Challenge
In October 1998, Hurricane Mitch hit Honduras with devastating effects that included a severe shock to the financial sector due to an upsurge in the volume of bad debt and substantial financial losses. By 2003, the stability of the Honduran banking system was weakened. The 2003 Financial Sector Assessment Program (FSAP) update highlighted significant vulnerabilities in the financial sector, including weak compliance with the internationally accepted Basel Core Principles for effective banking supervision, insufficient loan loss provision reserves for loans adversely affected by exogenous shocks, low capital asset ratios, and high numbers of non-performing loans. In addition, there were major weaknesses in the legal framework and practices to combat money laundering, and the country’s payments system had a number of structural shortcomings resulting in high exposure to credit, liquidity, legal, operational, and settlement risks for both fund transfers and securities transactions.
Solution
This technical assistance project worked with CNBS from 2004 to 2013 to help adopt a risk-based supervisory model by amending financial sector laws (including the Financial System Law) and issuing regulations governing their implementation. In addition, the project provided input for the operation of a high-level early warning committee of all relevant financial sector authorities able to undertake prompt corrective actions if financial system entities deteriorate. It also supported CNBS in improving its capacity to detect illegal financial transactions, contributing to an increase in the number of suspicious transactions reported monthly, from 12 in 2004 to more than 60 in 2013.
Moreover, the project helped modernize the Central Bank of Honduras by acquiring and implementing a modern general ledger, an automated foreign exchange auction module, a Real-Time Gross Settlement (RTGS) System and Central Securities Depository, and an electronic document management system. The new systems replaced numerous fragmented, cumbersome, vulnerable and error-prone systems. Together, they constitute the key financial infrastructure for the operation of the country’s large-value payments and government securities systems, foreign exchange auction system, and interbank market, enabling the efficient implementation of monetary policy.
Results
The financial system of Honduras has benefitted from the initiatives supported by the project in terms of improved performance and reduced risks:
- The authorities found the initial diagnostics and business plans funded by the project very useful to better understand and address the weaknesses of the system.
- Supervision of the banking sector improved significantly due to the implementation of an ambitious plan to strengthen the supervisory capacity of CNBS.
- Overall, the project contributed to restoring confidence in the financial system and consequently to the growth of the economy through a higher savings rate and greater availability of financing. Lending by banks went up from 31% of GDP in 2004 to 42% in June 2013. Among other things, the total volume of deposits in the banking system grew from US$3.4 billion to US$9.1 billion between 2004 and 2013. Bank performance also improved significantly, with the level of non-performing loans decreasing from 8.7% to 2.2% over the same time period.
The Central Bank successfully introduced new banking technology:
- The new general ledger and connected systems (including the foreign exchange auction module) became operational in 2012.
- The new RTGS payment system became operational in March 2013 with all banks connected. The RTGS has already improved the efficiency and security of the country’s large payments, reducing the time needed to settle such transactions from up to four hours to less than a second, and allowing participating banks to review their transactions online.
These new technologies also contribute to enhancing the operational efficiency of monetary and exchange rate policies. In turn, these benefits will help Honduras deepen its financial system to serve more individuals and businesses in a less costly manner.
Link to MDGs
The project contributed to Millennium Development Goal 8: Develop a global partnership for development. In particular, the regulatory reforms and capacity building at CNBS contribute to MDG Target 8A: Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. The introduction of modern tools, including IT infrastructure, at CNBS and the Central Bank contribute to MDG Target 8F: In co-operation with the private sector, make available the benefits of new technologies, especially information and communications.
Bank Group Contribution
The total cost of the project was US$11 million at inception, equivalent to SDR7.2 million. The International Development Association (IDA) contributed US$9.9 million through a technical assistance loan. The Government of Honduras contributed US$1.1 million. The Bank’s resources were used mainly to strengthen the capacity of the Central Bank and the Banking and Insurance Commission through technical assistance and the acquisition of necessary Information and Technology infrastructure.
Partners
The principal partners were government agencies directly involved with the financial sector, including the Central Bank, CNBS, the Ministry of Finance, and the Technical Secretariat of the Presidency. A Project Coordination Unit at CNBS, which provided fiduciary support to manage the project, coordinated implementation.
The international financial community—the World Bank, the International Development Association (IDA), the International Monetary Fund (IMF) and the Inter-American Development Bank (IDB)—coordinated to support the reforms. The IMF provided a Poverty Reduction and Growth Facility. The IDB provided additional complementary technical assistance. IDA provided a subsequent policy loan in support of the policy reforms.
Moving Forward
The Bank and the Borrower are discussing options for further technical assistance in areas such as drafting regulations to implement new laws; developing a new supervisory framework for the cooperative sector and others; developing a financial inclusion strategy that would focus on rural and agricultural finance systems and the corresponding public sector activities; and implementing measures to strengthen the oversight of insurance and banking systems, including aspects related to combating money laundering. The Central Bank foresees further consulting and equipment needs to continue improving its systems while broadening them to address emerging needs of the general ledger and payments system.
Beneficiaries
The beneficiaries of this project include Honduran financial institutions, whose performance has improved because of the strengthening of the regulatory framework and financial system infrastructure. The 21% of all adults in the country who hold an account at a formal institution will also benefit, insofar as savings in the form of bank deposits and other investments will be less vulnerable to potential losses. Greater confidence in the financial system will also contribute to a higher savings rate and thus greater availability of financing for investments.