Strategy and Institutional Framework

Beginning in 1996, the 15 countries began to implement a number of long-term strategies. First, they began to bolster bank licensing requirements, imposing higher capital requirements and reducing the number of new licenses issued. Second, they strengthened bank exit policies. During 1997, liquidations of insolvent institutions continued in Georgia, Kazakhstan, the Kyrgyz Republic, Lithuania, Moldova, Russia, and Ukraine. These measures have considerably decreased the number of banks, thus somewhat reducing the scope of the problem. Third, the 15 countries have continued to reinforce their overall banking supervision capacities, attempting to limit farther deterioration of the banking system and to prevent a recurrence of problems. Fourth, a majority of countries have started to implement bank restructuring policies, including financial as well as operational restructuring, involving mergers and split-offs, restrictions on the activities of the weak banks in the system, and initial attempts to restructure the large formerly state-owned banks. In all cases, the countries under review indicated that in 1997 they were continuing these policies, which had proven to be effective. Particularly in the case of operational restructuring, these are not one-off measures, but efforts extending over several years.

In many of the countries, the authorities have received assistance in their restructuring programs from the IMF and the World Bank, as well as other agencies. World Bank Financial Sector Adjustment Loans or other instruments have explicitly addressed banking sector reform in Armenia, Azerbaijan, Estonia, Kazakhstan, the Kyrgyz Republic, Latvia, Lithuania, Moldova, and Uzbekistan. The IMF has collaborated closely with the World Bank in a number of the countries.⁹

Restructuring Policies

In the past two to three years, the mix of restructuring policies has varied across countries. Most countries reviewed in this study have mandated higher capital requirements for banks, in some cases through a phased approach extending several years—for example, Armenia, Azerbaijan, Georgia, and Russia. Countries have also introduced more stringent loan classification and provisioning rules for doubtful and past due loans. These measures have jointly forced banks to attract additional capital, merging or terminating their activities, a process that continued during 1997. Central banks have in certain cases injected additional liquidity into the system, in order to preserve stability in the short term, as in Armenia, Kazakhstan, Russia, and Ukraine in 1997. Judging whether such liquidity support constitutes short-term bridge financing rather than solvency support for unsound banks is often very difficult. In some cases impaired assets have been removed from banks’ balance sheets and placed in asset management bodies. In other instances, supervisory authorities have imposed temporary administration upon troubled banks.

An important weakness in three countries—Moldova, Russia, and Ukraine—has been a reluctance to restructure the large banks, which control the bulk of the assets, with the result that efforts to date have focused on smaller banks. In some cases, large banks have lobbied against restructuring attempts. Nevertheless, the authorities will need to deal with large banks urgently, since they influence market confidence, and will need to be sufficiently healthy and well-managed to successfully process enhanced intermediation demands in the coming years. In Russia, systemically important banks are subject to intensive monitoring by a separate department within the central bank; these banks are also being separately monitored by a World Bank-led group of international bank supervisors.

Banking Sector Consolidation

In most of the countries the banking sector is undergoing a healthy process of consolidation as a result of firmer exit policies, tighter licensing policies, and, less frequently, more bank mergers (e.g., Kazakhstan). Overall, the total number of banks in the 15 countries decreased from more than 3,600 in 1994 to about 2,500 at the end of 1997 (Table 4.1). In Russia, which has the greatest concentration of banks, the number of banks has fallen from more than 2,500 at the end of 1994 to 1,764 at the end of 1997. In the Baltic countries, the total number of banks has declined from 107 to 55. A substantial number of banks have also closed in Armenia, Azerbaijan, Georgia, and Kazakhstan. This trend has allowed the remaining banks to grow in size and to increase their capital levels.

Table 4.1.

Number of Banks, by Country

Source: Country authorities.

¹Includes 52 branches of the former Agroprom Bank.

²188 active.

³189 active.

Table 4.1.

Number of Banks, by Country

Country	1994	1995	1996	1997
Armenia	52	35	33	30
Azerbaijan	211	180	136	102
Belarus	47	40	38	37
Estonia	23	18	14	12
Georgia	229	101	61	83
Kazakhstan	191	130	101	98
Kyrgyz Republic	18	18	18	20
Latvia	57	40	33	32
Lithuania	27	16	12	11
Moldova	26	27	21	22
Russia	2,517	2,295	2,030	1,764
Tajikistan	16	19	23	26
Turkmenistan	—	—	15	671
Ukraine	226	230	2282	2253
Uzbekistan	26	18	29	29
Total	3,666	3,167	2,792	2,526

Source: Country authorities.

¹Includes 52 branches of the former Agroprom Bank.

²188 active.

³189 active.

View Table

Table 4.1.

Number of Banks, by Country

Country	1994	1995	1996	1997
Armenia	52	35	33	30
Azerbaijan	211	180	136	102
Belarus	47	40	38	37
Estonia	23	18	14	12
Georgia	229	101	61	83
Kazakhstan	191	130	101	98
Kyrgyz Republic	18	18	18	20
Latvia	57	40	33	32
Lithuania	27	16	12	11
Moldova	26	27	21	22
Russia	2,517	2,295	2,030	1,764
Tajikistan	16	19	23	26
Turkmenistan	—	—	15	671
Ukraine	226	230	2282	2253
Uzbekistan	26	18	29	29
Total	3,666	3,167	2,792	2,526

Source: Country authorities.

¹Includes 52 branches of the former Agroprom Bank.

²188 active.

³189 active.

Prudential Regulations

In the majority of countries in this study, the minimum capital required to obtain a banking license has been raised to acceptable levels, with minimums set at the equivalent of $1 million, and, in many cases, at the EU standard of the equivalent of 5 million euro. This represents major progress compared to only a few years ago, when a bank could be opened with some tens of thousands of dollars. These policies have contributed to a decrease in the number of banks, and have helped ensure that new banks start business with the critical mass needed to establish reliable business operations and to serve as a cushion for start-up losses.

Capital adequacy levels are the principal indicators of banks’ ability to cushion losses without passing them on to depositors. Since 1996, capital adequacy requirements have been considerably strengthened in two-thirds of the countries under review; in five countries a capital adequacy ratio of 10 percent of risk-weighted assets has been introduced, and in another four countries a ratio of 8 percent has been introduced.¹¹ The Basle 8 percent minimum ratio is intended for internationally active banks in an established environment. In countries with a higher risk profile, and with data quality problems, a higher ratio is desirable. Estonia raised the minimum required capital to 10 percent from the previous 8 percent in October 1997, while Lithuania reduced the level to 10 percent from 13 percent effective in early 1997.¹² Risk-weighting tends to follow international practice; Estonia has raised the risk-weighting of loans to local government institutions and claims guaranteed by local governments to 100 percent, from the previous level of 50 percent.

Average capital adequacy ratios of banks have increased in seven countries.¹³ In eight countries the average capital adequacy ratio is 10 percent or higher.¹⁴ In only three countries that have reported an average ratio for 1997 is the actual ratio less than 8 percent.¹⁵ The reported ratios should be regarded with caution, however, because the 15 countries do not always draw clear distinctions between capital and provisions. Loan classification and provisioning regulations, although in place in all countries except Tajikistan, are not always applied correctly by the banks or verified by the supervisors. Capital levels may also be overstated as a result of calculation methods that do not correspond to international practices, and inappropriate underprovisioning practices.

Asset quality is a key indicator of bank soundness.¹⁶ On a simple crosscountry average, nonperforming loans as a percentage of total loans are reported to be 10 percent, with a standard deviation of 8 percent (Figure 4.2).¹⁷ In the large majority of countries, asset quality has improved, although concerns persist as to the accuracy of the asset quality data, because of continued weak on-site inspection skills and insufficiently developed accounting practices. The absorption of losses from previous periods has progressed, leading to a lower amount of remaining nonperforming claims. As banks’ liquidity management improves and alternative safe investments become available, the large-scale shift made by many banks to investment in low-risk government securities will need to be reduced. In the short term, however, this shift improves the risk profile of bank balance sheets. In Tajikistan and Uzbekistan, the ratio of nonperforming loans to total loans increased in 1997, although in these countries reported loan losses may have risen as a result of the application of more stringent rules on loan classification and provisioning than in previous years.

View Full Size

Nonperforming Loans, 1995-97

(In percent of total loans)

Source: Country authorities.¹1995 data not available; 1994 data used.

• Download Figure
• Download figure as PowerPoint slide

In the crucial area of loan classification and provisioning, improvements are being introduced in most countries reviewed in this study, although in most cases a simple matrix showing percentages of loans in each category is still applied mechanically on the basis of overdue periods and collateralization.¹⁸ In all countries except Moldova and Tajikistan, interest accrual is suspended on overdue loans. In some countries, such as Russia, an element of supervisory discretion has been introduced that permits bank inspectors to impose higher provisions than suggested by the matrix if the analysis of the payment capacity of the borrower warrants this caution. Systems still remain weak, however, to the extent that banks do not generally have good data for assessing the need for provisioning, and bank supervisors lack skills or resources to verify bank provisioning levels based on their assessment of the payment capacity of borrowers. To develop this capability requires practical experience, although additional training may also be required. Also, because of persistent budgetary problems, full tax deductibility of specific provisions has been introduced in only a few countries.

Risk diversification rules are also generally applied, and in most countries limits have been brought down to acceptable international standards. Bank exposure to single borrowers or connected groups of borrowers should not exceed 25 percent of regulatory capital.¹⁹ In some countries, a limit of 20 percent is applied. A weakness in this respect is the insufficient implementation of supervision on a consolidated basis, and therefore the ease with which these regulations can be circumvented. Even more than in established market economies, liquidity is a key concern for banks in the countries under review, and is often given excessive importance by management and supervisory authorities over profitability and long-term solvency. All countries apply liquid asset ratios. Required levels are in the order of 20 percent of short-term obligations.

Other Supervisory Issues

In most countries, licensing requirements stipulate that bank management must have adequate training and banking experience. Clearly, this criterion cannot be isolated from local availabilities. A lack of qualified bankers remains a structural problem in many countries. Credit risk assessment and loan review skills need to be further developed. Limits on lending to shareholders are typically between 10 percent and 20 percent of the bank’s regulatory capital, thus limiting conflict of interest between the bank and its shareholder borrowers.²⁰ Again, because of the risk involved in banking in these countries, this relatively conservative approach, as well as a lower limit than those applied in established market economies, is appropriate. Compliance is difficult to verify, however, in light of continuing weaknesses in consolidated supervision. Lending to insiders—that is, management and related parties—is often strictly regulated on paper but not always strictly enforced in practice in many countries, and may not be higher than a few percent of regulatory capital. The once widely prevalent practice of government directed lending has been suppressed in most countries. As international experience has shown, limitations on bank autonomy with regard to credit allocation tends to lead to poor asset quality.

Banks in the countries under review still have not established credit allocation policies that are sufficiently strong to prevent renewed asset quality problems or to assure that increased intermediation demands can be handled responsibly. An important issue for the future remains the ability of bankers to price credit risk. Better enterprise accounting and disclosure will be an important factor, as well as increased emphasis on cash-flow-based, rather than collateral-based lending, and improved internal credit review and provisioning procedures.

In the field of accounting and audit, compliance with International Accounting Standards (IAS) is in many cases still in a developmental phase (see also Chapter 6). A specific bottleneck in almost all countries is the lack of consolidated accounts and supervision on a consolidated basis.²¹ These missing elements have implications for compliance with most prudential regulations. Supervisors, therefore, cannot sufficiently assess the formal and informal connections of banks and their shareholders, and concomitant connected lending. Although 13 countries report having moved to IAS as the basis for bank accounting and reporting, in most cases, refinements still need to be made and experience gathered.²² In many countries, financial statements still basically do little more than restructure data collected on the basis of the former accounting system into a format that is compatible with IAS. The underlying ledger data are generally not compiled according to IAS.

In all these countries, banks are obliged to have an internal audit function, and must by law submit their annual financial statements to an external audit. Additionally, banks that participate, for instance, in World Bank banking sector assistance projects, such as the Financial Institution Development Project, must have audits performed on the basis of IAS. In the Baltics, Russia, and other countries of the former Soviet Union, where some banks are beginning to tap international capital markets, banks must be able to present IAS financial statements to their market counterparts, notwithstanding separately structured central bank reporting and accounting systems.

Supervisory authorities have generally introduced basic prudential reporting formats and inspection programs and, in most countries, banks must now submit prudential reports on a monthly basis, and undergo onsite inspections more frequently. Weaknesses persist in the quality of the data submitted, the skills of off-site analysts, and the effectiveness of onsite inspections. Quality of analysis will improve with experience, and as longer time series of data become available and better accounting standards are introduced, supervisory authorities will be able to improve their peer group analysis. Inspectors will need to focus on the analysis of borrowers’ payment capacity and the adequacy of provisioning levels reported by banks, to correctly establish the bank’s net worth.

In all countries except Kazakhstan, the number of supervisory staff relative to the number of banks under supervision has increased since 1997. Absolute numbers of banking supervision staff have increased in six countries, remained stable in six others, and declined slightly in the remainder.²³ As the number of banks has generally decreased, the ratio of supervisory staff per bank has risen. For the coming period, the issue is not only the acquisition of additional numbers of staff—specifically in Azerbaijan, Estonia, Georgia, Tajikistan, Turkmenistan, and Ukraine, where the ratio of staff to the number of banks is relatively low—but the improvement in the quality of staff and the retention of qualified staff.²⁴

Working relations between the supervisory authorities and commercial banks still need to be improved. Supervisory authorities have a tendency to issue too many new regulations without sufficient prior consultation, with too great a frequency and too little time to prepare implementation. For their part, commercial banks still need to develop a basic awareness of the underlying common sense of the prudential requirements, and focus on reporting the substance of their operations rather than the form, such as meeting the imposed ratios. Inspection teams still too often include nonsupervisory staff, such as tax inspectors. Under these conditions it is not possible to move from the excessively adversarial relationship that now exists between banks and their supervisors to a more collegial and productive one.

The supervisory authorities in most countries have enjoyed sufficient autonomy to carry out most of their responsibilities. They have been able to conduct bank restructuring policies—mainly of the smaller banks—and to successfully intervene in weak or insolvent banks, imposing temporary administration or closing banks. In a few countries, for instance Moldova, the supervisory authorities’ decisions have been challenged in the courts, sometimes successfully. One major shortcoming of the supervisory authorities in a number of countries has been the hesitancy to deal with the weaknesses in larger institutions. In Russia, the supervisory authorities need to obtain better information on the risks incurred by the large banks that form part of financial-industrial groups. The statutory authority of central banks to close such large banks, should they be found nonviable, needs to be clarified. Liquidations of banks for which the licenses have been withdrawn is a slow and very uneven process in most countries, mainly because there is still too great a dependency on shareholder cooperation in liquidating banks. Moreover, the legislative framework for bank bankruptcy remains very weak.

Bank Restructuring

Priority must now be placed on completion of the restructuring and rehabilitation of the largest banks, since they are crucial for the stability of the system. For many reasons, however, these institutions have been the last to be addressed. This must change so as to obtain a complete view on the risk profile of these institutions, with attention given to the affiliates of the larger banks. In view of the power of these banks, effective measures to restrain imprudent behavior will only be successful if they are firmly based on a pre-established consensus between the political and the supervisory authorities. The supervisory authorities will need to take the initiative in this area. Bank exit policies must be swift and clear if they are to help rebuild confidence in the banking sector. Rules on bank intervention need to be firmly grounded in the relevant laws, which will need to be reviewed to assess their adequacy and effectiveness. In some countries, many banks whose licenses have been revoked remain active, and rules permitting the bankruptcy of banks need to be introduced or reviewed. Expedient and equitable liquidation procedures need to be introduced. Finally, shareholders should not be involved in the liquidation process.

Loan workout remains an issue that many countries see as important. The resolution of nonperforming loans must be accompanied by appropriate measures to restructure the enterprise sector. Most important, banks must develop good skills to assess and price risk.

Banking Supervision

A central concern is the quality of data. Without reliable data, effective supervision is impossible, and banks cannot be run profitably. Improvements in the calculation of capital and capital adequacy are needed, taking into account adequately estimated and verified provisions for nonperforming assets. These improvements are essential for the assessment of the financial soundness of banks. Provisioning should not only be based on loan performance evaluation, but also on forward-looking analyses of the payment capacity of borrowers through an effective cash-flow analysis. Provisioning rules should allow sufficient supervisory discretion in imposing adequate provisioning levels, because standard provisioning matrices do not address questions concerning the payment capacity of debtors. Taxation of specific provisions should be abandoned, since this procedure tends to decapitalize banks. In addition, bank management should consider the further development of techniques for consolidation of accounts and supervision on a consolidated basis so that risks incurred by banks through the activities of their subsidiaries, branches, and other related entities can properly be taken into account.

Rapid adoption of International Accounting Standards that focus on banks’ net worth and not on the flow of funds is essential for progress.²⁶ Key areas are accounting on an accrual basis, the consolidation of accounts, and much greater emphasis on the substance-over-form principle. Again, to help foster a more material rather than a formal compliance-oriented approach to banking supervision, in all countries offsite analysis and on-site inspection skills should focus more on asset quality and provisions, performance, risk diversification, market-risk sensitivity, and connected entities than just on formal compliance. Inspections should also address management quality and internal risk management systems. The more advanced markets, such as those in the Baltics and Russia, will need to address banks’ derivative activities in their off-site analysis and inspections. Without better relations between supervisors and banks, effective supervision remains seriously handicapped because of banks’ inclinations toward window dressing and other forms of data manipulation. Corrective measures against banks should focus on remedial rather than punitive action, which often leaves the underlying weakness unaddressed. Banking supervision should focus exclusively on issues of bank soundness, and not on quasi-policing or tax inspection functions.