72154 CONFIDENTIAL RESTRICTED USE ONLY (NOT FOR USE BY THIRD PARTIES) FINANCIAL SECTOR ASSESSMENT REPUBLIC OF ARMENIA AUGUST 2012 FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY EUROPE AND CENTRAL ASIA REGIONAL VICE PRESIDENCY A joint IMF-World Bank mission visited Yerevan from February 1 - February 14, 2012 to undertake an update of the Financial Sector Assessment Program (FSAP) conducted in 2005.1 This report summarizes the main findings of the mission, identifies key financial sector vulnerabilities, and provides policy recommendations. 1 The team for this FSAP Update was led by John Pollner (World Bank) and Jennifer Elliott (IMF) and included Su Hoong Chang, Kenji Fujita, Dinah Knight and Erik Lundback (all IMF), Brett Coleman, Katia D’Hulster, Uzma Khalil, Consolate Rusagara, Heinz Rudolph, Hemant Baijal (all World Bank) as well as external experts Michael Deasy (former Central Bank of Ireland), Mindaugas Leika (Central Bank of Lithuania) and Richard Symonds (former World Bank). Guillermo Tolosa (IMF Representative in Yerevan) and Armineh Ghazaryan (IMF local office) and Edgar Karapetyan (Analyst, World Bank Yerevan Office) also participated in the mission. 2 GLOSSARY AML/CFT Anti-Money Laundering and Combating the Financing of Terrorism BCP Basel Core Principles BPS Basis points CAR Capital adequacy ratio CBA Central Bank of Armenia CPSS Committee on Payment and Settlement Systems CT1 Core Tier 1 DGF Deposit Guarantee Fund ECB European Central Bank ELA Emergency Liquidity Assistance FATF Financial Action Task Force FSAP Financial Sector Assessment Program FSC Financial Stability Committee IAIS International Association of Insurance Supervisors ICP Insurance Core Principles IFRS International Financial Reporting Standards IOSCO International Organization of Securities Commission MOF Ministry of Finance MOU Memorandum of Understanding NBFI Nonbank financial institution NPL Nonperforming loan P&A Purchase and Assumption PCA Prompt corrective action RTGS Real-Time Gross Settlement RWA Risk-Weighted Assets 3 OVERALL ASSESSMENT AND SUMMARY OF MAIN RECOMMENDATIONS Armenia has a small but growing financial system dominated by banks. The system was resilient to a serious economic contraction and exchange rate depreciation in 2009 and remains sound. Growing levels of credit, albeit from a relatively low base, and the deepening of dollarization will mean the system is more vulnerable in future. Levels of non-performing assets remain low and the system on the aggregate is well capitalized. Key risks in a few institutions are credit risk for foreign exchange loans, concentration of assets and deposits--both on the asset and liability side—as well as rapid credit growth, especially in foreign currency loans. While a number of measures have been taken to limit foreign currency risk, the mission recommended a liquidity coverage requirement in foreign currency, which will help address liquidity risk since the Central Bank of Armenia (CBA) has a limited ability to extend foreign currency emergency liquidity assistance. CBA supervision should use Pillar II to address possible weaknesses in risk management in banks and risks such as a concentration risk which may be institution specific, and should undertake a systematic analysis of the forex exposure of borrowers, beginning with large borrowers. The authorities have in place a well founded regulatory and supervisory system. The CBA is the ‘mega regulator’ charged with banking and non banking supervision as well as financial stability, crisis management and resolution. The CBA is well resourced and has a very professional and dedicated staff. The CBA’s broad range of responsibilities has the potential to undermine the wide credibility it currently enjoys in the market and the authorities should be vigilant to limit and manage competing mandates. For example, the CBA should not use its resources as a source of capitalization or recapitalization of regulated entities, and should ensure that its development mandate remains secondary to financial stability objectives. The framework for sharing of confidential information with foreign counterparts should be enhanced to meet international standards. The CBA’s supervision of the financial sector is generally robust but regulatory frameworks require enhancement. The framework for banks could be strengthened with sounder definitions of large exposures, a clear responsibility on banks to report any changes in operations that could have a material adverse impact to the supervisor, and clear risk management standards. Supervisory practice would be improved through the use of Pillar II, requiring supervisors to more actively address institution specific risk – CBA staff clearly have the capacity and willingness to take on this dimension of supervision. While insurance supervision is comprehensive and thorough and the regulatory framework is adequate to meet current needs, it would be timely to enhance insurance regulations to better reflect international regulatory developments and to tailor prudential and market conduct regulations to support the establishment of life insurance industry. The pension regulation framework is being constructed—the authorities should be cautious in developing a credible regulatory framework at the CBA with suitable investment policy, fee structure, custody safekeeping and consumer protection regulation. 4 There is a crisis management framework in place that has allowed the CBA to respond effectively to the 2009 crisis. The framework could be improved with clearer delineation of resolution and liquidation procedures in law. Emergency liquidity assistance should be clearly defined and any longer term or recapitalization assistance should be undertaken by the government, rather than the CBA. In terms of access to finance, Armenia has both a low credit to GDP ratio and low ratio of deposits compared to its peers. Lending is concentrated in Yerevan, while access in other regions could be improved through wider payment system options in the market infrastructure allowing financial transactions to take place through non-bank outlets and in more remote areas. Streamlined collateral claim procedures and pooled loan sales should be considered to free up credit, as well as development of a secured transactions framework and infrastructure to broaden the basis of collateral with which to extend credit. Intermediation spreads at Armenian banks have declined but still remain higher compared to some regional peers. While not the only factor, the relative small size of banks implies proportionately larger overhead costs, an area where technology such as e-banking and automation may contribute to reducing spreads. The non-bank market remains underdeveloped, with very limited alternatives to bank funding or deposits. Pension reform will be introduced beginning in 2014, bringing additional investments to the market. Comprehensive planning for implementation of the reform is needed as a matter of priority, including an analysis of transition financing, licensing standards for asset managers, and rules governing investment policy. The lack the depth of the capital market is impeded by dollarization and the limited size of the economy. The same lack of capital market will make it difficult for both pensions and life insurance to develop. The authorities are taking steps to enhance markets, for example by introducing a term cash market that would allow for a foreign exchange forward market to develop. Additional steps can be considered in terms of broadening market development from a focus on equity and bond issuances (which require transparent disclosure and other costs) to promoting additional securities including simple securitizations, potential small privatizations as well as focusing government bonds on selected but larger issuances on a few but well selected benchmark points on the yield curve. 5 Armenia FSAP Update: Main Recommendations Recommendations Priority Timeframe Plan introduction of liquidity coverage ratio for foreign High Immediate currency Introduce use of Pillar II supervisory techniques High Medium term Amend law to require banks to immediately report changes High Immediate to operations that have a material adverse impact on the bank Amend legislation to clarify to allow for clearer and earlier Medium Medium term triggers for provisional administration to conduct resolution operations. Amend Deposit Guarantee legislation to allow funds to be Medium Medium term used in resolution operations; and shorten depositor pay out period Develop sound framework for the investment policy and High Medium term asset manager regulations for pension funds Develop pension supervision capacity at CBA High Medium term Assess reform transition cost to reduce debt-financed High Medium Term portion of pension reform Amend the Civil Code and other relevant laws to simplify Medium Medium term and accelerate registration and execution of collateral 6 I. FINANCIAL AND MACROECONOMIC SETTING A. The Financial System 1. The Armenian financial sector is dominated by banks. The system has a relatively low level of intermediation with credit to the private sector corresponding to less than 26 percent of GDP, compared to about 33 percent in Georgia and Moldova, or 44 and 62 percent in Russia and Ukraine, respectively. There is a nascent insurance industry and capital market; there are few institutional investors—a funded pension system framework just being completed for future implementation. 2. The banking sector is fragmented—there are 21 commercial banks,2 with the largest having less than 11 percent of system assets. Approximately half of the banking sector (by assets) consists of subsidiaries of foreign banks, from Russia, France, UK, Cyprus and Kazakhstan. Domestic banks are generally smaller but the second largest is a domestic bank. Banks are profitable relative to comparable banking sectors (see Figure 1). There are few interlinkages between banks and a limited interbank market. 3. The non bank sector is underdeveloped with a small but growing insurance sector and a tiny capital market. Developing this sector is a priority for the authorities as pension reform and other policy measures are being taken to promote the presence of institutional investors and product innovation. 4. Dollarization has been a defining feature of the Armenian economy since independence, although dollarization deepened following the crisis. The preference for dollars is, in part, due to the high levels of remittances emanating from the large diaspora population (7 million versus just over 3 million in-country) residing in Europe, the U.S. and Russia. The 2009 dram devaluation increased the holdings of dollars as a safer haven. The authorities have taken measures to limit further dollarization including both increased risk weights and provisioning charges on dollar assets as well as higher reserve requirements on dollar deposits. Further foreign currency lending is limited to corporations and a very small mortgage sector. 2 In addition, there is one development bank, established in 2011and not yet fully operational. There is also a special purpose national mortgage company. Both of these institutions are supervised by the CBA. 7 B. Effects of the Global Crisis on the Economy 5. The Armenian economy was hard hit by the beginnings of the financial crisis in 2008, culminating in a GDP contraction of 14.1 percent in 2009. The contraction was caused by adverse shocks to the current and capital accounts, particularly emanating from Russia, leading to a contraction of remittances (see Box 1) and a collapse in the construction sector, and deteriorating export prices and demand. As a result, the current account deficit widened substantially and the exchange rate depreciated sharply.3 6. The economy has since rebounded, but is still in a recovery phase. Fiscal consolidation is ongoing and continued efforts are needed. Inflation has come down rapidly in 2011 and the policy rate was lowered in September 2011, the first time since September 2009. C. Implementation of 2005 FSAP Update Recommendations 7. The previous FSAP Update identified foreign currency lending and increased credit growth as sources of risk, which they remain today. The report called for greater integration of prudential regulation and macroprudential monitoring, which has been undertaken by the CBA. The report also recommended greater standards for bank governance and banking supervision, many of which have been introduced. An insurance law has been introduced per the recommendations. The 2005 report focused on monetary operations, which have been considerably strengthened in the interim period. Challenges remain in the conduct of monetary policy, including high volatility in short-term interest rates and consistency with a floating exchange rate regime. D. Vulnerability Analysis – Key Macroeconomic and Financial Risks 8. A possible downturn in the Russian economy and a drop in commodity prices are key risks to the real economy. Armenia is a small open economy with a significant dependence on remittances, primarily from Russia and is vulnerable to a shock to the Russian economy due to a drop in oil prices and spillover from the euro area. As exports consist largely of raw materials such as minerals and metals, a drop in commodity prices for the exporting Armenian mining industry is also a risk. While these risk factors are not new, the space for policy responses has decreased as the public debt to GDP ratio has increased substantially since 2008. 9. Given bank ownership structures, direct spillover effects from parent banks in the euro area would likely be limited. Second round effects of a downturn in Europe and, in particular, Russia, might have a greater impact on banks through increased credit risks in the real sector, including through lower remittance inflows, which to a considerable extent are channeled directly into investments or income supplements rather than saved in banks. 3 In 2009 a Stand-by Arrangement was signed with the IMF to support the crisis response, which was followed by a three year Extended Fund Facility/Extended Credit Facility supported program in mid-2010. 8 10. The large external current account deficit is a potential vulnerability. The current account deficit was reduced by more than 3 percentage points in 2011, but remains high at 11½ percent of GDP. While external adjustment is continuing and capital inflows have remained strong (FDI, official financing, banking flows), risks of pressures on the dram. E. Banking Sector Risk Assessment 11. The sources of financial sector vulnerability have not fundamentally changed following the global financial crisis. However the sector’s starting position has shifted in the face of another shock. The basic structure has not fundamentally altered and key macroeconomic risks are largely the same, but recent developments have brought important changes:  The shares of foreign currency in both deposits and lending have increased significantly.  The recovery in the banking sector is still ongoing, and while banks have weathered the worst of the crises, their capital buffers have declined from pre-crisis levels (in part due to increased risk weights on foreign currency assets). In particular, loan portfolios are somewhat weaker as evidenced by NPL ratios..  As in many other countries, policy buffers have been reduced since 2008. Public debt to GDP has increased and gross international reserves, which were used to defend the currency in 2008 and 2009 (before it was allowed to fall), and are on par with pre- crises levels. In this context, it may also be noted that the current account deficit, despite a narrowing, remains sizeable and external debt to GDP has increased from less than 30 percent in 2008 to a projected 65 percent in 2011.  The level of credit is higher and should be monitored including its potential impact on the economy if a similar shock as in the recent crisis were to occur. 12. One positive factor in the post-shock environment is a greater awareness of exchange rate risks among banks and borrowers. For example, it appears that some commercial banks have stepped up their risk management regarding credit risks stemming from exchange rate volatility. Similarly, households and businesses now have very recent experience of a sharp depreciation and are more likely to appropriately take that into consideration. 9 Figure 1. NPL Ratio to Gross Loans NPL ratio to gross loans (percent) 12 excluding watch, including write-offs CBA definition 10 8 6 4 2 0 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Sources: CBA 13. Provisioning against NPLs, according to the local definition, was at a moderate 41 percent coverage at end-September 2011. This is somewhat below pre-crises levels, but well above the low point of 26.5 percent in 2009. When using the more common calculation of NPL provisions including loans written-off but excluding watch category 2 loans; NPLs had provisioning coverage of 103 percent at end-September 2011. This compares favorably to other countries in the region, partly reflecting Armenia’s relatively low level of, and moderate increase in, NPLs. One caution would be that NPLs tend to evolve at a lag to credit growth. CBA data shows an average loan-to-value of 33.66 percent for loans registered in the credit registry. 14. NPLs vary among banks, and in some the levels are elevated. As of end December 2011, NPLs in five banks exceeded 10 percent, including write-offs. A key factor behind the asset quality deterioration in these banks is the concentration of their credit portfolio with large exposures to just a few borrowers. 15. Since many foreign currency borrowers do not have a corresponding foreign currency income stream this clearly adds to the credit risk. Recognizing these risks, the CBA has introduced tighter capital and provisioning rules for foreign currency loans (see below). There is no systematic collection of information to what extent foreign currency borrowers are naturally hedged through a corresponding income stream, and it is not taken into account for capital requirements, although some banks do incorporate this analysis into internal risk management. Many borrowers, including individuals and small businesses, have foreign currency revenues, including from remittances. 16. The solvency stress test results suggested that Armenian banking system is robust enough to withstand simulated shocks. Solvency stress tests simulated the impact of one baseline and two recession scenarios: moderate and severe slowdown in economic activity pared with a significant AMD depreciation vis-à-vis the USD. Several banks would need limited amounts of additional capital. It should be noted that during shock periods, banks may be 10 constrained in their abilities to generate additional capital as an increase in interest rates would worsen their income streams. While this is partially because Armenian bank portfolios are dominated by fixed interest rate loans, the pass-through of funding cost increases to customers is not entirely constrained since the maturity mismatch between assets and liabilities is low (about four months) and current interest rate spreads are relatively high. Combined with additional loan loss provisions that might be required, though, this could further erode capital buffers. However, with relatively high capital buffers at the moment, this helps banks mitigate these risks. 17. Concentration of individual banks’ exposures constitutes a clear vulnerability. Although concentration in the banking system is low (HHI index is only 6664), banks’ loan portfolio concentration is fairly high and warrants particular vigilance from the authorities. Concentration risk is not unexpected in a small financial sector and concentration risk is especially important for small banks that have small loan portfolios with a number of bigger clients. Stress tests assuming that the largest borrower will fail reveal that several small and mid- sized banks would need additional capital; although as in the case of macro scenarios, these amounts are very limited.5 Failure of the four largest borrowers would lead to more significant impact; however the amount of recapitalization needs in terms of GDP would still be limited on account of the relatively small size of the Armenian banking system and the small size of the most vulnerable banks. 18. Banks appear to be well capitalized. The capital adequacy ratio (CAR) declined from 27.5 at end-2008 to 19.6 at end September 2011, though a large part of this was as a result of regulatory changes requiring higher asset risk weights. Leverage increased from 435 to 540 percent, possibly reflecting a general trend of increasing risk appetite within the banking system. Capital is mostly Tier 1, accounting for about 90 percent, and there are only a couple of banks where Tier 2 accounts for more than 20 percent. The direct effects from any deleveraging by banks in EU and other advanced economies would likely be small in Armenia. There is only one bank in the system which is majority owned by an EU based bank. Through the third quarter 2011 there was no sign of any reduction of exposures by any sizable foreign owned bank. It appears that all banks would meet Basel III capital levels should those be implemented. 19. Armenian banks are mostly deposit funded. The customer deposit to non-interbank loan ratio has declined from high levels in the past, but has been fairly stable around an average 91 percent in the last four years. Banks have increased its funding from foreign banks, including parents, international organizations, the government, and the CBA. The interbank market is fragmented and does not constitute a significant source of bank liquidity or funding. 20. Liquidity stress tests highlight that banks are able to cope with large scale liquidity outflows. However, outflows in foreign currency alone are less manageable in some cases even though AMD liquidity is largely available. The banks maintain fairly large liquidity buffers in 4 Hirshman-Herfindahl Index equals sum of squared market shares for each bank. Maximum value is 10000. 5 Stress tests were based on Q3 2011 data. In Q4 one bank increased its capital ratio. 11 both domestic and foreign currency. The CBA imposes strict liquidity requirements, although no differentiation among various currencies is made. Banks are not exposed to market funding risk, as main sources of funding for majority of banks are domestic and IFI deposits. Foreign-owned banks indicated that in the case of a systemic liquidity event they expect support from parent institutions. Figure Figure 1: Armenia 2. Armenia FSI FSI Ratio's Ratios: - Peer Peer Countries Countries Analysis,February February 2012 Analysis, 2012 Regulatory Capital / RWA Bank Capital to Assets 0 10 20 30 40 0 10 20 30 Moldova Armenia Ukraine Georgia 2011 2011 Armenia 2006 Moldova 2006 Georgia Ukraine Turkey Russia Russia Turkey NPL / Total Loans Provisions / NPL 0.0 20.0 40.0 60.0 80.0 0 50 100 150 200 Ukraine Turkey Georgia Russia 2011 2011 Moldova 2006 Ukraine 2006 Russia Georgia Armenia Moldova Turkey Armenia ROE ROA -10 0 10 20 30 -1.0 0.0 1.0 2.0 3.0 4.0 5.0 Turkey Armenia Georgia Turkey 2011 2011 Russia 2006 Georgia 2006 Armenia Moldova Moldova Russia Ukraine Ukraine Source: GFSR, February 2012; CBA; Staf f Calculations Note: per country: top bar is 2011, bottom bar is 2006. 12 II. FINANCIAL SECTOR DEVELOPMENT A. Financial Intermediation Efficiency and Costs 21. Despite significant recent growth, Armenia’s banking sector still exhibits relatively low credit penetration, and interest rate spreads though declining, are higher than in comparable countries. The average ex-ante interest rate spreads (the difference between weighted average lending and deposit rates) declined from 12.1 percent in AMD and 12.7 percent in USD in 2005, to 10.3 percent AMD and 7.5 percent USD by end 2010. Increasing competition in the AMD funding and credit markets has significantly narrowed spreads to an average of 8.6 percent in AMD, and 5 percent in USD by end 2011. However, such averages mask significant differences between banks, economic sectors and market segments. Smaller banks pay a higher premium for deposits in the local market. Access to relatively cheaper, longer term and less volatile lines of credit from IFIs and parent banks as part of the crisis response helped reduce the cost of dollar funding for most banks since 2010. The inability of banks to hedge the FX induced credit risk in dollar denominated loans is a further cause of high intermediation costs. 22. Intermediation efficiency remains relatively low as measured by the net interest margin (interest revenue-interest expense/assets) which in Armenia is 7.1 percent compared to a regional median of 5.3 percent. In comparison, countries within the same income group have an average intermediation spread of 4.6 percent. Overhead operating costs verus total assets for the banking system are also higher averaging 4.6 percent compared to a regional median of 3.5 percent, though they are lower than Georgia which has 5.8 percent and Moldova at 5 percent. However, Armenian banks exhibit a high cost / income ratio averaging at 85 percent as at end Sept 2011. NPL ratios are low and their effect on the net interest margin seems modest. Armenia as well has a fully functional private Credit Bureau and a public credit registry both of which banks consider efficient in providing borrowers’ credit information. 23. High intermediation spreads thus seem to be a function of the additional risk charges on holding dollar denominated assets and loans, an insufficiency of AMD deposit funding, and the relatively small size of banks with commensurate larger operational overheads. As such, the main feasible area for cost reduction which the authorities could consider supporting would be further consolidation of small banks where feasible, and promoting innovative technology and automation to reduce operational and overhead costs and secure electronic based service delivery channels that could enhance efficiency and reduce operational and administrative costs. 13 B. Access to Finance 24. Banks account for 92 percent of the financial system’s assets, while credit organizations account for 5.5 percent. Private sector credit to GDP remains low at about 26 percent,6 compared to the ECA7 median of 41.9 percent. Lending is concentrated in Yerevan: about one-third of the adult population resides in Yerevan, but Yerevan accounts for 66 percent of bank lending and 56 percent for credit organizations. 25. The penetration of deposit services in Armenia remains among the lowest in the region. Banks are the only licensed provider of deposit services in the country. At end 2010, the deposit-to-GDP ratio was 16.9 percent, compared to the ECA median of 40.3 percent. In 2010, there were 589 deposit accounts per 1,000 adults, compared to 914 for ECA. 26. Micro, small and medium enterprises (MSMEs) access to loans is limited due to lack of capacity. MSMEs often lack the necessary skills to be considered creditworthy. They may also either lack skills to produce reliable financial reports on which a lender can rely, or not want to share financial information with a bank or a credit organization. Microfinance could be expanded by defining it more clearly, possibly rebranding its institutions (currently falling under the rubric of universal credit organizations) so as to characterize some of their specialized functions, and promoting greater involvement of such institutions in donor and government credit programs. 27. While the collateral regime has improved in recent years, shortcomings remain in several areas, limiting the realization of using collateral to expand credit. First, there appears to be a limitation in existing practice on the registration of floating security interests (e.g., accounts receivable or inventory). To allow security interests to attach to such classes of goods more widely, training of judges and financial institutions should be conducted to clarify that it is legally allowed and to provide technical guidance for its implementation. Second, the process of registering collateral is costly and time-consuming, requiring several steps that typically take over a week and several physical movements of the lender and borrower to deliver or retrieve documents. 28. Third, the process of foreclosing on the collateral of a defaulting borrower, taking possession of the property, and selling it is risky and time-consuming. The step of foreclosure has been partially addressed through the option of arbitration rather than going through the judicial system. Once there is an arbitration decision and confirmation by the court which is conducted relatively speedily, the process of taking possession and selling the collateral 6 This reflects IFS figures. CBA reports 27.1 percent in 2010. For consistency and comparison purposes, IFS data is used in this report unless otherwise noted. 7 Europe and Central Asia (“Europe” includes only EU new member states). 14 is a second stage and reverts to the court requiring notification to the borrower, which can easily be evaded. Recent changes in the civil law, which also provides an option for financial organizations to foreclose through out of court proceedings, however, is reported by the authorities to have led to time-saving and efficient processes for many banks. 29. The development of the leasing market should also be promoted. Leasing can be expanded by first equalizing the tax regime between lease-financing and loan financing, and considering giving leasing a tax advantage for a period of time to develop the market. As well, leasing capacity and technical know-how should be developed in banks and credit organizations. 30. Recommendations to expand credit and deposit services include: a. Improving the collateral realization process; b. Promotion and expansion of microfinance; c. Regulatory modifications to promote leasing and mortgage pool sales. C. The Pension Sector 31. The approval of a law that allows the creation of a multi-pillar pension system is a positive development. The organization of the pension fund industry takes into account international best practices, allowing competition in the areas of asset management and pooling in the areas of account management and reporting functions, where it is possible to take advantage of significant economies of scale. The Armenian government should strengthen the efforts to consolidate the political support for the reform both within and outside the government coalition. 32. The main risk of reversal of the pension reform is that it may end up being completely financed with debt. While there is a perception that the fiscal cost of the reform is low, the reform did not include an explicit mechanism for financing the transitional deficit. In order to provide sustainability to the pension reform, the government should make explicit the mechanism of financing of these deficits, which should have a tax financed component in the first years after the reform. Otherwise, pension funds (as well as other capital markets fund and bond asset managers) could end up with large holdings of government bonds to finance the transition cost. 33. A still high level of dollarization also poses barriers to the development of the securities markets needed for pension fund asset managers. The development of the money market, through the joint initiative currently being undertaken by Nasdaq OMX (the country’s stock exchange) could generate sufficient liquidity to support a currency forward market. This initiative should be aligned with further streamlining the yield curve, through a government debt strategy focused on fewer but stronger benchmark points, so that they may have more liquidity in the secondary market, and intermediaries may use such instruments to develop a spread curve for Armenian dram (AMD) risk The existence of a stronger yield curve may facilitate the entry of 15 foreign investors taking more strategic positions in AMD, and avoiding the unnecessary financial risk to companies of issuing foreign currency debt in AMD earning sectors. 34. The CBA strategy should focus the licensing strategy on selecting a limited number of experienced asset managers for the mandatory pension funds. In order to reduce risks during implementation of the reform, the CBA should bring asset managers with global presence, proven risk management capacity, and with a strategic view of the Armenian economy. The authorities should carefully design regulatory entry requirements (e.g.,: capital, reserves, etc.) to ensure that costs remain reasonable to avoid excessive barriers while focusing on fund managers with state of the art risk management technology, recognized investment qualifications and global experience. The CBA needs to make sure that asset managers bring the costs to more reasonable levels. High marketing costs passed on to contributors as occurred in several countries, can be avoided by initially randomly allocating contributors to funds and subsequently allowing switching once the market is operating. 35. Finally, high quality asset managers do not guarantee that they would invest assets in portfolios that maximize future pensions. A framework for pension regulation should be developed and implemented by the CBA. Such framework should define amounts allowed to be invested abroad to diversify the portfolio, and consider imposing a benchmark (market index) for such investments. Regulations should set requirements for minimum duration of the assets, and the type of risks that the government expects to be hedged (i.e., inflation, interest rates). The regulation should be careful in defining a lifecycle default option for those individuals that do not make an explicit selection of portfolio (balanced, conservative and fixed income fund D. The Insurance Sector 36. The insurance industry in Armenia is small and has recently consolidated. Assets held by insurers accounted for only 1.3 percent of total financial sector assets as at end-2010. The key risks of the Armenian insurance industry are risk accumulation arising from natural catastrophes and credit exposures to reinsurers. It is critical that insurers have effective risk management to control their retentions of risk accumulations arising from catastrophic events such as earthquakes and establish prudent risk strategies and tolerance limits. Due to limited financial and underwriting capacity, insurers typically reinsure a significant portion of the large risks accepted. To ensure the security of reinsurance protection, the CBA requires reinsurers to meet its eligibility criteria. Insurers’ investments were highly liquid, mainly in deposits with domestic banks, due to the limited investment opportunities locally. Some insurers are exposed to foreign exchange risks arising from deposits denominated in foreign currencies, mainly in US dollars. The CBA has identified this risk and has proposed standards to become effective July 1, 2012. The cost and practical ability to hedge may pose challenges. Insurers held only 9 percent of their assets in government securities. 37. Significant challenges confront the establishment of a life insurance industry in Armenia. At the time of assessment, there was no licensed life insurer in Armenia. Armenians 16 may purchase life policies from insurers outside of Armenia and some do so through insurance intermediaries. Some general insurers who operated as composite insurers prior to 2006 converted their small volume of term life insurance to personal accident policies. The low level of awareness of the benefits of life insurance protection and shallow financial markets are key impediments to the development of a life insurance industry. E. Securities Regulation and Capital Market Development 38. Universal banks dominate the securities sector, but the structure will change with the advent of new investment and pension funds. Due to the low level of market activity, in 2011 there were very few independent investment service providers (8) compared to banks that were registered to carry out such activity (21). In the future it is likely that some of the investment service providers will re-register to become asset managers since that is where the bulk of the activity in the capital markets will be. Banks will also extend custodial services, although they cannot act as both custodians and asset managers. As asset management services increase the CBA should be aware of developing conflicts of interest. 39. As the market develops, the CBA will need to consider whether it wants investment service advisors to act as dealers, i.e., as counterparties holding own positions. This can provide for much more liquidity in the market. Currently, rules for intermediaries only cover transactions in which the intermediary is a broker, as a result of the requirement that all secondary trading takes place on the NASDAQ/OMX. New rules would be required such as those limiting the “mark-up” in price between what dealers bought the securities for and the price they sold it to the customer. 40. The future development of the capital markets in Armenia will depend in a large part on the development of a significant institutional investor base. Recognizing this, the Armenian Parliament passed a new Law on Investment Funds (LIF) to provide for the regulatory framework for the development of the fund industry in Armenia. Investor protection provisions in applying the LIF should be monitored, for example, by ensuring that civil liability provisions are well known to all parties, and enforced, allowing an investor to seek remedies from an asset manager or custodian for failing to act in his/her best interests. The law should also set clear standards for the segregation of the assets of the investment funds from the assets of the custodian and the custodian’s other clients. 41. Following mass privatization, the stock market has seen a decline in listed securities that continues to this day. When NASDAQ OMX arrived in Armenia (after purchasing the Armenian Stock Exchange and later the central depository), the decision was made to let a large number of privatized companies exit the exchange, but there have been few issues to replace them. The NASDAQ OMX also owns several exchanges including in the Nordic and Baltic countries and thus provides a potential common platform for inter-country trading and potential integration of Armenia’s market once developed, within a broader regional market. Most trading in the capital market for now, however, is limited with only one active stock trading in Armenia 17 and outside the exchange government bonds mainly are traded over-the-counter and then registered in the CBA’s system, CBANet. 42. The demand for securities could grow with the roll out of the pension funds. But the suppliers of securities are scarce and currently have few incentives to issue stocks or bonds given transparency requirements and ownership takeover threats. Bond issuers cannot yet compete with the lower administrative and underwriting costs for obtaining bank loans. 43. Developing initiatives for increasing the supply of capital market securities will therefore require a multi-pronged effort. This compares to the traditional ‘organic’ growth of markets, given Armenia’s small ‘financial space,’ and efforts should thus include simultaneous initiatives to generate competition and innovation in the sector. These may include various spheres of intervention such as regulations for developing bonds and asset backed securities, efforts at privatizing shares in remaining state owned companies (such as various energy companies as well as water, minerals and telecommunications enterprises) all of which would generate more liquidity and competition in securities markets, and include initiatives such as: a. Securities regulation oriented to financial market access and product development; b. Institution-specific led initiatives by the National Mortgage Company and the Development Bank; c. Public sector strategic initiatives on debt management and privatization. III. FINANCIAL SECTOR OVERSIGHT A. Cross-border Cooperation and Information Sharing 44. Armenia is home to a number of cross-border institutions and the CBA enjoys good relations with foreign counterparts. In particular the CBA has frequent contact with its counterpart the Central Bank of Russia, as Armenia is host to 3Russian banks and an Armenian subsidiary operates in Russia. It has MOUs with a number of countries, with the notable exception of the UK FSA, home regulator of a large subsidiary in Armenia. While there are no legal impediments to the UK FSA sharing information, the CBA cannot share with the UK. On a practical level, the CBA has little involvement with the UK FSA—although this is not due to the unwillingness of the Armenian authorities. 45. In keeping with international standards, the CBA should have greater flexibility in sharing of information with foreign regulators. Under the law, the CBA can only provide information to a foreign regulator where it has an MOU in place with that regulator; the CBA should be able to provide information where it can satisfy itself that any information released to another regulator will be used for supervisory purposes only and will be subject to appropriate confidentiality standards at the receiving institution. Currently the CBA has no ability to initiate 18 an investigation on behalf of a foreign authority, a shortcoming that must be addressed, inter alia, to meet IOSCO requirements. B. Banking Supervision 46. The Basel Core Principles assessment found that, in general, the CBA has a well structured banking supervisory regime in place and its supervisory department appears adequately staffed. That said, more work remains to be done for a sound and comprehensive implementation of Pillar 2 and its integration in the supervisory methodology. Although the absolute minimum legal requirements for Pillar II are in place, the assessors recommend more frequent (i.e., annual) structured dialogue with banks' Board or Senior Management on their capital adequacy assessments. The Pillar II assessment should at least include credit concentration risk, interest rate risk in the banking book, indirect foreign exchange risk as well as risks that are difficult to quantify such as reputational and strategic risk. An example that appeared in stress testing is that of small banks with both a concentration in assets and liabilities, risks which could be addressed via a Pillar II assessment. Pillar II assessments should form the basis for the setting of the supervisory cycle and scheduling of targeted examinations as well as individual capital ratios that will be better aligned with the risk profile of individual banks. 47. There is room for reviewing and enhancing CBA’s regulations to put greater emphasis on risk management instead of control. A re-assessment of the distribution of provisions between mandatory regulations and “comply or explain” guidance also needs to be performed. Moreover, specific risk management guidelines for the assessment and monitoring of indirect foreign exchange risk, the revaluation of positions as well as guidelines for the internal validation of risk management model should be issued. C. Insurance Supervision 48. While the regulatory regime is adequate for the current stage of market development, there is scope for enhancement to take account of international regulatory developments and the establishment of a life insurance industry in Armenia. To improve observance with the ICPs, the authorities are advised to expedite the issuance of regulations governing insurers’ derivative activities and the finalization of regulatory requirements to combat insurance fraud. The solvency regime could be fine-tuned to provide for transparent solvency control levels and supervisory intervention ladder, address group solvency requirements and regulatory treatment of assets supporting technical provision that are encumbered. Regulatory requirements relating to risk management could be enhanced to better reflect international best practices. It would also be timely to formulate an appropriate group- wide supervision framework in line with the current standards of the IAIS. To support the development of life insurance, there is a need to tailor both prudential and market conduct requirements to protect the long-term financial commitments of life policyholders. 19 D. Regulation of Payments and Settlement Systems 49. The payment and settlement systems infrastructure for both large value as well as retail payments is well developed. Existing basic data collection tools and methods should be replaced with a more organized and automated monitoring system (i.e., data warehousing tools and systems). It would also be desirable to have some aspects of monitoring be conducted automatically and in near real time. It is also recommended that the human resource capacity of the Payment Systems Oversight Division (PSOD) be strengthened. The CBA should also examine international examples of how the payment systems oversight capacity has been enhanced especially with the advent of innovative payment instruments, such as mobile payments. Suggested examples include the ECB, Swiss National Bank, US Fed, and the Central Bank of Russia. 50. The CBA should enhance the legal and regulatory framework to enable development of the market in electronic money products – prepaid cards, virtual wallets, mobile payments. The CBA should clearly define regulations for prepaid products, payment services and e-money issuers, so they are not overly restrictive for eligible non-bank payment service organizations to effectively participate in the issuance of such products and promote financial inclusion. For the development of mobile payment services, CBA should encourage the Armenian Unified Card Payment System (ArCa) to utilize its account-to-account product feature to develop a centralized clearing mechanism through which mobile network operators and interested commercial banks can participate. E. Consumer Protection in Financial Services 51. Disclosure of information to consumers needs to be improved to provide them with easy-to-understand, full and comparable information on financial products. Basic disclosure documents should be developed for consumers; these would spell out of the primary characteristics of a financial product in a short document written in easy to understand language, thus enabling a financial consumer to make a more informed choice. This should include, inter alia, in depth explanations of risks of products with foreign exchange features, understandings on computing comparable net pension returns on investments under asset management, and other financial products and services. 52. The CBA should coordinate with other agencies and Ministries on a national financial education strategy. Financial education programs both within the school system and for the general public need to be developed, coordinated and evaluated as a joint activity of the CBA, Ministries of Finance and Education, the Mediator and market participants based on a long-term national financial education strategy. F. Anti-Money Laundering and Combating the Financing of Terrorism Framework 53. A full anti-money laundering and combating the financing of terrorism (AML/CFT) assessment was undertaken by the IMF and MONEYVAL in February/March 2009. 20 Considerable progress was made since Armenia’s first AML/CFT evaluation in September 2003 by MONEYVAL.8 However, some deficiencies remained, notably in the areas of confiscation and provisional measures, financial secrecy laws, customer due diligence, designated non- financial businesses and professions, the criminalization of the financing of terrorism and finally freezing and confiscation of terrorist assets pursuant to United Nations Security Council Resolutions 1267 and 1373. G. Macroprudential Framework 54. The CBA has employed a number of macroprudential policy tools to address risks of Armenian banking system stemming from dollarization. The CBA has applied higher risk weight and higher provisioning for FX lending than for dram lending to mitigate credit risks associated with foreign exchange lending. To reduce the direct currency mismatch risks, the CBA restricts the banks’ net open position to 7 percent of the capital. The CBA has also applied a higher reserve requirement ratio for foreign currency liabilities to stave off deposit dollarization. Though the changes in the reserve requirement ratios were made with a view to strengthen monetary transmission through deposit de-dollarization, it is expected to reduce foreign exchange lending under the relatively strict net open position restriction. Nonetheless, further improvements can be made in following areas: a. Monitoring the currency mismatch of borrowers; b. Introduction of liquidity coverage ratios by currency; c. Further clarification of the terms of reference of the Financial Stability Committee; d. Greater public communication on systemic risk monitoring and macroprudential policy formulation. IV. LIQUIDITY, CRISIS MANAGEMENT AND SAFETY NETS A. Emergency Liquidity Assistance 55. The CBA provided unusual financial support to banks following the 2009 crisis. The CBA Law allows the CBA to provide a broad range of emergency assistance to banks. In addition to short-term liquidity assistance with a maturity not exceeding six months with collateral, the CBA is able to, in exceptional cases, extend loans with “special lending procedures and conditions,” including unsecured loans with terms up to five years. The scope of the CBA’s emergency assistance should limited to secured loans to solvent organizations. More permanent crisis assistance, including capital support, should be provided directly by government on the clear advice of the CBA. 8 MONEYVAL is the FATF-style regional body of which Armenia is a member. 21 B. Bank Resolution 56. The CBA has a broadly appropriate range of powers to intervene and resolve problem banks, but these powers could be clarified and strengthened. The powers are progressively intrusive, which should allow the CBA to deal with increasingly severe problems at a bank. Tools include measures to compel remedial action while the bank remains under private control, as well as a number of measures that can be taken once the CBA has determined that private control of the bank should cease (i.e., appointing an administrator to resolve the bank as a going concern, revoking the license of the bank, selling the bank’s assets, or ultimately commencing bankruptcy and liquidation). In each of these areas, improvements could be made to facilitate the effective use of the tools: a. The CBA’s power to instruct shareholders to raise capital could be more explicit; b. The triggers for provisional administration should be fine tuned and allow for intervention at an earlier stage of the bank’s distress; c. Procedural time delays for provisional administration to be appointed, should be reduced; d. A framework that allows for the prompt, orderly liquidation of failed banks should be established. C. Deposit Insurance 57. Further steps should be considered for the deposit guarantee fund (DGF) to become an effective safety net participant; namely, shortening the payout period, and permitting the use of DGF resources in purchase and assumption transactions. It is not uncommon for a deposit guarantee scheme to limit its activities during its infant stage. The authorities should consider whether it is the appropriate time to further align the DGF with best practice, in particular whether the payout period (currently 3 months) could be shortened to approximately 20 days. In addition, the DGF can be made more effective as a bank resolution tool by allowing it to “fill the balance sheet gap” for good assets and insured deposits and other liabilities transferred to a healthy institution through a purchase and assumption transaction if doing so is less costly to the DGF than a direct payout to insured depositors. Table 1. Armenia: Selected Economic and Financial Indicators 2006–2013 2006 2007 2008 2009 2010 2011 2012 2013 Act. Act. Act. Act. Act. EBS/11/94 Proj. Proj. Proj. National income and prices Real GDP (percent change) 13.2 13.7 6.9 -14.1 2.1 4.6 4.6 4.0 4.0 Gross domestic product (in billions of drams) 2,656 3,149 3,568 3,142 3,502 3,837 3,871 4,219 4,583 Gross domestic product (in millions of U.S. dollars) 6,384 9,206 11,662 8,648 9,371 10,037 10,126 10,472 10,857 Gross domestic product per capita (in U.S. dollars) 1,982 2,853 3,606 2,647 2,840 3,012 3,039 3,112 3,194 CPI (period average; percent change) 3.0 4.6 9.0 3.5 7.3 9.4 7.8 3.6 4.2 CPI (end of period; percent change) 5.4 6.7 5.3 6.7 8.5 6.7 4.7 4.7 4.0 GDP deflator (percent change) 4.6 4.2 5.9 2.6 9.2 6.0 5.7 4.8 4.5 Poverty rate (in percent) 1/ 26.5 25.0 27.6 34.1 ... ... ... ... ... Investment and saving (in percent of GDP) Investment 35.9 37.8 40.9 34.7 33.4 33.2 33.0 32.7 33.5 National savings 34.1 31.4 29.0 18.9 18.7 21.7 20.8 21.8 23.9 Money and credit (end of period) Reserve money (percent change) 41.1 50.9 5.3 13.8 -0.8 10.9 17.4 10.4 ... Broad money (percent change) 32.9 42.3 2.4 16.4 10.6 14.0 19.0 13.5 ... Velocity of broad money (end of period) 5.5 4.6 5.0 3.8 3.8 3.7 3.6 3.4 ... Commercial banks' 3-month lending rate (in percent) 17.1 18.6 17.9 19.1 17.7 ... ... ... ... Central government operations (in percent of GDP) Revenue and grants 18.0 20.1 20.5 20.9 21.0 21.7 21.7 21.1 21.2 Of which : tax revenue 14.5 16.0 16.8 16.1 16.2 16.4 16.3 16.8 17.0 Expenditure 2/ 20.0 22.4 22.2 28.6 25.9 25.6 25.3 24.2 23.5 Overall balance on a cash basis -2.2 -2.2 -1.2 -7.9 -4.5 -3.9 -3.6 -3.1 -2.3 Government and government-guaranteed debt (in percent of GDP) 21.1 17.8 16.1 40.2 39.2 45.2 42.1 43.2 41.9 Share of foreign currency debt (in percent) 89.5 88.2 84.0 88.9 87.4 88.5 87.5 87.4 85.3 External sector Exports of goods and services (in millions of U.S. dollars) 1,510 1,777 1,757 1,336 1,937 2,207 2,295 2,490 2,699 Imports of goods and services (in millions of U.S. dollars) -2,536 -3,589 -4,748 -3,683 -4,212 -4,631 -4,639 -4,832 -5,025 Exports of goods and services (percent change) 6.7 17.6 -1.1 -24.0 45.0 18.5 18.5 8.5 8.4 Imports of goods and services (percent change) 19.4 41.5 32.3 -22.4 14.4 9.1 10.1 4.2 4.0 Current account balance (in percent of GDP) -1.8 -6.4 -11.8 -15.8 -14.7 -11.5 -12.2 -10.9 -9.7 FDI (net, in millions of U.S. dollars) 450 701 940 725 562 641 652 692 762 External debt (in percent of GDP) 31.4 31.6 29.5 57.8 64.6 … 65.5 66.8 64.5 o.w. public debt (in percent of GDP) 3/ 18.9 15.7 13.6 35.7 34.2 36.9 36.8 37.7 35.8 Debt service ratio (in percent of exports of goods and services) 3/ 3.9 2.9 3.1 5.4 4.7 4.8 4.2 10.4 15.6 Gross international reserves (in millions of U.S. dollars) 4/ 1,072 1,659 1,407 2,004 1,866 1,872 1,806 1,754 1,725 Import cover 5/ 3.6 4.2 4.6 5.7 4.8 4.7 4.5 4.2 4.0 Nominal effective exchange rate (percent change) 6/ 9.9 14.1 6.3 -8.4 -2.7 … … … … Real effective exchange rate (percent change) 6/ 8.7 14.1 8.6 -7.5 1.5 … … … … End-of-period exchange rate (dram per U.S. dollar) 364 304 307 378 363 … … … … Average exchange rate (dram per U.S. dollar) 416 342 306 363 374 … … … … Memorandum item: Population (in millions) 3.2 3.2 3.2 3.3 3.3 … … … … Sources: Armenian authorities; and Fund staff estimates and projections. 1/ From 2008, the poverty rate is computed using a different methodology based on the new household survey. 2/ Including the gas subsidy in 2006 – 08. 3/ Based on government and government-guaranteed debt. 4/ Excluding the special privatization account (SPA), but including the Russian project loan. 5/ Gross international reserves in months of next year's imports of goods and services, including the SDR holdings. 6/ A positive sign denotes appreciation. 22 Table 2. Armenia: Structure of the Banking Sector Armenia: Structure of the Financial System Dec-09 Dec-10 Sep-11 Total assets % of total Total assets % of total Total assets % of total Number % of GDP Number % of GDP Number % of GDP (in ARM Mln) assets (in ARM Mln) assets (in ARM Mln) assets Banks 21 1,346,105 100.0 42.8 21 1,553,097 100.0 44.4 21 1,889,324 100.0 48.7 Of which: Five largest banks* 5 647,424 48.1 20.6 5 710,402 46.7 20.3 5 882,305 46.7 22.7 Domestically-controlled 10 643,438 47.8 20.5 10 723,498 45.8 20.7 10 865,536 45.8 22.3 Foreign-controlled 9 617,343 47.5 19.7 9 755,750 46.9 21.6 9 928,234 46.9 23.9 State-owned 1 21,571 1.6 0.7 1 22,462 1.7 0.6 1 32,908 1.7 0.8 Memo items: GDP (ARM Millions) 3,141,651 3,501,638 3,882,690 Source: ARKA and WEO, Sep 2011 *Of the five largest banks, 1 is domestically-controlled and 4 are foreign-controlled, and their data is accrodingly included in these two categories. 23