I. KEY OBJECTIVES OF THE GOVERNMENT S PROGRAM TO LIQUIDATE BANRURAL AND CREATE FINANCIERA RURAL

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized MEXICO Rural Finance Development Structural Adjustment Loan (Loan 718-ME) Second Tranche Release - Full Compliance I. KEY OBJECTIVES OF THE GOVERNMENT S PROGRAM TO LIQUIDATE BANRURAL AND CREATE FINANCIERA RURAL 3. The broader policy objective of this loan is to support an important stage of the reform of Mexico s development banking sector. Specifically, this loan supports the liquidation of Banrural, a Government owned development bank, and the creation, in its place, of the new Financiera Rural (FR), a non-banking decentralized institution that cannot mobilize deposits or issue debt and that is in charge of promoting the development of rural financial markets. FR is funded directly through budgetary allocations, it must maintain the value of its capital endowment in real terms, report periodically to Congress, lend only to low and middle income rural producers, and move, over time, fully to second-tier lending. 4. Since the mid-l98 s, the Mexican Government has adopted measures to reform stateowned financial institutions. In 1986, the Government approved Organic Laws (Charters) for all development banks, creating a new charter: Sociedad Nacional de Cre dito. The process of financial sector reform also involved modifications to risk classification and provisioning rules for development bank loans (May 1993) and capitalization rules (July 1994). The Tequila crisis prompted the liquidation of two development banks and induced the govemment to initiate restructuring plans for the development banking system. More recently, the National Program to Finance Development (PRONAFIDE) for 22-26, calls for the modernization of development banks to help achieve the social and economic goals presented in the National Development Plan. 5. The Government s efforts to reform the development banks are in line with the recommendations of the FSAP carried out in mid-21. These efforts focus on three areas: Legal and institutional reforms to promote and strengthen non-bank financial intermediaries and popular banking. These reforms include: (i) enactment of the Law of Savings and Popular Credit (LACP) and amendment to the General Law of Organizations and Auxiliary Credit Activities and to the General Law of Cooperatives; (ii) creation, in April 21, of the National Financial Services Bank (BANSEFI) to promote savings from among low-income populations and promote the development of savings and credit institutions; (iii) creation, in mid-21, of the National Mortgage Bank (Sociedad H@otecaria Federal- SHF) a development bank for housing finance; and (iv) development, in late 22, of FIRA s (Agricultural Related Trust Fund) program to lend through special purpose finance companies. Legal and regulatory reforms to improve the governance and accountability of development banks. During 2 and 22, reforms were introduced to subject

2 2 development banks to the same regulation and supervision as commercial banks. These reforms also aim at promoting the operational efficiency and cost effectiveness of development banks, and limit the losses that they may cause to the Treasury. Restructuring of development banks. The restructuring emphasized their role of development agencies in charge of developing the financial markets in areas not well covered by the private banks. As development agencies, these institutions are funded directly through the budget, ceasing to take deposits from, and issue debt to the public. Their lending activities are (over time in some cases) limited to second-tier lending through banks and non-bank financial intermediaries, and their capacity to provide subsidies is limited, making those that they provide more targeted and transparent. 6. These reforms set the basis for a more efficient and transparent development banking sector, and go a long way towards reducing the problems associated with direct government intervention in the banking sector such as lack of transparency in the allocation of subsidies, high hidden fiscal costs, and negative incentives for private providers of financial services. Within this framework, the Government of Mexico decided to close Banrural, which was the public bank that generates the largest fiscal losses, and create in its place Financiera Rural. 11. PROGRESS IN IMPLEMENTING THE GOVERNMENT S PROGRAM 7. The Government of Mexico has made major advances in the implementation of its program, including measures taken prior to Board Presentation in compliance with First Tranche Release conditions: Congress approved on December 13, 22 the Charter of Financiera Rural (Ley Orghnica de la Financiera Rural -LOFR). Congress approved on December 13, 22 a modification to the Incomes Law of the Federation for the Fiscal Year 22, to include a budgetary allocation of MXP49.9 billion to liquidate Bamral and to provide an initial equity and budget to FR. The Secretariat of Finance and Public Credit (SHCP) approved, on April 1, 23, procedures for the liquidation of the Banrural System as a banking institution. FR provided to the Bank a Strategic Statement (Programa Institucional) approved by its Board of Directors (Organo de Gobierno), outlining mission and objectives, target markets and clients, instruments for providing credit, promoting investment and providing technical assistance, and a policy of limited credit expansion (no more than 1 percent) in the first year of operations with respect to the level of lending provided by Banrural in 22. FR submitted to the Bank a financial projections model of its operations, agreed to with the Bank. The model included pro-forma balance sheets and income statements. FR provided to the Bank a Regional Organization Plan approved by its Board establishing the number of branches (no more than loo), their geographic distribution, and branch staffing levels based on projected size of branches. The management structure of FR was established, including: the nomination of the Board of Directors, formed by representatives from the Federal Government, the social sectors and an independent counselor. The top management was nominated,

3 3 including the General Management (Direccidn General). Four main Committees have been established: Operations, Credit, Risks and Human Resources ACTIONS TAKEN TO FULFILL THE SECOND TRANCHE RELEASE CONDITIONS A. Satisfactory Progress in carrying out the Program Loan Agreement, Article 11, Section 2.2 (d) (i): Bank to be satisfied, based on evidence satisfactory to the Bank, with the progress achieved in the carrying out of the Program. 8. This condition has been met. The Bank received a letter of Sector Development Policy, signed by the Subsecretary of Finance and Public Credit, dated May 9, 23 describing the strategy that the Government is following for the restructuring of its development banks, with particular focus on the liquidation of Banrural and the creation of FR. The Letter indicates the commitment of the Government to: Require FR to implement interest rate policies congruent with the objective of financial sustainability required by its Charter. To this objective, the authorities are adjusting the interest rates charged by FIRA to avoid creating incentives for interest rate arbitrage among clients that are common to both institutions; and Provide, if required in the short term, and for a limited period of time, budgetary support to cover part of FR s operating costs to allow it to lend at low but close to market interest rates to its lower income clients. Interest rates charged by FR should always cover the funding costs and the risk of the operation avoiding market distortions. 9. At the closing of October 24, FR had placed 139,946 loans for MXP6.9 million, with an average loan size of MXP52,OOO. As of that date, the book value of the portfolio amounted to MXP6.374 billion, with a non-performing ratio of less than 4 percent. FR s operations during 24 have not required subsidies or transfers from the Federal Government. These results show that FR s management has been successfbl in establishing the basis for a financially viable institution. B. Macroeconomic Performance Loan Agreement, Article 11, Section 2.2 (d) (ii): Bank to be satisfied, based on evidence satisfactory to the Bank, that the macroeconomic policy framework is satisfactory. 1. This condition has been met. Mexico s economic recovery started in the fourth quarter of 23 and continued during 24. Real GDP expanded by 3.9 percent year-on-year in the first half of 24 and by 4.4 percent year-on-year during the third quarter of 24, marking ten consecutive quarters of expansion. GDP growth for 24 is expected to remain above 4 percent.

4 4 This robust economic growth reflects a strong dynamism of exports, particularly to the USA, and the strengthening of the domestic demand. The economic recovery of the USA and high international oil prices resulted in exports expanding by 13.3 percent in the first half of 24 compared with the same period in 23. Imports increased at a rate of 1.2 percent during the same period. High remittances from Mexicans working abroad and the expansion of domestic credit has stimulated consumption growth and, more recently, investment, including foreign direct investment (FDI). In this favorable environment, the current account deficit of the first half of 24 was nearly one third lower than that of the first half of 23. By end-24, the current account deficit is expected to be about 1.4 percent of GDP. 11. The recovery in demand and consistently high prices of some raw materials has fuelled inflationary pressures, although inflation remains low compared with historical levels. In November 24, annual inflation reached 5.4 percent, above the 4 percent upper limit of the Central Bank (BOM) inflation target for 24. This situation has led BOM to tighten monetary supply through increases in the corto (the borrowed reserves objective) with the resulting increase in domestic interest rates. However, the peso-dollar exchange rate has shown a tendency to strengthening, which is helping to moderate inflationary expectations. 12. During the 24, fiscal policy has been oriented to meet the fiscal deficit target of.3 percent of GDP. To this effect, approval of increases in public expending above the 24 budget require prior additional revenues from oil exports. It is estimated that at by end-24, the public deficit, not counting the expenditures for the Program of Voluntary Separations, will be within the.3 percent target. Market sentiment toward Mexico remains positive as evidenced by its investment-grade status. 13. The expectation is that economic growth will decelerate to 3.5 percent in 25, as a result of the recent tightening of monetary policy, a possible deceleration o f economic growth in the USA, and delays in getting Congressional approval o f important structural reforms to boost competitiveness. 14. The IMF Board concluded the 24 Article lv Consultation with Mexico on October 18, 24. Directors commended the authorities for policies that continued to underpin macroeconomic stability and investor confidence. They welcomed the authorities commitment to further fiscal consolidation and endorsed their medium-term goals, which call for further fiscal adjustments to lower ratios o f pubic debt to GDP. Directors stressed the need to reinvigorate the structural reform agenda, where recent progress had been disappointing owing to difficulties in forging the needed political consensus. C. Other Actions (a) the institutions conforming the Banrural System have ceased to operate as banking institutions; (b) the licenses to operate as banking institutions of the institutions conforming the Banrural System have been revoked by SHCP; (c) the remaining assets of the institutions conforming the Banrural System have been transferred to Financiera Rural or directly or indirectly, to a liquidating agency; and (d) the deposit accounts opened in the institutions conforming the Banrural System have been closed or

5 5 transferred to one or more institutions authorized by CNBV and/or SHCP to operate as financial institutions. 15. This condition has been met. The liquidation of the Banrural system was established in the LOFR in Article 2 and Transitory articles Second, Third and Tenth. Article 2 authorizes the Federal Government to fund the dissolution and liquidation of the Banrural System. Article Second Transitory establishes that as of July 2, 23, the Organic Law of the Banrural System is abrogated as well as the organic regulations of the thirteen credit institutions that conform the Banrural System. Article Third Transitory decrees the dissolution and orders the liquidation of the thirteen credit institutions that conform the Banrural System and establishes that their liquidation should start on July 1, 23. Article Tenth Transitory establishes that the movable and immovable assets of the credit institutions in liquidation will be transferred to FR or to other public entities following procedures to be determined by the SHCP. 16. As confirmed by the legal opinion issued by SHCP, Banrural operated under a Charter (Ley Organica) and not with a banking license from the SHCP. For this reason, SHCP cannot revoke Banrural s banking license. However, the abrogation of Banrural s Charter as of July 2, 23, implies the cessation of Banrural s banking operations. Banrural still exists as an entity under liquidation, because the judicial process of liquidation takes long time, but it is not authorized to operate as a banking institution. 17. In April 23, SHCP nominated the Fideicomiso Liquidador de Intituciones y Organizaciones Auxiliares de Credito (FIDELIC) as liquidator of the Banrural System. The liquidator, under instructions of SHCP, proceeded to transfer Banrural s good assets to FR, including loans as well as movable and immovable assets. The transfer process ended in November 24. Assets transferred to FR amount to MXP2.18 billion of credit portfolio and MXP24.3 million of fixed assets. Banrual s residual assets remain in a find administered by SAE (a successor of FIDELIC) for their liquidation. The deposit accounts in Banrural have been transferred to BANSEFI. 18. Evidence presented of these transfers are the following: Oficio nominating the liquidador of the Banrural System. Oficio No /3 of April 1,23, from the Director General SHCP to the Director General of FIDELIC. Oficio No. 368-VI-162/4, from the Directora General Adjunta of SHCP, providing legal opinion confirming that: (a) the institutions of the Banrural System are in process of liquidation and dissolution and do not have anymore attributions to operate as credit institutions; and (b) Banrural and Financiera Rural are entities of the Federal Public Administration, governed by their own charters; and that these entities, prior to their dissolution, could perform banking and credit services, as described in their charters, without the need for an authorization or license from the Federal Government. Certification of the transfers of asset of the BANRURAL System to FR. Oficio No. DG/23/4 of June 11, 24, from the Director Gelteral of Banrural under Liquidation, to the Director General of SHCP, certifying that loans and credits from Barural and movable and immovable assets have been transferred to FR, and that the conciliation of the amounts involved had been carried out by the liquidator with the favorable opinion of

6 6 the external auditors. Copy of the Conciliation Acts of May 12, 24; May 14, 24 and June 1,24, signed by both entities and with the opinion of the external auditors. Oficios authorizing the transfer of the liquid assets to FR. Oficio No /4 of June 11, 24 and Oficio No. 368-OW4 of November 3, 24, both from the Director General of SHCP to the Liquidador of Banrural and the Director General of FR. These oficios authorize the liquidator to transfer to FR remaining liquid assets. Dispositions and actions related to the transfer of the deposit accounts in Banrural to BANSEFI. Oficio No /3 of April 29, 23, from the Director General of SHCP to the Director General del Banco Nacional de Credit Rural, giving his no objection to the transfer of Banrural s deposits to BANSEFI. This oficio refers to the favorable opinions to the transfer issued by BOM and CNBV. Financiera Rural has provided to the Bank a Strategic Plan approved by Financiera s Board which: (a) provides an empirical analysis identifying Financiera s target markets, clients (including their risk profile) and distribution systems and products to reach said clients; (b) directs Financiera s second-tier lending activities including; (i) a time frame for building a second-tier lending business; (ii) the organizational structure for conducting second-tier operations (including procedures to reduce conflict of interest between first and second-tier activities); (iii) the eligibility criteria for potential financial intermediaries; and (iv) the basis of a technical assistance program to strengthen new rural financial intermediaries; and (c) provides for the establishment of a management information system and financial control system to monitor the activities of Financiera. 19. This condition has been met. FR s Operations Committee approved the Strategic Plan (SP) on November 3,24. Evidence presented includes: e e e e resolution of FR s Consejo Directivo (Board) of October 27, 24, signed by its Prosecretario delegating to the Operating Committee the authority to analyze and authorize the SP of the institution, based on Article 33 Section xxviii and Article 39, Section vi of LOFR; copy of the Minutes of November 25, 24, signed by its Acting Secretary in which the Operations Committee approves the SP of the institution; a document entitled Strategic Plan of Financiera Rural, which delineates the medium term perspectives of the institution and financial projections of the operations for the year 24 to 21; and copy of the functional design and implementation details of FR s Management Information System (MIS). 2. The SP of FR has been elaborated with the assistance of an international consultant hired by USAID, with terms of reference that reflect the specific provisions for the SP spelled out in the Bank s conditionality. The SP reviews the advances made by FR during its first year of operations and looks at the next stage as that of consolidation and strengthening of FR s operations, and the establishment of a second-tier lending business. The SP spells out the institution s mission and vision, as well as its objectives in several areas including: financial objectives, evaluation and control of risks, development of systems, development of new

7 7 products, and development of second-tier activities. documents elaborates on the following aspects: The approved SPY and other relevant 21. Provides an empirical analysis identijjing Financiera s target markets, clients (including their risk profile) and distribution systems and products to reach said clients. Although an empirical analysis to identify new target markets has not been carried out, FR, with the help of external consultants, has made an effort to develop the risk profile of the client base received from Banrural, using historical data (two years). Based on this analysis, FR s Risk Management Unit calculates the risk premium that it incorporates in the interest rates charged on different types of loans. The risk premium is based on expected losses calculated as the probability of nonpayment multiplied by the exposure and by the severity of the loss. The expected loss is reduced by the quality of the guarantees. The risk profile of Banrural s clients has been used to develop credit scoring models. Consequently, we consider that this condition has been substantially met. 22. Directs Financiera s second-tier lending activities including; a time frame for building a second-tier lending business. The SP enumerates the actions that FR is taking, together with other government entities, to promote the establishment of rural financial intermediaries. The strategy recognizes that the number of financial intermediaries is limited and that the development of more intermediaries will take time. Based on the results of 24, FR will identify the potential intermediaries and provide technical assistance, through third parties, to develop their capabilities. FR has as a target to increase the share of second-tier lending to 25 percent by end-26 and to 5 percent by end-212; the organizational structure for conducting second-tier operations (including procedures to reduce conflict of interest between first and second-tier activities). The SP proposes that in order to avoid conflicts between first and second-tier activities, these activities need to be clearly differentiated in the Credit Manual. Consequently, the Credit Manual has a separate section to regulate credit through financial intermediaries and applies different interest rates for these two activities. The SP envisages hrther studies to identify and address other potential conflict of interests between first and second-tier activities; the eligibility criteria for potential financial intermediaries. The eligibility criteria for financial intermediaries is spelled out in the Credit Manual; and the basis of a technical assistance program to strengthen new rural financial intermediaries. The SP builds on ongoing and hture diagnostic work of the capabilities of existing financial intermediaries, to provide the basis for a technical assistance program to improve their capabilities. The strategy envisions that the technical assistance services to financial intermediaries and to producers will be administered by a separate department and provided by third parties, to reduce conflict of interests with its lending operations. 23. Provides for the establishment of a management information system (MIS,) and financial control system to monitor the activities of Financiera. The SP establishes as a priority of the institution the establishment of an MIS and spells our the basis for its design. FR has advance significantly in this objective. FR started by improving the system that it inherited from

8 8 Banrural. With software developed in-house, FR is now able to conduct all its operations on-line and to get information on a daily basis from all its branches (through dedicated lines). The basic structure (functional design) of the new MIS has been developed and it is already in operation. Future improvements will depends on the completion of other modules from which it gets information such as the accounting and credit modules. FR expects to have the MIS fully operational during 25. An important feature of the new MIS is that it will have a cost allocation system that will allow senior management to evaluate the practices of individual profit centers. The MIS will allow management to measure results from the point of view of products, clients and centers of responsibility. Financiera Rural (a) has submitted to the Bank, manuals, approved by Financiera s board, including: (i) norms, policies and procedures to provide loans; and (ii) recovery procedures for non-performing loans; and (b) has tested and implemented credit scoring models to determine the eligibility to receive loans from Financiera. 24. This condition has been met. The evidence presented with respect to compliance with point (a) includes: copy of the resolution from FR s Board of May 23,23, which approves the Manual of Norms and Credit Policies; and copy of the Manual of Norms and Credit Policies (Credit Manual). 25. The Credit Manual contains nine chapters which describe the concepts, rules, norms, participants and operations of the four stages of the credit process: business development, analysis and decision, instrumentation, and follow-up and recovery. It also covers all the aspects related to integration, custody, administration and control of the credit files. 26. The evidence presented with respect to compliance with (b) includes: a report of activities of the Unit for the Integral Administration of Risks (CAR); and a description of the credit risk models implemented by FR, including the credit scoring system, its methodology and validation exercises. 27. FR has established a credit scoring system with the help of an international consulting firm. The credit scoring system is a method of credit risk evaluation based on parameters such as the type of credit or the socioeconomic characteristics of the client. This system has been in operation in FR, on an experimental basis, since September 23. It has been implemented for working capital loans below 2, UDIS (indexed investment units) since mid-july 24. Loans above 2, are evaluated individually. The main parameters to evaluate the credit risk are socioeconomic characteristics of the clients and characteristics of the credit request. CAR does a monthly follow-up of the results generated by the models. Validation of these models will be carried out once enough result information is available. The Auditor has certified that Financira, as of six weeks before the Second Tranche Release Date, complies with CNBV s prudential regulations, including norms for risk classification and provisioning of loan portfolio.

9 9 28. This condition has been met. The evidence presented is: Note by the extemal auditors, dated December 9, 24, certifying that FR complied with the following: For 23: J FR requested and obtained authorization from CNBV (OJicio No of October 2,23) to apply the methodology to determine the preventive estimates for credit risks corresponding to the period September 3 to December 31, 23, the same that was authorized for the Banrural System for the commercial credit portfolio. J According to Circular 1514 issued by the CNBV, FR recognized the preventive reserves to cover the determined credit risks. J The Financial Statements and the respective notes for the 23 audited financial statements present the classification and grouping of the credit portfolio according to the requirements established by the CNBV; according to Circular No.1488 which complements the accounting criteria of Circular No which is in effect since January 1,2. For 24: J The financial statements prepared for the 24 fiscal year have been prepared according to the rules of aggregation and accounting practices issued by CNBV J FR requested and obtained authorization from CNBV (OJicio No of September 29, 24), to continue applying the methodology to determine the preventive estimates for credit risks until CNBV issues dispositions with general character; J The Financial Statements and the respective notes for the 23 audited financial statements present the classification and grouping of the credit portfolio according to the requirements established by the CNBV, according to Circular No which complements the accounting criteria of Circular No which is in effect since January 1,2 The subsidies and transfers received by Financiera under any concept have been clearly declared and identified in each report submitted to the Borrower's Congress (up to six weeks before the Second Tranche Release) under Article 48 paragraphs I, 11, and I11 of the Financiera Law. 29. This condition has been met. FR has not received subsidies or transfers in the 24 budget. Consequently, it has not had the need to report to Congress on this issue. The evidence received is the following: OJicio No. 313 A 18 of February 3, 24 from the Director General of Secretaria de Hacienda to the Director General de Banca de Desarrollo, SHCP, informing of the budgets authorized to development banks and funds under the SHCP, including FR for 24, and Annex to this OJicio with the budget for FR for

10 1 24. In this budget, there is no authorized amount under the items subsidies and transfers o f the Federal Government to FR. 3. At the inception of FRY the Government and FR authorities recognized that the Government would have to subsidize part of FR's initial operating costs, to allow it to lend to the poorer segment of its clients at a relatively low interest rate. This was deemed necessary due to FIRA's subsidized interest rates to the same segment o f borrowers. It was agreed, however, that subsidies would be a temporary and clearly identified measure, and that FR would implement a policy on interest rates geared to ensure its financial sustainability (defined as net income equal or greater than zero). However, since its inception, FR has followed a prudent lending strategy. The level of past due loans (loans with 91 days with no payment of interest or principal) in FR is less than 4 percent (compared with 48 percent for Banrural). The average interest rate charged by FR is 12 percent, slightly below the interest rate that FR's financial model (developed with the help of IDB and the Bank) projected as necessary to maintain FR's capital in real terms, with expected provisions of 4 percent. 31. Also, there have been some positive developments with respect to the ability of FR to compete with FIRA's subsidized loans. First, the level of subsidy of FIRA's loans has decreased. FIRA used to lend at CETES (treasury bonds) minus 6 points, and required its intermediaries to lend at CETES. Now FIRA lends at TIIE (interbank equilibrium interest rate), which is above CETES, minus six points, and allows its intermediaries to lend at market rates. Second, the SHCP is making an effort to better coordinate the activities of all the agencies involved in rural financing. The strategy in the short term contemplates closer coordination between FIRA, FR and the other financial institutions, and possible a consolidation in one institution of the back office activities of all public financial institutions. In the longer term, SHCP is considering the merger of FIRA and FR. IV. CONCLUSION 32. In view of the overall performance and progress with the implementation of the program supported by the Loan, and in compliance with the specific conditions of release as described in Section 2.2 (e) and Schedule 2 of the Loan Agreement, the Bank has informed the Borrower of the availability of the second tranche in the equivalent of USD 15 million.