This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 04 TEGUCIGALPA 002062 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR WHA/CEN, WHA/EPSC, EB/IFD, S/CT, AND INL/LP 
STATE PASS USTR FOR CENTAM DIRECTOR AND L MOGHTADER 
STATE PASS AID FOR LAC/CEN 
TREASURY FOR ETHAN ILZETSKI 
 
E.O.12958: N/A 
TAGS: EFIN ECON EAID EINV PTER SNAR PGOV HO
SUBJECT: SUMMARY OF THE FINANCIAL SYSTEM ASSESSMENT OF 
HONDURAS: HIGHLY FRAGILE AND VERY VULNERABLE 
 
 
¶1. (SBU) SUMMARY. On April 28, 2003, the IMF staff submitted 
to its Board of Directors the results of the Financial 
System Stability Assessment (FSAP) performed by a joint 
World Bank-IMF team between October 2002 and February 2003. 
This cable contains a summary of their findings. In the 
report, the Fund classified the financial system in Honduras 
as "highly fragile" and "very vulnerable."  The problems 
within the financial sector merit immediate restructuring in 
order to limit their adverse effects on sustainable economic 
growth.  The report contains five sections: (1) Monetary 
Policy and Systemic Liquidity Management, (2) Financial 
Structure and Regulation, (3) Money Laundering and Terrorism 
Financing, (4) Financial System Soundness and Stability, and 
(5) Crisis Management Framework and Recommendation. This 
cable highlights the key findings of the report in order to 
assist Washington policymakers in understanding the critical 
problems in the Honduran financial sector and the key 
objectives of the World Bank's new financial sector project 
(approved in June 2003).  This information, while 
unclassified, is highly sensitive and should be kept close 
 
SIPDIS 
hold by policymakers.  End Summary. 
 
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Monetary Policy and Systemic Liquidity Management 
--------------------------------------------- ---- 
 
¶2. (SBU) Although generally favorable on the role of the 
Central Bank of Honduras (CBH), the FSAP expressed concern 
about its management of the foreign exchange market through 
daily auctions.  The authors noted that, although focusing 
primarily on the stability of the exchange rate to maintain 
price consistency, the program is directed at reducing 
inflation by reducing liquidity in the market, a policy that 
emphasizes control of the money base rather than the 
exchange rate. 
 
¶3. (SBU) Thanks to foreign investment and other inflows as a 
result of Hurricane Mitch relief efforts, the level of 
foreign currency has contributed to a relatively stable 
foreign exchange market.  However, this could change in the 
future.  The report urged that the restrictions on the 
foreign exchange auction be modified and simplified.  The 
FSAP suggests using the marginal market-clearing price for 
foreign currency (Dutch auction) rather than the individual 
bidding price (American auction) to determine the winning 
bids in the exchange auctions. 
 
¶4. (SBU) Another monetary policy vulnerability noted is the 
foreign exchange surrender requirement for banks and 
exchange houses.  These institutions are not allowed to 
supply foreign exchange demands with their foreign exchange 
purchases.  As a part of this restriction, the CBH requires 
them to surrender 100 percent of their foreign exchange 
purchases on the next business day.  However, it takes two 
business days for the institutions to receive the purchased 
foreign currency.  The FSAP recommends lowering the 
percentage surrender requirements as well as decreasing the 
time between purchasing foreign currency and acquiring it. 
This would then allow for greater efficiency in the banking 
sector in the short run. 
 
¶5. (SBU) To limit the growth of the monetary base 
(countering the weekly foreign exchange auctions), the CBH 
used central bank securities (Certificados de Absorcion 
Monetaria, or CAMs) to stabilize the level of net foreign 
assets.  This resulted in large quasi-fiscal costs that have 
created an increased deficit for the CBH and added to the 
vulnerability of the CBH's financial position.  To counter 
these potential weaknesses, the FSAP suggests that Honduras 
strengthen the money market to include liquidity management. 
 
¶6. (SBU) The FSAP proposes increased transparency and 
openness in the Central Bank's operations.  The assessment 
also warns against a dollarization policy in Honduras (a 
view shared by the GOH).  Dollarization in Honduras would 
constrain the CBH's capacity to implement monetary policy 
and would increase liquidity risks in the financial sector, 
among other problems. 
 
¶7. (SBU) Another important area of monetary policy falls in 
the domain of debt management.  The report's authors 
recommend better strategy coordination between fiscal and 
monetary authorities.  Additionally, the authors suggest 
development of a market-oriented government funding strategy 
that would include development of a secondary bond market. 
 
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Financial Structure and Regulation 
---------------------------------- 
 
¶8. (SBU) While the FSAP recognizes the improvements in 
National Banking and Insurance Commission's regulation of 
the financial sector over the last few years, it mentions 
five critical flaws that require immediate correction. 
First, the FSAP authors suggest that the CNBS consolidate 
its operations to ensure the widespread application of laws 
and regulation monitored by a centralized, regulatory body. 
Second, the capital requirements need to be addressed. 
Reserves are insufficient to absorb expected losses, so 
unexpected losses cannot be covered.  Tightening of the 
capital requirements would help to end the inflated 
accounting of capital and provide sufficient reserves to 
back any expected losses.  Third, loan classification and 
provisioning require improvement.  The Honduran standards 
for loan provisioning fall well below the norms of other 
Central American countries.  After Hurricane Mitch in late 
1998, the government adopted a series of measures granting 
debt forgiveness and tolerated a high number of non- 
performing loans in the banking system.  These policies need 
to be restructured.  Fourth, the report recommends that the 
CNBS promote accountability for minimum corporate governance 
requirements.  For example, a written loan origination 
manual for each bank would help create a sustainable risk 
management system as well as enhance corporate governance in 
the banking sector.  Finally, the CNBS needs to transform 
from a purely supervisory body to a "more risk-oriented, 
forward-looking" agency.  To achieve this transformation, 
the CNBS should expand its actions to encompass more than 
checking for compliance. 
 
¶9. (SBU) The legal framework for the banking system is 
another area addressed in the FSAP.  The report notes the 
severe problems in Honduran property registration.  The 
process is slow, obsolete, subjective, and risky. 
Bankruptcy law is another distinctive problem area (almost 
never used in Honduras).  Companies tend to close their 
business without concern for outstanding debt, partially 
stemming from lack of faith in the judicial system.  To 
combat these inefficiencies and the problems they pose for 
the financial sector, the GOH needs to encourage new 
legislation to update property registration and bankruptcy. 
 
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Money Laundering and Anti-Terrorism Financing 
--------------------------------------------- 
 
¶10. (SBU) The FSAP recognized that the March 2002 law to 
combat money laundering (ML) represented a significant step 
for the country in this area.  Under the new law, there are 
now stiffened penalties for money laundering as well as 
increased preventive measures.  The law enhances the 
capacity of law enforcement officials to combat this crime 
and broadened classification of ML offenses (combined with 
expanded mandates for confiscation of assets) will assist 
officials in the investigation and prosecution of suspected 
money launderers. 
 
¶11. (SBU) The FSAP authors cautioned that the implementation 
process remains riddled with potential setbacks.  Limited 
resources, both in funding and training, could hamper the 
effectiveness of the legislation.  Officials need training 
and experience to combat money laundering.  They also lack 
useful technological resources, such as access to software 
capable of detecting suspicious transactions.  Without such 
technology, employees are reduced to manual means of 
detection, which creates opportunity for human error and 
corruption.  In addition, without strategic cooperation, 
various governmental entities risk duplicating law 
enforcement efforts.  To eliminate this waste of scarce 
resources, the roles and responsibilities of each 
organization need to be clearly delineated. 
 
¶12. (SBU) The authors emphasized the limited legal scope of 
the Honduran money laundering law in the area of terrorism 
financing.  Terrorism financing is listed as potential 
grounds for a money laundering charge but is not identified 
as a crime in and of itself.  The FSAP recommends that the 
GOH identify a competent body to address this issue and to 
have an explicit mandate to freeze assets of suspected 
terrorists.  Note: The CNBS has in fact issued a large 
number of freeze orders of assets held by terrorists since 
September 2001 and the financial system has complied with 
these freeze orders in a prompt fashion.  No terrorist 
assets have been found in Honduras to date, however, so the 
legal authority has not been tested.  End Note. 
 
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Financial System Soundness and Stability 
---------------------------------------- 
 
¶13. (SBU) The FSAP classifies the financial system in 
Honduras as highly fragile, especially the banking sector. 
Although the capital adequacy ratios and provision coverage 
are improving, the tendency to overstate capital and hide 
losses renders the system vulnerable and limits the 
country's potential for economic growth.  With the banks 
earning close to zero profits, a cushion to absorb any 
shocks to the financial sector does not exist. 
 
¶14. (SBU) The combination of the repeated agricultural loan 
forgiveness measures and the blanket deposit guarantee 
contribute to severe moral hazard and fiscal contingency 
problems.  These programs, designed to assist struggling 
farmers after the devastation of Hurricane Mitch, have 
created large numbers of non-performing loans (NPLs) that 
weaken the asset quality of the banks. 
 
¶15. (SBU) Cooperatives, which are not regulated by the CNBS, 
appear to have less liquidity than Honduran banks.  Although 
the figures for the cooperatives are not official, the 
liquidity percentage of total assets (16 percent) is 
reported at about half of Honduran banks (31.7 percent).  A 
high number of overdue loans have contributed to this lack 
of liquidity in cooperatives. 
 
--------------------------------------------- -- 
Crisis Management Framework and Recommendations 
--------------------------------------------- -- 
 
¶16. (SBU) The 100 percent guarantee of deposits, enacted in 
1999, stabilizes the banking sector through protection of 
depositors.  The temporary stabilization should have enabled 
a sustainable restructuring of the system to occur in the 
last three years.  However, only limited restructuring has 
occurred, and the fiscal costs are mounting.  The blanket 
coverage of deposits becomes an incentive to potential risk- 
takers, which contributes to the instability of the banking 
system.  Additionally, the continual coverage of deposits by 
the Deposit Insurance Fund, FOSEDE, has created a negative 
net worth for this fund.  This, in turn, undermines consumer 
confidence in the value of FOSEDE as a true financial safety 
net. 
 
¶17. (SBU) The FSAP report suggests that the GOH move quickly 
toward a limited deposit insurance system.  The report 
recommends additional transparency within FOSEDE. 
Disclosure of goals and financial information in an annual 
report would instill a higher level of confidence in the 
FOSEDE, which now operates under a veil of confidentiality. 
 
¶18. (SBU) The transition to a limited deposit insurance 
system requires certain conditions to exist before 
implementation.  First, the report suggests that all 
insolvent banks should close operations.  Second, the CNBS 
should monitor the finances of reporting institutions and 
intervene at the first sign of problems.  Third, FOSEDE must 
have a positive net worth.  Fourth, the financial system 
must have a strong liquidity potential coupled with a stable 
macroeconomic framework.  These elements would help prevent 
difficulties in the transition from a blanket coverage 
policy to a limited deposit insurance guarantee. 
 
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COMMENT 
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¶19. (SBU) The FSAP report is a valuable diagnostic tool that 
will help the GOH, the various multilateral institutions in 
Honduras, and bilateral donors in efforts to head off a 
future financial crisis.  A careful reading of the report 
also provides cautionary warnings.  None of these problems, 
which were years in the making, will disappear easily. 
Many, such as cleaning up the bad loan portfolios and 
rationalizing property registers, will require financial 
resources far beyond the GOH's means.     Others, the 
transfer from a blanket deposit guarantee policy to a 
limited deposit insurance guarantee, have been shied away 
from in the past because of their potential to 
unintentionally trigger the financial crisis that everyone 
seeks to avoid.  The Embassy, in particular USAID and the 
Economic Section, are staying in close touch with the GOH, 
the World Bank, and the IDB to ensure complementarity among 
our respective assistance programs (including AID-funded 
work with the Banking Commission and a Treasury money 
laundering technical assistance project).  End Comment. 
 
PALMER