Can DFIs add value? -FIRA’s Experience –

The World Bank Can DFIs add value? -FIRA’s Experience – Presentation prepared by: Francisco Meré September 22, 2004

Agenda • Introduction • New business model • FIRA: A Value-Creating FDI • Future directions

FIRA is a second-tier trust fund created by the Mexican government within the central bank 50 years ago • Designed to promote agricultural development through the provision of short and long term funding to the banking system to finance agriculture • At the time, capital, debt and interbank lending markets were highly underdeveloped • Due to banks´ underserving to agriculture, a mandatory lending regulatory requirement was in place until late 80´s • FIRA´s loan portfolio was heavily subsidized from onset • Original assumption was that enhanced funding would encourage an increase in credit to farming • Loans concentrated in primary (commodities) activity • Later incursion in credit guarantee schemes with no premium charged $27,748 $35,185

% of population living in such municipalities 50 40 30 20 10 0 Mexico South & Center Center * Center- Northwest Northeast Southeast west Dec-95 Jun-01 Banking liberalization, NAFTA and tequila crisis posed new challenges to FIRA, while ag sector still underserved FIRA´s products were not attractive to banks and therefore its lending fell 70% between 1994 and 1998 Traditional commodities agriculture was challenged by trade liberalization, thus risk perception about the sector was increased Less than 10% of banking system loans go to agriculture Large percentage of rural population without access to banking system Debt markets have developed, thus enhanced funding is not an answer Municipalities without bank branches (%) 100 80 60 40 20 0 Mexico South & Center Center * Center- Northwest Northeast Southeast west Dec-95 Jun-01 Source: Mexico´s CNBV, INEGI

We have a new market-oriented approach: from development banking to banking development EVOLUTION Ag + rural financial market development. Ag. development focus Primary activity Value chain (food system) and off-farm activities scope Client driven Product driven approach Uncapped non-focused subsidies Value added approach and focused “smart” subsidies instrument

With our new approach, FIRA has achieved higher private sector engagement (double digit growth for five consecutive years) Change in credit stock by commercial banks using FIRA´s funds (million Mx. Ps.) Commercial banking Lending in millions (Million Mx Ps.) Banrural closure Lending to low income producers August 2003-2004 (million Mx. Ps.) Commercial bank lending to low income farmers (million Mx. PS.) 81% 17% Low-income Mid-income Source:FIRA

We have gradually moved away from subsidy-based operation to value-added activities From 2001 to 2003, interest rate subsidies have declined 19 percent in absolute terms From 1998 to July 2004, the spread between FIRA’s lending rate and interbank lending rate has been reduced in 530 points

While keeping our risk-bearing portfolio under control and reducing our expected loss Expected loss in guaranteed portfolio (%) Source: FIRA

Our strategy is based on four pilars Value proposal (Know your market) (know your client) Financial innovation Professional management Adequate governance

F I R A Transaction costs reduction Market making Asymmetric information solutions Value creation FIRA´s new activity is aimed at solving market failures/imperfections with a market approach and a clear vision of financial market development

F I R A Cost transaction reduction Market making Asymetric information solutions Value creation Financial market outreach to low income rural entrepreneurs is being fostered with “smart subsidies” rather than interest rate subsidies Covers screening and transaction costs associated with first time small borrowers Reduces discrimination by size of borrower Declining with 3-year-life Portable by borrower among different FIs Creates information (public good) Transaction costs subsidy Outreach subsidies Partially covers the cost of creating new human infrastructure to enter marginal markets Covenant by bank to net increases in lending to those marginal markets Allocated on a per annum basis and subject to auditing Infrastructure Development subsidy

F I R A Cost transaction reduction Market making Asymetric information solutions Value creation Transaction costs subsidy has led to an increasing outreach TCS 1998 – 2004(usd millions) * As of August 2004 2003 August 2004 Source: FIRA

F I R A Cost transaction reduction Market making Asymetric information solutions Value creation Financial constrain catch 22: low income borrowers are perceived high risk; their size limits their access to risk management instruments • FIRA has become the leading broker for interest rate derivatives for ag and rural sector (swaps) • US$660 million book with 80% having a maturity greater than 3 years • Roughly 22% of total loan portfolio is hedged • FIRA charges for the service • Position is 100% hedged with international (investment grade) counterparties • Value-added activity: • Develops/expands market and access • Information generation • Lowers transaction costs for all agents

F I R A Cost transaction reduction Market making Asymetric information solutions Value creation FIRA offers very competitive rates by bundling the fixed interest rate credit demand in batches Informative weekly rate proposal Interest rate swap closing Cash flow grouping Farmer’s requests C.F. Bundling = More Volume = Attractive Interest Rates Fixed interest rate credit disbursement Demand for the product has soared Source: FIRA

F I R A Cost transaction reduction Market making Asymetric information solutions AGRIBUSINESS PROCESSOR Value creation PRODUCER An innovative approach to investment banking creates value for food system and develops financial markets INVESTOR Funding and partial enhancement Debt issue SPV Transfer of rights • Senior tranche • Junior tranche with sinking fund 1. Supply agmt. 2. Loan Value chain integration through better supply chain mgmt. Reduction of transaction costs and risk via portfolio approach No subsidies; fee-based structuring service First loss enhancement by industry, market making enhancement by FIRA at a premium Transactions account for 5% of loan portfolio and growing Gradual decline in FIRA´s level of enhancement

F I R A Cost transaction reduction Market making Asymetric information solutions Value creation Structuring of ABS for commodity inventory financing has been key for financial innovation as well as for market and institutional development • Alliance with world-class partners • Warehousing sector development • Creation of risk assessment capabilities in financial sector • Broad acceptance of structure • Low VaR linked to price of underlying commodity • Commodities such as sugar, corn, wheat, sorghum, shrimp and live cattle • Portfolio has accounted for 10% of total loans Portfolio sale Other Investors (Rabobank, Deutsche bank) Repo of CD Servicer Mexican Banks OTC hedge Credit derivative

Traditional second-tier lending is of little use in more developed markets • Second-tier lending without interest rate subsidies is only attractive to weaker FIs, then the concern shifts to an adverse selection problem • A more active approach to solving information, risk management and transaction costs problems is needed • Interest rate subsidies have proved not only distorting but ineffective by FIRA´s independent third party evaluations • Transaction costs and infrastructure development/roll-out subsidies are transparent and measurable

As a consequence of industry concentration, we’ll be more active on FI development • Six banks account for: • 83% of FIRA´s loans • 73% of banks´ loan portfolio • 66% of total assets • 70% of all bank branches • We are now doing business with two newly created banks and 14 non-banking FI • FIRA´s commitment is to be a non-dominant source of funding to those FIs

We see ourselves evolving to be a leader in financial innovation and market development • Consolidate structured finance function through the creation of extended maturity, multi-crop revolving facilities, and going public with those structures • Exit existing derivatives activity (transfer to market) and engage in more sophisticated markets (weather derivatives, etc) • Public entity with private behavior

Can DFIs add value? -FIRA’s Experience –