models built by the SF based on 1994-2006 default data that it has collected. In the case of the commercial loan portfolio – which includes the small firm and medium-sized firm market segments – these rules came into effect in July 2007. Since no internal credit risk model has yet been approved by the SF, all credit institutions have to use the same reference model and thus the same provisioning levels by rating category for their commercial loan portfolio exposures. In addition, the SF has adopted a counter-cyclical provisioning regime under which excess provisions are built during ‘good times’ to act as a shock absorber/cushion during ‘bad times’. Given that historical default data include the 1999 crisis, the PD rates currently used for provisioning purposes are much higher than actual defaults; such an effect is particularly pronounced for SME loans, whose performance is highly cycle-sensitive. For example, according to the reference model, the highest-rated (AA) loan to a small firm is assumed to have a PD rate of 7.52 percent, while the actual default rate currently is less than half that level. The confluence of these factors has recently led to a built-up of loan loss provisions by some banks in order to comply with these regulations, which could raise the cost of (and therefore access to) credit for the relevant market segments. Although this might simply reflect the authorities’ intention to raise average provisioning levels across the entire banking system, the use of the same default parameters stemming from the SF’s reference model across all credit institutions is problematic because it penalizes those entities that are better managed (and vice versa). However, once the SF begins to validate banks’ internal credit risk models, it is expected that performance differences across credit institutions (which should be reflected in their provisioning levels) will become more apparent.

The legal and contractual environment in Colombia was also highlighted by credit institutions as a major constraint for SME credit. The problems that were mentioned relating to creditor rights and insolvency proceedings have already been identified and described extensively in the relevant literature<sup>36</sup> . In particular, notwithstanding the use of collateral, the loss given default incurred by credit institutions is not adequately reduced due to inefficient enforcement and collection mechanisms (e.g. limited use of private enforcement or mechanisms with minimum judicial intervention, long processes and abusive use of procedural defense mechanisms) and the bias against creditor rights in insolvency proceedings. The rigidity of the security interest regime, the diminished priority attached to mortgaged debts or pledges by civil law, and certain weaknesses in the registry systems (lack of electronic interconnection, geographic fragmentation, and slow procedures) contribute to the low regard in which collateral is held. In response, credit institutions have structured their products to cope with this risk (see section 5.1 below) and have reduced their reliance on collateral as a source of repayment in the event of borrower default. The recently-approved new bankruptcy law 1116/2006 and forthcoming changes to the civil code on enforcement procedures improve, but will not fully resolve, some of the aforementioned problems<sup>37</sup> .

> 36 See CEAL (July 2005) and Rouillon (May 2006) for a description. According to the World Bank Group’s _Doing Business_ 2008 report, Colombia is ranked low (147<sup>th</sup> globally) in terms of the efficiency of its judicial system in enforcing a commercial dispute.

> 37 See Rouillon (May 2006) for more details. Changes in the new law include the possibility of judicial validation of out-of-court reorganization agreements, the simplification of procedures for an accelerated recognition of controversial claims in insolvency proceedings, the establishment of provisions to streamline and encourage actions seeking personal liability against directors and officers of the insolvent company, the

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