Strategic Requirements for Next Stage Financial Sector Reforms in Armenia

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Strategic Requirements for Next Stage Financial
Sector Reforms in Armenia

• By Michael Borish
• May 29, 2005

2
Introduction

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

3
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

4
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 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
• 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 million. Average loans to real sector 15
  million. Average deposits 25 million. Average
  capital
• 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 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 (
• 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 (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

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Non-Bank Issues Pension

• PAYG operated on cash basis with no audit and
  payments
• 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 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

19
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

22
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 dont 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.
• mborish_at_rogers.com
• www.borish.com
• Tel [phone]
• Fax [phone]