooling off” period of one year (six months in the case of long term flows); compensation applies if measure in effect for less than that period but impedes investor operations substantially, and in all cases where the measure is in effect for longer.
  - NAFTA has similar transfer language but may be overruled in situations of balance of payments difficulties or at the request of the IMF.
  - Preconditions for liberalization of short term capital flows include: macroeconomic stability, appropriate exchange rate policies, and adequate financial supervision, particularly of banks’ risk management capabilities.
  - Central American parties to CAFTA currently impose very few capital controls; committing to free transfers per U.S. bilateral definitions should not substantially change status quo but surrendering future option to impose such measures could raise concerns about crisis management.

### The case for “open regionalism” and GATS interaction
- CAFTA characteristics and risks
  - CAFTA’s financial services chapter likely to use a more transparent negative list approach and stronger commitments regarding free transfers and dispute settlement than the FSA.
  - CAFTA may discriminate against third-country suppliers; incentives point toward agreements exceeding WTO commitments.
  - Efficiency and legal considerations argue for balanced, coherent obligations across CAFTA and WTO to avoid first-mover advantages to inefficient providers and preserve bargaining power in multilateral negotiations.
- GATS Article V requirements and rules of origin
  - GATS Article V: regional agreements must cover substantially all trade, remove substantially all discrimination between parties, and not raise overall barriers to suppliers from outside the agreement.
  - GATS Article V.6 liberal rules of origin: juridical person constituted under laws of a party is entitled to treatment under the agreement provided it engages in substantive business operations in the territory of the parties.
  - NAFTA example: liberal rule of origin enabled non-NAFTA providers to enter Mexican market via U.S. subsidiaries.
- Recommendation
  - Central American countries are advised to expeditiously table offers corresponding to CAFTA commitments under ongoing GATS negotiations to gain multilateral leverage and avoid legal uncertainty; CAFTA expected to conclude by end 2003 but WTO negotiations will conclude later.

### Potential effects, impediments to integration, and country-specific deterrents
- Overview
  - Assessing CAFTA effects on CAFTA-6 financial sectors is speculative due to unclear substance and transition periods.
  - If market access restrictions continue on prudential grounds, primary effects will be enhanced regulatory clarity, predictability, and greater investor confidence via transparent dispute resolution.
- Determinants of foreign bank entry
  - Profitability and market size (fixed costs, economies of scale).
  - Strong nonfinancial trade and foreign direct investment links — “banks follow their clients”.
  - Regulatory environment quality; corruption and inefficient contract enforcement raise costs.
- CAFTA likely impacts
  - Reduce risks to contract enforcement through common transparency standards, enshrined transfer rights, and independent arbitration — reducing credit risk and transfer risk.
  - May harmonize regulation and strengthen cross-border supervision, enlarging effective market size and attracting foreign providers.
- Regional weaknesses and country deterrents
  - Regulatory, judicial, and institutional frameworks in several Central American countries lag peers.
  - Five of the CAFTA-6 have inefficient bankruptcy procedures; scores for contract enforcement and credit market information in several countries are comparable or sometimes higher than Mexico.
  - Costa Rica: three state-owned banks account for over half of assets; public sector monopoly in insurance; state guarantee on liabilities and tax exemptions on dollar deposits.
  - Honduras: legally mandated debt restructurings in agricultural sector provided debt forgiveness and interest relief—government interference can undermine credit culture and raise expectation of bail-outs.

### Benefits and risks of foreign entry
- Potential benefits
  - Upgrading of skills and technology.
  - Enhanced competition lowering interest margins and improving access of domestic firms to external finance.
  - Foreign institutions likely to hold higher quality assets and reduce volatility due to parental backing, superior risk management, and home country supervision.
  - Greater scope for risk sharing may be important given Central American economies are open, relatively undiversified, and subject to common shocks.
- Potential risks
  - Greater capital mobility may induce greater real exchange rate variability and financial risks from unhedged foreign exchange liabilities.
  - Subsidiaries of foreign banks may cut credit lines in parallel with parent withdrawals.
  - Intensifying competition may reduce franchise value of domestic banks, inducing excessive foreign borrowing and domestic credit expansion that impairs loan quality.
  - Weak prudential supervision and expectations of public bail-outs exacerbate moral hazard.

### Adjustment needs — macroeconomic and prudential policies
- Macroeconomic policy priorities
  - Manage financial market expectations; avoid impressions of exchange rate stability that induce unhedged foreign currency exposures.
  - Exchange rate regimes (predominantly crawling pegs; El Salvador dollarization) may constrain lender of last resort functions.
  - Fiscal policy must provide adequate funding for liquidity support schemes to respond credibly to incipient banking crises.
- Prudential policy priorities
  - Converge incentive structures across Central America.
  - Effective consolidated supervision of financial conglomerates (including offshore banks) to prevent weakest supervisory authority from attracting risks.
  - Harmonization via adoption of international standards and closer cooperation between supervisors, potentially facilitated by CAFTA provisions on regulatory cooperation, reciprocal information exchange, and technical assistance.

### Key prudential areas for supervisors — findings and standards
- Capital adequacy
  - Capital adequacy requirements:
    - Costa Rica, the Dominican Republic, Guatemala, Honduras, and Nicaragua: 10 percent of risk adjusted assets.
    - El Salvador: currently at 11 percent, will be increased to 12 percent by 2005.
  - All are above the Basle Committee standard of eight percent of risk adjusted capital.
  - Enforcement needs: adequate accounting and auditing standards (asset valuation, loan classification, provisioning, depreciation).
  - FSAP findings: lack of effective consolidated supervision casts doubt on reported capital figures; loan classification and provisioning rules often lenient, excessive reliance on collateral, rules based on past performance rather than repayment capacity; absence of rules preventing “evergreening” of loans.
- Prudent risk management
  - Enforce limits on institutions’ scope for taking exchange rate risk amid high and increasing dollarization.
  - Currency depreciation could affect bank solvency when banks or borrowers face currency mismatches.
  - Current practices (summary of Table 3):
    - All countries except Nicaragua and Honduras impose limits on net open foreign exchange positions.
    - Only Honduras and the Dominican Republic appear to impose limitations based directly on borrower’s capacity to honor obligations.
  - Dollarization concerns: El Salvador’s full dollarization could become a springboard for capital flows into the region.
  - Foreign currency deposit shares in total deposits (excluding El Salvador):
    - Nicaragua: 71 percent
    - Costa Rica: 43 percent
    - Honduras: 33 percent
- Financial sector and corporate discipline
  - Need strong supervisory authority with independence and legal protection from actions by troubled banks.
  - Legal framework required for resolution of bank problems: financial disclosure, timely corrective actions, appropriate bank exit policies, intervention and management replacement.
  - FSAPs reveal profound deficiencies: regulatory forbearance, creative rescue operations, absence of legal protections for supervisors, monitoring weaknesses leading to fraud (cited cases: Dominican Republic and Nicaragua).
- Viable deposit insurance and liquidity support
  - Lender of last resort and deposit insurance are key to depositor confidence and rescuing solvent but illiquid institutions.
  - Moral hazard considerations necessitate incentive-compatible insurance design; region faces substantial work in this area.

### Table 3 — summary of FX position and credit operation regulations (as presented)
- Open foreign exchange position limits (marked X in source): Costa Rica, Dominican Republic, El Salvador, Guatemala.
- Limits to lending locally in foreign exchange (marked X in source): Dominican Republic, Honduras.
- Differential treatment of deposit accounts in foreign exchange: reserve and liquid asset requirement measures noted for Dominican Republic and Honduras.
- Source for table: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, AREAER, and country authorities.

### Deposit Insurance Schemes in Central America — summary, country practices, and key statistics
- Regional summary
  - Five of the six countries have some form of explicit deposit guarantee in place, though in the Dominican Republic this covers only savings and loans institutions.
  - Costa Rica provides a guarantee for deposits only in the three state-owned banks.
  - Most explicit deposit insurance schemes have been introduced over the last few years and are still undercapitalized, presenting a substantial contingent fiscal liability, and undermining confidence in the financial sector as a whole.
- Country-by-country descriptions
  - Costa Rica
    - Three state-owned banks enjoy full state guarantee on all their liabilities but no deposit insurance is in place for private banks.
    - Draft amendments to the central bank and banking law presented to Congress at end-2002 sought to introduce, among other things a limited coverage, privately funded, deposit insurance for private banks.
  - Dominican Republic
    - While no explicit deposit insurance scheme exists, except for deposits in savings and loans, an implicit deposit insurance scheme seems to operate since the central bank has returned deposits in failed institutions.
  - El Salvador
    - A deposit insurance scheme is managed by the Deposit Guarantee Institute (IGD). The institute provides, in principle, limited deposit insurance to banks, but currently lacks resources since it is at its capitalization stage.
  - Guatemala
    - A limited deposit insurance scheme was instituted in 1999 by the Law for the Protection of Savings (FOPA Law). The explicit deposit insurance scheme contemplated under the FOPA Law has not started to operate because a number of banks has refused to agree to the contract creating the trust fund that will administer the banks’ contributions.
  - Honduras
    - An explicit deposit insurance fund (FOSEDE) guarantees a maximum of L150,000 per depositor, per financial institution.
    - A total of L308,959,217 was available as of December 31, 2002.
    - FOSEDE collects fees from its members, but also has access to an unlimited and automatic line of credit from the central bank in case the required payment of deposits exceeds the amount of its available liquid assets.
    - In addition, the government is responsible for the remainder up to the full amount of such deposit.
    - The blanket guarantee will be reduced to 50 percent in September 2003 and then eliminated in September 2004, while the limited deposit insurance will remain unchanged.
  - Nicaragua
    - The explicit deposit insurance fund (Fondo de Garantía de Depósitos, FOGADE) covers up to US $ 20,000 per depositor.
- Key statistics and dates preserved verbatim
  - L150,000 (maximum guarantee per depositor, Honduras)
  - L308,959,217 (available in FOSEDE as of December 31, 2002)
  - end-2002 (timing of draft amendments presented to Congress in Costa Rica)
  - 1999 (institution date of Guatemala's FOPA Law)
  - September 2003 (scheduled reduction of Honduras blanket guarantee to 50 percent)
  - September 2004 (scheduled elimination of Honduras blanket guarantee)
  - US $ 20,000 (coverage per depositor by Nicaragua's FOGADE)

### Conclusions and policy recommendations (from V. CONCLUSIONS AND POLICY RECOMMENDATIONS)
- Financial services provisions in CAFTA:
  - will make market access to financial sectors in the region more transparent and predictable.
  - may spur the integration of regional financial markets through the harmonization of regulatory standards.
  - present an opportunity to underpin ongoing efforts at financial reform.
- Greater foreign participation is likely to:
  - strengthen risk-assessment standards,
  - transfer new technologies,
  - enhance the efficiency of intermediation.
- Policy recommendations
  - Parties to CAFTA should "swiftly table comparable offers for market access within the WTO, whose current trade round is scheduled to conclude not long after CAFTA."
  - Heightened capital mobility and more vigorous competition will increase the need to strengthen supervisory functions previously outlined in the chapter.
  - Some countries "may very well see the need to reimpose temporary and selective capital controls during crises that arise."
  - Properly designed greater real and financial integration "will make such crises less rather than more likely."

*Source: IMF content unit titled "introduction of new financial products, and grant exemptions for measures taken for prudential reasons."*

### Box 1. Banking Market Access Restrictions in Central America

### Box 1. Banking Market Access Restrictions in Central America

### Country-by-country market access provisions
- Costa Rica
  - Foreign banks are allowed to establish wholly owned subsidiaries of foreign banks, but not branches.
- Dominican Republic
  - Foreign banks may establish subsidiaries, branches, or agencies when authorized by the Monetary Board.
  - Foreign branches are subject to capital requirements.
  - They must submit a feasibility study justifying the economic need.
  - In its commitments under the 1997 Financial Service Agreement (FSA), the Dominican Republic indicated that the equity participation of foreign investors in banks is restricted to 49 per cent of the subscribed and paid-up capital.
- El Salvador
  - Foreign banks may establish subsidiaries, branches, or representative offices.
  - Foreign branches are subject to capital requirements.
  - At least 75 percent of ownership of shares in banks or finance companies must be maintained for the following persons:
    - (a) Salvadorian or Central American natural persons;
    - (b) Salvadorian legal persons whose shareholders or majority members are the natural persons referred to in the preceding subparagraph;
    - (c) Central American banks in whose country of origin there is supervision in accordance with relevant international practices and which meet the legal and regulatory provisions in force in their country of origin;
    - (d) Foreign banks and other financial institutions in whose country of origin there are prudential regulations and supervision in accordance with relevant international practices and which are classified as first grade financial institutions by internationally recognized risk rating companies; as well as companies controlling first grade foreign banks and other financial institutions subject to consolidated supervision in accordance with relevant international practices.
- Guatemala
  - Foreign banks may establish subsidiaries, branches, and representative offices.
  - Foreign branches are subject to capital requirements.
  - In its commitments under the 1997 Financial Service Agreement (FSA), Guatemala indicated that employees must consist of 90 percent Guatemalan workers who must receive 85 percent of total wages.
  - Training of Guatemalan personnel is required in specialized fields.
- Honduras
  - Foreign banks may establish subsidiaries, branches, and representative offices, subject to authorization from the Central Bank of Honduras (BCH) and a National Commission.
  - The BCH can refuse such authorization when the home country does not grant reciprocity.
  - The types of entry restrictions on foreign banks depend on how they deliver financial services (through branches, subsidiaries, representative offices, etc.).
  - Subsidiaries and branches can undertake the same operations permitted for domestic banks.
  - The legally-established branch offices are subject to the same laws, regulations and resolutions as national entities, including capital requirements, except where international treaties to which Honduras is a party stipulate otherwise.
  - Foreign bank representative offices can only conduct asset operations (granting credit or making investments) not liability operations in the country.
- Nicaragua
  - Foreign banks may establish subsidiaries, branches, and representative offices.
  - Before opening, the foreign branch has to meet all the prerequisites established for banks to operate in Nicaragua.
  - The branch will be considered a resident of the state for any legal purpose and must abide by all the laws in Nicaragua, including capital adequacy requirements.
  - Representative offices can issue credits and invest in the country but can not accept deposits from the public.

### Notable quantitative restrictions and requirements
- Dominican Republic: equity participation of foreign investors in banks restricted to 49 per cent of the subscribed and paid-up capital.
- El Salvador: at least 75 percent of ownership of shares in banks or finance companies must be maintained for specified domestic or qualifying regional/foreign entities.
- Guatemala (FSA commitment): employees must consist of 90 percent Guatemalan workers who must receive 85 percent of total wages.

### Operational and supervisory constraints
- Capital requirements apply to foreign branches in multiple countries (Dominican Republic, El Salvador, Guatemala, Nicaragua).
- Authorization and reciprocity provisions: Honduras requires BCH and National Commission authorization and may refuse when home country does not grant reciprocity.
- Residency and legal compliance: Nicaragua treats foreign branches as residents for legal purposes and subjects them to all Nicaraguan laws, including capital adequacy.
- Functional limits on representative offices:
  - Honduras: representative offices limited to asset operations (granting credit or investments), not liability operations.
  - Nicaragua: representative offices can issue credits and invest but cannot accept deposits from the public.

*Sources: Country authorities and country schedules under the 1997 WTO Financial Service Agreeement.*

### introduction of new financial products, and grant exemptions for measures taken for

### introduction of new financial products, and grant exemptions for measures taken for prudential reasons.

### Prudential measures and trade agreements
- Prudential measures in U.S.-Singapore agreement refer to the “maintenance of the safety, soundness, integrity or financial responsibility of individual financial institutions or cross-border financial service suppliers” (emphasis added).
- Under the U.S. bilateral agreements:
  - Parties may not stipulate targets for the nationality of senior managerial personnel—a provision broader than GATS commitments.
  - Investors may initiate state-to-state or investor-to-state dispute settlement before panels which will reach final and binding arbitration.
- The NAFTA and U.S. bilateral agreements use a more transparent negative list approach than the FSA positive list; both approaches can in principle yield similar market openness without necessarily constraining regulators’ flexibility to adopt prudential measures.
- Example: Mexico imposed limitations on foreign providers’ market shares with a transition period up to 2000, but these limitations were dismantled ahead of time after the financial crisis of 1994 when Mexican banks required fresh capital and technologies; NAFTA is credited with substantial increase in foreign presence in Mexican financial system since the mid-1990s.

### Implications for capital account restrictions
- Effects depend on the nature of the service and mode of supply:
  - Liberalizing cross-border deposit taking essentially requires liberalization of corresponding capital account flows.
  - Financial advisory services should not have important implications for the capital account.
- GATS provisions:
  - Require that capital inflows be permitted only if “essential” for cross border supply of services, and “related” to establishment of commercial presence in scheduled sectors/modes.
  - Contain safeguards allowing reimposition of capital account restrictions in case of balance of payments problems or to safeguard financial stability.
- U.S. bilateral agreements (e.g., U.S.-Chile):
  - “Transfers” include transactions in capital account and current account (dividends, interest, royalty).
  - Investors may effect transfers immediately, in a freely usable currency, and at the market rate of exchange.
  - Under U.S. agreements parties may restrict transfers, but such measures are subject to compensation after dispute settlement procedures following a “cooling off” period of one year (six months in the case of long term flows).
  - Country will be subject to compensation should the measure be in effect for less than that period but impede operations of the investor substantially, and in all cases where the measure is in effect for longer.
- NAFTA contains similar transfer language but may be overruled in situations of balance of payments difficulties or at the request of the IMF.
- Recent experience suggests preconditions for liberalization of short term capital flows include:
  - Macroeconomic stability, appropriate exchange rate policies, and adequate financial supervision, particularly of banks’ risk management capabilities.
- Central American parties to CAFTA currently impose very few capital controls; committing to free transfers per U.S. bilateral definitions should not substantially change status quo but surrendering future option to impose such measures could raise concerns about crisis management.

### The case for “open regionalism”
- CAFTA’s financial services chapter likely to differ from the FSA by:
  - More transparent negative list approach.
  - Stronger commitments regarding free transfers.
  - Dispute settlement procedures.
- For Central American countries CAFTA covers an important trade relationship and incentives point toward agreements exceeding WTO commitments, potentially discriminating against third-country suppliers.
- Efficiency and legal considerations argue for balanced, coherent obligations across CAFTA and WTO to:
  - Avoid first-mover advantages to inefficient providers from preferential liberalization.
  - Preserve bargaining power in multilateral negotiations.
- GATS Article V requirements for regional agreements:
  - Must cover substantially all trade, remove substantially all discrimination between parties, and not raise overall barriers to suppliers from outside the agreement.
- GATS Article V.6 liberal rules of origin:
  - A juridical person constituted under laws of a party is entitled to treatment under the agreement provided it engages in substantive business operations in the territory of the parties.
  - In practice NAFTA’s liberal rule of origin enabled non-NAFTA (e.g., European) providers to enter Mexican market via U.S. subsidiaries.
- Recommendation:
  - Central American countries are advised to expeditiously table offers corresponding to CAFTA commitments under ongoing GATS negotiations to gain multilateral leverage and avoid legal uncertainty; CAFTA expected to conclude by end 2003 but WTO negotiations will conclude later.

### Potential effects and adjustment needs — overview
- Assessing CAFTA effects on CAFTA-6 financial sectors is speculative due to unclear substance and transition periods.
- If existing market access restrictions are continued on prudential grounds, primary effects will be from enhanced regulatory clarity, predictability, and greater investor confidence via transparent dispute resolution.

### Impediments to financial integration
- Determinants of foreign bank entry:
  - Profitability and market size (fixed costs, economies of scale).
  - Strong nonfinancial trade and foreign direct investment links—“banks follow their clients”.
  - Regulatory environment quality; corruption and inefficient contract enforcement raise costs.
- CAFTA’s likely impacts:
  - Reduce risks to contract enforcement by setting common transparency standards, enshrining transfer rights, and providing independent arbitration—reducing credit risk and transfer risk.
  - May be used to harmonize regulation and strengthen cross-border supervision, enlarging effective market size and attracting foreign providers.
- Regional weaknesses:
  - Regulatory, judicial, and institutional frameworks in several Central American countries lag peers.
  - Comparative indicators: Five of the CAFTA-6 have inefficient bankruptcy procedures; scores for contract enforcement and credit market information in several countries are comparable or sometimes higher than Mexico.
- Country-specific deterrents:
  - Costa Rica: prominence of three state-owned banks accounting for over half of assets; public sector monopoly in insurance; state guarantee on liabilities and tax exemptions on dollar deposits.
  - Honduras: legally mandated debt restructurings in agricultural sector provided debt forgiveness and interest relief.
  - Such government interference can undermine credit culture and raise expectation of bail-outs.

### Benefits and risks of foreign entry
- Potential benefits:
  - Upgrading of skills and technology.
  - Enhanced competition lowering interest margins and improving access of domestic firms to external finance.
  - Foreign institutions likely to hold higher quality assets and reduce volatility due to parental backing, superior risk management, and home country supervision.
  - Greater scope for risk sharing may be important given Central American economies are open, relatively undiversified, and subject to common shocks.
- Potential risks:
  - Greater capital mobility may induce greater real exchange rate variability and financial risks from unhedged foreign exchange liabilities.
  - Subsidiaries of foreign banks may cut credit lines in parallel with parent withdrawals.
  - Intensifying competition may reduce franchise value of domestic banks, inducing excessive foreign borrowing and domestic credit expansion that impairs loan quality.
  - Weak prudential supervision and expectations of public bail-outs exacerbate moral hazard.

### Adjustment needs — macroeconomic and prudential policies
- Macroeconomic policies:
  - Key prerogative: manage financial market expectations; avoid impressions of exchange rate stability that induce unhedged foreign currency exposures.
  - Exchange rate regimes (predominantly crawling pegs; El Salvador dollarization) may constrain lender of last resort functions.
  - Fiscal policy must provide adequate funding for liquidity support schemes to respond credibly to incipient banking crises.
- Prudential policies:
  - Need convergence of incentive structures across Central America.
  - Effective consolidated supervision of financial conglomerates (including offshore banks) is required to prevent the weakest supervisory authority from attracting risks.
  - Harmonization may be achieved via adoption of international standards and closer cooperation between supervisors, potentially facilitated by CAFTA provisions on regulatory cooperation, reciprocal information exchange, and technical assistance.

### Key prudential areas for supervisors
- Capital Adequacy:
  - Capital adequacy requirements:
    - Costa Rica, the Dominican Republic, Guatemala, Honduras, and Nicaragua: 10 percent of risk adjusted assets.
    - El Salvador: currently at 11 percent, will be increased to 12 percent by 2005.
  - All are above the Basle Committee standard of eight percent of risk adjusted capital.
  - Enforcing minimum capital requires adequate accounting and auditing standards (asset valuation, loan classification, provisioning, depreciation).
  - FSAPs found weaknesses: lack of effective consolidated supervision of financial conglomerates casts doubt on reported capital figures; loan classification and provisioning rules often lenient, excessive reliance on collateral, rules based on past performance rather than repayment capacity; rules preventing and identifying “evergreening” of loans absent.
- Prudent risk management:
  - Enforce limits on institutions’ scope for taking exchange rate risk amid high and increasing dollarization.
  - Currency depreciation could affect bank solvency when banks or borrowers face currency mismatches.
  - Current practices (summary of Table 3):
    - All countries except Nicaragua and Honduras impose limits on net open foreign exchange positions.
    - Only Honduras and the Dominican Republic appear to impose limitations based directly on borrower’s capacity to honor obligations.
  - Dollarization concerns: El Salvador’s full dollarization could become a springboard for capital flows into the region.
  - Foreign currency deposit shares in total deposits (excluding El Salvador):
    - Nicaragua: 71 percent
    - Costa Rica: 43 percent
    - Honduras: 33 percent
- Financial sector and corporate discipline:
  - Need strong supervisory authority with independence and legal protection from actions by troubled banks.
  - Legal framework needed for resolution of bank problems: financial disclosure, timely corrective actions, appropriate bank exit policies, intervention and management replacement.
  - FSAPs reveal profound deficiencies: regulatory forbearance, creative rescue operations, absence of legal protections for supervisors, monitoring weaknesses leading to fraud (cited cases: Dominican Republic and Nicaragua).
- Viable deposit insurance and liquidity support schemes:
  - Lender of last resort and deposit insurance are key to depositor confidence and rescuing solvent but illiquid institutions.
  - Moral hazard considerations necessitate incentive-compatible insurance design; region faces substantial work in this area.

### Table 3 — regulations on banks’ foreign exchange positions and credit operations (summary)
- Open foreign exchange position limits: Costa Rica, Dominican Republic, El Salvador, Guatemala (marked X)
- Limits to lending locally in foreign exchange: Dominican Republic, Honduras (marked X in source)
- Differential treatment of deposit accounts in foreign exchange: reserve and liquid asset requirement measures noted for Dominican Republic and Honduras in source
- Source for table: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, AREAER, and country authorities.

*Source: IMF content unit titled "introduction of new financial products, and grant exemptions for measures taken for prudential reasons."*

### Box 2 demonstrates, practices differ widely. Five of the six countries have some form of

### Box 2. Deposit Insurance Schemes in Central America

### Summary of regional practices
- "Box 2 demonstrates, practices differ widely. Five of the six countries have some form of explicit deposit guarantee in place, though in the Dominican Republic this covers only savings and loans institutions. Costa Rica provides a guarantee for deposits only in the three state-owned banks."
- "Most of the explicit deposit insurance schemes have been introduced over the last few years and are still undercapitalized, presenting a substantial contingent fiscal liability, and undermining confidence in the financial sector as a whole."

### Conclusions and policy recommendations (from V. CONCLUSIONS AND POLICY RECOMMENDATIONS)
- The financial services provisions in CAFTA:
  - will make market access to financial sectors in the region more transparent and predictable.
  - may spur the integration of regional financial markets through the harmonization of regulatory standards.
  - present an opportunity to underpin ongoing efforts at financial reform.
- Greater foreign participation is likely to:
  - strengthen risk-assessment standards,
  - transfer new technologies,
  - enhance the efficiency of intermediation.
- Parties to CAFTA should "swiftly table comparable offers for market access within the WTO, whose current trade round is scheduled to conclude not long after CAFTA."
- Heightened capital mobility and more vigorous competition will increase the need to strengthen supervisory functions previously outlined in the chapter.
- Some countries "may very well see the need to reimpose temporary and selective capital controls during crises that arise."
- Properly designed greater real and financial integration "will make such crises less rather than more likely."

### Country-by-country descriptions (as presented in Box 2)
- Costa Rica:
  - "Three state-owned banks enjoy full state guarantee on all their liabilities but no deposit insurance is in place for private banks."
  - "Draft amendments to the central bank and banking law presented to Congress at end-2002 sought to introduce, among other things a limited coverage, privately funded, deposit insurance for private banks."
- Dominican Republic:
  - "While no explicit deposit insurance scheme exists, except for deposits in savings and loans, an implicit deposit insurance scheme seems to operate since the central bank has returned deposits in failed institutions."
- El Salvador:
  - "A deposit insurance scheme is managed by the Deposit Guarantee Institute (IGD). The institute provides, in principle, limited deposit insurance to banks, but currently lacks resources since it is at its capitalization stage."
- Guatemala:
  - "A limited deposit insurance scheme was instituted in 1999 by the Law for the Protection of Savings (FOPA Law). The explicit deposit insurance scheme contemplated under the FOPA Law has not started to operate because a number of banks has refused to agree to the contract creating the trust fund that will administer the banks’ contributions."
- Honduras:
  - "An explicit deposit insurance fund (FOSEDE) guarantees a maximum of L150,000 per depositor, per financial institution."
  - "A total of L308,959,217 was available as of December 31, 2002."
  - "FOSEDE collects fees from its members, but also has access to an unlimited and automatic line of credit from the central bank in case the required payment of deposits exceeds the amount of its available liquid assets."
  - "In addition, the government is responsible for the remainder up to the full amount of such deposit."
  - "The blanket guarantee will be reduced to 50 percent in September 2003 and then eliminated in September 2004, while the limited deposit insurance will remain unchanged."
- Nicaragua:
  - "The explicit deposit insurance fund (Fondo de Garantía de Depósitos, FOGADE) covers up to US $ 20,000 per depositor."

### Key statistics and dates preserved verbatim
- L150,000 (maximum guarantee per depositor, Honduras)
- L308,959,217 (available in FOSEDE as of December 31, 2002)
- end-2002 (timing of draft amendments presented to Congress in Costa Rica)
- 1999 (institution date of Guatemala's FOPA Law)
- September 2003 (scheduled reduction of Honduras blanket guarantee to 50 percent)
- September 2004 (scheduled elimination of Honduras blanket guarantee)
- US $ 20,000 (coverage per depositor by Nicaragua's FOGADE)

*Source: Financial Sector Assessment Reports, and national authorities.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2003/_pdp03.pdf_