Transcript Slide 1

Strategic Requirements for
Next Stage Financial Sector
Reforms in Armenia
By Michael Borish
May 29, 2005
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Introduction
Basic Challenges and Risks
 Banking sector
 Insurance
 Pension
 Securities markets
 Non-bank credit institutions
 Accounting and financial information
 Building blocks for the future
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General Economic Trends re FSD
• Macroeconomic stabilization, but low monetization (M3/GDP, grey
economy) characteristic of CIS
• Persistent poverty, low PPP per capita incomes
• Tax avoidance/evasion and de-formalization constrain deposit
mobilization
• Firm size/resource constraints/low FDI (partly offset by remittance
flows)
• Productive employment low/unemployment high
• Country risk/borders and trade
• Summary: improving macroeconomic indicators, but
political/country risk + weak indicators related to
enterprises and households makes it a difficult
environment for financial intermediation
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Profile of Financial Sector
• Banks largest re assets, revenues, after-tax earnings
• TOTAL bank assets by end 2004: $700-$750 million
(25% of GDP)
• Loans and deposits increasing, but still low even by CIS
per capita standards
• Banks’ TOTAL after-tax earnings <$20 million in 2004,
o/w HSBC was about 20%
• Banks’ “dominance” reflects underdevelopment of other
financial services: insurance revenues about $4 million
(2003), no pension funds, leasing and mortgage finance
are nascent, micro-finance loans <5% of bank credit
• Summary: FS is small, low in impact. Favorable
trends in terms of intermediation, but still low at
about 20% of GDP.
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Developments in Banking
• Increasing stability: CARs high, NPLs low, rising
proportion of earning assets, few problem banks,
compliance with key prudential ratios
• Rising intermediation levels (deposit mobilization and
lending), largely due to increase in household deposit
mobilization and consumer loans
• However, banks are small. Average assets: <$40 million.
Average loans to real sector: $15 million. Average
deposits: $25 million. Average capital: <$7 million.
• High concentration of deposits with HSBC makes
funding base of other banks less stable
• Small size of bank capital limits balance sheet-based
earnings opportunities: large loans < 20% of capital,
therefore < $1 million (2004) on average.
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Challenges in Banking: Scale and Pricing
• Small size means  #1: banks unable to generate
economies of scale without major volume increases,
adding to per unit costs of transactions and products; #2:
less in the way of earnings per loan due to the smaller
size of the loan; and #3: mismatch with financing needs
of large-scale and some medium-sized firms.
• Small size consequences  high net spreads on loans
• High net spreads also result from perception of risk,
therefore risk premium assigned to smaller companies
without assets easily pledged or potentially repossessed
• High net spreads are also a consequence of the weaker
funding base of the banks (scarcity issue)
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Challenges in Banking: Earnings
• Apart from loans, earnings sources are limited: $27
million (2004), or about $1.5 million on pre-tax basis per
bank from transfers, currency exchange, payroll, trade
finance, etc. (less minus HSBC)
• Costs not high, but limited earning assets and other
sources of revenue mean productivity measures are
low (<$19,000 per employee in 2004)
• Costs low due to low expenditure on audit, equipment
maintenance, training/human capital formation, market
intelligence
• After-tax earnings low, although RoA/RoE reasonable
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Challenges in Banking: Funding
• Funding is a challenge for banks:
enterprise deposits are low + non-deposit
liabilities are limited (syndicated
borrowings, mezzanine financing) +
aggregate capital is small
• Banks have not issued securities on local
exchange
• Private placements??
• Tax avoidance/evasion
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Challenges in Banking: Asset Management
• “Macro”-level: #1: scarcity of useful data and
information on industries/sectors weakens
capacity to structure portfolios on risk-adjusted
basis + #2: absence of effective credit bureau
weakens risk evaluation capacity re borrowers
and specific transactions
• Both weaknesses make it more difficult to
evaluate borrowers and transactions, structure
loans, and price risk
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Challenges in Banking: Asset Management
• “Micro”-level: #1: Credit risk management
capacity limitations re underwriting skills and
standards + #2: Portfolio management
limitations re structuring loan portfolios,
measuring for systematic risks (covariance),
assigning probabilities of default loss,
provisioning contingencies re unexpected
losses, and setting credible RAROC targets
• Strategic planning
• Missed opportunities re weak risk measurement
and management
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Challenges in Banking: Non-credit Income
• Product/service development: potential with
plastic cards for households, small businesses
• Low participation of large and medium-sized
enterprises limits potential for banks
• Cash management, payroll, custodial, FX
trading, trade finance
• Hedging/derivatives
• Loan sales
• Absence of above makes banks more
dependent on credit-related earnings, which
heightens their own institutional risk
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Challenges in Banking: Diversification
• Earnings limitations may increase banks’ desire
to become “universal”, but where are the
systems and risk management capacity?
• Competition in loan market positive for
borrowers, but what happens if quality declines
along with loan interest rates?
• Will desire for term funding bid up deposit rates
and further shrink net interest margins?
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Challenges in Banking: General
• General weakness of system: absence of prime-rated
investment for capital, risk management, know-how,
market linkages
• Governance weakness: no real tradition of independent
and specialized advisors to boards; predominance of
closely-held culture
• Potential risks: inability of banks to manage #1: credit
risk in a declining interest rate environment as
competition intensifies  adverse selection to capture
business and potential earnings; and/or #2: market risk
if there is a dramatic shift in exchange rates, interest
rates, or pricing on commodities to which portfolios are
exposed
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Challenges in Banking: General
• Another possible vulnerability: inability to manage evolution to
“universal” or “full-service” bank due to absence of needed systems
and oversight
• Capacity to handle major financial inflows is doubted, although
reserves held offshore have declined as a % of total in 2004
• Reputation risk related to capital (not just capital adequacy),
management systems, supervisory capacity and cross-border
coordination, correspondent networks
• Summary: Few systemic risks in banking, at present
if any. Future development to increase earnings as
interest rates decline and competition increases may
add to risks, particularly if this converges with a
market downturn. Degree of governance and
management capacity to handle these risks is
unclear.
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Non-Bank Issues: Insurance
• Insurance sector: premium revenues <$4
million (2003) = $205,000 per active
company = $2 per capita = .01% of GDP =
th in world in
small; by contrast: Latvia was 88
2003 with $220 million in premium
revenues
• Weak insurance framework = no
institutional investors
• MoFE budget for supervision: $12,000
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Non-Bank Issues: Pension
• PAYG operated on cash basis with no audit and
payments < poverty level (<$16/month)
• Low contributions and disbursements
• Recent administrative improvements have helped to
reduce deficits and improve records
• Absence of 2nd and 3rd pillars = 0 institutional investors
• Sustainability dubious without changes to early
retirement, level of contributions, professional
management based on clear investment policies and
oversight for value preservation/growth
• Weak employment and grey economy undermines
prospects with or without mandatory contributions
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Non-Bank Issues: Securities Markets
• Markets underdeveloped although systems in place
• Government securities only instruments trading; issues
about $75 million per year, with increasing maturities
• However, no corporate bonds, mortgage bonds,
municipal bonds, or new equity issues
• Turnover <$1 million per year = about $3,000/trading
day = small
• No real free float = ??? minority investor rights and
low/no liquidity in the market
• Major constraints: #1: business culture; #2: lack of
transparency and adequate disclosure; #3: poor financial
condition; #4: size of firms; #5: institutional investors
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Non-Bank Credit Issues
• Leasing and mortgage finance nascent
(about $1 million each in exposures in late
2004)
• Micro-finance groups’ loans = $13-$14
million, about 5% of banks’ loans to
enterprises and households
• Links between NCBOs and banks
underdeveloped
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Legal Framework-Secured Transactions
• Secured transactions framework improving, but
imperfect due to lack of commercial training and
inadequate institutional support structures
• Absence of comprehensive property and pledge
registries digitally accessible for credit risk purposes
• Other problems reported, although magnitude unclear:
fraudulent signatures, illicit payments, appeals, eviction
of squatters
• Past problems re loan recovery one of reasons cited by
banks re risk aversion
• Economic Courts overwhelmed re ADR
• Most businesses lack assets to pledge, or are unwilling
to do so re tax avoidance issues; banks want housing
and vehicles, little else
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Legal Framework- Insolvency
• Framework for debt restructuring considered
underdeveloped
• Untested in terms of use for debt resolution
and contract enforcement re borrowers
defaulting on loans to banks
• Question of judicial experience in commercial
matters, and tradition of debtor protection
• Key legal issue relates to consolidation (e.g.,
holding company, parent company, joint and
several liability)
• Framework weaknesses constrain lending
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Accounting and Audit
• Banks required to be compliant with IAS/IFRS (RAAS)
• AAAA reports that 31 RAAS principles inconsistent
with 41 IAS principles, and RAAS has not been updated
to reconcile with 5 IFRS principles
• Limited domestic capacity in IAS/IFRS and ISA
• 20 accountants with comprehensive training in
international standards
• Insufficient capacity permeates accounting, audit, and
general financial reporting throughout economy
• Flawed information  flawed credit risk evaluation
and/or higher risk premium = higher cost of credit
• Weak accounting and audit = weak corporate
governance in all spheres
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Transparency and Disclosure
• No real tradition of open information disclosure
• Concerns of account garnishing and tax inspections 
under-statement of revenues, income and assets  less
available to pledge for secured loans
• Insufficient information and disclosure  higher costs of
credit due to higher risks, and inability to attract investor
interest through the capital markets
• Insufficient transparency and disclosure  inadequate
framework for institutional investment
• Markets trade on information. Reliable, timely
information is in short supply in Armenia,
constraining financial sector development and
economic growth
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General Constraints
• Absence of trust and confidence in institutions
• Weak funding base limits quantum of loan funds
available
• Low average capital and exposure limits of CBA
constrain amount and size of loans
• Earnings: those who have them don’t need bank loans
 small segment of households and businesses as
targets
• Traditional problems in business and legal environment
 risk premium = high net spreads  borrowing
perceived to be less attractive
• Underdevelopment of non-bank sector
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General Recommendations
•  Strategic coordination for each financial sub-sector
via working groups on legal/regulatory and institutional
needs for market development and stability. Example:
how would accounting reforms impact individual
segments of financial sector? How would these be
implemented? What are the key tax and audit issues?
•  International standards: BIS, IAIS, IOSCO, OECD…
•  Regulatory capacity: Transfer risk, consolidated
accounting, etc; CBA is a good start
•  Accounting and audit: Professional standards and
ongoing certification; recognition of importance to quality
and timeliness of financial information for market,
regulatory and managerial purposes
•  Corporate governance: Minority shareholder rights;
board qualifications and training; autonomous internal
audit; incentives for better disclosure practices
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Banking Recommendations
•  Development of credit risk and portfolio
management capacity driven by sound and well
managed RAROC/ROE targets
•  “Universal” on phased basis, with firewalls to
protect against capital impairment and threats to deposit
safety
•  Tax administration and account protection need to
be addressed more explicitly to be less of a perceived
obstacle to enterprise deposit mobilization
•  Secured transactions framework based on
comprehensive and digitized property and pledge
registries + judicial/ADR that protects creditors’ rights
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Insurance and Pension Recommendations
•  Mandatory savings can be accumulated via 3rd party
motor, 2nd pillar pension
•  Insurance: separate life and non-life; need more
capacity for solvency and reserve management
•  Pension reform should be a high priority with a focus
on movement to professional management and
administration under formally audited conditions and
following best practice re solvency, investment policy,
disclosure, board oversight, management, etc.
•  Investment policy should focus on fiduciary
responsibilities; economic development benefit should
be based on safe instruments with rising risk profiles as
institutional capacity for risk management develops,
NOT quasi-fiscal applications and uses (e.g., Chile)
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Securities Market Recommendations
•  Securities markets should be encouraged but not
force fed, building initially on government securities
market
•  IOSCO and OECD re governance,
reporting/disclosure
•  Joint listings
•  Yield curve via government securities market
•  Mortgage market, leasing and banks as issuers of
corporate bonds
•  Not just Glendale: savings-based plans for business
loans, housing investments, etc. (Russia, Middle East)
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Non-Bank Credit Recommendations
•  Refinements are needed in primary
mortgage markets before movement to
secondary markets is feasible
•  Information needs and valuation
standards for lending and securitization
•  Leasing, factoring, commercial
finance, etc. should be promoted and the
environment made conducive
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Questions/comments:
Michael Borish and
Company, Inc.
[email protected]
www.borish.com
Tel: 1-613-744-3159
Fax: 1-613-744-3569
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