The econometric results show that it is feasible to estimate robust price and inflation equations for Georgia. The long-term price equation expresses prices as a function of money, the exchange rate, and real income and may be interpreted as portraying equilibrium in the goods market. The paper also represents statistical data of transportation indicators, population and employment, personal income tax, monetary survey, average monthly wages, developments in commercial banking, interest rates, prudential indicators of commercial banks, balance of payments, and so on.


The econometric results show that it is feasible to estimate robust price and inflation equations for Georgia. The long-term price equation expresses prices as a function of money, the exchange rate, and real income and may be interpreted as portraying equilibrium in the goods market. The paper also represents statistical data of transportation indicators, population and employment, personal income tax, monetary survey, average monthly wages, developments in commercial banking, interest rates, prudential indicators of commercial banks, balance of payments, and so on.

III. Banking Sector Reforms and Financial Developments in Georgia11

A. Summary and Introduction

35. The Georgian banking system was last closely analyzed in the context of the October 2001 Financial System Stability Assessment (FSSA). This chapter seeks to update the analysis, providing a new assessment of progress made and identifying the challenges that remain.

36. The 2001 FSSA indicated that financial intermediation was under-developed, dominated by banks, and faced significant vulnerabilities to exchange rate and credit risks. It noted that, while considerable progress had been made to strengthen banking supervision, important weaknesses remained to be addressed. The report also indicated that many of these weaknesses would be remedied by legal reforms under consideration at that time. The report cited the main risks to the financial system as coming from the relatively high fiscal deficit and external debt, which could lead to pressures on the exchange rate, prices, and output, with repercussions on the banking system. At the same time, weaknesses identified in the banking system and the quasi-fiscal costs of dealing with insolvent banks were viewed as potential triggers to a deterioration in the macroeconomic environment.

37. The picture that emerges now indicates that Georgia’s banking system is more robust and less vulnerable than at the time of the 2001 assessment. This has largely been the result of significant progress by the National Bank of Georgia (NBG) in introducing key reforms in the legal and regulatory frameworks for banking supervision, and in strengthening its capacity for implementation of these measures. However, if macroeconomic conditions continued to be unsupportive and domestic capital markets remained under-developed, then future growth of the banking system could be constrained and remain a source of risk to the system. And while strengthened banking supervision has reduced systemic risk, the quasi-fiscal costs of dealing with insolvent banks could still have a substantial adverse effect on macroeconomic conditions.

B. Structure of the Banking System

38. The Georgian financial sector remains small by international standards and by comparison with other countries in the region. Total assets of the banking system have risen since 2001 but still amounted to only 15 percent of GDP at end-June 2003. Monetization, as measured by the ratio of broad money (M3) to GDP has risen steadily, from 10.2 percent as of end-2001 to 11 percent as of end-June 2003. Foreign currency deposits have been by far the most dynamic segment of M3. Growth of M2 excluding foreign currency deposits has consistently lagged behind that of M3 since 1997. M2 (excluding foreign currency deposits) in Georgia remains among the lowest in the world, at 6 percent of GDP, compared to Kazakhstan at about 13 percent, and Poland at approximately 42 percent as of end-June 2003.

Table III-1.

Georgia: Share of Broad Money (M2) to GDP

(In percent)

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Sources: Economic Database Sharing System, IMF; EBRD Transition Report; central bank reports; and Fund staff estimates.

Simple average of Armenia, Georgia, Kazakhstan, Lithuania, and Moldova.

39. The size and regional characteristics of the Georgian banking system have changed little over the past two years. The banking system still comprises resident regional small and medium-sized banks, five large banking institutions with branch networks throughout the country, and two foreign banks. Consolidation has continued, with the number of banks falling from 29 at end-March 2001 to 25 at end-June 2003. While this is sharply down from the peak of 229 banks in 1994, Georgia remains over-banked relative to the size of the population and the economy. Recognizing the need for further sectoral consolidation, the NBG’s Banking Supervision Department (BSD) is strengthening its supervisory actions aimed at smaller banks playing little or no role in financial intermediation. While these banks are not systemically important, the NBG and other commercial banks feel that the sector’s public reputation continues to suffer somewhat from their continued operation. At the same time, the NBG is creating incentives for mergers and acquisitions among domestic banks by increasing the minimum required capital to €5 million, in line with European standards.

40. While this approach may lead to further reductions in the total number of banks, it is also likely to increase the concentration of assets that has accompanied sectoral consolidation. At end-June 2003, the five largest banks in the country held about two-thirds of the system’s total assets and loans and about three-fourths of deposits. This has implications for competition and market discipline in the sector that will have to be monitored closely by the BSD in evaluating banks’ proposals for mergers and acquisitions.

Table III-2.

Georgia: Licensed Banks, June 30, 2003

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Sources: National Bank of Georgia; and Fund staff estimates.
Table III-3.

Georgia: Number of Banks per Million People

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Sources: Economic Database Sharing System, IMF; EBRD Transition Report; and central bank reports.

Simple average of Armenia, Georgia, Kazakhstan, Lithuania, and Moldova.

41. Georgia’s formerly state-owned banks inherited an extensive branch network, which imparts some advantage relative to the other domestic banks. However, they have also had to contend with poor management, over-staffing, a challenging transition to Western banking practices, and inefficiencies that the country’s successful private banks have not faced. As sectoral consolidation proceeds, most observers expect to see more mergers and acquisitions aimed at exploiting synergies between these two groups of banks. This trend has already become apparent in the context of bidding on government tenders held in 2003 for the distribution of various social payments, which prompted a number of banks to assemble and bid as consortia rather than as individuals.

42. There are no legal or regulatory barriers impeding foreign investment in the Georgian banking system. Although only two wholly foreign-owned banks operate currently, this does not fully capture the extent of foreign investment and involvement in the country’s banking system. Foreign investment in commercial banks is carried out both by participation in the share of bank capital, with approximately one-third of the authorized capital of commercial banks now composed of foreign capital. Additional foreign involvement in the sector results from the allocation of various types of targeted loans by international financial institutions (IFIs). These external credit lines accounted for approximately 16 percent of total banking system liabilities at end-June 2003. Extension and replenishment of these credit lines depends on the Georgian banks’ ability to demonstrate that the money has been used to provide credit to targeted borrowers, and that the loans are being properly managed and serviced. This system has provided participating banks with critical oversight and transfer of best practices. On-lending has typically been focused on the country’s small and medium enterprise sector, with new credit lines now planned to support development of the mortgage lending market. In the past, these credit lines carried government guarantees, some of which were ultimately called and became budgetary liabilities when the banks involved were no longer able to service them. However, these guarantees are now being unwound, and planned new projects will no longer have this feature.

Table III-4.

Georgia: Banking Ownership by Type and Number of Institutions, June 30, 2003

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Sources: National Bank of Georgia; and Fund staff estimates.

C. Banking System Operations and Recent Developments

43. Total deposits of commercial banks have grown over the past four and a half years by an annual average of 32 percent, with a particularly steep increase (39 percent) in foreign exchange-denominated deposits (Table A-18).

44. Commercial bank credit to the government over the past two years has been minimal, consisting of relatively small purchases of government securities in 2001, 2002, and the first half of 2003. By contrast, bank credit to the rest of the economy has grown steadily since 2000, by an annual average of 22 percent through end-June 2003. Official data suggest the distribution of credit is quite concentrated. The trade and industrial sectors dominate, absorbing upwards of 70 percent of total loans by economic activity.

Table III-5.

Georgia: Banking System Balance Sheet, June 30, 2003

(In millions of GEL)

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Sources: National Bank of Georgia; and Fund staff estimates.

45. Average spreads between deposit and lending rates have been broadly steady at 22-23 percent since end-2001 (Table A-20). However, this average conceals divergent trends in the foreign currency interest rate spreads, which have fallen from 22 percent to 18 percent, and domestic currency interest rate spreads, which have risen from 22 percent to 27.7 percent over the same period. Spreads remain high for a number of reasons, including: (i) uncertainty regarding future macroeconomic developments and associated limited public confidence in the government’s economic policies; (ii) continued inefficiencies in the management and branch structure of some banks that keep lending rates high; (iii) continued high reserve requirements; and (iv) lingering difficulties in enforcing property rights and seizing collateral.

D. Dollarization of the Banking System

46. Georgian officials and representatives of the banking system indicate that price and exchange rate stability have increased public trust toward the lari and expanded its usage. Additionally, strengthened supervision has promoted increased public confidence in the banking sector. However, these factors have not been sufficient to offset depositor concerns about fiscal performance and country and currency risk. Consequently, dollarization has been increasing over the past few years. The share of foreign currency deposits in total deposits, which had peaked at 86 percent at end-2001, fell slightly in 2002, but has risen once again to 86 percent at end-June 2003. As indicated above, the asset side of Georgian banks’ balance sheets is also highly dollarized, with foreign currency-denominated loans making up 86 percent of total loans at end-June 2003. (See paragraph 51 below for a discussion of prudential measures taken this year to address this source of foreign exchange risk.) As a result, the NBG’s influence over monetary transmission mechanisms and interest rate formation is highly constrained.

47. The NBG has extensively analyzed trends in dollarization and taken a number of steps aimed at stimulating lari demand. The frequency of interbank credit auctions has been increased to daily sessions. An overnight credit facility has been introduced, with preliminary announcement of the interest rate offered. Provided the fiscal position is significantly strengthened, government securities could be a promising direction for tapping into domestic demand for safe, liquid, lari-denominated assets; however, the Ministry of Finance has not yet taken the necessary steps to improve the functioning of the primary dealer system and secondary market for these instruments.

48. In an attempt to reduce dollarization, the authorities have recently introduced a differentiation of mandatory reserve requirements according to currencies. This is intended to strengthen banks’ incentives to attract lari deposits and reduce the relative role of dollar deposits in the banking system. Previously, reserve requirements comprised 13 percent on both domestic and foreign currency deposits, of which one percentage point could be fulfilled from balances in correspondent accounts with the NBG, calculated on an average basis over a period of 10 business days. The revised requirements reduce the reserve requirements on deposits in Georgian lari (GEL) to 8 percent. In addition, 4 percentage points of this requirement can now be fulfilled from balances in correspondent accounts with the NBG (on a 10-day average basis), further reducing the effective reserve requirement on lari deposits. Reserve requirements on foreign-currency deposits remain at 13 percent. The NBG is also contemplating an increase in the remuneration on GEL deposits from 4.5 percent to 5 percent and a reduction in the rate on foreign currency deposits from 4.5 percent to 2 percent, with implementation tentatively planned for later this year. An increase in the allowance for averaging of requirements on foreign currency deposits is planned for some time in 2004. By increasing banks’ incentives to attract lari-denominated deposits, the NBG hopes to induce a similar reallocation on the lending side of banks’ balance sheets toward more lari-denominated lending.

49. The differentiation of reserve requirements seems to offer both advantages and disadvantages. Regarding the former, it would appear to be a minimally disruptive way to increase the lari-denominated share of the money supply over which the NBG can exert influence, thereby tightening monetary control. (Past international experience with differential reserve requirements shows that they have tended to undermine monetary control, but these were typically differentiated on the basis of whether deposits had internal or external use. In those cases, regulatory arbitrage produced financial innovations that worked to support the internal use of deposits with the lower reserve requirement cost.) By contrast, the uncertainty about shifts associated with regulatory arbitrage worked to lessen monetary control. This policy may also render the design of Georgia’s monetary program more complex, since the introduction of differential reserve requirements complicates the task of making robust assumptions regarding the overall money multiplier.

E. Banking System Soundness and Vulnerability

50. The prudential condition of the banking system in Georgia has, on balance, improved since the 2001 FSAP. The nonperforming loans ratio has fallen from 11.6 percent at end-2001 to 7.4 percent at end-June 2003 (Table A-21). The liquidity ratio remains at a relatively high level of 44.4 percent in June 2003. The capital adequacy ratio (CAR) has declined noticeably from 33.1 percent at end-2001 to 20.1 percent at end-June 2003. This decline, however, does not reflect a significant loss of net worth but rather an increase in risky assets.

51. The 2001 FSAP highlighted the vulnerability of Georgian banks to indirect foreign exchange risk, stemming from the fact that many borrowers had little foreign exchange earnings with which to repay foreign exchange loans. To address this risk, the NBG introduced regulations in September 2002, requiring foreign currency-denominated loans to carry a 200 percent risk weight unless borrowers have a demonstrated source of foreign currency earnings. Given the high and growing share of dollar loans on Georgian bank books (the share of loans made in foreign currency rose from 82 percent at end 2001 to 87 percent at end-June 2003), the imposition of this requirement led to a significant decline in the CAR from earlier reported levels. Still, the near 20 percent CAR under current risk classifications represents a strong capital position.

52. Updated stress tests conducted by the NBG indicate that the system is well able to absorb a range of shocks. This largely results from improvements made in risk identification, monitoring, and management practices. The principal vulnerability remains, as indicated in the FSAP stress tests, the potential indirect credit risk from a large depreciation. The increased risk weighting on such exposures was meant precisely to address this problem. Additional stress tests also revealed that the earnings of a few of the small banks are vulnerable to disruptions to the servicing of T-bill debt.

Table III-6.

Georgia: Stress Test for Depreciation Shock /1

(As of May 2003)

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Shock assumes the combined effects of a 15 percent depreciation, a 5 percentage point increase in interest rate levels, and a resultant downgrading of loans as follows: for standard loans, 20 percent downgrade to classified; for each category of (non-loss) classified loans, 10 percent downgrade to the next lowest category.

53. Macroeconomic indicators point in different directions with respect to banking system vulnerability. Since 2001, two key achievements of Georgian macroeconomic policy have been the maintenance of low inflation and broad exchange rate stability. These factors have contributed to the steady growth of deposits and credit observed over the past few years. However, GDP growth remains slower than in the pre-1998 period; real interest rates remain high; foreign exchange reserves are low; and the fiscal situation remains fragile with a high level of domestic expenditure arrears. Output growth has begun to accelerate, but any further setbacks could limit the increase in profitable lending opportunities and constrain borrowers’ ability to repay. The weak fiscal situation poses a continued threat to macroeconomic stability, with potentially negative effects on banks’ solvency and liquidity.

F. Regulatory and Prudential Framework

54. The NBG has acted on the majority of recommendations made by the 2001 FSSA and by the January 2003 MFD technical assistance mission aimed at strengthening the legal and regulatory framework for banking supervision. Having made these key changes, the NBG now considers the framework for effective supervision to be complete.

55. The revised “fit and proper” amendment to the law on commercial banks was resubmitted to parliament and signed by the president in December 2002. Although the revisions explicitly denied the NBG the power to amend the criteria for ownership by regulation and constrained the NBG to applying the criteria only at the time of appointments, the limited terms of directors have given supervisors a good deal of practical flexibility. As a result, the NBG to date has rejected renewals of directors six times. Another banking law amendment provides supervisors with legal protection against liability arising from carrying out their responsibilities.

56. Anti-money laundering legislation was approved by the parliament in June 2003, and a Financial Monitoring Service has been established under the auspices of the NBG. Addressing a major concern, the law clearly demarcates the reporting process from tax evasion investigations. Most enabling amendments to other legislation necessary to provide an effective enforcement mechanism were approved by parliament in July 2003, including those related to property confiscation for violators. One final element related to certification still require parliamentary approval, which the Council of Europe has asked the authorities to secure by April 2004.

G. Banking Supervision

57. In addition to introducing necessary legal and regulatory reforms, the NBG has successfully implemented key operational recommendations of the 2001 FSSA aimed at increasing the effectiveness of supervisory efforts.

58. The NBG has begun to employ progressively stronger measures for several problem banks, including formal orders and memoranda of understanding. At the same time, the NBG has opted to follow a more informal approach to problem bank resolution in a number of instances. This has entailed operating under private understandings and confidential letters with bank owners, rather than under formal MOUs and temporary administration. On balance, this approach, while risky in terms of moral hazard, appears to have worked well. Problem banks have often been put under stricter supervisory monitoring, replaced management, and been recapitalized or downsized. In this way, the NBG has made good progress in streamlining the organization, reporting, implementation, and conclusion of bank liquidation procedures.

59. Although the NBG has not obtained the authority to set conditions on the choice of banks’ external auditors, it has noted that most of the larger banks in Georgia utilize funds from donors that require external audits by major international firms. The potential negative repercussions of this limitation are largely mitigated by the fact that the NBG has at times adopted a more conservative attitude on asset classification and other accounting issues than international auditors. Nevertheless, the NBG has indicated that it will continue to push for this additional authority over banks’ external audits.

60. Policies regarding the approval and frequency of on-site inspections have been amended to increase flexibility in scheduling inspections and the frequency of inspection of problem banks. Full on-site inspections for banks with CAMEL ratings of 3-5 are now conducted every 6 months.12 Banks rated 1-2 get a full examination every 18 months, but may be subject to occasional targeted inspections.

61. In keeping with the increased emphasis on risk-based supervision, the NBG has changed the organizational structure of BSD and created a dedicated team tasked with analyzing systemic risks, including through regular stress testing. The unit has updated earlier FSSA stress tests and tested banks’ liquidity and exposure to T-bills. It also analyzes banking system trends, potential resolution and merger strategies, and the effects of regulatory changes on the banking system. Members of BSD have been receiving additional training both from visiting experts and through participation in international programs to strengthen skills in loan classification procedures. However, the main area in which the NBG continues to encounter difficulty regarding organizational change is in increasing the staffing levels and compensation for NBG staff engaged in banking supervision, to reflect the increasing size and complexity of their workload and to slow the outflow of trained staff to the commercial banks.

62. Outreach and cooperation efforts have advanced. The NBG has improved contacts with bankers and draft regulations are now submitted for comment to the Bankers’ Association. The NBG is negotiating MOUs of cooperation with supervisors in Azerbaijan, Greece, and Turkey, whose banks operate in Georgia. Cooperation with other domestic financial supervisors has not yet been formalized.

63. Going forward, the NBG plans to develop further the credibility and predictability of banking supervision and encourage further sector consolidation, by increasing banks’ required minimum capital to the equivalent of €5 million, in line with EU standards. Once this process is completed in the next 2-3 years, the NBG plans to move ahead with the introduction of a deposit insurance scheme, the modalities of which are now being discussed between the NBG and the Georgian Bankers’ Association. BSD staff view this as a key step for reducing macroeconomic vulnerabilities that could stem from problems emanating from the banking sector.

H. Non-Bank Financial Institutions

64. Credit unions are the largest non-bank deposit-taking institutions in Georgia. Regulatory provisions allowing the creation of credit unions were approved in the context of the 2002 law “On non-bank deposit-taking institutions.” Since the adoption of this law, the NBG has licensed (and currently supervises) 42 credit unions, with total assets equivalent to GEL 1 million. There are no investment banks or leasing companies operating in Georgia.

I. Agenda for Financial Development and Reform

65. As the discussion above indicates, the authorities have made significant progress toward putting the country’s banking system on sounder footing, including through implementation of most recommendations of the 2001 FSAP, although additional effort will be needed to implement the few recommendations that remain outstanding. These include securing authority for setting conditions on the choice of banks’ external auditors, and increasing staffing levels and compensation for NBG staff engaged in banking supervision.

66. Key challenges that Georgia’s banking supervisors will face going forward include:

  • Adapting supervision to changing conditions brought on by further consolidation of the banking system, particularly with respect to increase in size (and systemic importance) of individual banks.

  • Facilitating the development of deeper, broader capital markets to increase diversity of opportunities for financial intermediation and to increase diversity and competition in the sector.

  • Maintaining their current conservative approach to supervision in order to compensate for likely continued macroeconomic uncertainties.


Prepared by Patricia Brukoff, Edward Frydl, and Eka Galdava (IMF office in Tbilisi).


A key product of an on-site bank exam is a supervisory rating of the bank’s overall condition, commonly referred to as a CAMEL rating. The acronym “CAMEL” refers to the five components of a bank’s condition that are assessed: Capital adequacy, Asset quality, Management, Earnings, and Liquidity. Ratings from 1 to 5 are assigned for each component in addition to the overall rating of a bank’s financial condition. Banks with ratings of 1 or 2 are considered to present few, if any, supervisory concerns, while banks with ratings of 3, 4, or 5 present moderate to extreme degrees of supervisory concern.