Chapter

7 Central Bank Accounting and Internal Audit

Author(s):
International Monetary Fund
Published Date:
May 1997
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Author(s)
John Dalton

The broad focus of reforms in central bank accounting and internal audit has been on the implementation of accounting systems that are both relevant and practical for supporting the policy actions of central banks in transition economies. The prime objective has been to present financial information in a manner consistent with internationally accepted accounting principles and standards.

Work on internal audit generally has been limited to introductory and strategic issues. Here the main focus has been on establishing independent internal audit units within the central bank, identifying key risks faced by central banks operating in market-based economies, and introducing basic structures and procedures reflecting modern internal audit functions.

Recent Trends and Country Experiences

Over the past four years, central bank reform efforts in accounting and audit have focused mainly on accounting, where a range of issues has been explored including the development and introduction of new accounting policies and practices; the development of new charts of accounts; the introduction of new procedures and controls; the preparation and presentation of financial statements; and the application of modern technology to perform accounting functions.

Progress with Implementation

The rate of progress in implementing accounting reforms has varied markedly across countries (Table 15). Over the past twelve months, several have passed beyond the core implementation phase. These countries, which include the Baltic states and Moldova, now use accounting systems that embody internationally accepted accounting principles and standards and present their annual financial statements in a format reflecting European and international standards.

Table 15.Accounting Reforms Supporting Market-Based Policies in the Transition Countries
Current Information Source for PolicymakersNew Chart of Accounts and Related PoliciesInternational Accounting Standards (IAS) Financial StatementsInternational Assessment of Accounting Reforms
ArmeniaMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted; parallel operation commences April 1.Financial statement format consistent with IA5 under development for adoption in 1996. along with accrual-based profit measurement.First IAS external audit (1995 accounts) in progress (March).
AzerbaijanMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted; awaiting comment from commercial banks. New formal balance sheet available for internal use at central bank.Some legislative barriers to IAS financial statements. Profits measured on cash basis.
BelarusMonetary and financial reports based on “old” chart of accounts, modified for new activities, until end of 1995. New charts of accounts for the national bank and commercial banks introduced in January 1996.New chart introduced in January 1996; format of balance sheet and statistical reports under review.New financial statement format and contents, consistent with IAS. Profits measured on accrual basis.
EstoniaMonetary and financial data based on new chart of accounts format.New chart adopted but recording is done using old chart then converted to new format reports.Profit measurement and financial statement format reflect IAS, but recording and processing of information using “old” system complicates financial statement preparation.
GeorgiaMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted; project team at early stages of implementation.Advanced foreign exchange system requires integration with broader accounting system. Profits measured on cash basis.
KazakstanMonetary data based on old chart; financial information available on new chart basis.New chart installed and operating in parallel with old chart for testing.IAS format balance sheet prepared. Further work being done on subsystem integration. 1996 profits will be based on accrual concept.First IAS external audit, findings under review.
Kyrgyz RepublicMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted; new general ledger software in process of installation.New general ledger will be able to produce IAS style statements and adopt accrual basis.First IAS external audit to be undertaken in 1996.
LatviaMonetary and financial data based on new chart of accounts.New chart installed. according to IAS. ProfitsFinancial statements prepared 1994 and 1995. measured on accrual basis. Working on accounting for new financial instruments.“Clean” IAS audit opinion in
LithuaniaMonetary and financial data based on new chart of accounts.New chart installed.Financial statements prepared according to IAS and under audit. Profits measured on accrual basis.IAS audit completed for 1995.
MoldovaMonetary data based on old chart; financial information available on new chart basis.New chart installed.IAS balance sheet available but further work needed on other components of financial statements, such as notes, and other internal reports.
RussiaMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart under consideration, along with commercial bank chart. Substantial revisions to old chart for “new” central bank activities. IAS-consistent policies adopted for foreign exchange accounting.Conceptual issues relating to accrual basis and provisioning need to be resolved for adoption of IAS financial statements.IAS audits completed for 1993 and 1994, findings under review.
TajikistanMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart under consideration and accounting policies vet to be determined.Profits measured on cash basis
TurkmenistanMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart under consideration and accounting policies yet to be determined.Profits measured on cash basis
UkraineMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted and under review. Some conceptual issues (accrual, provisioning) require resolution.Integration of foreign exchange subsystems into accounting framework under consideration. Profits measured on cash basis.
UzbekistanMonetary and financial reports based on “old” chart of accounts, modified for new activities.New chart drafted; reporting formats and operating systems under review.Integration of foreign exchange subsystems with broader accounting system under examination. Profits measured on cash basis.

Several other countries are also making good progress with plans for major reforms. Armenia and Kazakstan are running versions of their new charts of accounts in parallel with the old charts as a prelude to full conversion, and the Kyrgyz Republic has developed a new chart of accounts and will commence parallel running as soon as the installation of new accounting software has been completed. In Azerbaijan, Belarus, and Uzbekistan, central bank accounting staff have developed new charts of accounts that are consistent with the IMF-recommended framework and are ready for installation.

For those countries that still have some way to go in the reform process, the work generally remains focused on core issues and overcoming a range of impediments to reform. Completing the core implementation phase involves the introduction of new accounting policies and reporting formats that are consistent with international standards and are significantly different from those previously used.

New accounting policies must reflect, for example, the accrual basis, rather than the cash basis, for the recognition of income and expenses. Monetary and exchange market operations require policies for the fair, and where possible market-based, valuation of transactions and assets; for the recognition of gains or losses arising from transactions in those assets; and for prudent provisioning policies to cover possible impairment in asset values. Finally, policies must also set target levels for capital reserves to help protect the financial independence of the central bank.

New reporting formats are required to provide a full range of information on central bank operations, such as monetary and exchange market activities, fiscal agency responsibilities, and payments system operation and regulation. Financial statements that meet international standards must include a balance sheet—in more summary form than the previous trial balance sheet—and a separate statement of income and expenditure and net profits. They must also contain additional notes providing a summary of major accounting policies used, and supplementary information to the balance sheet and income statement to fully reflect the financial condition and results of the bank.

Success in Dealing with Common Issues

The divergent rates of implementation of accounting reforms reflect a varying degree of success by individual countries in dealing with common issues. There are three necessary conditions for reform that must be present both at the outset and throughout the reform process. First, senior management commitment is essential in all areas. A feature of senior management support of accounting reforms in many of the relatively advanced cases has been the establishment of a clear mandate for the accounting department to manage the reform project across the entire bank. Second, those implementing the reforms need access to suitable qualified staff and appropriate equipment. Third, there is a need for coordination with other reform projects, such as in the areas of commercial bank accounting and banking supervision, and payments system reforms.

Various impediments must be overcome during the accounting reform process. The main obstacles and impediments currently found in the transition countries relate to inadequate training on new concepts and inadequate systems for professional development, indecision over appropriate charts of accounts for central and commercial banks, and technical and financial resource constraints.

Conceptual problems largely stem from the differences between the cash basis of Gosbank accounting and the accrual basis of international accounting, coupled with different purposes underlying reporting of financial information. Strengthening the accounting department to lead the in-house training in international standards and practices is an important step to overcoming this obstacle and is particularly crucial in larger countries with extensive branch structures. In addition, promoting professional bodies can facilitate the development of accounting standards and professional education programs that are based on international standards.

In most countries, the question of whether there should be a uniform chart of accounts for both the commercial banks and the central bank or two separate charts has arisen. Difficulty in resolving the question can delay the introduction of accounting reforms for both commercial banks and the central bank. As central bank and commercial bank operations diverge in a market-based economy, so will the respective charts of accounts. Decisions and programs regarding commercial bank accounting and reporting standards may need to proceed separately from those for central bank accounting.

Most countries face technical and financial resource constraints in introducing accounting reforms. The solutions vary across countries and are not necessarily a matter of obtaining large amounts of computer equipment or loan funds. Perhaps the most successful approach has been to start with a simple system and then develop it further, rather than attempting to install a multipurpose accounting software package from the start.

Trends and Priorities in Accounting Reform

Differing rates of progress, along with the constraints noted above, are reflected in the nature of reform issues of importance for individual countries. While there remains commonality of interest in some issues, some countries have to focus on a set of specific reform topics that are unique to their circumstances and with a timing that is unrelated to developments elsewhere. Against this background, reform issues can be grouped into core implementation issues, advanced technical issues, and new issues.

Core Implementation Issues

A number of countries, including Azerbaijan, Georgia, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan, are at varying stages of dealing with core implementation issues. For them, priority should be given to issues associated with adopting international accounting concepts and standards, organizing the accounting system, implementing new charts of accounts and related accounting subsystems, and essential procedures and internal controls. For most of these countries, there are a number of key issues relating to whether the country is prepared to adopt accounting policies and reporting formats that reflect International Accounting Standards (IAS).

In Tajikistan and Turkmenistan, almost the entire range of core issues needs to be addressed in determining the course of accounting reform. In Russia, important issues regarding implementation of new arrangements in a central bank operating across a large geographic area need to be addressed. Reform work to date has largely focused on implementing accounting procedures for new central bank activities within the existing accounting framework. Further work is needed to develop an accounting system that is consistent with IAS. Other countries, including Belarus and Ukraine, have made substantial steps toward developing a new chart of accounts, but more work is needed in such areas as developing IAS-consistent policies, and reporting formats for their financial statements. On the other hand, Georgia will require further work on accounting system development and related procedural aspects, while Azerbaijan and Uzbekistan are at a stage where resolving issues relating to integration of accounting systems and other operating systems could enable them to progress from developing to installing their new accounting arrangements.

Advanced Technical Issues

As countries move ahead with implementation, reform issues focus on more technically advanced topics. One key issue centers on the factors relevant to the determination and, separately, the distribution of central bank profits. Related to this is the need for detailed technical accounting procedures relevant to central bank monetary and exchange market operations.

Market-based valuation and central bank profits. Decisions on the valuation of central bank assets and liabilities (such as foreign and domestic government securities) can have a major impact on the measurement of central bank profits, and amounts potentially available for distribution to the government, with commensurate implications for the central bank’s monetary program.

Legislative requirements that net profits of the central bank shall be transferred to the government usually give rise to strong concerns that net profits available for distribution do not contain unrealized gains. This puts a specific demand on accounting systems to be capable of separating gains realized from transactions in assets from any unrealized valuation adjustments that may arise from movements in market prices19 so that any transfers to government reflect only realized profits.

The potential for realized gains and positive valuation gains is, of course, matched by the potential for losses, particularly since central bank decisions for monetary or exchange operations are not motivated by a profit objective. In the context of the distribution of central bank profits, one important accounting issue becomes the determination and maintenance of adequate levels of central bank reserves and provisions. Policy decisions in this area must be determined by bank boards, in accordance with legal provisions. Since transfers to reserves and provisions represent a reduction in profits available to government, it is imperative that accounting policies reflect consistent and transparent approaches for maintaining the financial soundness of the central bank.

Government securities accounting is still a new area for many countries. Fledgling government debt markets have resulted in relatively little practical exposure to central bank market operations using government securities as monetary instruments, and the associated accounting and internal control of issues, income recognition (accruals and realized gains and losses from transactions), market-based valuations, and appropriate separation of duties for control purposes.

Foreign exchange accounting. The introduction of foreign currencies to the central bank’s accounts has required new subsystems for processing transactions and maintaining dual currency records. Often, these subsystems are kept independently of a bank’s “domestic” currency financial records, and divided, and perhaps uncertain, responsibilities for monitoring controls and accounts can increase the risk of errors or losses going undetected. A range of technical issues needs to be addressed, including calculation of realized gains or losses, frequent exchange rate revaluation of foreign currency holdings, integration of foreign currency and domestic currency accounting systems, reconciliation and confirmation of transactions and balances, and greater attention to ongoing internal control aspects (separation of duties, authorization, verification, record keeping in support of financial records).

Country-specific issues. Beyond the general issues discussed immediately above, there are also some specific areas of focus that are relevant in the Baltic states, Armenia, Kazakstan, the Kyrgyz Republic, and Moldova. Armenia will be developing new financial statements that follow IAS and incorporate recommendations coming from the first external audit of its financial accounts. Moldova, having adopted a chart of accounts and balance sheet format reflecting IAS, plans to refine its financial statements presentation and extend the use of the new recording framework to its other reports. Kazakstan and the Kyrgyz Republic will need further work installing, integrating, and using accounting software for both general and specific applications that are relevant to their new charts of accounts and reporting frameworks. In Latvia and Lithuania, the new reporting frameworks will need to be supported by strengthening the professional and technical skills of staff, notably in areas related to the increasingly sophisticated financial instruments now being used.

External audit issues are becoming more relevant for the transition countries and several central banks have already appointed international firms as their external auditors. Notwithstanding the regulations or standards in a particular country, international external auditors are required to express their opinions on the basis of IAS. This requires, of course, that central banks have clearly established accounting policies for all major areas of operations and are prepared to give the auditors reasonable access to all the information necessary for them to form an opinion.

New Issues

Internal audit is a reform issue requiring priority in almost all countries. Reform efforts need to focus on developing internal control systems and internal audit practices for assessing the risks facing central banks, the effectiveness of controls, and the reliability and accuracy of accounting systems. As banks progress with reforms of monetary and exchange policies, an effective internal audit function becomes crucial to the minimization of risks associated with the key central bank assets and liabilities involved.

Most countries have made varying progress in this area, but almost all have far to go. For example, although all countries have some form of internal audit function, many reform issues have to be addressed including (1) establishing a clear separation between the internal audit function and any commercial bank audit responsibilities of the central bank; (2) determining an appropriate charter and work plan for a “modern” internal audit unit; (3) identifying the main risk areas where internal audit focus should be directed, such as foreign exchange and domestic monetary operations, commercial bank correspondent and reserve accounts, payments services, and electronic data processing; (4) reviewing and assessing the essential internal controls, responsibilities, and documentation; and (5) ensuring the availability of necessary staff and systems to perform ongoing audit surveillance work.

The development of an effective internal audit function will also require that attention be given to improving internal controls to protect the bank from financial risks and other losses. Among the important areas where controls will need to be reviewed or developed by line management are the protection of cash and valuables, foreign exchange operations, financial instruments associated with monetary operations, and electronic data processing systems. While internal audit cannot be responsible for developing internal controls, staff must be sufficiently trained to be able to assess the relevance, application, effectiveness, and efficiency of internal controls.

Appendix Statements by Delegations
Armenia: Main Achievements

This statement covers the period September 1991 to February 1996, from the declaration of Armenia as an independent republic to the present day. It is a brief history of the Central Bank of the Republic of Armenia and a review of its main achievements in central banking reform and priorities for the future.

The central bank has evolved against a background of turbulent events over which it has had little or no control. An earthquake in 1988 severely damaged the country’s infrastructure and caused a major refugee problem. In addition, Armenia has suffered massive losses due to the breakdown of trade arrangements with the Baltics, Russia, and other countries of the former Soviet Union and an economic blockade. The early challenges were formidable. There was a need for the old national bank to adapt its operations to many new factors: Armenia’s independence; the country’s incipient transformation into a market economy; the establishment of new relationships with other central banks; the introduction of a national currency, the dram; and the stabilization of the economy.

Current Economic Position

In 1994, the central bank introduced a tight monetary policy. It had the effect of stabilizing the economy and growth resumed. Inflation, running at the rate of 1,884 percent in 1994 declined to 32 percent at the end of 1995. The exchange rate also stabilized and has been floating in a narrow range around dram 400 to $1 since mid-1994. The decline in GDP was reversed and growth of approximately 5 percent was recorded in 1994 and 1995. Fiscal policy has also been tightened, reducing the government deficit from 50 percent of GDP in 1994 to less than 10 percent in 1995.

Despite the dramatic improvements, there is little confidence in the banking system, which is undercapitalized and inefficient, and is thus relegated to a marginal role in savings mobilization and intermediation. A large portion of banks’ assets remain nonperforming, reflecting in part previous policies of directed credit. It is in this light of good news and bad news that reforms within the central bank are reviewed.

In May 1992, the IMF identified the issues to be addressed over the ensuing years and provided a structure for reforms to be developed and implemented. The issues, discussed below, are banking legislation, payments systems accounting, the conduct of monetary policy, foreign exchange operations and financial markets, banking regulation and supervision, and organizational issues.

Banking Legislation

The central bank was established in April 1993 on adoption by Parliament of “The Law About the Central Bank of the Republic of Armenia,” and “The Law About the Banking Activities of the Republic of Armenia.” Prior to that date, the National Bank of Armenia faced the challenges of reforming the entire banking system, not only the central bank, without an appropriate underlying legal framework.

The Law About the Central Bank provided the central bank with independence that had previously been lacking, and under that law all reforms to the banking system have been implemented. As a natural consequence of the rapid changes that have taken place in the financial sector, revisions and amendments to the law have become desirable. A revised law on the central bank, which will give clarity to the independent nature of the bank, is now under discussion in Parliament. It will provide greater transparency to the responsibility of the central bank in formulating and implementing monetary policy and emphasize the accountability it has in reporting progress on monetary policy and financial developments to Parliament.

At this stage of the reform process, opportunity is being taken to revise other legislation, which includes the law on banks and banking, the bank insolvency law, the collateral law, and the bankruptcy law. It is expected that all these will be enacted by the end of 1996.

Accounting

In common with other central banks in the region, the central bank and the commercial banking system in Armenia have been based on the Gosbank system. It has been recognized for several years that there was a need to modify accounting methodology, the plan of accounts, and financial statements to conform more closely with the practices in market economies.

Over the last three years, the central bank has been receiving various forms of technical assistance from the IMF, various international organizations, and participating central banks. This has included assistance to introduce the best international accounting practice in both the central bank and commercial banks. In June 1995, an IMF-appointed resident advisor joined the central bank to further assist in this reform process. At the same time, the central bank set up a separate Accounting Project Team comprising eight young qualified staff from various areas of the bank to work with the advisor. These reforms have also included improvements in internal control processes and the setting up of a separate Internal Audit Department at the central bank.

A number of accounting reforms have been introduced at the central bank, and a new chart of accounts is now being implemented to accommodate accounting practices that conform to International Accounting Standards. This chart of accounts is also currently being expanded to handle a similar transition for commercial banks. The central bank’s 1995 accounts have also been subject to external audit by KPMG, an international auditing firm, on the basis of international accounting and auditing standards.

Associated computer software changes have also been necessary to accommodate this move. Development of cost-center and project-tracking codes has also been necessary to meet the needs of internal central bank budgeting and management information. The software changes have been performed by a local software group with assistance from the Bank’s own Automation Department. It has also been necessary to accommodate a broader range of loan and deposit accounts (in foreign and domestic currency) than those just required for central bank operations so that when the chart of accounts is expanded to the commercial banks, the full range of account possibilities can be accommodated.

Necessary changes in underlying computer software cannot be over-stressed. It is critical to the success of the new chart of accounts implementation that computer software development receives top priority. In particular, moving from the traditional single module approach to a range of modules interfacing with the accounting systems, along the lines of international practice, will be necessary.

It has also been necessary to update the existing account definitions and incorporate new definitions for all accounts. This has been developed in both printed form and as personal computer-based “help screens,” so that users can call up old account numbers and view them linked to new chart of account numbers. End-report users have also been identified, and their existing needs will be met from the new chart of account reports. Any requests for new reports have been viewed as later enhancements to the project so as not to inhibit current development.

The development of a spreadsheet approach linking the old chart of accounts’ daily balances (the existing synthetic accounts transactions) to the new chart of accounts format trial balance has facilitated the transition process. This has been a critical tool for preparing end-1995 accounts on an international accounting standards basis, and for parallel running of old and new approaches with the introduction of a new chart of accounts. The central bank has developed an automatic software linkage to present its daily trial balance on both the old and new bases. Extensive ongoing training and discussion across a number of areas of the central bank remains critical to both successful implementation of accounting reform and ongoing improvements in accounting systems generally.

It has been necessary for the central bank’s board to approve a new set of central bank accounting principles that, when fully implemented, will bring it in line with International Accounting Standards insofar as they can be applied to a central bank.

The new accounting principles relate to market valuation of major central bank assets; for example, gold, foreign and domestic securities investments, and fixed assets such as buildings, as well as the central bank loan portfolio. To adopt a current market valuation for loan assets, it has been necessary to write off nonperforming loans as an expense and to set up adequate provision for doubtful loans, which is then deducted from the assets in the annual financial statements. The introduction of accrual accounting, instead of the essentially cash-flow basis, also provides a better measure of accounting performance and is consistent with international practice.

Internal central bank budget procedures, as well as costing of the central bank’s services to clients, were not very sophisticated in the past. For 1996, an internal operating expenditure budget and a separate capital budget have been developed. Because the necessary computer software coding reforms for the new chart of accounts are being implemented during 1996, a fully computerized budget monitoring system, comparing actual outcomes to budget, will not be possible until next year. In the meantime, manual and personal computer-based monitoring systems are being used. Costing of the central bank’s activities to ensure that client services, for example, government banking and cash distribution, are being performed as efficiently as possible is another aspect of management information systems. The computer software changes being introduced will facilitate this process but more work still needs to be done.

The central bank set up a separate Internal Audit Department in late 1995, which now comprises some eight staff, and an Audit Charter has been approved by the central bank. Also, job descriptions and a broad two-year internal audit program based on areas of perceived risk have been finalized and internal audits commenced. Initial emphasis is being given to potential high-risk activities of the central bank such as those related to foreign exchange activities.

Banking Supervision

Between 1991 and 1993, the absence of adequate legislated authority to properly regulate financial markets resulted in an unsatisfactory beginning for private banking in Armenia. Essentially, given this absence of “restrictions,” a permissive atmosphere quickly developed within the industry. The system suffered from low-capital levels, inadequate economic standards, and an underdeveloped supervisory staff to monitor bank activities. Consequently, a number of banks and financial credit organizations were created, primarily, to exploit the adverse economic and social circumstances.

In April 1993, banking legislation was ratified by the Supreme Council of the Republic of Armenia. Unfortunately, the proper role of the central bank was not fully defined for quite some time after that date, and the Law About the Central Bank of the Republic of Armenia was not implemented until after the appointment of the central bank’s board (i.e., early 1994). This law provides for the appointment of the chairman, the first deputy chairman, and the six other members of the board. Two directors are assigned by the government, two by the Supreme Council of the Republic of Armenia, and two by the chairman of the central bank. The chairman and first deputy chairman are appointed for seven years, and the directors for five years.

By January 1, 1994, 58 banks were operating in the republic. The number included formerly state-owned banks that had acquired the status of shareholders’ banks. The market also included 14 branches of foreign banks.

After a tentative start, a strong evolutionary process of supervision began. The central bank has made great strides toward establishing modern banking supervision and regulation in Armenia. Initially, a committee was formed to monitor the banking system, which was followed by release of the central bank’s first banking regulation on required financial standards. These standards included minimum level of statutory capital; the own-funds-to-assets ratio; balance sheet liquidity indices; required reserves to be kept with the central bank; and loan limits to single borrowers.

The departments of supervision, regulation, and licensing were combined, facilitating information sharing between on-site and off-site users of bank data. Significant progress was made toward developing on-site audit and off-site surveillance programs along international guidelines. At the same time, comprehensive training programs were embarked upon. To this end, an IMF resident advisor joined the central bank in February 1995 to generally assist the department in raising the quality of its regulation and supervision activities.

This early activity has been followed and reinforced by new regulations contained in Resolution 78 of April 1995. The resolution established stronger norms closer to international guidelines in respect of the following prudential standards:

  • The minimum total capital and statutory capital: banks were required to achieve their minimum statutory capital by January 1, 1996, that is, dram 50 million, plus dram 5 million for every additional branch. They were then obliged to increase their minimum total capital in annual increments up to the equivalent of $1 million expressed in dram by the year 2,000. Total capital is defined as the sum of fixed capital and other funds and reserves.

  • The ratio between total capital and assets effective July 1, 1995 was defined as 1:16.67; and effective July 1, 1996, 1:10 (or 6 percent and 10 percent, respectively).

  • The ratio between liquid assets and total assets effective July 1, 1995, was defined as 1:5; from January 1, 1996, as 1:3.33; and from July 1, 1996, as 1:2.85 (or 20 percent, 30 percent, and 35 percent, respectively).

  • The maximum exposure to a single borrower should not exceed the following percentage of the capital of the bank—effective July 1, 1995, 50 percent; from January 1, 1996, 35 percent; and from July 1, 1996, 20 percent.

Rules in respect of establishment and licensing of banks are being redefined, the professional integrity of managers of newly established banks was highlighted, and the procedures for suspension of banking activities were strengthened.

During 1995–96, the loan portfolios of 40 commercial banks had been examined. The examination led to a greater appreciation of the extent of nonperforming loans within the commercial banks and establishment of a provisioning procedure to cover losses arising from bad loans.

Introduction of the new system of prudential standards has had a significant effect on banks and several have been obliged to cease operating. By the end of 1995, the number of operating banks had been reduced to 35, and foreign branches to 3.

To raise the efficiency of supervision, a new bank reporting form has been designed. This has led to an improvement in the quality of information received by the central bank and a higher level of off-site supervision. An additional improvement in monitoring standards has followed introduction of the American CAMEL rating system.20

Notwithstanding the substantial reforms in bank supervision implemented by the central bank, the commercial banking system is fragile. It is recognized that if Armenian banks are to compete on an equal footing with international banks, now beginning to be established in Armenia, the banks must be strengthened.

During 1995, the central bank hosted a conference of central banks from Transcaucasian and Central Asian countries under the auspices of the Basle Committee. The objective of the conference was to improve communication and liaison within the region on bank supervision through formation of a regional group.

Organization and Structure of the Central Bank

The central bank has been required to undertake significant organizational changes in its transition from a branch of Gosbank to a fully fledged central bank in an emerging economy. The present structure is based on the recommendations of international financial institutions, as well as studies of functional divisions within prominent European central banks. It has also evolved over three years and has been subjected to fine-tuning based on actual experience.

Changes will continue to be made as the bank’s business develops and staff become more experienced and better trained. To this end, independent departments have been periodically reviewed for efficiency and function. During 1994, for example, licensing, supervision, and regulation departments were merged into a single department, and in 1995 international and foreign exchange operations, monetary and credit, and securities departments were brought into closer proximity. This latest organizational change is important, as it brings closer together the three departments concerned with development and implementation of monetary policy.

Along with structural realignments, human resources are also reviewed for efficiency and function. Staff training has a high priority, and full use is taken of training opportunities both in Armenia and abroad, and of technical assistance. In this connection, the Central Bank of Armenia presently has the benefit of three resident IMF advisors specializing in the areas of accounting, bank supervision, and operations. The central bank continues to experience losses of trained staff to the commercial banking sector that is able to offer more attractive salaries. It is recognized that such losses reflect economic changes taking place in Armenia and are inevitable at this stage. These staff moves are, however, of direct benefit to the financial community as a whole, as skills levels in the commercial banking sector are raised.

The Payments System

The central bank has made remarkable progress in developing payment systems, improving interbank settlements, and reducing the time required for settlement transactions. Only two years ago the need for action was urgent. Initially, the central bank helped develop a “banking mail” service between the central bank and the largest commercial banks. This somewhat basic service nevertheless accelerated interbank mail deliveries, providing deliveries between the banks within one to five days. Previously, these transfers may have taken two weeks or more. From this simple beginning has evolved a new payments procedure in the capital city of Yerevan; a new payments procedure for intraregional payments; and a new procedure for interregional payments.

In April 1994, an Interbank Committee on Payments System Development in Armenia was created with industry-wide representation. In April 1995, a specialized Payments System Development Department was created within the main Payments Department of the central bank. It was these two entities that recognized the need to develop an electronic-delivery system in Armenia for the following reasons: inefficiency in paper delivery by post or courier; the inaccessibility of some regions in winter; the need for reliable and rapid final customer payment to increase the monetary efficiency of the economy; and the need to reduce the risks and costs associated with the buildup of float in the payments system.

Inevitably, a countrywide system would require substantial funding and design expertise, which would take time and be difficult to procure. An interim solution was identified using the existing data telecommunication infrastructure, including the government telegraph network. This telegraph e-mail network was used by the central bank and three major banks. The disadvantages of this somewhat rudimentary system became quickly evident and the need for a countrywide, modern, and secure system was reinforced. The lack of a public service provider of such a system obliged the central bank to take the lead in this new project.

As a result, implementation of a new electronic system named CBANET will begin in May 1996 and is forecast to be fully operational by January 1997. The system will provide a primary e-mail application. It will process credit transfers from the outset, with other instruments to be added at a later date; distribute statements of account and other predefined reports; distribute transaction confirmations; and permit transmission of free format files. It will have the capacity for considerable future development that could include real-time gross settlement for high-value transactions; bulk credit transfers; direct debit; credit and debit cards; and automated teller machines (ATMs).

Development of this system has been achieved through the financial and technical assistance of the U.S. Agency for International Development (USAID), (EC-TACIS21), and the IMF, coordinated by the Central Bank of Armenia. Ownership of the system remains with the central bank and users are all commercial banks and their branches in Armenia.

A further development of CBANET will be the ability to make cross-border transactions through links with the SWIFT network. A bank association of SWIFT users has been established in Yerevan, and it is anticipated that this service will be implemented in September 1996.

The absence of an appropriate payments system prevents development of the banking system in a market economy. Full implementation in Armenia of CBANET is therefore of great importance to the banking system and is a significant step in the reform process.

Conduct of Monetary Policy

The development and successful implementation of monetary policy is one of the greatest responsibilities of the central bank. The monetary department of the bank must, therefore, have the necessary resources both human and technological to function efficiently. With these criteria in mind, the bank’s organizational structure has undergone several changes and presently the conduct of monetary policy rests on three departments working closely together: the Monetary Policy Department; the Domestic Operations Department, and the Foreign Operations Department. Very recently, the three departments were formally merged.

The Monetary Policy Department has responsibility for the development of monetary policy and economic research, and achieves this through its five divisions: Economic Research; Budget Relations; Balance of Payments and Foreign Exchange Policy; External Debt Service; and Monetary Policy Implementation. All monetary programming, macro-economic analysis, forecasting and reporting, monitoring links with the budget, and monitoring effective use of monetary instruments are concentrated in this department. It maintains close links with the Ministry of Finance to assess budgetary needs. It also prepares reports and recommendations for the Monetary Policy Committee.

The Domestic Operations Department has responsibility for implementing policy within the domestic markets. It does this through its three divisions: Foreign Exchange Domestic Market; Credit Operations; and Securities. Operational activities include the auctioning of central bank credit, the auctioning of treasury bills as agents of the government, and foreign currency interventions at daily foreign currency auctions.

Credit auctions were introduced during 1994 and sales volumes rose from dram 1 billion a month to dram 4 billion at the end of 1995. To be authorized to participate in the closed, uncollateralized auctions, the commercial banks were subject to prior qualification based on prudential standards and approval of the Monetary Policy Committee. Following the introduction of treasury bills and to halt losses incurred by the central bank from nonrepayment of credits, banks were required to provide full collateral from January 1996. Following introduction of this requirement, demand at the credit auction has ceased, attributable in part to insufficient volumes of treasury bills on issue.

Treasury bills of 28- and 91-day maturities were introduced by the Ministry of Finance in September 1995. The central bank acts as agent for the government and manages treasury bill operations. Regular weekly auctions are held with sales of approximately dram 600 million a month being achieved. In an effort to encourage development of the treasury bill market, the central bank announces daily its selling and buying rates for treasury bills. In addition, the central bank is shortly to begin offering to enter into repurchase agreements.

A Lombard-credit window has been approved by the central bank’s board for provision of short-term fully collateralized credit, and will be opened in the near future.

Over the last two years, the central bank has developed the domestic foreign exchange market through supporting the establishment of three foreign exchange auction centers. The auctions have maintained competition, narrowed margins between buying and selling rates, and reduced commission charges on currency trades.

An interbank foreign exchange market was established at the beginning of 1996 as an evolution of the foreign exchange auctions at which banks had come to rely on the central bank to meet their demands rather than seeking currency within the market. The central bank announces daily its buying and selling rates. Interest in this market is growing while declines in the auction turnover are being seen.

The Foreign Operations Department has responsibility for implementing policy within foreign markets. It does this through two divisions: Correspondent Account Management; and Reserves Management. Reserves Management is overseen by the Investment Committee, which meets on a regular basis and receives daily reports from the division.

Central Bank of Armenia—Current State of Reform

From what has been said above, it is evident that the Central Bank of Armenia has made substantial progress over the last two years in adopting a wide range of reform measures. The organization of the bank allows for efficient use of available human resources. The weaknesses in banking legislation have been addressed, and revised laws are expected to be enacted during 1996. The conduct of monetary policy continues to develop in a satisfactory manner. Banking supervision is in place. Accounting reform is well advanced, and implementation of a modern payments system is on schedule for completion in early 1997. There is reason, therefore, for some satisfaction, although not complacency, over progress made in the central bank. Unfortunately, the picture is not uniformly bright, and serious weaknesses remain in the banking system, as mentioned earlier, that must be addressed in the immediate future.

Banking Sector Weaknesses and Priorities for the Future

The problems faced by the banking system are many and invariably serious. For clarity, they may be listed as follows: high levels of nonperforming debt and the need to implement the new provisioning requirements; low levels of capitalization and the need to implement new capital requirements; the need to mobilize domestic savings and build public confidence in banking services; and the need for commercial banks to expand the range of their services and to adopt international standards of accounting. These problems must be addressed under a comprehensive plan for strengthening the banking system.

There are other issues to be addressed that follow on from reforms presently in progress: the need to develop secondary markets that the central bank is finding difficult to do; new legislation will bring new challenges and the judiciary must be trained to handle concepts previously unknown to them; a deposit insurance scheme to protect bank depositors must be established in the not-too-distant future if confidence in banks is to be restored—the views of the IMF on this subject are well known and we appreciate the necessity of strengthening banks first but the need to give some depositors some reassurance remains. This list is not exhaustive but gives a clear picture of what lies ahead and what the priorities must be. Solutions will be costly, difficult, and time-consuming, but if a strong banking system is to be achieved, corrective action must be taken either by the central bank or the commercial banks, separately or together.

The central bank is grateful to the World Bank for recently assessing the situation in the banking system in Armenia. Their proposals are broadly in line with the central bank’s views, and implementation of the first stage, which will include detailed portfolio assessments of all banks and establishment of a pilot work-out program, is imminent.

Analysis of the portfolio assessments results will determine the central bank’s strategy. It should be emphasized, however, that the objective is to strengthen the system and where possible assist banks to grow. There may be clear evidence in some instances that assistance is not warranted, in which case the bank will be allowed to fail or be closed.

The problems of the banking system in Armenia are clear to the central bank and are being addressed. Fortunately, the central bank is now in a stronger position to face them than three years ago. However, it recognizes that the reform process has several years to run before the full benefits of a market economy can be achieved.

Azerbaijan: Structural Reforms at the National Bank

Efforts to stabilize the economy and to introduce more market-oriented institutional structures got off to a slow start in Azerbaijan, largely because of political instability and the conflict with Armenia. However, with the aid of an IMF Structural Transformation Facility approved in April 1995 and a 12-month Stand-By Arrangement approved in November 1995, good progress is now being made in economic stabilization. Progress in structural reforms, on the other hand, has been more limited, even though inflation has slowed markedly and the fall in income appears to be coming to an end.

Efforts to transform the national bank into a modern and efficient central bank also got off to a rather slow start, with only limited progress being made through late 1994. However, following the appointment of a new chairman and vice-chairman, progress accelerated markedly, and the national bank has shown an eagerness to absorb additional technical assistance support. Technical assistance has now been provided in virtually every area of the national bank’s operations, including monetary instruments, monetary policy, research and analysis, financial market development, foreign exchange operations and reserves management, central bank accounting, financial sector legislation, payments systems, and banking supervision, and varying degrees of progress can be reported in virtually every area. In 1996, considerable attention has also been devoted to developing a framework for restructuring the banking system.

At present, the primary monetary policy instruments are monthly credit auctions and biweekly auctions of foreign exchange at the Baku Interbank Currency Exchange (BICEX). While the automatic overdraft facility was abolished in 1994, new refinance credit is still provided directly to Agroprombank, although the credit is subject to a cap; refinance credit to Prominvest Bank and the International Bank is being withdrawn (state-owned banks are not allowed to participate in the credit auction). Reserve requirements are 15 percent for all deposits except interbank deposits, which have a 5 percent required reserve ratio. Restrictions on banks’ deposit and lending rates have been abolished, as have most restrictions on deposit withdrawals and on the number of deposits an enterprise may have.

Progress in the area of monetary research and analysis has been more limited. While the Research Department has been established, it remains largely unstaffed. It has made only limited progress in establishing short-and medium-term forecasting systems. Short-term liquidity forecasting techniques are particularly in need of improvement. In addition, a strategic approach tying short- and medium-term objectives to long-term targets is yet to be developed.

Progress in financial market development has also been limited. While there is some activity in the interbank market, most banks use the national bank to place their excess reserves through the credit auction. Technical assistance has been provided on developing a treasury bill market, but treasury bill auctions have yet to begin.

The exchange rate of the manat is freely determined and unified. Most exchange restrictions have also been eliminated, and the authorities have stated their intention to accept the obligations of Article VIII or the IMF’s Articles of Agreement. Foreign exchange trading takes place at the BICEX auctions, although enterprises are no longer required to surrender their foreign exchange holdings to the auction. Plans are also being made to hold daily auctions and to remove restrictions on foreign exchange trading outside the BICEX.

All official foreign exchange reserves were transferred to the national bank in March 1995. At that time, a simple reserve management structure was recommended, which would focus on safety and liquidity rather than yield. This required that official reserves be shifted from local banks and foreign banks with low credit ratings to prime offshore banks and to official agencies, such as the Bank for International Settlements and the largest central banks. These measures are in the process of being implemented.

In the area of central bank accounting, a modified version of the old Gosbank chart of accounts is now in use at the national bank, and a new chart has been developed based on the recommendations of the IMF. The new chart is already being used internally at the national bank, and it will be formally introduced once comments have been received from the commercial banks.

Progress is being made in improving the legal framework for the financial sector. With the assistance of the IMF, new central bank and banking laws have been drafted, and they are now being debated in Parliament. The government also has announced plans to strengthen a number of other aspects of the legislative framework for the financial sector, including, inter alia, amending the Mortgage Law to improve the rules governing the use of movable property as collateral; amending the Bankruptcy Law to include enforcement provisions; adopting a new Land Code based on market principles; and introducing a new Civil Code that will harmonize and rationalize laws on contracts and private property rights.

Some progress has also been made in payments systems development. A system of regional settlement centers, with one national bank settlement account per bank per region, has been implemented, and transactions that would overdraw a bank’s settlement account are now rejected. In addition, a system of correspondent accounts at the national bank has been put into place. On the other hand, there are still frequent delays in clearing and plans have not been started for developing either a large-value transfer system or a securities transfer system.

Considerable progress has been made in the area of banking supervision. Most basic prudential standards have been established and both on-and off-site monitoring have been started. Licensing standards and capital requirements have also been tightened, including capital requirements for existing banks. The national bank also has considerable flexibility in its authority to exercise its supervisory powers, including exit policy. In addition, important shortcomings in the regulations governing loan classification, provisioning, and suspension of interest on overdue loans are now being addressed. While commercial bank accounting is not yet based on International Accounting Standards (IAS), agreement has been reached to implement IAS-based rules by January 1997.

Plans are being developed for a comprehensive program to restructure the banking sector, and aspects of that work have already been started. The focus of the program is twofold. First, efforts will be made to establish the necessary conditions for the development of an efficient and stable private banking system. This will include tightening capital requirements and prudential regulations, and merging or closing any banks that are unable to meet the more stringent requirements. (The effort is being supported by a tightening of regulations covering bank licensing, the introduction of IAS-based accounting standards, and improvements in—and the enforcement of—banking and financial sector legislation.)

Second, plans are being put in place for a major restructuring of the four state-owned banks, all of which are facing varying degrees of financial difficulties. However, given the low level of development of the private banking sector, the liquidation of all four banks is not seen as a feasible option at the present time, since they still provide important payments services, while the Savings Bank remains the main depository for household savings. Accordingly, the restructuring plan for the state-owned banks envisages (1) limiting their lending operations; (2) consolidating their payments activities; and, (3) eventually privatizing or liquidating all four banks.

The restructuring effort is already under way. The Savings Bank has been placed under new management and a stronger supervisory board has been installed. In addition, its lending operations have been sharply curtailed, and the Ministry of Finance has provided a liquidity support loan to allow depositors to withdraw their funds should they so desire. Deposit rates are also to be adjusted based on the bank’s income possibilities. Depending on its financial condition in mid-1997, either the bank is to be liquidated or a privatization plan is to be developed.

Agroprombank must now focus on its core agricultural operations, with its lending activities limited to self-liquidating, collateralized crop loans, collateralized working capital loans to agro-processing and agricultural firms, and investments in central bank and government securities. Its access to national bank refinance credit has also been capped, and it has been told to intensify its loan-recovery operations. If its financial situation improves within 12 months, attempts will be made to privatize the bank, otherwise it will be liquidated.

The financial condition of Prominvest Bank is very weak, and it no longer plays a significant role in the industrial sector. Furthermore, prospect for large-scale loan recoveries is not good, given the weak state of the enterprises to which it has made loans. Prominvest has been told to cease all deposit taking and lending operations, and it has been cut off from new national bank refinance credit. In addition, a new oversight committee has been established, a controller has been appointed, and the World Bank is undertaking a diagnostic study of the bank. Furthermore, any recovered funds must be invested in central bank and government securities, and plans are being developed to sell off its performing loans. An attempt will be made to sell the bank for a limited period—perhaps one year—before its license is withdrawn and the liquidation process is started. However, liquidation currently seems to be the most likely outcome.

All national bank deposits are to be withdrawn from the International Bank by the end of 1996, and its activities are to be restricted to fully collateralized lending and investment in government and central bank securities. Efforts to improve loan recovery are also already under way, and the bank is being audited. The International Bank has until mid-1997 to prove its viability, at which time either it will be liquidated or privatization plans will be developed.

Belarus: Reform and Future Perspectives

The Republic of Belarus has a two-tiered banking system that conforms with organizational standards adopted in developed countries.

The National Bank

The National Bank of the Republic of Belarus (NBB) determines the direction of monetary policy and regulates and supervises banks’ activities. Objective assessment of trends and processes in the monetary sphere directly and in the country’s economy as a whole is of decisive importance in elaborating a successful strategy for monetary policy, its mechanisms, and realization.

During 1995, the economy developed under conditions of contradictory tendencies. On the one hand, many preconditions for macroeconomic stabilization were formed: (1) enterprises continued to adjust to market conditions; (2) the rate of economic decline slowed down and in some industries business activity increased; (3) the rate of inflation slowed down; (4) the state budget deficit declined and was increasingly covered from noninflationary sources; and (5) the trade balance with the Western countries improved.

In addition, several positive tendencies emerged in the monetary sphere: the confidence in the national currency rose; and the share of rubel savings of the population increased. These developments in the monetary sphere were achieved by means of administrative and economic methods in regulating monetary relations. Among them the most important are the following.

  • The rate of growth of the rubel emission of the national bank slowed down in 1995. In 1995, the rubel money supply increased by 3.9 times and the net domestic assets of the national bank in rubels by 2.7 times. The debt of commercial banks on centralized credits declined by 19 percent during the year. The economy was financed mainly by repayments of credits extended earlier.

  • A consistent policy aimed at raising reserve requirements to commercial banks’ deposits was pursued. They were increased from 5.5 percent at the beginning of 1995 to 12 percent at the end. Interest rates on deposits and credits approached gradually the rate of inflation and finally became positive in real terms. The national bank established the minimum deposit rates on deposits attracted by commercial banks, thereby helping to stabilize monetary conditions.

  • In 1995, the national bank tried to reach a balance between demand and supply by granting increasing amounts of credits through the market mechanism. Their share amounted to 73 percent of the total volume of centralized credits in the fourth quarter of 1995.

  • The securities market expanded. It was increasingly used to regulate the liquidity of the banking system and the noninflationary financing of the state budget deficit.

On the other hand, the following factors have had a negative impact on the development of the monetary sphere: (1) the rate of growth of the money supply has remained high and still has a significant influence on the growth of the price level; (2) the rate of term deposits of the monetary resources of the population has declined; (3) it has been difficult to maintain a stable exchange rate for the Belarussian rubel under conditions of high inflation and increasing current account deficit; (4) the gold and hard currency reserves of the country have declined since August 1995; and (5) monetary policy relies increasingly on administrative measures such as credit ceilings and lines, norms of required reserves and restriction of operations on interbank market.

Taking into account the present economic situation, the national bank has defined the main directions of monetary policy for 1996: to strengthen the positive tendencies and processes in the monetary sphere and lower the influence of the negative factors.

The strategic target is to limit the increase of the consumer price index to not more than 2.5 percent a month. The reduction of the inflation rate is expected to be achieved by maintaining the money supply within reasonable limits and positive real interest rates, and conducting flexible exchange rate policy, taking into consideration overall economic conditions.

In order to achieve the inflation target mentioned above, money supply will not be allowed to increase by more than 34 percent and will reach Rbl 23.5 trillion at the end of the year.

The balance of trade and the overall balance of payments are expected to register deficits in 1996. The national bank will therefore be compelled to sell foreign currency. Under such conditions, the growth of the money supply is expected to result from the extension of credit.

To prevent the reduction of commercial banks’ refinancing and to increase it to a certain extent within the proposed credit expansion, it is necessary to cut the national bank’s financing of the budget deficit and to direct these resources to other sectors of the economy. A significant role is assigned to reforming the credit procedure. The use of government securities (obligations of the Ministry of Finance and the national bank) and liquid nongovernment securities (shares, bonds, commodity bills) as collateral for the envisaged expansion of the national bank credit to the commercial banks will increase the reliability of the credits, strengthen the guarantee of their return, and support them as effective instruments of the regulation of money liquidity.

A change of mechanism and conditions for setting the refinancing rates will also serve these purposes. The basic rate will be set on the basis of the interest rate established in the interbank credit market. Differentiated refinancing rates are planned to be established according to the degree of liquidity of the collateral.

To ensure more effective use of credit resources, measures directed toward enlarging the responsibility of the banks and economic agents are envisaged. Credits will be granted to effective programs to increase lost own-capital and to improve profitability.

In 1996, it is planned to give credits to the government and to other sectors of the economy at the refinancing rate. At the same time, the national bank as an agent of the government will deepen the market for government’s securities, thus facilitating increased noninflationary financial resources to the state budget deficit.

In the foreign exchange sector, it is planned to combine market approaches with state regulation. This will be executed under conditions of the balance of payment deficit and an insufficient external financing to cover it. In our estimation, some devaluation of the exchange rate of the national currency (not more than 2 percent a month) is reasonable and possible. We also should account for further reduction of the currency reserves of the country.

The main market tools for regulating the foreign exchange market will be the following:

  • currency interventions by the national bank;

  • regulating the official exchange rate of the Belarussian rubel to correspond with trading on the interbank currency exchange and interbank exchange market; and

  • developing the interbank exchange market to speed up foreign currency settlements and to use currency resources wisely.

To regulate unexpected processes on the foreign exchange market, the following steps are planned:

  • concentrate hard currency reserves of the country in the national bank (they are still partly concentrated within the Ministry of Finance);

  • speed up decision making concerning the use of external sources of foreign exchange; and

  • develop and introduce mechanisms to strengthen state control over foreign exchange inflows and ensure control over import payments to prevent hiding foreign currency abroad.

For interbank settlements, continue efforts to complete the modernization of the payments system so that it will comply with international standards and to achieve settlements on large and urgent payments in a real-time mode (real-time gross settlement system). Creating and enforcing rules on payment obligations remain an acute problem, as well as legalizing electronic payments.

Following the need to solve the main problems of monetary policy mentioned above, the government is now improving the organizational structure of the national bank and the technical aspects of banking transactions to bring them in line with international standards. The National Bank of Belarus has carried out recently the following transformations, based upon the recommendations of the IMF.

Organizational Structure

In 1995, the organizational structure of the national bank was changed with the aim of performing the functions of the bank more effectively by improving coordination between individual services and avoiding duplication in their activities. Brief descriptions of the main duties of the national bank’s divisions clarified the tasks of every structural unit management and each division’s own internal control system.

Accounting

With substantial assistance from experts from the World Bank and Central and Western Europe, who worked under the guidance of the IMF, a new chart of accounts was introduced in early 1996 for the national and commercial banks in accordance with international standards.

Internal Audit

The Internal Audit Department (IAD) established in 1994 made considerable progress in adjusting its level of work to international standards: with the participation of experts from the U.S. Federal Reserve System, auditing regulations and standards were worked out and are being followed. The organizational structure of the department was also developed.

To strengthen the independence of the IAD, the IMF recommended setting up an Audit Committee, which would have a similar structure as those of Western banks. To develop the internal control system, it was recommended that a Temporary Committee be established comprising representatives of the main directorates and heads of branches, as well as an Internal Audit Department specialist. The national bank is considering these proposals and preparing measures to implement them.

The Banking System

The second level of the banking system consists of the commercial banks (state-owned, mixed, and private) that provide credit, settlements, and other banking services to the domestic sector and are independent in their activities and in establishing interest rates. It is likely that activating an investment process in the country will require establishing a specialized bank, working on a nonprofit basis. It would concentrate on investing in projects connected with new technologies.

Too-low interest rates give rise to the possibility of capital outflows. That is why during 1996 the refinancing rate must exceed by one to two points the refinancing rate in neighboring countries. Such an increase would attract additional resources into the country and reduce pressure on the foreign exchange market.

The national bank considers it necessary to take measures directed toward the financial rehabilitation of the banking system—in particular, to restructure the debt of state enterprises to banks into long-term financial obligations with the right to sell or pledge them, to create in the banks a loan-loss reserve for the provisioning of problem loans, and to create an information system on large credits and unreliable clients.

To develop the banking system, the amount of foreign capital in the authorized funds of banks will be regulated in two ways: (1) by limiting the number of foreign banks with 100 percent of foreign capital, and (2) by limiting the number of banks with Belarussian and foreign capital (joint banks).

Recently, as a result of the national bank’s efforts, the growth in the number of banks has ceased and their number is beginning to decline. As of January 1, 1996, 18 commercial banks had formed the required authorized capital in the amount of E C U 2 million. The fulfillment of this requirement by a further 12–15 banks is expected during the first quarter of 1996; 8–10 banks will not be able to raise their initial capital according to the requirement; therefore, a number of them are merging. Some banks will be given a status of credit organization with a limited number of operations on the financial market.

During 1995, the own-capital of banks in the national currency almost tripled. Inflation during this period amounted to 250 percent, so that own capital stayed roughly unchanged in real terms. The assets of the banking system increased during the previous year two- to fivefold and the ratio of own-capital to assets, which is also an indicator of sufficiency, increased by 11.5 percent. Nonetheless, a number of problems remain.

Increased state influence on the credit policy of the commercial banks could help direct, their money resources to support the most important state programs. In the first stage it is necessary to determine which banks can help finance state programs. In the second stage, it is necessary to develop special agreements between the government and specific banks in which will be stipulated the obligations of a bank credit support to and settlement service of a concrete industry. Preference will be given to establishing banks with joint capital and foreign investor contribution of not less than ECU 1–2 million.

In banking supervision, special importance will be given to developing an early warning system. Such a system will help determine potential bankruptcies on early stage, thereby allowing time to take measures to prevent or ease the liquidation of banks.

To regulate the banks in the area of solvency, liquidity, and large risks, all are required to calculate the liquidity ratio (K2) on the first of each month. The ratio is a synthetic parameter of the bank’s liquidity that takes into account the state of the bank’s assets in accordance with a degree of liquidity, the liabilities according to the risk of the simultaneous removal, and the correlation of the assets and the liabilities according to the schedule of repayment.

A table is used to calculate the liquidity ratio by the following periods: “demand,” “up to three months,” “from 3–12 months,” “more than a year.” According to the degree of the liquidity, the following percentage weights of liquidity are used: zero percent, 20 percent, 50 percent, 80 percent, and 100 percent. To evaluate liabilities according to the risk of their simultaneous removal, the following weights are used: zero percent, 20 percent, 60 percent, and 100 percent.

The table permits evaluation of a bank’s liquidity on each of the selected periods as well as a unified synthetic evaluation. Taking into account the changes in the general economic situation in the republic and the peculiarities of the dynamics of the bank’s liquidity, the national bank amends the procedure for its calculation.

The early warning system for “problem situations occurrence” was created with the assistance of experts from the Federal Reserve System of the United States. The short-term liquidity (up to six months) is one of the four factors that are taken into account for obtaining a true evaluation of the bank’s solvency. Supervisory measures are applied to the national bank if it does not comply with the norm of liquidity ratio or if a general negative tendency in the bank’s liquidity is revealed.

In conclusion, it should be noted that the success and positive results of the projected monetary policy will be stronger in a more dynamic economy free of its current problems. To this end, the following are of primary importance:

  • create a stable economic base for restraining inflation and stabilize of the exchange rate of the Belarussian rubel on the basis of increasing labor productivity and reducing production costs, thereby minimizing the balance of payments deficit;

  • reduce the general tax pressure and lower the ceilings on tax duties;

  • establish a mechanism for preserving and enlarging an economic agent’s own working capital, develop and realize for each state enterprise a program for financial recovery, reduce the number of non-payments, and address the situation of bankrupt enterprises through reorganization, liquidation, and sale;

  • establish conditions for developing small and medium-sized businesses, especially in services and production of consumer goods; and

  • form a legislative, normative, and administrative base that takes into account the interests of all individuals in the country.

Georgia: Reforms in 1994–95

Establishing a state authority in independent Georgia proved to be a difficult process. Among the obstacles were the breakdown of old economic ties, the war in Abkhazia, the civil conflicts, paralyzed law enforcement institutions in the large territories of the country, as well as the inability of the government to design and implement consistent economic policies. During 1991–94, the total volume of production decreased by 70 percent, contributing to a dramatic decline in budget revenues.

In the circumstances, the government was forced to finance the budget deficit mainly with credits from the banking system and foreign borrowing. In addition, during 1992–93, the National Bank of Georgia conducted expansionary monetary policies that resulted in a huge increase in the money supply and hyperinflation.

In the beginning of 1994, the financial imbalance in the system reached an extraordinary magnitude: the monthly inflation rate was over 70 percent, the exchange rate depreciated dramatically, and in September 1994, the U.S. dollar equaled 5 million coupons. In the second half of 1994, the government of Georgia together with the IMF and the World Bank designed a comprehensive financial stabilization and structural reform program. The national bank played a major role in the implementation of the stabilization program, complying with all the monetary objectives.

At the same time, to encourage repayment of loans extended by state commercial banks on the basis of permission previously granted by the national bank, the complete identification of such loans was initiated by the commerical banks; proper accounting entries were made on the balance sheets of all the involved banks. As a result, state commercial banks became more active in recovering such loans. Preparatory work was conducted to change the existing lax payment regime, which allowed for the processing of transactions even when there were not enough credit balances on the correspondent accounts of the banks.

Since October 1994, the payment process has been organized through correspondent accounts within the limits of actual credit balances. As a result, an automatic overdraft facility was closed and the so-called air-money creation was abandoned.

Additional important steps were taken to control the money supply; in particular, government accounts were consolidated in the national bank. In other words, under the new regime all government revenue is accumulated in the special Ministry of Finance account with the national bank. The previous expenditure financing was abandoned as well. In the old regime, the ministry would open “credits” for individual expenditure units without actually transferring money; besides, the above process was not linked to the actual amount of revenue. As a result, bank liquidity was adversely affected while money supply grew unjustifiably.

In the same period, the national bank was granted the sole responsibility to manage the country’s official international reserves. The source of such reserves was the 32 percent compulsory surrender requirement of foreign exchange proceeds of entrepreneurs. Previously, these reserves were managed by the ministry. The transfer of the foreign exchange reserves provided the national bank with an effective instrument to regulate the money supply.

The 1994 monetary policy of the national bank, together with the reforms in other sectors, has established a strong foundation for financial stabilization in the country, which was strongly supported by the IMF through a Systemic Transformation Facility. As a result, at the end of 1994 the coupon/dollar exchange appreciated sharply and reached the level of 1.3 million coupons per $1.

Reforms initiated by the national bank in 1994 were successfully continued in 1995. The main objectives for 1995 were the further strengthening of monetary as well as foreign exchange regulatory capacity, rehabilitation of the banking system, and strengthening of the liquidity position. The primary objective was to conduct anti-inflationary policies and to achieve exchange rate stability. Anti-inflationary monetary policy focused on the control of expansion in monetary aggregates.

To reduce the rate of money expansion corresponding targets were set for net domestic assets and net foreign assets. Implemented monetary policy had a favorable impact on the asset structure of the national bank, which in turn ensured compliance with the quantitative targets.

For instance, on January 1, 1996 actual net foreign assets exceeded the targeted level by lari 57 million and was equal to lari 91.2 million. In terms of 1995 foreign trade, it is equal to 7.8 months of imports. This is far above the internationally recognized target of three months of imports. At the same time, the net domestic assets were below the targeted level by lari 45.5 million and equaled lari 63 million on January 1, 1996. Since the national bank was able to restrict the borrowing both from the government as well as from the banks, the progressive growth of money supply was stopped. This led to a decrease in the intensity of inflationary trends. Despite the fact that actual reserve money exceeded the program target by lari 11.6 million on January 1, 1996, the average monthly inflation rate in 1995 was only 4.1 percent, which is 17.4 percent less than the average monthly inflation rate for 1994.

The increase in reserve money during 1995 had little inflationary impact as it represented the reversing of currency substitution. In particular, people exchanged $37.9 million and 70.6 billion Russian rubles during the first week of the introduction of the new national currency—lari—which became the sole legal tender in Georgia on October 21, 1995. Reversing the currency substitution allowed the national bank to gain real control over the money supply and its components and to make adequate analyses.

For instance, after the introduction of the new national currency, about 70 percent of reserve money came from currency in circulation, which demonstrates once again that individuals and legal entities still lack confidence in the banking system; of course, other factors also contribute to the existing situation.

The national bank, taking into account the fact that the economic recovery needed an efficiently functioning financial resources market, established a new financial institution, the Interbank Credit Auction, which is designed to help banks manage their liquidity; the mechanism encourages the establishment of market interest rates on bank funds.

During 1995, the total volume of trading on the auction equaled lari 2.4 million. The interest rate set on the auction showed a declining tendency; for the first auction the rate equaled 61 percent a year; for the last auction in 1995, it was equal to 33 percent a year. During the year, supply and demand forces have gone through significant cycles in their behavior, which in turn was reflected in the interest rate fluctuations.

Despite the small number of banks participating in the auction as well as small volumes of the auction trading, the interbank credit auction is a serious step toward establishing a financial market and, in line with the recovery of the economy, is expected to become more active. Our optimism stems from the fact that during October–December 1995, the total volume of trading on the auction equaled lari 1.4 million, which is 57 percent of total trading within the year.

The exchange rate policy of the national bank was implemented in the context of overall monetary regulation. The policy aimed to achieve the following objectives:

  • Actively using the exchange rate set for the national currency as an efficient instrument against inflationary expectations.

  • Balancing short-term, sharp fluctuations in the supply and demand for foreign exchange with the aim of avoiding losses among participants, preserving confidence in the market, and eliminating speculation.

  • Accumulating foreign exchange reserves and their management to ensure high level of liquidity and monitoring the developments on the foreign exchange market through national bank interventions.

Efforts of the national bank were successful. They led to the normalization of the internal foreign exchange market. During the year, total volume of foreign exchange sales on Tbilisi Interbank Currency Exchange totaled lari 68.7 million, from which lari 54.5 million (79 percent of the total) was sold by the national bank. The national bank also managed to preserve exchange rate stability.

The basis of the success was the international reserve position of the national bank. In cooperation with the IMF experts, an International Reserve Management Program was developed in line with strategic objectives. In 1995, a Foreign Exchange Reserves Management Committee was set up at the national bank to implement the state policy in this area. Based on the decisions of the committee, official, international reserves are invested internationally in first-class bank deposits.

Stability of the foreign exchange market and accumulation of reserves at the same time allowed the national bank to take an important step toward economic liberalization and promotion of entrepreneurship. In particular, since the beginning of 1996 the compulsory surrender requirement of foreign exchange proceeds was eliminated. As a result, both banks and entrepreneurs have been left with extra resources to expand their operations. The above measure will favorably affect exports, the balance of payments and will lay a strong foundation for economic recovery.

Macroeconomic stabilization depends heavily on the smooth and efficient functioning of the banking system. The national bank, improving its supervisory capacity, aims for the restructuring of the banking system, institutional rehabilitation of individual entities, improvement of their liquidity positions, and sound management practices.

Taking into account actual developments in the banking system and promoting interests of depositors and the soundness of the banking system in line with the recommendation of international financial institutions, the national bank introduced in 1994 prudential ratios and various economic coefficients to control commercial banking activities. In 1995, the above-mentioned ratios were further revised.

In 1995, the national bank took serious steps to encourage commercial banks to develop strong internal audit and supervision capacity. The national bank was motivated by the results of individual inspections, which revealed banking mispractices. The aim was to improve the banks’ control over their accounting practices. It would allow them to identify violations on a timely basis and take necessary corrective measures.

On January 1, 1996, nonperforming loans accounted for lari 41.9 million, 15 percent of the total assets. To deal with the problem, the 1996 budget law allowed for the establishment of reserves against such loans according to national bank directives. Total reserves set aside by banks for restructuring of bad assets during the previous periods were insignificant.

Of 229 banks registered in Georgia at the beginning of 1995, 126 failed to comply with existing legislation. Banking licenses have been revoked for all those banks because they represented a serious threat to the interests of their depositors as well as to the public’s confidence in the system. In addition, 36 branches have lost their licenses.

To promote safe and sound practices in the banking system, the national bank, in November 1995, informed banks that it would proceed with the bank certification process. The certification process focuses on the extensive review of business plans and reports submitted by commercial banks. Bank inspection, as well as other supplementary material, is also taken into account during the certification process.

The national bank approach to the certification of banks is quite careful. Wherever it comes across a case where a bank fails to comply with the requirements, the problem is discussed jointly including the type of sanction to be applied. If a bank fails to comply with the requirements and in addition is considered insolvent, the national bank unconditionally revokes the license. The above measures cannot be considered as negative, since the safety of the banking system depends not on the number of banks in the system but on the efficiency of their intermediation.

From the above, one can conclude that only those banks in which the public has confidence and are oriented to satisfy the needs of the national economy will remain. The national bank took measures to improve the existing payments system; in particular, a new e-mail system was established. In 1995, improvements in the payments system allowed single transaction processing time to be reduced twentyfold. In the banks, large branch network regional clearing centers were established with the assistance of the national bank. As a result, headquarters of banks gained the opportunity to actively manage their branch operations.

In line with the recommendations and technical assistance provided by the IMF, the World Bank, and the European Union, the national bank continues its efforts to further improve the payments system. This should allow for the real-time interbank transaction processing through the electronic data transfer based on new telecommunications systems. In other words, an internal transaction will be processed in a maximum of two days. Today, the possibility of noncash transactions among legal entities is becoming a reality. This, in turn, will reduce the volume of cash-based transactions outside the banking system and have a favorable impact on price stability. At the initiative of the national bank, Georgia became a member of the following international banking communications systems: SWIFT and Reuters.

Since the second half of 1995, a World Bank-sponsored and internationally recognized auditing firm, Deloitte & Touche, together with the national bank staff, has been working on establishing a new plan of accounts compatible with the market-oriented banking system. Most of the work has already been completed. Now, the development of an adequate software is being undertaken.

The national bank has set up a new commercial bank reporting system that allows us for the first time to publish banking statistics bulletins. Special reports on export-import operations and foreign borrowing are being prepared for the compilation of balance of payments.

The consecutive implementation of the stabilization process laid the foundation for the successful negotiations of an Enhanced Structural Adjustment Facility (ESAF) (the IMF’s Board of Directors approved the ESAF program for Georgia on February 28, 1996). The program replaced the previously negotiated Stand-By Arrangement with IMF.

The above measures laid a foundation for the successful introduction of a national currency—lari—a monetary unit fulfilling all the functions of the economic category.

A smooth functioning banking system depends on the adequacy of the legal framework. During the given period, the national bank issued numerous directives, normatives, and project laws for discussion in Parliament. The most important events were the adoption of the national bank and Commercial Bank Laws by the Parliament in June 1995 and February 1996, respectively.

The achievements for the period demonstrate the successful implementation of monetary and exchange rate policies. Bank supervision, currency regulation and control, and the payments system are the areas of great success. The national bank will direct all of its efforts in 1996 to achieve a targeted 2 percent a month inflation level. Monetary policy will remain tight. A decrease in the inflation rate will have a favorable impact on the investment climate in the country through the increased long-term deposit base as well as additional long-term foreign capital investments.

As a result, we expect good employment opportunities, increase in nominal and real disposable income, lower interest rates on loans, and positive rates on deposits. In addition, much attention will be given to the final rehabilitation of the banking system, which will be able to satisfy the credit needs of the economy through increased efficiency in deposit resource and investment allocation. A new plan of accounts compatible with internal standards will be implemented. It will eliminate the drawbacks of the old system and will make the accounting practices clear and flexible. The foundation is laid for the establishment of government securities and national bank paper market, which will be an additional instrument for the liquidity management.

Kazakstan: Activities and Initiatives

The banking system in Kazakstan has undergone a complex and rapid evolution in recent years; it began to evolve in 1988 as the former central planning system began to disintegrate. Subsequently, the number of banks began to expand rapidly as enterprises and cooperatives were given the right to establish their own banks. By the end of 1991, the number of banks had increased to 72. In 1992, a change in banking regulation permitted specialized banks to engage in lending to all sectors of the economy. Newly established banks were also permitted to accept deposits and provide loans to state enterprises. Four of the specialized banks were reestablished as joint stock banks, with state-owned enterprises as their primary shareholders.

Specific characteristics of the Kazak banking system are that deposit-taking banks are not permitted to engage in investment activities (i.e., to hold shares and bonds of nonbanking institutions) nor are foreign banks permitted to have branches in Kazakstan—only subsidiaries are allowed. At the same time access for foreign banks to the banking system is fairly easy provided that they are willing to commit enough capital and fulfill all the regulations.

In the years 1992–94, the banking system in Kazakstan experienced the rapid growth in a number of banking institutions that was typical of the former Soviet bloc countries. The absence of realistic supervisory powers and the low level of federal banking experience of both the commercial banks and the regulators caused a weakness in the core of the industry that remains a problem today. The legislation and regulatory framework governing the operations of banks remained very weak until only recently.

The lack of substantive qualitative criteria for the establishment of a bank resulted in an explosion in the number of banks, as well as the volume of banking activities. Much of the focus of improvement in the national bank’s adjustment in 1994 was in bank licensing. Lack of control over the banking sector and practices allowed the problems and pitfalls of the banking business to escalate to a point where a large number of problem banks arose. At that time, the national bank as supervisor of the banks did not have the institutional capacity to properly carry out the responsibilities for the licensing of banks. In recognition of this, new review procedures were adopted in 1995 to rationalize the licensing process, which, while designed to improve the decision-making process, effectively ceased the granting of new licenses.

The number of banks peaked at approximately 220 in 1993. As part of the national bank’s efforts to restructure the industry, we are continuing with an aggressive posture toward reducing the number of weaker banks. This is being effected through the rapid liquidation of insolvent institutions. As of the end of 1993, there were 203 banks; in that same year the national bank closed 21. At the end of 1994, there were 183 banks, with another 33 closed in the same year. For 1995, the total number of banks was reduced to only 131, after the national bank liquidated 55 throughout the year. Several mergers have also taken place over the past three to four years, and we expect continued consolidation in the industry. There are presently 118 licensed banking institutions in Kazakstan.

Early restructuring efforts focused on the problems associated with the specialized state banks. These banks were large relative to the overall industry but were, and are, beset by problems common to the banks in the newly independent states: poor or inexperienced management, or both, low liquidity; and large, problem loan portfolios. Efforts are primarily designed to break away the problem assets of these banks and house them in various forms of development banks. For instance, the former foreign trade bank (Alembank) has been split into two large institutions, with the state-owned development bank (Eximbank) assuming the problem assets and liabilities of many of the state debtors. Other efforts have focused on the problems of the agricultural bank among others.

The increase in bank resolutions is in anticipation of a larger-scale effort to enhance the competitiveness of domestic banks through the systematic adoption of international banking practices. The national bank has designed and is set to implement a program that sets forth a framework under which banks are scheduled to achieve specific improvement targets in various aspects of their business operations. The program provides incentives for banks to adopt “best banking practices,” including accounting reforms, compliance with regulatory standards, internal governance, and overall financial management practices explained in a forthcoming policy statement. All banks will be required to develop their own improvement plans, which will be subject to review and approval by the national bank’s Director of Supervision. The program differs from, for example, the Russian program, called “International Standards Banks,” in that it does not provide for the national bank to certify to the public the condition or soundness of the individual banks taking part in the program. Rather, our goal is to provide incentives for banks to implement their own institutional development program. These incentives are structured around a set of objectives that, if met, will enable the banks to apply for a license to engage in a number of activities. These include owning investment banks, engaging in government-guaranteed foreign credits, and other significant practices.

In an effort to improve the industry, the national bank, along with the government of Kazakstan and in cooperation with various development agencies, has or will undertake a number of efforts designed to restructure the banking industry. This long-term bank improvement program described above is to be supported by the improvements that will be brought about by the operation of several of these other restructuring initiatives. There are also various programs either being implemented or planned for the future that are aimed at reducing the bad debt load that is hampering the development of the banking industry. The Rehabilitation Bank project will refinance and restructure the operations of the country’s largest state companies. Other potential restructuring efforts include bank twinning of seven or eight Kazak banks with their Western partners, and donor agency-supported technical assistance.

Banking Supervision

To support the improvement of the banking industry practices, the national bank is creating new policies and procedures implementing both on- and off-site prudential bank supervision practices that are consistent with or based on international standards. The reforms are undertaken with the goal of moving from a system of supervision based upon determining compliance with supervisory or other normatives to one that focuses on the financial strength or safety and soundness of the institutions. This fundamental change is revolutionary and will result in a much more effective supervisory process. The national bank is providing the infrastructure and training necessary for personnel within the bank to perform the supervisory function according to the new standards.

The modernization of the national bank’s Bank Supervision Department is currently in process as the entire organization is being restructured to enhance the use and effectiveness of the new supervision practices. The reforms cover virtually all areas of commercial banking and supervision, including licensing practices, the adoption of new supervisory policies and procedures, resolution of problems within banks and the banking system, bank restructuring and recapitalization, and bank liquidation. The national bank is also providing the training necessary to implement the new practices in an effective manner. The steps involved are in process and in various stages of completion. The overall plan is outlined below.

To change the strategy for banking supervision it is necessary to rethink the way the work is gathered, processed, evaluated, and acted upon within the Bank Supervision Department. Doing so will achieve the desired level of supervisory capacity, skill, and effectiveness. In January 1996, the national bank underwent restructuring aimed at achieving more solid results from its efforts. The general goal for the reorganization was to gather and evaluate supervisory information in such away as to focus activities where most attention is needed and to provide policymakers with the best tools for making decisions. This would be accomplished by refocusing the work flow toward providing a set of individuals with all the information available and necessary to evaluate and monitor their group or collection of banks. By vesting the responsibility for monitoring specific banks’ activities in one individual, called a Supervision Chief (head of a division), with adequate support from assistants and analysts, we expect to achieve much stronger oversight of individual banks and an enhanced ability to predict systemic problems.

The Supervision Chief is provided all supervisory data developed by the various subgroups under his or her purview and therefore will have a strong overall view of the operations of the banks in their caseload. We basically divided the banks into groups to be supervised full-time by a Supervision Chief. The five groups, one of which comprises nonbanks, contain their own groups of off-site analysts and on-site inspectors, as well as licensing and data management specialists. We divided the different support functions and departments into the same work groups so that the overall team could work together more effectively. The on-site examination reports will provide a means of determining the financial condition of the bank, and the off-site reports will provide interim monitoring between examinations. The structure will allow the Supervision Chief to specialize in the operations and risks of the small group of banks and will provide a better level of bank oversight.

Part of the restructuring included closing the regional offices of the department to increase the staff where it is most needed, in the main office in Almaty. When the finalization of the restructuring was achieved, we had reduced staff countrywide by 157, keeping 112. This also allowed us to realign the compensation structure for the remaining staff and attract some additional talented individuals.

We are currently in the middle of the development and implementation of the national bank’s general bank supervision approach outlined by the Board’s policies regarding the supervision and regulation of commercial banks under an off-site surveillance system coupled with on-site inspection. The group of policies cover the essential guidance to bank and national bank personnel on appropriate banking practices based on international standards and are the same as the principles of banking outlined in our bank improvement program. In addition, there are policies that cover other elements of banking and bank supervision operations, including licensing, on- and off-site inspection, financial performance, enforcement of prudential regulations, problem bank enforcement actions, and liquidation of problem banks.

Work in the licensing area is focused on the implementation of specific policies and procedures governing the application, review, evaluation, and decisions for granting new commercial bank licenses. This will be supported by and consistent with the adoption of new, comprehensive financial and regulatory reporting. The goal of all of the reforms is to bring our system of supervision into line with international practices by implementing an integrated supervision system. For instance, our comprehensive reporting reforms will be used to perform substantive off-site surveillance, as well as provide necessary information for licensing applications and bank liquidation packages. In addition, the national bank is spearheading the adoption of an accrual accounting system consistent with international standards and the domestic business environment. Both the accounting and financial reporting movements are being coordinated to provide banks a framework in which to internally develop the capacity to modernize and improve their own performance and practices.

Internally, the national bank is providing for the computerization of the new financial performance and other information into a supervisory database to facilitate timely and effective identification of potential or emerging problems within individual banks, as well as the system as a whole. The new capability will be supported by regular departmental management reporting on the monthly and quarterly status of individual banks. This will enable the staff to focus efforts where needed and use efficiently the comprehensive new inspection procedures and standardized reporting as a basis for corrective action. In addition, it is expected that the development of a database of statistical information on banks will expand the ability of subsections of the Bank Supervision Department and other departments within the national bank to perform their functions more efficiently and thoroughly. The other departments include Accounting, Statistics and Analysis, and Bank Liquidation.

The national bank is implementing a new, comprehensive career development program designed around a structured, sequenced training program to provide the staffing expertise necessary to perform the new, more complex practices. The program adopted includes formal classroom training, on-the-job training, periodic performance measurement and evaluation, and a certification testing program. This career development path is really built around the restructure of the departmental functions described above. The program is to include written job descriptions and specific performance appraisal criteria. The objective is to bring our own institutional capacity up to the standards we have set for ourselves. The overall development of our supervisory efforts is fully dependent on our ability to support and transform our staff and organization into a more efficient unit. (The training of national bank employees is under way, and the certification of the first group of employees will be in approximately 1.5 to 2 years.)

As detailed above, the national bank has been active in the resolution of weaker banks. This was made more effective through the institution of new bank liquidation policies and procedures. It was the national bank’s desire to make the function more seamless, efficient, and effective. This was achieved by introducing new liquidation regulations and specific procedures designed to facilitate the banks’ resolution.

To continue to improve the effectiveness of current central and commercial banking laws, regulations, and directives of the national bank, we are constantly reviewing and documenting the areas of weakness in the legal framework. This process of constant review and documentation will enable us to provide a more comprehensive and effective regulatory function as we move ahead. The regulatory framework is one of the keys to developing the banking sector, and our ability to effect corrective action on behalf of the national bank and depositors is an important requirement. Some of the areas in which we have made major changes include bank licensing, liquidation, lending limits, and prudential regulations. Our latest revision to the prudential normatives included the adoption of a minimum capital adequacy regulation that is fully consistent with the spirit of the Basle Agreement. In the future, we plan to modify or implement regulations to support many of the changes referred to above, which will support our general goal to promote the development of a stable banking sector.

Kyrgyz Republic

In 1991, having acquired independence, the Kyrgyz Republic found itself in a difficult position, as did many other countries of the former Soviet Union. The collapse of the Soviet Union, which functioned as one organ, resulted in the destruction of the ties between business entities, thus permanently or completely paralyzing the operation of many enterprises. The top priority of the republic, therefore, was to find a way out of this critical situation to ensure continued progress of the government’s economic reforms. During the past years, there have been changes in the structure of ownership. The government has also abolished price controls on nearly all goods, has entirely liberalized external trade, and has taken necessary measures to create an appropriate legal framework that serves as a basis for the development of a market economy. One of the measures taken was the establishment of a two-tier banking system comprising the National Bank of the Kyrgyz Republic (central bank) and commercial banks. This was lawfully confirmed by the adoption of the Laws on the National Bank of the Kyrgyz Republic and on Banks and Banking Activities. On May 10, 1993, the national currency, the som, was introduced.

According to the legislation, the National Bank of the Kyrgyz Republic implements a monetary policy that ensures a low inflation rate and stabilization of the national currency. It also performs supervisory functions with respect to commercial banks’ activities with the aim of protecting the interests of depositors and creditors of the banks.

The main instruments of the monetary policy pursued by the national bank are credit auctions, treasury bill auctions, foreign exchange auctions, and the reserve requirement. The current required reserve ratio is 15 percent. Fluctuations in financial markets are adjusted by regulating the volume of treasury bill issues and foreign exchange. All the instruments mentioned are of the indirect-control type. Their function is to influence the performance of banks and nonbank institutions, mainly through market-based regulation mechanisms ensuring a more effective placement of financial resources.

The main purpose of the credit auctions is to indicate the actual market level of interest rates, as well as to provide for effective distribution of resources. In contrast, directed lending, as experience has shown, frequently leads to nonrepayment of loans.

An important aspect of the national bank’s activities, in cooperation with the Ministry of Finance, is further development of the government short-term treasury bill market, aimed at both noninflationary financing of the budget deficit and expansion of the monetary policy instruments through operations in the developing securities market.

The national bank has managed to smooth out the fluctuations of the som exchange rate by regularly conducting foreign exchange auctions and liberalization of the foreign exchange regulations.

The monetary policy pursued through 1994 and early 1995 resulted in a radical decrease in the rate of inflation. Thus, while in 1993 the rate of inflation was 1,365 percent, it decreased to 87 percent in 1994, and to 17 percent during the first four months of 1995. At the credit auctions conducted by the bank, the interest rate decreased from 190–150 percent in 1994 to 45–40 percent in the current year. The exchange rate between the som and the dollar has stabilized, and since August 1994 it has stayed, with insignificant fluctuations, at som 10–11 per U.S. dollar.

In April 1995, commitments were made under Article VIII of the Articles of Agreement of the International Monetary Fund, ensuring current account convertibility of the currency. Furthermore, there are no restrictions on capital account transactions.

Taking into account the indicators achieved, it can be noted that prerequisites are being put in place at the macroeconomic level for developing investing activities.

Review of the Existing Banking System

Eighteen commercial banks with 170 branches have been registered and are operating in the Kyrgyz Republic. Four large commercial banks were established on the basis of the former state banks; the rest of the banks were established with new capital, including foreign capital. The approved Law on Foreign Investments provides a favorable environment for foreign investment. If foreign capital makes up 51 percent or more of the share capital of a bank, such bank is exempted from profit tax for two years.

At the present time, two new banks are in the process of opening. Nearly all the head offices of banks are located in the capital of the country, the city of Bishkek. The commercial banks are owned mainly by non-state organizations and individuals. Thus, out of the total bank share capital som 200 million, there is only one bank, which is totally owned by the state, Kyrgyzelbank (former Savings Bank). In 2 banks, the state holds more than 50 percent of the stock; in 11 banks the share of the state ranges from 4 percent to 32 percent; and 4 banks are entirely privately owned. All the banks, with the exception of Kyrgyzelbank, have licenses to conduct foreign exchange operations. Many commercial banks have established correspondent relations with banks in 15 countries, including Japan, the United States, Germany, the United Kingdom, and France. All the banks, with the exception of Kyrgyzelbank, are universal. They have a legal right to make investments and render a wide range of banking services to individuals and corporations representing different economic sectors.

Most banks have branches in three large regions (oblasts) such as Chu, Osh and Jalal-Abad. In the remaining three regions, the density of bank offices is not high. The overwhelming majority of bank offices belong to the commercial banks, which were established on the basis of state banks. However, those banks that were established during the past several years have achieved certain success and are beginning to compete with the former state banks.

Problems of Commercial Banks and Their Causes

Certain problems became evident in the process of developing the country’s banking system. Thus, according to recent analyses, half of the banks are insolvent. Several factors explain the situation. The most significant one is the direct loans, mainly to the agricultural sector and processing industries, that the government channeled through the state banks in the past. The overall decline in output, as well as the privatization of large farms on conditions that allow new owners not to make commitments to pay off debts to banks, contributed to the accumulation of bad debts at such banks. Problems in the banking system today were also brought about by the very difficult economic situation in 1993 and 1994 and certain shortcomings in management of the banks. This particularly affected the former state banks, which previously implemented governmental programs of financing the economy and are still managed in line with the stereotypes of a centrally planned economy. The banks proved to be unprepared to operate under the conditions of high inflation and have never managed to appropriately adjust their interest rate policy to the subsequent decrease in the rate of inflation that took place in 1994. The high rates of inflation of 1992–93 produced an illusion of huge revenues and ever increasing profitability. The credit policy of the banks relied heavily on high lending rates as a result of high interest rates on deposits. At the same time, they did not take into account the fact that high interest rates on loans increased the risk of nonpayment. Accordingly, when the nonrepayment of loans became overwhelming, the banks suffered a sharp decrease in the interest income accompanied by an increase in the interest expenses. And that, in turn, led to the insolvency of certain banks.

The banking system is in need of skilled staff and management and requires considerable financing for training programs. Those banks that have managed to recruit competent employees, provide training for their staff, and develop advanced managerial methods have fewer problems and, in spite of their short existence, are able to compete with the former state banks and earn a profit.

The increasing credit risk and nonrepayment of the previously made direct loans caused liquidity problems for most banks. Liquidity management was poor. To support liquidity needs and create an impression of well-being, banks paid high interest to attract deposits. The main portion of these new deposits was used to pay interest on the previously received deposits. Costly deposits and nonrepayment of loans increased interest rates on loans, which only exacerbated the situation and caused an increase in losses. As of today, the banks posing systemic risk are mostly paralyzed or verging on collapse. Most banks have ceased to perform the main bank function, that is, to act as financial intermediaries. There is almost no lending to the economy. Radical measures are required to get the banking system out of this situation.

Measures to Strengthen the Banking Sector

Recognizing the necessity to regulate the activities of the banking sector, the national bank at the end of 1993 had established the Banking Supervision Department as part of the central bank. The staff of the Banking Supervision Department has been trained at various international organizations, and from 1994 has been actively developing instructions on bank-licensing activities, bank management, and capital adequacy assessment in compliance with the requirements of the Basle Committee for Banking Supervision. In October 1994, the national bank became a founding member of the Central Asian/Trans-Caucasus Banking Supervisors Group under the auspices of the Basle Committee on Banking Supervision.

To identify and mitigate the risks in the banking system, the national bank has taken a number of measures:

  • To improve the quality of bank management, regulatory documents have been issued regulating changes in bank control.

  • Recommendations were made with respect to the credit policies of banks requiring that they establish credit committees, maintain credit files, classify loans, and make provisions for loan losses according to classifications.

  • Recommendations were made on liquidity management, including the assessment and methods of liquidity management.

  • To improve the quality of bank management, changes were made to the bank’s licensing procedures, and requirements were set with respect to the professional suitability of managers of commercial banks.

  • To deal with problem banks, certain documents regulating their operating conditions were adopted. In addition, regulations on the introduction of direct bank supervision and temporary administration have also been implemented.

  • In accordance with international standards, a system of regulatory reporting has been developed and introduced. It includes, but is not limited to, balance sheet, the structure of capital, off-balance sheet statement, income statement, maturity distribution of assets and liabilities, classification of assets by risk, and calculation of loan-loss reserves, as well as a listing of loans to insiders and related persons.

  • Instructions detailing examination planning, conduct, control and report of examination format have been developed and implemented. Inspections are carried out through both external supervision and on-site visits.

The existing accounting system does not allow a quality analysis of a bank’s condition. For example, even if a bank is insolvent, current accounting practices may indicate a profit. The new regulatory documents, as well as reporting forms based on international standards, allow the problems of the banks to be quantified and appropriate measures to be taken. It must also be noted that the improved efficiency of supervisory personnel enabled a much deeper and timelier recognition of bank problems. Thus, in 1994 three banks were closed, and in 1995 licenses of two were suspended. These measures were taken because of the hopeless condition of these banks and the liquidation did not represent a systemic risk. Such actions were possible because the earlier adoption of the Law on Bankruptcy was subsequently supplemented by the Instructions on Aspects of Application of the Law on Bankruptcy to Banks.

Special attention is being paid to the licensing of banks and the exercise of supervisory functions over the activities of commercial banks. There are certain obligatory procedures and requirements that must be met to obtain a bank license. Such procedures decrease the risk resulting from incompetent bank managers and key officers. In addition, the legality of the sources of funds invested in the capital of a bank is investigated, thus reducing the risk of penetration of illegal elements into the banking system. In 1994, the national bank started to enhance its supervisory activities. The supervision over the activities of commercial banks is getting more and more in line with international standards. The bank inspections address all components of the C A M E L system.22 The capital adequacy assessment is performed on the basis of the Basle Agreement. To conduct external (off-site) supervision, banks are required to submit periodic reports using the accounting forms accepted by international practice. This allows considerable improvement in the quality of examinations and assessment of the scale of problems existing in the banking system.

Trends in the Development of New Banks

It must be noted that the existence of systemic risk problems in the banking sector of the country are related to the banks that were established on the basis of the former state banks. At the same time, some banks established with new capital have successfully addressed existing difficulties and endured the competition in the marketplace. These banks are now profitable due to the high professionalism of their managers and staff. In other words, the deterioration in the financial condition of many banks comes not only from the problems in the economy, but to a greater extent, from poor management.

Recently, the volume of foreign investments in the banking system of the country has been increasing. This development was fostered by the fact that foreign investments are legally protected and the law allows for tax exemptions for certain joint-venture banks. In particular, more than 50 percent of the investments in banks in the last year was provided by foreign investors. A further increase in foreign investments will boost competition and the credibility of the banking sector to an appropriate level. The soundness of the system will also be strengthened.

Systemic Banks (Insolvency Crisis)

The main difficulties arise from the former state banks, which pose systemic risk. They have numerous branches in most regions of the country, and in some locations these are the only banks. The deterioration of the capacity to manage numerous branches, the weakening of control over the bank personnel, and an increase in the number of nonperforming loans are the causes of the deterioration in the financial condition of the former state banks. Nonrepayment of loans has led to the liquidity crisis and insolvency of the banks, posing systemic risk.

Structural Reform of the Banking System

Since it is impossible to carry out restructuring of the banking sector without establishing an appropriate legal framework, the Kyrgyz Republic continues to make efforts to ensure improvements in financial legislation. Thus, the national bank has started to prepare bills to amend or add to (1) the Law of the Kyrgyz Republic on Banks and Banking Activities; (2) the Law on the National Bank of the Kyrgyz Republic; and (3) the Law on Deposit Insurance Fund. These bills will further improve the existing legislation on bank supervision and regulation of banking activities.

Proposals have been submitted to the government with respect to the new draft of the Civil Code concerning the legal tender in the Kyrgyz Republic and bank insolvency. Draft instructions concerning prevention of the money laundering activities in the banking system have also been prepared by the national bank.

The government and the national bank are completing the development of a new Law on Collateral. At the present time, banks and other entities have many problems in connection with the registration and repossession of collateral. The existing system of registration is inadequate and cannot exclude the possibility of illegal operations with collateral. The proposed law is expected to solve these problems.

The national bank has done a great deal to improve prudential regulations. Documents for bank supervision that have been developed and adopted include Procedures for the Establishment of Commercial Banks on the Territory of the Kyrgyz Republic; Changes in the Composition of Bank Personnel, Influencing Its Management and Control Over Its Activities; Measures Aimed at Revitalization of the Financial Condition of Commercial Banks; Instructions on Aspects of Application of the Law on Bankruptcy to Banks; Regulations on Interim Administration; and Management of Problem Banks.

The national bank is also working on the transition to a new chart of accounts to be adopted in 1996, which will comply with internationally accepted accounting practices in 1996, and on measures designed to improve and upgrade the bank payments system. At present, the National Bank Clearing System is in five regions of the country and one region is preparing to put it into operation.

The measures that the national bank is taking in cooperation with other organizations, including the foreign institutions, have brought about certain results. However, they have not solved the main problem associated with the financing of a large bad-debt burden. It is necessary to carry out structural banking sector reforms: sell or close some branches, establish several banks on the basis of one bank, merge certain banks, change the administrative structure, and strengthen internal and external controls. These measures will create prerequisites for recapitalization of the banks and allow writing off the remainder of bad debts through loan-loss reserves formed by the banks.

The banking sector of the republic receives technical assistance from various international institutions. However, not all of the country’s banks and the participants in the banking activities receive technical assistance. Additional assistance is needed to provide training to promising employees in new banking methods, accounting, strategic planning, and utilization of new technologies.

At the present time, the National Bank of the Kyrgyz Republic and the World Bank are working on the preparation of the Financial Sector Restructuring Program.

Moldova

Since declaring independence, the Republic of Moldova has made significant progress in the process of shifting to a market-oriented economy. A number of measures have been to stabilize the economy at the macro-economic level, and particular gains have been made in monetary policy. The most important stage was the introduction of the national currency, the Moldovan leu, on November 29, 1993, and the implementation of a tight monetary policy by the National Bank of Moldova. Since the leu was introduced, the exchange rate of the national currency has remained stable, with a nominal devaluation from leu 3.8500 to the U.S. dollar to leu 4.4990 at the beginning of 1996.

Since late in 1993, Moldova has been adhering to a tight monetary policy supported by a Systemic Transformation Facility (STF) and Stand-By Arrangements from the IMF. The stabilization program includes the market-based distribution of credits, a significant slowdown in the rate of growth in the monetary base and net domestic assets, and the setting of “ceilings” for lending by the national bank to the government and the banking system. As a result, the inflation rate plummeted from 2,000 percent in 1993 to 105 percent in 1994, and to 23.8 percent in 1995.

The decline in the inflation rate had a positive effect on the refinancing rate of the national bank, which, since January 1994, has been positive in real terms. The national bank has done away with concessional credits. And, since 1994, the refinancing rate has not been determined through administrative methods but has been established on a regular basis at credit auctions held by the national bank. This method has become the main means of distributing credit resources of the national bank to commercial banks. The volume of credit resources sold by the national bank is determined in accordance with the process for implementing the monetary program. In addition, the interest rate is established on a market basis, using the relation between supply and demand for loans. In February of this year, the refinancing rate was 21 percent, compared with February 1994 when it was 377 percent.

In the process of the reforms and of reducing the inflation rate, the national bank has gradually reduced reserve requirements as well. In February 1994 they were at an average of 25 percent, while in October 1995 they were reduced to 8 percent for all types of attracted resources; at 3 percent, the national bank has established an interest rate for commercial banks that is consistent with the inflation rate.

While continuing to rely primarily on credit auctions, the national bank began in 1995 to use new instruments for implementing its monetary policy: it began performing open market operations with short-term treasury bills—state certificates, which the government issues and floats regularly at auctions held by the national bank together with the Ministry of Finance. Foreign investors also have the opportunity to acquire government securities of this type.

Open market operations will replace credit auctions as the principal instrument of monetary policy as soon as the volume and liquidity of the government securities market allow. The goal is to phase out credit auctions completely by the end of 1996. Starting on January 1, 1996, in accordance with the financial program, all credits issued to banks by the national bank were fully backed by some form of security.

The expansion of open market operations, together with the acceptance of treasury bonds as security for national bank credits, will lead to the growth and development of a secondary market for these securities. The government will encourage the acquisition of treasury bonds by investors in addition to banks, by advertising these securities and selling them through commercial banks.

At present, operations on the domestic foreign currency market remain an important instrument of monetary policy. The national bank performs its operations both on the Chisinau Currency Exchange, which operates on a daily basis, and on the interbank market. The interbank market in Moldova is fairly well developed, evidence of which can be seen in steady growth in the volume of transactions among Moldovan banks involving the purchase and sale of foreign currency, and their predominance over transactions at fixing sessions, which are declining. This means that in the near future it will be possible to make the change to a new method for determining the official exchange rate of the national bank based on the results of trading on the interbank market.

A gradual liberalization of exchange control over a period of just three years made it possible on June 30, 1995 for Moldova to assume the obligations of Article VIII, Sections 2, 3, and 4, of the Articles of Agreement of the International Monetary Fund. As of now, there are no restrictions in Moldova with regard to effecting current international operations. This means, in effect, that the national currency is convertible, and it enables economic agents to buy and sell foreign currency for all current account operations and also for certain operations involving the movement of capital. Convertibility for current operations, together with the steps that have been taken to liberalize trade and payments, will encourage Moldovan enterprises to engage in more efficient production and to make investments, and it also serves as a sign of openness and economic freedom for foreign investors.

An important event of the past year was the adoption by the Moldovan Parliament of new laws on the national bank and on financial institutions. Both laws were drafted with the help of the IMF and include new and updated elements, granting the national bank absolute independence in the development and implementation of monetary and foreign exchange policy, and they create a legislative basis for a reliable and viable financial system.

Under the new law, the national bank has the necessary independence and power to meet its principal objective—maintaining the stability of the Moldovan leu, and it is accountable to Parliament and the public for its activities. The national bank is the only institution in Moldova with responsibility for the supervision, licensing, and regulation of the activities of financial institutions.

The Law on Financial Institutions is intended to protect the interests of the private investor, so as not to allow excessive risk in the financial system; it is also intended to create a strong and competitive financial sector and to utilize market mechanisms to improve financial services. A license from the national bank is required to provide financial services.

All of the factors mentioned above confirm that Moldova’s financial system has been given the legal support necessary to carry out the strategic function of supporting the viability and steady development of a market economy.

There are currently 29 commercial banks and 3 branches of foreign banks in Moldova. Sixteen have a general license from the national bank, which permits them to perform international foreign exchange operations.

Commercial banks perform operations involving the purchase and sale of currency for their own needs and for their customers on the domestic foreign currency market. Commercial banks have accounts opened in first-class foreign banks in approximately 21 countries. In their current activities, commercial banks are performing operations that are enabling them to earn the trust of foreign banks, which have begun to grant them loans in foreign currency.

The requirements imposed on commercial banks by the central bank should guarantee a minimization of risk in banking activity, in addition to the creation of equal conditions for their operation and fair competition among financial institutions. Today, the national bank is working in the direction of capital accumulation and increasing the profitability and effectiveness of the banking sector. The national bank is working on improving and strengthening banking supervision. New methods are being introduced, which are based on an in-depth and detailed analysis of each bank, as well as a new reporting system.

A great deal of work has been done on the introduction of international requirements for banking supervision, which should guarantee the stability of the banking system.

Moldovan banks are switching over to an electronic payments system. This will make it possible to effect interbank settlements on an international level. The national bank is working very hard to convert Moldova’s banking system to world accounting standards. Last year the national bank made the switch to a new accounting system, and this year there are plans for all financial institutions to make the transition.

The economic reforms of the past three years have been quite successful and they have received high marks from the international community, and the national bank remains one of the driving forces behind these reforms.

Foreign Exchange Operations

The national bank is carrying out its monetary and foreign exchange policy in accordance with the new Law on the National Bank, which was passed in July 1995. According to the new law, the principal task of the national bank is to achieve and maintain the stability of the national currency.

The currency market in the Republic of Moldova began to take shape as an independent market with the collapse of the rubel area and the first steps toward implementation of an independent economic and emission policy. In 1992–93, serious steps were taken to develop and implement foreign exchange regulation and to create foreign exchange reserves, primarily through borrowing from the IMF and other international organizations, which meant that when the national currency was introduced in late 1993, a full-fledged currency market was created in Moldova that was capable of rapid and successful development. Acceptance of the obligations of Article VIII of the IMF’s Articles of Agreement meant the de facto elimination of restrictions on international operations still in place at that time, complete liberalization of current account operations, and convertibility of the Moldovan leu.

The Department of Foreign Exchange Operations and Foreign Relations, whose structural organization includes front, middle, and back offices, with all of the necessary technical equipment—personal computers, Reuters screens, as well as highly skilled personnel—is responsible for implementing the methodology and strategy for developing the currency market, and also for operations on the domestic currency market and management of the foreign exchange reserves of the national bank.

The existence of sufficient reserves ($250 million at the beginning of 1996, compared with $3 million in 1992) and steady liberalization of exchange control enabled the national bank to pursue a policy on the domestic currency market that led to the stabilization of the national currency (devaluation over the 2.5 years since the introduction of the national currency was just 18 percent), as well as to the elimination of multiple exchange rates and to the development of a currency market. The official exchange rate of the Moldovan leu against foreign currency is a floating rate and is based on the outcome of daily fixing sessions at the Interbank Currency Exchange, depending on supply and demand. The official exchange rate of the national bank is used for statistical and accounting purposes.

Moldova’s commercial banks perform operations with foreign currency on an interbank market that has grown significantly in volume, and they have gradually been giving preference to these operations over participation in the Interbank Currency Exchange. Moldova’s leading banks have joined SWIFT and are on the Reuters network, which enables them to perform operations in accordance with international standards. Banks independently set currency quotations, without any restrictions, governed only by the supply and demand of one currency or another. The fact that the extent of national bank interventions on the domestic market was minimal over the past year and consisted only of evening out fluctuations in the exchange rate indicates that we have managed to saturate the market and that the situation has stabilized. This is also confirmed by the growing interest on the part of banks and economic agents in neighboring countries in our relatively small, but successfully developing currency market.

In determining the volume of interventions by the national bank on the domestic currency market, the Department of Foreign Exchange Operations and Foreign Relations works with the Monetary Policy Department to coordinate basic targets and indicators on a monthly basis, and when necessary, on a weekly basis, which is driven by the need to pursue a coordinated and uniform policy in all areas. It should also be noted that the spot currency market in Moldova is functioning quite successfully as well: the exchange rate on the spot market essentially coincides with the exchange rate on the interbank market, and the difference between the purchase and sale rate is less than 1 percent.

As far as the national bank’s foreign exchange reserves are concerned, as already noted, they have grown by a significant margin, to $250 million in 1996, which at present is sufficient to meet the needs of imports into Moldova for four months. In its management of the reserves, the national bank is guided by the principles of reliable investment of the funds and their liquidity. The strategy and structure of the investment portfolio are determined by the investment committee. The principal investment instruments at this time are repo operations (approximately 25 percent), deposits in first-class foreign banks (about 55 percent), treasury bills of various states (5 percent), funds invested under management contracts (7 percent), and so on. In determining investment strategy and evaluating investment activity, a benchmark is set, the selection criterion for which is based on the status of currency markets. At this particular stage, proceeding from the conditions of liquidity and proper servicing of the country’s foreign debt, the national bank is adhering to a strategy of investing mainly in short-term and reliable instruments. It should be mentioned that despite a fairly conservative and strict approach to managing reserves, income from the management of foreign exchange reserves in 1995 exceeded the national bank’s expenditures on servicing IMF credits, which is a very important outcome, considering the fact that for nine months the national bank had negative net foreign assets.

In light of the fact that management of foreign exchange reserves is a new sphere of activity for the national bank, improving the professional skills of personnel and providing technical equipment are among the priorities that will make it possible in the future to diversify and step up operations on the currency market, moving away from simple deposit operations involving investments in the European capital market to a broader spectrum of investment instruments in Europe.

In 1996, the national bank is faced with the task of further strengthening the entire banking system, thereby creating a foundation for the stable development and strengthening of the currency market, increasing the foreign exchange reserves of the entire country, and turning Moldova into an attractive financial center.

ket, on the other, create a situation in which government securities are becoming the main instrument for solving a broad range of problems.

Although the Russian government securities market appeared nearly three years ago, its volume amounts to nearly $20 billion, or 5 percent of GDP, and its daily turnover is about $500 million, or 2.5–3 percent of the market volume. The annualized yield on rubel transactions during the first two months of 1996 reached nearly 70 percent and the average monthly volume of funds raised on the GKO-OFZ (short-term government bonds and federal loan bonds) market to finance the budget deficit stood at more than $600 million at the end of 1995.

The GKO-OFZ market has already proved its ability to perform the main functions inherent in this instrument. The use of funds raised from the issue of government securities for financing the budget deficit allowed the central bank to considerably reduce the volume of direct credits to the Ministry of Finance and subsequently stop extending such credits altogether. On the other hand, the central bank received a market instrument for implementing its monetary policy, which was repeatedly tested in critical situations on the credit and internal foreign exchange markets. For the banking system, the government securities market has become a major means of maintaining the balance sheets’ liquidity.

The successful implementation of these functions became possible thanks to rapid growth of the market. Qualitative and quantitative expansion within this process has affected such aspects as market volume, the number of participants, the range of the instruments used, and the infrastructure.

At the present stage of development of the government securities market, priority is attached to attracting foreign investments. The financial sector of the Russian economy has reached such a level of maturity that the use of foreign investments cannot become a brake on its further development and will even help improve the infrastructure. From this point of view it is particularly important that investments should be made in the national currency.

At present, nonresidents’ investments in GKO-OFZ are subject to rather stringent regulation both in terms of volumes of transactions and their yields. Securities can only be bought with the rubels purchased from the Bank of Russia in foreign exchange swap operations. The rate of the first part of the transaction is set on the eve of the auction, while the rate of the second part is fixed on the day after the auction. Investments can only be made for the entire maturity of the issue, as a result of which the precise rubel yield becomes known on the day of the auction. Thus, the required final yield of the transaction in foreign currency is established on the day after the auction when the rate of the second part of the transaction is fixed. As for the volumes of transactions, they depend on the volumes of the swap operations transacted by the Bank of Russia.

More than $400 million was invested as a result of the first auction with the participation of nonresidents, and the final annualized yield was set at 25 percent in U.S. dollars. Subsequently, steps were taken to gradually reduce the yields to bring them closer to world levels for similar instruments.

In addition to providing funds for immediate financing of the federal budget deficit and facilitating the implementation of the monetary programs, foreign investments in rubels will help solve some other problems. It is, above all, the problem of creating a vast internal foreign exchange market for both spot and futures transactions. So far, these markets are too small to fulfill the required functions. In other words, an additional impetus needs to be given by regulating authorities. From the financial point of view, the “currency band” introduced in 1995 is nothing else but compensation for the inadequacy of the Russian currency market. In this context, an additional sustained two-way flow of funds will be useful for developing the market as a whole and hedging in particular.

Another important result of the expansion of the rubel investment flow within the framework of the process of de-dollarization of the Russian economy will be an additional impetus to the development of the money market, which, for its part, is the necessary condition of financial stabilization. The circulation of additional instruments on the domestic market will also stimulate development of financial brokerage and consolidation of the corresponding infrastructure. In combination with the aforementioned factors, additional demand for banking services will help strengthen the Russian banking system and increase its reliability.

We regard these processes as closely connected with the further development of the GKO-OFZ market. Despite the hopes laid on the consequences of participation of nonresidents in this market, the main investors and brokers of the Russian government securities market will be Russians and it is the Russians that the central bank has in mind in drafting guidelines for the reform of this market. One can single out here the following basic trends.

Regional trading floors began to participate in the GKO-OFZ market in 1995, and at present government securities are traded in the real-time regime not only in Moscow, but also in St. Petersburg, Novosibirsk, Rostov, Yekaterinburg, and some other cities. The important thing is not that additional funds are attracted to a specific market, but that a national infrastructure has begun to emerge, which in the long run will make it possible to conduct a wide range of financial and stock exchange operations.

Another big step in the development of the market will be the introduction of repo operations, which will not only provide the central bank with a new mobile instrument to regulate banking liquidity, but also open up additional opportunities for the market participants. All these measures should help increase market immunity to external factors.

The introduction by the central bank of Lombard crediting, that is, a mechanism of refinancing based on the use of government securities, confirms the leading role of the GKO-OFZ market from the viewpoint of the share of this sector of the financial market as well as from the viewpoint of the technologies used.

In addition, plans are afoot to make a number of changes inside the market structure, as a result of which private investors will gain access to the market and its efficiency will increase thanks to reorganization of the structure and functions of the authorized dealers.

Such reforms in the government securities market will help further stabilize and improve the performance of the financial system and the economy as a whole during its transition to a market model of development.

Turkmenistan: Central Bank Reforms

Turkmenistan has already achieved notable success in central banking reforms. There is a visible two-tier banking sector that operates throughout the country. The government introduced the manat, the new national currency in November 1993, in a successfully conducted countrywide exchange program. The central bank has greatly improved its operational ability in managing the country’s gross foreign exchange reserves. It has installed SWIFT equipment and the Reuters dealing system and trained its staff in their use. It has also established relations with central banks and major international banks in leading financial countries. The bank sent many of its staff to courses on a variety of relevant topics at the Joint Vienna Institute, the IMF Institute, and the Bank of England Center for Central Banking Studies and regularly participates in regional training initiatives. The central bank joined other Central Asian and Transcaucasian republics last year in a regional supervisory group associated with the Basle Committee for Banking Supervision.

The Turkmenistan government has granted increasing responsibility to the central bank for monetary and external policies, as it has come to realize that macroeconomic instability impedes the country’s ability to realize the benefits of its investment in institutional and human capital, harms the banking sector, and worries international investors.

On December 27, 1995, the government announced a major Economic Reform Program that included unification of the exchange rate, the resumption of foreign exchange auctions, and channeling part of export surrender requirements to the auction. Credit allocation by decree was discontinued and credit auctions were introduced. The policy removed ceilings on bank lending rates and on the refinance rate that would hence forth be market determined. The central bank has adopted a tight monetary policy that includes only modest financing of the budget, which is designed to reduce inflation to a single digit on a monthly basis by December 1996. Despite a temporary return to a multiple exchange rate for several weeks from late February the exchange rate is once again unified. The central bank has resumed its foreign exchange auctions on a regular basis and has revised its financial program in discussion with IMF.

Future Priorities

The central bank will continue to press for increasing autonomy over monetary policy and will seek to achieve harmony between fiscal and monetary policies in close cooperation with the Ministry of Economy and Finance. It is expected that the central bank and the ministry will together coordinate public debt management through a joint committee that will examine the mechanisms for the future issue of treasury bills at market-determined interest rates through the auction mechanism. The central bank will continue the struggle against inflation as a priority objective.

Addressing Banking Sector Weaknesses

The central bank regards the financial soundness of the banking system of paramount importance and the availability of timely data a priority. This will require the support of the international community over the medium term. The IMF, the World Bank and the European Bank for Reconstruction and Development (EBRD) are all supporting central bank programs to remedy weaknesses in the financial sector.

Human Resource Development

Bank staff are generally weak in credit and operational matters despite having a good general level of education. The central bank opened a residential interbank training center in 1995 that trains bank staff from the central bank and commercial banks in the capital and in the provincial branches. The center has a fully equipped computer training unit thanks to a World Bank credit. The center cooperates with regional centers like the Kazakstan International Institute of Banking whose trainers have mounted a variety of one-week courses on international banking topics including letters of credit and aspects of lending.

The central bank has engaged a French company, CFPB, that specializes in banking sector education. CFPB is a nonprofit organization. Its shareholders are 13 French commercial banks, and it has long experience in the region. CFPB’s team leader arrived in Ashgabat in April to start the courses for selected commercial and central bank staff, which run throughout 1996. The contract was awarded under the World Bank loan. Senior commercial bankers will spend some weeks in Europe on a study tour of banking institutions; the tour is part of the contract package.

Banking Regulation

The banking sector has a poor record on provisioning for bad and doubtful debt and there is a possibility that write-offs could erode the capital base of the weaker banks. A contract has been awarded under the World Bank loan to experienced consultants with international and regional experience in bank regulation. The consultants will aid the central bank to prepare regulations on a number of essential topics. In the meantime, the central bank has prepared a draft regulation that when introduced will require banks to maintain specific provisions against doubtful and bad loans. The draft provides a method of determining when the quality of a loan has deteriorated to the extent that calls for provisions.

Banking Supervision

The same World Bank loan will provide technical assistance for both off-site and on-site bank supervision. The chosen consultants have the necessary experience in supervisory matters. An experienced Federal Reserve Bank examiner is a frequent visitor to the central bank under an IMF technical assistance program and will continue to assist the development of supervisory standards. Cooperation at the regional level with the Basle committee will ensure that Turkmenistan moves closer to international standards.

International Standards of Accounting

The central bank is using the World Bank loan to explore the introduction of International Accounting Standards in Turkmen banks. So far no contract has been awarded. The central bank will ultimately adopt an accounting plan that the IMF developed in response to requests from a number of central banks in transitional economies.

Settlement System

The central bank will introduce an electronic countrywide settlement system to replace the present arrangements. An initial report by Dutch experts is currently under study. The system will have adequate capacity to take care of peak loads at month ends. It will be sufficient to provide a service to other government users at nonpeak times. Financing of the equipment and the accompanying technical assistance is from the World Bank loan. There will be close cooperation with the Ministry of Communications to ensure system compatibility.

External Audit Approach

Involvement in international trade and relations with foreign correspondent banks require that Turkmen banks are financially sound. One proof of such soundness is the publication of financial statements that have been audited by recognized external auditors. The second phase of an EBRD on-lending project contains preconditions for satisfactory external audit within the foreseeable future.

Project Identification

The business community and the banking sector lack expertise in the identification of projects and their implementation. The EBRD loan project has supplied consultants to work with the banking sector to improve this aspect of the banking business. It is likely to remain an obstacle to major credit proposals at least in the medium term. The associated problems are of banks’ weak analytical capacity and low monitoring ability.

Statistics

The central bank will benefit from the appointment of an IMF regional balance of payments advisor to continue the work of earlier statistical missions. The advisor will share time among three central Asian republics, including Turkmenistan. More timely and more accurate balance of payments data are essential for successful financial programming.

Conclusion

We are confident that the central bank has the will to remedy the weaknesses in the banking sector and that given continued institutional and donor support, it will have the means to do so. The economy of Turkmenistan will improve as we gain wider access to international markets for our gas and other energy products. The central bank intends that the banking sector should be ready to play its part vigorously in a revived and restructured economy.

Ukraine: Banking System

When Ukraine became an independent state, the necessity to establish an appropriate banking system arose. In accordance with the Law on Banks and Banking, the principles and structure of such a system were elaborated. It is a two-level system that consists of the national bank and commercial banks.

The National Bank of Ukraine is the central bank of the state and its sole emission center. It implements the unified state policy in monetary, credit, and foreign exchange regulation spheres. Commercial banks are the main link in the national credit system; they are of different types and ownership forms and are established as joint-stock companies by both natural and juridical persons. On January 1, 1996, 230 commercial banks were registered in Ukraine.

The main positive changes in the banking sector during the last two years are the following:

  • the conduct of a purposeful monetary policy, oriented to macroeconomic stabilization, which promoted further decrease in the inflation rate;

  • creation of the national payment system, with implementation of new progressive technologies and transfers of funds on the basis of electronic payments;

  • putting into operation the Mint and Banknote Factory to manufacture Ukrainian money;

  • a continuing increase in the authorized capital of commercial banks to financially strengthen the banking system, and strengthing of banking supervision;

  • increased liquidity and efficiency of the banking system, which promoted its further development;

  • a gradual introduction of servicing the national budget deficit through government securities;

  • measures to liberalize the Ukrainian foreign exchange market;

  • a slowing in the fall of the exchange rate of Ukrainian karbovanets (krb) to foreign currencies:

  • achieving stabilization of the official exchange rate of Ukrainian karbovanets to foreign currencies and a stable parity between official and market rates;

  • a continuing increase in volumes and improvement of the structure of the official foreign currency reserves for support of the karbovanet rate, providing for the most effective foreign currency interventions and conducting international settlements;

  • the start of the banking accounting reform, implemented according to the requirements of monetary statistics and banking supervision; the practice of daily compilation of consolidated balances in the system of the national bank and banking system as a whole;

  • the continued development of the legislative basis on monetary policy issues and banking supervision;

  • strengthening of the links with the international financial institutions; and

  • the issue of official national bank publications on a regular basis: the monthly statistics bulletin (in Ukrainian and English) and the magazine The NBU Bulletin.

The Ukrainian banking system is functioning in unstable conditions and a complicated market economy. A number of factors impede the development of the banking system:

  • Insufficient legislative basis for banking activities. The national bank developed and submitted to the Parliament and to the Cabinet of Ministers draft Laws on the National Bank of Ukraine, on Banks and Banking Activities, on the Foreign Exchange Regulation System, on Deposit Insurance, on Credit, and others.

  • The nonpayment crisis between businesses has intensified. During 1995, the increase of business arrears continued and the situation in the country with nonpayment remains difficult. During a long period, many enterprises did not fulfill their commitments to the budgets, and detained the settlements between suppliers and consumers of gas, oil, and electricity and with other enterprises.

  • Some banks have inadmissibly small, registered, and actually paid authorized funds. Undoubtedly, such banks cannot guarantee security of the funds of their depositors and shareholders in the present situation. The national bank introduced a fair mechanism of increasing the authorized funds of commercial banks.

The main strategic aim of monetary policy is to create financial stability and strengthen the national currency by decreasing inflation. The national bank has planned the following measures:

  • reduce direct lending to the Ukrainian government by financing the government from the funds received from the sale of government securities with the aim of stopping direct lending to the government in the future;

  • regulate the money market through Lombard crediting (against collateral of state securities), credit auctions, and foreign exchange transactions on the secondary securities market;

  • renew confidence in the national currency through the national bank’s operations with foreign exchange reserves;

  • introduce currency reform, which is necessary to strengthen the financial and monetary system, to hasten economic reform;

  • further stabilize, liberalize, and expand the foreign exchange market.

Payments System

The national bank realizes common national policy in money circulation and credit and exchange regulation; promotes strengthening national currency; arranges interbank settlements; coordinates the operation of the banking system as a whole; and effects supervision over its activity.

Commercial banks of different types and ownership are established by legal entities and individuals as joint-stock or shareholding companies. As of January 1, 1996, 230 commercial banks have been registered in Ukraine.

The strategy for developing the banking system in Ukraine is aimed at providing higher efficiency of commercial bank activities and improving their role in solving economic and social problems of the society.

Developing and implementing the electronic interbank payment system (EPS) in early 1994 was an important achievement in advancing the banking financial sector. In all regions of Ukraine and Crimea, 25 regional settlements houses were established, which were linked into a public common network of settlements houses in Ukraine. The network is a three-linked structure with a central settlement house at the top, located in Kiev. Actually, all Ukrainian banking institutions (over 2,400 commercial banks and their branches) effect payments through correspondent accounts of the national bank institutions and participate in the interbank settlements within the country. EPS operation is controlled by the national bank. EPS incorporates software packages that provide exchange of electronic documents, their verification, analysis, and fraud protection.

The electronic interbank payment system handles payments of legal entities (clients of commercial banks) in the mode close to the real-time mode and maps them in the correspondent accounts of banks with the national bank. Participants receive necessary information on liquidity forecasting. Payments from banks are accepted only within the limits of their correspondent accounts—that is, a bank is entitled to allocate only the actual resources it possesses. Such a procedure minimizes the system risk inherent in similar systems. An opportunity to debit the other participant is given only to the divisions of the national bank. The main operation mode is to transfer electronic documents and preclude use of paper-based technology.

The system handles about 350,000–400,000 payments a day, totaling over krb 150 trillion, which is two or three times higher than the value on current correspondent accounts of the clients using the system. The aver-payment systems and systems of internal automatization of banking activity, in particular, with “client-bank” systems.

With the aim of decreasing domestic currency cash circulation, the national bank together with commercial banks took a decision to implement plastic cards for cashless settlements of individuals. To this end, in September 1995, the 17 largest banks with the participation of the national bank organized “Ukrcard,” a closed-joint-stock company to develop and implement the National Plastic Card Settlement System.

The participants of “Ukrcard” and the national bank have developed the National Settlement System, which takes into account the experience of several European systems available and some systems implemented. The system is based on the use of up-to-date and reliable plastic, smart cards (cards with a microprocessor and a cryptography protection system), and a current electronic interbank payment system. Another payment instrument envisaged by the project is a debit card that guarantees payment for consumer and service transactions.

Implementation of credit and corporate cards is also planned. They are analogous to international cards like Visa, Eurocard, MasterCard, and others. A corporate card will provide services to legal entities performing functions of a debit and payment card. The National Settlement System will also provide payments for Visa, Eurocard, and MasterCard international systems when servicing foreigners in Ukraine and Ukrainians abroad. The pilot project is planned to be realized in at least two regions of Ukraine in 1996.

The pilot-project implementation will be based mainly on the use of the equipment of foreign companies. Simultaneously, preparatory work will be directed at organizing domestic production of the National System elements (through joint ventures, purchasing licenses, and working domestic enterprises).

Prospects of the National Payments System Development

At present the existing system of interbank payments meets the needs of the Ukrainian economy. However, taking into account the increased economic activity in the country, connection to international payment systems, development of the electronic securities market, and implementation of mass payments for consumer goods and services, a new payment system is needed, one that is based on new concepts, technology, and software.

The national bank is developing the new payment system, which will include the following new components:

  • a centralized subsystem of operating correspondent accounts of banking institutions within the country;

  • a centralized subsystem of urgent money transfers for effecting payments in the real mode (with on-line facilities);

  • a subsystem of clearing settlements for effecting interbank payments in a package mode in one day on a regional basis;

  • a subsystem of mass payments for consumer goods and services with plastic cards;

  • interfaces with the developing electronic systems of the securities market, foreign exchange transactions, and so forth;

  • fourth-generation language; SQL, and other modern facilities and technologies, to process and keep data in protected environments, and operate centralized databases in the national bank’s subdivisions;

  • on-line money transfers accompanying payments data exchange with banks using “client-server” technology;

  • ability to meet in full the future demands; the package mode technology shall remain for banks having no possibility to operate modern technologies and environments for timely payments;

  • flexible and reliable means of entering other interbank payment systems, such as SWIFT, payment systems of the Baltics, Russia, and other countries of the former Soviet Union, and so forth;

  • back-up systems to secure continuous functioning in case of natural or malicious acts;

  • steady improvement of interbank payment systems and their integration in the electronic interbank payment system; and

  • enlarged services to the members of the electronic payment system and increased the system reliability and protection.

Uzbekistan: Achievements and Future Reform

The strategy for forming and developing the banking system of the Republic of Uzbekistan is in keeping with the program of the economy’s phased transition to a market economy. The most important achievements in developing the banking reform system were (1) the legal and normative consolidation of a national banking system with a two-tiered structure; (2) growth of the number and forms of services offered by commercial banks; and (3) the creation of the foundations of the financial infrastructure. In this case, ensuring stability of the banking system was a fundamental prerequisite of reform.

At the same time, bank reform required parallel solutions of important problems, such as developing the methods of regulating monetary circulation and credit, tightening financial discipline of enterprises and banks in the sector, forming an effective payment system, improving the quality of services offered by banks, raising it to the level of international standards, and others.

Creation and improvement of banking legislation, including adoption of the Law on Banks and Banking on February 15, 1991, played an important role in reforming the banking system. Adopted in 1995, the Law on the Central Bank of the Republic of Uzbekistan not only supplemented the legal principles of the banking system but also clearly delimited the special status, goals, tasks, and powers of the Central Bank of the Republic of Uzbekistan. The draft of the new Law on Banks and Banking, which is currently undergoing open discussion, creates all of the needed legal conditions for a stable and effective banking system.

A trend toward demonopolization of banking services was observed in developing commercial banks in the first phase of the reforms. The government and the central bank are now devoting considerable attention to expanding services, reducing the role of the state in the banking sector, and creating a competitive environment within it. In particular, the central bank will implement measures directed at differentiating commercial banks by function and the amount of their authorized capital, such that the following will be distinguished: (1) full-service commercial banks possessing main-branch banking licenses for all types of operations; (2) commercial banks with a limited range of banking operations; and (3) banks authorized to carry out special operations (mortgage, export-import, long-term loans, and others).

Of major significance in this direction are expanding services offered by banks and upgrading their quality, providing customers extensive information so that they may optimally deposit free monetary resources; activating interbank competition for customers; and improving the quality of the banking sector’s activity in general.

Regulation of monetary circulation and credit by the central bank within the context of current monetary policy brought about important changes in the activity of commercial banks as well. Transition to a market-oriented economy necessitated the central bank’s adoption of traditional market tools for monetary regulation. The central bank now has a potentially large role to play in mobilizing credits for the economy through the credit and finance system, inasmuch as high reserve requirements effectively take resources out of the hands of banks. Although the existing reserve requirements are rather high, in the absence of alternative monetary tools this temporary measure is justified. Together with the growth of real interest rates on the central bank’s auctioned credits to positive figures, the reserve requirement helped to reduce the rate of growth of inflation.

As for the interest rate, the other tool of monetary regulation, as of April 1995 the central bank went over to offering a larger share of its credits to commercial banks through credit auctions at the refinancing rate, which is the minimum rate for credit resources at auctions. The refinancing rate is reviewed monthly in correspondence with the current level of inflation and with particular indicators of inflation in the future. Operations such as offering credits at auctions or issuing certificates of deposit are no longer unusual but are increasing in frequency.

Measures of monetary policy, such as introducing a mechanism for distributing centralized and interbank credits through auctions of credit resources at market rates, establishing the necessary norms for required reserves held in the central bank, and measures under an anti-emission policy helped to absorb excess liquidity in the economy and ultimately led to a decrease in the inflation rate. Attaining positive interest rates, which are a fundamental prerequisite of profitable banking, was a positive consequence from the standpoint of developing financial intermediaries. The terms under which enterprises obtain credits and bank refinancing grew tighter and deposit and loan rates grew considerably, to real positive values, as a result of implementing a stabilizing policy. World experience shows that, as a rule, such stabilizing processes cause significant growth of the arrears of enterprises.

The problem of ensuring repayment of credits has influenced the decrease in liquidity and solvency of commercial banks. Presence of so-called bad debts of insolvent customers among the assets of certain commercial banks creates serious barriers to effective application of credit policy. In this connection, one of the means of improving the financial position of banks could be for the state to issue long-term securities equal in amount to its debts to banks, such that these bad debts would be transformed into assets of commercial banks.

In addition, it would be of some importance here to take steps to widen the services offered by banks and to upgrade their quality by providing customers extensive information so that they may optimally deposit monetary resources, activating interbank competition, and improving the quality of the banking sector’s activity in general.

The interbank credit market developed owing to tightening of centralized credits. As a consequence, the share of interbank credits used to cover the credit investments of many banks has increased, which in turn is causing the risk of interbank defaults to increase. Considering this, the central bank is implementing measures to diversify liability operations to reduce the risk that banks may become insolvent.

There was a noticeable increase in the share of bank credits in the structure of capital investments in 1994—95. This trend means that the republic’s economy is beginning to stabilize; it is an extremely positive trend and is evidence of a rise in the economic interest of commercial banks in crediting investment processes.

Formation of the stock market’s legal base and initiation of the second phase of privatization in 1995 created conditions allowing entry of commercial banks into securities operations. The Law on Securities and the Stock Market, adopted on September 2, 1993, was a legal document fundamental to establishing the securities market. As privatization accelerated, primary market trading in the stocks of enterprises and commercial banks enjoyed extensive development, and a market dealing in bills of exchange, which have been used as settlement and payment resources, came into being and developed swiftly. It should be noted that commercial banks, which have become aware of the possibilities the securities market offers in expanding their resource base and investing assets, in controlling liquidity, and in maintaining a solvent balance sheet, have started participating more actively in the stock market. Introduction of bill circulation last year, acceleration of business settlements, and reinforcement of payment discipline were important to business, as is evidenced by the dominant position of bills of exchange in the sales structure of securities.

It should be recognized that the level of development of the secondary securities market does not currently permit economic agents to effectively extend credit and borrow in the short term. In compliance with the “Basic Directions of Monetary Policy for 1995,” the central bank intends to introduce operations in the open market with government securities, discounting and rediscounting of bills of exchange, acceptance of securities as pledge for credits, and greater flexibility in using the required reserves of commercial banks as a policy tool. Together with the government’s introduction of highly reliable government and guaranteed securities and with activation of the work of investment funds and insurance companies, these measures will ensure further development of the securities market.

Another trend that should be mentioned is the increase in the number of commercial banks having the right to carry out foreign exchange operations. Last year, the central bank took steps to increase the number of banks regularly carrying out operations with foreign exchange. The monopoly of the Bank of Foreign Economic Activity on these operations is being eliminated in this sphere to provide other commercial banks with a niche in the foreign market. The tasks of stocking the domestic market with consumer goods and updating the technological level of capital necessitated development and engagement of a mechanism of internal conversion.

The Republican Exchange Market, which began regular trading in foreign exchange on April 15, 1994, is an inseparable attribute of the market financial system. In 1995, the foreign exchange sales volume reached $1.5 billion.

Authorized banks have established exchange bureaus to exchange cash in sums to freely convertible currency. Sums are exchanged for freely convertible currency at buy and sell rates set by banks on the basis of supply and demand.

By providing general licenses for foreign exchange operations, the central bank created conditions under which authorized banks could establish correspondent relations with foreign banks. Besides maintaining operational ties, the central bank gets support from its correspondent banks in specialist training and in consultation services. The central bank’s relations are evolving most productively with the Deutsche Bank, the Deutsche Bundesbank, the Union Bank of Switzerland and Credit Suisse, the Bank of England, the Banque de France, and the Bank of India.

To bring banking closer to international standards and gain entry into the world banking system, affiliates and branches of well-known foreign financial institutions are needed. There is also a need not only for developing a concept on expanding the network of banking structures inside the country, but also for suitably increasing the number of branches and offices of Uzbek commercial banks outside the country. This will bring banking closer to international standards and hasten entry into the world banking system.

Active creation of specialized credit and financial institutions, which exist in countries with a market economy and which are, together with banks, an important component of a state’s financial system, began in 1995. This is an objective brought about by the need for dividing up the credit sphere among different types of financial institutions. Specialized finance and credit institutions were thus established—the Business Fund, the Madad Insurance Company, the Uzbekinvest National Insurance Company, and private insurance and investment companies. To develop such financial institutions further, the government and the central bank are building a comprehensive legislative base governing the activity of nonbank financial institutions clearly delimiting the activities of banks and other financial institutions such as insurance, trust, and leasing companies.

The purpose of reforming banking supervision was to ensure effective monitoring, inspection, and auditing of the activity of commercial banks. The greatest importance was attached in this direction to regulating the rules of the activity of commercial banks, adapting standard liquidity and risk ratios to market conditions, improving report forms, and other important problems.

Improved methods of regulating the activity of commercial banks were introduced as of January 1, 1996 to stabilize monetary circulation and provide for the needed liquidity of commercial banks. These methods include bringing the standards for adequacy of capital and liquidity closer in line with international standards, introducing rules governing mutual relationships of banks with “connected” persons, and imposing severe vertible currency at buy and sell rates set by banks on the basis of supply and demand.

By providing general licenses for foreign exchange operations, the central bank created conditions under which authorized banks could establish correspondent relations with foreign banks. Besides maintaining operational ties, the central bank gets support from its correspondent banks in specialist training and in consultation services. The central bank’s relations are evolving most productively with the Deutsche Bank, the Deutsche Bundesbank, the Union Bank of Switzerland and Credit Suisse, the Bank of England, the Banque de France, and the Bank of India.

To bring banking closer to international standards and gain entry into the world banking system, affiliates and branches of well-known foreign financial institutions are needed. There is also a need not only for developing a concept on expanding the network of banking structures inside the country, but also for suitably increasing the number of branches and offices of Uzbek commercial banks outside the country. This will bring banking closer to international standards and hasten entry into the world banking system.

Active creation of specialized credit and financial institutions, which exist in countries with a market economy and which are, together with banks, an important component of a state’s financial system, began in 1995. This is an objective brought about by the need for dividing up the credit sphere among different types of financial institutions. Specialized finance and credit institutions were thus established—the Business Fund, the Madad Insurance Company, the Uzbekinvest National Insurance Company, and private insurance and investment companies. To develop such financial institutions further, the government and the central bank are building a comprehensive legislative base governing the activity of nonbank financial institutions clearly delimiting the activities of banks and other financial institutions such as insurance, trust, and leasing companies.

The purpose of reforming banking supervision was to ensure effective monitoring, inspection, and auditing of the activity of commercial banks. The greatest importance was attached in this direction to regulating the rules of the activity of commercial banks, adapting standard liquidity and risk ratios to market conditions, improving report forms, and other important problems.

Improved methods of regulating the activity of commercial banks were introduced as of January 1, 1996 to stabilize monetary circulation and provide for the needed liquidity of commercial banks. These methods include bringing the standards for adequacy of capital and liquidity closer in line with international standards, introducing rules governing mutual relationships of banks with “connected” persons, and imposing severe measures and sanctions against banks remiss in upholding the soundness of their financial position.

Measures are being implemented in this direction today to stimulate establishment of independent auditing companies that could make evaluations of the financial status of commercial banks, improve banking supervision to reveal problem banks early so that the appropriate measures could be implemented in relation to them, and create an independent agency to develop and employ a unified system for evaluating banks and to regularly publish their ratings.

Development and introduction of new accounting systems and a new chart of accounts for the central bank and for commercial banks also had importance in many aspects. In 1994, the central bank concluded a contract with the firm Arthur Andersen to improve accounting, reporting, and the auditing service. In this connection, the contract foresaw preparation of preliminary versions of a new chart of accounts for the central bank and for commercial banks, a description of accounts transitional between the traditional chart of accounts and the new chart, and bank report forms based on the new chart of accounts.

The central bank implemented measures to improve the payment system. Measures were carried out to computerize interbank transfers and settlements, to improve the software of the electronic payment system, and to introduce new payment instruments (checks, payment orders, letters of credit); bills of exchange issued by commercial banks have started coming into wide use in transactions, which is helping to solve the default problem.

Information and analytical support of the activities of the central bank required radical reconstruction. In this context, measures were successively implemented to improve collection, statistical treatment, and analysis of economic information. Various training organizations preparing personnel for work in banking and financial institutions were established in the period under analysis. For example, the Regional Banking Training Center, of which the central bank was one of the cofounders, was organized.

On the whole, banking reform will develop in 1996 in the direction of stabilizing monetary circulation further and creating favorable conditions to stimulate the productive activity of economic agents.

Central Bank Reform In the Transition Economies

ISBN 1-55775-608-2

The Group of Seven comprises Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.

The group of cooperating central banks includes those of Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.

Papers and proceedings from the meetings were published under the title Central Banking Technical Assistance to Countries in Transition (Washington: International Monetary Fund, November 1994), and the meetings were also the subject of an article “ Meeting on IMF-Coordinated Technical Assistance Stresses Role of Central Banks,” in IMF Survey (May 16, 1994), p. 167.

The meetings were briefly described in “Central Bank Reforms Advance in Baltic and CIS Countries,” IMF Survey (July 29, 1996), p. 299).

The countries under discussion are the Baltic states of Estonia, Latvia, and Lithuania, and the CIS states of Armenia, Azerbaijan, Belarus, Georgia, Kazakstan, Kyrgyz Republic. Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan, hereinafter referred to as the transition economies.

As of May 1996, Stand-By Arrangements arc currently operative in the other countries. Tajikistan may, however, soon follow the others in elaborating a program that could be supported by the fund, and there have been useful, albeit hesitant, discussions with Turkmenistan on a reform effort there.

Although the exchange rate arrangement in Latvia is formally classified by the Fund as “other managed floating,” in practice, the exchange rate has been successfully pegged to the SDR.

Note: The authors would like to thank Kiran Satry for able research assistance.

Enterprises currently receive credit from the following sources other than bank credit: credits from other enterprises (including involuntary credit in the form of arrears), credits by employees (i.e., salary arrears), credits from the government (direct credits, arrears in pension fund contributions, payroll taxes, and so forth), credits from the central bank, and foreign credits.

This can he viewed as an initial de facto financial restructuring of banks’ balance sheets. Borish, Long, and Noel compare this approach with the approach taken by the Central and Eastern European countries where state banks were initially recapitalized by removing old loans from bank balance sheets so as to restore solvency and profitability, and allow state banks to compete with private banks (Michael S. Borish, Millard E. Long, and Michel Noel. “Banking Reform in Transition Economies.” in Finance and Development (September 1995), pp. 23–26.

Note: The author would like to thank Kiram Sastry for able research assistance.

kazakstan introduced an indirect control on interest rates because borrowers that pay interest rates above 1.5 times the refinance rate of the National Bank of Kazakstan are not permitted to count the extra interest payments as a cost in their profit-and-loss statements. In 1995, Turkmenistan limited the commercial banks rate of return to 4 percent of a bank’s assets. Although banks are free to set deposit rates, such a limit on profits acts as a deterrent to increase lending rates.

A liquidity forecasting framework enables a central bank to forecast banks’ reserves and to manage liquidity in the banking system based on that forecast.

Understanding refinance facilities, central banks grant credit at the commercial bank’s discretion at a preannounced rate.

In practice, the Russian authorities have kept the refinance rate significantly above the reference rate in the interbank market.

In Ukraine, the proceeds of the auction may only be used to finance targeted sectors.

Monetary operations in countries with currency board arrangements (Estonia, Lithuania) are limited to the amount of foreign exchange reserves in excess of those needed to provide full backing of base money. Nevertheless, central banks in these countries can play a role in enhancing banks’ liquidity management and in developing money and government securities markets.

Reserve averaging provides commercial banks with a cushion to absorb unexpected liquidity flows out of the system. However, active liquidity management and adequate financial discipline in the banking system are needed to ensure that the averaging technique does not cause large volatility in reserve holdings. To limit the latter, central banks can shorten the maintenance period and introduce limits on daily variations from the stated average.

In Russia, dealers or brokers participate in government securities primary auctions and secondary market trading sessions; however, they do not act as market makers, and a proper primary dealer agreement has not been adopted.

See Chapter 7 for a discussion of reforms in the payments system in Baltic and CIS states.

Realized pains represent a transfer of real resources, while valuation adjustments indicate a potential for such a flow that can only he realized through liquidation (i.e., sale) of the relevant asset.

A CAMEL rating is a measure of the relative soundness of a bank. The term stands for capital, asset, management, earnings, and liquidity. Bank supervisory agencies rate these on a scale of 1–5 to evaluate a bank’s credit.

The F.C-TAC.1S Program is a European initiative for assistance to the transition economies and Mongolia. Ed.

A CAMEL rating is a measure of the relative soundness of a bank. The term stands for capital, asset, management, earnings, and liquidity. Bank supervisory agencies rate these on a scale of 1–5 to evaluate a bank’s condition.

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