EL SALVADOR TECHNICAL NOTE FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE FINANCIAL INCLUSION NOVEMBER 2010

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted. FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE EL SALVADOR FINANCIAL INCLUSION TECHNICAL NOTE NOVEMBER 2010 THE WORLD BANK FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY LATIN AMERICA AND THE CARIBBEAN REGION VICE PRESIDENCY INTERNATIONAL MONETARY FUND MONETARY AND CAPITAL MARKETS DEPARTMENT

2 ii Abbreviations and Acronyms AML ATM BCR BMI CNR GDP LAC MIX NCB NPL POS PPP ROSC S&L SME SSF Anti-Money Laundering Automatic Teller Machine Central Bank of El Salvador (Banco Central de la República del Salvador) Multisector Bank of Investments National Credit Registry Gross Domestic Product Latin America and the Caribbean Microfinance Information Exchange Banking Norms (Norma Contable para Bancos) Non-Performing Loan Point of Sale Purchasing Power Parity Report on Standards and Codes Savings and Loans Association Small and Medium Enterprises Financial System Superintendency (Superintendencia del Sistema Financiero)

3 iii Contents Executive Summary... 1 I. Overview of Financial Access and Usage Patterns... 2 II. Funding and Savings Products Commercialized... 5 III. Market Participants... 8 IV. Legal and Regulatory Impediments to Credit V. Supervisory and Regulatory Perimeter Issues VI. Transparency, Consumer Protection and Financial Literacy Tables and Figures Tables Table 1. Key Policy Recommendations Table 2. Variations in Financial Service Infrastructure and Activity, by Department...4 Table 3. International Comparison of Size of El Salvador s Microfinance Sector...7 Table 4. Institutions Providing SME and Microfinance: Main Indicators....9 Table 5. Permissible Activities of Financial Institutions..15 Figures Figure 1. Access to Finance: Evolution and International Comparison..3 Figure 2. Evolution and International Comparison of Credit Provision 6 Figure 3. Ex-Post Interest Margin Decomposition...10 Figure 4. Contract Enforcement and Collateral: International Comparison 12

4 1 EXECUTIVE SUMMARY 1 Financial service provision has expanded since the 2004 FSAP update, but access to financial services could expand greatly through mobile banking. An estimated 47 percent of adults in El Salvador have deposit accounts at a regulated financial institution, similar to the Latin American average. However, branch coverage and other elements financial infrastructure lag behind comparator countries. The majority of credit and deposit-taking activity takes place in San Salvador, with many other departments financially underserved relative to their population. A map of existing financial services providers in the different municipalities would help assess the current situation and be a valuable input on the formulation of a strategy to improve access. Mobile banking methods such as the use of correspondent agents by financial institutions and new technologies would improve access to financial services in currently underserved regions. Since 2008, credit to small and medium enterprises (SMEs) has declined sharply and credit to microenterprise remained limited, while consumer credit proliferated. Consumer credit is likely to be used by many micro and SMES to fund their business, albeit at higher interest rates. Although a range of range of bank and non-bank institutions serve the micro and SME finance market, significant financial services provision is occurring outside of the regulatory perimeter. Although commercial banks provide the vast majority of loans outstanding overall, both in terms of number and volume, a large number of non-bank institutions (e.g. cooperative banks, savings and loans societies, cooperative associations, cajas de crédito and non-bank finance companies) play an important role in micro and SME finance. These institutions provide a range of credit products, including mortgage loans and consumer lending. Some of these unregulated institutions capture deposits from their members, which presents a risk to consumers, since these entities are not covered by deposit insurance. Currently, few unregulated institutions are moving towards regulated status. Improvements in credit information systems, simplification of credit documentation processes and a strengthened legal framework for factoring could help facilitate SMEs access to credit. Judicial inefficiency, burdensome documentation requirements and fragmented credit information lead to over collateralization and limit access to credit in El Salvador. Also, no specific treatment exists to favor microfinance loans in the regulatory code while existing prudential norms (NCB-022) favor the supply of consumer and mortgage credit more than commercial credit. Factoring activity is growing rapidly outside of the banking system, and has the potential to ease credit constraints for SMEs but there are weaknesses in the legal framework for factoring. Issues of financial transparency and consumer protection are of increasing importance to the Salvadoran authorities, although resources for enforcement are limited. Advances have been made in the legal framework for consumer protection. To improve disclosure practices further, the Ley de Protección al Consumidor should require lenders to publish the total dollar cost over the life of the loan. Both public and private entities are engaging in educational activities to promote financial literacy have the potential to play an important role in curbing 1 This note was prepared by Rekha Reddy (World Bank, LCSPF).

5 2 overindebtedness. However, the consumer defense agency (Defensoría al Consumidor) lacks sufficient resources for enforcement of consumer protection laws. Table 1. Key Policy Recommendations Recommendations Objective Discussion Map financial services available at the municipal level including unregulated institutions and remittance providers To provide a solid data driven foundation for strategies to promote financial inclusion Chapter 1 Promote regulatory changes that permit the use of non-bank agents in financial transactions and the emission of electronically stored value instruments (e-money) Improve the legal framework for factoring by facilitating the legal transfer of an invoice to a third-party. Reduce biases towards consumer credit, by removing discrepancies in past-due classification treatment of consumer and enterprise loans in Norm Strengthen oversight of currently unregulated entities institutions and reconsider the regulatory architecture to cover a greater number of entities. Harmonize and modify existing documentation requirements for credit and registration of assets from the Código de Comercio, Código Tributario and AML (anti-money laundering) laws. Modify the Consumer Protection law (Ley de Protección al Consumidor) to require lenders to publish the total dollar cost over the life of the loan. To make financial services more accessible by adding more physical access points To strengthen a system with significant potential to improve financing options for SMEs. To promote the use of credit for productive purposes To promote the stability of the financial sector and protect the deposit base of the population To simplify and reduce requirements that restrict access to credit on low-value transactions To promote transparency of costs Chapter 1 Chapter 2 Chapter 4 Chapter 5 Chapter 6 Chapter 6 I. OVERVIEW OF FINANCIAL ACCESS AND USAGE PATTERNS 1. Financial service provision has expanded since the 2004 FSAP update, but much of the population remains underserved by formal institutions. As shown in Figure 1a, deposit and credit accounts have increased in absolute terms (by 32 percent and 22 percent respectively) as have physical access points for financial services. An estimated 47 percent of adults in El Salvador have deposit accounts at a regulated financial institution, similar to the Latin American

6 3 average 2. Wealthier Central American comparators Panama and Guatemala have more depositors per capita, suggesting significant room to increase outreach. Figure 1: Access to Finance: Evolution and International Comparison a) Deposit and credit accounts have b) along with branch and ATM increased infrastructure. 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000, , ,729,389 No. Deposit Accounts 1,674,188 No. Loan Accounts , ,144 1, Number of Branches Number of ATMs Source: FSAP Analysis of SSF Data (regulated institutions) c) Deposit account provision (per 100,000 d) but El Salvador has relatively few adults) is in line with regional standards branches per capita El Salvador Guatemala Honduras Nicaragua Panama Latin America El Salvador Honduras Guatemala Nicaragua Panama Branches per 100,000 adults ATMs per 100,000 adults Source: FSAP Analysis of CGAP Financial Access Database Branch coverage and other elements financial infrastructure lag behind some comparator countries. El Salvador s 22.9 ATMs per 100,000 adults was a similar ratio to that of other comparator countries. More points exist for Salvadorans to physically access financial services: the number of branches has increased by 44 percent and the number of ATMs 57 percent. However, despite this increase, El Salvador s 8.9 branches per 100,000 adults (a proxy 2 This estimate is based upon (i) December 2009 IGD data on the number of persons with deposit accounts at each regulated financial institution and (ii) cooperatives providing data to FEDECACES and FEDECREDITO on the number of associates. Although the data identifies unique depositors within an institution, it does not exclude double counting of the same person with accounts in multiple institutions. To avoid double counting the banked population, the 70 percent of the total number of accounts in El Salvador is included in this estimation. This assumption is based upon the opinions of financial services professionals in El Salvador and observed values of similar data for other developing countries.

7 4 for population access to financial services) is lower than in other Central American countries with the exception of Honduras. Similarly, El Salvador s ratio of 250 POS (point of sale) devices per 100,000 adults was nearly half that of Guatemala and Panama. 3. The majority of credit and deposit-taking activity takes place in San Salvador. Onethird of the adult population resides in San Salvador, where poverty is relatively low. However, San Salvador holds 52 percent of all deposits, and 66 percent of all loans. Much of the infrastructure for regulated financial services exists there, as shown in Table 1: regulated financial institutions have 38 percent of their branch presence and half of their ATM presence in the San Salvador department. Financial service provisions in the poorer northern departments is much more limited. The elaboration of a census of financial services available at the municipal level, including unregulated institutions and remittance service providers would provide basis for identifying the most underserved populations and help in the design of a targeted financial inclusion strategies. Table 2. Variations in Financial Service Infrastructure and Activity, by Department Department No. % of Total Branches Branches % of Adult Population Branches per 100,000 Adults Value of % of No. Deposit Deposit ATMs Accounts Accounts ($mn) % of Deposit Value Value of Credit Accounts ($mn) % of Credit Value Ahuachapán 16 3% 5% % $ 158 2% $ 140 1% Santa Ana 36 7% 9% % $ 506 6% $ 416 4% Sonsonate 24 5% 7% % $ 218 2% $ 323 3% Chalatenango 15 3% 3% % $ 170 2% $ 67 1% La Libertad 74 15% 11% % $ 1,687 19% $ 1,525 15% San Salvador % 32% % $ 4,737 52% $ 6,836 66% Cuscatlan 11 2% 3% % $ 84 1% $ 79 1% La Paz 16 3% 5% % $ 92 1% $ 162 2% Cabanas 16 3% 2% % $ 168 2% $ 66 1% San Vicente 10 2% 2% % $ 66 1% $ 90 1% Usulutan 19 4% 5% % $ 201 2% $ 157 2% San Miguel 36 7% 8% % $ 582 6% $ 397 4% Morazan 9 2% 4% % $ 108 1% $ 38 0% La Union 23 5% 4% % $ 298 3% $ 102 1% Total % 100% 8.9 1, % % $ 10, % Source: FSAP Analysis of 2009 SSF data and 2007 Dirección General de Estadística y Censo (DIGESTyC). Census data for population estimates. 4. The use of banking correspondents and mobile payments systems could help expand access to financial services to underserved populations. Modifications to El Salvador s legal and regulatory environment for new technological channels and banking correspondent agents (third parties with authorization to deliver payments and other financial services, typically retailers) have the potential to increase physical access points where a branch may not necessarily be cost effective. SSF is currently allowing utility payments at retail institutions via POS (point-of-sale) devices, but could make further adjustments, by (i) establishing the jurisdiction of the BCR over these transactions and (ii) issuing regulations that define the use of

8 5 e-money and allowing licensed and supervised financial institutions to conduct financial transactions via the use of agents. 3 II. FUNDING AND SAVINGS PRODUCTS COMMERCIALIZED 5. In recent years, consumer credit has proliferated, along with concerns of overindebtedness. As shown in Figure 2a, between 2004 and 2009, the number of loans to individuals increased by 33 percent. Loans to salaried workers are offered with relatively favorable terms by the banks that hold employee payroll accounts, often reaching 5-7 years in duration. Credit card use has proliferated, and is expected to increase with recent legal changes that allow a greater number of financial institutions to offer these services. At end-2009, 615,000 credit cards had been issued. Of 755,539 active loans in the Central de Riesgos as of December 2009, 49 percent have more than 1 credit account, and 18 percent have more than 3 credit accounts. 6. Concerns over credit worthiness have discouraged some financial institutions from serving the low-income consumer market. Delinquency has increased in these segments, as households take on more debt. Although half of all credits in 2009 were for less than US$1,000, lenders like Procredit Bank are exiting this market, which they feel is more risky. A 2010 proposed law (Ley Especial de Protección a la Persona Deudora) that would require banks to have special workout plans to facilitate debt repayment by bankrupt individuals, has raised concerns in some financial institutions regarding its potential negative effect on the payment culture. 7. Meanwhile, the share of credit to SMEs has been declining. According to SSF data, credit from all regulated institutions to firms classified as small or medium size totaled to US$1.2 billion at end 2009, slightly more than 10 percent of total credit. Little hard data on SME lending by non-regulated institutions is available. As shown in Figure 2b, between 2004 and 2009, the number of loans to firms increased only 2 percent down from a peak in However, the value of credit classified as small or medium has decreased slightly from 35 percent to 31 percent of credit to firms. The recent financial crisis appears to have particularly squeezed small enterprises, as their share of credit dropped from 16 percent to 9 percent between 2008 and Some of the banks interviewed stated that they are exiting the lending market for smaller firms, which is increasing the funding costs for this segment. Nearly 80 percent of loans have a balance less than US$5,000. Anecdotally, credit between US$30,000 and US$75,000 remains the most difficult amounts for firms to attain, as these amounts are too large for most microfinance focused institutions to provide. As in other countries, SMES have less access to credit than larger firms; only 44 percent of small firms and 53 percent of medium sized firms had credit, far lower than the 78 percent of large firms with credit. 3 Aguirre, E, Días, D and Seltzer, Y. (2009) Informe de diagnóstico sobre el marco jurídico y normativo de la banca sin sucursales en El Salvador. August.

9 6 Figure 2: Evolution and International Comparison of Credit Provision a) Consumer credits have increased while credit to firms plummeted 1,800,000 1,600,000 1,400,000 1,200,000 1,000, , , , ,000 0 No. Loans to Individuals 1,626,455 47,733 No. Loans to Firms ,000 49,500 49,000 48,500 48,000 47,500 47,000 46,500 46,000 45, % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% b) The share of enterprise credits to micro and SMEs 4 has declined. 20% 19% 19% 21% 22% 15% 18% 18% 16% 9% 4% 4% 4% 5% 6% Goverment Source: FSAP Analysis of SSF Data (regulated institutions) c) The percentage of SMEs 5 with credit is in d)...as is bank financing of SME working line with regional standards capital relative to other countries. Large Medium Small Micro El Salvador Guatemala Honduras Nicaragua Small Medium Large El Salvador Guatemala Honduras Nicaragua 49% 64% 71% 63% 20% 13% 19% 7% 20% 9% 13% 7% 9% 21% 9% 7% Internal financing Bank financing Supplier/customer credit NBFI, family or other Panama Panama 66% 19% 9% 6% % 20% 40% 60% 80% 100% Source: FSAP Analysis of World Bank enterprise survey data (2006) 8. Nevertheless, credit to SMEs remains in line with regional standards. According to the 2006 World Bank enterprise survey data shown in Figure 2c, 49 percent of urban firms have credit. This percentage is slightly above the Latin American average (47 percent) and broadly in line with the percentage in other Central American countries. As shown in Figure 2d, for Salvadoran small firms, roughly half of all funding for working capital comes from internal resources, lower than other Central American comparators. The remainder is drawn from bank credit (20 percent), credit from suppliers or advances from customers (13 percent) or other sources such as family members or non-bank financial institutions (NBFIs) (20 percent). 9. Credit to microenterprises also remains limited. Microfinance credit as measured by the Financial Superintendence (Superintendencia del Sistema Financiero, SSF) inched up from 4 4 Loans classified as micro were made to businesses with up to 600,000 (US$68,580) in annual sales and up to 10 employees. Small businesses have 600,000-6 million ($685,500) in annual sales and employees. Medium businesses have 6 million- 40 million in annual sales and employees (1 =.1143 USD). 5 This enterprise survey of urban firms uses the following definitions small firms=5-20 employees, medium=20-99 employees, and large=100+ employees.

10 7 to 6 percent of total firm credit, between 2005 and Estimates of the size of the total microfinance portfolio range from US$223 million (regulated institutions by SSF, December 2009 data) to US$350 million (data from 13 microfinance institutions reporting to the Microfinance Information Exchange (MIX Market) to US$911 million (98 regulated and nonregulated institutions tracked by MicroEnfoque magazine, June 2009), depending on the definitions and coverage of the data source. According to MicroEnfoque, 60 percent of this credit is split evenly between commercial and consumer credit, with another 15 percent dedicated to housing microfinance. In comparison to the Latin American regional average (see MIX Market data in Table 2), the Salvadoran microfinance sector is slightly more developed, in terms of penetration of population, although the data is limited to institutions who report to the system. Table 3. International Comparison of Size of El Salvador s Microfinance Sector Country Gross Portfolio (US$ millions) Number of active borrowers Average loan balance per borrower (US$) Percent coverage of population Average loan balance as percent of GNP capita (PPP$ 6 ) El Salvador ,752 1, % 17% Guatemala , % 8% Honduras , % 8% Nicaragua , % 32% Panama ,571 1, % 9% Latin America 15, ,900, % - Source: MIX (Microfinance Information Exchange) Market database, December 2008 data. Population and GNP per capita information from World Bank Development Indicators database. 10. Factoring activity is growing rapidly outside of the banking system, and has the potential to ease credit constraints for SMEs. A 2008 figure from Factoring Chains International estimated factoring volume to be US$185 million, and some estimates put the 2010 figure closer to US$250 million. Factoring services are a minor business line for international banks, primarily serving large firms that represent minimal credit risk. Assets of regulated factoring services have declined since Factoring firms, which are non-regulated, have less conservative lending practices and quicker procedures than banks and have been experiencing high activity growth. These firms offer factoring as a commercial transaction, typically with more flexible documentation and without the additional guarantees solicited by banks. 11. The regulated leasing industry remains limited. A legal framework exists for leasing through regulated financial institutions (Ley de Arrendamiento, 2002), but the product has not reached scale. Last year, financial conglomerates booked just 837 leasing loans totaling just $1.7 million. Tax laws in El Salvador discourage banks from offering leasing, as they pay more 6 PPP (Purchasing Power Parity) is used to compare purchasing power across countries. PPP adjusted GDP facilitates comparability between countries while minimizing bias in exchange rates to calculate outputs.

11 8 income tax on leasing operations than on loan operations, even if the same interest rate is charged. Like factoring, much of the activity in leasing is occurring outside of regulated financial institutions and public data for them do not exist. 12. Financial institutions offer a range of deposit services. According to December 2009 SSF data, sight deposit accounts grew 24 percent between 2004 and 2009, while term deposits of less than a year decreased by almost the same percentage. The average value of a deposit account is about $2,400. All type of financial institutions are permitted to offer savings deposit accounts, while commercial and state banks are more focused on the provision of sight deposits. Regulated institutions are permitted to capture deposits from the public, while the deposit-taking actions of non-regulated institutions are limited to their members. III. MARKET PARTICIPANTS 13. A range of bank and non-bank institutions serve the micro and SME finance market. The regulated entities include commercial banks, cooperative banks, 7 some savings and Loans societies (S&Ls), certain worker s banks and a federation of worker s banks and cajas de crédito (FEDECREDITO). Other savings and loans cooperative associations, cajas de crédito, finance companies (mortgage, leasing, factoring), associations and foundations (NGOs) are unregulated and also serve this market (see Table 3). Each entity occupies different market niches, with S&Ls, cooperative associations and the NGOs generally serving poorer clients than the banks. Most provide a range of credit products, including mortgage loans and consumer lending. 14. Although commercial banks provide the majority of loans outstanding overall, nonbank institutions provide an important part of micro and SME finance. Commercial banks provide the vast majority of credit volume, and more than 70 percent of the total number of loans in the system. Using average loan size of each institutional category as a proxy for level of segment focus, S&Ls (both those regulated by SSF and unregulated savings and loans cooperative associations affiliated with the INSAFOCOOP, FEDECACES and FEDECRECE federations) and foundations/associations (NGOs) are focused on the poorest clients, with average loan sizes of US$1,725 or less. In contrast, the regulated cooperative banks had average loans of US$7, Regulated cooperative banks report healthy financial indicators. As shown in Table 3, non-performing loans (NPLs) for regulated cooperative banks (2.9 percent) are higher than in the micro and SME focused commercial banks but well-below the NPLs of S&Ls (4.0 percent) and unregulated institutions, where NPLs can approach 10 percent. Cooperative banks provision more than their commercial bank peers as well. Regulated cooperative banks, S&Ls and nonregulated financial institutions affiliated with a federation all report capital adequacy ratios 7 As defined in Article 2 of the Cooperative Banks and Savings and Loan societies, regulated cooperative banks include: savings and loans cooperatives that also capture savings from their members and the public and savings and loans cooperatives where the sum of deposits and capital exceed 600,000 colones.

12 9 (CAR) higher than 20 percent (Table 3). Although they have higher financing costs, cooperative banks are among the most profitable regulated institutions. 16. Spreads vary among categories of financial institution. Net interest margins for commercial banks are slightly lower (6.3 percent in 2009) than for public banks (6.8 percent) and cooperative banks (7.1 percent). Margins are highest for regulated S&Ls (21.1 percent) who face less competition in their lower-income housing market. As shown in Figure 3a, S&Ls earn far more in interest income than cooperative banks, with an ex-post lending rate (loan interest income to average sector net loans) of 29 percent in comparison to 13 percent for cooperative banks. At the same time, regulated S&Ls pay higher ex-post deposit rates (8 percent) than cooperative banks (6 percent), and have higher provisioning costs. For both types of entities, personnel costs represent roughly 37 percent of the spread. Some of these differences can be attributed to the different markets served by the institutions. Cooperative banks have the majority of their portfolio in consumer and mortgage loans, which have fewer processing costs, while the S&Ls are more focused on smaller enterprise loans, which often involve shorter terms and a more costly, labor intensive credit evaluation process. Table 4. Institutions Providing SME and Microfinance: Main Indicators Micro/SME Focused Commercial Banks Subject to Prudential Norms Cooperative Banks Savings & Loans Regulated Federation with Mostly Unregulated Members FEDECREDITO (Caja/Worker Bank) Federation* FEDECACES (Federation of Savings and Loan Cooperatives) Unregulated Institutions FEDECRECE (Federation of Savings and Loan Cooperatives) INSAFOCOOP (Data for Unaffiliated Savings and Loans Cooperatives Only) Other Associations/ Foundations Total Assets $ 475,979,414 $ 474,819,406 $ 69,749,610 $718,343,491 $ 211,304,129 $ 25,656,154 $ 127,830,291 $ 54,140,040 Loans Outstanding $ 318,207,524 $ 376,292,576 $ 59,669,564 $ 564,898,877 $ 163,791,377 $ 20,116,848 $ 82,235,496 $ 45,116,700 Number of Loans Outstanding 153,077 51,906 38, ,346 46,804 11,665 88,979 53,263 Average Loan Size $ 2,079 $ 7,250 $ 1,546 $ 3,757 $ 3,500 $ 1,725 $ 924 $ 847 Total Deposits 354,887, ,239,013 $ 6,768,995 $ 250,662,184 $ 135,913,352 $ 17,491,706 $ 45,748,887 N/A Loan/Deposit Ratio 90% 160% N/A 225% 121% 115% 180% N/A NPL 1.9% 2.9% 4.0% 4.2% 8.4% 3.8% 1.2% 9.6% Provisions/Total Loans 2.6% 3.0% 5.6% ND 14.3% ND ND ND CAR 14.6% 25.8% 26.9% 25.4% 22.1% ND ND ND ROA 0.2% 1.3% -1.7% 2.3% 0.5% ND ND ND ROE 2.3% 6.2% -2.0% 10.2% 2.2% ND ND ND No. Deposit Accounts 381,425 61,216 N/A 261, ,727 ND ND N/A No. Institutions No. Branches 79 ND ND ND 76 Financing Cost 4.8% 5.8% 7.0% % ND ND ND Sources: SSF, FEDECACES, FEDECREDITO, INSAFOCOOP, ASOMI and the MIX (Microfinance Information Exchange) Note:(1) All data is from December 2009, except for FEDECACES (March 2010),FEDECRECE, INSAFOCOOP and the MIX (December 2008) (2) The MSME focused banks in this table are Procredit and BFA. (3) This table does not include: (i) data on 100 savings and credit cooperatives registered with INSAFOCOOP but whom do not provide data (ii) data from finance companies (mortgage finance, leasing,factoring etc.) or (iii) the MSME portfolios of commercial banks such as Banco Agricola. (4) Both regulated Savings & Loans became deposit taking at the end of (5) FEDECREDITO is subject to regulation as a federation, but 52 of its 55 member institutions are not. (6) FEDECACES is unregulated, however 2 of its 33 member institutions are regulated.(7) The data listed under INSAFOCOOP does not include their members who are also affiliated with FEDECACES or FEDECRECE. Data for loans outstanding is not available--loans disbursed are used instead.

13 Profits have increased and efficiency improved at cooperative banks with the decline in overhead costs. For cooperative banks, the 7.1 percent net interest margin can be broken down into costs for tax, provisions, profit and overhead costs, the most significant of which are personnel costs. As shown in Figure 3b, overhead costs have declined from 4.3 percent in 2005 to 3.4 percent in 2009, while the profit margin has increased from 2 percent to 2.4 percent. Efficiency of these institutions, as measured by average loans managed at any given time per worker, varied from 80 to 200 loans per employee, with an average of 110. Efficiency is even lower for many non-regulated microfinance institutions. For microfinance institutions that provide very small loans, average efficiency is well under 100 loans per employee at many institutions, with the exception of those who use the group methodology. Figure 3: Ex-Post Interest Margin Decomposition a) Cooperative Banks and S&Ls, 2009 b) Cooperative Banks, % 20.0% 15.0% 10.0% 5.0% 0.0% 7.1% 21.1% Spread 2.6% 8.0% Personnel costs 0.8% 1.0% Other Overhead Cooperatives 2.4% 5.3% 6.8% 1.0% 0.4% 0.1% Profit Provisions Tax S&L 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0.2% 0.2% 0.2% 0.3% 0.4% 0.5% 0.2% 0.8% 0.7% 1.0% 2.0% 1.1% 1.2% 0.8% 2.4% 2.2% 0.9% 1.3% 2.4% 0.8% 3.1% 1.6% 2.6% 2.5% 2.6% Tax Provisions Profit Other Overhead Personnel costs Source: FSAP Analysis of SSF Data (regulated institutions) Source: FSAP Analysis of SSF Data (regulated institutions) 18. Additional longer-term funding to non-regulated entities from the public development bank (Banco Multisectorial de Inversiones, BMI), would reduce the costs of credit for micro and SMEs. The Ley de Creación of the BMI was recently changed to allow it to lend to unregulated institutions. BMI has a specific US$10 million fund for unregulated microfinance institutions that adhere to well-defined performance criteria (the requirement that NPLs be less than 7 percent eliminates many institutions). Regulated financial institutions find the interest charged by BMI expensive, whereas many unregulated microfinance institutions and finance companies have far greater credit needs. They are willing to pay between to 8 to 10 percent for credit from other second-tier lending institutions, well above BMI rates. BMI lends too many of these institutions without fixing a maximum rate they can apply to their customers. 19. Past lending in microfinance by government agencies has been marred by delinquency and inefficiencies. Although most government support to micro and SME finance is channeled through regulated financial institutions, 8 some remnants of direct lending remain. 8 Additional information on government support to micro and SME finance is provided in the Technical Note on Development Banks.

14 11 One smaller institution which lends directly is FOSOFAMILIA, an 11 year old government agency serving just 3,000 microfinance clients (primarily via group loans) is a remnant of past government lending, with a current portfolio of approximately US$3 million. NPLs built up in prior years approach 20 percent and cannot be removed without legislative approval. With an unsustainable, overstaffed operating structure, this entity requires decisive action to close or merge it into another entity. IV. LEGAL AND REGULATORY IMPEDIMENTS TO CREDIT GROWTH 20. Judicial inefficiency, in the form of lengthy procedures to enforce contracts, is a key impediment to credit growth. The 2004 Insolvency and Credit Rights ROSC (Report on Standards and Codes) found that the execution of collateral through the judiciary system seems to be the main cause of delay and an obstacle in the use of collateral, particularly for movable assets that they produce or possess. In 2010, this issue remains problematic. World Bank Doing Business indicators show that contract enforcement in El Salvador (786 days) takes longer than the regional average (as shown in Figure 4a), although improvements have been made in reducing the number of procedures involved from when the plaintiff files the lawsuit until the actual payment. Some banks suggested these cumbersome procedures inhibit many loans, particularly for machinery and equipment for SMEs. El Salvador does not have either a small claims court, and alternative dispute resolution mechanisms such as arbitration and mediation are barely used. For example, it can take more than a year to enforce a claim on a guarantee through the court system, which can explain much of the low level of claims against these guarantees (discussed in detail in the technical note on public banks) and consequently the low usage of guarantees within the financial system, of approximately 3 percent of total portfolio Fragmented information from the system of credit bureaus impairs the ability to make credit decisions on low-income borrowers. Although credit bureau coverage of the private bureau (DICOM/Equifax) is relatively high, modifications to the credit bureau framework are needed to improve credit decisions. Due to bank secrecy norms, the many unregulated financial institutions that provide credits focused on low-income borrowers are not permitted access to the full data provided to credit bureaus by regulated institutions (such as SSF s credit risk database). Only debts deemed unrecoverable (more than 180 days for consumer credit, 360 days for housing finance) are accessible to all, which does not permit all financial institutions to monitor a borrower s deterioration in status over time. The other credit bureaus (INFORED and Procrédito) to which these non-regulated institutions report their data are limited in scope. 22. High collateral requirements in El Salvador inhibit SME credit. Delays in executing collateral through the legal system, which reduce the value of the pledge, and lack of complete credit histories prompt banks to request high collateral levels. Eighty percent of urban firms in El Salvador have collateralized loans. However, the value of collateral required in El Salvador (151 percent) is higher than both the average for Latin America and the Caribbean (133 percent) and for other regional comparators as shown in Figure 4b. Small enterprises face the most stringent 9 Basagoitia, José Antonio. (2009) Diagnostico del Sistema Financiero de El Salvador. December.

15 12 requirements: the average value of collateral required for a small firm is nearly 175 percent of the loan value, far higher than for large firms (130 percent), and for other regional comparators, as shown in Figure 4c. Small enterprises are particularly squeezed, particularly when they seek larger credits than can be provided by a microfinance institution, but are limited by thresholds for unsecured loans, and often the movable assets (ex: inventory, equipment) they have available as collateral are deemed overly risky by banks. Factoring and leasing are developing outside the regulated financial sector as an alternative to collateralized loans, although the size of the market for both products remains limited. Figure 4: Contract Enforcement and Collateral: International Comparison a) The length of time to enforce a contract remains problematic for financial institutions Procedures (number) Time(days) Cost (% of claim) El Salvador 30 El Salvador 786 El Salvador 19 Guatemala 31 Guatemala 1,459 Guatemala 27 Honduras 45 Honduras 900 Honduras 35 Nicaragua 35 Nicaragua 540 Nicaragua 27 Panama 31 Panama 686 Panama 50 LAC 40 LAC 707 LAC Source: World Bank Doing Business data (2010) b) Collateral requirements are among the highest in the LAC region c) with small firms facing the biggest requirements. El Salvador 151 Guatemala 125 Honduras 78 Nicaragua 129 Panama 88 Latin America Value of collateral needed for a loan (% of Loan Amount) 174 El Salvador Guatemala Honduras Nicaragua Panama Source: FSAP Analysis of World Bank enterprise survey data (2006) Small Medium Large Value of Collateral needed for loan (% of loan amount) 23. SME access to credit could improve by strengthening the legal framework for factoring. Currently, the commerce code does not allow firms to cede to factoring intermediaries the invoices they receive from the distributors they supply. Therefore, invoice discounting as opposed to true factoring is prevalent. A special negotiable invoice that was recently introduced (factura cambiaria) allows factoring intermediaries to take action to collect on the debts of

16 13 distributors to their providers in the case of default, but as in other countries, large firms are reluctant to use it. There is interest in the electronic platform that recently begun operating following the NAFIN model, but it has yet to achieve scale. Development of factoring requires strengthening of the factura cambiaria instrument and support of the authorities for its use by the largest Salvadoran firms at the top of the productive chain. Also, factoring intermediaries should be allowed to participate in the electronic platform as well as distributors. 24. Documentation requirements and certain regulatory norms limit access to commercial credit of microenterprises and SMEs. Salvadoran SMEs seeking access to financing will have to provide sufficient and credible information of their financial condition and performance to potential lenders and investors. Firms with assets above US$12,000 are required by the Código de Comercio to present financial statements. Tax compliance is required for credits above US$30,000, for any transaction that requires borrowers to register assets (like a home) with the National Registry (CNR), and to avoid AML penalties. This limits enterprise credit to more informal firms, who then seek shorter, more expensive consumer credit without such documentation requirements to fund productive activities. 10 These documentation requirements should be reduced for low-value transactions and harmonized. Although SSF norms (NCB-022) state that financial institutions can establish their own documentation requirements for credits under US$100,000, overlapping requirements from various the commerce codes, tax code and AML have led many financial institutions to require financial statements and proof of tax compliance for loans of all sizes. As noted in the World Bank Accounting and Auditing ROSC (2005), reducing obligations for SMEs related to the provision of financial statements would facilitate their access to credit. 25. No specific treatment exists for microfinance loans in the regulatory code. Modifications to norms to establish a definition and particular treatment of microfinance (defined here as small loans for productive purposes) are under debate, in a consultation process led by microfinance network ACCION International. The expected benefit of this law is to provide appropriate requirements such that it is easier to approve and monitor the performance of a loan for microfinance purposes. However, this norm may not necessarily increase access to finance: particularly if the historical performance of microfinance loans is deemed to be poorer than in other loan categories, they may become even more expensive to provide. Currently, microfinance loans often carry higher rates than consumer loans, which are considered safer because of the salary guarantee provided. In any case, the impact of such legislation may be limited, given the large number of unregulated institutions providing microfinance. 26. Existing prudential norms (NCB-022) favor the supply of consumer and mortgage credit more than credit for firms. First, consumer and mortgage credit can be considered normal up to 30 days, whereas credit for firms is classified as sub-normal starting from the 15 th day. This is a major disincentive, as it can take months for loans to be return to the normal classification by SSF and counterintuitive, given consumer credit s higher rate of delinquency. 10 However, competition in the consumer loan market means that salary loans in El Salvador carry attractive interest rates and can reach 5-7 years in duration.

17 14 Second, consumer credit (including credit cards) and mortgage credit are only subject to classification as past-due, whereas enterprise loans are subject to both past-due and an analysis of economic situation and ability to pay. Institutions not specialized in microfinance sometimes have difficulties applying the required economic analysis required by SSF to analyze smaller enterprises with minimal bookkeeping. V. SUPERVISORY AND REGULATORY PERIMETER ISSUES 27. Significant financial services provision is occurring outside of the regulatory perimeter. As shown in Table 3, both regulated and unregulated institutions (most of which are cooperative associations) can provide credit, accept deposits and issue credit cards, although cooperative institutions are limited to capturing member deposits, rather than serving the general public. It is estimated that unregulated entities collect US$500 million in member deposits and have a loan portfolio of US$900 million as detailed in Table 4. Although data on each of the 300 plus unregulated institutions is not available, data provided by the cooperative INSAFOCOOP (Instituto Salvadoreño de Fomento Cooperativo, a public corporation with responsibility to register and monitor activities of hundreds of cooperative associations) show diversity in the scale of these institutions. Many of the unregulated institutions were very small (30 percent had less than US$100,000 in deposits from members), while 14 percent of the institutions held more than US$1 million in client deposits, and 8 percent held more than US$5 million. Institutions where the sum of the member equity contributions and member deposits exceed US$84 million automatically become regulated, but SSF has no way to determine whether institutions exceed this threshold. Institutions that fall below this threshold that are not providing financial services to the public can choose when to apply to be licensed. 28. Multiple oversight bodies for financial services increase the risk of regulatory arbitrage. Other than the commercial banks, just 9 financial institutions (a mix of worker s banks, savings and loans and cooperative associations) and 1 federation (FEDECREDITO) are regulated by SSF. The Superintendencia Mercantil and INSAFOCOOP have jurisdiction over some unregulated institutions (see Table 4), although in practice, both entities have limited information systems, few resources and few penalization powers, even when institutions do not report yearly data as required. As a result, INSAFOCOOP cannot produce comprehensive, up-todate data on the active portfolio of institutions it licenses. This is particularly problematic because SSF has few mechanisms to determine activities of institutions operating outside of the regulatory perimeter. The Law of Cooperative Banks and Savings and Loans require that institutions whose sum of member equity contributions and member deposits exceed US$84 million automatically become regulated, but SSF has no way to determine whether institutions exceed this threshold. 29. Network organizations play an informal oversight role for many unregulated institutions, with no obligation to pass along information to SSF. As shown in Table 3, many unregulated financial institutions are affiliated with network organizations, such as FEDECREDITO, FEDECACES, FEDECRECE and ASOMI. These organizations play a variety

18 15 of roles such as: collector of data, auditor, technical assistance provider, back-office services provider and even lender of last resort. FEDECREDITO (a regulated institution) is the largest of these groupings and engages in voluntary oversight of its largely unregulated member institutions (like the unregulated FEDECACES). However, the Law of Cooperative Banks and Savings and Loans do not provide auxiliary supervisory powers. As their oversight role remains informal, neither entity is required to share information about its members with SSF. Similarly, SSF is not required to review the quality of oversight conducted by FEDECREDITO. Table 5. Permissible Activities of Financial Institutions Entities Subject to Prudential Regulation Unregulated Institutions Category Banks Cooperative Banks Savings and loans (Sociedades de Ahorro y Crédito) Cooperative Associations From Public From Members Credit Provision To To Minimum Public Members Capital Requirement Law Yes N/A Yes N/A $16 million Ley de bancos Yes Yes Yes Yes $ 6 million Ley de bancos cooperatives y sociedades de A y C Yes N/A Yes N/A $3,502,000 or Ley de bancos cooperatives y 1,408,000 (if sociedades de A y C focused on MSMEs) No Yes No Yes N/A Ley General de Asociaciones Cooperativas, Ley de Instituto Salvadoreño de Fomento Cooperativo Cooperative Societies No Yes No Yes N/A Codigo de Comercio, Ley de bancos cooperatives y sociedades de A y C Cajas de credito No Yes No Yes N/A Codigo de Comercio, Ley de bancos cooperatives y sociedades de A y C Finance companies (mortgage, leasing, factoring) No No Yes N/A N/A Codigo de Comercio NGOs (Foundations/Associations) Deposit Taking No N/A Yes N/A N/A Ley de Asociaciones y Fundaciones sin Fines de Lucro Supervision/ Oversight SSF SSF SSF INSAFOCOOP Superintendencia Obligaciones Mercantil 30. Few unregulated institutions are moving towards regulated status under the existing framework. Regulation often implies upgrades to information technology systems, changes to ingrained governance practices, financial costs, the loss of tax advantages and a lengthy approval process. Although SSF supervision of hundreds of unregulated financial institutions is not feasible, of the existence of a large quantity of public deposits that are not guaranteed by deposit insurance (IGD) is not a desirable outcome either. One disincentive may be the ability of unregulated institutions to offer deposit services to members (as shown in Table 4): the law does not specify significant savings as a part of requirement for membership, such that a person can become a member with the small sum of a US$1 deposit, which does not restrict many people from affiliating. VI. TRANSPARENCY, CONSUMER PROTECTION AND FINANCIAL LITERACY 31. El Salvador has made strong advances in the legal framework for consumer protection. The Ley de Protección al Consumidor clearly defines the need for transparency of

19 16 costs and lays out a required level of service to the client by the financial institution with clear penalties for non-compliance. The Defensoría al Consumidor receives and resolves complaints, requesting assistance from the corresponding supervisory authority. SSF supervisors follow up on complaints as requested, or in the case of credit cards which are governed by a distinct law, receive the complaints directly. 32. However, it lacks sufficient resources for enforcement of consumer protection laws. With just 20 staff working on oversight, enforcement of laws is limited. The Defensoría does not have sufficient manpower to do more than basic monitoring, so the consumer protection law is more passively enforced through complaints. And in the case of credit cards issued by nonregulated institutions, there is a gap in the complaints resolution system, due to the lack of a supervisor with the means to resolve the complaint. 33. Entities engaging in educational activities to promote financial literacy have the potential to play an important role in curbing overindebtedness. In 2008, the financial authorities and the Consumer Defense Fund began a program of financial education. In 2009, they signed an agreement of cooperation for financial education with the goal of strengthening the knowledge of consumers and investors about financial services. Other significant activities to promote financial transparency include SSF s publication of interest rates and commissions according to maturity and product and fee schedules, in newspapers, although they may be overly complex for an unsophisticated consumer. One potential activity to consider is to require financial institutions to give 48 hours for clients to review all costs and commissions before signing a contract. 34. El Salvador has made advances in the legal framework for consumer protection, but could strengthen the existing law to require lenders to publish the total dollar cost over the life of the loan. This change would make costs more easily understandable by consumers than the current requirements to publish interest rates and commissions separately. This would build upon the increased disclosure provisions provided in the 2009 credit card law. The consumer defense agency receives and resolves complaints, although it does not have manpower to do more widespread monitoring.