Report No. 17689-ES

El SalvadorRural Finance:Performance, Issues, and OptionsApril 10, 1998

Finance, Private Sector & InfrastructureCentral America DepartmentLatin America and the Caribbean Region

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CURRENCY EQUIVALENTSCurrency Unit Col6n (0)

$1 = 8.7 (May, 1996)

ABBREVIATIONS AND ACRONYMS

AMPES Association of Salvadoran Small and Medium Enterprises (Asociaci6n de Pequen7os yMedianos Empresarios Salvadorenos)

BMI Multisectoral Investment Bank (Banco Mulitsectoral de Inversiones)BCR Central Bank of El Salvador (Banco Central de Reserva de El Salvador)BFA Agricultural Development Bank (Banco de Fomento Agropecuario)CAM Microenterprise Support Center (Centro de Apoyo a la Microempresa)CEDEAGRO Agricultural Sector Time Deposits (Certificado de Dep6sitos a Plazo Agropecuario)CC Commercial Code (Codigo Comercial)EAP Economically Active PopulationFAO United Natios Food and Agriculture OrganizationFEDA Agricultural Development Trust Fund (Fideicomiso Especial de Desarrollo

Agropecuario)FEDECACES Federation of Salvadoran Credit Unions (Federacion de Asociaciones Cooperativas de

A.horro y Credito de El Salvador)FEDECREDITO Federation of Credit Banks (Federaci6n de Cajas de Credito)FIGAPE Guarantee Fund for Small Enterprises (Fondo de Financiamiento y Garantiapara la

Pequeha Empresa)FIS Social Investment Fund (Fondo de Inversi6n Social)FOCAM Credit Fund for Environmental Activities (Fondo de CrMdito para el Medio Ambiente)FOGAPE Guarantee Fund for Small-Scale Entrepreneurs (Fondo de Garantias para Pequenos

Empresarios)FOGARA Agricultural Guarantee Fund (Fondo de GarantiaAgropecuaria)FOSAFFI Financial Sector Recapitalization Fund (Fondo de Saneamiento y Fortalecimiento

Financiero)FUSADES Salvadoran Foundation for Economic and Social Development (Fundaci6n Salvadoreila

para el Desarrollo Econ6mico y Social)IDB Inter-American Development BankINSAFOCOOP Cooperative Institute (Instituto Salvadoreflo de Fomento Cooperativo)ISSS Salvadoran Social Security Institute (Instituto Salvadoreho de Seguridad Social)ISTA Salvadoran Institute of Agricultural Transformation (Instituto Salvadoreno de

Transformaci6n Agraria)MAG Ministry of Agriculture and Livestock (Ministerio de Agricultura y Ganaderia)NGO Non-governmental OrganizationNIT Tax Identification Number (Nu2mero de Identificaci6n Tributaria)PROPEMI Program for the Promotion of Small and Microenterprises (Proyecto de Promoci6n a la

Pequeha y Micro Empresa)PRN National Reconstruction Program (Programa de Reconstruccidn Nacional)SCC Savings and Credit Cooperative (Asociaciones Cooperativas de Ahorro y Credito)SSF Superintendency of the Financial System (Superintendencia del Sistema Financiero)TIBP Basic Deposit Interest Rate (Tasa de Interes Bdsica Pasiva)

Managers and Staff ResponsibleVice Presidendt: Shahid Javed BurkiDirector: Donna Dowsett-CoiroloSector Leader: Mark Cackler and Ian BannonTask Managers: Rodrigo Chaves and Susana Sanchez

EL SALVADORRURAL FINANCE: PERFORMANCE, ISSUES, AND OPTIONS

Table of Contents

EXCUTIVE SUMMARY: MAIN FINDINGS AND RECOMMENDATIONS ............................................. i

CHAPTER 1. INTRODUCTION ........................................................... I

BACKGROUND AND OBJECTIVES ........................................................... 1DATA ............................................................ 1ORGANIZATION OF THE REPORT ........................................................... I

CHAPTER 2. FINANCIAL SECTOR REFORM, POLICIES, AND INTERMEDIARIES............................2

FINANCIAL SECTOR REFORM FROM THE 1980s To THE I 990S ............................................................ 2Regulation, Legislation, Supervision ............................................................ 3Privatization of Financial Institutions ........................................................... 3Liberalization of Interest Rates ........................................................... 4Reserve Requirements and Sectioral Allocation of Credit ............................................................ 4 Debt Refinancing or Restructuring Programs ........................................................... 5

FINANCIAL INTERMEDIARIES AND LENDERS ............................................................ 6Specialized Financial Institutions ............................................................ 6Private Commercial Banking ........................................................... 8Semi-Formal Institutions ........................................................... 8

MARKET SHARES OF FORMAL AND SEMI-FORMAL LENDERS ........................................................ 9IS AGRICULTURAL CREDIT SCARCE? ....................................................... 9

CHAPTER 3. EL SALVADOR: RURAL CREDIT MARKETS................................................................12

THE RURAL HOUSEHOLDS ....................................................... 12LENDERS AND TECHNOLOGIES ....................................................... 13THE RELATIVE IMPORTANCE OF FORMAL, SEMI-FORMAL, AND INFORMAL LENDERS .................................................... 14CHARACTERISTICS OF LOAN AND DEBT CONTRACTS ....................................................... 15PERFORMANCE OF RURAL CREDIT MARKETS ....................................................... 18

The Participation of Rural Households in RCMs ....................................................... 18The Matching of Debtors and Lenders ....................................................... 20

CHAPTER 4. PERFORMANCE OF RURAL FINANCIAL INTERMEDIARIES.........................................21

OUTREACH ........................................................ 22FINANCIAL PERFORMANCE ........................................................ 23

Performance of BFA ........................................................ 24Performance of Client-Owned Organizations ........................................................ 28

MAIN ISSUES ......................................................... ................................ 29

CHAPTER 5. THE ENVIRONMENT FOR FINANCIAL TRANSACTIONS, AND NEW FINANCINGINSTRUMENTS ................................. 30

ENVIRONMENT FOR FINANCIAL TRANSACTIONS ............................... 30NEW F INANCING INSTRUMENTS ............................... 3 1

CHAPTER 6. RECOMMENDAT'IONS ............................. 35

ECONOMIC ENVIRONMENT ................................ 35DiSTRIBurioN NETWORK ............................. 36

Governance, Regulation and Supervision of BFA, FEDECREDITO and FEDECACES ....................................... 36Technology Transfer: Private Banks and Financieras .................................... .,39

BIBLIOGRAPHY ................................................................. 40

Annex A Regulation, Legislation, and Supervision .45Annex B Financial System and Economic Indicators .48Annex C Rural Household Survey .52Annex D Specialized Financial Intertnediaries: Financial Indicators .55Annex E Debt Refinancing or Restructuring Programs .62

LIST OF TABLES

Table 2-1 Summary Statistics of the Financial System for 1989 and 1995 ..................................................................3Table 2-2 Comparison of CEDEAGRO/CEDEVIV and other Term Deposits ............................................................5Table 3-1 Annual Household Income (colones) ................................................................. 13Table 3-2 Debtors versus Non-Debtors .................................................................. 13Table 3-3 Characteristics of Loan Contracts by Lender: Amount, Maturity, and Interest Rates ................................ 16Table 34 Debt Contracts by Lenders: Amount and Nominal Interest Rates (% p.a.) ................................................ 17Table 4-l Outreach Indicators: 1995 ................................................................. 22Table 4-2 BFA: Government Assistance and Interventions .................................................................. 25

LIST OF FIGURES

Figure 2-1 Real Annual Lending and Deposit Rates ................................................................... 4Figure 2-2 Agriculture Share in GDP, Debt Balances, and Disbursed Credit .............................................. 1............. aoFigure 3-1 Loans Received: Market Shares ................................................................. 15Figure 3-2 Rural Household Debt: Market Shares ................................................................. 15Figure 3-3 Participation of Rural Households in Credit Markets ...................................... ............................ 19Figure 3-4 Participation of Rural Entrepreneurs as Debtors ................................................................. 19Figure 4-1 BFA: Distribution of Loans by Economic Sector, 9/95 ................................................................. 26

LIST OF BOXES

Box 2-1 Innovative Finance: Financiera Calpia ................................................................. IIBox 4-]L Risk of Financial Intermediation .................................................................. 23Box 4-2 Similarities and Differences between FEDECREDITO and FEDECACES Systems ................................... 28Box 4-3 FEDECACES ................................................................. 29

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EXECUTIVE SUMMARY

MAIN FINDINGS AND RECOMMENDATIONS

1. This report analyzes trends in agricultural credit and savings mobilization, examines the performance ofmain rural financial intermediaries, provides a diagnosis of rural household participation in credit markets, andreviews the prospects and constraints for the adoption of improved financial mechanisms. Aggregate trends in thepast decade suggests that a substantial decline in profitability of Salvadoran rural sector, especially agriculture,may be at the root of the problems identified in rural financial markets. The steady decline in relative agriculturalprices may have made the agricultural sector less creditworthy than other sectors while probably increasing itsdemand for external liquidity. Sectoral shares in domestic credit have declined faster than sectoral contributions toGDP.

2. After a period of substantial stress and lack of confidence in the financial system, a number of correctivemeasures were adopted beginning in 1989: privatization and recapitalization of banks and finance companies(financieras); liberalization of interest rates; removal of barriers to entry; and reorganization of the supervisoryagency (SSF). While these measures represent significant progress in strengthening the financial system, severalshortcomings remain: (i) despite the entry of new institutions, three large banks continue to dominate the bankingsystem; (ii) further improvements are needed in banking supervision, and the legal and regulatory framework forsecured transactions; and (iii) various Government decisions have undermined financial discipline, notably debtforgiveness programs (open or disguised).

3 The Government may have worsened the performance of financial markets through its participation in thesector, notably by: (i) excessive administrative costs and delinquency within the public development bank; (ii)strategic defaults promoted by debt forgiveness programs; (iii) interest rate subsidies; and (iv) potential regulatoryproblems affecting private organizations (e.g., credit cooperatives). Finally, the informal financial sector wasfound to be quite underdeveloped. The scant supply of informal credit may result from the difficulty of enforcingcredit contracts in rural areas. The country's recent conflict and the instability in conflict areas certainly weakenedtraditional enforcement mechanisms.

Agricultural Credit and Savings

4. Agricultural Credit. The share of agriculture in formal sector credit flows has declined significantlyover the last five years. Its share in total outstanding debt has also declined, although slightly less (see Chapter 2).Successive periods of low returns should make these units less profitable and less creditworthy and may inducelenders to allocate resources to other sectors. At the same time, this pattern could have increased units' demand forexternal financing or on the contrary reduced their demand because of lower returns.

5. Private banks provide three-fourths of total formal credit to agriculture, while specialized financialintermediaries (especially BFA., the agriculture development bank) account for one-fourth of the total, in spite oftheir relative specialization (about one-half of their portfolio in agriculture compared to less than 10% in privatebanks). In terms of number of clients, however, the agricultural clientele of private banks is limited to less than2,000 clients, while the agricultural clients of BFA are estimated at about 20,000. Adding the agricultural clientsof all banks and financieras, including the BFA, we reach a figure of about 25,000 clients, or less than 10% of allagricultural enterprises. This limited access is confirmed by the survey findings (see below). The existence ofimportant under-served sectors in rural areas may explain, for example, the rapid expansion in agricultural lendingby a new innovative provider (Financiera Calpia) which has been able to develop a portfolio of more than 2,000small-scale farmer clients (micro- and small rural entrepreneurs) in less than 2 years, in addition to its establishedclientele of about 10,000 urban micro- and small enterprises.

6. Savings Mobilization. Deposit services are primarily provided by banks both in urban and rural areas.Outside San Salvador banks mobilized 32.9% of all savings in 1995. Bank density ratios have improved both inurban and rural areas since 1992, although the proportion of bank branches outside San Salvador has decreased.

i

ii El Salvador: Rural Finance

Performance of Rural Financial Intermediaries

7. The financial analysis of BFA, FEDECREDITO and FEDECACES systems, and Financiera Calpia --intermediaries active in rural financial markets-- reveals, among other findings, that:

* BFA's most significant limitations are: a governance structure that allows for political intervention, andgoals tlat are inconsistent with its financial viability, a hybrid role as an instrument of the State held tothe rules and standards of commercial banking, a de facto constraint on BFA's loan pricing in anenvironment of liberalized interest rates, and substantial losses due to high operating costs and poor loanrecovery. Reorganization efforts have been inconsistent, closing non-bank activities to then re-open them,and managing a number of governuent programs which essentially burden the bank with unprofitableactivities. Debt forgiveness programs mandated by the Government have affected BFA the most, as theensuing loss of repayment discipline further contaminates its portfolio with bad debt, while itsinstitutional mandate forces it to continue lending to a high-risk borrower class.

* Recent improvements in management at FEDECREDITO have not yet brought it up to commercialstandards. The credit-union sector affiliated in FEDECACES is also in a process of slow recovery.'Finally, Financiera Calpia, with innovative techniques of service provision, state-of-the-art informationmanagement and market pricing has been able to develop a rural portfolio of small-scale clients with highrecovery rates.

Access to Credit Services in Rural Areas

8. Rural credit markets (RCMs) in El Salvador are shallow because rural households have limited access to creditservices-less than 12% of rural households received a loan in 1995 (see Chapter 3). About 20% of rural households hadoutstanding debt balances from formal or informal sources. Furthernore, rural households do not have access to a varietyof lenders, as only 0.3 % reported debt balances with more than one type of lender. The weak participation of ruralhouseholds in credit markets is explained by both demand- and supply-side factors. On the demand side, 870/o of ruralhouseholds did not apply for loans in 1995. Although information regarding the weak demand for credit could not be fullyassessed, the findings suggest that households find it difficult to use movable goods as collateral, and that access to formallenders is limited to those rural households with titles for real estate property. Furthermore, the terms and conditions offinancial products traditionally available in RCMs may be inadequate for rural entrepreneurs seeking to diversify awayfrom depressed and unstable activities.

9. A combination of factors likely hinder the supply of credit: (i) an underdeveloped institutional infrastructure;(ii) Government interventions which crowd out private lenders by allowing weak public sector institutions to lend withpoor recovery and low interest rates; (iii) debt-forgiveness programs which have created serious credibility problems bypromoting strategic defaults; (iv) previous interventions in agricultural marketing that have prevented the development ofinformal financing sources such as crop purchase credits; and (v) the recent conflict and the resulting insecurity in ruralareas, which impeded the development of informal markets by weakening the traditional enforcement mechanisms usedby informal lenders, and which have not been replaced by formal legal structures or new informal mechanisms.

10. Among the rural households that did report loan transactions, formal sector lenders provided three-fourthsof the total amount borrowed, with BFA accounting for 61% of this total (see Chapter 3). These findings are atodds with previous studies, where the bulk of loan amounts was accounted for by informal sources. The share ofinformal loens in the total number of loan transactions, 49%, is also much lower than that registered in previoussurveys, where informal loans represented about 80% of the loan transactions effectively performed by ruralhouseholds.

Il. Loan contracts with formal and informal lenders showed different interest-rate, loan-size and maturitycharacteristics. Informal sector lenders charged nominal interest rates equivalent to an annual rate of almost

Currently, there are proposals to make FEDECACES and FEDECREDIT() formal financial intermediaries under SSFsupervision and regulated by a special financial cooperative law. The potential shortcomings of this approach arediscussed below.

Executive Summary: Main Findings and Recommendations iii

100%, while nominal average rates on formal loans were slightly over 18%.2 High interest rates differentialsbetween formal and informal lenders suggests that albeit at relatively high lending transaction costs compared tourban areas, there is room for provision of viable credit services in rural areas.

Main Issues and Recommendations

12. El Salvador has made significant progress since the early 1990s in creating adequate conditions forprivate sector growth. In particular, the substantive reforms and liberalization of the financial sector have enableda conducive environment for financial intermediation where institutions can function without the burden ofexcessive regulation and pricing restrictions. The issues that remain, and the recommendations to address them,are presented here in a hierarchy of significance, under four headings: (i) restructuring of the main rural financialintermediaries (BFA, FEDECREDITO, FEDECACES) and of their governance, regulation, and supervision; (ii)financial sector competitiveness and supervision; (iii) technological transfer; and (iv) modernization of legalframework for securing financial transactions.

13. There is no single proven institutional model for El Salvador to follow in order to deepen its ruralfinancial markets. Any type of institutional re-structuring requires, among other factors, an adoption of cost-effective financial innovations to provide financial services appropriate to rural areas, and measures that enablethe use of new financing instnrments. Provided appropriate conditions are present, three non-exclusive institutionalmodels have proven successful in other countries. The recommendations below are based on these three non-exclusive alternatives:

* The full privatization of a public bank, or a clearly defined split of a public financial institution, akin tothe Unit Desa system of the Bank Rakyat Indonesia (BRI)

* Thorough reform in the regulation and legal structure of the credit cooperative system to eliminate thegovernance problems that have plagued such organizational forms

* The down-scaling of operations among bank and non-bank commercial intermediaries, following the pathof banks such as Colombia's Caja Social, and non-banks such as El Salvador's own Financiera Calpia.

Financial Sector Competitiveness and Supervision

14. To improve financial sector competitiveness the Government should:

• Consolidate the restructuring and liberalization of the banking system, especially through: consolidationof ownership restrictions; disclosure of interest rate information; implementation of a rating system forfinancial institutions; and strengthening of SSF through training and modernization.

* Remove from the menu of policy interventions debt refinancing/forgiveness programs as an effort torestore repayment discipline in rural areas.

Governance, Regulation and Supervision of Rural Financial Intermediaries:

BFA

15. As presented above, the central issue dominating the BFA's operations are governance, politicalinterference and its imposition of special social mandates. Although there is ample room for improving managerialpractices and information systems, and for adopting better lending and savings mobilization practices, seriousdoubts will always remain with respect to the incentives of BFA's management to implement such improvementsunder the existing government ommership and governance structure.

16. The immediate step should be to eliminate all non-financial operations assigned to BFA, and transferaway from the bank all welfare-related mandates. The ensuing actions would be a rigorous audit to determine themarket value of BFA's equity and a detailed analysis of the spectrum of options for its divestiture-including thepossibility framework in order to privatize some of BFA's branch network as independent local unit banks. Theregulatory implications of this possibility are analyzed below. An implication of the proposed strategy is to

2 The average interest rate differentials between formal and informal lender for loans and outstanding debt balances are 81percentage points and 22 percentage points, respectively.

iv El ,alvador: Rural Finance

suspend BFA's current efforts and investments in information technology. At this stage it is not known, forexample, whether any investments made to integrate the branch network's information systems will be consistentwith an optimal strategy for BFA's divestiture (e.g., independent unit banks).

17. Is it possible to refonn BFA to make it a sustainable public development bank? To achieve sustainability,BFA would have to be compelled to adopt general principles that are necessary conditions in the sustainableprovision of financial services to small and medium entrepreneurs in rural areas. The political cost of reformingBFA along this way may be fairly close to that of divesting the institution altogether, because any meaningfulreform requires rreducing or eliminating the rents extracted by three constituencies: bureaucrats, larger borrowers,and politicians. These groups would probably fight off refonn with the same strength with which they wouldoppose divestiture. Reform is a gradual, long-tern and reversible process that puts time on the side of theseconstituencies to organize opposition. In contrast, divestiture may be achieved swiftly and irreversibly.

18. The following are examples of change control actions that could be pursued until the time in which BFAis completely divested to the private sector. These actions are, in any event, required intermediate steps fordivestiture:3

* Organizational control: the objective should be to provide control of BFA to individuals who are notsubject to political pressures and who are not representative of the bank's borrowers. This objectivewould require: (i) reforrn of the law and charter of the bank because the Board of Directors is currentlyintegrated by political appointees (Ministers) and representatives of the beneficiaries (farmer groups). Inthe meantime, the Government's political appointees should vote (in block) for measures and policiesaimed at improving the bank's performance (e.g., suspend current investments in modernizing BFA).

* Distribution network: BFA branches are characterized by a large fixed-cost structure and are mostlylocated in highly populated urban centers. The fixed costs of operating branches could be reduced byreducing branch staff, and by selling buildings and reallocating branches in smaller rented offices-preferaebly in locations not served by commercial banks.

* Credit policies and targeting: BFA should change its credit policies to increase its outreach to smallrural entrepreneurs and, more importantly, to protect itself from rent-seeking organized groups ofborrowers. In particular, it should significantly reduce the maximum amount of credit granted to a singleborrower (e.g., maximum of 4 times the country's per capita income). It should increase interest ratessignificantly and finance all types of rural entrepreneurs (not only farmers). This policy, combined withcollection incentives on the part of branch managers (mostly the threat of closing problem branches),would reduce the amount of rents an individual borrower may extract and, hence, would also reduce theincentives to establish and organize opposition to the reforms.

* Credible sink-or-swim strategy: the Government should make credible the fact that the resourcescurrently at the disposal of the organization represent a once-in-a-lifetime capital endowment. It should bemade clear to these groups that branches that are not sustainable will be closed within 6 months.

FINANCIAL COOPERATIVES (FEDECREDITO AND FEDECACES):

19. Financial Cooperatives (FEDECACES and FEDECREDITO). The Govemment is consideringunification of the regulation, governance, charter and status of the savings and credit cooperatives (cooperativasde ahorro y crddito), most of them affiliated to FEDECACES, and the cajas de credito affiliated toFEDECREDITO. Such unification would imply the emergence of a single organizational form for savings andcredit cooperatives (SCCs), and the subjection of the resulting unified systems to SSF supervision, which mayinclude deposit insurance. Moreover, the Government may chose to include this regulatory reform in a broaderbody of legislation to cover non-bank financial intermediaries, with or without cooperative ownership. Although

3A complete package of damage control actions (including quantitative goals) and divestiture steps should result from theproposed detailed analysis of BFA's operations and financial situation. Such analysis should be completed as soon aspossible.

Executive Summary: Main Findings and Recommendations v

there may be clear advantages to unifying the regulatory and supervisory framework for SCCs, the proposedreforms need to take into account the potential risks involved in chartering these new intermediaries.

20. The main governance features of the organization that would result from the proposed new structure are:ownership by both depositors and borrowers, one-member-one-vote rule for decision making by generalassemblies, and voluntary association and withdrawal of members. Potentially negative implications of thesegovernance features on the capital structure of the organization need to be explicitly regulated upon by the newlegislation. Specifically, minimum capital requirements would need to be complemented with rules governing thewithdrawal of share capital, and the accumulation of institutional capital.

21. International experience with credit cooperatives. The international experience of financialcooperatives is rather mixecd in terms of perfornance and viability. Supply-led cooperatives such as the unionesde credito in Mexico have resulted in financial collapse, and other networks such as the Costa Rica SCCs haverequired govermment bail-out after short-lived success. On the other hand, successful experiences of credit-unionreform and modernization have been documented in Guatemala and the Dominican Republic, aside from theAfrican examples of Benin, Cameroon and Togo.4

22. Fiscal liabilities. The Government may assume contingent liabilities from the reforms being proposed, asit does by chartering any type of financial intermediary. Even if explicit deposit insurance is not provided, theGovernment may be unable to avoid bailing-out SCCs in case of financial difficulty as they would be under SSFsupervision and their depositors would be numerous and unsophisticated. Protecting large numbers ofunsophisticated depositors, on the other hand, ought not to deter Govermment from diversifying the financialsystem, especially when the amounts involved represent a minimal share of total deposits in the financial system.

23. The new framework. In the new framework, the legal ability to carry out specific financial intermediationactivities needs to be directly contingent upon the fulfillment of requirements and conditions set forth by the newbody of legislation. Most importantly, minimum capital requirements for entering the regulated system and rulesfor the accumulation of institutional (non-withdrawable) capital should ensure the rapid build-up of a stablecapital base. In addition, risk-weighted capital adequacy rules should at a minimum be equivalent to thoserequired from other deposit-taking institutions.

24. Specific rules preventing "borrower-domination" (extraction of benefits by coalitions of members at theexpense of the organization's financial viability) should be made part of the framework (e.g., prohibiting dividendallocation on the basis of borrower-patronage) to reinforce internal rules modern SCC organizations typicallyfollow.

25. The new framework should establish reserves and allowances created from earnings to maintain capitallevels adequate to cover potential losses from loans and investments. The legislation should also require provisionsfor loan losses, guided by portfolio classification rules similar to those applied to other regulated institutions.Likewise, norms on portfolio concentration and insider lending, and reserve requirements (encaje) comparable tothose of other deposit-taking institutions should apply to the new institutional charter.

26. In the case of the current affiliates of FEDECACES and FEDECREDITO, minimum capital requirementswill have obvious consequences on the magnitude of the consolidation process that will likely follow theregulatory reforms. From about 36 and 50 affiliates, respectively, the networks are likely to dwindle in number ofaffiliates to about a dozen each, primarily through mergers (much like the consolidation observed in the Mexicocajas populares after the 1992 reforms). Hence, the total amount of deposits now falling under SSF supervisionmay initially decrease, to then recover as the newly regulated institutions gain public confidence.

4 In Africa, SCCs were not exposecl to the donor-induced subsidized-credit trajectory most SCCs networks in Latin Americaexperienced in the 60s and 70s.

vi El Salvador: Rural Finance

27. Prudential supervision mechanisms. Building SSF capacity and establishing prudential supervisionmechanisms need to accompany any regulatory reforms implemented by the Government. Regulatory functionsshould not be allocated to the federations, as it is unlikely that it would be possible for them to credibly supervisetheir affiliate-owners. Instead, mechanisms that supplement the SSF capacity with private external audits andexamination of the SCCs should be established, to function under the guidance of a small high-quality team of SSFspecialized supervisors.

28. A transitional period to adopt and adjust to the new legislation will be required. In addition, theGovernment should carefully consider the future of existing financial cooperatives and other credit-grantingorganizations that will not meet the new requirements. Specifically, access to BMI funds by non-regulatedintermediaries should be strictly ruled by the creditor as no explicit or implied guarantee will apply to thoseentities.

Increasing Access through Technology Transfer and Modernization

29. Technology transfer. The down-scaling of operations among bank and non-bank commercialintermediaries can be achieved through research and development of new financial technologies, and thepromotion of their adoption. The Government should familiarize private financial intermediaries, as well as theBCR and SSF officials, with successful technologies in lending and deposit mobilization in rural areas. Forexample, private banks in Indonesia operate successfully in rural finance. Furthermore, the Government shoulddesign incentive packages to encourage the adoption of these innovative financial techniques and methods. InMexico, the WVorld Bank is currently sponsoring a technical assistance program to provide incentives for privatebanks to offer financial services to rural communities.

30. New financing instruments. Because the Government has done little to promote the use of new financinginstruments, the general guidelines proposed in the 1995 Country Economic Memorandum (CEM) would beappropriated. The main recommendations to expand use of new financing instruments are summarized below:

* Improve the environment and legal framework for new financing instnuments such as leasing andfactoring.

* Consolidate the reforms currently in progress, and the study of new ones and amendments to the FinancialInstitutions Law that clarify the rules that govern leasing should be adopted.

* Set guidelines and uniform treatment for leasing, factoring and discounting of commercial paper.

* Develop an enabling framework for asset-backed securities, reducing notary costs and eliminatingmulliple taxes.

31. Colllateral security issues. The Government could increase access to credit services by reducing thecosts of using collateral to secure credit transactions. To reduce the costs of collateral use: (i) improve legalframework to facilitate the creation, perfection, and enforcement of security interests; and (ii) modernize registriesto reduce transaction costs and delays of registering security interests such as mortgages and liens. Furthermore,consider CEM recommendations to expand use of liens on inventory and commercial equipment.

Chapter 1. INTRODUCTION

BACKGROUND AND OBJECTIVES

1.1 The study addresses the question of access to finance by rural households, and provides a diagnosis of theperformance and overall competitiveness of rural financial markets. It also examines the prospects and constraintsfor improved and innovative financial mechanisms.

1.2 The importance of moire effective financial intermediation has been highlighted in previous Bankdocuments in connection with, among other issues, the lack of opportunities for financial savings. This, along withother factors, explains the continued low domestic savings levels observed in spite of an increase in nationalsavings fueled by worker remittances.5 Since a more than proportionate share of migrants originated in the ruralsector, the need for increased depth and efficiency is even more pronounced in rural financial markets thanelsewhere.6

1.3 Although El Salvador has long abandoned administered credit allocation policies, the "project-oriented,collateral-based" traditional lending practices of commercial banks, as opposed to the client-oriented performance-based untargeted modem methods, has tended to increase the concentration of commercial credit in an elite ofrelatively successfil, and large, farmer and agribusiness clients.

1.4 Four main issues are typically associated with efficient financial intermediation, namely: (a) themacroeconomic environment, (b) sectoral policy context, (c) financial market constraints, and (d) legal andregulatory barriers.7 The study focuses on the last two of these problems. We keep in mind and remind the reader,however, that ultimately the key shortcomings in sectoral growth and competitiveness may not be found in thefmancial market but in sectoral or macro policies. Rural finance does have a role to play, nevertheless, and largeroom for improvement exists foir rural finance to help the sector adjust to the challenge of globalization.

DATA

1.5 The report relies on secondary and primary sources of data. The secondary sources come from reports andbulletins from the BCR and the SSF, on published and unpublished documents prepared by FUSADES, and onrecent studies carried out primarily under the auspices of USAID and IDB. In addition, numerous and extensiveinterviews were conducted at public and private institutions and organizations during a Bank mission in May1996. The primary source of data is the 1996 FUSADES survey of rural households. This survey containsinformation about several aspecis of the productive activities of 628 households from the rural areas of ElSalvador.

ORGANIZATION OF THE REPORT

1.6 The report comprises six chapters and five annexes. Chapter 2 reviews the financial sector reforms andpolicies of the 1980s and 1990s, highlighting the areas in which further adjustments seem necessary. It alsoanalyzes the extent to which the rural sector is adequately served with financial services. Sectoral patterns offinancial services provision, and the institutional structure of the financial sector are critically reviewed. Thequestion of access to financial services, especially credit, by rural households is addressed in Chapter 3, on thebasis of the FUSADES survey. Rural household participation in financial transactions, and the factors thatinfluence this access are analyzed there. The performance of three major rural financial intermediaries (BFA,

'World Bank (1995).6 It has been estimated that 25% of the rural households in El Salvador receive remittances from abroad, accounting on averagefor as much as 11% of their income (L6pez, 1996)7 Yaron and Piprek (1997).

2 El Salvador:

FEDECREDITO, IFEDECACES) relative to that of commercial banks is analyzed in Chapter 4. The environmentfor financial transactions and new financing instruments, and the potential for these new instruments to beeffective in rural aueas are discussed in Chapter 5. Key conclusions and recommendations to develop financialmarkets are offerecd in the final chapter.

Chapter 2. FINANCIAL SECTOR REFORM, POLICIES, AND INTERMEDIARIES

2.1 During the 1980s, the financial system El Salvador experienced a loss of public confidence due tounfavorable investment conditions, market inefficiencies, and delinquency problems. The problems of delinquentdebt originated from the nationalization of the banking system; the conflict; inadequate supervision of banks, andconcentrated loan portfolios. The portfolio of problem loans of the nationalized financial system mounted duringthe 1980s as more producers were unable or unwilling to meet debt service requirements. At the end of 1989,banks were left with inadequate capital positions. The threat to the stability and viability of the financial systemand the deterioration of the loan portfolio forced the Government to implement drastic measures, starting in 1989,including but not limited to the privatization of banks and financieras and the adoption of major changes in theregulation, legislation and supervision of the financial system.

2.2 This chapter presents the main elements and the effects of the financial sector reforms of the 1990s. Whilesignificant progress has been made toward strengthening the financial system in recent years, the followingshortcomings call for attention by policy makers: the banking system remains concentrated in three banks;improvements are still needed in the supervisory and regulatory framework; and debt refinancing programs havecreated negative effects for private lenders and induced strategic default behavior by borrowers. The chapter thenanalyzes the institutional structure of the financial sector. Brief profiles of the institutions active in rural financeare presented here. More extensive analyses of BFA, FEDECREDITO and FEDECACES are carried out inChapter 4.

2.3 Next, the key question addressed in this chapter is whether the agricultural sector is under-served withlending services vis a vis its inherent profitability and potential, and relative to the access to financial services inother sectors of tlhe economy. The findings reported here indicate that the share of agriculture in formal sectorcredit flows has declined significantly over the last five years, while the sector's share of total outstanding debt hasnot declined as much. Sectoral credit participation seems to reflect the relatively poor sectoral performanceassociated with its deteriorating terms of trade, rather than serious constraints or barriers in the banking sector.However, Financilera Calpia which started in 1995 with agricultural lending has rapidly developed a portfolio ofmore than 2,000 farmer clients with loan sizes averaging less than 0600 in less than 2 years.

FINANCIAL SECTOR REFORM FROM THE 1980s To THE 1990s

2.4 By the end of 1989, after 10 years of a nationalized financial system and an environment of financialrepression, the financial system (banks, financieras, Banco Hipotecario and SFIs) had so many delinquent loansthat it was technically bankrupt. Delinquent loans amounted to %3,861 million or 37.4% of'the loan portfolio andthe negatiye equity of these institutions was 02,212 million or 26% of deposits (see Table 2-1). 'The insolvency ofthe banking system prompted Government intervention in order to restore public confidence in the system, andavoid a bank run that would have compounded the country's already critical situation in a Ieriod of civil-war andeconomic instabillity.

2.5 The nationalized system was used to finance the Government's budget deficit, priority segments of theprivate sector, especially export agriculture, and agrarian reform beneficiaries (Danby, 1995). The Government'sreluctance to foreclose loans to these favored groups lead to the practice of refinancing loans on concessionalterms that made it advantageous to delay repaying. During 1987-91 an average of 26% of the outstanding loan

Rural Finance 3

balances of commercial banks were in the refinanced category (Abt, 1993). In addition to refinancing practices,banks lacked crucial information on financial health and indebtedness of clients, and corresponding registry of thereal-estate collateral of the loams were signs of a deficient information management system.

2.6 To avoid the potential collapse of the financial system the Government started a process of financialliberalization. Since 1989, this process has restored public confidence in the system, supported the efficientperformance of financial institutions and promoted economic development. The main elements of this processincluded: reforming the regulatory framework for financial institutions and for the SSF; privatizing commercialbanks and Savings & Loan Associations; liquidating three state-owned banks; establishing a special fund topurchase the worst performing loans from commercial banks (FOSAFFI); liberalizing interest rates; eliminatingdirected credit programs; and creating uniform reserve requirements across financial intermediaries. As a result ofthese reforms, at the end of 1995, lending and deposit rates were positive in real terms, privatized banks andfmancieras had 06,066 million of net capital, and the number of financial institutions had almost doubled withrespect to 1989 (Table 2-1).

Table 2-1 Summary Statistics of the Financial System for 1989 and 1995.Indicator 1989 1995Quasi4noney/GDP' 16.0 27.3Real Interest Rates (% per annum)Lending 0.7 8.2Deposit -1.2 3.9

Banks and Financieras bNo. of Branches 230 270No. of Institutions 11 21No. of Employees 7,681 12,635

Capital of privatized Banks and Financieras -¢2,212 million 06,066 million% of loans in category 0 and E 36.7 % 3.4%H-H Index for Assetsd 1,690 1,569Sources: * Intemational Financial Statistics, various issues. BCR (1996, Cuadro 7) and SSF Bulletin, 1995. Includes: Agricola Comercial, DeComercio, Cuscatlin, Desarrollo, Salvadorehio, Hipotecario, Ahorromet, Atlacati, Casa, and Credisa. c BCR (1996. Cuadro 10). d SSF Bulletin,1995, and BCR Bulletin, 1991 p. 32 and p.48. The H-H index is equal to the sum of squares of the market share of assets of each firm.

Regulation, Legislation, Supervision

2.7 In the early 1990s, the Government passed a number of laws that partially corrected the regulatoryframework for financial institutions. However, the enhancement of certain aspects of the regulatory framework isneeded to fully consolidate the reform. Strengthening prudential supervision, and rules for new financinginstruments are areas for new reforms of particular importance. Improvements are still needed in the rules thatgovern non-lending financial mechanisms such as leasing, factoring, and warehouse receipts that do not appear tobe fully covered in the upcoming legislation, but the effect of adequate regulation may be significant (Chapter 5).

2.8 The modification of the banking legislation and regulation of 1996 represented an important anddecisive step in improving the soundness of the financial system. These modifications resulted in a tighteningof capital adequacy requirements from 8% to 10%; reduced loans to insiders to 15% of stock and capitalreserves; and the establishment of a system for information sharing. A detailed account of current regulationscovering entry, ownership, capital requirements, portfolio concentration and inside lending, supervision, loanrisk classification and information sharing is presented in Annex A.

Privatization of Financial Institutions

2.9 Based on a privatization law passed in November 1990, the Government privatized five banks and fourfinancieras from 1991 to 1994. Prior to the privatization process the Government began to strengthen commercialbanks and financieras to attract private investors by exchanging bad loans with Government bonds issued byFOSAFFI and by direct capital injections. Investor bought a total of , 1,143 million of stock, out of which 0 135.4corresponded to employees. Even though the privatization process limited equity participation to 5% for singleinvestors, this requirement was bypassed, as employees and small investors bought stock for large investors.

4 El Salvador:

2.10 The privatization of banks and the removal of barriers to entry into the banking system have had aminimal effect on the market structure of the system.8 Although the number of financial institutions has almostdoubled, new entrants held only 9% of total system assets in 1995. In fact, the H-H index for assets, an indicatorfor industry concentration,9 decreased slightly from 1,690 to 1,569 between 1991 and 1995. Assets wereconcentrated in three banks (Banco Agnicola, Salvadorenlo, and Cuscatlan) which in 1995 had the same share oftotal banking assels as in 1991 (61%).

Liberalization of Interest Rates

10 ___ 2.11 Beginning November 1990,BCR liberalized interest rates. As

s ------------------------------------------------------ .shown in Figure 2-1, this measureresulted in positive real deposit rates

o - \ ' ' E | > 1 M / r / | which apparently attracted a large5 ' S \-o co C: Y 3 number of depositors. The volume of

quasi-money (time deposits, current-10 ----------------- - ~ ----------------------------- --------------------------- savings, and foreign currency deposits)

as percentage of GDP has increased-15 reflecting public confidence in the

-- Deposit - Lending financial system. In 1994, quasi-moneyand M2 reached levels of 29.9 and

Source: International Financial Statistics 40.5% of GDP, respectively, theFigure 2-1 Real Annual Lending and Deposit Rates highest levels since 1980. Finally, the

liberalization of interest rates togetherwith other measures have created conditions which have attracted new financial intermediaries into the marketthrough increased profitability of financial activities.

2.12 Because banks must now pay higher interest rates for their deposits, they will need to charge higherlending rates in order to remnain profitable. However, higher lending rates may have an adverse selection effect aslow credit risk borrowers exit the market and leave banks with riskier loan portfolios. Danby (1995) argues thatrecent concentration of loan portfolios in the construction sector and high levels of excess liquidity suggestdifficulties findinlg good clients.

Reserve Requirements and Sectoral Allocation of Credit

2.13 The BCR currently uses selective reductions in reserve requirements as an instrument to stimulate long-term sources of funds for the financial sector and channel funds to housing and agriculture. The funds raised withthese savings instruments have a reserve requirement of 15%, and all the reserves are remunerated. These savingsinstruments are CEDEVIV which targets housing and CEDEAGRO (introduced in 1996) which targetsagricultural production.

2.14 As incentive instruments, CEDEVIV and CEDEAGRO give banks and financieras substantial flexibilitysince their participation is voluntary and there is no restriction on the lending rate of those funds. Banks andfinancieras may be willing to offer CEDEVIV or CEDEAGRO deposits after considering costs of funds, liquidity

See BCR (1990) for a description of the privatization process.9 This index is equal to the sum of the squared market share of assets of each firm. Higher values of this index imply agreater concentration of the industry. For reference, if all 13 banks had equal market shares, the H-H would be 769.

Rural Finance 5

management, the interest rate elasticity of the demand for savings, and the demand for credit from eligible housingand agricultural activities.'°

2.15 During 1992-1995 depositors showed an increasing preference for term deposits. For example,CEDEVIV increased its share from 2.8% to 11% of savings balances and reported real growth rates in excess of50% (Table B-5). The aggressiveness of banks in promoting this long-term deposit instrument is matched by astrong allocation of credit to housing construction.

2.16 CEDEVIV has been very popular in the department of San Salvador. However it is unlikely thatCEDEAGRO will be able to replicate

Table 2-2 Comparison of CEDEAGRO/CEDEVIV and other Term CEDEVIV's success in mobilizing fundsDeposits for various reasons. First, the instrumentConcept Cost of Funds Deposit Rate assumes that banks do not lend toCEDEAGRO (two years) 16.92% 15.50%OneDyear TD 15.19% 12.50% agriculture due to a lack of funds and highSxmonths TD 16.44% 13.50% deposit rates. Second, since most30idays TD 14.56% 12.00% agricultural lending for working capital is30 days TD 14.56% 12.00% ~~~~~short-term, the instrument forces banks toSource: Calculations of the authors. The deposit rates were taken from thepublication of Banco Cuscatlin on April 1996. lt was assumed that the TIBP have a maturity mismatch. Third, anequals 11.71% and that CEDEAGRO will be offered at CEDEVIV's rate. important weakness of CEDEAGRO is

that land purchases are not included as a possible use of the funds. Hence, the narrow targeting of these funds toselected agricultural activities may deter conservative banks from using this instrument as extensively as would bedesirable. Finally, after adjusling for differences in reserve requirements and remuneration of these reserves,CEDEAGRO has the highest cost of funds among term deposits (Table 2-2).

Debt Refinancing or Restructuring Programs

2.17 Refinancing delinquent debt raises two concerns. First, if the restructuring of the debt reduces the netpresent value of the original contract, then borrowers in good standing will have incentives to stop paying theirloans because they face less favorable terms than delinquent borrowers. Second, these programs may encourageeconomy wide strategic default and create a culture of no repayment as borrowers simply default and wait for thenext refinancing program. Despite the potential negative effects, in 1992 the Government started a debtforgiveness program to compensate producers affected by the conflict and in 1996 it passed two new refinancingprograms to promote agricultural production. A sunmary of these three debt forgiveness programs are explainedbelow; a more detailed explanaition is presented in Annex E.

2.18 War-related Debt Reifinancing Program. The Ley para la Rehabilitaci6n de Sectores ProductivosDirectanente Afectados por el Conflicto (D.L. 292) attempts to renegotiate, on concessional terms, the delinquentdebt of producers directly affected by the conflict. The Decree, approved in July 1992, had two main objectives:refinance the debt to allow borTowers to pay back; and restore the creditworthiness of delinquent borrowers toincrease their access to credit. However, a restrictive definition of "those directly affected by the conflict"; hightransaction costs for potential beneficiaries, and conservative banking criteria applied to each specific case at thelevel of branch bank agencies have limited the use of the Decree by potential beneficiaries. In order to overcomesome of these limitations, the D.L. 292 has had two major modifications. In February 1994, the Decreerecalculated back interest at 6% for beneficiaries whose original debt was below lt100,000 (Decree 814).Furthermore, banks were not allowed to charge commission or fees for processing applications. In August 1994,the debt of beneficiaries with original loans below 05,000 from BFA or FEDECREDITO was forgiven (Decree114).

10 CEDEAGRO could finance: (a) working capital loans for agriculture with the exception of coffee and sugar cane; (b)agricultural investments as delimited by the BMI; and (c) agribusiness investments, excluding investments on sugar mills orbeneficios de cafe. On the other hand, CEDEVIV finances: (a) acquisition and construction of housing by low and mediumincome families; and (b) acquisition of long-term mortgage loans that were originally financed with CEDEVIV funds.

6 El Salvador:

2.19 As of April 1996, 17,753 applications had been received for a total of s1,609.1 million. The total amountof interest reduced is estimated at ¢413.7 million. Although BFA received the largest number of applications (60%of applications), they accounted for only 23% of total funds requested, while private banks and financierasreceived applications for 70% of this total. This reflects the different clientele served by these intermediaries.

2.20 Debt Forgiveness for Agriculture. In June 1996, the Government issued two debt forgiveness programswhich target the agricultural and agrarian debt in an effort to stimulate agricultural production. Since 1989, theagricultural sector of El Salvador has been greatly affected by the policy reforms introduced. As a result of thesereforms and the end of the conflict, rural and agricultural producers have been forced to adjust their economicactivities.

2.21 The sources of delinquency in agriculture are related to: difficulties created by conflict; the effects ofdroughts; rent-seeking behavior induced by Government intervention in credit markets; the impact of a strongcurrency on agricultural profitability; and the diversion of credit funds to unproductive activities (Abt. 1993).Indeed, many authors have concluded that the environment created by the conflict was the most important cause ofagricultural delinquency (Abt., 1993; Fusades, 1994; MAG, 1995). The war affected agricultural productionthrough various channels such as payment of war taxes, invasions and kidnappings. Uncertainties caused by theconflict may have forced farmers to operate below efficient production levels causing low returns.

2.22 The agrarian reform process originated the so-called deuda agraria (agrarian debt). As reported by MAG(1995) the agrarian debt resulted from: the low productivity of agrarian reform beneficiaries due to poor landquality and inexperience; lack of a recovery strategy by the Government; the conflict; and lack of working capital.

2.23 Ley de Apoyo a la Reactivaci6n del Sector Agropecuario (D.L. 698). The Law targets all agriculturalproducers, but agricultural producers directly affected by the conflict (those that qualify under D.L. 292) receivedspecial treatment. It is estimated that a total of l,152.7 million will be forgiven of which $486.1 millioncorrespond to agricultural loans that qualified under D.L. 292.

2.24 Ley de Restructuraci6n de la Deuda Agraria (D.L. 699). The Law allows for 60% discount for promptpayment of the original agrarian debt, the so-called adelantos ISTA-BFA, and FFRAP debt. The beneficiaries areagricultural cooperatives, communal associations, and beneficiaries of Decrees 842, 207, 839 and 713 of theagrarian reform. The D.L. 699 resembles the failure of the agrarian reform process and the inadequacies of theland market in El Salvador. It has negative consequences on the repayment culture because it penalizes thoseborrowers that were in good standing at the time of the Decree while loan defaulters are rewarded.

FINANCIAL INTERMEDIARIES AND LENDERS

2.25 El Salvador has a diversity of formal and semi-formal institutions providing financial services. Theseinstitutions can be classified into six categories: specialized financial institutions, second-tier bank, private banks,fmancieras, credit cooperatives, and non-governmental organizations.

Specialized Financial Institutions

2.26 The Government's key rural finance institutions are: specialized financial institutions such as theAgricultural Development Bank (BFA), the Federation of Credit Banks (FEDECREDITO) and the SmallInvestment Guarantee Fund (FIGAPE); specialized guarantee funds such as the Agricultural Guarantee Fund(FOGARA) and the Guarantee Fund for Small Enterprises (FOGAPE); the Multisectoral Investment Bank (BMI);and the Agricultural Trust Fund (FEDA). The BFA, FEDECREDITO and FIGAPE target rural producers andmicroenterprises and their loan portfolio accounted for 4.8% of total loans of formal and semi-formal lenders(Table B-7).

Rural Finance 7

2.27 Banco de Fomento Agropecuario. The BFA was created in 1973 as an autonomous, public sectorspecialized financial institution after reorganization of the Peasant Welfare Administration (AdministracionBienestar Campesino), which operated a credit program since 1962. The bank has operated under the sameregulations and supervision as private commercial banks, although it has clearly different objectives. The BFA hasa network of branches and semi-agencies with the most substantial rural presence in El Salvador. It has a total of27 branches -located mainly outside San Salvador- and 15 semi-agencies which mainly offer deposits facilities.

2.28 As presented in Chapter 4, the BFA has many problems that undermine its financial performance: agovernance structure that allows for political intervention, and goals that are inconsistent with its financialviability, a hybrid role as an instrument of the State held to the rules and standards of commercial banking, a defacto constraint on BFA's loan pricing in an environment of liberalized interest rates, and substantial losses due tohigh operating costs and poor loan recovery. Reorganization efforts have been inconsistent, closing non-bankactivities to then re-open them, and managing a number of government programs which essentially burden thebank with unprofitable activities. Debt forgiveness programs mandated by govermment have affected BFA themost, as the ensuing loss of repayment discipline further contaminates its portfolio with bad debt, while itsinstitutional mandate forces it to continue lending to a high-risk borrower class. Finally, the bank is overstaffedand 30% of its 1,463 employees are located at headquarters.

2.29 Federacion de Caias de, Credito (FEDECREDITO). FEDECREDITO is a federation of cajas de credito(rural credit funds) and bancos de trabajadores (workers' banks) which started operation in 1943 as anautonomous specialized financial institution. FEDECREDITO was founded under the Rural Credit Law whichwas revised in 1991 (Law of Credit Funds and Workers' Banks). As of December 1995, FEDECREDITO's assetsamounted to $401 million, and had 242 employees.

2.30 Although it is an autonomous institution owned by the members of the credit funds and workers banks,FEDECREDITO has historically been subject to strong governnent intervention. The rural credit funds and theworkers' banks are borrower-ovmed organizations that provide loans only to their members. These loans finance arange of expenditures such as purchases of vehicles and livestock, merchant- and trade-related expenditures, aswell as famnily expenses (i.e., medical). The loans are provided through special credit programs: agricultural credit;credito popular; credito de hienestar familiar; credit for microenterprises; and special lines of credit such asFEDA and FOCAM (El Diario de Hoy, 5/15/96).

2.31 Loan Guarantee Programs. Although loan guarantee programs have not proven effective in improvingcredit access and to support small enterprises, the Government has established two guarantee schemes to supportthese enterprises: the Agricultural Guarantee Fund (FOGARA) and the Guarantee Fund for Small Enterprises(FOGAPE), which emerged from the Peace Accords. In May 1990, BCR created FOGARA with an initial capitalof 100 million to provide loan guarantees for small farmers and agrarian reform beneficiaries. This fund isadministered by Banco Cuscatalin, a private commercial bank. FOGARA guarantees up to 70% of the loanamount and the borrower must pay 2% of the covered amount.

2.32 Banco Multisectorial de Inversiones (BMI). The Banco Multisectorial de Inversiones (BMI) is a publicsecond-tier bank founded in 1994 to relieve the BCR from the management of multiple credit lines and allow it tofocus on monetary policy. Its main goals are to help increase the amount of resources available to the privatesector for medium- and long-term investments, to promote economic growth, and to increase the competitivenessof micro- and small-enterprises among others. As of December 1995, the BMI had total assets of 03,312 millionand outstanding loan balances of '2,916 million which represent a 22% increase over December 1994.

2.33 FEDA (Fideicomiso Especial de Desarrollo Axropecuario). The Government recently established atrust fund for agricultural activities (FEDA) with an initial assignment of 0 100 million, managed by BMI. As ofApril 1996, this trust fund had an outstanding balance of 021.4 million. Since the start of operation a total of p24.3million has been granted. The objective of FEDA is to promote modernization of the agricultural sector throughlong-term financing to increase production, employment and the competitiveness of the sector. FEDA offers credit

8 El Salvador:

for livestock; aquaculture and fisheries; agricultural development; conservation, distribution and marketing ofagricultural products and their industrial derivatives; and non-traditional agro-industrial enterprises.

Private Commercial Banking

2.34 The privalte commercial banking sector includes commercial banks andfinancieras which are not allowedto issue checking accounts and offer credit transactions related to international trade. At the end of 1995, ElSalvador had licensed 12 private banks and 8 financieras with a total of 178 and 74 branches respectively.Although the performance of private banks andfinancieras is beyond the scope of this report, an issue of concernis the growth of the loan portfolio. As explained earlier, during 1991-1995 the real loan portfolio of banks grewvery rapidly at an average of 30% per year. This could be a sign of potential credit risk problems. For example,the outstanding real portfolio going to the construction sector grew at a rate of 66% per year during the sameperiod.

2.35 Banks and financieras have an increasing urban focus as their branches are concentrated in the SanSalvador Department with little presence in the rest of the country. In 1995, 57% percent of private bank branchesand 59% of financiera branches are located in the capital. In San Salvador, banks and financieras served onaverage 15,121 people per branch, while the rest of the country they served 37,180 people per branch. Thegeographical coverage of banks and financieras outside the San Salvador implies a greater distance betweenlenders and their clients that is translated into higher transaction costs for users that may induce potential clients(depositors and borrowers) to withdraw out of the market.

2.36 This urban focus impacts the geographical distribution of savings. Term deposit and passbook depositaccounts and balances are concentrated in San Salvador, even though this department has less than one-third of thetotal population (Table B-6). In 1995, 62.8% of savings balances of these two instruments were mobilized in thedepartment of San Salvador and the remaining 37.2% outside San Salvador." This gap in savings was greater 3years before, with the urban areas providing 65.5% of savings and rural areas 34.5%.

Semi-Formal Institutions

2.37 FEDECACES. The Federation of Savings and Credit Cooperatives (FEDECACES) is a legallyconstituted organization of savings and credit cooperatives (cooperativas de ahorro y credito) founded June 1966.It operates as a second-tier organization that provides financial services to affiliated and non-affiliated savings andcredit cooperatives (FEDECACES, 1995).

2.38 A total of 352 credit unions are registered win INSAFOCOOP, of which 150 are active. Thirty-eight ofthese credit unions are affiliated to FEDECACES, with more than 38,000 members. The savings and creditcooperatives occujpy a prominent place in the non-regulated semi-formal financial sector. Members of thesecooperatives are primarily microentrepreneurs, mostly men, engaged non-agricultural activities, although 30% ofthe affiliates are in rural areas.

2.39 Non-Governmental Organizations (NGOs). NGOs are heterogeneous in terms of the services offered andof their objectives. The principal NGOs established El Salvador include: the Centro de Apoyo a la Microempresa(CAM), the Programa para la Pequenia y Microempresa (Program for the Promotion of Small and Micro-enterprises (PROPEMI), Fundaci6n Salvadorenia de Apoyo Integral (FUSAI), the Integrated CommunityFoundation of El Salvador (FINCA/EL SALVADOR), and the Segundo Montes and Vecindad Community Bank(BANCOMO).

2.40 In terms of volume of loans, the NGOs sector is relatively small. The loan portfolio of CAM, FUSAI, andPROPEMI accounted for 0.3% of the loan portfolio of the system. NGOs concentrate in credit services, and arenot legally allowed to mobilize savings from the general public. In 1992, the UNDP carried out an inventory of

" These figures include BFA deposits which accounted for 1.2% of deposits in 1995.

Rural Finance 9

NGOs in El Salvador. It was found that out of 186 NGOs, 49 NGOs provide credit services and 5 of them arecompletely specialized in credit services.

MARKET SHARES OP FORMAL AND SEMI-FORMAL LENDERS

2.41 In 1995, the market shares of formal and semi-formal lenders reveals that private banks and financierasare the main players in financial markets in El Salvador (see Table B-7). However, SEIs account for an importantshare of agricultural loans and of equity. The discussion of agricultural lending is presented in the next section.

2.42 The most relevant featuires shown in Table B-7 are:* In terms of assets, the cooperatives affiliated to FEDECACES and FEDECREDITO had almost the same

share of total assets of the system, 0.9 and 0.8%, respectively.* In terms of equity, SFIs have a disproportional share of 16.5% mainly due to BFA having 14.8%. As

discussed in Chapter 4, the BFA has received large capital injections.* In terms of deposits, the two systems of credit cooperatives (FEDECACES and FEDECREDITO) have a

marginal participation in savings mobilization, 0.7% of the savings balance in 1995. In terms of volume, SFisplayed a proportionally very small role in savings mobilization given their size and particularly given theircountry-wide presence. Commercial banks have increased their share in savings mobilization. Of the threesavings instruments used in El Salvador, Banks accounted for 81.3% of their balance in 1995, as compared to76.8% in 1992. These savings instruments are passbook deposits accounts, term deposits, and HousingCertificates (CEDEVIV). The increasing participation of commercial banks comes from their aggressivepromotion of CEDEVIV and from the transformation of some financieras into banks.

- In terms of branches, the SEIs have a wide presence in the country as its branches accounted for 26.5%, withFEDECREDITO having 17.3% and BFA 6.9%. Private banks have thus been able to capture a larger share ofsavings volume relative to the size of their branch network. Part of this phenomenon is, of course, explainedby the smaller size of demanid deposits and savings accounts offered by BFA branches -mainly located in ruralareas- as opposed to private commercial banks which operate mainly in urban areas.

IS AGRICULTURAL CREDIT SCARCE?

2.43 The agricultural sector has lagged behind other sectors in the Salvadoran economy in terms of its GDPshare and its credit share. After accounting for more than one-fourth of total GDP 1980, its share declined to16.5% of GDP in 1991, and continued steadily decreasing to 13.7% in 1995 (Figure 2-2). Various factors haveinduced the slowdown of agriculture. A striking decline in sectoral terms of trade and in apparent sectoralprofitability; the large incidence of export crops in overall agricultural output; the stagnation in international pricesfor these crops; and a fixed exchange rate policy are among these factors.

2.44 Despite govermnent efforts to accelerate agriculture growth with credit, the banking sector has reducedagricultural lending relative to olher sectors, resulting in a decline of the share of agriculture in total banking crediteven more pronounced than its fall in GDP share. The increase in real lending rates has forced investors to searchfor projects with better returns, amd to face higher financial charges. From this perspective, the sectoral allocationof credit has moved away from the agricultural sector which has lower returns, to manufacturing and commercialprojects which can better absorb higher interest payments.

2.45 The magnitude of the decline of share of agriculture in total banking credit can be measured with twoindicators: outstanding loan balances (stock) and disbursed credit (flow). Real credit of commercial banks to allsectors has expanded rapidly in recent years. The outstanding loan balance of the commercial banking systemgrew on average at 31 % per year in real terms, from 06,460 million June 1991 to 0 18,978 million in June 1995(colones of 1990). However, the agricultural real loan balances expanded at 22% per year in that same period(Table B-2). As a result, the share of agriculture the stock of bank credit diminished from 14.3% in 1991 to 10.6%in 1995, thus increasing its sliglit "deficit" with respect to its share in GDP from 2.2 to 3.1 percentage points.

10 El Salvador:

However, these rates do not include refinanced balances, as refinancing (stock) data for 1995 are not reported bysector. Using an estimate of agricultural refinance for 1995, the decline in participation in the stock of formal debtwould be from 22.8% in 1991 to 15.2% 1995.

2.46 Disbursed credit (flow) to agriculture, including refinancing, decreased from 24.9% of totaldisbursements in 1991 to 13.4% in 1995. New disbursements (i.e., excluding refinance) show an even morestriking decline, from 21.4 to 9.9% of total credit disbursements over the same period. Hence, the amount ofrefinanced-loans has increased in agriculture faster than in other sectors. For example, refinanced disbursed loansto agriculture grew 4 times faster than that of non-agriculture between 1991 and 1995 (24.9% and 6.4% p.a.,respectively). The increase of refinanced disbursed loans to agriculture reflects increasing repayment problems ofthe sector . The amount of agriculture refinanced disbursed credit accounted for 14% of the total disbursed creditto agriculture in 1991, and increased to 27% of the total in 1995. Meanwhile, the share of non-agriculturalrefinancing out of a total credit disbursed to non-agriculture (including refinancing) declined firom 9.5% in 1991 to4.4% in 1995.

2.47 The increase repayment problems of the 30 1agricultural sector partially explains the relative 25-

decline of the share of agriculture in credit allocation.It also explains why the decline the agriculture share 20 - .

of the stock of crediit is not as marked as that reflected - --- _by the flow measures, since overdues disguised asrefinanced balances continue accumulate in the end- 'o - .of-year figures reported by the banking system. - .-.

2.48 In sumnnary, the share of agriculture 1991 .9,2 I993 1994 1 995

commercial banks credit flows has declined r .. GDP .b .-.b.r.-...

significantly over the last five years, while the Figure 2-2 Agriculture Share in GDP, Debt Balances, and Disbursedsector's share total outstanding debt has not declined creditas much. These trends have manifested during a period of overall banking sector growth and financial reforms, anddynamic performance of non-agricultural sectors such as commerce. These facts collectively suggest that sectoralcredit participation reflects the relatively poor sectoral economic performance, rather than constraints or barriersin the banking sector to agricultural lending. The relative decline in formal credit flows occurs at a time whenrequired changes product mix and changes technology are important measures to increase agricultural sectorprofitability. Financial markets can facilitate those changes.

2.49 Who is providing agricultural credit? Looking at the sources of credit for the agricultural sector as awhole in September 1995, private banks provided 74% of total credit granted to agricultural enterprises, whileSFIs accounted for 26% and financieras for 0.5%. Private banks and SFIs clearly have different economic sectorsof specialization. As of September 1995, the SFIs loan portfolio was almost equally split between agriculture andnon-agriculture sectors (47% and 53% respectively), while only 10% of private bank and 0.4% of financieracredit is extended to agriculture (Annex B, Table B-8).

2.50 In terms of the number of clients, therefore, SFIs served approximately 90% of totail agricultural clients,while private banks and financieras served the remaining 10%. In 1995 BFA served approximately 32,000 clients(agricultural and non-agricultural combined) with about 31,700 loans. Given a 60% portfolio composition ofagricultural credit, we can estimate that the number of clients with agricultural loans was about 19,200. InDecember 1995, FEDECREDITO had 11,145 agricultural loans in its portfolio which can be used as a goodapproximation of its number of clients. In contrast, three of the largest banks of El Salvador (Salvadoreiio,Agricola, and Comercio) and Financiera Calpia lend to a total of 3,391 agricultural clients, of which 2,151 areclients of Calpia, a's estimated through interviews with credit officials from those institutions (see Box 2-1).

Rural Finance 11

2.51 The banking system concentrated agricultural credit in two traditional export crops: coffee and sugarcane. Sixty-four percent of the total credit disbursed to agriculture in 1995 went to these crops. Traditional exportcrops such as sugar cane and coffee are attractive due to well-developed infrastructure for their marketing, highprofit margins, and low cost of enforcing credit contracts. Banks can reduce their credit risk by requiringborrowers to provide an orden irrevocable de pago from the coffee beneficios and sugar mills. In other instances,banks lend directly to these beneficios and mills, which in turn may give advances to crop growers towardsupcoming harvests.

2.52 The difference in the market shares in terms of loan portfolio and number of clients suggests that privatebanks and SFIs serve different market niches within the agricultural sector. Banks specialize in large loans tocoffee beneficios, sugar mills, and large-scale farmers. In contrast, SFIs serve mostly small agricultural producersand agrarian reform beneficiaries.

BX 2-1 Innati Fice: Financiera Calpid. ~ ~ ~ ~ ~ ~ ~ .... :: :. : - - : ... . . -: - ... .... ...--

Calpi& wasced 'in 1l995_ with. the trnformation of Servicio Crediticio de AES,'a'se' i-f ncintenediy,. mito a- finafciera, wth -teni'1cal assistance from 'GTZ and fuding from 1DB., 'CAEI o spo .Imission. is to provide loans to microenterprises in the infonnal sector at real interestprates which provide for vcos recoery and

........... .. .... . ... . . ...-_allow for. nancial and institutional sustainability. The importance of micro and small bui'nesses in El Silvd is reflec inIhe ,fi-t tha.m're' than, .9% of productive units and about 50% of the economically active popltinarefound pin th informalsector-accoutg. fior- an- estimnted 40% of.GDP. In March 1995. Calpia had disbursed 31,477loas' f abo .1' 9 noper,ted-one ,cenWt unit an'd braches with a team of 68 professionals. The key to Calpia approah t .i. ,,leding i thorcredit risk analysis. It does not allocate any of its budget to supervision. with analysts' time spent on risk .anysis an .e.atiloan disbursement, and recovery of funds.

Curr.en'tly, Calpit serves 12,300 clients, of which about 1,800 are engaged 'nagicul activities The majo -of clientsr '.wom''.. .(F.ud go, 1995). It extends agricultural and non-agricultua credit, ba o a i s .e ... Foa of 6 brahich ovide: loans to agriculture. According to its officials, Calpin started 1995 - aagricu

'of 4 ill-n, .uhich had risen to al11 million by year-end. Although agricultural lans greww 175%i. :12 monts tedelinquency rate remains at 1-1.5%.

AgricuLtural loans account for about: 18% of the total loan portfolio, despite the fact that agricultural cedit was introduced.y i late 194. Calpia. proes credit tofarers who do not have access to othersources, with loan amountsas small as 05O.

MoJstloa,nsare for working capital, withian average term of 6-9 months, for a maximum--of 1-8 months lnterest rates charged varyby sector,.Accordingto its officials, Calpia subsidizes interest rates on agricultural credit, whiclh:are offered at 3%/ per mouth,althou tcost 5.6% per month Loans to trade and services, cost 3.25% and are offered at 4%.per Moth. Loans are classifiedin two categories. (a) A for loans with an-ers of less than 30 days- and (b) E for loans with arr'''s omore. than 30 days. he.delinquency rate in. 1995 (amount of delinquent loans over total loan portfolio) was 2.22%.

Source. Miion inte ihvarious professionals at Financiera pi y 16 and 22, 996..

12 El Salvador:

Chapter 3. EL SALVADOR: RURAL CREDIT MARKETS

3.1 This chapter analyzes the availability of credit services to rural households in El Salvador. The mainobjectives are the evaluation of the performance of rural credit markets (RCMs) and the knowledge of "whoreceives credit services, under what conditions, and from whom". The data set used in this chapter come from the1996 FUSADES survey of rural households. The survey contains information about several aspects of the productiveactivities of 628 rural households from all regions of El Salvador. These households were stratified according to the maineconomic activities: (a) farmers; (b) landless agricultural households; (c) landless non-agricultural households; and(d) landless households with mixed sources of income.

3.2 The evidence presented in this chapter suggests that the perfornance of RCMs is poor. The rural credit markets(RCMs) in El Salvador are shallow because rural households have limited access to credit services: less than 12% ofrural households received a loan transaction and about 20% had outstanding debt balance from formal or informalsources. Furthermore, rural households do not have access to a variety of lenders, as only 0.3% reported debt balanceswith more than one type of lender. Rural households have little opportunity to participate in credit markets because of theweak supply of ancd weak demand for credit. On the demand side, 870/o of rural households did not apply for loans in1995. Although information regarding the weak demand for credit could not be assessed, the findings suggest thathouseholds find it cdifficult to use movable goods as collateral. Furthermore, access to formal lenders is limited to thoserwual households that could offer real estate properties as collateral.

3.3 The supply of credit may be impeded by a combination of factors: (a) an underdeveloped institutionalinfrastructure; (b) government interventions which croNvd out private lenders by allowing weak government-ownedinstitutions to lend with poor recovery rates and low interest rates; (c) debt-forgiveness programs which have createdserious credibility problems by promoting strategic defaults; and (d) previous interventions in the marketing ofagricultural products have prevented the development of informal sources of funding such as crop purchaser credits.

3.4 The rural economy may have difficulties in adjusting to the policy reforms implemented since 1989. As a resultof these reforms, rural households may need to change their productive activities, adjust their scale of operations, or investin new technologies. The performance of financial markets is crucial to the success of rual household's alttmpts toundertake those changes. Shallow credit markets may force rural households to rely on internal sources of funds whichare often limited. Furthermore, assortive matching patterns imply that rural credit markets are broken down into smallclusters in which each type of lender serves a particular clientele. The survey shows that informal lenders rely onidiosyncratic information generated through personal relationships to screen their borrowers, a practice that limits the sizeof the market.

3.5 This chapter is organized as follows. First, the characteristics of rural households, lenders and credit marketshares are presented. The conditions of loan and debt contracts are provided next. Then, the performance of rural creditmarkets is addressed from the perspective of participation and interest rates differentials.

THE RURAL HOUSEHOLDS

3.6 Rural households are varied in their levels of productive income. Table 3-1 shows the quartile distribution ofthe annual household income that rural households earn from their economic activities.12 The average income of thefourth quartile is almost 10 times larger than the average income within the first income quartile. Furthermore, in realterms the income of the first and second quartiles are below the real GDP per capita for 1995.

12 Annual householid income includes the monetary income and the imputed value of non-monetary revenues received by thehousehold. It does not include agricultural production costs.

Rural Finance 13

Table 3-1 Annual Household Income (colones)Numbber Average S. D. Minimum Maxkmem Averag hI

Annual Household Income Obs ¢ of lef1I quartile 157 5,459.9 1,982.1 610.0 8,640.0 3,899.9

2ndquartile 157 11,621.0 2,014.1 8,700.0 15,000.0 8,300.73equartile 157 20,158.9 2,946.7 15,002.4 25,715.0 14,399.24th quartIle 157 52,732.0 69,810.1 25,744.0 812,800.0 37,665.7TOTAL 628 22,492.9 39,360.5 610.0 812,800.0 16,066.4

Source: Encueesa Desarrollo Rural, 1996. The GDP per capita in 1990 colones fbr 1995 was c8,254.

3.7 Comparative statistics on selected variables were calculated for rural households. These households wereclassified according to their participation in credit markets as debtors. Debtors are those households dtat reported anoutstanding debt balance at the time of the survey. As shown in Table 3-2 debtors and non-debtors are different invarious aspects. On average debtors live in smaller municipalities, are younger, have larger households, highershare of income from wage employment in non-agriculture, higher non-agricultural income, and lower incomefrom other sources and from wage employment in agriculture. However, borrowers and non-boffowers differ in asmaller number of variables thzn debtors and non-debtors. On average, borrowers are younger, participate more ingroups and associations, and have higher levels of non-agricultural income (rable C-i).

Table 3-2 Debtors versus Non-DebtorsAll Households Debtors Non-ebtors

Variables Mean S. D.. Mean S. D.. Mean S. D.Age of household head 45.7 14.3 42.7 13.6 ' 46.5 14.4Average age of household members 26.3 11.7 23.8 8.8 26.9 12.3Number of people in household 5.9 2.5 6.5 2.6 ^ 5.7 2.5Participation in groups (% households) 9.7 29.6 14.1 35.0 8.6 28.0Income from:

non-agricultural activities 890.5 9,373.1 2,357.7 20,055.9 ** 518.6 2849.6wage employment in agriculture 4,477.2 6,712.0 3,609.1 5,123.4 4,697.3 7,045.5other sources 1,628.5 4,703.3 828.5 4,243.0 ** 1,831.3 4,795.7

% income from wage employment in 36.8 44.0 47.9 52.5 * 34.0 41.1non-agriculturePopulation in the household municipalkty 38,298.1 43,550.8 32,485.3 30,195.7 39,771.6 46,237.4of residenceSource: Encuesta Desarrollo Rural, 1993IrPr differences between means significant at the 90/95/99 percent confidence intervals, respecvely.

LENDERS AND TECWMOLOGIES

3.8 The financial system includes three type of intermediaries: (a) formal, regulated by financial authorities;(b) semi-formal depending on whether they have a government-granted license to provide financial services oroperate under a specific regulation; and (c) informal. The formal sector includes private commercial banks,specialized financial institutions and financieras, supervised by SSF.

3.9 The semi-fornal sector includes non-bank financial intermediaries and NGOs. For the purpose of thisstudy, the informal sector includes commercial credit providers, moneylenders, friends and relatives, and traders.Commercial credit providers are enterprises or individuals that exchange goods or services today for the promiseof repayment in the future. These lenders provide the loans in-kind and the effective interest rate charged isimplicit in the credit price of the goods or services sold.'3 Moneylenders are individuals who provide loans atexplicit interest payments. Friends and relatives are individuals that give credit for altruistic and reciprocityreasons without a profit motive, usually at no interest. Traders provide cash or input advances in exchange for apromise to deliver certain outputs in the future. The main example of this category are compradores de cosecha orcoyotes.

13Unfortunately, the survey does not contain information regarding the differential between the cash and credit price, and theamount of downpayment requested by these lenders.

14 El Salvador:

3.10 Lending Technologv. Any lender must develop a method to grant and recover loans. This method has twocomponents: operational and information. The operational component is related to the organizational structure,management information systems, physical infrastructure, and internal control mechanisms of lenders. Theinformation component of the lending technology reflects a particular solution to the problems of adverse selection,moral hazard, and enforcement that characterize RCMs. These problems arise from differences in informationbetween borrowers and lenders and the separation of disbursement and repayment over time. In order to reduce thedegree of information asymmetry, lenders spend resources to screen their loan applicants, monitor borroweractions and enforce loan contracts. The costs of acquiring or buying information depends on the nature of theinformation-gathering technology used by lenders, the heterogeneity of rural households, and lenders' a prioristock of knowledge.

3.11 Lenders use standard or idiosyncratic information generated by borrowers and/or lenders to screen andmonitor borrowers and to enforce credit contracts. The ability to read and use standard information is not affectedby the distance between borrowers and lenders. Its value can be easily transmitted across distance. However, thevalue of idiosyncratic information declines with the distance between lenders and borrowers. Examples ofstandard information are: audited financial statements, real estate property appraisals, credit reports, and stockprice quotations. Idiosyncratic information such as reputation is generated by interactions among local residents,or among agents in the same market.

3.12 The household survey provides indirect evidence regarding the relative importance of these two types ofinformation. Infonnal lenders rely mainly on idiosyncratic infonmation such as borrower attributes and actions toscreen their clients and enforce loan contracts. Rural households reported that the most common requirements ofinformal lenders are personal attributes such as reputation in the locality. For example, 17.8% of informal lendersrequire a good reputation from their loan applicants. However, the same households reported that formal lendersuse standard information to screen their borrowers by looking at the ability and willingness of rural households topledge real collateral. For example, as reported by rural households, the most important requirement of formallenders is real estalte collateral (70.5% of transactions).

THE REILATIVE IMPORTANCE OF FORMAL, SEMI-FORMAL, AND INFoRMAL LENDERS

3.13 The markcet shares for each type of lenders are measured in terms of the total number of individualtransactions and the total volume of transactions as reported in the household survey. Figure 3-1 summarizes themarket shares (amounts and number of transactions) of the different types of lenders for 1995.14 During 1995,formal sector lenders provided 76.1% of the total loan amounts borrowed by rural households, with the BFAaccounting for 61.2% of this total. This shows that BFA specializes in servicing rural households, in contrast toprivate banks which provided three-fourth of total credit to agriculture (Chapter 2) but represent only 4% of thetotal loan amount reported by the households in the survey. The share of informal lenders in terms of total amountborrowed, 17.7%, differ substantially from the one reported by Cuevas et al. (1991) and by Moll et al. (1997)where informal loans accounted for 66% and 10% of credit received during 1991 and during 1992-1994respectively.

14 Although the suntey recorded all loans received during 1991-95, the analysis concentrates on loans received in 1995 because itseems that households had difficulties in remembering loans received in previous years.

Rural Finance 15

3.14 In sharp contrast to other countries andTansactions 111111 Amount with previous studies for El Salvador, the survey

80.0-70.0 - findings suggest that informal credit m ahets are60.0- -relatively underdeveloped. The informoal sector50.0- -accounts for 48.8% of loan transactions, in contrast40.0- -with previous studies, where informal loans30.0 - represented between 64% and 80% of the loan20.0 - _ transactions performed by rural households. Loan

'10_0 ---- --------- M ---------- ---- services are provided mainly by BEFA (30%);0.0o _ |111 || _L; friends and relatives (16.3%); and comeercial

Formal Semi-formal Informal credit (15%). Government intervention in theFigure 3-1 Loans Received: Market Shares marketing of agricultural products may have

contributed to the scanty representation ofinterlinked credit contracts. For example, some agricultural products were marketed through goverrmnent-ownedagencies (e.g., INCAFE, INAZUCAR, and IRA).

I X*% Transactions 0% Balance X 3.15 The relative importance of formal,7D.0 semi-formal and informal lenders in terms of60.0 - outstanding volume of debt is su sta tiallyso.o 4I.-i- .I- -i ldifferent from the shares of ount4 0.0- 3__:7= [= ...borrowed in 1995. The shares of the30.0 informal sector in of volume of outstading

.... Y ........ .~~~~~... .... . ... ... 20.0 -.... > . ; : - ; ... ......... : .... debt and transactions increased, While that10.0 for formal and semi-fom . sectors0.0 decreased. The data show that 3 .1 1% of the

Formal Semi-formal Informal total volume of debt and 62.3% of the

Figure 3-2 Rural Household Debt: Market Shares number of outstanding debt contracts werefrom informal lenders. These appear more

realistic estimates of the relative importance of informal lenders.

CHARACTERISTICS OF LOAN AND DEBT CONTRACTS

3.16 The characteristics of credit contracts prevalent in rural credit markets are presented in Table 3-3 andTable 3-4 and derive from the features of contracts reported by rural households during 1995, and from theoutstanding debt balances. Five elements of the loan contract are considered: loan amount, maturity, interest rate,repayment problems, and collateral and guarantee. The main findings are: (a) formal and informal lenders provideloan contracts with different characteristics (e.g., interest rates) and exist side by side; (b) the characteristics ofloan contracts received by different borrowers depend on the lenders to which they have access; and (c) privatebanks provide larger loan sizes that allow them to charge lower effective interest rates than other types of lenders.

3. 17 Amount. While it varied significantly, the average loan size across lenders was 04,040. rhe formal sectorprovided the largest loans by far in rural credit markets in El Salvador with an average loan of 07,725. Loansbetween p5,000 and 0 10,000 represented 42% of the number of loans and 37.1% of the total amount disbursed byformal lenders. The semi-formal sector ranked second with an average loan of ¢2,439, followed by the informalsector which provided loans with an average size a little over half of that ( 1,441).

3.18 BFA provides the second largest loans in rural credit markets (p8,020) which is almost twice as large as theaverage loan granted by FEDECREDITO (,4,833). Moneylenders loans placed sixth in rank and averagedp1,645, while NGOs had the smallest average loan size (p707). Friends and relatives grant verv small loans with53.8% amounting to less than 1,000 and 19% of the total amount disbursed.

16 El Salvador:

Table 3-3 Characteristics of Loan Contracts by Lender: Amount, Maturity, and Interest RatesAverage % Transactions of Each Lender

Type of Lender No. Loan Maturity Effective Interest Land Verbal RepaymentObs. Arount (Months) Rate (% p.a.) Collateral Proriises Problems

Fonnal 31 7,725.0 16.3 18.3 57.6 7.0 33.3BFA 24 8,019.8 12.8 18.2 58.3 8.7 33.3FEDECREDITO 3 4,833.3 18.0 19.7 66.7 - 66.7Other Formal 1 13,000.0 72.0 66.7 -Private Banks 3 6,500.0 22.0 17.7 33.3 - 33.3

Seml-formal 8 2,439.1 17.9 51.3 25.0 18.5 12.5NGOs 2 706.5 10.5 59.1 - 57.5 -Bancos Comunalb 6 3,016.7 20.8 48.2 33.3 15.5 16.7Cooperatives

Informal 39 1,441.0 7.8 99.3 10.3 60.6 28.2Comrnmercial Credit 1 2 1,491.7 9.0 28.3 8.3 36.3 16.7Moneylender 11 1,645.5 7.3 199.5 18.2 69.1 45.5Friends/Relatives 13 1,092.3 6.6 0.0 - 84.9 23.1Interlinked Credit 3 2,000.0 8.7 324.0 33.3 50.0 33.3

TOTAL 78 4,040.9 12.2 58.0 31.3 17.3 28.8Source. Encuesta Desarrollo Rural, 1996The number of observations varies for each variable because of missing data.

3.19 The average loan amount granted to different groups of rural households vary considerably. For example, farmhouseholds receivedL loans averaging ,6,154 almost three times larger than landless households working inagricultural activities (02,194). Landless mixed-income households received very small loans with 50%amounting to less than 1,000 and accounting for 4.7% of the total amounts received.

3.20 The average outstanding debt balances held with different lenders show different values than that of loansgranted. However, the same pattern of market specialization is evident. For example, the average debt with formallenders is almost 4 times higher than that of informal lenders. The average debt held with private banks was 2.2times higher than the average loan size granted by infornal lenders in 1995.

3.21 Maturitvy Formal, semi-formal, and informal lenders provide loans with different maturities. Semi-formal andformal sector loans had a significantly longer repayment period, averaging 17.9 and 16.3 months respectively, ascompared to informal loans (7.8 months). Formal sector loans are usually granted with a maturity between 6 to 12months. Sixty-four percent of loans and 40.6% of the amount disbursed by formal lenders were in that category.As might be expecled, the informal sector required shorter repayment period than formal and semi-formal lenders.Fifty-seven percent of the loans and 47.4% of the amounted disbursed by informal lenders had a maturity of lessthan 6 months.

3.22 The maturity of loans vary with the type of household because they have different access to alternativelenders. For mixed-income landless households the average duration of loans is 2.5 times of agricultural landlesshouseholds. The average maturity of loans received by farm households is 10 months, and the correspondingaverage of non-agricultural landless household is 15.5 months. As a whole, rural households received small loansvith a short term repayment period. For example, 25.7% of the loans had a maturity between 6 and 12 months anda size between 0500 and 02,000.

3.23 Nominal Interest Rates. Loan transactions in RCMs have a wide range of nominal interest rates. Theaverage interest rate ranges from 17.7% p.a. in the case of private banks to 324% in the case of interlinked credittransactions. Infoimal lenders charged the highest interest rate with an average of 99.4% p.a.. Semi-formalintermediaries followed with an average rate of 51.3% p.a., while formal lenders required a much smaller returnfrom rural households, or 18.3%. The very high financial cost of informal loans may be explained by the shortmaturity and small amounts of the transactions. The nominal interest rates charged by lenders within the same groupvaried significantly more for informal than for formal lenders. The coefficient of variation (CV) is the highest in the caseof infomral lenders, equal to 243. 1%.'

5 The coefficient of variation equals the standard deviation of the variable divided by its mean.

Rural Finance 17

3.24 The interest rates charged to different groups of rural households varied. Rural households that belong tothe fourth quartile of income paid an average nominal interest rate of 15.1%, which is 8 times the average chargedto rural households that belong to the first quartile of income. The average interest rate charged to farm householdswas 7 times that of landless households working in the non-agricultural sector.

3.25 The nominal interest rates on outstanding debt balances are generally lower than that of loans granted in 1995.The nominal interest rates charged on loans correspond to the cost of acquiring additional debt, (marginal cost) while theinterest rates on debt balances represent the average cost of debt (average cost).

Table 3-4 Debt Contracts by Lenders: Amount and Nominal 3.26 Repayment Problems. The surveyInterest Rates (% p.a.) collected information to calculate two proxy

MeanType of Lender N Debt Amount Nominal Interest indicators of loan default: the percentage of

Rate (% p.a.) loan transactions and the percentage totalFonnal 44 7,138.5 17.6 amount borrowed that experienced repaymentBFA 28 6,12.62 17.4 problems. Within each approach, theFEDECREDITO 4 2,810.3 18.5Other Formal 7 8,502.9 18.5 percentage of repayment problem occurrencePrivate Banks 5 14,360.0 18.8 was computed by institution and as aSemi-formal 8 3,350.0 16.3NGOs 2 5,200.0 20.5 percentage of all nstitutions These proxiesBancos comunales/ 6 2,425.0 14.3 of delinquency have the followingcooperatives drawbacks: (a) the information was collected

Commerial Credit 87 2,2959. 306 from borrowers who may under-reportMoneylender 13 3,728.9 145.3 delinquency; (b) the amounts used to proxyFriends/Relatives 38 695.7 - arrears correspond to the loan size and not toInterlinked Credit 4 2,175.0 200.4Other lnformal 3 3,300.0 33.2 the outstandmg balance at the time of theTOTAL 134 3,728.9 31 3 arrears; and (c) the delinquency problems of

Source: Encuesta Desarrollo Rural, 1996 informal sector loans may be overestimated

because the questionnaire ignores that these loans are usually granted with flexible repayment terms.

3.27 Twenty-nine percent of all loans received by rural households experienced repayment problems. Formal andinformal sectors have the same proportion of delinquent loans (13.8% of all loans). However, formal sector loansaccounted for 17.5% of the total amount. Delinquent loans by BFA alone accounted for 10% of total numbergranted, followed by moneylenders 6.3%, friends and relatives 3.8% and FEDECREDITO 2.5%.

3.28 Repayment problems are more severe for formal lenders than for their informal and semi-informal counterpart interms of the number of individual loans. The very poor recovery rates of the formal sector are due to the dismalperformance of FEDECREDITO with two-thirds of the number of loans granted in delinquency and BFA with onethird of loans granted in delinquency. Interestingly, private banks displayed the same record as BFA. Formal sectorloans in arrears equaled 23% of the total amount granted by this sector. The corresponding percentages for loans from thesemi-formal and informal sector were 25.6 and 37.6%, respectively. In terms of amount borrowed, informal lenders havemore repayment problems than fbrmal internediaries.

3.29 Landless agricultural households fell in arrears more frequently (36%) than farm households (30.4%), non-agricultural landless households (26.9%), and mixed landless households (0%). Hence, agricultural landless householdsseem to pose the highest credit risk. The loans that fell in arrears amounted to 3 7.4% of the total amount disbursed to suchborrowers, and to 36% of the total number of loans. In contrast; mixed landless households did not report repaymentproblems.' 6

It may be the case that loans granted to mixed landless households were not yet due at the time of the interview.

18 El Salvador:

3.30 Cllate al and Guarantees on Loans. Lenders in El Salvador rely mainly on land as collateral to guaranteeloan repayment. Lender groups can be ranked by their use of real collateral as follows:* Fonnal lenders have the strictest collateral requirements. Land collateral are mainly used by formal lenders

who required it for 57.6% of their loans. These loans amounted to 63.3% of the total amount disbursed byformal lenders to rural households. Furthermore, formal lenders used animals and other property as collateralfor 18.4% of their total amount disbursed and for 18.2% of their loans.

* The semi-formal sector mainly relied on fiduciary contracts, which were used to guarantee 50.2% of loanamount granted by the sector and 12.5% of loans. This was a result of its wide-spread use with BancosComunales and Cooperativas. NGOs relied heavily on verbal promises (57.5% of total loan amount) and cropguarantees: (42.5% of this total).

e As expected, informal sector lenders had to rely mainly on verbal promises and informal agreements, whichwere used to guarantee 74.3% of transactions and 60.6% of loan amount granted by the sector. Moneylendersaccepted four types of collateral, with verbal promises backing the majority of them (69% of loan amount and63.6% of transactions they granted). Only 6.1% of moneylenders' disbursements to rural households had landas collateral.

* Friends and family use the least stringent collateral requirement. Seventy-seven percent of loans disbursedwere backed by verbal promises, which also accounted for 84.9% of the amount disbursed.

3.31 The reliance on fiduciary contracts and informal arrangements to guarantee loans indicates that ruralcredit markets in El Salvador may be segmented. On average, about 59.7% of loans received by rural households wereguaranteed widtout real collateral. These types of credit contracts make the use of local knowledge and idiosyncraticinformation about potential borrowers an important ingredient in the provision of credit. The increase mobility thatresulted from the conflict has weakened the flow of local information between informal lenders and their clients.Consequently, the lending transaction costs have increased resulting in a reduction of the supply of credit ofinformal lendevrs. These lenders may have lost some of their comparative advantage in servicing low incomeclients. The pool of already know creditworthy clients was suddenly reduced as they migrated to other areas or theprofitability o:f their activities was hampered. An efficient use of collateral may reduce both lender and borrowertransaction costs. Collateral acts as a signaling device to show borrower commitment and incentive to repay theloan.

PE, RFORMANCE OF RURAL CREDIT MARKETS

3.32 Credit markets in El Salvador are very similar to those in Mexico but differ from those in the rural areasof other developing countries. These two countries have experienced similar events such as macroeconomic andstabilization lprograms initiated in the late 1980s, nationalization and privatization of commercial banks, andgovermment intervention in output and input markets. As in Mexico, Salvadoran RCMs are: (a) very shallow asfew rural households have access to credit services from any source (e.g., formal or informal); and (b)characterized by a matching system in which households are matched with a specific sector (e.g., formal orinformal).

The Participation of Rural Households in RCMs

3.33 The participation in RCMs of El Salvador is different from that of other developing countries. First, SalvadoranRCMs presenlt very low rates of participation as measured by the number of borrowers and debtors. According to thesefindings, 11.8% of rural households had received a loan from any source (e.g., formal, semi-informal, orinformal) in 1995 and 20.2% had outstanding debt balances at the time of the survey. These unusually low ratesof participation in credit markets differ from previous studies that reported 9% to 15% of rural householdsreceiving loans from formal sources, while observed rates of access to informal finance ranged from 15% to61 %. The reported rates of participation in the rural areas of Bolivia, Costa Rica, Honduras, Mexico, Nigeria,The Philippiries, and Thailand range from 45% to 96%.

Rural Finance 19

3.34 Second, almost the same number of ruralhouseholds received loans from fonnal or informallenders, in contrast to other developing countries Formal 1.1% Informal

where the number of rural households receiving 5 .. 4%

loans from informal sources is 2 to 16 timeshigher that those from foarmal lenders. Only5.3% of rural households borrowed from formallenders, 1. 1% borrowed from semi-formal Non-

lenders, and 5.4% received loans from informal borrowers

lenders (Figure 3-3). However, 6.7% of rural 88.2%

households had outstanding debt from formallenders, 0.8% from semi-formal sources, and Figure 3-3 Participation of Rural Households in Credit Markets

12.4% from informal lenders (Figure 3-4).

3.35 The participation of rural households in credit transactions is related to their land endowments and theeconomic sector in which they operate. Farmers have the lowest participation rate in credit markets, as 16.7%had any outstanding debt balance. Access to credit services increases for landless households, as 21.3% ofthem had positive level of debt. Furthermore, non-agricultural landless households had the highestparticipation rate, as 24.7% of them were debtors.

3.36 The type of lenders to which rural80.0 - ..households have access is also associated with70.0 . - ---- the economic sector in which they operate and600 .0---------.----.-.-.-.-.-- - - ----- -.- their land endowments. A larger share of

500 0- farmers (9.4%) had outstanding debt balances40.0 - with formal lenders than corresponding landless30.0 --....... _ households (5.5%). In addition, non-agricultural20.0.- . --- landless households had the highest access to100. - _ _ infonnal lenders as 17.2% of them reported debt00oInformal o balances. Veiy similar percentages of male-headed

o and female-headed households reported outstanding

Figure 3-4 Participation of Rural Entrepreneurs as Debtors debt balances, close to 20%. Seven percent of maleheaded households were debtors from formal

lenders, while the corresponding r ate for female headed households was only 4%.

3.37 Participation rates and The type of lender to which rural households have access is not associated with theirlevels of income. Similar percentages of first quartile and the fourth quartile reported debt balances with formal orinformal lenders, close to 8.2% and 11.5% respectively.)7 In other developing countries, households with low levels ofincome are more likely to have access to informal lenders, especially friends and relatives. In El Salvador, BFA (a formallender) is the main provider of credit services in the rural areas and targets a wide range of clients. Even thoughparticipation rates are not affected by household income, the characteristics of loans and debt are associated withit. As expected, rural households that are richer, as proxied by their income, received larger loans and had largeroutstanding debt balances than their poorest counterparts.

3.38 The weak participation of rural households in credit markets results from the interaction of lenders andborrowers characteristics and of the economic environment in which these agents interact. The supply of financialservices may be impeded, among other things, by the following reasons:

17 The Chi-square test for the association between participation and income levels yields that the null hypothesis of no associationcan not be rejected.

20 El Salvador:

* Previous government interventions in output and input markets hampered the development of informal sourcesof finance, such as supplier and crop purchasers.'8

* The civil war and the induced migration have weakened the availability of idiosyncratic information and thecost advantage of informal lenders in screening potential borrowers.

* Debt-forgiveness programs have had a negative spillover effect by promoting strategic default. For example,Financiera Calpia reported that after the most recent debt forgiveness program many borrowers wanted toreceive the same benefits from the financiera.

* Underdeveloped institutional infrastructure that result in poorly defined property rights and a weak andinefficient legal system. These conditions give borrowers opportunity to default in their loans,

* Reliance on traditional lending technologies that entail large fixed costs which makes rural lendingunprofitable with small loans and a limited volume of transactions.

3.39 The effeetive demand for credit is weak as 87.2% of rural households did not apply for loans during 1995.Unfortunately, the survey did not record why rural households did not request loans. The demand for credit isaffected by: (a) interest rates; and (b) transaction costs of borrowing such as timeliness, number of trips, travelexpenses, and fees and commission. These transaction costs are affected by: (a) lending technologies and theirassociated screening requirements; and (b) the ability of rural households to signal creditworthiness to lenders.

3.40 Access to formal loans is limited to those rural households that have adequate levels of real collateral andthat demand larger loans that can support the high costs of using real collateral. As reported by rural households,70%/o of forma!l sector lenders require the title of the house or land to grant a loan. Even though informal sectorlenders rely on local information and applicant's reputation to grant a loan, the conflict may have reduced theavailability of local information which is generated through daily interactions in other markets such as output,input, and labor.

The Matching of Debtors and Lenders

3.41 Only two rural households in El Salvador reported outstanding debt balances with different types oflenders (e.g., formal, semi-formal or informal). As in other developing countries, rural credit markets exhibitassortive matching patterns that sort and link borrowing households and lenders according to classes. This regularityresuts fiom cost complementarities between lending technologies and borrower abilities to convey information abouttheir risk types to lenders (Sanchez-Schwarz, 1996).

3.42 A multinomial logit model is fitted to the participation of rural households as debtors in RCMs. Theresults of the model indicate that rural households do not have uniform access to formal and informal lenders.'9

Rural households that have debt balances with formal lenders participate in groups and associations, and have landendowments. In contrast, debtors of informal lenders have larger household size, and a higher share of off-farmnon-agricultural labor income. Rural households that are more likely to be non-debtors have smaller householdsize and a lower share of off-farm non-agricultural labor income. Although, various lenders provide loan contractswith different size, interest rates, maturities, and collateral requirements, the clientele of these lenders are notdifferentiated by size as measured by household income.

8 Adverse selection, incentive, and enforcement problems can be solved through linkages between credit market and othermarkets (i.e., input and commodity markets).9 The multinomial logit model is a discrete regression model in which the dependent variable is classified into m categories. Theparticipation of rral households in credit markets was classified into three categories: non-debtors, debtors from formal lenders,and debtors from informal lenders. The categories of infornal and semi-formal lenders were merged.

Rural Finance 21

Chapter 4. PERFORMANCE OF RURAL FINANCIAL INTERMEDIARIES

4.1 This chapter summarizes the overall performance of three financial intermediaries (Fls) operating in ElSalvador: the Banco de Fomnento Agropecuario (BFA), the Federaci6n de Cajas de Credito y de Bancos de losTrabajadores (FEDECREDITO); and the Federaci6n de Asociaciones Cooperativas de Ahorro y Cr6dito(FEDECACES). The BFA was created in 1973 to assist small farmers and rural producers, and now serves about32,000 clients. The FEDECREDITO system began operations in 1943, currently offer credit services tomicroentrepreneurs and has 57 affiliates with 201,316 members. The FEDECACES system, founded in 1966, has38 affiliates with 38,406 members. The three FIs differ in two aspects: clients and financial products. The BFAtargets small agricultural producers, while FEDECREDITO and FEDECACES systems serve mainly micro, smalland medium enterprises. The institutions differ in termns of the financial services offered. BFA and FEDECACESaffiliates offer savings and credit services, while FEDECREDITO affiliates focus on credit products.

4.2 These FIs have been singled out for analysis because they are perceived to be an important instrument todeliver financial services (credit and savings) to under-served sectors of the population. In 1995, theseintermediaries accounted for 6.1% of the net loans of the formal financial sectors, however the field surveyreported that these FIs amounted for 65.7% of the total amount disbursed in rural areas.20 An assessment of theperformance of these intermediaries is timely because the Government is looking for the identification of possibleroles and policy refortns and instruments that could assist these intermediaries in providing financial services tothe rural population. The review of these institutions draws upon previous study, available data, including financialstatements and field visits.

4.3 A comprehensive comrparative analysis of these FIs cannot be done because of gaps and inconsistencies inthe available data. In particular, consolidated data for the two federations and their corresponding affiliates werenot available. As a result, the, financial performance of each federation and its affiliates is presented separately.This highlights the difference between the FEDECACES and FEDECREDITO systems: while the latter operatesas a vertical structure with most funding for the affiliates being provided by the federation, FEDECACESaffiliates are essentially independent units relying primarily upon locally mobilized funds. As a consequence, forthe FEDECACES system, one should focus more on the affiliates than on the federation, while the opposite is truefor the FEDECREDITO system. For the latter, there is an inherent risk of double-counting in the figures reportedfor the federation and the affiliates, a risk that one cannot be certain to have fully under control. Throughout thechapter FEDECACES and FEDECREDITO refer to the federations, while their networks (federation andaffiliates) are denoted as FED]ECREDITO and FEDECACES systems.

4.4 The presence of these rural financial intermediaries in El Salvador have been costly for the Government.Recapitalization measures, and government transfers due to foreign exchange losses have drained the budget anddeprived other sectors of the economy. During 1990-94, the Government transferred ,2,361.4 million to privateand autonomous financial institutions (FUSADES, 1994). In general, these intermediaries have not mobilizeddeposits efficiently. They are characterized by inadequate provisions for bad debts, poor financial reporting, anddeficient regulatory and legal frameworks.

4.5 Following Yaron (1992), two criteria for the performance of RFIs are used: (a) the level of outreachachieved; and (b) self-sustainability. Self-sustainability is defined as the ability of the financial intermediaries toobtain a return on equity at least as high as the opportunity cost of equity. The subsidy dependence index is used tomeasure the level of self-sustainability. Outreach is measured by number of loans and savings accounts, theaverage size of loans and savings accounts, and the real growth of assets. Detailed financial statements of the FIsare presented in Annex B.

20The relative importance of the affiliates of FEDECREDITO and FEDECACES in the market of loans has remained stable since1991. However, BFA's share of total net loans has declined from 5.2% in 1991 to 3.5% in 1995.

22 El Salvador:

OUTREACH

4.6 The clients of the institutions are engaged in different economic activities. BFA targets agriculturalproducers, while the two cooperative systems serve microentrepreneurs. The clientele of the two federations havedifferent gender profiles. The clients of FEDECACES affiliates are mostly men, while the clients ofFEDECREDITO affiliates are mostly women (especially the program of Credito Popular).

4.7 FEDEICREDITO can provide its services only to rural credit funds and workers' banks. In contrast,FEDECACES provides financial services and technical assistance to credit cooperatives that are not affiliated tothe system. FEDECREDITO and its affiliates grant loans under individual and group lending technologies, whilethe BFA and FEDECACES affiliates use individual loans.

Table 4-1 Outreach Indicators: 1995FEDECREDITO FEDECACES

BFA Federation Affiliates Federation AffiliatesNo. of clients or members 32,000 201,316 - 38,406No. of clients in rural areas 19,200 12,595 n/a nta n/aReal growth rate of assets (1994-1995) 6.3 -4.4 12.6 -27.4 4.0Number of affiliates or branches 27 branches 51 rural credit funds 38 credit cooperatives

and 6 workers' bankNumber of employees 1,463 242 704 51Loan OutreachNo. of loans 30,977 68,345 87,025 nta n/aLoan portfolio (thousands of colones) 1,189,700 340,938 516,758 39,385 334,718Average Loan Size (colones) 38,406 4,988 5,938 nta n1a bNumber of Loans per staff 21 282 124 nta n/aSavings OutreachNo. of accounts 57,259 n/a n/a n/a n/aSavings Portfolio (thousand of colones) 369,736 23,123 20,589 4,222 222,855Average Account Size (colones) 6,457Source: Annual Reports of BFA, FEDECREDITO, and FEDECACES; Fundaungo (1995); and Interviews* BFA: 60% of the number of agricultural loans; FEDECREDITO: number of loans to agriculture plus 58% of the number of loans of theprogram Credto Fopular. Fundaungo (1995) reports that 58 % of the clients of that credit program lived in rural areas.Fundaungo (1995) reports for two SCCs that loan size ranges between one to 350 thousands of colones.Correspond to passbook savings and certificate of deposits

4.8 Loan Outreach. The data indicate that the BFA and FEDECREDITO have a limited loan outreach as theyserved about 16% of all agricultural enterprises. However, as shown in Chapter 2 BFA granted 30% of all loansreceived by rural households in 1995. According to BFA officials, the bank serves 32,000 clients on a regularbasis and 38,000 clients as a result of the Peace Agreements.2 ' About 30,000 of BFA's current clients receiveloans of less than 0 100,000.

4.9 Comparing the average outstanding loan size among these institutions with the average loan size reportedin the rural household survey reveals that BFA serve a more diverse clientele than FEDECREDITO. The averageloan size of the BFA is p38,406, however, the rural household survey shows that loans granted by BFA had anaverage size of 08,019. The average loan size of BFA may seem disproportionally high but it is 21 times lowerthan that of the average agricultural loan of two banks that account for 37.5% of the agricultural loans.

4.10 In 1995, the real growth rate of the loan portfolio of the BFA and FEDECACES have been moderate ascompared to FEDECREDITO and FEDECACES affiliates, and the average Salvadoran bank. The real growth

21 In 1992, BFA had 9,024 clients (Wenner and Utunafla, 1993)

Rural Finance 23

rate of the loan portfolio was 8.5% for the BFA, 22.9% for FEDECACES affiliates, 17.3 percent forFEDECREDITO affiliates, 4.5 for FEDECACES, and 17% for the average bank.

4.11 Savines Outreach. The FIs are allowed by law to use different mechanisms to mobilize savsings.FEDECREDITO is restricted to offer forced savings services that are attached to credit programs. In contrast,BFA and FEDECACES can offer voluntary savings and in recent years have initiated strong savings mobilizationprograms. High rates of real growth of deposits shows that savings mobilization efforts have been successful forBFA and for FEDECACES affiliates. In 1995, the real growth rate of deposits was 43.1% for the BFA, 23.7% forFEDECACES affiliates, against -22.2% for FEDECREDITO affiliates (see Table D-1 1). The relative success ofthe BFA in savings mobilization during the past three years, suggest that the demand for savings in the rural areashave been overlooked in El Salvador.22 The average savings account for BFA was of 06,457, or 18% lower thanthe average savings account of commercial banks outside the San Salvador department.

4.12 Savings mobilization efforts at the BFA, however, are far from satisfactory. Mobilized savings accountedfor 31% of the BFA's loan portfolio and for 29% of assets in 1995 (Table 5-1), a factor that contributes to itscontinuing dependence on outside funds and subsidies. In contrast, FEDECACES affiliates finance two-thirds oftheir loan portfolios with deposits mobilized from their members and the general public, a share much closer tothat shown by commercial banks (see Table D-12).

FINANCIAL PERFORMANCE

4.13 The financial performance of the BFA was compared against the average Salvadoran bank. Whilecomparing a development bank to the average commercial bank may have some drawbacks due to the differencesin clientele and business practices, this type of analysis can be useful in revealing general industry trends andhighlighting the strengths and weaknesses of this institution. The FEDECACES and FEDECREDITO systemswere compared against each other when possible. Trends in the financial performance of these intermediaries werealso summarized for 1993-95.23

Box 4-1 Risk of Financial IntermediationCredit Risk. Credit rsk refers to the- potential variation in net Interest:Rate Risk. Interest rate ris=k is the inincorne'that results from non-repayment ordelayed payment. interest rates will adversely affect net interest margin due'to a

mismatch of rate-sensitive assets and liabilities when interest rates:fluctuate..

capital .or- Solvency Risk. Capital risk refers to the potential Liquidity risk. Liquiidity of an .assets: refers to the ability of-an-decrease in tnet,assets.yvalueleading to insolvency. An insolvent owner to convert the asset to cash withminimal. loss from price andfinancial.intermediary.can notmeetr cash outflows:due to operating depreciation. Liquidity risk then refers to hvariation in netexpe 4 deposit s 'wthdrawals, and maturtdebt obligations. income:causes by aJfinancial.intenediaries' dfficul to obtain

cash at a reasonable cost..O-erational Risk. O .peraiarisk is the variation in net income Subsidy-dependence Risk. Reductions in the-annua fl..ow Of

- ark-et vaue of euity due to :the ossibility that operating subsidies may -.endanger the stability of the intermediary and.eense .. tvary significanty fom what is expected due to therefore, the holdihgs of ts depositors if any. More importadlyoperaing co6ts, ,employeeso errors, incidence of employee and the Instability of services discourages repayrent. and deteriorates

..customer theft, and other factors, customer relationships.S$ou'r.c .. Koch1(1990) and Chaves and Gonzalez (1992)-Net intee tn44uaIi the rato of net interest income to eaming assets.

4.14 An important caveat needs to be introduced when analyzing the FEDECACES system: the "locus ofsustainability" is not the federation (as it is in FEDECREDITO given its vertical structure) but the individualaffiliates, for which we did not have sufficient data. This means that the SDI calculated for the federation wouldnot have the same meaning (or level) as that estimated for the affiliates had data been available, and can hardlyreflect the subsidy dependence of the system since most of the network savings mobilization is recorded at the

22 Unfortunately, the household survey did not ask for financial savings.23 The data used for the analysis of the BFA and FEDECREDITO were derived from the financial statements published by theSSF while for FEDECACES financial statements published in its annual reports were used.

24 El Salvador:

affiliates, not the federation. For example, the SDI estimated for FEDECACES is much higher than the levelcalculated for the BFA, even though the FEDECACES affiliates relative reliance on external funds is less thanone-half that of the BFA (see below).

4.15 The financial analysis is organized by types of fundamental risk in financial intermediation. These risksare: (a) credit iisk; (b) interest rate risk; (c) liquidity risk; (d) operational risk; and (e) capital or solvency risk(Box 4-1). Each type of risk is associated with the uncertainty in the realization of net returns on assets. Inaddition, development banks face subsidy-dependence risk, which is associated with the possibility of reduction inthe annual flow of subsidies that may endanger the stability of the intennediary and, if they mobilize deposits, thesavings of its depositors (Chaves and Gonzalez-Vega, 1992). Financial indicators are presented in Table D- 11 andTable D-12.

Performance of BFA

4.16 The BFA is a stated-owned bank founded in 1973 that competes with private commercial banks and otherfinancial institutions in offering financial services such as loans, savings, wire transfers, checking accounts andmoney orders. In December 1995, BFA's assets amounted to 0 1,635 million which accounted for 4.1% of the totalassets owned by commercial banks.

4.17 Besides its regular banking activities, BFA manages other programs according to government mandates.These programs are: (a) Programa para Reserva Estrategica de Alimentos Basicos; and (b) Government trustfunds. The combination of banking activities with these other programs weakens the reputation of BFA as acommercial bank. In 1989, BFA entered a period of reorganization, by initiating the closing of its non-bankingactivities, such as marketing of fertilizer and grains. Nevertheless, BFA now plans to create a almacen generaldep6sito, an inmobiliaria, and a brokerage firm (puesto de bolsa).

4.18 Significant government transfers have been necessary to keep BFA afloat due to its very low recoveryrates, subsidized interest rates, directed credit programs, and the exertion of political influence to the detriment ofsound business policies and banking practices (IPC, 1993). Table 4-2 shows assistance from Government andother measures undertaken in recent years.

4.19 Profitability. The performance of BFA in termns of return on assets (ROA) is not satisfactory and has beendeclining since 1993. BFA's return on assets (0.2%) fell short of the average private bank (1.7%) and used lessdebt-financing so that its equity multiplier was almost 8 times smaller.

4.20 The three main factors affecting the profitability of BFA are: administrative expenses; quality of the loanportfolio; and high proportion of fixed assets. Operating expenses were well above that of the average bank mostlikely because BFA grants smaller loans and targets small agricultural producers. BFA was less efficient incontrolling expenses as compared to the average bank since it had a profit margin of 0.9% (against 12.1% of theaverage bank). BFA's asset utilization (operating income / average assets) of 17% was insufficient to offset itslower profit margin, resulting in a low ROA. Provision for loan losses relative to operating income is four timesthat of the average bank because BFA's management recognizes that the bank is exposed to large losses fromproblem loans and thus reports an amount of interest income which overstates what will actually be earned.

Rural Finance 25

Table 4-2 BFA: Government Assistance and Interventions.Year Measures1969 * BFA exchanged lbad loans for FFRAP bonds for 0176.8 million."1990 * 8FA received government bonds (bearing 14% per year) for ¢227.9 million as a payment for bad loans from agrarian

reform beneficlaries (adelantos-ISTA-BFA) and In exchange of ¢91.1 million of FFRAP bonds.eb1991 * Government assumed BFA's debt to foreign creditors for ¢533 million of which ¢400 million went to BFA's capital. The

remaining were refinanced at 4% per year. a* BFA bought back $11 million worth of loans which were sold to FFRAP.b

1992 * BFA pay back debt related to forelgn creditors for ¢122.3 million of which ¢107.7 paid with Bonos de Conversi6n yConsoldacdin de l DVeuda Pabica

* D.L. 2921994 * The debt of beneliciaries of D.L. 292 of less than ¢5,OOO was forgiven (Decree 114). According to BFA's official this

debt forgiveness represented ¢25 million1996 * D.L. 698 and D.L. 699 (Chapter 2).Sources: Carrandi (1992). IPC (19D93), and 'Memorias BFA, 1992

4.21 Fixed assets represented 7.8% of total assets, and are comprised mostly of warehouses and agriculturalprocessing equipment for grcnos bdsicos that BFA has been unable to sell. The bank started a program to increasethe utilization of its warehouses in August 1996 and undertook a feasibility study to operate its four warehousesfrom one subsidiary company. However, the business prospects of what is being proposed are not good, thefacilities are technically in excellent repair. Lacroix (1997) proposes to lease the facilities to private investors asan alternative to circumvent privatization and to avoid recognizing a big capital loss.

4.22 Credit Risk Management. Despite government interventions to rehabilitate BFA's loan portfolio, its creditrisk surpasses that of the average bank for all financial ratios. Past due loans were four times higher than theaverage bank accounting for 22.5% of loans in 1995. BFA's annual provision for loan losses, measured as apercentage of the average loan portfolio, was 12.7% in 1993, 3.2% in 1994, and 4.4% (3.4 times higher than theaverage bank) in 1995. Even though BFA is exposed to higher credit risk, its annual lending interest rate averages309 basis points lower than ithat of the average bank. BFA has increased its lending rate in real terms, reachingpositive values in 1995. Its interest rate policy is not consistent with its credit risks.24

4.23 The bank was able to improve the quality of its loan portfolio over the last three years, after a long historyof delinquency problems (IPC, 1993; Abt., 1993). Reserve for loan losses as a percentage of the average annualloan portfolio serves as a proxy of the riskiness of the loan portfolio and the adequacy of loan loss reserves whencompared to the risk classification of loans. This indicator was 34.9% of loans in 1993, 30.6% in 1994, and26.1% in 1995. Loans classified in risk categories D and E represented 27.9% of risk assets, or 8.2 times than thecorresponding figure for the bianking system as a whole (3.4%).

4.24 BFA has implemented the following actions to increase loan repayment: (a) creation of a "gerencia derecuperaci6n"; (b) installation of new software to keep track of defaulted loans, classify loans according to risk,and monitor loan disbursement; and (c) creation of an incentive system for prompt payment (BFA Memorias,1995).

4.25 BFA's delinquency piroblems can be seen as a by-product of the agrarian reform that started in 1980. Thebank was then forced to grant loans to recently-formed cooperatives without experience in farm management,generating in this way, the so-called "adelantos-ISTA-BFA" delinquent portfolio. When Phase II of the agrarianreform started in 1980, BFA's policy of granting loans to small beneficiaries further inflated the delinquentportfolio and generated a pattern of repayment problems which worsened the viability prospects of the bank.

24 IPC (1993) summarizes the major obstacles for BFA to raise its lending rates.

26 El.Salvador.

4.26 The composition of BFA'sportfolio reflects its driven mandates and

Manufacturing Other the political interference it has sufferedComnmerce 5% 5% over the years. Figure 4-1 indicates that

10% , -54.6% of total outstanding loan balances

were used to finance agricultureactivities. The other activities financed

Agricuture by BFA are: other sectors (25.7%) which

Other ( kedi_ 54% included refinanced loans, commerce(Refinancing) (9.9%), manufacturing (4.6%), and

26% services (2.9%). A close look at the

"other" category may uncover diverseforms of politically motivated lending.

Figure 4-1 BFA: Distribution of Loans by Economic Sector, 9/954.27 Capital Adeqiuacv. Government

transfers to restore BFA's capital resulted in a strong capital position that is consistent with the risky profile of itsloan portfolio. However, the real value of its capital has been declining since 1991. During the last three yearsequity averaged real growth of -8.2%. BFA's decapitalization results from low levels of net income that areinsufficient to compensate for inflation.

4.28 The bank had an unadjusted equity to assets ratio of 39% and a risk-adjusted capital to assets ratio of46% 1995-the second highest among commercial banks.25 Total capital was 63.4% of total liabilities and offbalance sheet items, which is almost 16 times higher than the minimun required by law and 6.9 times higher thanthe average bank.

4.29 Operational Management. BFA has improved management of its administrative expenses during 1993-95,but continues to have lower productivity indicators than the average bank. As a percentage of its average loanportfolio, administrative expenses of BFA reached 9.2% in 1995, almost two times higher than the average bank.BFA's administrative costs were equivalent to 12.4% of its average annual net loan portfolio, as compared to3.5% for banks. Given its extensive network of rural branches, centralized operations, and small loans it would beexpected that the BFA would have high overhead expenses. Yaron (1992) explains that operational costs of 5 to6% of the average annual loan portfolio are reasonable for an institution that targets low-income rural producers,while in practice operation costs of 8 to 10% arc commonly observed in development banks in Latin America(Cuevas and Poyo, 1989).

4.30 The productivity of BFA's employees is lower than that of the average bank. BFA employed almost fourtimes more people relative to its assets than the average bank. The BFA had 1,463 employees, of which about 500are located at the main office, with administrative costs of 121.5 million. The number of employees increased in1995 to handle activities related to the Plan de Reconstrucci6n Nacional (PRN). Another indicator of the lowproductivity of BFA is the number of loans per employees. At the end of 1995, each BFA employee serviced onaverage 21 loans, less than one-sixth of the average for Financiera Calpia which also serves low income clients.

4.31 Ownership and Organizational Structure. An important factor that affect the performance of the BFA isits governanoe structure. BFA is governed by a Board of Governors which is composed of the President of BFA-who, along with the vice-president, is named by the President of the Republic-representatives from the Ministryof Economy, officials from the cooperative sectors and the President of the Central Bank. The current governancestructure pennits members of the Board to use BFA for political purposes instead of focusing on its financialviability. The Board of Governors sets policies that are implemented by the Board of Directors and the topmanagement of the bank.

25 The banking law requires a proportion between equity and weighted assets of 8%.

Rural Finance 27

4.32 Borrowed Funds. Borrowed funds from BMI and foreign institutions, as a source of liquidity, increasedfrom 18.8% of assets in 1993 to 28.7% in 1995. BMI loans to BFA represented 99.3% of borrowed funds in1994, while in 1995 they accounted for only 67.8%. The relative decline in BMI funds has been brought about byan increase in borrowings from foreign institutions.

4.33 Savinns Mobilization. The "savings idea" has been around BFA for a long time, and in recent years it hasresulted in significant changes, of its liability structure. This change is the result of BFA's official policy to changethe image of the bank from a lending window to a financial intermediary that depends on savings mobilization tosupport its credit operations. The savings mobilization efforts have increased deposits from 13.8% of assets in1993 to 29% in 1995. Even though deposits relative to assets in the average bank are 2.5 times larger than inBFA, they have been growing at BFA in real terms 15.3 times faster than deposits at the average bank. Accordingto BFA officials, the bank has opened 15 sub-agencias that offer savings opportunities in rural areas. Women arean important target of the molbilization program, as reflected by the regular raffles of equipment such as sewingmachines and planchas de pup7usas used by the bank to promote savings.

4.34 Savings mobilization always create liquidity risks due to unexpected withdrawals of funds. BFA is in abetter position than the average bank to cover cash requests from depositors and borrowers. It had 44.2% of itsdeposits in commercial banks and BCR, while the average bank had only a third of its deposits available as liquidassets. Increased savings mobilization has resulted in an increase of interest expenses with respect to interestincome. This ratio increased from 26.4% in 1993 to 32.6% in 1995, due to the reduction of the relative importanceof subsidized borrowed funds ifrom BMI.

4.35 Index of Subsidy Dependence. The subsidy dependence index was calculated for the period 1993-95 toobtain an indication of whether BFA has been making progress in reducing its dependence in subsidies. Thecalculated SDI makes the foll,owing assumptions: (a) miscellaneous subsidies are zero; (b) reserve requirementsare not remunerated; and (c) loans from foreign institutions are not acquired at concessional rates. It is expectedthat the total amount of subsi,dies is underestimated because it is likely that loans from foreign institutions areborrowed at concessional rates, and that BFA has received direct or indirect subsidies from the Government. Inany case, the estimation of SDI can be useful in revealing general trends of subsidy dependence and should beconsidered as a lower bound.

4.36 The SDI calculations indicate that BFA has worsened its subsidy dependence performance during 1993-1995 and had a moderate degree of subsidy dependence in 1995 (100.8%). This means that BFA would have hadto increase its average lending interest rate by 100.8%, from 20% to 40.7%, to eliminate subsidies. BFA increasedits dependence on subsidies due to low levels of net income, and an increase of concessional borrowed funds.

4.37 Trust Funds Administration. The administration of these trust funds increases overhead expenses forBFA. Among the four trust funds administrated by BFA, the Plan de Reconstrucci6n Nacional (PRN) accounts for92.1% of the loans granted from these funds (BFA Memorias 1995). The number of beneficiaries since thebeginning of the PRN reached 25,277 of which 15,889 received disbursements during 1995. According to BFA'sofficials, in 1995, the bank opened 9 branches and expended 40% of total operating expense to serve thesebeneficiaries. It needs to be determined whether BFA receives any monetary benefits from this activity. In anyevent, linking BFA to PRN has perverse reputation effects on BFA's loan recovery rates.

4.38 Summary and Evaluation. In 1995, BFA faced the same structural problems that it did in 1992. Theseproblems are: (a) increasing SDI; (b) significant Government transfers have been necessary to keep BFA afloat;(c) unsatisfactory and declining rate of return on assets; (d) high operating expenses which are well above those ofthe average private bank; (e) despite government interventions to rehabilitate BFA's portfolio, its credit risksurpasses that of the average bank for all financial ratios; (f) while management has cut administrative costsduring 1993-95, BFA continues to have lower productivity indicators than the average bank; (g) the currentgovernance structure is amenable to politicization of decisions; and (h) savings mobilization efforts have increaseddeposits from 14% of assets in 1993 to 29% in 1995.

28 El Salvador.

Performance of Client-Owned Organizations

4.39 Two independent systems of credit cooperatives developed independently in El Salvador. These systemsare organized under the umbrella of their corresponding federations: FEDECREDITO and FEDECACES. Thesimilarities and differences between these two systems are presented in Box 4-2.

4.40 The performance of these two systems in terms of return on assets (ROA) and return on equity (ROE) isnot satisfactoiy and has been declining for FEDECREDITO and FEDECACES affiliates. The common factorsaffecting the lprofitability of these intermediaries are high administrative expenses and credit risk managementwhich are documented below. After adjusting FEDECREDITO's income statement, it had a ROE of -0.7% thelowest among all FIs.26

4.41 Credit Risk Management. The credit risk of FEDECREDITO, and FEDECACES surpasses that of theaverage bank. The reserve for loan losses accounted for 7.5% of its gross outstanding loans for FEDECREDITO,4.8% for FEDECACES, and 5.8% for FEDECREDITO affiliates. The two federations have implemented actionsto increase loan repayments. FEDECACES's measures include: supervision to the savings and credit cooperatives(SCCs), technical assistance to SCCs that have shown deficiencies in credit risk management, and refinancing.The actual credit risk faced by the two systems (the federations and their affiliates) and the adequacy of thereserve for loan losses can not be properly evaluated. There is a need to improve the accounting procedures of theinstitutions by providing information on rescheduled loans. The reporting of arrears is generally poor.

4.42 Capital Adequacy. In 1995, the two federations had negative real growth rate of equity, however theiraffiliates showed positive real growth rate. The federations are eroding their capital base due to low levels of netincome and high operating expenses. The unadjusted equity to assets ratio of FEDECACES, FEDECREDITO andFEDECREDITO affiliates increased during 1993-95.

4.43 Operational Manatement. The operational expenses percentages calculated for these institutions arehigh, however, they show promising trends.27 These estimates indicate a lower bound because some of theinstitutions have received subsidized technical assistance. The data show a wide range of operational costs asmeasured against average annual assets. For 1995, these operational costs varied from 5.6% (FEDECACESaffiliates) to 8.7% (FEDECACES federation) of total assets.

Box 4-2 Similarities and Differences between FEDECREDITO and FEDECACES Systemsffi ffi E . . . . ... . EE E i * = t ^ .................... ii .........Eii ..E.hREnsafiAense. . . . . . .

. . EE EEE i vlrEson' :E:iEiE : e iii i ........................-.................. . ......................I........... .. ................ E REE lZw;

X Savings Mobilization. The FEDECACES.systm ha. Cifent-Owned. The: pr-blemns. of o ..10 own l-:n-stIlon-- n-shown a greater ephas7s on savings mbili2ation than theS f n which are increased by-the rule of oe-an-oevote are f

:EDECREDITO system. present in both federations-and their affiliates which result in..* hAflits In toFEDECREDITO low le o4 io:Anternal monin (a 19. ai r

..... mu ie dential supertvisionisu ................is.requiredanFEDECACS affiliates arecreatedby local initiativef mn do e Unfficato E Te tw ooperative systems of EIno .need appa cI FEDEACES. Sa0000:0\lvador00 ar X tadng tsimilar stetors th ntgrtiont ofa.. n '.-......r.n: T e is no minimum t.................f............. - ;filiate, .ep -ar (a)t

.............-1 u n torat a savins and creditcorae acountingsof tirafilte: (b).Imp su..rbut:the ----i..u.num number.:f: f of members I; fteen, activities; .(c)raft.ing of newa leva iframewr f- the.................DE CES iI t i s (d) traI ...................ning acivities of enl and(s)

.. t--o.ofeach -meme. -i nt, at, 2.O s retuired * tIA. tot h . e :to

... . ;. ; ; . . ... ...;. .. .. .. ..

t...,,:,. .create.a c.. o crDi.l Thne 8CR drarr law proposed to otain..delegat. superv.so. y role frorn the .. te miorerAis hslnit 0 000 -eroranimfuheinafiiaes....... ...... .. ...... ..i p ow. -0-00 --- ;"n ;; 0* tWHIM -" *W - E:- r :l t ;i;j;

4.44 FEDECREDITO, and the affiliates of FEDECREDITO and FEDECACES improved management ofthieir administrative expenses during 1993-95. While steadily improving, the productivity of FEDECREDITO'semployees was lower than that of the average bank. FEDECACES affiliates presented the lower level of

26 FEI)ECREDlTO has the policy of accounting as revenue the reversion of reserves.27 Provision for loan losses are not included as operational expenses.

Rural Finance 29

administrative expenses as a percentage of assets (5.6%) than FEDECREDITO affiliates (7.6%). FEDECACESactivities such as staff training contributes to lower operational expenses of its affiliates, but its ability to controladministrative expenses at the federation deteriorated during 1993-95. As a share of average annual assets, thesecosts went from 6.8% in 1993 to 8.7% in 1995. The ratio of operational expenses and assets of FEDECREDITOaffiliates (7.6%) is higher than their federation (5. 1%).

4.45 Index of Subsidy Dependence. The Subsidy Dependence Index (SDI) was only computed for thefederations because of the shortage of available data. The data indicate that the two federations differed in theirlevel of subsidy dependence. Furthermore, FEDECREDITO increased its level of subsidy dependence during1993-95. FEDECACES at ithe federation level had a high degree of subsidy dependence in 1995 (234.5%). Thismeans that FEDECACES would have had to increase its average lending interest rate by 234.5, from 11.9 to39.7%, to eliminate subsidies its dependence of subsidies. The structure of the FEDECACES network and itsfunctioning makes this indicator misleading, however. While the unit of operation and performance is the affiliatecredit union, the federation is the official recipient of technical assistance grants and soft loans. A more accurate,and meaningful, analysis of the subsidy dependence of the network would require further detail in the dataavailable.

Box 4-3 FEDECACESThe Fe,eratlon of Savns: and Cr'di' Cooperati'es (FEDECACES) Is a legjally constituted d''e '4 of sa

lnd credit. ...oope.ti.e (as.c, clones cooperatives de ahorro y.cr6ofto, SCCs) founded ..in..Ju 9..ne ,19 6. It.. seco-a n-ierorganat atrovie... nnl.. s..t affiliatedandd non-afliatedsavings and cd erats i A ,1

I : .tol f 352 -credit unions. are registered with INSAFOCOOP, of which 150 are active. .(Fundaungo, 1.995). mlyioh t SCCsar 4'f.0- e wianh;FEQECACES ad credit cooperatives affiliated wth FEDECACES a r p n reguated 42m0ormalfinanci s t with tal ets of,¢ 42.4 millIon n 1995 these coo prativ had '38,406 mbs

Afte pass t h te se of erng Xw anempis on. savings mobili FE AS hs as isobjeties a}ocandenoic:1nte§ratlon f .the siaving ad crdit coopratives of El Salvador; (b) finiancial strengtheningothl oeratrves thro h. h est ishmert of systems which allow them t ' a 'ttrt inve't and effiently m anag an a iresources, and p:) promotionof the organiation, affiliation and development of new saving and credit cooperatives. F EDECACES has setas its new role ̂.the.* esta ment tof a sytem of cooperatv financial intermediation." Howve theaffilits e ve dive'i s ad a tlgre .wth thnew :ro. of FEDECACES. Consequentty, the achievement of the proposed new role may be:thten. In an event the

inana viab"`b of FEDECACES affliates must be strengthen before any measures are taken towards integration.

4.46 Ownership and Organizational Structure. The current governance structure of FEDECREDITO allowspolitical interference in the financial decisions of this system of client-owned institutions. For example, almost halfof the members governing board which is responsible for setting financial policies represent the Ministries ofEconomy and Agriculture, and BCR. The president of this board (named by the President of the Republic) alongwith managers for administration, finance, credit and operations are responsible for planning, implementing andmonitoring daily operations and compliance with laws and financial regulations (Abt., 1993). The owners' lack ofcontrol and management of FEDECREDITO has weakened its financial viability. The proposed project of reformof the FEDECREDITO will address this deficiency by restoring the control of the organization to its members.

MAIN ISSUES

4.47 The FIs reviewed have many similarities and differences. All three institutions started as supply-led FIsfocusing in the delivery of credit services rather than providing savings facilities. The BFA and FEDECREDITOsystem have been subject to strong political interference and the imposition of special "social" mandates clearlydominates the institutional philosophy and their operations.

4.48 Remilatorv Framework and On-going Reforms. The legal frameworks of the Fls is fragmented into threelaws, one for each Fl. Even though, the BFA is regulated as a commercial bank, its governance structure andmandates are clearly defined by the Ley Orgdnica del BFA. Due to the similarities between the FEDECACES andFEDECREDITO systems the Government is considering the unification of the regulation, governance, charter,and status of these systems. Such unification would imply the emergence of a single organizational form for thecountry's credit cooperatives and would include them under the supervision of the SSF. The implications of suchunification are addressed in Chapter 6.

30 El Salvador:

4.49 Decapitalization. The BFA and the two federations of cooperatives are eroding their capital in real terms.Even though FElDECREDITO's capital declined in real terms last year, the capital of its affiliates grew 16.7% inreal terms in the same year. FEDECACES (federation) experienced the largest declined of capital in real terms butits affiliates show the lowest decline of all Fls.

4.50 Operational Expenses. The performance of FIs in terms of administrative costs measured against the FI'sassets varied suabstantially. The difference in administrative costs between FEDECACES and FEDECREDITOaffiliates can be explained, in part, by their different average loan size. In general, credit programs which involvedthe handling of small loans are more likely to incur higher administrative costs. The BFA has improved themanagement of its administrative expenses during 1993-95, but continues to have lower productivity indicatorsthan other FIs, but FEDECACES. The productivity of all FIs' employees is lower than that of the average bank.However, FEDECREDITO had a higher value of assets per employees than BFA and FEDECACES.

Chapter 5. THE ENVIRONMENT FOR FINANCIAL TRANSACTIONS, AND NEWFINANCING INSTRUMENTS

5.1 This chapter turns to the question of what are some of the more appropriate vehicle agencies and productsto deliver quality financial services to under-served sectors of the population. What financial products, includingnon-bank credit products, offer possibilities for expanding rural credit, reduce its cost, or alleviate informationasymmetry problems? Are there legal, regulatory, or policy barriers to the development of such products? If so,what can be done to remove them?

5.2 The chapter reviews first the status of the overall business environment for financial transactions, drawingupon the 1995 CEM and its background material, especially Hanson (1993), mission interviews and observations.Furthermore, specific barriers affecting new, especially non-credit, financial products are discussed and reformsare proposed. We identify opportunities for additional reforms in leasing, housing and mortgage finance, collateralregistries, and the use of electronic cards. Among these, the modernization of registries, with private sectorparticipation, and the integration of technical standards and networks for electronic transfers appear as the mostpromising.

ENVI1RONMENT FOR FINANCIAL TRANSACTIONS

5.3 The business environment for financial transactions may have a discriminating effect against the poor(Fleisig, 1995). Examples of laws with discriminatory effects are: limits or barriers to using movable property,accounts receivables, and loans as collateral; and requirements that loan contracts must be in writing and signedby the borrower. Barriers to using movable property limit access to credit for those individuals or enterpriseswithout real estate properties.

5.4 Compared to many other developing countries, El Salvador has done relatively well in creating thepreconditions required for growth in the private sector. Its laws and regulations have been found generallyadequate for commercial transactions, including the borrowing of investment funds from formal institutions. Nofixed obstacles exist in the Commercial Code (CC) or other laws that actively prohibit basic, contemporaryfinancing arrangements. Rather, other obstacles, such as lack of information networks, and lack of explicit legalguidelines for advanced financing, suppress much financing activity. A variety of new laws formalizing leasingand the factoring of accounts receivable, as well as slight modifications to the Commercial Code, are needed to

Rural Finance 31

enable new financing opportunities. Enforcement on a variety of levels, however, remains weak and will stillrequire improvement

Table 6-1 El Salvador: Type of Collateral and LegislationType of Collateral Financial Contract El SalvadorMovable property Lcoans, Leasing Collateral registration is lengthy. Registries need to be improved.

The CC does not have an explicit provision for leasin.~~~~~~~~~~............ ....................................... I............................................. ,,..., ,,., , ... , .................. , :.. ...........Accounts receivable Factoring, chaKtel paper Accounts receivable alone do not have legal standing; they must

financing be formalized as pagares. Receivables may not be held and

Warehousing receipts Supplier-trade credit Receipts can be endorsed and used as collateral. There are.p~~~~~~~~~~~~~~~~~roblems of qualitv, standarizatlon and renutation.

............................................ .......................................... ,p .....................Inventories Floating liens on inventory The CC does allow liens on inventory, but the provisions are

limited (Art. 839). It is costly to create a secunty interest oninventory because it requires registering every item in the inventoryto secure it. The borrower and the lender must check the accuracyof the list1 which is expensive and cumbersome.

Negotiable instruments: Bill of Trade Credit It is relatively easy to create a security interestexchange (letra de cambio),promissory notes (pagar6s),and checks (cheques).Source: Hanson (1993)

5.5 In El Salvador, acceptable collateral may be registered at their appropriate registries. This point isemphasized because previous reports have claimed that certain types of security cannot be registered and that thelaws of El Salvador should be changed to include them, for example bills of exchange (or checks), letters of credit,and warehouse receipts. While the law allows creditors to take these instruments as security for credit, it is alsotrue that they may not be registered in the Commercial Registry under Article 4 of the Regulations. However, itshould be noted that not all documentary security interests need to be filed at the registry in order to be secure, andthat it is in fact inefficient to do so, as possession of the original document in some cases is required to collect onthe pledged assets. In fact, when lawyers in El Salvador are asked about the limitations on registering bills ofexchange, none saw it as a problem, as such instruments wouldn't be registered anyway. Table 6-1 summarizes thestatus of regulations pertainin,g to different types of collateral and financial contracts.

NEW FINANCING INSTRUMENTS

5.6 Governments have an important role to play in creating appropriate incentives for the introduction ofmodem, innovative methods of financial services provision in rural areas. Local expertise exist and local skills canbe further developed to provide required human capital. Furthermore, in the overall picture of donor activity,promoting the transfer of financial technology and improved management information systems, and financing start-up costs, represent relatively small amounts of grant financing or soft funding with high payoffs in terms ofenlarged, effective outreach to under-served clients.

5.7 In addition to capacily building alternatives, it is necessary to consider alternative approaches based ontwo observations. First, since credit is fungible, the problem of financing rural small-scale enterprises must bethought of in the larger context of all types of credits available to small business owners-considering bothconsumer and business credits, and credits from the banking and non-banking sectors. Such alternatives may wellinvolve consideration of some financial instruments and markets that are not particularly focused on and arecertainly not restricted to rural or microenterprise-oriented credits. Second, financial products and technologiesthat permit reduction in the large transaction costs of making small bank credit should be considered.

5.8 Leasing. The leasing industry can be an important provider of microenterprise credit in addition to thecommercial banking system. (Commercial banks can themselves be important participants in the leasing industryeither through on-balance-sheet leasing or through leasing subsidiaries.) Leasing can provide point of purchasecredit, up to 100% financing, greater assurance against technical obsolescence, and reduce debt to equity ratioscompared to straight debt financing. These factors make leasing a particularly attractive form of financing for

32 El Salvador:

microenterprises, farmers, or rural industries. In turn, lease receivables are an attractive asset to securitize andleasing companies can be important commercial bank clients. Leasing accounts for between 15-35% of allbusiness equipment financing in many countries of the world. Yet, the leasing industry remains quiteunderdeveloped in El Salvador.

5.9 There are some relatively minor problems with leasing in El Salvador. First, the Salvadoran commercialcode does not explicitly deal with leasing28. While the current legal situation does not bar leasing transactions, andsome do occur, many participants do remain somewhat concerned (perhaps needlessly or excessively) aboutexecuting lease transactions. Second, the market for leasing, particularly operating leases, would remain ratherlimited given the small size of the Salvadoran market and the difficulties of trading used goods. Third, it isnecessary to clarify the relevant tax treatment and accord a tax treatment that encourages leasing withoutsubsidizing it.

5.10 Home and Real Estate Loan Markets. The development of a home mortgage market offers an indirect butvery important possibility of reducing microenterprise credit constraints in general. In less developed home financemarkets, a large part, possibly the whole, of the home investment is equity-financed. The proportion of personalequity financing is typically higher at lower income levels. Thus, the development of a home mortgage market andhome equity loan market can free up a large part of personal savings for possible business investment. Such loansentail much lower information asymmetries and risks for lenders, and are thus possible to make far faster and lessexpensively than loans to a small business. Clearly, such loans may finance investments as well as greaterconsumption. But because home stocks are so large (2-4 times GNP), even a modest debt financing of, say, 20%of the aggregate housing stocks can expand aggregate credits by an order of magnitude. Such an increase cannotbut relieve some of the financing constraints on business investment. In some developed countries, home mortgageloans equal or well exceed the total assets of the banking system.

5.11 There is considerable potential for liberating the personal equity of a large fraction of the populationthrough home mortgages in Salvador. However, the extent to which such additional credit will trickle down to thelower income rural or agricultural borrowers depends on several factors including the unit value, formality,registration, ease and cost of mortgage documentation, notarizing, etc.. Clearly, the more valuable the home unitsare, the easier to finance. Nonetheless, mortgage loans are being successfully made for units worth $3,000-5,000in Peru. There are significant problems in recording properties and liens thereon. El Salvador is divided into 14departments, which are covered by 10 property registries that constitute Registro Propiedad de Raiz. Theseregistries are not automated, have serious record-keeping and retrieval problems, and currently it can take as muchas 12 months to get a property registered. Some efforts are being made to develop modern registries with thecollaboration of private sector agencies. For instance, Ahorromet, a finance company with strong mortgageinterest, has collaborated in developing a modem computerized registry. There is a need for modernizingregistries, both for real estate as well as for commercial transactions.

5.12 Possibility of an Asset Backed Securities Market. Housing finance cannot develop adequately onlythrough the banking system, since financing long term housing loans with bank deposits would leave the banksvulnerable to serious maturity mismatch. El Salvador has attempted to overcome this problem by offering specialconcessions (lower legal reserve requirements and higher interest rates on such reserves) on long term depositswhich are utilized for housing finance (Chapter 2). While such attempts are understandable, they create segmentedfinancial markets based on specific subsidies. Ideally, banks should originate and package the mortgage loans,selling them off to bond market investors as mortgage-backed securities. Such a development would be highlydesirable for the development of bond markets and institutional investors. However, mortgage- and asset-backedsecurities market is a relatively new financial innovation which requires a facilitating legal framework which hasnot been developed in Salvador. Countries with Napoleonic law traditions typically encounter severe problems in

2 The Law of Financial Institutions (passed in 1989) has long been slated for a substantial overhaul since 1991 when the draft ofan extensive revision of this law was prepared. The amendment has not beeni passed for a variety of reasons. The draft providesfor a much more complete regulation of the leasing industry, thereby further deepening concerns regarding the legal status oftransactions entered into prior to passing the amendment.

Rural Finance 33

developing such markets due to the notary system, which is usually a very restrictive and expensive franchise. Inthese countries, the creation of a special purpose vehicle is needed for issuance of mortgage-backed securities, andproblems of multiple taxation of the same transaction arise. It would be highly desirable to identify the extent ofsimilar problems in El Salvador and take remedial action.

5.13 Supplier-trade Credit. Suppliers and trading institutions such as equipment suppliers, feedlots, abattoirs,packing, refrigerating and other processing plants could have an important role in granting credit to rural and smallbusiness. These institutions who have natural business relationships with rural entrepreneurs have greaterinformation about their clients and a better ability to deter default and possess and resell collateral thancommercial banks.

5.14 The development of su]pplier-trade credit requires financing of warehouse receipts, of inventory, and ofaccounts receivables. Licensed warehouses are authorized to issue warehouse receipts and warrants. Warehousereceipts and warrants can be endorsed, thus providing the endorsee the collateral of underlying inventory, andcreating the possibilities of financing. However, the current warehousing system has several drawbacks forefficient storage of grains and their use as collateral which has hindered the acceptance of warehouse receipts ascollateral (Lacroix, 1997). The current law does not contain penalties for forging, altering or counterfeitingwarehouse receipts and warrants or for the unlawful use of commodities stores. Hence, there are problems ofquality, standardization, and reputation that may restrict acceptability and financing of receipts of specificwarehouses.

5.15 The commercial code allows use of inventory as collateral, but recording requirements are difficult andcan be improved upon. A commercially registered lien on inventory requires specific listing of each item. Afloating lien requires a notarized and court-authorized public document (escriturapilblica) following an expensiveprocess. On the other hand, accounts receivable do not have a legal standing, unless the underlying claim isreduced to a pagarM (a promissory note), which is typically not the case for trade credits.

5.16 Factoring. Factoring is of particular importance to rural and agricultural microenterprises, especiallythose who supply to large retailers, sugar mills, or other processing plants. Because factoring provides financingbased on the creditworthiness of the larger client rather than the microenterprise supplier, even suppliers with poorcreditworthiness, accounting, or lack of collateral can obtain such credit. Salvadoran commercial code does notdisallow factoring. There are at. least two commercial factoring agencies: Fadesa and Rapicash. The proposedamendment to the Financial Institutions Law referred to earlier also provides for fuller regulation of factoringindustry. When implemented, such regulation will remove any lingering uncertainty about the status of factoringcompanies.

5.17 Use of Credit and Smart Cards. Use of smart cards and credit cards are expected to produce phenomenalbenefits for small and rural lending. First, the cards can drastically reduce the administrative costs of making aloan for the lenders.29 Second, the increased use of smart cards and credit cards (which may be thought of as singleloan, not so smart, electronic cards) reduce the system-wide cash float with individuals and increase the level ofbank deposits. Third, it allows banks to forge profitable business ties with suppliers to their card-holder clients(with the suppliers effectively acting as disbursement agents for the bank), increasing their willingness to financesuch suppliers' accounts receivables. But most important benefits are likely to emerge as the banks startsystematically analyzing the considerably more informative histories of withdrawals, credit use, and repaymentpatterns generated by the cards. Over time, intelligent analysis of these data can dramatically reduce the cost andproblems of information asymmetry, permitting banks to identify more responsible and regular customers. Creditcards permit the lenders (issuing banks) to make loans based on very inexpensive, but limited and thus high risk,credit evaluations. The risks are controlled through tiny credit extension initially, perhaps smaller even than the

29 Financiera Calpia reported that smart cards reduced its administrative costs of small loans by as much as 6% of the loanamount annually, in the first nine months of its introduction. Cards are used to make loans varying between ¢500 to 0200,000 andthey can be programmed to process several loans (Calpia uses them to make three working capital loans, one investment loan,and one seasonal working capital loan), with complex disbursement criteria.

34 El Salvador:

cost of a thorough credit evaluation itself, with higher credits possible only through a track record of responsiblepayments.

5.18 Electronic cards benefit rural and other microenterprises in many ways. As businesses, increased use ofcard payments allows microenterprises to extend relatively inexpensive credit to their own clientele and raise theirsales. Second, they benefit from savings in bank administrative costs that are passed on to them. Third, the cardscan dramatically reduce the borrowers' own transaction costs; including the cost of unnecessary float by providingborrowers with point-of-purchase loans, the costs of visiting the bank, and some of the costs of providinginformation to the lender.

5.19 The benefits of this modem technology are limited by short-sighted commercial strategies used bySalvadoran institutions. Credit cards, smart cards, ATMs share a substantial common infrastructure. Thus sharingof common standards and networks would greatly increase the efficacy of the whole system and its economies ofscale. There are about 200,000 electronic cards in El Salvador now. There are several competing proprietaryATM networks in El Salvador using incompatible standards, and thus limiting access of customers. There are notechnological problems in integrating them. Some financial institutions are issuing electronic cards that can onlybe used within their own branch network. Others limit issuance of smart cards to their best clients (due to prestigeconnotations). These practices seriously limit the use and cost savings potential of these payment methods. Thereis thus a need for the Central Bank to take the lead in the development of integrated standards and networks,including perhaps development of screens that would facilitate transactions by illiterate users.

5.20 Further development of this industry, and reducing its costs, would require appropriate legal structures foraccurate identification of borrowers, sharing credit history information across lenders and borrowing instruments,development of credit rating bureaus, cooperation among lenders to avoid wasteful duplication of products, andlowering the cosis of underlying technology. These developmental measures are necessary to deepen financialmarkets generally.

5.21 In summary, opportunities for additional profitable reforms exist in leasing, housing and mortgagefinance, collateral registries, supplier credits, and the use of electronic cards:* In leasing, the principal reform is clarification of the relevant enabling framework and tax treatment, perhaps

through passage of the amendment of the Financial Institutions Law.* Housing finamce needs to be further developed by appropriate study and development of a facilitating

framework for asset-backed securities, reduction of notary costs, facilitating a special purpose vehicle, andavoiding multiple taxes. This market has traditionally faced severe problems in most Napoleonic codecountries, although the needed reforms have not been studied in El Salvador.

* Real asset registries and commercial registries need to be modernized to reduce the existing large costs anddelays of registering homes, mortgages, liens and other security interests. Promising reforms involving privatesector participation need to be replicated elsewhere in the country.

* In terms of supplier credits, principal reforms would be easing recording requirements for using stocks ascollateral, and reforms of the commercial code to permit accounts receivables to be used as collateral.

* There is considerable potential for reducing costs of small credits economy-wide by expanding the use ofelectronic payments, credit cards and smart cards. The Central Bank should take the lead in integratingrelevant technical standards and current competing and incompatible networks. There is also a greater needfor education of intermediaries in exploiting the full potential of these technologies by not limiting itsjudicious application to a wider clientele.

Rural Finance 35

Chapter 6. RECOM[MENDATIONS

6.1 El Salvador has made significant progress since the early l990s creating adequate conditions for privatesector growth. In particular, the substantive reforms and liberalization of the financial sector have enabled aconducive environment for financial intermediation where institutions can function without the burden of excessiveregulation and pricing restrictions. However, the exclusion of entire borrower classes is apparent in thecommercial bank (non-BFA) loan portfolio. As shown in Chapter 3, RCMs in El Salvador are shallow because ruralhouseholds have limited access to credit services-less than 12% of rural households received a loan in 1995 and about20%h had outstanding debt balances from formal or informal sources. The weak participation of rural households in creditmarkets is explained by both demand- and supply-side factors.

6.2 Some form of govermnent intervention may be desirable, but traditional solutions to increase the supply ofcredit in rural areas have had tudesirable outcomes. Traditional solutions in Asia, Africa, and Latin America haveattempted to augment the supplly of credit through a variety of means. Administrative or fiscal initiatives includedirected credits, usury laws, interest rate ceilings, explicit or implicit subsidies, tax breaks for borrowings used forsmall-enterprise loans, among others. Directed credit programs have misallocated resources and tend tocompromise prudential superAision of banks involved and increase pressures for regulatory forbearance.Specialized banks have suffered from a myriad of problems of misdirected credits, highly non-diversifiedportfolio, non-businesslike operations of the specialized institutions, bad loans, and perpetual dependence onspecific government or external funding.

6.3 There is no single proven model for El Salvador to follow in order to deepen its rural financial markets.The failure of past governnent intervention to improve the performance of financial markets may be overcome ifthe Government formulates adequate strategies to deal with the issues at hand. The development of rural financialmarkets should have two main goals: increasing the availability of viable, competitively priced, and untargeteddeposit and credit services from formal financial intermediaries and promoting competition in the sector. Thisobjective is tantamount to increasing the outreach and the sustainability of formal financial intermediaries ruralareas. Such an effort would increase overall access to rural financial markets and change the composition of thatmarket niche by including entrepreneurs whom the formal sector does not currently serve. A combination ofstrengthening the economic environment and the distribution network can help us meet both goals. Therecommendations are organizeci into these two areas.

ECONOMIC ENVIRONMENT

6.4 An economic environment in which property rights, contracts, and financial services can prosper is theGovernment's primary responsibility. Such an environment consist of improved legal framework for enforcingcontracts and making use of collateral; networks for sharing information between lenders (e.g., credit checks);regulatory framework; and financial policies and competition. Specific recommendations are:

6.5 Collateral security issues. The legal framework affects the cost of transactions, the characteristics ofcredit contracts, and the access of small clients to financial services. The Government could increase access tocredit services by reducing the costs of using collateral to secure credit transactions. To reduce cost of collateraluse it is necessary to: (a) improve legal framework to facilitate the creation, perfeetion, and enforcement ofsecurity interests; and (b) modernize registries to reduce transaction costs and delays of registering securityinterests such as mortgages and liens. The restructuring of the public registries should be coordinated with thecorresponding legal reforms, which would create the necessary pre-conditions for well functioning credit markets.Furthermore, consider 1995 GEM recommendations to expand use of liens on inventory and commercialequipment.

36 El Salvador:

6.6 New fmancinR instruments. Because the Government has done little to promote the use of new financinginstruments, the general guidelines proposed in the 1995 CEM would be appropriated. The three mainrecommendations to expand use of new financing instruments are: (a) improve the environment and legalframework for new instruments such as leasing and factoring; (b) consolidate the reforms currently in progress,and the study of new ones and amendments to the Financial Institutions Law that clarify the rules that governleasing should be adopted; and (c) set guidelines and uniform treatment for leasing, factoring and discount ofcommercial paper.

6.7 Financial sector supervision and competitiveness. To improve financial sector competitiveness theGovernment should implement two strategies. First, the liberalization of the banking system could be consolidatedespecially through: consolidation of ownership restrictions; implementation of a rating system for financialinstitutions; and istrengthening of SSF through training and modernization. Furthermore, the recommendations ofthe 1995 CEM can be used as a checklist. Second, the Government should remove from the menu of policyinterventions debt refinancing/forgiveness programs as an effort to restore repayment discipline in rural areas.Also effective prudential regulation and supervision is particularly important in El Salvador due to the entry ofnew financial institutions and the rapid expansion of credit during 1991-1995.

DISTRIBUTION NETWORK

6.9 The secmnd area of policy intervention relates to the restructuring of the distribution network of financialservices. Any type of institutional re-structuring requires, among other factors, an adoption of cost-effectivefinancial innovations to provide financial services appropriate to rural markets, and measures that enable the useof new financing instruments. Provided appropriate conditions are present, three non-exclusive institutional modelshave proven successful in other countries. The recommendations below are based on these three non-exclusivealternatives detailed below:* The full privatization of a public bank, or a clearly defined split of a public financial institutions, akin to the

Unit Desa system of the Bank Rakyat Indonesia (BRI).* Thorough reform of the regulation and legal structure of the credit cooperative system to eliminate the

governance problems that have plagued such organizational forms.* The down-scaling of operations among bank and non-bank commercial intermediaries, following the path of

banks such as Colombia's Caja,Social, and non-banks such as El Salvador's own Financiera Calpia.

Governance, Regulation and Supervision of BFA, FEDECREDITO and FEDECACES

6.10 BFA. As presented Chapter 4, the central issue dominating the BFA's operations are governance, politicalinterference and its imposition of special social mandates. Although there is ample room for improving managerialpractices and information systems, and for adopting better lending and savings mobilization practices, seriousdoubts will always remain with respect to the incentives of BFA's management to implement such improvementsunder the existing government ownership and governance structure.

6.11 The imrediate step should be to eliminate all non-financial operations assigned to BFA, and transferaway from the bank all welfare-related mandates. The ensuing actions would be a rigorous audit to determine themarket value of BFA's equity and a detailed analysis of the spectrum of options for its divestiture -including thepossibility framework in order to privatize some of BFA's branch network as independent local unit banks. Theregulatory implications of this possibility are analyzed below. An implication of the proposed strategy is tosuspend BFA's current efforts and investments in information technology. At this stage it is not known, forexample, whether any investments made to integrate the branch network's information-nation systems will beconsistent with an optimal strategy for BFA's divestiture (e.g., independent unit banks).

Rural Finance 37

6.12 Is it possible to reform BFA to make it a sustainable public development bank? To achieve sustainability,BFA would have to be compellled to adopt general principles that are necessary conditions in the sustainableprovision of financial services to small and medium entrepreneurs in rural areas. The political cost of reformingBFA along this way may be fairly close to that of divesting the institution altogether, because any meaningfulreform requires reducing or eliminating the rents extracted by three constituencies: bureaucrats, larger borrowers,and politicians. These groups would probably fight off reform with the same strength with which they wouldoppose divestiture. Reform is a gradual, long-tenn and reversible process that puts time on the side of theseconstituencies to organize opposition. In contrast, divestiture may be achieved swiftly and irreversibly.

6.13 The following are examples of change control actions that could be pursued until the time in which BFAis completely divested to the private sector. These actions are, in any event, required intermediate steps fordivestiture:

* Organizafional control: the objective should be to provide control of BFA to individuals who are not subjectto political pressures and who are not representative of the bank's borrowers. This objective would require: (1)reform of the law and charler of the bank because the Board of Directors is currently integrated by politicalappointees (Ministers) ancl representatives of the beneficiaries (farner groups). In the meantime, theGovernment's political appointees should vote (in block) for measures and policies aimed at improving thebank's performance (e.g., suispend current investments in modernizing BFA).

* Distribution network: BFA branches are characterized by a high fixed-cost structure and are mostly locatedhighly populated urban centers. The fixed costs of operating branches could be reduced by reducing branchstaff, and by selling buildings and reallocating branches in smaller rented offices-preferably in locations notserved by commercial banks.

* Credit policies and targeting: BFA should change its credit policies to increase its outreach to small ruralentrepreneurs and, more importantly, to protect itself from rent-seeking organized groups of borrowers. Inparticular, it should significantly reduce the maximum amount of credit granted to a single borrower (e.g.,maximum of 4 times the coumtry's per capita income). It should increase interest rates significantly and financeall types of rural entrepreneuars (not only farmers). This policy, combined with collection incentives on the partof branch managers (mostly the threat of closing problem branches), would reduce the amount of rents anindividual borrower may extract and, hence, would also reduce the incentives to establish and organizeopposition to the reforms.

- Credible sink-or-swim straiegy: the Government should make credible the fact that the resources currently atthe disposal of the organization represent a once-in-a-lifetime capital endowment. It should be made clear tothese groups that branches that are not sustainable will be closed within 6 months.

6.14 Financial Cooperatives (FEDECACES and FEDECREDITO). The Government is consideringunification of the regulation, governance, charter and status of the savings and credit cooperatives (cooperativasde ahorro y credito), most of them affiliated to FEDECACES, and the cajas de credito affiliated toFEDECREDITO. Such unification would imply the emergence of a single organizational form for savings andcredit cooperatives (SCCs), ancl the subjection of the resulting unified systems to SSF supervision, which mayinclude deposit insurance. Moreover, the Government may chose to include this regulatory reform in a broaderbody of legislation to cover non-bank financial intermediaries, with or without cooperative ownership. Althoughthere may be clear advantages to unifying the regulatory and supervisory framework for SCCs, the proposedreforms need to take into account the potential risks involved in chartering these new intermediaries.

6.15 The main governance features of the organization that would result from the proposed new structure are:ownership by both depositors and borrowers, one-member-one-vote rule for decision making by generalassemblies, and voluntary association and withdrawal of members. Potentially negative implications of thesegovernance features on the capital structure of the organization need to be explicitly regulated upon by the newlegislation. Specifically, minimum capital requirements would need to be complemented with rules governing thewithdrawal of share capital, and the accumulation of institutional capital.

38 El Salvador:

6.16 International experience with credit cooperatives. The international experience of financialcooperatives is rather mixed in terms of performance and viability. Supply-led cooperatives such as the unionesde credito in Mexico have resulted in financial collapse, and other networks such as the Costa Rica SCCs haverequired governnent bail-out after short-lived success. On the other hand, successful experiences of credit-unionreform and modernization have been documented in Guatemala and the Dominican Republic, aside from theAfrican examples of Benin, Cameroon and Togo.30

6.17 Fiscal liabilities. The Government may assume contingent liabilities from the reforms being proposed, asit does by chartering any type of financial intermediary. Even if explicit deposit insurance is not provided, theGovernment may be unable to avoid bailing-out SCCs in case of financial difficulty as they would be under SSFsupervision and their depositors would be numerous and unsophisticated. Protecting large numbers ofunsophisticated depositors, on the other hand, ought not to deter Government from diversifying the financialsystem, especially when the amounts involved represent a minimal share of total deposits in the financial system.

6.18 The newframework. In the new framework, the legal ability to carry out specific financial intermediationactivities needs to be directly contingent upon the fulfillment of requirements and conditions set forth by the newbody of legislation. Most importantly, minimum capital requirements for entering the regulated system and rulesfor the accumulation of institutional (non-withdrawable) capital should ensure the rapid build-up of a stablecapital base. In addition, risk-weighted capital adequacy rules should at a minimum be equivalent to thoserequired from other deposit-taking institutions.

6.19 Specific rules preventing "borrower-domination" (extraction of benefits by coalitions of members at theexpense of the oirganization's financial viability) should be made part of the framework (e.g., prohibiting dividendallocation on the basis of borrower-patronage), to reinforce internal rules modern SCC organizations typicallyfollow.

6.20 The neNv framework should establish reserves and allowances created from earnings to maintain capitallevels adequate to cover potential losses from loans and investments. The legislation should also require provisionsfor loan losses, guided by portfolio classification rules similar to those applied to other regulated institutions.Likewise, norms on portfolio concentration and insider lending, and reserve requirements (encaje) comparable tothose of other deposit-taking institutions should apply to the new institutional charter.

6.21 In the case of the current affiliates of FEDECACES and FEDECREDITO, minimum capital requirementswill have obvious consequences on the magnitude of the consolidation process that will likely follow theregulatory refonns. From about 36 and 50 affiliates, respectively, the networks are likely to dwindle in number ofaffiliates to about a dozen each, primarily through mergers (much like the consolidation observed in the Mexicocajas populares after the 1992 reforms). Hence, the total amount of deposits now falling under SSF supervisionmay initially decrease, to then recover as the newly regulated institutions gain public confidence.

6.22 Prudential supervision mechanisms. Building SSF capacity and establishing prudential supervisionmechanisms need to accompany any regulatory reforms implemented by the Government. Regulatory functionsshould not be alllocated to the federations, as it is unlikely that it would be possible for them to credibly supervisetheir affiliate-owners. Instead, mechanisms that supplement the SSF capacity with private external audits andexamination of the SCCs should be established, to function under the guidance of a small high-quality team of SSFspecialized supervisors.

6.23 A transitional period to adopt and adjust to the new legislation will be required. In addition, Governmentshould carefully consider the future of existing financial cooperatives and other credit-granting organizations that

30 In Africa, SCCs were not exposed to the donor-induced subsidized-credit trajectory most SCCs networks in Latin Americaexperienced in the 60s and 70s.

Rural Finance 39

will not meet the new requirements. Specifically, access to BMI funds by non-regulated intermediaries should bestrictly ruled by the creditor as rio explicit or implied guarantee will apply to those entities.

Technology Transfer: Private Banks and Financieras

6.24 The successful experience of Financiera Calpia demonstrates that realistic loan pricing, appropriatemanagement information systems, and innovative lending techniques can be used to effectively expand outreach torural small-scale producers. As described in Chapter 2, Financiera Calpia developed a rural client base of almost2,000 farmers (about 15% of its total clients in 1995) in less than 2 years, with a loan balance at the end of 1995of 11 million colones, about 18% of Calpia's total loan portfolio. Delinquency rates in its agricultural portfolioremain at 1 to 1.5%, comparable to their urban micro and small loans.

6.25 Key to Calpia's succesis, urban and rural, have been its innovative lending techniques, and its modeminformation systems for general management and portfolio control. It is important to highlight the features ofCalpii's lending as they radically differ from the practices of conmmercial banks in El Salvador. Indications of thisstriking contrast are the much hligher productivity of loan officers in Calpia, about six times that of an averagebank officer, and the better quality of its portfolio, with a delinquency rate about one-fourth that of the averagecommercial bank.3 ' While bank loan officers in their agricultural units typically carry 45 to 70 clients, a Calpiacredit officer works closely with 200 to 400 clients, depending upon the proportion of new borrowers included inthe workload.

6.26 At present, Financiera iCalpia is the only institution in El Salvador using modem, innovative techniquesand practices, along with realistic pricing of financial services and effective management information systems. It iscertainly not alone, however, in Latin America. Other non-bank financial institutions successfully apply a similarapproach, such as Caja de los Andes in Bolivia (as Calpia, also preceded by an NGO), and the Cajas Municipalesde Ahorro y Credito in Peru. Moreover, leading commercial banks involved in microfinance, notably the CajaSocial in Colombia, are adopting comparable methods to carry a large portfolio of small loans in a sustainablemanner.

6.27 The question arises as to why other financial institutions in El Salvador have not adopted these modernlending methods and management practices to expand their outreach to under-served sectors. An important part ofthe answer to this question is the start-up investment required in technical assistance, training, and cautioussubsidization. How best to implement innovative financial technologies is difficult without local trials andexperimentation. Given the nature of research and development as a public good, governments could fund thesetrials to develop sustainable technologies for delivering financial services to small rural entrepreneurs. Forexample, Calpia emerged as a regulated financial intermediary after its predecessor NGO, AMPES/ServicioCrediticio had been in operations for 6 years with technical and financial assistance provided primarily by GTZand IDB. On the other hand, large, established commercial banks (e.g., Caja Social) are able to gradually adoptthese innovations with less of a need for infant-industry subsidization.

6.28 By promoting and supporting pilot programs that familiarize local financial intermediaries with successfulinnovations and encourage their adoption or adaptation, the Govermment could demonstrate that it is possible tosupply financial services to small and micro-entrepreneurs in a sustainable matter. Such evidence will guidedecision makers in the adoption of an adequate policy towards the sector, will persuade interest groups to acceptsuch reforms, and will induce increased private sector participation to serve traditional excluded populations. Thisexperimentation is essential because mistakes in the design and implementation of large scale reforms in ruralfinancial markets may be extrernely expensive. The design of such an experimentation research program shouldconsider four elements: clients and financial products, financial intermediation technologies, organizational forms,and managerial incentives.O

31 Calpia's delinquency is strictly measured as portfolio at risk.

40 El Salvador:

BIBLIOGRAPHY

ABANSA. Directorao y Servicios de Instituciones del Sistema Financiero de El Salvador. San Salvador. 1994.

Abt. (Wenner and Umania). "Agricultural Credit Market: Assessment in El Salvador" APAP, Phase III, TechnicalReport No. 130". 1993.

Banco Central de Reserva de El Salvador. "Leyes, Reglamentos e Instructivos del Sistema Financiero." 1990.

Banco Central de Reserva, BMI. Resumen General de Solicitudes de Credito Amparadas a la Ley para laRehabilitaci6n de los Sectores Productivos Directamente Afectados por el Conflicto, Presentadas alSistema F-inanciero y FOSAFF1 y Solicitudes en Apelaci6n en BCR. April 1996.

Banco Central de Reserva. Anteproyecto de Decreto de Reformas a la Ley de Fedecred&to. San Salvador. Julio1995.

Banco Central de Reserva. Fortalecimiento y Privatizaci6n del Sistema Financiero, San Salvador. April, 1990.

Banco Central de Reserva. Programa de Reformas del ,istema Financiero. San Salvador. 1996

Banco Central de Reserva. Revista Trimestral. San Salvador. Various issues.

Banco de Fomentci Agricola. Memorias de Labores. San Salvador. 1995.

Benito, Carlos. "Debt Overhang and Other Barriers to Growth of Agriculture in El Salvador" Agricultural PolicyAnalysis Project, Phase II. Technical Report No 134, USAID. 1993

Carrandi, Alnunfo R. "Evaluaci6n de la Actividad Crediticia y Definici6n del Rol del Banco de FomentoAgropecuario en el Financiamiento Agricola." Arizona State University. December 1992.

Chaves, Rodrigo and Claudio Gonzalez-Vega. "The Design of Successful Rural Financial Intermediaries:Evidence from Indonesia." World Development. 24: 65-78.

Cuevas, Carlos E'. and Jeffrey Poyo. "Costos de Intermediaci6n en el Banco Agricola de la RepublicaDominicana. Ohio State University. 1989.

Cuevas, Carlos E. "Costs of Financial Intermediation in the Banking System of El Salvador." Report to the Centerfor Latin American Studies. Arizona State University. 1990.

Cuevas, Carlos E., Douglas H. Graham and Julia A. Paxton. "The Informal Financial Sector in El Salvador."Report prepared for USAID El Salvador. Columbus Ohio: The Ohio State University. 1991.

Danby, C. "Challenges and Opportunities in El Salvador's Financial Sector." World Development. Vol. 23. No.12. pp: 2133-2152. 1995.

FAO/WB. "El Salvador: Proyecto de Tierras y Servicios al Agro. Documento de Trabajo: Mejoramiento delSector Financiero Rural." November, 1994.

FOSAFFI. Memoria de Labores. San Salvador. 1992.

FUNDAUNGO. "'Microfinanzas en El Salvador: Lecciones y Perspectivas." December 1995.

Rural Finance 41

FUSADES. "Una Estrategia de Desarrollo Agricola para El Salvador, 1994-2000." Documento de Trabajo No.37. San Salvador. 1994.

Hanson, Rebecca. "An Assessment of the Legal and Regulatory Framework for Enterprises in El Salvador."Washington, D.C.: IDB. October, 1993.

Inter-American Development Bank. "El Salvador: Global Credit Program for Microenterprises. Loan Proposal.October, 1993.

IPC. "El Salvador: Evaluation of the Financial and Institutional Viability of the Banco de Fomento Agropecuario.June 1993.

Lacroix, Richard L. "El Salvador: The Warehouses of Banco de Fomento Agropecuario." unpublished manuscript.May, 1997.

L6pez, Ram6n. "Rural Poverty iin El Salvador; A Quantitative Analysis." in Ramon L6pez and Alberto Vald6s(eds) Rural Poverty in Latin America, forthcoming. 1997.

Ministerio de Agricultura y Ganaderia, Grupo de Opciones de Politica Agraria. "Consolidaci6n y Restructuraci6nde la Deuda Agraria." San Salvador. November, 1995.

Moll, H.A.J., r. Ruben, E.W.G. Mol and A.A. Sanders. "Segmentation of Rural Financial Markets: AnExploration of the Borderlines in El Salvador." manuscript, Wageningen Agricultural University

Rioseco, German. CentralAmerican Rural Credit Study. Unidad Regional de Asistencia T6cnica. RUTA. 1994.

Sanchez-Schwarz, Susana M. "Assortive Matching of Borrowers and Lenders: Evidence from Rural Mexico."Unpublished Ph.D. dissertation. The Ohio State University. 1996.

Sorto, Francisco and Alexander Segovia. "La Reforma Financiera de ARENA: Hacia D6nde se dirige laPrivatizaci6n de la Banca?," Politica Econ6mica, 1: 1-25. 1992.

Superintendencia del Sector Financiero. Normas y Reglamentos.

Superintendencia del Sistema Financiero. Boletin Estadistico. San Salvador. December, 1992 -1995.

World Bank. El Salvador. Meeting the Challenge of Globalization. Report No. 14109-ES, October 19,1995.World Bank. El Salvador. The Challenge of Poverty Alleviation. Report No. 12315-ES, June 9, 1994.

World Bank. "El Salvador: Competitiveness Enhancement Technical Assistance Project. Technical Annex."Report No. T-6679-ES. Washington, D.C.: World Bank. September, 1995.

Yaron, J., M. Benjamin and G. Piprek. Rural Finance: Issues, Design and Best Practices. World BankDiscussion Paper, 1997.

Yaron, Jacob. "Assesing Development Finance Institutions." World Bank Disucssion Papers No. 174. 1992.

Yaron, Jacob. "Successful Rural Finance Institutions." World Bank Disucssion Papers No. 150. 1992.

ANNEXES

Annex A. REGULATION, LEGISLATION, AND SUPERVISION

REGULATION, LEGISLATION, SUPERVISION

1. Regulation and Legislation. During 1990 and 1991, the Government undertook several reforms tothe regulatory framework of financial institutions to increase their performance. New laws were drafted andapproved for the BCR and banks and financieras. The new law for the BCR increased its administrativeautonomy, while prohibiting the BCR to directly or indirectly finance central Govemrnment or publicenterprises and set interest or exchange rates. The law for Banks and Financieras introduced more stringentprudential norms such as capital adequacy requirements.

2. The legislation introduces market segmentation by limiting the scope of financial activities of banksand financieras. Financieras are limited to the intermediation of non-demand deposits, while commercialbanks are allowed to provide all modem banking services. A drawback of the legislation is that it ignoresnon-bank financial mechanisms such as leasing, factoring, and warehouse receipts.

3. At present, there is a. number of draft laws under review by the authorities. These are: Ley deinstituciones Auxiliares de Crdito, Ley de las Instituciones Oficiales de Credito, Ley de las Institucionesde Seguros, Ley de Fondos de lnversi6n, Fondo de Garantia de Dep6sitos, Ley de la Superintendencia,Ley de FEDECACESy del Sistema Cooperativo.

4. The Superintendencv of the Financial System. The reorganization of SSF was initiated with theapproval of the Ley Organica7 de la Superintendencia del Sistema Financiero in November, 1990. Theelements of this reorganization targeted its weak authority and lack of autonomy from BCR and theexecutive power, and its obsolete supervision system. To perform its new responsibilities, SSF wasreorganized into four divisions: (a) bank and finance companies; (b) insurance and pension fimds; (c)securities exchange; and (d) administration and finance. It supervises 140 institutions with about 215employees. An ongoing reform of the Superintendency calls for its division into three independentsuperintendencies: one for the mercado de valores, one for the pension fund administration, and one forbanks and financieras. The last one will have three intendencies: banks and financieras, insurance, andcredit cooperatives.

5. Limitations of ownership. The banking law imposes limits on ownership based on nationality and'on a 1% restriction on capital ownership which can be lifted subject to SSF approval. The legislationassigned to Salvadoran nationals the majority ownership of financial intermediaries, i.e., foreigners couldnot own more than 50% of total capital. However, the last modification to the banking law allows foreignbanks (Central America and other countries) to own 75% of stocks. This measure should foster theparticipation of foreign banks in the financial system through the purchasing of existing banks or throughthe incorporation of new institutions. At the moment, the Government is evaluating a proposal to sell BancoHipotecarIo to a foreign bank.

6. Capital Requirements, Minimum capital and capital adequacy are the two main restrictionsregarding capital requirements in El Salvador.' The minimum capital requirement to enter the market is 050million for banks and 025 million for financieras. The capital adequacy ratio, the ratio of equity to riskweighted assets, was raised to 10% in January 1996, from 8%. SSF established a transitional period of six

The main functions of capital are: (a) to serve as a cushion which supports a finn's normal risks; (b) to convince depositorsthat adequate coinsurance protection exists; and (c) to absorb losses with enough margin to inspire confidence to depositors.

45

46 El Salvador: Rural Financeyears to allow banks and financieras to meet the new capital adequacy ratio. For the purpose of this ratioequity consists of: (a) primary capital such as stocks and legal reserves; and (b) secondary capital such asretained earnings and 50% of net income. Furthermore, any investments in other institutions are subtractedto prevent artificial infusions of capital or the so-called double leveraging.

7. Assets are classified into three categories that receive a weight of 100% (loans), 50% (lines ofcredit), 20% (government bonds) and 0% (cash and due from banks) according to risk. The main merits ofthe risk-based calpital requirement are the recognition of a risk differential among assets, and the inclusionof off-balance sheet items. However, the main drawbacks are that it ignores other types of risk, such asliquidity and interest rate risk, correlation among assets or between liabilities, establishes arbitrarycategories, and its does not use the market value of assets. In addition, it is difficult to appraise the value ofoff-balance sheet items.

8. Diversification Rules. The legislation also restricts the concentration of outstanding loan balancesaround a single customer (Art. 104). This limit is set to up to 15% of the equity capital of the financialintermnediary. However, this limit can be raised up to: (a) 30% if the loan is guaranteed with real collateral;(b) 50% if the ollateral consists of deposits; and (c) more than 50% if guarantee with line of credit offoreign banks, or deposits.

9. Limits on Loans to Insiders. The amount of outstanding loan balances that may be granted to bankinsiders was reduced from 50 to 15% of stock and capital reserves in January 1996 (Art. 110). SSF gaveestablishing banks a period of two years to adjust to the new ratio requirement. Insiders are thoseemployees involved in the administration of the institution as directors or managers and those stockholdersthat own more than 3% of the stocks.

10. Limits on loans to insiders is an important aspect of prudential regulation since the intermediary'sowners may use these loans to recapture a proportion of their equity contribution. Under the new limit, astockholder that owned 3% of the stocks can receive an average loan size up to 6.4 times his/her actualownership.2 The previous 50% requirement implied that the same stockholder could receive 21.2 timeshis/her actual ownership.

11. Supervision. The supervision of financial intermediaries in El Salvador may be characterized as asituation in which SSF performs these functions with respect to banks, financieras and other institutions,but it has implicitly delegated to FEDECREDITO the supervisory responsibilities of its affiliates. Thereare some costs and benefits of the implicit delegation of supervisory activities to FEDECREDITO whichare analyzed in Chapter 5.

12. The supervisory activity of SSF can be described as a two-tier monitoring system. The first-tier iscalled off-site supervision an consists of a series of reports that the financial intermediaries have to send toSSF. The seconi-tier of SSF supervision system is on-site supervision, which takes place only when off-site supervision data show that a particular internediary is experiencing problems. Since the 1990 reformprogram, bank supervision has increased substantially.

13. The department of financial analysis of SSF executes off-site supervision by doing a monthlyanalysis of financial statements with a completely computerized system. The main goal of this off-sitesupervision is to provide an early-warning mechanism about changes in the financial performance of anintermediary that may become insolvent, illiquid or both. SSF requires from banks and financieras the

2 The calculation was done using the formula: [Ratio of Loals to insiders / % ownershipl l I + (reserve capital / stocks)].

Annexes 47following: (a) balance sheets and income statements should be prepared and sent to the SSF monthly; (b)financial statements should be published in widely-read newspapers quarterly; and (c) monthly submissionof risk classification of borrovvers.

14. Loan Risk Classificaltion. The main objective of loan risk classification is to make risk exposureexplicit and to require lending institutions to protect their solvency by taking adequate provision for loanlosses. SSF classifies loans to enterprises, consumption loans, and mortgage loans with three differentcriteria. For enterprise loans, there are five credit risk categories (A, B, C, D, and E)with an attachedrequired provision for expected loan losses.

Table A-1 Loan Risk CategoriesRisk Borrower Characteristics RequiredType Loan Reserves

A Excellent capacity to repay and solid project proposal. 0%B Good project, however technical and marketing risk exist 1%C Projects with weak financial conditions. Delinquent less than 60 days. Collateral value becomes 10%

important.D Dubious repayment possibilities. Delinquent less than 180 days on previous loans. 50%E Insolvent clients. Delinquent more than 180 days on previous loans, no guarantee. 100%

Source: Wenner and Umafha (1993, Table 3.5).

15. Consumption and mortgage loans are classified into categories A to E depending on the days ofarrears of the loan. These loans are classified as type A if they have been less than 30 days late.Consumption loans are categorized as type E if the number of days in arrears is more than 120 days. Incontrast, mortgage loans must be classified as type E when they are late for more than 360 days.

16. Each bank gives a credit rating to their clients according to the instructions of SSF. It supervisesthe risk classification of loans performed by banks and financieras. The departmnent of risk assets of SSFsamples 35% of risk assets of the system three or four times per year. SSF requires banks to sample up to80% of their risk assets balances.

17. Credit Bureaus and Information Sharing. Current legislation requires SSF to manage a riskclassification system about the borrowers of banks and financieras. The institutions that report to the creditbureau are banks and financieras, insurance companies, FOSAFFI, FEDECREDITO, FIGAPE,FONAVIPO, Fondo Social para la Vivienda, Instituto Nacional de Pensiones de los Empleados Publicos,Instituto de Previsi6n Social de la Fuerza Armada (SSF).

18. Access to borrower credit risk classification reduces borrowers and lenders transaction costs.Currently, lending officials use the database operated by the SSF as a preliminary screening device ofpotential clients. Banks have a clear preference for borrowers classified as type A or B because their lowerreserve requirements imply a hiigher rate of return. Banks and financieras must provide SSF with the creditrating of borrowers when the loan is approved. In addition to credit rating, banks and financieras mustprovide other information such as: sector of economic activity, date of the loan, outstanding debt, and typeof collateral.

19. The SSF gives banks and financieras a monthly report with the credit ratings of borrowers.Although the outstanding debt of borrowers or the number of loans are not shared, banks and financierascan explicitly request that iniformation to SSF. Borrowers are identified through the Numero deIdentification Tributaria (NIT). The upgrading of the credit rating of a borrower must by approved by theSSF if the total debt of the borrower is more than 0500,000. SSF uses the information provided by banks tocalculate delinquency problems by sector of economic activity.

48 El Salvador: Rural Finance

Annex B. FINANCIAL SYSTEM AND ECONOMIC INDICATORS

Table B-I El Salvador: GDP by Sector of Economic Activity (%)Economic Sector 1991 1992 1993 1994 1995Agriculttre 16.5 16.5 16.0 13.8 13.7

Coffee 4.4 4.5 3.8 3.3 3.0Cotton 0.1 0.1 0.1 0.1 0.0Basic Grains 3.1 3.7 3.4 2.8 3.2Sugar Cane 0.7 0.7 0.7 0.6 0.6Ottwr crops 2.4 2.1 2.2 2.2 2.2LIvestock 2.6 2.4 2.1 2.0 2.0Oher 3.0 2.9 2.7 2.8 2.7

Non-Agriculture 83.5 83.6 85.0 86.2 86.3Total 100.0 100.0 100.0 100.0 100.0Source: BCR Bulletin, January-March 1996

Table B-2 Commercial Banks: Distribution of Outstanding Loan Balances and AverageReal Growth Rate by Sector of Economic Activity (Millions of Colones of 1990)

Economic Sector Avg Real GrowthJure 1991 June 1995 Rate p.a. S

Agriculture 925 14.3 2,014 10.6 21.5Mining 6 0.1 18 0.1 30.0Manufacturing 1,479 22.9 3,360 17.7 22.8Construction 363 5.6 2,729 14.4 65.6Electricity 7 0.1 15 0.1 20.4Cornmerce 1,725 26.7 7,373 38.9 43.8Transpcrt 81 1.3 408 2.2 49.8ServIces 245 3.8 1,145 6.0 47.0Other Credit 25 0.4 - - -Refinancing 1,604 24.8 1,915 10.1 4.5Agriculture 548 8.5 n/a n/a n/aNon-AglrIcukure 1,056 16.3 nla n/a n/a

TOTAL 6,460 100.0 18,978 100.0 30.9Sources: For 1991: BCR, Boletin Trimestrul, Octubre-Dkhembre 1993. For 1995: Unpublished data of BCR'The awVrag, real growth rate equals to ((Be/8E1)

25 - 1)1 00

Annexes 49

Table B-3 Commercial Banks: Credit Disbursed by Sector of Economic Activity (millions of colones)Economic Sector 1991 1992 1993 1994 1995Total Agriculture 2,272 3,383 3,796 2,424 2,933Agriculture 1,951 2,878 3,290 1,997 2,151Agriculture Refinancing 321 505 495 427 782

Total Non-Agriculture 6,839 12,699 15,149 16,88 18,883Mining 5 2 13 17 6Manufacturing 2,589 4,486 4,641 4,618 4,868Constructon 387 1,610 2,855 2,989 2,190Electricity 5 5 8 19 30Commerce 2,809 3,948 5,086 5,285 7,868Transport 165 256 426 562 654Services 197 486 567 773 798Other Credit 34 400 27 119 228Consumer Loans - 983 1,047 1,500 1,411Non-Agriculture Refinancirng 648 524 478 606 829

TOTAL 9,110 16,082 18,934 18,912 21,816Source: BCR Bulletin Various Issues

Table B-4 Commercial Banks: Credit Disbursed by Sector of Economic Activity (% of total)Economic Sector 1991 1992 1993 194 1996Total Agriculure 24.9 21.0 20.0 12.8 13.4Agriculture 21.4 17.9 17.4 10.6 9.9Agriculture Refinancing 3.5 3.1 2.6 2.3 3.6

Total Non-Agrlculture 75.1 79.0 80.0 87.2 86.6Mining 0.1 0.0 0.1 0.1 0.0Manufacturing 28.4 27.9 24.5 24.4 22.3Construction 4.3 10.0 15.1 15.8 10.0Electricity 0.1 0.0 0.0 0.1 0.1Commerce 30.8 24.5 26.9 27.9 36.1Transport 1.8 1.6 2.3 3.0 3.0Services 2.2 3.0 3.0 4.1 3.7Other Credit 0.4 2.5 0.1 0.6 1.0Consumer Loans - 6.1 5.5 7.9 6.5Non-Agriculure Refinancing 7.1 3.3 2.5 3.2 3.8

TOTAL 100.0 100.0 10.0 100.0 100.0Source: 8CR Bulletin Various Issues

50 El Salvador: Rural Finance

Table B-5 Saving Instruments by Type of Institution (millions of colones)1995 1994 1993 1992 1991

¢rn % ¢rn % Om % Om % ¢m %

Passbook Deposits 9,707.9 34.2 9,213.2 37.7 8,268.0 41.0 7,471.4 47.8 3,771.0 42.5

Commercial Banks 8,367.8 29.5 n/a n/a 6,572.1 32.6 5,809.1 37.1 3,771.0 42.5Financleras 1,340.1 4.7 n/a n/a 1,695.9 8.4 1,662.3 10.6 n/a n/a

Term Deposits 15,280.6 53.9 13,051.7 53.5 10,922.7 54.2 7,625.0 48.7 4,781.6 53.9Commercial Banks 12,152.3 42.9 nia n/a 8,596.5 42.6 5,903.0 37.7 4,781.6 53.9Financheras 3,128.2 11.0 n/a n/a 2,326.2 11.5 1,722.0 11.0 n/a n/a

CEDEVIV m 3,114.3 11.0 1,924.4 7.9 833.6 4.1 440.3 2.8 235.8 2.7Commercial Banks 2,526.0 8.9 n/a n/a 567.8 2.8 302.4 1.9 235.8 2.7Flnancheras 588.3 2.1 n/a n/a 265.8 1.3 138.0 0.9 n/a n/a

FEDECREDITO 23.1 0.1 39.2 0.2 n/a n/a n/a n/a n/a n/aSCC affiliated with 222.9 0.8 185.1 0.8 138.8 0.7 107.4 0.7 83.8 0.9FEDECACES

TOTAL 28,348.7 100.0 24,413.6 100.0 20,163.1 100.0 15,644.2 100.0 8,872.2 100.0Sources: For 1995 and 1992, BCR, Boletin Trmestral, 1995 and 1992: Classification of Deposits by Geographical Zones; for 1991, 1993 and1994: unpublished data provided by the BCR* CEDEVIV begins being issued in 1992 by Banks and 1993 by Financieras. Prior to that, three-year certificates were issued..

Table B-6 Passbook Deposits and Term DepositsIn and Outside San Salvador. Selected Features, 1992, 1995

1992 1995Dpt of San Outside San Dpt of San Outside San

Salvador Salvador TOTAL Salvador Salvador TOTAL

Average Account Size (0) 9,504 6,491 7,590 12,771 7,533 10,149Banks 10,288 5,805 8,027 12,120 7,844 9,948Financleras 7,719 4,408 6,388 15,853 5,775 11,186

Average Accotnt Size (¢ of 1990) 8,272 4,779 6,605 9,051 5,339 7,193Banks 8,954 5,052 6,986 8,590 5,559 7,050Flnancheras 6,718 3,836 5,559 11,235 4,093 7,927

% of Accounts 52.3 47.7 100.0 49.9 50.1 100.0Banks 49.6 50.4 100.0 49.2 50.8 100.0Fhnancieras 59.8 40.2 100.0 53.7 46.3 100.0

% of Balance 66.6 34.5 100.0 62.8 37.2 100.0Banks 63.5 36.5 100.0 60.0 40.0 100.0Financieras 72.3 27.7 100.0 76.1 23.9 100.0

% of Balance within each area 100.0 100.0 100.0 100.0 100.0 100.0Banks 75.2 82.0 77.6 78.3 88.5 82.1Financieras 24.8 18.0 22.4 21.7 11.5 17.9

% of Branches (%) 46.4 53.6 100.0 63.3 46.7 100.0Banks 46.4 53.6 100 50.8 49.2 100.0Financieras n/a n/a n/a 60.3 39.7 100.0

% of Population 29.5 70.5 100.0% of Rural Population 11.4 88.6 100.0% of Rural Population In each Deparbtent 19.1 62.3 49.6Nunber of People per Branch 10,501 28,623 18,958Nunber of People per Bank Branch 23,263 48,086 36,561 15,121 37,180 25,983Source: BCR and SSF bulletin

Annexes 51

Table B-7 Formal and Non-bank Lenders in El Salvador, December 1995 (millions of colones)%. Net Agric.

Type of Institution Assets % Equity % Deposits Loans % Loans % Branches %I 1~~~~~I(9196)I

Specialized Financial Institutions 2,147 4.5 664 16.5 498 1.4 1,478 4.8 774 25.6 104 26.5

BFA 1,635 3.4 592 14.8 474 1.4 1,067 3.5 719 23.8 27 6.9FEDECREDITO 401 0.8 48 1.2 23 0.1 341 1.1 55 1.8 68 17.3FIGAPE 111 0.2 24 0.6 0 0.0 71 0.2 - - 9 2.3

Private Banksb 38,150 80.2 2,636 65.7 28,508 82.0 23,858 77.9 2,229 73.8 178 45.3

Financierasb 6,852 14.4 569 14.2 5,557 16.0 4,915 16.1 16 0.5 82 20.9

SCC affiliated to FEDECACES 420 0.9 145 3.6 223 0.6 260 0.8 29 7.4NGOs n/a n/a n/a 0 0.0 105 0.3 n/a

Centro de Apoyo ala n/a n/a n/a 0 0.0 24 0.1 n/aMicroempresa 9/95 d

Fundaci6n Salvadorefla de n/a n/a n/a 0 0.0 4 0.0 n/aApoyo Integral (FUSAI) 12/94 d

PROPEMI 12/94 d n/a n/a n/a 0 0.0 76 0.2 n/a

TOTAL 47,670 100.0 4,015 100.0 34,786 100.0 30,616 100.0 3,019 100.0 393 100.0Sources:*Unpublished data of SSF.b Bulletin of SSF December 1995

FEDECACES, Memorias 1995. Data is as of June 1995 and correspond to 29 credit cooperatived Fundaungo (1995

Data on loans granted by FEDECACES and NGOs by sector of economic activity was not available. Hence, although they do finance agriculturalactivities their shares could not be calculated. As a result, shares in agricultural lending of other intermediaries are overestimated.

Table B-8 Sectoral Distribution of Loan Portfolios of Banks, Financieras and Specialized Financial Institutions(millions of colones, 9/95)

Economic Sector SFI a % Private % Financieras % Total %Banksb

Agriculture 774 46.7 2,229 9.9 16 0.4 3,019 10.6(% of total agriculture) 25.6 73.8 0.5 100.0

Non-Agriculture d 883 53.3 20,239 90.1 4,390 99.6 25,513 89.4(% of total non-agriculture) 3.5 79.3 17.2 100.0

Total 1,657 100.0 22,468 100.0 4,406 100.0 28,532 100.0(% of total) 5.8 78.7 15.4 100.0

Sources: Unpublished Data of BCR and Memorias of FEDECREDITO and CalpiaCalpia: According to Memorias 1995, 23% of the loan portfolio is agriculture d Includes 'other activities (refinancing)

52 El Salvador: Rural Finance

Annex C. RURAL HOUSEHOLD SURVEY

Table C-1 Debtors versus Non-debtorsAll Households Debtors Non-Debtors

Mean S. D. Mean S. D. Mean S. D.

Age of household head 45.7 14.3 42.7 13.6 ... 46.5 14.4Male household head (Dummy) 0.9 0.3 0.9 0.3 0.9 0.3Years of Edlucation of household Head 3.0 3.2 3.0 3.2 3.0 3.2Average agie of household members 26.3 11.7 23.8 8.8 26.9 12.3Average education household members 3.7 2.5 3.4 2.1 3.7 2.7older than 12 years-oldHousehold size 5.9 2.5 6.5 2.6 ... 5.7 2.5Household members that migrated 0.7 1.2 0.8 1.3 0.6 1.2Participation in Groups (Dummy) 0.1 0.3 0.1 0.4 0.1 0.3Farmers (Dummy) 0.3 0.5 0.3 0.4 0.3 0.5Household Annual Income 22,492.9 39,360.5 20,772.5 28,172.4 22,929.1 41,735.0

Agriculural Income 6,465.7 35,632.4 4,193.6 13,203.6 7,041.6 39,326.6Nonagricuftural Income 890.5 9,373.1 2,357.7 20,055.9 518.6 2,849.6Wage Inicome in agriculture 4,477.2 6,712.0 3,609.1 5,123.4 * 4,697.3 7,045.5Wage Income in non-agriculture 9,031.0 14,047.6 9,783.6 11,917.2 8,840.3 14,542.6Other Sources 1,628.5 4,703.3 828.5 4,243.0 1,831.3 4,795.7

Share income from wage employment in 36.8 44.0 47.9 52.5 ... 34.0 41.1non-agricultureDistance to Secondary School (Kms) 6.1 9.9 5.7 10.0 6.2 9.8Distance to Pavement Road (Kms) 5.9 6.7 6.1 7.5 5.8 6.5Population iin the household municipality 38,298.1 43,550.8 32,485.3 30,195.7 ... 39,771.6 46,237.4of residencePercentage of rural population in the 68.0 20.2 67.5 19.5 68.1 20.4household municipality of residenceMunicipality Population Density 230.0 165.2 2359 190.2 228.4 158.4

Source: Encuesta Desarrollo Rural, 1996* significant at the 95% and 99% confidence intervals, respectively

Annexes 53

Table C-2 Borrowers versus Non-borrowersAll Households Borrowers Non-borrowers

Mean S. D. Mean S. D. Mean S. D.

Age of Household Head 45.7 14.3 43.4 13.5 46.1 14.4Male Household head (Dummy) 0.9 0.3 0.9 0.3 0.9 0.3Years of Education of Household Head 3.0 3.2 3.3 3.3 2.9 3.2Average age of household members 26.3 11.7 23.5 10.0 26.6 11.9Average education of household 3.7 2.5 3.7 2.4 3.7 2.6members older than 12 years-oldHousehold size 5.9 2.5 6.2 2.6 5.8 2.5Household members that migrated 0.7 1.2 0.6 1.0 0.7 1.2Years in Locality 70.3 18.7 71.0 18.8 70.2 18.7Participation in Groups (Dummy) 0.1 0.3 0.2 0.4 0.1 0.3Farmers (Dummy) 0.3 0.5 0.3 0.5 0.3 0.5Household Annual Income 22,492.9 39,360.5 23,921.5 39,519.4 22,302.1 39,371.2

Agricultural Income 6,465.7 35,632.4 6,231.9 16,653.6 6,496.9 37,455.9Nonagricultural Income 890.5 9,373.1 4,090.7 26,310.9 463.1 2,583.5Wage Income in agriculure 4,477.2 6,712.0 4,966.8 8,650.7 4,411.8 6,415.9Wage Income in non-agriculture 9,031.0 14,047.6 7,614.3 16,004.1 9,220.3 13,770.4Other Sources 1,628.5 4,703.3 1,017.8 4,749.8 1,710.1 4,695.3

Share income from wage employment in 36.8 44.0 34.1 48.7 37.2 43.3non-agricultureDistance to Secondary School (Kms) 6.1 9.9 6.3 12.0 6.1 9.5Distance to Pavement Road (Kms) 5.9 6.7 5.9 7.0 5.9 6.7Population in the household municipality 38,298.1 43,550.8 36,792.0 36,132.8 38,499.3 44,472.3of residencePercentage of rural population in the 68.0 20.2 64.8 20.3 68.4 20.2household municipality of residenceMunicipality Population Density 230.0 165.2 223.9 126.3 230.8 169.8

Source: Encuesta Desarrollo Rural, 1996I/'** difference in means significant at the 95 percent and 99 percent confidence intervals, respectively.

Table C-3 Relative Importance of Formal, Semi-formal, and Informal Sectors in Rural AreasLoans Received in 1991 Outstanding Debt Balances

Sector No. %No. %Anount No. %No. % BalanceFormal 33 41.3 76.0 46 33.3 64.7BFA 24 30.0 61.1 29 21.0 35.3FEDECREDITO 3 3.8 4.6 4 2.9 2.3Other Formal 3 3.8 4.1 8 5.8 12.3Private Banks 3 3.8 6.2 5 3.6 14.8Semi-formal 8 10.0 6.2 6 4.3 4.1NGOs 2 2.5 0.4 2 1.4 2.1Cajas/bancocomu/coope 6 7.5 5.7 4 2.9 2.0Informal 39 48.8 17.8 86 62.3 31.1Commercial Credit 12 15.0 5.7 26 18.8 11.9Moneylender 11 13.8 5.7 15 10.9 10.0Friends/Relatives 13 16.3 4.5 38 27.5 5.4Interlinked Credit 3 3.8 1.9 4 2.9 1.8Other Informal 3 2.2 2.0

TOTAL 80 100.0 100.0 138 100.0 100.0Source: Encuesta DesaITolIo Rural, 1996

54 El Salvador: Rural Finance

Table C-4 Estimated Coefficients of Multinomial Logit Model of Access to Credit ServicesPFormal I Non-Debtor Pinfmal I Non-bMor

Variable Coeffici Std. Error Coefficle Std. Efrorent nt

Constant 0.6664 3.0980 2.2100 2.2800

Log (age of household head) -0.5507 0.6010 -0.5943 0.4205

Average education of household members older than 12 years -0.0974 0.0781 -0.0982 0.0587oldMale household head (Dummy) 0.3869 0.7605 -0.1477 0.4400Household size 0.1177 0.0643 0.1468 0.0502-Number of extended family that migrated -0.0400 0.1564 0.2376 0.0892 ...Number of years In the locality 0.0083 0.0099 0.0121 0.0079Log of annual household income -0.2147 0.2119 -0.2736 0.1737Share of wage income in non-agricultural activities 0.0066 0.0042 0.0087 0.0031Participation In groups (Dummy: 1= Yes 0=No) 1.1770 0.4275 ... 0.2233 0.4131Population in the household municipality of residence -0.0103 0.0061 -0.0064 0.0040Percentage of the population in the rural areas in household's -0.0102 0.0102 -0.0103 0.0071municipality of residenceFarm-household (Dummy) 0.9416 0.3890 -0.3419 0.3445L8.... 9 ...............................................................................................................................................................................

Likelihood Ratio Test: Chi-Squared (df.-24) = 64.89

Number ol Observations: 620Source: Multinomial Logit Estimation/I- significant at the 90% 1 95% 1 99% confidence interval respecively

Table C-S Marginal Effects of Explanatory Variables on the Probability of Having DebtP Nan-O.bto Pronns P ubmi

Variable Coeff. Std. Error Coeff. Std. Error Coeff. Std. ErrorConstant -0.2381 0.4349 0.0217 0.1781 0.2165 0.2966Log (age of household head) 0.0817 0.0839 -0.0258 0.0341 -0.0558 0.0573Average education of household members older than 12 years 0.0138 0.0110 -0.0046 0.0046 -0.0092 0.0076oldMale household head (Dummy) -0.0045 0.1070 0.0218 0.0413 -0.0172 0.0721Household size -0.0193 0.0090 0.0054 0.0039 0.0139 0.0069Number of extended family that migrated -0.0203 0.0222 -0.0037 0.0083 0.0240 0.0171Number of years in the locality -0.0015 0.0014 0.0004 0.0006 0.0012 0.0010Log of annual household Income 0.0357 0.0296 -0.0098 0.0126 -0.0259 0.0212Share of wage incomne in non-agricultural activities -0.0011 0.0006 * 0.0003 0.0002 0.0008 0.0004*Participation in groups (Dummy: 1= Yes O=No) -0.0767 0.0583 0.0619 0.0311 0.0147 0.0396Population in the household municipality of residence 0.0011 0.0008 -0.0005 0.0003 -0.0006 0.0006Percentage of the population In the rural areas in householdcs 0.0014 0.0014 -0.0005 0.0006 -0.0010 0.0010municipality of residenceFarm-household (Dummy) -0.0127 0.0550 0.0529 0.0279 -0.0402 0.0422

Source: Multinomial Logit Estimation...* significant at the 90% 1 95% 1 99% confidence interval respectively

Annexes 55

Annex D. SPECIALIZED FINANCIAL INTERMEDIARIES: FINANCIAL INDICATORS

Table D-1 BFA: Profitability Measures 1993-95Ratio 1993 1994 1996ROE = Net Incoe / Average Equity 10.0 2.6 0.4ROA = Net Income I Average Assets 4.8 1.2 0.2Equity Multiplier = Average Assets I Average Equity 2.1 2.2 2.6Asset Utilization = Total Operating Income I Average Assets 28.4 16.9 17.0Proft Margin = Net IncomelTotal Operating Income 17.0 7.0 0.9Net Interest Spread = Yield on Assets - Cost of Liabilities 3.6 4.6 4.8Profit Margin Coinponents

Interest Expense I Total Operating Income 12.6 24.7 29.0Operational Expenses / Total Operating Income 28.8 51.6 47.3Provision for Loan Losses/ Total Operating Income 37.9 16.7 22.7

Average Interest Cost of Liabilities 8.6 8.6 8.8Deposits - 7.9 7.2Borrowed Funds - 8.7 9.1Average Yield on AssetsGross Loans - 13.9 15.0Net Loans - 20.0 20.3Average Real Grcoss Yield on AssetsGross Loans - 5.6 4.1Net Loans 11.3 8.8Market Share of Total Assets 4.1Real Growth Rate!Gross Loans 5.5 9.8 2.2Net Loans 12.1 17.5 8.5Past-Due Loans -27.3 22.4 -14.3Borrowed Funds 4.7 13.9 13.1Deposits 19.8 24.3 43.1Equity 3.4 -7.6 -8.8LIabilities 8.2 14.6 17.3Assets 5.9 4.0 6.3Source: Audited Financial Statements Published by the Superintendency of Banks, and the SFA.

56 El Salvador: Rural Finance

Table D-2 BFA Risk Indicators 1993-95Ratio 1993 1994 1996Credit RiskProvsion for Loan Losses / Average Gross Loans 12.7 3.2 4.4Averag Past Due Loans a / Average Gross Loans 26.8 23.5 22.5

Average Reserve for Loan Losses/ Average Gross Loans 34.9 30.6 26.1D and E / Risky Assets b 32.0 32.0 27.9

Capital RiskAverage Equity / Average Assets 48.1 44.7 39.0Equiy / Weighted Assets b 55.0 55.0 46.0

Average Equity I Average Uability and Contingencies 92.6 80.1 63.4Operational ManagenentAverage Assets / Number of Employees (In 0000s) 924.3 1,034.4Operational Expenss /Average Net Loans 14.8 14.4 12.4Operational Expenses / Average Eaming Assets 9.9 10.1 9.1Operational Expenses I Average Assets 8.2 8.7 8.0

Uquidity RiskAverage Borrowed Funds / Average Assets 24.8 25.9 28.0Average Cash and Due from Banks / Average Deposits 56.1 51.0 44.2Subsidy Dependence Index 93.5 97.6 100.8Comnposition of Assets and LiabilitiesFixed Assets (% Assets) 10.1 9.4 7.8DeposKs (% Assets) 18.0 21.6 29.0Borrowed Funds (% Assets) 24.7 27.0 28.7Equity (% Assets) 47.5 42.2 36.2Deposits (% Net Loans) 31.9 33.7 44.5Source: Audited Financial Statements Published by the Superintendency of Banks, and the BFA.a More than 90 days past due b SSF Bulletin

Table D-3 FEDECREDITO: Profitability Measures 1994-95Ratio 1994 1995ROE = Net Income / Average Equity -5.0 -0.7ROA = Net Income / Average Assets -0.6 -0.1Equiy Mukiplier = Average Assets / Average Equity 8.6 8.5Assd Utilization = Total Operating Income / Assets 14.9 16.6Profit Margin = Net Income/Total Operating Income -3.9 -0.5Proft Margin Components

Interest Expense / Total Operating Income 65.9 64.2Administrative Expense / Total Operating Income 35.1 30.7Provision for Loan Losses/ Total Operating Income 2.9 5.6

Average Interest Cost of Uabilities 12.0 12.9Market Share of Total AssetsReal Growth RateGross Loans 6.1 14.8Net Loans 12.7 16.8Past-due loans 42.8 -26.0Borrowed Funds 7.6 9.0DeposKts -14.9 -46.6EquKy 7.0 -2.2Labilitles 6.0 -4.7Assets 6.2 -4.4' The reversion of resov of loan loses, which FEDECREDITO reports as income, weresubtracted from the net-non-interest income.

Annexes 57

Table D-4 FEDECREDITO: Risk Measures 1994-95Ratio 1994 1995

Credit RiskProvwsion for Loan Losses / Average Gross Loans 0.6 1.2Average Past Due Loans a / Average Gross Loans 4.6 4.2Average Reserve for Loan Losses/ Average Gross Loans 10.8 7.5Capital RiskAverage Equity / Average Assets 11.6 11.8Average Equity / Average Liability and off-balance sheet 9.2 9.3itemsOperational ManageumientAverage Assets / Number of Employees (in 0000s) 1,322.4 1,552.5Operational Expenses I Average Net Loans 8.3 7.0Operational Expenses / Average Eaming Assets 5.9 5.6Operational Expenses / Average Assets 5.2 5.1Uquidity RiskBorrowed F'jnds I Total Assets (%) 63.4 68.4Cash and Due from Banks / Deposits (%) 29.7 35.0Subsidy Dependence Index 86.5 89.0Comnposition of Assets and LiabilitiesNet Loans (* assets) 64.9 79.2Fixed Assets (% assets) 4.8 4.3Deposis (% assets) 10.3 5.8Borrowed Funds (% assets) 63.8 72.7Equity (% assets) 11.6 11.9Deposits (% net loans) 15.9 7.3

Source: Financial Statements published by FEDECREDITO

58 El Salvador: Rural Finance

Table 0-5 Cajas Rurales and Banco de Trabajadores: Profitability Measures 1994-95Ratio 1994 1996ROE = Net Income / Average Equity 11.1 8.1ROA = Net Incorne /Average Assets 2.0 1.6Equtty Multiplier = Average Assets / Average Equity 5.7 5.2Asset Utilization = Total Operating Income / Assets 25.4 25.7Profit Margin = Net Income/Total Operating Income 7.7 6.1Promft Margin Cornponents

Interest Expense / Total Operating Income 51.9 57.5Administrative Expense / Total Operating Income 31.0 29.6Provision for Loan Losses/ Total Operating Income n/a n/a

Average Interest Cost of Liabilities 17.8 20.1Real Growth RateGross Loans 23.9 19.8Net Loans 26.7 17.3Non-performing loans -25.5 -2.5Borrowed Funds 22.3 13.1Deposits 42.4 -22.2Equity 47.4 16.7Liabilities 18.1 11.6Assets 22.7 12.6Source: Financial Statements published by FEDECREDITO

Table D-6 Cajas Rurales and Banco de Trabajadores: Risk Measures 1994-95Ratio 1994 1995Credit RiskProvision for Loan Losses / Average Gross Loans 0.0 0.0Average Past Due Loans a / Average Gross Loans 5.0 3.5Average Reserve for Loan Losses/ Average Gross Loans 5.6 5.8Capital Risk

Average Equity / Average Assets 17.6 19.4Average Equity / Average Liability and Contingencies 18.0 20.9Operational Managemnent

Operational Expenses I Average Net Loans 10.1 9.4Operational Expenses / Average Assets 7.9 7.6Liquidity RiskBorrosved Funds / Total Assets (%) 63.0 63.1Cash and Due from Banks / Deposits (%) 127.7 172.1Subsidy Dependence Index n/a n/aComposition of Assets and LiabilitiesNet Loans (% assets) 79.3 82.6Fixed Assets (% assets) 6.1 5.3Deposits (% assets) 4.4 3.0Borrowed Funds (% assets) 63.0 63.2Equity (% assets) 19.0 19.7Deposits (% Net Loans) 5.5 3.7Sourcie: Financial Statements published by FEDECREDITO

Annexes 59

Table D-7 FEDECACES: Profitability Measures 1993-95Ratio 1993 1994 1995ROE = Net Income / Average Equity 4.4 3.5 4.5ROA = Net Income / Average Assets 1.0 0.9 1.3Equity Multiplier = Average Assets I Average Equity 4.4 3.9 3.4Asset Utilization = Total Operating Income / Average Assets 11.1 12.8 14.5Profit Margin = Net Income/rotal Operating Income 9.2 7.0 9.2Profit Margin Components

Interest Expense / Total Operating Income 21.8 21.8 18.8Operational Expenses / Total Operating Income 61.3 60.9 60.2Provision for Loan Losses/l Total Operating Income 1.7 1.7 2.1Expenses for Reserve / Total Operating Income 6.1 8.5 9.7

Average Interest Cost of Liabilifies 3.4 3.8 3.9Average Gross Yield on AkssetsGross Loans 11.7 11.6 11.3Net Loans 12.1 12.1 11.9Average Real Gross Yielid on AssetsGross Loans 3.9 3.5 0.7Net Loans 4.3 3.9 1.3Real Growth RateGross Loans 12.2 -3.1 4.4Net Loans 12.8 -4.0 4.1Past-Due Loans -21.1 7.4 -25.4Borrowed Funds -11.0 -7.3 -36.1Deposits 400.5 -37.4 24.5Equity 4.9 2.6 -13.5Liabilities -10.5 -11.1 -32.5Assets -7.1 -7.8 -27.4Source: Memorias de FEDECACES

Table D-8 FEDECACES: Risk Measures 1993-95Ratio 1993 1994 1996

Credit RiskProvision for Loan Losses /'Avg Gross Loans 0.4 0.4 0.4Avg Past Due Loans a / AvgS Gross Loans 12.8 11.4 10.1Average Reserve for Loan Losses/ Average Gross Loans 3.8 4.1 4.8Avg Refinanced Loans / Avg Gross Loans 11.6 10.3 10.9Capital RiskAvg Equity / Avg Assets 22.9 25.7 29.4Avg Equity / Avg Liability anid Contingencies 13.5 14.1 14.6Operational ManagementOperational Expenses / Average Gross Loans 13.0 13.2 12.1Operational Expenses I Average Net Loans 13.5 13.8 12.7Operational Expenses / Average Net Eaming Assets 10.7 11.6 11.2Operational Expenses / Average Assets 6.8 7.8 8.7Liquidity RiskAverage Borrowed Funds / Average Assets 67.6 66.4 63.0Average Cash and Due from Banks / Average Deposits 81.3 48.7 40.1Subsidy Dependence Index 285.2 239.2 234.5Composition of Assets and LiabilitiesNet Loans (% assets) 55.4 57.7 82.7Fixed Assets (% assets) 3.7 4.0 5.8Deposits (% assets) 7.5 5.1 8.7Borrowed Funds (% assets) 66.2 66.6 58.6Equity (% assets) 24.3 27.1 32.2Deposits (% net loans) 13.5 8.8 10.5Source: Calculated with Financial Statements published by FEDECACES

60 El Salvador: Rural Finance

Table D-9 FEDECACES Affiliates: Profitability Measures 1993-95Ratio 1993 1994 199S

ROE = Net Income I Average Equity 9.7 13.7 7.3ROA = Net Income I Average Assets 3.6 5.0 2.6Equity Multiplier = Average Assets / Average Equity 2.7 2.7 2.8Asset Utilization = Total Operating Income I Average Assets 17.4 18.6 9.7Proft Margin = Net Income/Total Operating Income 20.6 26.9 26.5Profit Margin Comnponents

Interest Expense / Total Operating Income 43.7 43.1 42.4Operational Expenses/ Total Operating Income 35.7 30.0 31.1Provision for Loan Losses/ Total Operating Income n/a n/a n/a

Average Interest Cost of UabilUtles 16.2 16.2 7.9Average Gross Yield on Assets 20.4 20.9 10.6

Average Real Gross Yield on Assets 12.0 12.1 0.1

Real Growth RateGross; Loans 17.0 22.9 5.8Deposits 20.2 23.7 8.9Equity 12.9 15.7 -1.1Liabilities 17.7 17.6 7.0Assets 15.9 16.9 4.0Source: Calculated with Financial Statements published by FEDECACESS Figuires correspond to June 1995

Table D-10 FEDECACES Affiliates: Risk Measures 1993-95Ratio 1993 1994 19S5'Captal RiskAvg Equity / Avg Assets 37.1 36.5 35.3Operational ManagementOperational Expenses / Average Gross Loans 8.4 7.3 3.8Operational Expenses / Average Assets 6.2 5.6 3.0Composition of Assets and Liabilities

Gross Loans (% assets) 74.5 78.3 79.6Deposits (% assets) 47.9 50.6 53.0Equity (% assets) 36.7 36.3 34.5Deposits (% loans) 64.3 64.6 66.6

Source: Calculated with Financial Statements published by FEDECACES'Figures correspond to June 1995

Annexes 61

Table D-1i Profitability Measures of Selected Financial Intermediaries, 1995Fedecredito Systema Fedecaces System

Ratio BFA Banks Federation Affiliates Federation Affiliates D

ROE = Net Income l Average Equity 0.4 27.2 -0.7 8.1 4.5 1 3.7ROA = Net Income I Average Assets 0.2 1.7 -0.1 1.6 1.3 5.0Equity Multiplier = Average Assets / Average Equity 2.6 15.1 8.5 5.2 3.4 2.7Asset Utilization = Total Operating Income I Average Assets 17.0 14.5 16.6 25.7 14.5 18.6Profit Margin = Net Income/Total Operating Income 0.9 12.1 -0.5 6.1 9.2 26.9Profit Margin Components

Interest Expense I Total Operating Income 29.0 59.3 64.2 57.5 18.8 43.1Operational Expenses I Total Operating Income 47.3 22.5 30.7 29.6 60.2 30.0Provision for Loan Losses Total Operating Income 22.7 5.3 5.6 n/a 2.1 n/a

Average Interest Cost of Liabilities 8.8 9.5 12.9 20.1 3.9 16.2Average Gross Yields on AssetsGross Loans 15.0 18.9 - - 11.3 -

Net Loans 20.3 0.0 - - 11.9 -

Average Real Gross Yields on AssetsGross Loans 4.1 7.6 - - 0.7 -

Net Loans 8.8 - - - 1.3 -

Real Growth Rate (1994-1996)Gross Loans 2.2 17.0 14.8 19.8 4.4 -Net Loans 8.5 17.0 16.8 17.3 4.1 22.9Past-Due Loans -14.3 -26.0 -2.5 -25.4 -Borrowed Funds 13.1 9.0 13.1 -36.1 -Deposits 43.1 2.7 -46.6 -22.2 24.5 23.7Equity -8.8 14.5 -2.2 16.7 -13.5 15.7Liabilities 17.3 8.0 -4.7 11.6 -32.5 17.6Assets 6.3 7.2 -4.4 12.6 -27.4 16.9Source: Financial Statements= The reported net income of Fedecredito was adjusted by subtracting the reversion for the reserve for loan losses.Correspond to 1994

Table D-12 Risk Measures of Selected Financial Intermediaries, 1995Fedecredito a Fedecaces

Ratio BFA Banks Federation Affiliates Federation Affiliatesb

Crednt RiskProvision for Loan Losses / Average Gross Loans 4.4 1.3 1.2 n/a 0.4 n/aAverage Past Due Loans a l Average Gross Loans 0.0 0.0 4.2 3.5 10.1 n/aAverage Reserve for Loan Losses/ Average Gross Loans 26.1 2.9 7.5 5.8 4.8 n/aD and E / Risky Assets b 0.0 0.0 - n/a n/aAvg Refinanced Loans / Avg Gross Loans n/a n/a n/a nla 10.9 n/aCapital RiskAverage Equity / Average Assets 39.0 8.0 11.8 19.4 29.4 36.5Equity I Weighted Assets c 0.0 0.0 n/a nla n/a n/aAverage Equity / Average Liability and Contingencies 63.4 9.2 9.3 20.9 14.6 n/aOperational ManagemnentAverage Assets / Number of Employees (in ¢000s) 1034.4 3987.5 1,552.5 n/a 1,068.3 n/aOperational Expenses / Average Net Loans 12.4 3.5 7.0 9.4 12.7 n/aOperational Expenses / Average Assets 8.0 3.3 5.1 7.6 8.7 5.6Liquidity RiskAverage Borrowed Funds / Average Assets 28.0 12.9 68.4 63.1 63.0 n/aAverage Cash and Due from Banks I Average Deposits 44.2 32.6 35.0 172.1 40.1 nlaSubsidy Dependence Index 100.8 n/a 89.0 n/a 234.5 n/aComnposition of Assets and LiabilitiesFixed Assets (% Assets) 7.8 3.4 4.3 5.3 5.8 n/aDeposits (% Assets) 29.0 72.8 5.8 3.0 8.7 50.6Borrowed Funds (% Assets) 28.7 14.7 72.7 63.2 58.6 n/aEquity (% Assets) 36.2 8.1 11.9 19.7 32.2 36.3Deposits (% Net Loans) 44.5 116.3 7.3 3.7 10.5 64.6Source: Financial Statements of the Institutionsa More than 90 days past dueb Correspond to 1994' SSF Bulletin

62 El Salvador: Rural Finance

Annex E. DEBT REFINANCING OR RESTRUCTURING PROGRAMS

DEBT REFINANCING OR RESTRUCTURING PROGRAMS

1. Debt refinancing programs are the main strategy used by the Government to deal with debtdelinquency. These programs raise two main concerns: (a) creation of incentives for borrowers in goodstanding to stop paying their loans with less favorable terms than delinquent borrowers; and (b)encouragement of strategic default. The three most recent debt forgiveness programs are explained below.

2. Ley para la Rehabilitaci6n de Sectores Productivos Directamente Afectados por el Conflicto(D.L. 292). D.L. 292 is a process to renegotiate on concessional terms the delinquent debt of producersdirectly affected by the conflict (agriculture and non-agriculture). The decree, approved in July 1992, hastwo main objectives: (a) refinance the debt to allow borrowers to pay back; and (b) restore thecreditworthiness of delinquent borrowers to increase their access to credit.

3. The Decree created the following measures for qualified delinquent debtors. First, their backinterest was recalculated at 8% and refinanced at the same interest for 20 years with two years of grace.Second, the it implemented a procedure to terminate any credit embargoes during the processing period ofthe Decree. These debtors continued with their risk classification of C, D, or E with respect to theirdelinquent debt and were classified again for new loans. They regained their status as credit-worthy, butbanks were required to establish a reserve against each loan. Third, the Government compensated banks forthe interest forgiven to rehabilitated debtors.3 This procedure was applied to both the banks that transferredtheir debt to FOSAFFI, as well as other banks, and in particular BFA. Fourth, a guarantee fund for smallenterprises (Fondo de Garantia para Pequefios Empresarios) was created to back new loans granted torehabilitated debtors. Benito (1993) argued that banks are discouraged from providing new credit torehabilitated debtors due to the costly procedures involved in accessing these guarantee fuinds.

4. D.L. 292 has had two major modifications. In February 1994, the Decree recalculated back interestat 6% for beneficiaries whose original debt was below ¢ 100,000 (Decree 814). Furthermore, banks werenot allowed to charge commission or fees for processing applications. In August 1994, the debt ofbeneficiaries with original loans below ¢5,000 from BFA or FEDECREDITO was forgiven (Decree 114).

5. The main limitations of D.L. 292 are: (a) restrictive definition of "those directly affected by theconflict"; (b) high transaction costs for potential beneficiaries; and (c) conservative banking criteria appliedto each specific case at the level of branch bank agencies.

6. As of April 1996, 17,753 applications had been received for a total of ¢1,609.1 million. The totalamount of interest reduced is estimated at ¢413.7 million. BFA and FEDECREDITO accounted for morethan 95% of the number of applications received and approved. About 60% of the number of applicationswere received by BFA, while 35% were received by FEDECREDITO. Although BFA received the largestnumber of applications, they accounted for only 23% of total funds requested, while private banks andfinancieras received applications for 70% of this total. The average loan amount the applications variedamong lenders. Applications from private banks averaged ¢1.5 million, while the average for BFA was034,500. FEDECREDITO had the smallest average loan application of all institutions at ¢5,600.

3 Difference between interest calculated at the original rates and those recalculated at 8% not subject to reserves.

Annexes 637. Private banks and financieras approved 72% of the total number of applications they received,granting 60% of the loan arnounts requested. FEDECREDITO and BFA, on the other hand, approved 99and 95% of total number of applications they received and granted 92 and 90% of the amount requested,respectively. This reflects the different clientele served by these intermediaries or less stringent evaluationcriteria. FIGAPE approved 59% of total applications it received, granting 92% of amount requested.

Agriculture and Debt Delinquency

8. In June 1996, the Oiovernment issued two debt forgiveness programs that target the agriculturaland agrarian debt as a mechanism to stimulate agricultural production. The rural sector of El Salvador hasbeen greatly affected by policy reforms introduced since 1989. As a result of these reforms and the end ofthe conflict, rural and agricultural producers are being forced to adjust their economic activities. Thesereforms included: (a) liberalization of basic grain prices; (b) elimination or privatization of agriculturalparastatals; (c) elimination of subsidized interest rates; and (d) trade reforms (FUSADES, 1994).

9. The sources of agriculture delinquency are related to: (a) difficulties created by conflict ; (b) theeffects of droughts; (c) rent-seeking behavior induced by Government intervention in credit markets; (d) theimpact of a strong currency on agricultural profitability; and (e) the diversion of credit funds tounproductive activities (Abt. 1993). In addition, the inadequate supervision of production programs onwhich credit is based and the attitude created by the subsidized credit organizations need to be emphasized.However, many authors haLve concluded that the environment created by the conflict was the mostimportant cause of agricultural delinquency (Abt., 1993; Fusades, 1994; MAG, 1995).

10. The war affected agricultural production through various channels such as payment of war taxes,invasions and kidnappings. lLJncertainties caused by the conflict forced farmers to operate below efficientproduction levels causing low returns. As reported by Abt. (1993) many farmers argued that exchangepolicies were the major cause of low profitability and loan defaults. Furthermore, the conflict created theopportunity for rent-seeking behavior, through lobbying for debt restructuring or forgiveness programs.

I1. The agrarian reform process originated the so-called deuda agraria (agrarian debt). As reported byMAG (1995) the agrarian debt resulted from: (a) the low productivity of agrarian reform beneficiaries dueto poor land quality and inexperience; (b) lack of a recovery strategy by the Government; (c) the conflict;and (d) lack of working capital.

12. Ley de Apovo a la Reactivaci6n del Sector Agropecuario (D.L. 698). The Law targets allagricultural producers, but agricultural producers directly affected by the conflict (that qualify under D.L.292) receive special treatment. It is estimated that a total of 0 1,152.7 million will be forgiven of whichp486.1 million correspond to agricultural loans that qualified under D.L. 292. Key measures are:* It allows for a 70% discount for prompt payment to agricultural producers who qualified under Decree

292. If qualified producers pay 30% of their debt held at BFA, FOSAFFI, FEDECREDITO, privatebanks or financieras, thei remaining 70% is forgiven. However, debt is totally forgiven for balancesbelow 05,000 of the debt owed by agricultural producers to those same creditors.

* The grace period for beneficiaries of D.L. 292 is extended to June 1997. As a result of this decree,FOSAFFI and the BFA will have to divide proportionally the interest accumulated during the extendedgrace period among installments of the remaining years.

* Authorizes FOSAFFI to apply a 40% discount for prompt payment of agricultural loans that do notqualify under D.L. 292. BFA and FEDECREDITO should apply the same discount to D or E loans.

* Its allows financial institutions to include as secondary capital the value of the loss generated as aresult of the reserve for loan losses of those agricultural loans that qualify under D.L. 292.

64 El Salvador: Rural Finance

13. Ley de Restructuraci6n de la Deuda Agraria (D.L. 699). The Law considers the original agrariandebt, the so-called adelantos ISTA-BFA, and FFRAP debt. Lenders involved are ISTA and Banco deTierras. The beneficiaries are agricultural cooperatives, communal associations, and beneficiaries ofDecrees 842, 207, 839 and 713 of the agrarian refonn.

14. D.L. 699 has negative consequences on the repayment culture because it penalizes those borrowersthat were in good standing at the time of the Decree while loan defaulters are rewarded.

15. The main measures of this Decree are: (a) a 60% discount for prompt payment of total debt(capital and interest) for the agriculture cooperatives of the agrarian reform and communal associations offarmers. Individual (personas naturales) agrarian reform beneficiaries will receive a 60% discount forprompt payment plus an additional 05,000 write-off. When the total debt is less than 016,665, it is fullyforgiven; ancd (b) ISTA and Banco de Tierras should also apply the 60% discount for prompt payment.

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