Uruguay's banking sector was headed by the Central Bank of Uruguay (Banco Central del Uruguay; hereafter, Central Bank), founded in 1967 and charged with regulating the nation's banking and financial system and performing such standard central bank functions as controlling the money supply, regulating credit, issuing currency, controlling foreign exchange, and overseeing the operations of the nation's private commercial banks. The Bank of Uruguay (Banco de la República Oriental del Uruguay--BROU), founded in 1896, had performed some of the functions of a central bank prior to the creation of the Central Bank. An autonomous entity, it remained in 1990 the country's largest and most significant commercial bank. The banking sector also included the Social Welfare Bank (Banco de Previsión Social), the Commercial Bank (Banco Comercial), and several other state-owned banks, such as Mortgage Bank of Uruguay (Banco Hipotecario del Uruguay), and the State Insurance Bank (Banco de Seguros del Estado), as well as a number of private commercial and savings banks.

In the late 1980s, Uruguay's financial sector was still feeling the effects of a profound banking crisis that had begun early in the decade. The crisis had its origins in the rapid expansion of credit to the private sector during the 1978-82 period. The unrestrained expansion of credit was made possible by the deregulation of the banks. As part of its effort to reorient the Uruguayan economy to the external market, the military government removed or reduced most restrictions on banks, including reserve requirements (which limit the amount of loans that can be made, relative to bank deposits), interest rate ceilings, and foreign currency regulations. The sudden removal of these and other restrictions encouraged banks to expand the supply of credit. The demand for credit also expanded because rising prices for exports convinced many ranchers and manufacturers to invest in land or equipment. The first signs of trouble came from the livestock sector. When world beef prices fell in 1980, rural land prices began to decline sharply, and ranchers began to have difficulty servicing their loans.

The crisis became widespread after the economy went into recession in 1981. By 1982 one-quarter of all loans to the private sector were considered nonperforming. The increasing dollarization of credit complicated the situation. Banks that had received large United States dollar deposits also made loans in dollars in order to avoid exchange-rate risk. The trend toward dollarization increased in early 1982 because banks expected a major peso devaluation. By late 1982, about 60 percent of all loans were denominated in dollars. When the fixed peso exchange rate was finally abandoned toward the end of the year, leading to a large peso devaluation, many already-troubled private companies, which earned pesos on the domestic market, suddenly faced dollar-denominated loans whose peso value had tripled.

Government intervention was required to prevent widespread bankruptcies. BROU devised a two-part strategy for dealing with the crisis. First, it provided credit to the private banks so that loans could be refinanced. About one-fifth of all outstanding loans (worth US$400 million) were refinanced by late 1982, allowing debtors a two- or three-year grace period and a lengthened repayment schedule. The loans were still in dollars, however, so that further devaluations of the peso remained a difficulty for debtors. BROU's second action was to acquire many loan portfolios from the private banks. The government thus propped up several private banks, actually buying out four of the twenty-four banks in the country. This policy prevented a banking collapse but significantly increased BROU's obligations, making it responsible for a large share of the public-sector deficit.

The financial sector remained in a precarious condition as the Sanguinetti government took office. By the end of 1984, the banking system had a negative net worth. In 1985, however, the banking system raised US$400 million in new dollar deposits. Although overall economic conditions improved during the first three years of the Sanguinetti administration, credit remained restricted and interest rates high, making it difficult for even solvent borrowers to obtain new loans. The government continued its efforts to strengthen the banks. For example, it planned to spend US$160 million in 1989 to restructure the four banks bought during the height of the banking crisis so that they could be sold to the private sector. Critics charged that these banks were too highly indebted, inefficient, and overstaffed to be sold. As of mid-1989, all but one of the banks remained under the supervision of BROU, Uruguay's largest bank (a state enterprise). One bank, the Commercial Bank, was sold to a group of international investors in 1990.

Dollarization of the banking system continued to increase. The proportion of money held in United States dollar accounts reached 84 percent in 1989. The major source of these funds was Argentina, whose savers sought a safe haven and a dependable currency. Uruguayan savers placed deposits in dollars to avoid exchange-rate fluctuations. Thus, the openness of the banking system may have prevented some capital flight, but the dollarization of bank deposits made it difficult for the government to conduct a monetary policy because the money supply could not be tightly controlled. Nevertheless, the government did not restrict the banking system to deposits in pesos, encouraging instead the further internationalization of Uruguay's banks, most of which were foreign owned. In addition, liberal offshore banking rules (for transactions among nonresidents) were introduced in 1989.

Although Lacalle supported the idea of Uruguay as an international banking center, he indicated in early 1990 that his administration planned to introduce legislation under which bank secrecy i.e., anonymous accounts, would be lifted in cases where illegal drug-money laundering was suspected. The government was pressured to change that aspect of its banking regulations after an alleged Colombian "drug lord" told United States officials that he and others often used Uruguayan accounts.

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