The Colombian Financial Sector From an Investor Perspective

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Mahesh Kotecha, CFA President, Structured Credit International Member of the Board of Directors, BRC Investor Services S.A Sociedad Calificadora de Valores Tel: 212-605-0123 Fax: 212-605-0222 [email protected]

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1. Financial Crisis and its Aftermath

2. Strengths of the Financial Sector

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FINANCIAL CRISIS AND ITS AFTERMATH 5.5% 9.23% Inflation 10.6% -10% Loan 17.29% 0.32% Deposit 4.1% -4.2% GDP 13.6% 18.1% Unemployment 25% -6.1% International Reserves 2004 1999 Indicators growth

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FINANCIAL CRISIS AND ITS AFTERMATH

Entities Liquidated or Merged (1998-2005)

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Mortgage and Publicly own Banks

•These were the most affected by the crisis

•Both groups have largely recovered

•Ratings for both groups have been raised.

•The publicly own banks received equity injection of $4.7

billion from the government

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Mortgage and Public Banks Have Been

Upgraded

AA+

A

Bank 4*

AAA

AA+

Bank 3*

AA+

A

Bank 2

AA+

AA

-Bank 1

Present Rating

Before Crisis

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Mortgage and Public Banks

Public Banks Mortgage Banks 10.3 6.1% 30.07% 2.85% 2004 13.0 22.2% -49.9% -3.8% 1999 10.5 11.7

Assets / Equity

3.9% 25.8%

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1. Financial Crisis and its Aftermath

2. Strengths of the Financial Sector

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STRENGTHS OF THE FINANCIAL SECTOR

Growth of the Financial Sector: 2000 – 2005

3.89 3.84 3.76 3.31 3.00 3.52

Net interest income / Total assets (%)

26.06 24.6 13.59 4.32 3.48 3.15

Equity growth (%)

20.17 21.16 7.95 5.31 9.00 2.46

Deposit growth (%)

17.75 20.58 6.85 5.3 -0.46 -8.6

Loans growth (%)

18.56 18.13 9.10 5.87 4.79 0.43

Assets growth (%)

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CAMEL Framework Can Be Used to Assess the

Financial Sector’s Performance

• BRC rates 23 financial institutions, including banks, CF, CFC and Leasing companies

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CAPITAL

-20 40 60 80 100 120 140

0 20 40 60 80 100 120 140

2004

1999

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ASSET QUALITY

13.6% 11.0% 9.7% 8.7% 6.8% 3.3% 0% 2% 4% 6% 8% 10% 12% 14% 16%

1999 2000 2001 2002 2003 2004

Assets quality 36.79 56.64 77.49 86.53 98.49 145.46 0 20 40 60 80 100 120 140 160

1999 2000 2001 2002 2003 2004

Coverage

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MANAGEMENT

• Better corporate governance criterions

• Higher level of provisions

• Improvements in risk managements

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EARNINGS

Corresponds to the net income of the Colombian financial sector, in real terms. Pesos 2004

- 4 , 0 0 0 , 0 0 0 - 3 , 0 0 0 , 0 0 0 - 2 , 0 0 0 , 0 0 0 - 1 , 0 0 0 , 0 0 0

-1 , 0 0 0 , 0 0 0 2 , 0 0 0 , 0 0 0 3 , 0 0 0 , 0 0 0

Millons of pesos (2004)

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Return on Equity and Assets: July 2005

8.0 9.0 10.0 11.0 12.0 13.0 14.0 15.0 16.0 Foreign banks Corp Financ CFC Leasing TOTAL Mortgage Banks National banks Public banks ROE z

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LIQUIDITY AND FUNDING

30% 35% 40% 45% 50% 55% 60% 65%

1998 1999 2000 2001 2002 2003 2004

CDT Saving act 0.8

0.9 1.0 1.1 1.2 1.3

Dep / loans

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Bank Supervision Has Improved

Capital requirements for market risk were introduced in December 2001

• As investment in government paper has risen sharply and as there is a limited number market makers, market risks are now more significant

A new loan classification system was introduced by the regulator

• SARC (Sistema de Administración de Riesgo Crediticio) credit risk model based on Basle II principles

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1. Financial Crisis and its Aftermath

2. Strengths of the Financial Sector

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WEAKNESSES OF THE FINANCIAL SECTOR

But the Financial Sector Remains Weak

• The depth of the financial sector has declined, with the ratio of [(M3 – cash) /GDP] falling from 35% in the early 90’s to < 30%

• Market capitalization of the stock exchange as % of GDP is lower than elsewhere in Latin America (<20% versus over 40% in Brazil)

• Limited access to equity and debt markets (especially for banks rated AA or lower) constrains further strengthening of the financial sector

• With the large holdings of government paper by banks, they are now subject to higher market risks because of maturity mismatches.

• One percent change in interest rates would have resulted in decrease in 2004 level of earnings by 17.07 percent *

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WEAKNESSES OF THE FINANCIAL SECTOR

But the Financial Sector Remains Weak (cont)

• In some cases the financial intermediaries have jumped into markets that may have worked for others without fully determining whether they are really ready for them: e.g., Microcredits, VIS

• Lack of competition from international banks limits the pace of

modernization of the financial sector and choice for the borrowers

• Frequent changes of tax regimes for corporation and individuals poses uncertainties

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1. Financial Crisis and its Aftermath

2. Strengths of the Financial Sector

3. Weaknesses of the Financial Sector

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FUTURE OPPORTUNITIES

Opportunity 1: Public Banks’ Privatization

ü

Privatization offers revenues for the government,

ü

Professional management for the banks

üMore competitive banking sector

O

But labor relations could pose challenges for the new owners

O

Further progress should be made in measuring, control and regulation of operational risk

O

Need to clarify government vision about the structure of the banking sector

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Opportunity 2: Securitization is Growing

ü

BRCIS has rated 25 securitizations

ü

Of these, just over a half -- 13 -- involve asset sales by banks

ü

We believe there is room for greater use of securitization for risk management and other purposes by banks

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Opportunity 3: Improving Risk Management

ü

With heightened market risks, more market oriented lending and the advent of Basle II principles, there is need to strengthen the risk management practice of banks

üModel-based systems of risk management need to be

considered and practical methods of risk assessment, risk mitigation and risk control need to be broadly implemented to avoid future financial crises

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Opportunity 4: Encourage international

competition

ü

The presence of international banks should be encouraged to increase the quality of competition

•

Benefits could include increased quality and quantity of banking services for corporate and retail customers

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Opportunity 5: Mergers and acquisitions

üBetween 1998 and 2000, the consolidation process was

necessary to emerge from the crisis

üIn 2005 the consolidation offers opportunities to

implement more effective strategies with the objectives of

ü

Cost reductions and increased returns

ü

Market position gains

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APPENDIX:

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RISK MANAGEMENT

Role of Ratings and Credit Models

ü

A credit rating is provided by an independent rating agency which

has some market credibility, a rating scale and a wealth of issuer that it has rated

•

Typically used for capital market investments

•

Increasingly used by regulated financial institutions

üCredit models are generally quantitative methods for determining

the likely that credit risks will arise in given market segments, typically (but not exclusively) corporate risks

•

Traditionally used in consumer lending where the law of large numbers made their use attractive

•

Many models now use ratings based default probabilities

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RISK MANAGEMENT

Comparing Ratings and Credit Risk Models

Applied more for risk and portfolio management purposes

Used in capital markets for

pricing and marketing securities Overall

assessment

Based on mathematical analysis and market data with tendency to be volatile

Based on both qualitative and quantitative criteria and rating committee process and

tendency to be relatively less volatile

Quality

Generally note used for issuance business but for risk management for proprietary asset management Use ratings for pricing and

underwriting decisions Intermediaries

Do not meet with model builders, who rely on public issuer data including stock prices

Meet with the rating agencies and explain their financials and outlook

Issuers

Use them for risk management, capital allocation, portfolio management

Use them for pricing, capital allocation, new issue marketing and secondary market trading Investors

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RISK MANAGEMENT

BIS Use of Ratings for Capital Adequacy

BIS proposals would replace existing risk categories with a “standard” system that assigns corporate, bank, or sovereign borrowers to varying risk weights based upon their credit ratings from recognized “external credit assessment institutions”

Eligibility criteria for “external credit assessment institutions” is a sensitive subject

Discretion of national regulators in each country

Mapping process of ratings to default performance should be as transparent as possible over as long a time frame as possible

Consistent use of rating agency mappings across borders may be difficult to ensure in light of the national supervisory discretion permitted in these matters

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RISK MANAGEMENT

Credit Models Complement Ratings

Sophisticated mathematical techniques have been developed to measure credit risks, focusing on three key parameters and how they change:

Frequency of payments problems, including delinquencies and losses

Recoveries in the event of losses

Exposure of the company’s credit portfolio to certain credit events

These alternative risk measurement and management systems may complement traditional credit ratings

Could be useful for unrated credits

Could be useful for portfolio management

Could be useful for stress testing

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MAHESH K. KOTECHA, C.F.A.

Mr. Kotecha is President and founder of Structured Credit International Corp. (SCIC), a financial advisory firm with expertise in ratings and structured finance. Its clients include Inter-American

Development Bank. Prior to forming SCIC, he was Managing Director of MBIA Insurance Corporation, of CapMAC Asia and CapMAC and an Alternate Director for ASIA Ltd . His previous responsibilities at MBIA included deal origination of all types of transactions and execution or corporate structured

financings.

He came to CapMAC in 1989 from Kidder, Peabody, where he was Director of the Market Analysis and Product Development Group in the Asset Finance Department. Mr. Kotecha led Kidder into the UK mortgage backed securities markets, structured the first public Collateralized Bond Obligation (CBO), and advised International Finance Corporation (IFC) and Turkey on capital markets issues. Previously, Mr. Kotecha worked for eight years at Standard & Poor's, where he was responsible for all ratings based on non-US collateral: mortgage and non-mortgage. Earlier, Mr. Kotecha worked for four years at the Federal Reserve Bank of New York and for three years at the United Nations Fund for Population Activities (UNFPA).

Mr. Kotecha holds a Master's degree in management from the Sloan School of Management at MIT, and a Bachelor's degree in physics and engineering from Harvey Mudd College in Claremont,

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