Strategic Requirements for Next Stage Financial Sector Reforms in Armenia

Strategic Requirements for Next Stage Financial Sector Reforms in Armenia By Michael Borish May 29, 2005

Introduction Basic Challenges and Risks  Banking sector  Insurance  Pension  Securities markets  Non-bank credit institutions  Accounting and financial information  Building blocks for the future

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

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.

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.

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)

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

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

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

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

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

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?

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

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.

Non-Bank Issues: Insurance • Insurance sector: premium revenues <$4 million (2003) = $205,000 per active company = $2 per capita = .01% of GDP = small; by contrast: Latvia was 88th in world in 2003 with $220 million in premium revenues • Weak insurance framework = no institutional investors • MoFE budget for supervision: $12,000

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

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

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

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

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

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

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

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

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

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

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)

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)

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

Questions/comments: Michael Borish and Company, Inc. mborish@rogers.com www.borish.com Tel: 1-613-744-3159 Fax: 1-613-744-3569

Strategic Requirements for Next Stage Financial Sector Reforms in Armenia