Report No. 15422-AZ Azerbaijan Financial Sector Review (In Two Volumes) Volume II: Annexes January 6, 1997 Country Department lil Europe & Central Asia Technical Department ECA/MNA Regions Document of the World Bank CURRENCY EQUIVALENT (December 31, 1995) Manat 4500 = US$ 1.00 ABBREVIATIONS AND ACRONYMS CPI - Consumer Price Index CSI - Contractual Saving Institution FDI - Foreign Direct Investment GDP - Gross Domestic Product HH - Households IAS - International Accounting Standards IMF - International Monetary Fund MoF - Ministry of Finance PFMI - Pension Fund Management Institution MPP - Mass Privatization Program NBA - National Bank of Azerbaijan SEC - Securities and Exchange Commission SOE - State Owned Enterprise SRO - Self Regulating Organization T-bills - Treasury Bills TABLE OF CONTENTS VOLUME H ANNEX A: RESTRUCTURING OPTIONS FOR STATE OWNED BANKS ................... A-1 ANNEX B: THE PRIVATE BANKS ........................... B-1 ANNEX C: PROVISIONS FOR BAD AND DOUBTFUL ASSETS: PRACTICES IN A SAMPLE OF OECD COUNTRIES ................................... C-1 ANNEX D: INTERNATIONAL ACCOUNTING STANDARDS: DISCLOSURES IN THE FINANCIAL STATEMENTS OF BANKS AND SIMILAR FINANCIAL INSTITUTIONS ........................................... D-1 ANNEX E: METHODS OF BANK SUPERVISION BY COUNTRY ................................. E-1 ANNEX F: DRAFT LAW FOR COUPON INVESTMENT FUNDS AND MANAGEMENT COMPANIES ........................................... F-1 ANNEX G: MODEL ACT - CHILEAN INSURANCE LAW .............................................. G-1 ANNEX H: SUPERVISION OF INSURANCE COMPANIES ............................................ H-1 ANNEX I: SUPERVISION OF PRIVATE PENSION SCHEMES ...................................... I-1 ANNEX J: SEIGNIORAGE AND INFLATION TAX ..................................................... J-1 ANNEX A RESTRUCTURING OPTIONS FOR STATE OWNED BANKS The Savings Bank Executive Summary The Savings Bank (Azerbaijan Sehmdar Kommersiya Emanat Banki -- Emanat Bank) is the continuation of the cash collection disbursement and collection agency for the household accounts under the old system. It therefore has not operated as a commercial bank and its staff has never had the training or the experience to operate as a bank. Due to bad lending and careless liability management, the Savings Bank is illiquid and insolvent. In late-1995, a very serious deposit run-off was halted with the injection of budget funds to the bank. The governmeit as the shareholder has taken important steps to stop the losses and the liquidity crisis of the bank. The question is what to do with this institution since it is practically the only institution that holds the Manat deposits of Azeri households and the State has an implicit obligation to the household depositors of this bank. The least cost option is to gradually liquidate this institution. The fiscal costs of recapitalization and creation of a new bank could be much larger than the value-added this new bank might provide to Azerbaijan. In order to continue the psychological comfort of the presence of a rural bank network, the remote and rural branch network could be merged with the Agroprom Bank while the rest of the downsized branch network could be sold to the emerging and new private banks in Azerbaijan. The gradual liquidation option implies freezing the lending activity of the bank with the excess funds invested in government bonds or deposited with the NBA. Meanwhile, a vigorous loan collection effort needs to continue within the bank. Large numbers of small branch units could be closed and the five regional offices of the bank could be abolished. All of these would result in a smaller operation. A gradual liquidation would involve a pay-off of the deposit base, which needs to be carefully planned. In a deposit pay-off scenario, priority should be given to those small rural depositors who have had the longest saving history for the bank. For this to be properly planned, the deposit structure of the bank would have to be clearly and completely classified. For immediate measures, the incremental available Manat 20 billion from the budget to the bank should be used only to pay off the principal instead of interest. In fact, short-term measures should be taken to stop interest payments from the bank. The important question in the medium term is how to give some protection to the small saver. In this case, households would be given the choice that they could deposit with the state-owned Agroprom Bank at lower interest rates or with the more risky but higher interest paying private banking sector, which has no deposit insurance. Ownersltip and Management The Savings Bank is the continuation of the Azer Sberbank (Savings Bank) of the former Soviet Union. It was initially converted into a closed (founders only) company in 1992, later into an open joinlt stock company, while taking over the assets and liabilities of the Sberbank Bank branch in Azerbaijan. Present ownership structure of the bank was initially designed to be 51% Ministry of Finance, 12% State Pension Fund, 10% each the Prominvest Bank and the Agroprom Bank, 1% State Insurance Company, 5% Karakaya Association, and the balance to private banks and individuals based on an authorized A-I capital of Manat 12 billion. However, the Ministry of Finance has an 80-85% share of the actual paid-in capital of Manat 6.3 billion. Consequently, the Savings Bank is a state owned bank. The Savings Bank collects household deposits, utility payments, and taxes from the households; it also pays wages and salaries, pensions, state bond redemptions to the population. The bank also handles the accounts for the state lottery. It has 88 branches, 5 regional centers, and 672 cash collection/disbursement units called 'small branches'. Total staff is 4036 with around 85-100 at the Head Office. The small branches employ 3-4 staff, branches 20-50 and the regional offices up to 100 and more. Some 400 small branches and 11 branches are located in and around Baku. The small branches act as collecting and disbursement agents. They report to 88 branches which are central collecting/disbursement units for their sub-branches and perform lending operations to enterprises and banks. The 88 branches report to 5 regional centers which are the duplicate of the head office in their administrative and reporting functions. The regional centers and the head Office also lend. The Savings Bank clears and settles through the NBA Clearing and Settlement Centers where 88 branches and 5 regional centers keep separate accounts. Total household deposits with the bank at October 1995 were Manat 79 billion in 4 million accounts giving Manat 19,657 per account. The Savings Bank holds 60-70% of the household deposits in Azerbaijan. These deposits do not have explicit government guarantee. The Savings Bank also holds some Pension Fund balances to which no interest is paid. Since 1992 the Savings Bank branches were lending to banks and enterprises the household deposits collected. The real interest rates on deposits and loans were negative until mid-1994 and on cash basis, the bank's cash receipts were larger than its cash payments. In 1994, the Savings Bank started experiencing deposit outflows to the non-bank charity organizations that were offering 20-25% interest per month. To avert this outflow, the bank started offering similar high interest rates with matching products. Together with increased rates, it also started offering 'Monthly Deposits' with no minimum balance and paying monthly interest. These monthly interest deposits ballooned to 65% of total household deposits by end- 1994. On the asset side, the bank increased its lending to local banks and enterprises with unmatched maturities to its funding base. Majority of the bank loans were for six months to one year, some up to two years with interest collected quarterly. The enterprise loans to approximately 500 diverse entities were given for three months to three years interest collected quarterly, sometimes monthly. At negative real interest rates, the banks and enterprises were paying back their loans. However, once the bank started charging the same interest rates it was paying to the depositors, majority of the loans started to be overdue in interest and principal. By end-1994, the Savings Bank was insolvent. The illusion of liquidity was maintained during the first quarter of 1995. By this time, the competitive charity organizations had started to go bankrupt and the Savings Bank started receiving deposit inflows since it continued with its high monthly interest payments. On cash basis, the bank started recording monthly losses of minimum Manat 5 billion starting in May 1995. The Ministry of Finance provided Manat 5 billion capital injection in August and a three year Manat 50 billion loan at I The Savings Bank paid 25% per month starting July 1994 until April 1995. The monthly interest was decreased to 20% per month until July-August 1995, to 10% until October 1, 1995. Starting October 1, 1995 the Savings Bank will pay 20% per year on a monthly basis ( 1.7% per month) on these monthly deposits. A-2 0.5% annual interest in October, to support the illiquidity of the bank. The management of the bank was temporarily transferred to a committee from the central bank and the Ministry of Finance. A loan recovery committee consisting of tax inspectors, some of the bank staff, and special government security forces started reviewing the past due loans one by one looking for ways of recovering uncollected interest and principal. The monthly interest rates were reduced from 20% per month to 10% per month and finally to 2.7% per month beginning in October 1995. The depositors were also persuaded on a case by case basis not to withdraw interest or prolong their deposits. At end-October 1995, some control over the cash outflow of the bank was achieved. The monthly deposit interest rates were decreased to 1.7% per month, roughly in line with monthly inflation. The temporary management committee was planning to hand over the management of the bank to the Management Board of the Bank which was expected to present a restructuring/recovery plan to the shareholders. The NBA has implemented a 100% reserve requirement on the incremental deposit inflows. Meanwhile, around 200 small branches were closed while work was ongoing to continue to close non-profitable branches together with staff attrition. Asset Quality In October 1995, the Savings Bank had the following estimated major balance sheet item 2 composition: Table 1: Balance Sheet of the Savings Bank As Of October 1, 1996 (in Manat Billion) Assets Amount Liabilities and Equity Amount Cash/Deposits in Banks 2 Household Deposits 79 Enterprise Loans 59 Interbank Borrowing (IBA) I Loans to Banks 25 NBA Loans 2 Fixed Assets 2 Reserve Fund/MoF Funds 30 Uncollected Interest 35 Income for Future Periods 35 Others 62 Other Liabilities 3 1 Paid-in Capital 7 Total 185 Total 185 The status of the loan portfolio was as follows: Table 2: Loan Portfolio of the Savings Bank As of October 1, 1995 (in Manat billion) Current Overdue Total Loans to Enterprises 20 39 59 Loans to Banks 2 23 25 Total 22 62 84 Since majority of the lending was done through branches without notifying the Head Office, there are no consolidated records for the overdue schedule. The head office credit department has indicated that of the loans booked from the head office, more than 80% of the overdue principal is over 2 This balance sheet is an estimate after an informal partial exercise. The fund accounting of Russian standards were disregarded and only major balance sheet items were recalculated with discussions with the management of the bank. A-3 180 days overdue. In addition to the overdue principal, the bank management indicated uncollected but recorded interest receivable was around Manat 35 billion. During the first nine months of 1995, the bank management and the special loan recovery committee, collected Manat 21 billion of principal and Manat 22 billion of interest. Loans to banks were to 75 banks with different amounts. Twenty-five of these banks were closed and their outstanding overdue to the Savings Bank is 6.2 billions (25% of the bank loans of the bank). Very few of the banks showed any interest in repaying their loans to the Savings Bank and majority of them were expected to be merged and/or closed-according to the management of The Savings Bank. Loans to enterprises were to some 500 enterprises. No records exist at the head office as to the ownership and/or operational situation of these enterprises except for those accounts where the head office has lent to directly. Majority of these loans were told to be given for international trade purposes. The non-repayment was explained by the fact that these enterprises had bought goods they could not sell due to war or blockage. The enterprise loans were given for diverse tenors where as long as the interest was paid, the loans were rolled over. These loans became overdue as the management of the bank refused to rollover. A brief review of the loans given from the head office showed that many of the loans had initial disbursement dates in 1993 and 1994. In general, although a complete credit portfolio evaluation was not done, it appears that a miimum 80% of the loan portfolio of the bank is doubtful and loss. No clear collateral exists since the bank could not take collateral until mid-1995 when the Law on Pledge was passed. The bank has minimal (around Manat 60 million) loans to individuals given in 1988/89 for housing purposes. These loans are for 10 years and more at low interest rates. Part of the loans are overdue (25-30%) due to death, families having to be moved, etc. Liquidity and Asset Liability Management The deposits in October 1995 were: Table 3: Deposits in the Savings Bank As of October 1, 1995 Type of Deposits Amount % of Total % Interest as of October I, (Manat Billion) 1995 Monthly Interest Bearing 52.4 66.4 20% per year or 1.7% per month Demand Deposits 17.1 21.6 10% per year at year end Children Deposits 0.9 1.1 100% per year at year end Time Deposits 6.4 8.1 12.1% perquarter Other Deposits 2.2 2.8 20% per quarter Total 79.0 100.0 The bank has had no liability and asset management. As has been explained above the bank had taken large interest rate, credit and maturity risks without taking any controls and assessing potential risks/losses. A-4 Earnings and Capital Adequacy The Savings Bank is illiquid and insolvent in October 1995. Part of the cost of this insolvency has already been financed by a Manat 50 billion injection from the budget. The bank already has recognizable losses of Manat 35 billion. A very rough projection is done below to calculate the capital need:3 Table 4: Estimated Recapitalization Requirements at end-1995 (in Manat billion) Amount Estimated Losses for 1995 45 Loan Loss Provisions (80% of principal) 68 Total 113 Less: Capital and Liquid Assets 13 Insolvency 100 Capital Requirement (Insolvency plus 8% of deposits and MoF loan) 110 Controls, Audit, and Institutional Development The Savings Bank has been operating as a cash collection and disbursement agency rather than a bank. Currently the bank is converting its account plan similar to that of the local banks. In the past, interest accrual for the deposits was done once a year at the end of the year and added to the outstanding deposit base. Consequently, the bank management does not have a full record of outstanding accrued interest liabilities on the household deposits. It takes 2-3 weeks minimum to consolidate the balances of the bank. Branches used to act independently from the head office in terms of funds management, lending, and internal operations. Albeit slowly, the bank was clearing intrabranch around Baku. The new clearing system where the branches will maintain independent and separate correspondent clearing accounts with the regional central bank clearing and settlement centers will make liquidity and funds management more difficult for the bank in the short run. Future Prospects If the Savings Bank's situation had happened to any bank, the authorities would probably liquidate the bank. In any bank liquidation, the cost is to the shareholders first and foremost. The depositors and other creditors of the bank would expect that the proceeds from the liquidation of the assets of the bank would be allocated to pay them back as these assets are collected/recovered. In the case of the Savings Bank, the shareholder of the bank is the government and the depositors are mainly the households. The fiscal cost of the bankruptcy of the Savings Bank has already amounted to Manat 35 billion in 1995. The incremental fiscal cost of recapitalizing the Savings Bank is calculated to be around Manat 100 billion. This incremental cost could be lower if an aggressive loan recovery program continue to be implemented. For example, the bank borrowers would be forced to repay their outstanding overdues to the Savings Bank prior to participating to NBA credit auctions. 3 The capital need calculation is based on: (a) the bank's shareholders would have to cover the losses incurred-i.e. capitalize the bank to cover for the necessary loan loss provisioning; and (b) the bank's shareholders would need to put in sufficient equity to cover the losses and to bring the bank's capital to assets ration to minimum 8%. A-S In many countries, savings institutions are considered to be primarily servicing the rural population/small savers, etc. The past high inflation and various external factors have already disintermediated the banking system, including the role of the Savings Bank as the intermediary for small savers. More than 80% of its branch network of the banking system is around Baku and the deposit distribution shows a geographic pattern -- about 50% around Baku. Average deposit balance is around Manat 20,000 -- much lower than the average monthly income of the population. The foreign currency deposits in the banking system are larger than the Manat deposits. There is an emerging private banking sector some of which are keen to start collecting household deposits. The collection and disbursement services could be done using the Postal System. Part of the reason for using the Savings Bank for cash salary wage and pension payments was due to the historical cash and non-cash Manat separation. This separation requires meticulous paper recording of each and every cash transaction which in turn necessitates manual labor. The separation of cash and non-cash together with paper processing/recording ought to be eliminated. Once this processing is eliminated, the emerging private banks would be able to offer salary disbursement services, household retail banking services since these services would become financially viable. The options for restructuring the Savings Bank are the following: 1. Recapitalize the bank and convert it into either a commercial or a retail bank The fiscal cost of this option is minimum Manat 135 billion (Manat 35 billion already incurred plus the recapitalization need) plus the cost of institutionalizing the bank (training, MIS, etc.). Depending on the mode of recapitalization this cost could be spread over time. The recapitalization of the bank could be done through a carve out the bad loans. Initially, the bank would be required to operate as a narrow-bank, i.e., placing incremental funding into low-risk government bonds or secured interbank credit auction lending. As the bank management learn to take risks/lend, the bank could start lending on its own. The carved-out loan portfolio recovery would need to be pursued. This could be done either through splitting the good and the bad bank within the bank with separate management, or transferring the loans to an external workout unit at a substantial discount.. The recapitalization of the bank could also be provided through a long-term bond issue by the Government where these bonds would carry an interest that is sufficient to cover the interest cost of the deposit base of the bank. 2. Downsize the bank and sell the downsized branch network to existing banks The costs of this option would be less than option I where only the deposit base of the bank need to be supported with a bond issue and no costs will be incurred to create a new bank. Assuming no loans are performing, the government would support these deposit liabilities with a bond issue The loan recovery effort needs to continue however. In some cases, the banks would perhaps be interested in buying the loans at a discount against the franchise/branch rights. 3. Downsize the bank through gradually paying off the urban deposit base or selling the urban branch network to existing banks and merge the downsized rural network into the Agroprom Bank. A-6 In this option, the costs would be higher that option 2 but a network to service the remote rural population would continue to operate for a while. This is the case of merging a bad bank with another bad bank. However, the Azerbaijan agricultural and rural sector needs a bank to meet their emerging needs. The Agroprom Bank after proper restructuring would be the institution providing the banking needs of this sector. Through this option the government would also provide a choice to the household depositors. That is, those households that want the comfort of government protections over their deposit base have to choice of depositing with the state-owned Agroprom Bank paying lower interest rates, or depositing with the private banking sector banks with no implicit government guarantee. Regardless of the options to be selected, the Savings Bank management immediately should do the following; * Eliminate the monthly deposit -- all to be converted to three month deposits or current accounts where interest is paid on the average balance at the end of the year. * Stop all monthly interest payments. If a depositor wants his money, first the principal will be paid then the interest due will be scheduled to be paid over a time period. * Eliminate the 5 regional centers * Continue closing unprofitable small branches * Stop all lending activity * Rank all loans outstanding by maturity/due date * Rank all loans and interest overdue by the names of borrowers and by time periods by which they are overdue -- 60 days, 90 days, 180 days, etc. * Continue supporting the existing loan recovery unit. * Start and complete classification of the deposit base: * breakdown of the deposit base by regions, districts; * breakdown of the developments in the deposit base between urban and rural areas; * breakdown of the deposits by maturity and volume; * components of income and expense items; * breakdown of the deposit base by principal and accrued interest. * Combine several of the same kind of accounts belonging to same individuals to decrease processing time and costs. * Use the reserve requirements and the incremental Manat 20 billion from the budget only for the repayment of principal and the attrition costs for the staff. The regulatory authorities could also implement following: * Issue instructions defining standard deposit products, i.e., three month deposit, etc. * Banks should be required to announce their standard deposit interest rates and products in the papers, in the branch premises. * Banks need to get the approval from the NBA for the maximum deposit interest rates they offer to their depositors. A-7 * The temporary management stays to manage the liabilities, i.e., the liquidation of the bank. * Any loan recovery and the incremental Manat 20 billion available credit line to the Savings Bank should be used only to repay the principal deposit base and staff attrition. The interest due should be scheduled over a one year time period with quarterly payments. * The NBA and the Loan Recovery Unit should review every loan overdue and/or outstanding to private banks. For those private banks that have an overdue principal and/or interest to the Savings Bank, the following could be done: * Offset the loan and interest overdue of each bank against its reserve requirements at the NBA and ask the banks to put in incremental reserve requirements. * Give priority to the Savings Bank from the liquidated assets of the banks that are closed. * Offset the loan and interest overdue against their foreign currency balances of these banks with the International Bank. * Call the bank management one by one and demand repayment. * Those banks that have overdue to the Savings Bank would not be allowed to participate in the foreign currency and credit auctions. * Those banks that have overdue to the Savings Bank would have their foreign exchange licenses of any kind removed until they repay. T The Loan Recovery Unit together with the management of the Savings Bank should prepare a list of the loans outstanding and overdue name by name starting with the highest borrowers. The overdue principal and interest should be ranked by the time they are overdue-by one month, three months, six months, etc. The following should be done: * If any of the loans overdue or current are to any shareholders or family members of the borrowers, these deposits should be immediately frozen and/or offset against the loans. * The major non-performing borrowers (excluding the housing loans) should be announced in the papers. * Each borrower starting from the highest should be tracked and a loan-by-loan negotiation should be done. These negotiations might involve some debt and interest forgiveness subject to a repayment schedule -- for example for each Manat 100 of loan and interest repaid, the borrower's outstanding balance would decrease by 10, etc. All of the above measures -- some of them are very drastic -- require proper legal framework which may be insufficient under the present environment. A-8 The Agroprom Bank Executive Summary The Agroprom Bank (Azeaycan Respublikasi Sehmdar-Kommersiya Agrar-Sanaye Bank -- the Joint Stock Commercial Agrarian Industrial Bank of the Azerbaijan Republic) is the most visible of the state owned banks and is currently liquid due to proceeds from a successful cotton harvest. However, the Agroprom Bank -- the state owned bank for agriculture and state agro-processing industry -- is actually losing money and insolvent. Its insolvency is estimated to be around Manat 200 billion in October 1995. Meanwhile, boosted by the temporary liquidity of the cotton harvest proceeds, the management and shareholders of the bank are trying to improve the corporate governance and the skill base of the bank with the hope of becoming an internationally acceptable universal bank that primarily focuses on agricultural sector. The overall restructuring of the bank should be handled in stages where the authorities should not further sell the shares of the bank to its borrowers and the public until the restructuring of the bank is completed. The restructuring of the bank would involve financial and operational restructuring phases. The financial restructuring should address the resolution of the non-performing loan portfolio and the operational phase the rebuilding the bank into internationally acceptable standards. Prior to any operational restructuring of the Agroprom Bank, the authorities need to decide whether in the long-run there is a need to have a bank that specializes in agricultural finance or whether the bank can or should be split into a rural finance agency and an universal bank that has a large presence in the rural areas in Azerbaijan. The long-term strategy with regard to financing of the privatized rural sector in Azerbaijan would inevitably have large impact on the final operational restructuring of the Agroprom Bank. Given the fact that the Agroprom Bank is insolvent, the first and the immediate step for the financial restructuring is the isolation4 of the bank from the rest of the banking system (except perhaps the short-term crop finance for 1996 harvest) while vigorous efforts should be directed for the collection of the non-performing loans and overdue interest. The profitable cotton harvest should enable majority of the borrowers of the bank to repay their outstanding interest and principal overdue. This isolation could be implemented for three to six months where the extent of the problems of the loan portfolio of the bank would become transparent. At the end of the isolation period, the existing problem loan portfolio would be shifted into a subsidiary and/or an internal work-out unit (or parts of the portfolio could be sold or transferred to other banks) which would also act like an investment banker in restructuring the borrower enterprises while implementing work-outs on the loans. The performing loan portfolio and the rest of the bank should then be started to be 'operationally' restructured depending on the strategy the bank's shareholders want it to achieve. In the medium and longer term-up to three years maximum, the shareholders of the bank could aim at institutional development of this bank with the goal of privatization of the bank to the privatized agricultural/rural sector of Azerbaijan. 4 Isolation would imply that the bank would continue to service its existing clients and collect household deposits. The bank would not borrow interbank. No new lending or roll-overs would be allowed for the borrowers that are not performing on a timely manner. The household deposits would be placed with the NBA earning interest equivalent to what is paid on these deposits during the period of isolation. Alternative would be for the bank to purchase short-term treasury bills against the incremental deposits. The isolation would not be longer than six months. A-9 Ownership and Management Taking over the Azerbaijan Branch of the USSR Agroprombank, the Agroprom Bank was converted first into closed (founders only) then open joint stock ownership in 1992. Based on its charter, the bank has 18 founders all of which are state entities. In October 1992, the bank had Manat 10.2 billion paid-in capital. Shareholdership of the bank based on this capital was: 56.2% Ministry of Finance, 5.7% Ministry of Agriculture, 1.9% staff of the bank, 9.9% State Insurance Company, 9.5% Azerittifak, 9% each Savings and Prominvest Banks, and the balance to state agricultural state entities. The Agroprom Bank has 82 branches and 1500 staff, 1 78 at the head office. The Agroprom Bank is the sector bank for financing the agro-processing and industrial sector along with agricultural production in Azerbaijan. After the conversion to open joint stock status, the branches have started selling bank's shares to the borrowers and other clients of the bank. Its clients are 473 entities that operate in the agricultural sector, 1200 Collective Farms (Kolhoz), 900 State Farms (Sofhoz) and other individuals and entities that would be related to the agricultural sector. Through its branches the bank provides payment and collection services, accounting and tax bookkeeping, salary and wage payments, cash services and short and long-term loans to its clients. The bank also monitors the receipts and payments of the State Pension Fund to the agricultural sector, payment services to the refugees from the occupied territories from the budget and has recently started collecting household deposits. It has 23% market share in household deposits second after the Savings Bank's holding of 63%. The branches operate as independent operating units. The presently planned clearing and settlement system also allows the branches to operate as independent units. There are loan limits per borrower per branch and a Credit Committee at the Head Office. All lending and deposit interest rates are determined from the Head Office. Branches are judged on their separate balance sheets since each branch is considered to be a separate tax entity and pays taxes separately. Overall, the head office has good control and awareness of the operations of the branches. Asset Quality The summary balance sheet of the bank in October 1995 was as follows: Table 5: Balance Sheet of the Agroprom Bank As of October 1, 1995 (in Manat billion) Assets Liabilities and Equity Cash 5 Enterprise Current Accounts 100 Bank Balances 3 Household Deposits 9 Loans 473 Enterprise Time Deposits 3 Reserves at NBA 14 NBA Loan 108 Fixed Assets 4 EU Grant Funds 14 Other Assets 28 Pension Fund Deposits 101 Interest for Future Periods 179 Paid-up Capital 11 Reserves 2 527 Total 527 A-10 The loan portfolio performance and composition is as follows: Table 6: Loan Performance and Composition (in iManat billion) End- 1994 October 1, 1995 Change Current Loans 131 270 139 Overdue Principal 43 26 -17 Overdue Interest 34 179 145 Total Loans 208 475 267 Memorandum Items: Borrowing From NBA in 1995 111 Principal Repaid to NBA in 1995 10 Interest Paid to NBA in 1995 61 The Agroprom Bank has done incremental Manat 121 billion lending in 1995. This incremental lending is funded primarily from the NBA. There is no directed or linked state funding in the loan portfolio. The management indicated that they had to give around Manat 5 billion to purchase the grape harvest under government pressure knowing that the wine producers are not profitable in 1995. The management is optimistic that as the cotton export proceeds are collected the outstanding overdue and current principal on majority of their loans have a good chance of repayment.5 The uncollected/overdue interest is thought to be due to bank having to charge too high interest rates since it had to pay market interest rates to the borrowings from the NBA.6 The bank is decreasing its loan interest rates parallel to its funding average funding cost and the inflation rate. Liquidity and Asset Liability Management The Agroprom Bank is not suffering illiquidity due to proceeds from cotton exports going through their bank. The bank will receive technical assistance from the Turkish Agricultural Bank in converting its present operational structure into improved standards. The bank is active in collecting household deposits especially from the rural population. The deposit interest rates are being decreased in line with the decline in inflation. No clear understanding of proper asset liability management is in place in the bank. This is further made difficult since the planned clearing and payments system design in the short run makes it impossible for the bank to clear interbranch/intrabank. Earnings and Capital Adequacy Due to interest not collected, the Agroprom Bank is not as profitable as it should be. On cash basis, the bank reports around Manat 39 billion profit for the first nine months of 1995. The average 5 No information on the loans outstanding to Ngorno-Karabag region under Armenia today was obtained. These loans are probably non-recoverable regardless of the resolution of the territorial dispute in future. 6 The Agricultural Bank was running large overdrafts in the previous MFO system. In February 1995, the MFO system was converted to the present no overdraft clearing system and the NBA converted the outstanding overdraft of 54 billion into a market interest paying loan. A-I I interest rate is 36% on the total loan portfolio based on the cash accounting. The interest rate on the interest paying liabilities is 60%. Therefore, the bank is operating with a negative margin, i.e., it is losing money. This is not visible from the present accounting application since the uncollected interest income is not booked as loss7 but as future income. The overdue principal amount is already larger than the paid-in capital of the bank. Regardless of its short-term liquidity, the Agroprom Bank is insolvent. The approximate amount of insolvency of the bank is around Manat 180-200 billion.8 Controls, Audit, and Institutional Development There are various controls over credit disbursements, correct accounting applications and expenses of the bank. Head Office is monitoring the branch activity via daily and monthly telex and telephone reporting of key account balances and other various activities. There is an Audit Committee supervising the bank on behalf of the shareholders. An internal audit department inspects the branches once a year. The management is keen to improve the institutional development of the bank. Cooperation and technical assistance from the Turkish Agricultural Bank is looked forward to. The account plan is in the process of conversion into more Western standards. The bank also wants to move into retail banking especially in the rural areas of Azerbaijan. Automation of the general ledger processing, establishment of ATM's, etc. is being thought of where a contract with Koc-Unysis will provide the automation hardware and software necessary. Future Prospects The Agroprom Bank is the most prominent bank in Azerbaijan. Although the bank is insolvent and loss making, it would be very difficult for the shareholders to liquidate this bank. It is also the only bank which is servicing the agricultural sector having no competition from the emerging banking sector. 7 Under international accounting standards, the accrued interest income would be reversed once the interest is overdue by 90 days. Under the cash accounting in Azerbaijan, interest is not accrued and the uncollected interest is recorded as future income on the liabilities and as uncollected interest on the assets side of the balance sheet. Therefore, the uncollected or future interest income is the opportunity cost or income foregone for the bank, i.e., a loss to be recognized. This overdue interest is booked as asset under the total loans with an offset entry in the liabilities as 'income for future periods'. Any forgiveness by the bank for this overdue interest is a loss to be recognized. The management was planning to do an interest write-off. However, in such a case the tax authorities have to approve that the bank is not avoiding taxes by writing-off the 'future' income which is already recognized. In calculating the extent of the insolvency and/or the need for new equity for the bank, the shareholders may just do an interest write-off or debt forgiveness or recapitalize the interest not collected into overdue loans and restructure the loans outstanding. The projected equity need would vary depending on the handling of the overdue interest. Most of the calculations here are done assuming the interest not collected will not be forgiven and thus capitalized and restructured. 8 There is yet no risk asset classification nor proper loan loss provisioning in Azerbaijan banking sector. The Manat 250 billion insolvency was very roughly estimated as: (a) principal and interest overdue/past and present losses of the bank MINUS (b) the existing paid-in capital of the banks PLUS (c) 8% of the total assets with no risk weighting of assets. This amount might be higher if the loan portfolio is properly risk classified. The bank is not charging interest on the overdue interest. A-12 The restructuring of the bank should be done internally along with plans to eventually privatize the bank. Meanwhile, no further share sales of the bank should continue. The Agroprom Bank should be the target for privatization after proper restructuring and the privatization of the agricultural sector. The financial and operational restructuring of the bank should be implemented in the following short and long-term time span. Short-Term (Immediate to 6 months) * Isolate the bank from NBA funding. * Rank the loans according to internationally acceptable criteria and separate the 'good' and the 'bad' loans. * Establish an internal loan recovery/work-out unit with separate management to start working and/or restructuring the problem loans and uncollected interest. * Handle crop financing for 1996 and the rural finance credit schemes with the bank as an agent rather than a risk taker. * Finance the 1996 rural lending program directly through the budget instead of NBA refinance. * Stop branch openings except if and when the Savings Bank's rural branches are taken over. * Continue training and institutional development within the bank. Medium-Term (6 months to 24 months) * End of the partial isolation of the bank where the problem loans than are not recovered need to be resolved.9 * Start potential integration of rural Savings Bank branch network/deposit base * Implement an audit under international standards to verify the quality of the loan portfolio and the degree of potential insolvency. Long-Term( Minimum after one year- up to three years maximum) * Privatize primarily to the privatized rural/agricultural sector. The Prominvest Bank Executive Summary The Prominvest Bank (Azerbaycan Senaya Investistiya Sehmdar Kommersiya Bank -- Azerbaijan Industrial Investment Joint Stock Commercial Bank or Prominvestbank) is both insolvent and illiquid. The bank had been the conduit for the financing the industrial and construction complex of Azerbaijan which in turn is in a difficult state. Unless the enterprise shareholders and borrowers of the Prominvest Bank are restructured and become viable, the bank has no future or value added to the emerging banking sector in Azerbaijan. 9 Those loans which are considered to be non-recoverable need to be written-off. Those loans that are showing potential long-termn recovery and those loans that need to be recovered through enterprise restructuring can be shifted/sold to either an external loan recovery entity at a deep discount or to the Industrial Bank which is recommended to eventually convert into a Work-Out Unit by itself with potential to become an investment bank. A-13 The NBA had already taken various measures to bring financial discipline to the bank with the expectation that the bank would then impose the same discipline to its borrowers/shareholders. This strategy has worked well so far in making the hidden insolvency of the bank become transparent to the shareholders and the management of the bank. This financial disciplining should continue. In fact, the Prominvest Bank should be first isolated from the rest of the emerging banking sector while an internal restructuring takes place. Then, if the shareholders isolate a viable good bank, this portion could be privatized through a merger or direct sale. The remaining 'bad' bank, i.e., the nonperforming assets, could then be liquidated or sold during a certain period of time. Ownership and Management The Prominvest Bank has taken over the Azerbaijan Branch of the USSR Promstroi Bank in 1991 and was converted into an open joint stock status in December 1992. About 52.7% of the paid-in capital is from Ministry of Finance, 34.9% to bank staff, individuals and other private shareholders and the rest to state enterprises and banks.10 Currently the bank has 20 branches and 1450 staff. The Prominvest Bank is the conduit for financing the Manat credit needs of the state industrial and construction sector. These industrial and construction state amalgamations and associations are direct and indirect shareholders of the bank. In the past, it continued issuing unlimited financing under the MFO system to these enterprises and/or government ministerial or other bodies. It is also the bank for the management of the state budget revenues and the disbursements and the State Pension Fund. The unlimited overdraft capability of the Prominvest Bank was stopped in February 1995 when the NBA issued a Manat 52 billion financing for the accumulated overdraft of the bank. Since then, the bank has been borrowing limited funding from the NBA at market interest rates. Since majority of its outstanding loan portfolio is non-performing, the bank has been put under a liquidity discipline with the cut-off of the non-limited overdraft financing. Consequently, it has done limited new lending and the management has placed priority to meet the payment needs of its clients instead of expanding its operations. The branches operate as independent units with lending capability up to certain limits. All the branches need to have separate correspondent clearing accounts with the NBA regional clearing and settlement centers. Since the management was unwilling to clear intrabranch on a timely basis to meet urgent payments, the NBA preferred to monitor the daily liquidity position of the bank through these separate clearing accounts and thus ensure that the bank does not discriminate among clients in meeting their payment orders. 10 Paid-in capital in October 1995 was Manat 7.7 billion. Composition of ownership is as follows: 52.66% to Ministry of Finance, 4.8% to the Agricultural Bank, 2.04% to State Pension Fund, 2% the Savings Bank, 34.85% to individuals and staff of the bank and the rest (about 4%) to various state and private enterprises. A-14 Asset Quality The balance sheet as of October 1, 1995 is estimated as follows: '' Table 7: Balance Sheet of the Prominvest Bank As of October 1, 1995 (in Manat billion) Assets Liabilities and Equity Cash and Deposits 5 Foreign Currency Deposits 12 Reserve Requirements 9 Pension Fund 5 Loans 296 Budget 8 Enterprise Deposits 20 NBA Loans 89 Income for Future Periods 131 Other Liabilities 31 Paid-up Capital 8 Reserves 6 Total 310 Total 310 The composition and the development of the loan portfolio is: Table 8: Loan Portfolio of the Prominvest Bank (in Manat billion) end- 1994 October 1, 1995 Change Current Loans 77.6 126.3 48.7 Overdue Principal 11.4 38.6 27.2 Overdue Interest 11.0 131.1 120.1 Total 100.0 296.0 196.0 Memorandum Items: Borrowing from NBA during 1995 89.3 Repayment of Interest to NBA in 1995 73.7 The major non-performing borrowers are Azeroil, Azer Chemical Complex, Ministry of Metallurgy, Azertransport, Electrical Machinery Complex and Azerbaijan Construction Companies accounting for more than 80% of overdue principal and around 65% of overdue interest. No serious effort to collect the overdue interest and principal was observed in the bank. The management is very familiar with the problems and the constraints of their borrowers. It was not clear as to whether the management was not collecting these overdues on their own atrophy or due to the assumption that since the bank and the borrowers are state, the state should solve the problem. " The actual daily balance of the bank was restructured netting out the receivables and payables of the Pension Fund, the Budget Operations and concentrating on the major items. A-15 The management has indicated that they are very selective in their new lending however. Of the outstanding current loan portfolio, management has indicated that 50% has good probability of getting paid. Of the outstanding uncollected interest and principal, the management is not very optimistic. Liquidity and Asset Liability Management The cut-off from unlimited overdraft capability in February 1995 and the limited funding from the NBA together with paying market interest rates, has brought financial discipline to the bank. In effect the NBA has acted prudently by freezing the bank to a certain extent. At this point the bank is illiquid and clearly insolvent. The non-performing loan portfolio is minimum three times the equity of the bank. The bank had continued being the accounting and bookkeeping unit for the state industrial complex while financing its founding shareholder enterprises. The management appears to have the basic concepts of prudent asset liability management but none of it is being implemented. Earnings and CapitalAdequacy On cash basis, the bank reports Manat 5 billion of income for the first nine months of 1995. Had the income statement and the balance sheet of the bank been reconstructed under non-Russian accounting standards and applications, the Prominvest Bank would show that it is loss making and insolvent. Before going into the actual insolvency of the bank, a two step approach is done below to answer the question if there is a good bank in the Prominvest Bank. The net asset value of the performing bank is calculated as follows: Table 9: Estimated Net Asset Value of the Good Bank Amount (Manat Billion) Performing/Current Loans 126 Liquid Assets 14 Total 140 Less: Equity 13 Less: Liabilities 135 Net Value (8) Even on the performing balance sheet, the bank has interest bearing liabilities about equal to its interest bearing assets. 2 Therefore, if the bank continues to operate as an on-going concern it has to make sure to collect interest on the current loan portfolio in order to pay or afford to pay interest on its liabilities. Since the management has indicated that they are not sure if 50% of the outstanding loans would be collected -- where majority of them have overdue interest anyway -- a 'good' bank or at least the operating bank does not have much chance of profitability or even breaking-even 12 There is yet no risk ranking of loans and matching loan loss provisioning guidelines. Therefore, the insolvency of the bank may be even more severe since here all the loans except account 620 are taken to be performing with no loan loss provisioning. The projected capital need is calculated based on the assumption that the uncollected interest/income for future periods is not to be written off but recognized as a liability of the borrowers where the bank is capitalizing this uncollected interest. (Please refer to footnote 4 in the Annex on the Agricultural Bank for further explanations.) A- 16 The estimated insolvency of the bank past is calculated as: Table 10: Estimated Insolvency of the Prominvest Bank as of October 1995 Amount (Manat Billion) Provision for Loan Losses 100 Less: Present Equity 13 Add: Estimated Losses for 1995 (minimum) 100 Total 187 Future Prospects -- Whtat Can Be Done The shareholders of the bank have the following short to medium-term(six month to one year) options; 1. Separate the bad bank and the good bank, recapitalize and privatize the good bank, and liquidate/restructure the bad bank. Alternatively, instead of splitting the bank, the assets are classified internally (and properly provisioned), a work-out unit is established to deal with the nonperforming assets, and the bank is sold with both the good and the bad assets after recapitalization. 2. Recapitalize the existing bank and implement measures such that the flow of new lending of the bank is given under clear financial discipline. Regardless of whichever option is selected, there is a clear cost to the budget, i.e., the state. Selecting Option 2 would result in immediate recognition of the fiscal cost but would create a moral hazard situation. The implementation of Option 1, on the other hand, would ensure that the presently implemented financial discipline on the bank continues. Thus, the enterprise borrowers (also the existing shareholders) also learn to behave as prudent and responsible economic entities. Short and medium-term steps for the implementation of Option I are as follows: Immediate to Six Months. Isolate the bank from the rest of the banking system by freezing the bank's borrowing from the NBA with no further funding coming from the budget and/or credit auctions. The loan portfolio of the bank would be then reviewed on a case by case basis and ranked under international standards. All loans that are below satisfactory would be designated to an internal work-out unit. This is the core of the bad bank. The bank implements a vigorous work-out on its loan portfolio. During the isolation period, the bank would not be allowed to open new branches, or accept interbank or household deposits. The bank would have to work out an agreement with other creditors on the disposition of cash from operations. Six to Twelve Months. At the end of the isolation period, one option is for the creation of a 'bad' bank that takes over the non-performing assets, the existing equity of the bank (if any), and the balances of the enterprises that are non-performing on their loans (if any). The identified 'bad bank' continues to be liquidated/restructured where it could be: (a) kept as a subsidiary of the bank working on debt recovery only; (b) capitalized and converted into an investment/merchant bank; and (c) consolidated under a temporary External Loan Recovery and Enterprise Restructuring entity that would also take all the non-performing loans and enterprises from the banking sector. This temporary entity would be in existence until the end of the privatization program. Anything outstanding would be then written-off against budget. The 'good' bank that is identified could be: (a) merged with the downsized International Bank and then privatized; (b) sold to foreign and or local banks; or (c) sold to the public or to staff and A-17 management. Another option is not to create a 'bad' bank', but sell Prominvest -- after recapitalization - - with both good and bad assets, and the new owner will decide on what to do with the bank. Because the bad assets are valued at or close to zero, there will be an incentive for the new owner to maximize collection on these assets. The present management of the bank is not eager to start a work-out operation within their bank. They may also not have the technical skills to implement such a program. The shareholders of the bank might consider changing the management of the bank immediately. If not possible, the management has to take the following immediate steps: * Make a list of outstanding loans starting by the largest borrower classified by loans current, loans overdue and interest overdue. Establish a special task force within the bank to work only on the loans overdue. * Stop collecting household deposits. * Close branches that are in rural areas or negotiate selling them to other banks. The existing branch network could be used for only the servicing of the existing client base. * Start attrition of staff-beginning with the rural branches and head office. * Stop all charity, entertainment, unnecessary operating etc. expenses. * Submit a good bank-bad bank breakdown to the shareholders by the end of 1995 The NBA and the Ministry of Finance need to consider the following: * As the Prominvest Bank is cut-off from the NBA financing, the interest accrual on the NBA refinancing needs to be stopped. The liability to the NBA could be rescheduled parallel to the recovery of the good assets on the bank. * Debt forgiveness on the interest overdue (more than the current loans) can be considered, i.e., the bank will record losses. This would have foregone tax revenue implications which needs to be resolved. - Shift the seasonal or working capital needs of the utility companies (that need to purchase energy, etc.) out of the bank to the budget where the bank may continue to act as an agent for the government. The working capital finance of the large industrial enterprises of critical importance could be linked to a base year production quota at the present prices. A-18 The International Bank Executive Summary The International Bank of Azerbaijan (IBA) is a state owned bank where the state ownership is represented by the Ministry of Finance. Having taken over the frozen assets and liabilities of Azervnesheconombank, IBA has continued to be the management unit for the reserves of the government and an agent of the all government guaranteed export credit and donor foreign currency credit lines. IBA also enjoys monopoly rights over all of the state and state enterprise foreign currency operations in Azerbaijan. State foreign trade enterprises are directed to work with IBA for their foreign currency operations. Majority of its funding is government and/or state sourced at very low or no interest. In effect, IBA is not a bank but a foreign currency treasury unit for the state. Restructuring IBA would involve separation of the foreign currency reserve management performed for NBA from the books of the bank. This could be done either through merging large part of IBA into the NBA, or separating the books of the bank that is managed for the NBA from its own operations. The managed portfolio on trust basis for the NBA could be reported on a daily basis to the NBA with close supervision of its operations. As of end-October 1995, the NBA has already started to take over the management of the reserves from the bank. The downsized/separated IBA is estimated to be insolvent with necessary capitalization needs of minimum USD 2 million in October 1995. The shareholders of the bank need to make a choice of either recapitalizing the bank or merging the bank with an existing bank or gradually liquidating/selling-off assets of the bank. Since IBA is a state owned bank with no household deposits, the final cost of any of these alternatives would be to the state and shareholder state banks and enterprises. The least cost of the three options might be gradual sale/liquidation of the assets of IBA. The fourth alternative is to sell the insolvent IBA to a foreign bank. Further privatization of the bank through share sales is not recommended at this point. Selling an insolvent state bank to the households under illusions of future dividends would undermine the credibility of the existing shareholders of the bank. The management and the shareholders of the bank should also stop opening branches and look into first developing internal institutional capability to operate as a bank on its own-separate from all of their agency business they are performing for the government- i.e. defining a strategy for the 'good' bank. Ownership and Management IBA was established as a state owned bank in 1991 taking over the Azerbaijan Branch of Vnesheconombank. 3 In late 1992, it was converted into an open joint stock bank where state ownership through Ministry of Finance continued to be 50.2%. The bank issued shares at nominal value of Manat 1000 per share and sold them to 13 enterprises and 1400 individuals for about Manat 250 million equivalent. The capital contribution of the Ministry of Finance was the present head office building of the bank which the bank later paid its book value back to the Ministry. Currently IBA's shares are traded over the counter among the individuals at around USD 20 per share. The bank does not maintain a share registry for the individuals. The enterprise shareholdership is registered at the bank. 13 Frozen assets at Vnesheconombank amount to USD 6million with a lower amount of frozen liabilities. It was not clear whether the bank was capitalized by the state when the Vnesheconombranch was converted into IBA. A-19 Paid-in capital in October 1995 was Manat 1.5 billion (around USD 300,000). The management has indicated that they were expecting another Manat 1.5 billion capital contribution from the Ministry of Finance. The main shareholders of the bank are: Table 11: Shareholdings in the International Bank Shareholder % of Total Ministry of Finance 50.2 Improteks Small Business 10.0 NBA Cash Department 8.0 Savings Bank 6.7 Universal Commercial Bank 2.0 Billur Bank 0.8 State Cihazlanma Factory 0.7 Azer Elektroterim Company (State) 0.8 Baku Elektroterim Company (State) 0.6 Newspaper Cik-Cik 0.2 Industrial Bank 0.4 Small Business TT 0.8 Pakelektromat Factory (State) 0.4 Individuals 18.4 Total 100.0 Accordingly, direct and indirect state ownership in IBA is around 67.4%. Shares to individuals are either preferred or common stock. Preferred stock is sold to the employees of the bank. IBA's branches currently continue to sell bank's common stock to interested individuals and entities. The bank should operate under the Joint Stock Company Law in Azerbaijan. The founder shareholders elect a Council for the bank which then appoint a Chairman of the Management Board. The management board consisted of the top management of the bank appointed by the Chairman. The annual shareholders meeting vote on capital increases, general policy and profit distribution based on the recommendation of the Council of the bank. An Audit Committee on behalf of the shareholders audit the performance of the bank reporting to the Council of the bank. The present Chairman of the Board of IBA is appointed from the NBA. The Board of 7 consist of top management of the bank and representatives from the NBA and the Ministry of Finance. IBA has 16 branches and 415 staff, 165 in the Head Office. IBA started opening branches recently. The branches operate as independent units with monthly balance sheet reporting14 to the Head Office. Branches have separate clearing and settlement accounts with the District Central Bank clearing and settlement centers. Branches can also borrow and place interbank without notifying the Head Office. Being very new, branches operate mostly in Manat. IBA is the foreign currency bank of Azerbaijan Government. More than 98% of the balance sheet of IBA is in foreign currency. All of foreign currency management and lending is decided by the Board and/or Chairman of the Bank. The Head Office Credit Department is very new where all lending decisions to banks and enterprises are decided by the Board or the Chairman. Branches are allocated maximum Manat 100 million for on-lending. 4 Under Russian accounting used in Azerbaijan, the balance sheet also includes income statement accounts. A-20 The Head Office Management is very centralized with few decision makers. IBA has few foreign language speaking staff. It is said to be the only bank that has Reuters dealing and SWIFT capability in Azerbaijan. Asset Quality The approximate asset composition of the bank in October 1995 was: Table 12: Asset Composition of the International Bank As of October 1, 1995 Amount % of total (USD 000) Cash -- Manat 20 - Cash -- Foreign Currency 4,556 3.5 Items in Transit -- Foreign Currency 36 - Overseas Bank Balances 18,308 14.0 Enterprise Loans -- Foreign Currency 50,000 38.4 Domestic Bank Loans/Deposits -- Foreign Currency 20,000 15.3 Overdue Loans 1,860 1.4 Overseas Correspondent Accounts 30,367 23.2 Others 5,524 4.2 Total 130,671 100.0 IBA manages part of the foreign currency reserves of Azerbaijan for the Central Bank. IBA is also the clearing and settlement center for the Interbank Foreign Currency Exchange. All the member banks of the Exchange maintain foreign currency accounts with IBA. Loans in foreign currency of USD 50 million are to around 50 borrowers of which 38 million have government guarantee. The major borrowers are: Table 13: Major Borrowers from the International Bank (in USD million) Borrower Purpose Amount Government of Azerbaijan foodstuffs, grain, and weapons 23.0 Azer Ittifak Cooperative foodstuffs imports 4.0 Azer Grain Corporation grain imports 6.7 Turan Air aircraft purchase 4.0 Nur Company restoration of a building 3.0 Azermetals Company na 0.7 Improteks Aircraft Factor na 1.5 Cinar Company na 0.3 Others na 6.8 Total 50.0 Manat Loans are to 30-40 borrowers disbursed from the branches. Manat loans and credit relationships are maintained through the branches where the head office credit department gets a monthly report. Branches are allowed to lend between Manat 10-100 million depending on the branch. All foreign currency loans are decided by the Board. The credit applications, structuring, etc. is handled by the Board members where the newly established credit department keeps the files. Pricing decisions are made by the Board also. A-21 Manat Loans would be for maximum three months with interest collected monthly. The minimum annual interest rate for Manat loans can be 100% per the instructions of the NBA.15 Foreign currency loans could be from 6 months to three years. The loans for import of goods are for six months, interest payable quarterly. Government guaranteed and other project credits are for 1-3 years with interest payable quarterly. Interest rates on the foreign currency loans are between 6-12%. Import finance loans are charged 12%, project finance credits 10% and the government loans 6% per year. For collateral, IBA has started taking pledge over fixed assets and movables after the acceptance of the Law on Collateral in 1995. The pledges for airplanes are registered by Azerbaijan Airways, mortgages over buildings at Goskominvest and other pledges through the local Notaries. No credit risk insurance is taken. Majority of the foreign currency loans are made under recommendation/instructions of the Government although the bank funds it. More than 90% of the outstanding loans are to the state and state owned enterprises. IBA also acts as an agent for the Government for the disbursed USD 61 million Turkish Eximbank export credit line and 50 million ECU European Union Loan. These loans are booked off- balance sheet. IBA takes minimal agency commission-actually none. Bank loans are to around 100 banks where no bank credit files are kept. No credit evaluation of the Azer banks are done. The dealers ask the Chairman to approve each deposit/placement to local banks. Average amount of bank placements are around USD 300,000 with tenors between I week to 6 months. IBA charges 15% per year on all of the bank loans regardless of tenor. IBA also has hidden reserves in the form of fixed assets. Currently the bank is financing the building of a new head office and have already spent USD 7 million which is not yet recorded as fixed asset on the books of the bank. Total investment in the building will be around USD 10 millions. IBA also owns majority of its branch buildings which are recorded at book value-much lower than their current market value.'6 Overdue loans are reported to be around USD 1.9 million -- 2.71% of total loans. Overdue loans are to Azer Grain Corporation, Azer Ittifak Wholesale Cooperative and several banks. The management is very keen to get out of bank lending. The overdue loans to the other two state entities have government guarantee. In terms of loan portfolio risk, IBA has potential loss from the bank loans/placements. Already this bank loan portfolio has started to be non-performing. The enterprise loans either carry government guarantee and/or to state enterprises an/or on-lent under the state instructions to priority projects. The crucial question with regard to IBA is whether the Government reserves managed by the bank have been used to fund the direct lending of the bank. If this is the case -- where there is high 15 Apparently the NBA has instructed the banks that they can charge for Manat Loans the minimum 'indicative' interest rate announced by the NBA -- currently that is 100%. 16 Apparently fixed asset revaluation is not allowed/done in Azerbaijan. A-22 likelihood that the bank placements may not be repaid -- then, IBA will register large losses at the cost of state reserves. Liquidity and Asset Liability Management The liabilities and funding base of the bank in October 1995 were: Table 14: Liabilities of the International Bank as of October 1995 Amount % of Total USD million Various Foreign Currency Deposits 23,265 17.8 NBA Funds 66,007 50.5 Blocked Letters of Credit 24,700 18.9 Manat Deposits 221 0.2 Foreign Currency Exchange Funds 1,040 0.8 Capital and Reserves 1,029 0.8 Retained Earnings 580 0.4 Estimated Earnings in 1995 2,840 2.2 Others 10,989 8.4 Total 130,671 10.0 IBA is paying 1% per year on the portion related to foreign currency reserve requirements of the banks to the NBA (USD 23 million or 10% of the funding base). The rest of the funding base is non- interest bearing. Should the government reserves, Azeroil deposit and the Interbank Foreign Exchange funds be transferred from IBA to the NBA, IBA would be downsized by minimum 50%, i.e., to around USD 55- 60 million. Earnings and CapitalAdequacy 1995 income before taxes are around USD 2.8 million. IBA is not paying interest on its funding cost. Majority of the income is coming from interest earned on the deposits overseas and the loans. This income is recognized on cash basis and no record of interest earned not collected is maintained yet. The income for the first nine months of 1995 result in 1.2% return on assets. This is very low given the fact that IBA is not paying interest on majority of its funding and IBA is supposed to be charging minimum 6% -- on average 10% -- on its total USD 70 million loan portfolio. It appears that IBA is either not collecting the interest on some of its loans or, not charging the interest rates it is quoting to be charging. The paid-in capital to total assets is 0.13%. Since majority of the assets of IBA are to the government and belong to the government, IBA's capital adequacy might not be an issue. However, the bank already has USD 1.9 million past due loans some of which might not be recoverable. In such a case, it is quite likely that IBA is insolvent. A-23 Controls, Audit, and Institutional Development Internal controls are weak. The best example is the interbank placements of USD 20 million that were made on the approval of a single individual. IBA is planning to be audited under international standards by Price Waterhouse for 1995. The staff interviewed is educated but unskilled in banking and management in a competitive environment. IBA is opening branches where there is no central management controls over the branch operations. IBA's comparative advantage over the other banks in Azerbaijan appears to be its capability to have more international banking experience-opening letters of credits, foreign correspondent accounts, some staff with international banking experience. Future Prospects IBA is not operating like a bank under internationally acceptable standards. In fact it is the foreign currency treasury of the Government of Azerbaijan. This is an inherited task from the past where the Vensheconombank was fulfilling such tasks. When the foreign currency reserves of the government is transferred out of IBA, IBA would be downsized to maximum 50% of its present size. The options for IBA can be: Merge part of IBA with the NBA and privatize the downsized bank. In such a case, the NBA could benefit from the foreign currency management skill base of IBA where the management of the government reserves and the interbank foreign currency exchange clearing would be handled from the NBA. The majority of the (enterprise) loan portfolio is under government guarantee and/or to the state enterprises. These loans are expected to be paid-off. As explained above, the downsized IBA would still be insolvent. The actual amount of insolvency would depend on the amount on non-recovered bank and enterprise loans plus the losses incurred. At this point this is estimated to be around USD 2 million minimum.17 If the downsized IBA is to be privatized, the potential shareholders need to put this equity. Merge part of IBA with the NBA and the downsized portion with the Prominvest Bank to be offered for privatization. This scenario would be as above, except in this case the downsized IBA would be merged into the Prominvest Bank. This is the case of merging two bad banks and restructuring them together. Merge IBA with the NBA and gradually sell off the remaining IBA to private banks, or to a foreign investor. Meanwhile, IBA management should start taking measures for containing the loss to the bank. Some of these measures are: * Stop opening new branches and downsize/rationalize the existing branch network. * Start working on the weakly performing loans on a case-by-case basis. This should especially be implemented for the foreign currency loans made to the private sector banks. These banks -- if they are in existence -- should first pay their loans plus interest due to IBA prior to qualifying for the bidding in the interbank foreign currency auction. 17 The outstanding bank loans of USD 20 million if not collected from the 100 banks disbursed would increase this insolvency by the amount of the uncollected amount of the loans. A-24 * IBA should separate the foreign currency book that belongs to the government from its own balance sheet. These reserves and deposits should be matched and placed with international banks and the NBA should get a daily report from IBA as to the status and management of these funds. * Start developing a strategy for the downsized bank looking for market role, priority clients, etc. The government and regulatory agencies might also consider to: * Start auctioning the agency business of IBA for donor-credit lines to the private banks. * Eliminate IBA's monopolistic position for handling foreign trade finance for the state sector needs. A-25 ANNEX B THE PRIVATE BANKING SECTOR Introduction 1. The observations and recommendations in this section are based on extensive discussions with senior management officials of sixteen of the country's representative private-sector commercial banks of which seven were ranked in size among the top twenty banks. In addition, the interviewed banks provided without exception their latest (October 1, 1995) financial statements and, in some instances, brief writeups of their histories and major activities. Finally, detailed statistics, also as of October 1, 1995, were subsequently provided by the country's banking authorities for all private-sector banks. Structure of the Commercial Banking Sector 2. Number and size of the banks. As of October 1, 1995, Azerbaijan had 185 commercial banks of which 171 were private-sector institutions, i.e., majority-owned (more than 50%) by individuals and/or private enterprises. The total number of banks has been shrinking considerably and is now down from about 240 a year ago. The remaining number of independently licensed banks is still very large for a country of the size of Azerbaijan, but a further substantial reduction in this number is expected to occur in the years ahead as a result of competition and increased minimum capital requirements. 3. The private-sector banks are uniformly young institutions, all having received their license since 1992 and fifty percent of them since only 1993. This private banking infancy explains some of the sector's major characteristics: generally very small banks in terms of capitalization and assets; small loan portfolios reflecting management's' risk-averse nature (which, in turn, is due partly to management's' lack of lending experience and credit evaluation skills); and a high rate of both entries and exits -- with the latter reflecting in part management's' lack of banking experience and a consequent high rate of involuntary exits. 4. As of October 1, 1995, the average size of the 171 banks in terms of paid-in capital was Manat 383 million (US$ 85,000 equivalent), with a range of Manat 12.4 billion for the largest bank to Manat 73 million for the smallest (Attachment 1, Page B-13). Paid-in capital of the majority of the banks interviewed was in the US$50,000 to US$150,000 range. When measuring total shareholders' equity as paid-in capital plus retained earnings, the average capitalization per bank increases to Manat 502 million (US$ 111,556 equivalent). However, retained earnings in the statistics provided generally consist of undistributed profits for the first 9 months of 1995, i.e., prior to dividend payouts and allocation to various funds many of which are of a non-reserve nature (e.g., pension and insurance funds). Consequently, until improved data become available, paid-in capital remains the most reliable indicator of a bank's capitalization. 5. The NBA's stated objective is to increase minimum paid-in capital requirements gradually for existing banks over the next several years. On January 1, 1996, the required minimum paid-in capital for existing banks was raised to US$50,000 equivalent and is scheduled to be raised further to US$100,000 equivalent in the course of 1996. By year-end 1997, the minimum is expected to be US$500,000 equivalent, equal to the minimum paid-in capital amount already required for new bank applicants. There is widespread agreement within the banking community that the current number of banks is simply too large in relation to the country's size, and that the NBA's policy of strengthening the banking sector by sharply reducing the number through raising the minimum capital requirements is correct. The most B-I often mentioned optimum number of commercial banks ranges from 20 to 40, with probably the lower number being the more realistic. 6. Ownership and customer structure. Many of the banks visited were "micro pocket banks", i.e., banks founded (generally in or around 1992) by groups of individuals and of closely held and mostly small private enterprises for the exclusive purpose of financing the credit and credit-related needs of their owners. In the few cases where the original owners included some state owned enterprises, the latter's ownership share has been drastically diluted over time. Ownership structure, however, has remained virtually unchanged in terms of number of owners and purpose of ownership. 7. Both owners and customers are to a large extent restricted to small trading companies. Major reasons accounting for this situation are: (a) the belated privatization of the industrial (manufacturing) sector which effectively shuts off major parts of this sector from being able to draw on the services of the private banks; and (b) the already stated purpose of the pocket banks which limits the interest of these banks in "outside" individual shareholders and customers. The consequences of this situation are twofold: (i) the current size and ownership of the banks are not expected to enable the banks to play a significant role in the future financing needs of the country's manufacturing sector, and (ii) the banking needs of households are not, and are not expected to be, met except for possibly the placing of (savings) deposits. However, with certain reforms -- notably improvements in the legal and regulatory framework, privatization, increases in minimum capital, and availability of good information -- the private banks have the potential of meeting the main financial needs of a market economy. Table 1: BALANCE SHEET COMPARISONS: ALL BANKS AND PRIVATE-SECTOR BANKS (as of October 1, 1995) (AZ Manat million) All Banks Private Sector Banks Private Sector/All Banks Paid-In Capital 93,671 65,569 0.70 Paid-In Capital and Retained Earnings 143,221 85,832 0.60 Total Assets* 3,102,468 544,057 0.18 Total Loans* 1,693,972 226,184 0.13 Total Deposits 1,901,812 441,076 0.23 *Total loans are gross and include capitalized past-due interest receivables. 8. The private sector banks compared with their state owned or controlled peers. The private banks' share of the entire Azerbaijan banking sector shows widely varying percentages depending on which balance-sheet categories are compared. In terms of most categories, the state owned and controlled banks have, at least during 1995, retained and by some measures even expanded their dominant position. However, the private banks have convincingly surpassed the state owned and controlled banks in terms of capitalization: as of October 1, 1995; the former held 70 percent of all paid- in capital and 60 percent of the combined paid-in capital and retained earnings (Tables I and 2). On the other hand, the private sector banks accounted for only 13 percent of all outstanding loans, reflecting their very limited lending activities. In contrast with representative loan-to-asset ratios found in western banks -- normally in the 60-80 percent range -- the Azerbaijan private banking sector showed an average ratio of only 41.6 percent. That and additional ratios reflecting the strongly capitalized position of the private-sector banks are shown in Table 3. B-2 Table 2: Major Balance Sheet Ratio Comparisons: All Banks and Private Sector Banks (as of October 1, 1995) All Banks Private Sector Banks Paid-In Capital/ Total Assets 0.030 0.121 Paid-In Capital and Retained Earnings/ Total Assets 0.046 0.158 Paid-In Capital/Total Loans* 0.055 0.290 Paid In Capital and Retained Earnings/Total Loans* 0.085 0.379 Total Loans*/Total Assets 0.546 0.416 Total Loans*/Total Deposits 0.890 0.513 * Total loans are gross and include capitalized past-due interest receivables. 9. Private sector fragmentation. As alluded to earlier, the private banking sector is highly fragmented in terms of the share distributions of some of the major balance-sheet categories (e.g., capitalization). Not only are even the largest private banks (except for one bank) small by any measure when compared to the state owned banks as well as to their private-sector peers in many other emerging countries, three of the five largest -- including the largest private-sector bank -- are majority-owned by foreign interests. The extent of fragmentation in terms of size differences among the various groups of private-sector banks and as reflected in market-share comparisons is shown in Tables 3 and 4. Table 3: Private-Sector Banks: Major Balance Sheet Comparisons, By Size (AZ Manat millions, as of October 1, 1995) All Banks Twenty Largest Banks Five Largest Banks Average Paid-In Capital 373 1,636 4,364 Average Paid-In Capital Plus 492 2,296 6,348 Retained Earnings Average Total Assets 3,160 13,881 45,334 Average Loans 1,313 4,313 11,607 of which: hard currency 739 2,827 7,234 Average Total Deposits 2,568 11,630 39,645 of which: hard currency 1,882 9,451 33,167 10. The current degree of fragmentation is expected to decline rather rapidly and substantially as a result of the trend towards fewer and larger unit banks. Main causes for this development are twofold: (i) the periodic sizable increases in minimum capital requirements, including recently established minimum paid-in requirement of $500,000 for new banks; and (ii) the expected continued entry of foreign banks and creation of new joint-venture banks. Increasing minimum capital requirements in particular will help reduce the number of private-sector banks, either through mergers of existing banks or through voluntary and involuntary exit: as of October 1, 1995, 79 out of the 171 private-sector banks had a shareholders' equity (paid-in capital plus retained earnings) below the minimum US$50,000 equivalent required as of January 1, 1996. B-3 Table 4: Market Share Comparisons of Private-Sector Banks, by Size Group (as of October 1, 1995) Percent of all banks, held by Twenty Largest Banks Five Largest Banks Paid-In Capital 52.6 34.1 Paid-In Capital plus Retained Earnings 55.4 37.0 Total Assets 52.0 42.8 Total Loans 38.9 29.0 of which: hard currency 45.9 32.9 Total Deposits 53.4 45.4 of which: hard currency 59.1 51.8 11. The expected reduction in fragmentation and the equally expected sharp increase in the size of the average private-sector bank will have several significant and positive consequences for the country's banking sector of which the following are the most readily apparent: (i) wider distribution in the ownership and a gradual demise of the pocket banks: the current pocket banks will have difficulty extracting the additional capital requirements from their existing shareholders and be forced to attract new ones, leading to a decline in connected or related lending practices; (ii) improved quality of bank management and greater long-term viability of the banking system: fewer and larger banks will allow for, and require, a more rigorous selection process of available management talent; (iii) improved capacity to meet the private sector's credit needs: improved management quality and larger resources, both financial and human, will further the development of needed analytical skills in the credit area, thus leading to a greater willingness and capacity to lend; and (iv) improved supervisory control over the banks by the NBA: fewer banks mean less stress for the NBA's supervisory and inspection departments, even if the unit size of the individual banks increases. Greater attention to individual banks becomes particularly crucial with the near-future introduction of loan classification, loan-loss reserve and capital adequacy requirements, etc. 12. The issue of foreign ownership. Three of the four largest private-sector banks are majority foreign owned (see Attachment I). Reasons for this foreign interest vary: in the case of Azak Bank -- the largest and, in effect, a consortium bank -- it appears to be directly related to the country's rapidly developing energy sector, given its major shareholders' involvement in the oil business. As for the other two, their part foreign ownership by Turkish institutions reflects the considerable and apparently still growing interest, both private and official, of Turkey in Azerbaijan and in its potential economic growth. There is little doubt that in the foreseeable future, given the country's favorable economic prospects and absent unexpected negative developments, banks from other western countries will also enter Azerbaijan's banking community. B-4 The Current Banking Environment 13. The banks' lending posture. The current environment is one of "don't lend if you don't have to, and, if you have to, restrict yourself to lending in dollars". With virtually no exception (one possible exception is the recently established joint venture Azerturk Bank, which is anxious to get a foothold in the country's Turkish business community), banks are taking a highly restrictive and conservative attitude towards lending. The main reasons are: (i) the still recent and vivid inflationary experience which banks are not yet convinced will not return in the foreseeable future; (ii) the very high Manat lending rates which banks consider too onerous and risky for themselves as well as for their customers (i.e., the latter cannot realistically afford them); (iii) the increasingly demanding attitude of the NBA in terms of regulatory requirements and their application (reflected in, among others, the high number of involuntary bank closings); and (iv) the seriously depressed economic conditions, including loss of major export markets, specifically Russia. 14. At the time of the mission (October/November 1995), glimmers of a possible general improvement were beginning to appear as reflected in an evident slowdown in the rate of inflation, a gradual decline in Manat interest rates, and the emergence of a more positive attitude in the business community that the worst may be over. (The latter appears at least partly tied to the rapid and sizable expansion in oil and gas production and exports expected in 1996 which already is reflected in a considerable upturn in the construction industry). This apparent general improvement in the business climate is tempered, however, by the uncertain political outlook. In short, some of the financially stronger banks may moderately loosen their lending policies in 1996, but any loan growth will be limited by the NBA's allegedly firm commitment to strengthen regulatory requirements in the areas of capital adequacy and loan quality, including the introduction of required loan-loss reserves. 15. Interest rates. By November 1995, short-term interest rates (there are no long term deposit or lending rates quoted) had begun to reflect the gradually improving monetary conditions in the country. In particular Manat rates had come down since the second quarter of 1995, while dollar rates had remained mostly steady. 16. Rate structures have remained high, however, in particular in Manat, with lending rates remaining well in excess of 100 percent per annum. Also, dollar rates, with short-term deposit rates averaging about 15 percent and higher and lending rates in the mid-twenties and upward, are very high for western standards. Both reflect the extreme scarcity of credit as well as the abnormally high risk levels as perceived by both depositors and lenders. 17. Interest rate spreads. Spreads between deposit and lending rates are high, with about 30-35 percent in Manat and 10-15 percent in dollars. When considering a recent rate of inflation of about 25 percent per annum, the spread difference between the two currencies does not appear to be out of line -- especially when considering that the recent stability of the Manat has generally been perceived as artificial. In short, an inflation-adjusted spread of about 10 percent for a credit-hungry and high-risk country such as Azerbaijan does not appear to be unrealistic. Miscellaneous Banking Issues 18. Bank size and capital adequacy. Bank asset size is not, and has never been, an indicator of financial strength. On the contrary, there have been many examples of bank failures once management replaced profitability (i.e. financial strength) with market power (e.g. size of loan portfolio). Yet size, when related to a bank's capital base, carries in it the ability to provide both larger size loans and a more B-5 diversified loan portfolio. Also, larger banks are generally (especially financially) better able to afford the development of technical expertise among their lending staff with respect to specific industries. In short, bank size offers certain "economies of scale" not available to the small banks. In the case of Azerbaijan, larger-size private-sector banks are therefore undoubtedly needed for the extension of larger and longer-term loans to the expected emerging private-sector industrial enterprises. 19. The single main determinant of a bank's financial strength is its capital adequacy, i.e., the size of its capital base in relation to its total, and especially to its risk, assets. Capital adequacy requirements are therefore major tools for the supervisory authorities to ensure a bank's financial strength and, therefore, the safety of its depositors. The NBA's regulations should therefore include, if they do not already, the following ratios: * Single borrower ratio. It is recommended that maximum exposure to a single borrower be 20% of the bank's common equity (paid-in capital plus retained earnings). The NBA must define what is included in exposure, e.g., loans (secured/unsecured), commitments, guarantees, open FX contracts, etc. * Loans to shareholders, directors, and other types of related borrowers. It is recommended that maximum exposure to a related borrower be 10% of the bank's common equity, with a maximum of 50% of common equity to all related borrowers. 20. The NBA should not micro-manage the commercial banks. However, in the use of ratios it should also pay attention to limitations on lending to single industry categories, minimum collateral ratios, maturity structure, and to other ratios designed to foster loan portfolio diversification and loan quality. For financial and operating ratios of major Azerbaijan banks, see Table 5. 21. Loan-to-asset ratios. The abnormally low loan-to-asset ratios reflect a variety of conditions most of which will, in the natural course of events, prove to be temporary. They include the following: a. Bank age. With the majority of banks less than two years old, management and staff have not yet been able to accumulate adequate experience and expertise to pursue an aggressive risk-associated lending stance; b. Bank size. With the average private bank having a staff of fewer than 19 individuals and a shareholders' equity of less than Manat 500 million ($110,000), a labor-intensive activity such as lending is difficult to pursue from an operational as well as profitability point of view; c. Profitability. As is the case with banks in most of the FSU countries, Azerbaijan banks have been able to realize sizable earnings with very little risk by concentrating on foreign-exchange (hard-currency) trading; d. Risk management. The lack of both economic and political stability and the absence of reliable information on the financial and managerial strength of potential non- shareholder related borrowers represent powerful barriers to an active lending policy; e. Banking culture. As pocket banks, the private banks are expected -- or even directed -- by their enterprise shareholders to primarily serve the latter's credit and non-credit needs. With viable private enterprises currently loath to borrow for purposes other than the financing of trade and related working capital needs due to high real interest rates, effective loan demand is limited. B-6 TABLE 5: Major Financial and Operating Ratios of the Twenty Largest Private-Sector Commercial Banks, Ranked According to Size of Paid-In Capital* (As of October 1, 1995) Name of Bank Paid-In Paid-In Total Loans/ Total Loans/ H.C. Loans/ H.C. Deposits/ Total Assets/ Total Loans/ Capital/ Capital/ Total Assets Total Deposits Total Loans Total Deposits No. of Employees No. of Employees Tot. Assets Total Loans (AZ Manat million) (AZ Manat million) AZAK .10 .71 .15 .17 .73 .96 2059 302 GUN AY .43 .50 .86 1.83 .97 .90 298 255 AZAL .26 47.10 .01 .01 1.00 .71 209 1.1 AZER-TURK .32 .75 .43 .66 1.00 .93 488 210 ARKO .09 .17 .49 .55 .62 .74 964 474 AZERDEMIRYOL .02 .07 .35 .37 .45 .67 287 100 NAKH-TURK n.a. n.a. n.a. n.a. n.a. .00 62 0 AZEKO .35 1.29 .28 .40 .60 .34 99 27 MARHAMAT .31 .34 .89 1.64 .94 1.00 1151 1030 EL .29 .40 .71 4.93 .80 .99 315 222 AZERIGAZ .06 .26 .25 .27 .90 .73 417 103 SOLID .99 6.81 .15 1.84 .70 .75 87 13 BILLUR .25 .31 .79 1.11 .74 .86 128 75 NNN .15 .19 .80 6.59 .56 .98 53 33 TAJ .09 .10 .90 1.30 .80 .89 231 208 BAKO .13 .24 .52 .64 .90 .76 59 31 GUN .16 .35 .58 .70 .12 .30 84 49 YURD .21 .57 .37 .50 .82 .40 37 14 ELIN .55 .75 .73 1.77 .88 .48 26 19 SARVAT .45 .46 .98 1.88 .37 .10 47 46 weighted average .12 .39 .31 .37 .67 .82 340 106 *Private-sector banks are defined as banks whose majority ownership (50% or more) is in the hands of individuals and/or private enterprises. Note: H.C. = Hard Currency B-7 22. All of the above conditions are expected to be reduced in significance or even to disappear completely over time. Specifically, it must be expected that, as a result of recent and prospective changes and improvements in the economic, legal, and regulatory environments, private sector banks will develop both a greater capacity and willingness to lend. For example, even with the present capitalization levels and a capital adequacy ratio of 8 per cent for risk-weighted assets, the private-sector banks could approximately quadruple their current lending levels to about Manat I trillion. In short, there is compelling evidence that the private banks have ample growth potential to assume the lending function held by the state-owned or controlled banks. 23. Bank regulation: loan classification and loan-loss provisions. These two related issues are already under discussion between the country's monetary and fiscal authorities and the IMF. Initial steps toward their introduction are expected to be taken in the course of 1996. As for provisions, a distinction should be made between general provisions, e.g., I to 2 percent of a bank's total loan portfolio, and specific provisions based on the recommended loan classifications and ratios provided by the Basle Committee and almost universally adopted and introduced by the developed countries. The tax and profitability implications of pre-tax provisioning make this issue into a highly political subject whose early and satisfactory (i.e., in favor of pre-tax provisioning) should be progressively pursued by the NBA. A realistic and almost unavoidable solution would call for the introduction of the Basle ratios over a limited number of years. 24. NBA bank supervision. The large number of small and closely held banks in Azerbaijan is an unplanned blessing when viewed against the current limited ability of the bank supervisory authorities to conduct effective offsite a well as onsite supervisory functions. Few people get hurt when one or several of these banks fail. However banks will become fewer and larger once the privatization process of the current state owned enterprises and some of the state owned banks takes form and the more aggressive and better managed banks will grasp the opportunity to broaden their customer (including lending) base by soliciting the newly offered businesses of the privatized enterprises. Banks will have to broaden their deposit base. This will mean active solicitation of individual (household) deposits, since it is doubtful that the interbank market can fulfill the funding functions.- Moreover, household deposits represent a more stable and less expensive funding base than commercial and interbank deposits. Protection of household depositors being a prime objective of bank supervisors, the supervisory function of the NBA must be strengthened and enlarged without delay if it is going to be capable to perform this function adequately. 25. Future role of the Manat. Currently the private-sector banks conduct approximately 75 percent of their transactions in US dollars. This situation seriously undermines the ability of the NBA to maintain effective control over its monetary policy and is at least partly responsible for the existence of a sizable underground economy. Little improvement in this condition can be expected, however, until the authorities are able to restore widespread faith in the stability of the Manat, a process which must be expected to require a considerable period of price and exchange-rate stability. The Banking Outlook 26. Increased credit demand. There is virtually unanimous agreement that, barring serious political instability, the Azerbaijan economy will be significantly affected over at least the next decade by the rapid development of its energy (oil and gas) resources. This development, already underway, will not only bring into the country sizable western financial and technical assistance, but also spur the growth of mostly indigenous support and service industries. In short, a realistic scenario shows a steady and significant increase in the country's economic growth rate, fueled by increases in per capita real income B-8 and in consumer demand and, in turn, by a significant expansion in private investment in virtually all sectors. 27. The speed and extent of this expansioni will, in the first instance, be guided by the country's economic policies. More fundamentally, however, the major determining factors will be the financial and entrepreneurial resources which the private sector is able to mobilize. There is little doubt that Azerbaijan's resources -- physical, human, and even financial -- are currently largely underemployed. The realization of the country's economic growth potential will require, among others, the mobilization of adequate internal as well as external credit resources by a "ready to lend", efficient, and competitive banking sector. The creation of such a banking industry in Azerbaijan within a reasonably short period of time -- given the expected rapid increase in credit demand -- will require the combined efforts of the country's private-sector banks themselves and, in coordination with them, those of the government. Specific requirements from the latter would include * a supportive and steady monetary policy with its major objectives of price and foreign- exchange stability; * a fiscal policy supportive of a strong and growing private banking sector, among others by assisting in strengthening the banks' capital base through treating loan-loss provisions as tax-exempt expenses; - an accommodating, enabling regulatory environment providing the private-sector banks with ample opportunity to expand the volume and breadth of their services, including a policy that provides a level playing field for both state owned and private sector banks; * an effective bank supervisory system designed to minimize bank failures and to protect depositors, creditors, and shareholders against mismanagement and fraud; a a comprehensive, well-designed and implemented bank training program for all levels of bank staff. The rapidly expanding demands on the banking sector by virtually all segments of the economy, plus the new regulatory requirements (specifically capital adequacy requirements and loan-loss provisi6ning) expected to be introduced over the next few years, will place heavy emphasis on bank management skills such as organization, planning, product development, and internal audit and control. Equally important for the banks' ultimate viability are proper training programs for lower- and mid-level personnel in technical skills such as modern (international standards) accounting techniques, credit analysis and evaluation, lending policies and procedures (term lending, collateralization, documentation, authorization), and management information systems. * Once commercial banking skills have been adequately mastered and control procedures established, banks may be able to actively participate in the creation of the emerging local money and capital markets, including in such activities as the issuing and trading of marketable financial instruments, securities underwriting, and securities analysis and portfolio management. The development of an investment/merchant banking capability within a "universal bank" concept should take place gradually, however, with the necessary technical skills creation in this area being paralleled by a concomitant development of the required legal and regulatory framework. B-9 Towards A Bank Training Capacity 28. Bank training organization. Bank training programs of various types, but all based on western banking practices, have been in existence in most of the FSU republics for several years. Many have been organized by, or with the assistance of, individual western banks and consulting firms and multinational institutions such as the World Bank (EDI), the EBRD, and the EU. Typical are the short, "nuts and bolts" types: pragmatic one-to three-week seminars focusing on specific subjects such as bank accounting or credit analysis and presented by current or past practitioners to audiences of bank staff. They tend to be extremely practical and have, in general, been well received by the participants. 29. A permanent trainingfacility. In the longer run, however, such short-term ad hoc seminars could be profitably supplemented by more comprehensive and permanent training programs designed to provide the banking sector with an ongoing supply of staff familiar with the most important elements and techniques of commercial banking. The initiative and execution of such a permanent project should be concentrated within the banking community, for example in an association of commercial banks. 30. The training program. At least in the beginning (i.e., during the first one to two years), the program should be designed and implemented with the aid of banking experts experienced in the organization and leadership of bank training projects. The curriculum would be an extended and more comprehensive version of the earlier mentioned short-term ad hoc seminars: presentations would at least initially -- until a cadre of local trainers had been developed -- be led by foreign experts skilled in all technical aspects of commercial, and subsequently investment, banking. The range of individual courses should be very broad, from periodic two-or three-day seminars for senior bank management to week- long (or longer) seminars for branch managers, to almost ongoing programs for clerical staff on a wide variety of subjects. The latter, in particular, could be offered at night and lead to the earning of a diploma upon the successful completion of the program. 31. The project should be formalized in the sense that the project would have its own physical facility, a Supervisory Board elected by the commercial banks, and a modest administrative staff to ensure the efficient management of the project. As for the project's financing, it is suggested that for the first several years the cost of the foreign experts be borne by grants from western donors, while local expenses be paid for by the Azerbaijan banking community, including through fees from the program's participants. 32. The role of the local universities and other institutions of higher learning. Parallel to the establishment of a practice-oriented and bank-run training program for bank staff, it is strongly recommended that at least some of the local institutions of higher learning develop and establish western-style business schools or programs (e.g., leading to an MBA) which concentrate on offering the more standard theoretical "business administration" courses such as accounting (including cost accounting), financial administration or corporate finance, statistics, computer technology (including MIS), international banking, etc. Such university-level business programs would form a potentially good background for future bankers who, upon graduation, could supplement their acquired theoretical knowledge with the "nuts and bolts" pragmatism offered in the bank seminars. B-10 ATTACHMENT 1 LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in eamings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees AZAK JV/JS 12/92 0.0 10.5 0 89.5 119,392 12419 542 17,522 12,768 105,253 101,107 1 58 GUNAI JV/JS 11/92 0 6 40 54 7,738 3,322 1,204 6,622 6,427 3,617 3,248 3 26 AZAL JS 1/94 41.7 0 58.3 0 10,436 2,685 702 57 57 7,451 5,317 1 50 AZER-TURK JV/JS 6/95 0.0 50 0 50 6,836 2,218 16 2,944 2,944 4,478 4,160 0 14 ARKO JS 11/92 0.1 12.7 87.2 0 20,236 1,739 843 9,963 6,218 18,030 13,283 0 21 AZERDEMIRYOL JS 11/92 0.5 37 62.5 0 68,866 1,655 6,631 23,873 10,702 63,923 42,882 1 1 240 NAKH-TURK JV/JS 9/93 0 0 51 49 373 1,350 -6 0 0 63 0 0 6 AZEKO JS 12/92 0.2 34.4 65.4 0 3,745 1,328 417 1,031 621 2,555 868 1 38 MARHAMAT COMM. 6/93 0 6 94 0 3,453 1,057 -15 3,089 2,889 1,888 1,887 0 3 EL JS 12/92 0 6.4 6.7 86.9 3,145 898 319 2,223 1,774 451 446 0 10 AZERIGAZ JS 11/92 7.8 55.8 36.4 0 13,751 878 1,270 3.412 3,069 12,656 9,179 0 33 MECII & R JS 11/92 0 3.5 96.5 0 1,690 814 57 1.584 1,300 811 444 0 21 SOLID JV/JS 6/94 0.0 12.4 30.5 57.1 694 688 27 101 71 55 41 0 8 BILLUR COMM. 12/92 8 86.5 5.5 0 2,568 631 273 2,037 1,506 1.828 1,567 0 20 NNN COMM. 2/94 0.0 34 66 0 3,728 560 28 2,980 1,662 452 443 0 50 TAJ COMM. 12/92 0 3.6 96.4 0 . 6,226 542 87 5,606 4,486 4,328 3,871 I 27 BAKO COMM. 11/92 0.0 0 100 0 4,129 527 95 2,159 1,944 3,386 2,584 2 70 GUN JS 12/92 0 33 67 0 3,200 527 30 1,847 222 2,642 793 1 38 YURD COMM. 10/92 5.3 94.4 0 0.3 2,421 514 211 897 740 1,797 714 2 65 NATIONAL JS 1/94 0 37.4 62.6 0 2,197 500 -43 1,275 788 1,728 1,030 0 8 ELIN COMM. 2/94 0 13.3 86.7 0 873 477 135 637 562 360 174 0 34 SARVAT COMM. 12/92 4.1 7.1 88.8 0 1,035 462 47 1,015 377 541 55 0 22 AZINVEST COMM. 10/92 I 60 39 0 1,630 453 306 1,197 444 1,330 562 4 28 MELLI IRAN COMM. 1/93 0 0 0 100 46,737 444 1,537 0 0 44,563 39,565 0 10 OZAI. COMM. 2/94 27.3 15.2 57.5 0 1,416 440 35 1,192 0 1,454 0 0 16 PARA JS 12/92 0.2 29.1 36.8 33.9 2,675 438 195 1,494 1,133 2,299 1,304 9 70 ANAR COMM. 2/94 5.1 6.7 88.2 0 1,197 416 49 377 0 809 0 0 17 BAKCITY COMM. 6/93 1.2 11.4 87.4 0 652 408 24 231 0 215 8 0 7 ISMAILLIYA JS 12/92 0 99.8 0.2 0 2,105 364 388 1,880 0 1,520 0 0 17 AVAND COMM. 2/94 0 85.2 14.8 0 2,086 335 -107 1,834 1,322 1,704 1,331 0 13 B-I l ATTACHMENT 1 LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in earnings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees PREMIUM COMM. 2/94 0 100 0 0 11,085 331 213 7,636 6,151 7,320 6,487 0 8 DOSTLUG COMM. 12/93 0 76.2 76.4 0 436 318 49 1 0 94 0 0 1 1 KHALG JS 12/92 0 88.4 11.6 0 2,824 316 -334 2,573 1,597 3,027 1,624 2 24 INTERCREDIT JS 12/92 1.4 98.6 0 0 4,539 314 53 4,247 3,504 3,908 3,529 1 13 AZERNAGLIYAT COMM. 12/92 8.3 36 55.7 0 1,148 310 508 643 0 740 0 3 48 DIYAR JS 12/92 0 88.2 11.8 0 2,798 309 -22 1,607 155 1,639 162 1 11 TABRIZ COMM. 6/93 0 0 100 0 436 304 40 367 315 129 72 0 19 AMRAKH COMM. 12/93 0.6 18.9 80.5 0 1,619 289 62 1,315 1,162 1,322 1,297 0 14 EMA iS 2/94 6.8 4.9 88.3 0 1,408 283 -10 986 798 1,107 975 0 8 MANAT COMM. 12/92 1.5 24 74.5 0 871 277 214 766 478 499 313 1 13 OGUZ COMM. 12/92 0 60.2 39.8 0 5,142 272 -337 4,072 3,626 4,036 3,705 3 37 ARGUNASH COMM. 1/94 0 0 100.0 0 3,903 269 197 2,891 1,753 3,497 2,655 0 5 MBANK JS 12/92 1 41 58 0 14,355 259 634 1,338 661 13,737 8,246 1 38 ILK JS 11/92 0 40 60 0 4,697 252 65 1,592 1,447 4,467 4,256 1 31 PRIVAT COMM. 1/93 0 16 84 0 1,813 250 13 735 0 1,072 938 1 22 SAF iS 6/93 0 75.1 24.9 0 3,915 250 11 3,725 103 1,263 271 0 8 MATIN COMM. 12/93 0 96.4 3.6 0 1,969 249 -104 1,964 880 1,751 881 1 11 DEBUT JS 12/94 0 0 100 0 1,322 247 43 50 0 1,076 176 0 12 UNSAL COMM. 6/93 2.3 34.3 63.4 0 1,282 247 -13 939 35 802 253 0 12 TRADE (ITB) iS 6/93 3.9 78.9 17.2 0 2,427 238 -498 1,797 913 2,124 1,604 0 12 ACADEM COMM. 12/92 2.69 2.5 94.9 0 666 237 8 289 0 404 25 0 12 AKINVEST JS 11/92 20.0 20 80 0 874 235 142 454 0 574 170 3 44 TRUST COMM. 2/94 0 7.8 92.2 0 1,062 233 52 61 0 51 277 1 14 ATA COMM. 1/94 5.6 13.3 81.1 0 1,210 231 22 1,113 1,084 971 964 0 10 ISH COMM. 12/92 0 88.2 11.8 0 1,147 231 -13 329 0 847 23 0 25 OZ iv 8/93 0 0 51 95.6 875 230 56 222 222 610 459 0 11 AZAD JS 12/92 0 75 25 0 1,739 228 124 1,549 433 1,329 448 3 50 CHIWAR COMM. 2/93 8.5 25.6 65.9 0 806 228 6 447 419 464 447 0 11 BAKMOS COMM. 1/94 0 6.7 93.3 0 73 225 -123 0 0 33 0 0 17 PROMTEKH iS 2/94 0 32.9 67.1 0 2,279 225 50 1,872 0 2,003 81 0 10 STAR JS 2/94 0.9 12.3 86.8 0 144 225 78 276 115 172 17 1 10 B- 12 ATTACHMENT 1 LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in eamings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees BAKI JS 12/92 0 20 80 0 1,303 222 43 1,041 86 1,046 922 0 10 NUR COMM. 12/92 0 82.2 17.8 0 46 222 34 0 0 17 0 0 7 AZSHARG COMM. 12/92 0 100 0 0 1.270 221 44 1,226 1,109 1,258 1,109 0 12 JABBARLI COMM. 12/94 0 35.6 64.4 0 205 212 -4 202 0 3 0 0 8 BAKCOMMERS COMM. 12/92 8.6 73 18.4 0 853 209 241 608 0 493 10 5 38 TAJIR COMM. 12/92 5 60 35 0 2,165 208 -54 1,525 591 1,935 910 1 27 AZTRANSIVEST JS 2/94 0 40 60 0 924 205 32 722 597 717 505 0 15 RASHAD JS 2/94 0 3.4 96.6 0 419 203 28 290 0 217 0 1 7 ELVID COMM. 2/94 0 100 0 0 653 202 124 565 0 322 0 0 13 DALGA COMM. 12/92 2.8 19 78.2 0 4,024 201 22 3.355 2,994 3,863 3,278 1 25 TURK COMM. 12/92 0 58 42 0 963 201 55 614 0 666 4 3 17 BALAKAN JS 11/92 1.5 17.5 81 0 248 200 42 238 0 22 0 0 7 NIGYAR COMM. 2/94 0 33 67 0 1,046 192 -130 1,044 123 654 0 0 4 SULTAN JS 11/92 0 91.5 8.5 0 655 192 28 610 0 90 0 0 5 SAIDA-AJZA COMM. 2/94 0 0 100 0 454 192 189 156 0 345 44 0 10 AZKOM JS 12/92 0 87.7 12.3 0 5,192 190 68 4,546 3,500 4,371 3,537 4 55 HABIB JS 6/93 0 2.6 97.4 0 227 190 22 221 0 23 0 0 7 RUZU COMM. 12/92 0 72 28 0 7,528 189 774 5,902 4,918 6,290 5.178 1 34 SAHIB JS 6/93 13.4 46.4 40.2 0 215 189 21 113 0 14 0 0 7 IZHGUZAR JS 12/92 14.8 61.2 24 0 1,511 188 -73 1,374 0 657 0 1 10 XXI CENTURE COMM. 2/94 0 13.4 86.6 0 452 186 -23 325 0 337 0 0 14 AZERKREDIT JS 12/92 2.6 11.5 85.9 0 319 184 25 280 0 149 0 0 7 SHUKUR COMM. 2/94 0 17.6 82.4 0 813 184 -12 122 0 9 0 0 5 DANIZBUSINESS COMM. 12/92 19.3 2 78.7 0 535 181 -27 205 0 416 6 2 35 KARVAN iS 2/94 0 100 0 0 365 180 1 1 265 0 106 4 0 18 MUGAN COMM. 11/92 0 45 55 0 197 180 7 176 0 7 0 0 9 BIRLIK COMM. 6/93 2.0 53 47 0 1,011 178 134 774 89 675 42 0 12 NIJAT iS 12/92 0.7 99.2 0.1 0 772 178 10 761 0 456 0 0 8 AZINTORG JS 12/92 0 99.9 0.1 0 1.617 177 -12 744 444 1,470 1,331 0 8 UMID COMM. 12/92 0 74.7 25.3 0 2,265 176 147 2,047 1,517 1,975 1,552 0 27 DARYA iS 2/94 20.9 62.3 16.8 0 920 175 51 753 0 507 18 0 16 B-13 ATTACHMENT 1 LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in eamings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees GARTAL COMM. 12/93 17.7 39.5 42.8 0 267 175 50 62 0 36 0 0 6 RABBAT JS 12/93 0 64.6 35.4 0 1,164 175 278 272 213 762 426 0 12 TIJARAT-SANAYE COMM. 2/94 0 39.4 60.6 0 571 175 250 219 0 278 45 0 21 KHAZAR JS 12/92 13.2 56.9 29.9 0 802 169 147 673 0 273 0 0 24 AZMAN JS 11/92 0 94 6 0 2,290 168 117 1,856 1,445 2,125 1,459 2 18 GARAGAYA COMM. 12/92 10.9 46.7 42.4 0 1,446 168 -51 319 0 1,515 845 0 1 1 ARAZ COMM. 11/92 2.4 97.6 0 0 232 167 7 230 0 33 0 0 4 ECONOM COMM. 11/92 4.2 40.5 55.3 0 577 167 10 349 0 437 135 0 10 GARANTIYA COMM. 12/92 5.5 94.5 0 0 1,478 166 68 1,055 813 1,098 816 1 23 INJA COMM. 2/94 1.4 46.4 52.2 0 1,152 164 36 875 0 602 0 0 It CHIRAG COMM. 4/94 0 20 80 0 563 163 23 447 437 381 346 0 17 CONTINENT JS 10/93 0 38.7 61.3 0 327 163 95 228 0 62 2 0 9 NURAN JS 12/92 0 19 81 0 3,169 163 -138 2,862 2,218 2,966 2,349 0 14 PARVANA iS 1/93 0 22.7 77.3 0 227 163 104 177 0 45 0 0 12 SHIR JS 12/92 0 91.7 8.3 0 1,471 163 -1 732 0 719 0 0 15 TIJARAT JS 12/92 29.4 22.6 48 0 1,258 163 8 1,118 1,020 1,059 998 0 16 AZERSFIARAB COMM. 12/92 29.9 46.5 23.6 0 494 162 132 167 0 334 0 0 12 CREDIT COMM. 2/94 0 63.7 36.3 0 861 161 22 623 0 277 0 0 5 EL-AZIZ COMM. 1/94 0 2.7 97.3 0 712 161 26 566 0 480 0 0 12 ULPAR COMM. 2/94 0 100 0 0 272 161 8 230 0 25 0 0 6 VILYASH COMM. 12/92 0 100 0 0 529 161 24 407 111 121 0 0 6 ARZU JS 11/92 17.4 17.4 82.5 0 187 160 3 100 0 4 0 0 9 ART JV/JS 8/93 9.4 0.2 74.2 16.2 1,822 160 196 457 333 1,477 830 1 12 ADJEMI COMM. 12/92 0 14.4 85.6 0 651 160 26 612 III 207 0 0 12 INGISHAF JS 12/92 0 81.3 18.7 0 401 160 62 171 0 165 0 0 16 ISCOOP JS 12/93 0 75 25 0 2,395 160 186 1,436 1,109 1,860 1,109 3 15 ISTCOM COMM. 6/93 0 59.1 40.9 0 1,084 160 4 1,026 0 903 0 0 8 OLIMP COMM. 6/93 13.5 72.6 13.9 0 3,457 160 95 1,359 1,331 1,940 1,333 0 15 AZBUSINESS COMM. 12/92 12.0 88 0 0 1,029 159 5 116 0 873 687 0 12 BAKU-CITY is 2/94 0 2.9 97.1 0 198 159 41 110 0 22 0 0 17 B- 14 ATTACHMENT 1 LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in earnings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees BABA iS 11/93 2.0 40.8 57.2 0 437 159 -58 337 0 373 0 1 9 CAPITAL, COMM. 12/92 0 37 63 0 643 159 100 61 0 476 59 0 18 GENJAINVEST COMM. 12/92 0 6.5 93.5 0 295 159 2 189 0 107 3 0 14 GARAYAZI iS 6/93 2.1 30.6 67.3 0 348 159 6 244 0 44 0 0 10 INSAF COMM. 6/93 3.8 41.8 54.4 0 556 159 114 311 43 337 125 0 12 RESPUBLICA JS 12/92 2.5 37 60.5 0 2.575 159 151 1,582 915 2,255 1,371 6 51 UNIVERSAL JS 12/92 13.5 74.5 12 0 1,045 159 241 671 591 674 540 1 29 VAKHID JS 1/94 0 40.3 59.7 0 591 159 40 350 0 205 0 0 8 VOSTOK JS 12/93 0 100 0 0 2,828 159 66 1,735 1,478 2.796 1.494 0 14 AZBANK JS 2/94 0.4 71.6 24.4 0 3,098 158 2 2,990 2,218 2,929 2.218 0 14 ATRA JS 12/92 0 26.8 73.2 0 231 158 47 155 40 0 I 0 18 BORCHALI COMM. 12/92 12.0 35 53 0 646 158 33 272 0 467 I 0 25 DEKA COMM. 12/92 28.8 71.2 0 0 225 158 21 71 0 59 0 0 11 FUTURE SHINING JS 10/92 0 70.8 29.2 0 275 158 69 92 0 80 0 0 15 FUZULI iS 2/94 0 28 72 0 266 158 91 164 0 17 0 0 9 GENJA iS 2/94 1.5 6.8 91.7 0 213 158 5 160 0 47 0 0 4 INAM COMM. 4/93 0 100 0 0 190 158 2 116 0 1 0 0 6 TURAN COMM. 12/92 16.1 64.7 19.2 0 2,868 158 72 1,307 0 2,585 652 5 14 AZEREL JS 12/92 4.0 71.6 24.4 0 766 157 9 46 0 604 5 0 15 ASIA COMM. 10/93 1.6 14.5 83.9 0 2,390 157 30 2,297 2,285 3,329 3.318 0 5 AYPARA COMM. 12/92 0 57.5 42.5 0 703 157 9 557 444 502 444 0 16 BAKIBIRJA iS 2/94 0.3 62.3 37.4 0 4,047 157 75 812 0 1,446 6 1 17 ELIF COMM. 10/92 0 100 0 0 1,598 157 -511 1,373 0 1,949 0 4 21 INSHAAT COMM. 11/92 1 76.4 22.6 0 1.089 157 -370 1,011 222 1,322 224 0 9 PAYTAKHT JS 11/92 0 64 36 0 531 157 47 335 0 217 0 0 11 RENESSANS JS 11/92 0 79 21 0 1,769 157 57 708 465 1,536 598 0 33 SIR iS 2/94 0 60.6 40 0 377 157 3 230 0 203 0 0 10 TUGAY COMM. 2/94 0 15.4 84.6 0 187 157 10 0 0 35 12 0 8 YENI iS 2/94 0 16 84 0 2,0501 157 -34 1,234 0 1.183 444 0 11 ANAM iS 6/93 0 64.7 35.3 0 463 156 2 284 0 97 0 0 9 B-15 ATTACHMENT I LIST OF PRIVATE-SECTOR BANKS AND MAIN CHARACTERISTICS* As of October 1, 1995 (AZ Manat million) Name of Bank Legal Year of Presently Owned by Foreign Assets Paid Retained Loans Deposits Number Number form license State Private Individ. particip. in earnings Total Of which hard Total Of which hard of of entpr. entpr. (Percent) Capital curr. denomin. curr. denomin. branches employees BAKFWIWVEST COMM. 12/92 34.9 65.1 0 0 1,526 156 -188 923 432 1,520 558 0 15 ENERGI iS 2/94 10.3 0 89.7 0 764 156 39 577 264 585 206 0 10 ELMAR JS 12/92 0 0 100 0 941 156 -10 793 0 148 9 2 32 FARKHAD JS 1/94 0 0 100 0 242 156 55 62 0 66 7 0 12 ILKAN iS 6/93 0 10.9 89.1 0 435 156 31 176 0 106 0 I 14 ROYAL COMM. 6/93 13.5 85.3 1.2 0 1,872 156 25 1,481 608 1,638 926 4 22 REFORM COMM. 12/94 0 0 100 0 1,605 156 54 1,428 1,328 1,474 1,459 0 9 ZAMIN COMM. 11/92 25.1 25.1 51.6 11.5 325 156 43 189 0 86 5 0 11 AZINCOM COMM. 2/94 17.5 10.5 72 0 519 155 -75 501 0 404 0 0 11 GERMES iS 6/93 0 27.2 72.8 0 953 155 -9 41 0 804 0 0 14 IMPERO iS 2/94 7.7 81.A 11.2 0 195 155 3 51 0 51 26 0 14 KHAZRI COMM. 10/92 3.2 26.8 70 0 341 155 0 232 0 150 0 0 12 SHUR iS 9/93 0 21 79 0 462 155 -51 399 0 153 0 0 7 ZAKATALI COMM. 12/92 0 0 100 0 180 155 20 11 0 5 0 0 7 SALTANAT iS 6/93 1.3 18.1 80.6 0 1,247 154 -I 1,036 887 1,064 887 0 18 DINAR COMM. 2/94 8.4 69.5 22.1 0 2,851 113 -158 2,187 1,377 2,321 1,377 2 7 NAKHCOM iS 11/92 13 82 5 0 556 100 40 523 0 231 0 2 15 GURULIJSH COMM. 2/94 2.6 52.3 45.1 0 643 91 -32 641 0 328 0 0 4 TOGRUL JS 12/92 0 100 0 0 753 73 13 646 0 623 0 4 15 Totals 544,057 65,569 20,263 226,184 128,583 441,076 324,023 3163 *Private-sector banks are defined as banks whose majority ownership is in the hands of individuals and/or private enterprises. B-16 Attachment 2 Commercial Bank Evaluations: A Review of Selected Major Azerbaijan Banks Introduction During the October/November, 1995, Financial Sector Review Mission to Azerbaijan, a total of sixteen private-sector commercial banks were visited and their management interviewed. Selection of the sixteen banks was made by institutions and individuals familiar with the Azerbaijan banking sector and reflected their impression of these banks as representing the potentially more viable segment of the industry. On the basis of the interviews and the information provided, eight banks were informally evaluated on the basis of their perceived managerial quality, size, financial strength, and role in the financing of the domestic private sector.. The results and a brief description of the main characteristics of each bank are provided below (all data, unless otherwise noted, are as of October 1, 1995; exchange rate: US$ = Manat 4,500). 1. Azak Bank Established in 1992 and now by far the largest and most strongly capitalized private-sector bank in the country. Azak bank owes its dominant position to its founders and current major corporate shareholders: the Russian oil company Lukoil (18%), its local daughter Lukoil Baku (12%), and private non-bank sector firms in Austria, Cyprus, Germany, and Turkey. Also, in accordance with Azerbaijan's bank regulations, Azak has a tiny and passive shareholding of a Russian bank. Major balance-sheet categories show (in millions of Manat), in particular, the bank's strong capital position and low risk-asset ratio (loans as a percent of total assets): Paid-in Capital 12,419 Paid-in Capital plus Retained Earnings 12,961 Total Assets 119,392 Total Loans 17,522 Total Deposits 105,253 Over 70 percent of the bank's loan portfolio consists of US dollar-denominated loans and 96 percent of its deposits are US-dollar denominated. All loans are to enterprises, primarily to finance trade. The bank's policy is to be a wholesale bank, i.e., it does not lend to individuals, although it does accept individual dollar deposits. Also, it currently does not lend in Manat. The bank appears to be highly liquid, with sizable cash balances and short-term placements with foreign banks. It is reportedly highly profitable, although given the current accounting procedures this could not be substantiated. Azak bank is the first, and so far only, private bank in Azerbaijan that has been audited by a western auditing firm (end-1994, Price Waterhouse). Azak Bank's niche is the financing of international transactions (not surprising, given its ownership). It has one branch. Its staff of 58 is relatively large given the size of its lending activities, but not necessarily unduly when viewed against the labor-intensive nature of international banking. A high percentage of its staff is young and some reportedly receive selective training in international banking, including abroad. Senior management is very thin, but apparently competent. B- 17 The bank, as is common among all Azerbaijan banks, does not have a credit policy and procedures manual. All credit decisions are made by the First Deputy Chairman, Mr. Bahram M. Mailov, after some rudimentary credit checking by young "analysts" on the moral and business reputation of the borrowers. Quantitative financial analysis is practically nonexistent -- and probably not very meaningful -- given the paucity of reliable financial information on nonbank borrowers. Mailov, undoubtedly the driving force in the bank and an impressive person of about 40, has single signing authority up to $500,000. Exposures above that amount (undoubtedly very few) need Board approval. Azak has a Supervisory Board of five members, all of whom represent enterprises; it also has a management board of 5 members. Azak Bank's business plan calls for continued focus on dollar-based international trade finance, but with a gradual widening of lending activities, including retail lending (already initiated) and medium and longer term project finance. Also, it expects to accept VISA cards in the near future -- somewhat surprising for a wholesale bank Azak bank has a solid reputation in the local banking community and is generally recognized as the leader of the industry. It appears to deserve its reputation. 2. Azerigazbank Established in 1992 by three state owned natural gas companies and two private trading companies, Azerigazbank currently has 13 shareholders of which the major ones are its Chairman of the Board, Chingiz Asadullaev, and extended family (30%); the Railway Bank (24%); Improtex, a private- sector conglomerate (18%); ILKIN, a trading company (7%), and Azerigaz, a natural gas company (the only state-owned shareholder, (5%). The bank is extremely conservatively managed, as witnessed by its high liquidity and very small loan portfolio in terms of its asset size (between May and November 1995 the bank refrained from making any loans). A major share of its income is derived from its hard-currency operations. It has a sizable client base (230), all of which are enterprises among which one is a state owned company, its shareholder Azerigaz. Loans are primarily extended to its shareholder trading companies. Major financials as of October 1, 1995 (in Manat millions) include the following: Paid-in Capital 878 Paid-in Capital plus Retained Earnings 2,148 Total Assets 13,751 Total Loans 3,412 Total Deposits 12,656 Azerigaz' assets and liabilities are largely US dollar-denominated. On the above-mentioned date, 90 percent of its loan portfolio consisted of dollar loans and 73 percent of its deposits were held in dollars. A major share of its income is consequently derived from hard-currency (primarily dollars) operations. Profits before taxes for the first half of 1995 reportedly amounted to Manat 653 million and profits after taxes approximately Manat 435 million. The dividend payout ratio of Azerigaz is roughly 40 percent. The bank has a good reputation in the banking community and its Board of Management makes a solid and prudent impression. Reportedly the bank has a secured line of credit of $100,000 from Mees & Hope (a well-known Dutch bank specializing in trade finance). Organizationally it has no branches and a staff of only 30. Worth noting is that management has installed an internal investigations unit. B-18 Azerigazbank has selected Price Waterhouse for its 1995 international standards audit. 3. Azerdemiryol Bank (Railway Bank) Azerdemiryol Bank was established in 1989 by Azerbaijan's State Railway Department and its Transportation Department. Since then the bank's ownership has changed drastically, with the state Railway Department holding a mere 3 percent of the shares and the private sector holding the remaining 97 percent. Ownership is widely distributed among 53 private enterprises and 1,141 individuals. Five enterprises (Ravan, Gorgud, Murad, Cinar, and 979) each hold about 7 to 8 percent of the shares and are the dominant shareholders. The bank is thinly capitalized in terms of paid-in capital, but has sizable retained earnings (see below). On the other hand, it reportedly has a steady and sizable liquidity position and a steady deposit base, with significant time deposits from the State Railway. For example, as of October 1, 1995, the bank had Manat 3.81 billion in 6-month corporate time deposits and Manat 3.09 billion in one-year deposits, all US dollar denominated -- a rarity in Azerbaijan in terms of maturity. As a reflection of its good standing in the financial community, the bank has reportedly attracted deposits from former individual customers of the failed savings bank. Major financial indicators as of October 1, 1995, show the following (in Manat millions): Paid-in Capital 1,655 Paid-in Capital plus Retained Earnings 8,286 Total Assets 68,866 Total Loans 23,873 Total Deposits 63,923 In contrast with conditions in most other major Azerbaijan banks, less than 50 percent (45%) of Azerdemiryol's loans were on the abovementioned date US-dollar denominated; however, 67 percent of its deposits consisted of US dollar deposits. The bank's entire loan portfolio consists of short-term loans. A breakdown shows loans to trading companies (69%), the construction industry (19.1%), pharmaceuticals (8.4%), and households (3.7%). Management has mentioned as one of its objectives an increase in lending to the household and micro-enterprise (retail) sectors. In this connection, and with its sizable customer and deposit base, it has started negotiations with a French firm to issue a smart (debit) card. Also reflecting its strong liquidity position, the bank is a steady placer of funds with six other Azeri banks. Senior management in the persons of Mr. Chingiz R. Asadullaev, Chairman of the Board of Management, and Mr. Vagif D. Davoudov, Deputy Chairman, appears above average in terms of managerial quality and banking experience. It expressed, among others, its concern about loan quality and the need for greater loan-loss reserves for its own bank as well as for the banking sector in general. Also, its policy of portfolio diversification and building a strong deposit base reflect management's adherence to sound banking principles. 4. Gun Ay Bank Established in 1992 by Makhmud Mamedov, the bank's current Chairman and reportedly a major shareholder, Gun Ay is part of the MNM group, a holding company which owns, in addition to the bank, an insurance company (Gun ay Anadolu Sigoria), a number of local enterprises in the newspaper, television, construction, building materials, and paint industries, as well as several trading companies. B- 19 The insurance company is majority owned by Anadolu Anonim Turk Sigoria Sirketi, an insurance subsidiary of the Turkish bank Turkiye is Bankasi. Mamedov is also the founder and current leader of the Azerbaijan Democratic Owners' Party, one of the country's political parties. Gun Ay was, as of October 1, 1995, the second largest Azerbaijan bank in terms of paid-in capital and third largest in terms of shareholders' equity (paid-in capital plus retained earnings). By year- end 1995, paid-in capital was expected to have almost tripled to about Manat 9 billion as a result of a planned Manat 5 billion stock issue open to the public (existing shareholders would receive limited preference). Even at existing figures, however, the bank is very strongly capitalized and reportedly highly liquid, as reflected in the following major financial data (as of October 1, 1995, in millions of Manat): Paid-in Capital 3,322 Paid-in Capital plus Retained Earinigs 4,526 Total Assets 7,738 Total Loans 6,622 Total Deposits 3,617 The bank's loan portfolio consists primarily of loans to shareholders and related companies. Loans to enterprises carry a maximum maturity of 2 years and to trading firms of 6 months. The bank currently does not take Manat deposits or participates in the interbank market, and operates almost exclusively on a dollar basis (97 percent of loans and 90 percent of deposits were US dollar denominated). Gun Ay appears highly profitable: profits before tax for the first 9 months of 1995 reportedly amounted to Manat 1.2 billion. This translates into a an ROA of about 16 per cent and an ROE of about 32 per cent. Sixty-five per cent of its profits are generated by foreign-exchange activities. The bank actively solicited US dollar time deposits in late 1995: on October 12 it advertised in the local newspapers that it would pay 20 percent (per annum) on 6-month dollar deposits and 25 percent on one-year deposits, with interest paid at maturity. These appeared to be high rates when compared with those offered by other banks. Lending rates quoted informally by management were 10 to 15 percent per annum for loans to industry (in all probability to connected or related clients) and 25 to 35 percent for loans to trading firms, with interest payable quarterly. The bank appears to be a true pocket bank, with its lending and related activities focused almost entirely on the financial needs of the MNM-connected enterprises. It is not a member of the Bankers Club and reportedly does not participate in the interbank market. Structurally it has a Baku head-office with a staff of only 26, plus three branches in three other cities with an additional 24 employees. It has a Supervisory Board of nine members and a Board of Management of five persons. The quality of management was difficult to ascertain. Interviews were held with Mr. Gojaev Alovset, General Manager; Mr. Huseyinov Malik, Foreign Relations Manager, and Mr. M. Sukru Torun, "Foreign Relations Coordinator" and a de facto representative of Turkiye is Bankasi who spends part of his time with Gun Ay. 5. Arko Bank Established in November 1992 by nine private trading companies, Arko Bank is currently wholly owned by REAL Holding owns about 20 trading companies. Ownership and senior management of the various entities are intertwined. The major force withini the holdinig as well as the bank is Nazim B-20 Gusseinov, Chairman of REAL HOLDING as well as President of Arko Bank, and reportedly majority shareholder of both (directly and indirectly through his ownership of connected enterprises). A second major player is Kamran F. Mustafayev, Chairman of Arko Bank. Officially 30 percent of the bank's ownership is in the hands of individuals and 70 percent is held by trading companies, but effectively the group, including the bank, are very closely held. As of October 1, 1995, Arko Bank ranked fourth among private-sector banks in terms of paid-in capital and fifth in terms of shareholders' equity (paid-in capital and retained earnings). Major financials for that date include, in Manat millions: Paid-in Capital 1,739 Paid-in Capital and Retained Earnings 2,582 Total Assets 20,236 Total Loans 9,963 Total Deposits 18,030 Profits before taxes for the first nine months of 1995 reportedly totaled Manat 397 million. Most recent profit distribution (early 1995) amounted to only ten percent of profits after tax instead of the normal payout ratio of 40-50 percent. This sharp reduction was based on the need to finance the bank's new head-office building. The bank's total number of clients was 258, consisting of both enterprises and individuals, and virtually all shareholder-connected. There are reportedly no bad credits. The bank does not operate any branches and its total staff numbers only 21. In terms of total assets per employee and total loans per employee -- both efficiency ratios -- Arko ranked third and second respectively among the country's twenty largest banks. Major plans for the near future include the following: * Have end-1994 and end-1995 results audited by Price Waterhouse (reportedly already arranged). * Initiate issuing debit cards. a Initiate issuing Manat certificates of deposit to individuals in denominations of Manat 100,000 to I million with maturities up to 3 years (no financial decision made as yet and interest-rate structure not yet decided upon). * Initiate investments in land, buildings, and hotels in order to take advantage of the expected economic boom and influx of foreigners. Despite its size and apparent role in the Azerbaijan economy, Arko Bank seems to shun an active role in the local banking community. It is not a member of the Bankers Club and other banks did not appear to be very familiar with its activities. Yet management -- Gusseinov, Mustafayev, and Suleyman Ibrahimov, Vice President of REAL HOLDING -- made positive impressions during two separate interviews. 6. Azal Bank Azal Bank was established in January 1994 by several state enterprises of which Azerbaijan Airlines is the major SOE. Current shareholdership consists for 41.7 percent by Azerbaijan Airlines and for the remainder -- in roughly equal shares -- by six private enterprises in both trade and manufacturing. B-21 Azal Bank is still viewed as the "airline bank" and seemingly correctly so. Its management does not appear to be greatly interested in the standard business of attracting deposits and making loans, but concentrates its efforts primarily on collecting and placing of funds generated by the sale of airline tickets. Consequently, as of October 1, 1995 its loan volume amounted to only 0.6 percent of its total assets, with the lion's share consisting of interbank placements with maximum maturities of 3 months. Azal is Azerbaijan's third-largest private-sector bank in terms of paid-in capital and fourth largest in terms of shareholders' equity (paid-in capital plus retained earnings). Its major balance-sheet categories, as of October 1, 1995 and in millions of Manat, show the following: Paid-in Capital 2,685 Paid-in Capital plus Retained Earnings 3,387 Total Assets 10,436 Total Loans 57 Total Deposits 7,451 Virtually all of the bank's business is transacted in US dollars, as reflected in the dollar denominated character of its loans and deposits. Azal appears to work on relatively small spreads (by Azerbaijan's standards) of about 2 to 3 percent between rates paid and received, reflective of its role as a placer in the dollar interbank market. Obviously its risk taking is limited when compared to the lending activities of the other commercial banks. Yet, given the narrow breadth of its activities and having only one branch, its staff of 50 appears large, and may indicate a lack of operating efficiency . Azal appears to be quite profitable, with reported earnings for the first nine months of 1995 of Manat 702 million. Its dividend pay-out ratio (not divulged) appears to be high, given that its retained earnings equaled its 1995 pre-tax undistributed earnings (included in retained earnings). Although the bank's financial strength in terms of its capitalization and profitability is considerable, its performance as a representative commercial bank must be considered mediocre when viewed against its sizable and apparently fairly stable deposit base and its virtually nonexistent loan portfolio. Also, potential improvement in its efficiency levels appears considerable, given its surprisingly high staff total. 7. Bako Bank Established in 1988 by state enterprises in the building industry and by agricultural cooperatives with an original paid-in capital of 500,000 Rubles, Bako Bank is reportedly the oldest private-sector bank in Azerbaijan, having been privatized in 1992 and now wholly owned by its employees (70). Although it ranks sixteenth in size in terms of paid-in capital (as of October 1, 1995), it is nonetheless one of the smaller banks in terms of other major balance sheet categories, as shown below (in millions of Manat): Paid-in Capital 527 Paid-in Capital plus Retained Earnings 629 Total Assets 4,129 Total Loans 2,159 Total Deposits 3,386 For the first 9 months of 1995 Bako Bank realized a modest profit before tax of Manat 95 million, considerably less than in the two previous years and reportedly a reflection of the sharply B-22 deteriorated economic conditions in Azerbaijan and a representative deterioration in the quality of its loan portfolio. Its capital grew marginally over this period, but its capital ratios worsened significantly. Bako Bank's loan portfolio consists of 90 percent in US dollar loans and its deposits consist of 76 percent in US dollars. It lends almost entirely to private trading firms and retail establishments, with some credits extended to manufacturing cooperatives (a remnant of its past). Currently the bank refrains from making loans because of the high interest rate levels. For the same reason it does not, at present, take Manat deposits. Its 0.52 loan-to-deposit ratio is nevertheless relatively high for current Azerbaijan standards, an other reason for management to follow a conservative lending policy which is also reflected in the sizable (1.3 billion Manat) deposits held with other -- both foreign and domestic -- banks. The current ownership makes it difficult for Bako Bank to increase its capitalization substantially, and it will probably be forced to attract new shareholders or to consider a merger -- a situation management is fully aware of. It is also one of the reasons why it is concentrating on generating non-lending revenues. For this purpose it has established an "Innovation Center", with its own in-house specialists, for the development and marketing of industrial and commercial projects to potential foreign investors. The strength of Bako Bank lies in its management and in particular in its President, Alim Azimov. An experienced (by Azeri standards) banker: thoughtful, aware of his bank's strengths and weaknesses as well as of its future direction, he is universally respected by his Baku banking peers. He also founded in the second half of 1995 the Azerbaijan Bankers Club, the youngest of two Azeri bankers associations with, as of 11/1/95, a membership of sixteen of the more important private-sector banks. 8. MBank Mbank was established in 1992 by major state and private enterprises. Present ownership is in the hands of 23 enterprises accounting for 42 percent of all outstanding shares (1 percent held by a state enterprise) and by individuals holding the remaining 58 percent. The bank, although one of the smaller ones in terms of its paid-in capital, appears to be one of the better managed when viewed against its results, range of activities, and objectives (see below). As for its balance-sheet structure, major categories show the following condition as of October 1, 1995 (in Manat millions): Paid-in Capital 259 Paid-in Capital plus Retained Earnings 893 Total Assets 14,355 Total Loans 1,338 Total Deposits 13,737 MBank's minimal loan portfolio on the abovementioned date stands in sharp contrast with the bank's extreme liquidity position: Manat 6.3 billion, or 43.8 percent, of its total assets were held in balances with the National Bank of Azerbaijan, and an additional Manat 5.6 billion, or 38.8 percent, were in the form of due-from correspondent accounts. As for the loan portfolio, 42 percent was hard-currency (US dollar) denominated. Approximately 6 percent of the loans were extended to state enterprises and 65 percent to private-sector trading firms engaged in the import and export of foodstuffs and technical items. The bank's loan-to-asset ratio of 9.4 percent on the date in question ranks among the lowest of all major banks having been actively operating longer than two years. Management is indeed highly risk averse in its lending policies: loan applications are reportedly considered only from enterprises which have been clients for at least one year, and the average maturity of the loan portfolio is slightly less than B-23 3 months (maximum maturity: 6 months). According to management, it had no "bad" loans. Loan approvals are generally made by a standing credit committee consisting of senior members of the Board of Management. As for the deposit total, 60 percent was denominated in hard currencies (US dollars). The bank at the time did not accept Manat time deposits. As for its earnings performance, profit before taxes for the first nine months of 1995 amounted to Manat 634 million, equal to its stated retained earnings (i.e., no earnings from previous years had apparently been retained). Major components included net income from foreign-currency transactions (Manat 390 million), net interest income (Manat 376.8 million), and net commission income (Manat 136.7 million). The single major non-interest expense category was administrative expenses of Manat 113.2 million. Additions to various "funds", including social security, insurance, "development", and "reserve" funds were included in "other expenses" of Manat 159.5 million. Specific loan-loss provisioning was not apparent. The bank's current staff at its Baku head office numbers 38. In 1993 MBank established its only branch, in Ganja, the country's third-largest city and major industrial center. Sixty percent of its clients are local enterprises. Current branch staff is nine. MBank's senior management, consisting of Mr. Natig E. Aga-zade, Chairman and Mr. Fuad A. Nadgafov, Vice Chairman, make a good impression. As many of their peers in the other Azerbaijan banks, they currently maintain a prudent and highly conservative lending posture. Also, they appear to have their (nonquantitative) business plan fairly well established. Major features include: * international standards audit of its 1995 results by Ernst & Young; continue to focus on developing its international business. MBank has already a "universal" license allowing it to undertake the full range of international banking services and an extensive (possibly too extensive) list of foreign correspondents; concentrate on developing client relationships with firms in the technology sector; * develop its in-house computer/MIS capabilities. B-24 ANNEX C PROVISIONS FOR BAD AND DOUBTFUL ASSETS: PRACTICES IN A SAMPLE OF OECD COUNTRIES Australia 1. Australian companies' legislation requires the director of a company to ensure, each year, that reasonable steps have been taken to write off all known bad debts and that adequate provision has been made for doubtful debts. It also requires disclosure in financial statements of the: (a) amount of bad debts written off in profit loss account; (b) the amount of bad debts written off against a provision and name of provision; and (c) the amounts set aside as provision for doubtful debts in respect of each class of debtors. Australian banks maintain both specific and general provisions for bad and doubtful debts. Specific provisions are maintained to cover identified doubtful accounts; general provisions are maintained to cover nonidentified losses and latent risks which are inherent in any lending portfolio. All known bad debts are written off against the provisions in the year in which they are identified and are tax deductible. The provisions are funded by a charge on the bad debts experience of the current year and the four preceding years, the current volume of lending and take into account growth factors. Australian banks' financial statements disclose balances of provisions for bad and doubtful debts and movements therein. There Reserve Bank of Australia does not regard provisions as part of a bank's capital base for the purpose of assessing capital adequacy. No special treatment is applied to provisions for international loans or transfer risk. Austria 2. According to the amendment to the Banking Act, banks have to limit appropriately the special risks of large-scale credits. The banks are free to provide an abstract risk cover by forming a reserve fund. Another risk cover, which is compulsory, is the new "Haftrucklage" (liable reserves), replacing the former "Sammelwertberichtigungen" (collective value adjustment; between 0.5 and 2 percent for different kinds of assets). The main difference is that banks will have the possibility tow rite back the "Haftrucklage" as compensation for a loss incurred, but have to build up the "Haftrucklage" again within the next five years. Obvious risks have to be covered by reserves or by special diminutions in value. Disclosed reserves are by definition those parts of the retained profit which may be used in form of legal or free reserves to cover losses. Individual provisions for diminutions in value represent corrections on the assets side of the balance sheet, especially in case of banks which are granting credits. As criteria for either legal or free provisions the assessment of the borrower's solvency and other concomitant circumstances (such as the offered collateral) are to be considered. fiscal classification of such provisions has to be classified according to the principles of assessment of Article 6 of the Income Tax Law according in 1972. Whether the provisions according to commercial law (which as to be carried out on the basis of the principles of orderly bookkeeping) corresponds with the fiscal provisions has to be examined case by case. There are no particular rules or procedures applying to provisions against international loans or transfer risk. Belgium 3. The general accountilg criteria applying to write-offs and loan provisions are that they should be made on the basis of the principles of prudence and truth, that they should be constituted in a systematic manner and that all foreseeable risks should be taken into account. In application to these principles, banks are required to write down claims for which a certain or likely loss is to be expected and to C-l constitute provisions (specific or general) to take account for foreseeable risks of depreciation. To the extent that value adjustments are necessary for which no special provision had been constituted, they will have to be entirely covered by own funds. From the fiscal point of view, banks are not subject to any particular treatment. In addition to actual losses, provisions for likely and specified future losses are tax deductible provided that: (a) the likelihood of losses results from specific circumstances that have developed during the fiscal period under consideration; (b) the amount of provisions is shown in a special account; and (c) the amount of tax deductible provisions is limited, at the choice of the bank to either five percent of taxable income for the year and to the extent that total outstanding provisions do not exceed 7.5 percent of the highest profit recorded in the preceding five years, or to 0.3 percent of the value of the relevant claims. 4. In 1984, the Banking Commission called upon the banks and private savings institutions to observe the following principles in respect of balance sheet precautions to be taken against country risk: (a) Apart from specific provisions to meet identified risks of virtually certain nonrecovery, the banks are asked to adopt a provisioning policy in respect of country risks. Without prejudice to other forms of provisioning, the earmarked general approach is recommended for this purpose. The policy must be formulated on the basis of a list of identified countries in respect of which the bank considers it is exposed to country risk and an evaluation of the degree of risk involved. Provisioning may not depend on the annual profits and must be entered (b) Interest which has not been paid within three months of falling due may not be taken into earnings except in special circumstances. (c) The allocation to earnings of commissions obtained when a loan is rescheduled must be spread over the life of the loan in question. Canada 5. There is currently no specific legislation in Canada which directly or indirectly affects Canadian chartered banks' provisioning for bad and doubtful assets. Under the authority of the Bank Act, the Inspector General of Banks (the IGB) issues accounting rules and instructions which govern uniform and unique accounting requirements for banks. In the absence of specific IGB rules or instructions, banks are expected to follow generally accepted accounting practices and procedures as prescribed by the professional association. Generally accepted accounting principles require loans to be valued at their net realizable values. Thus provisions are established to reflect this value. The IGB does actively review the banks' level of provisions in relation to the portfolio of the bank and other Canadian banks and the methods of assessing, measuring and controlling provisions to ensure that each bank had adequate systems in place to promptly and effectively recognize and control potential problems. In addition, if there were situations where a bank was perceived to have views significantly different from those of other banks, the IGB would express concern directly to senior bank management during the annual inspection of informal meeting. The banks have been advised to be conservative as regards specific situations and shareholders' auditors have been encouraged to review these situations and to ensure that the financial statements properly reflect the position of the bank. 6. A bank's provisions for bad and doubtful loans in the income statement are determined by computing an average loan loss experience ratio over the most recent five years and applying that ratio to year-end eligible loans outstanding. In general, the tax treatment of provisions does not affect the bank's decision to recognize bad and doubtful debts. However, Canadian banks are permitted to establish a balance in appropriations for contingencies up to a prescribed limit based on eligible assets. Loan losses C-2 in the forn of net write-offs and increases in specific provisions are charged to the appropriations for contingencies, whereas the previously described loan loss provision is credited to the account. Where such entries cause the appropriations account to recede below the prescribed limit, a bank is permitted to make a tax deductible transfer from retained earnings providing such annual transfer falls within prescribed size constraints. 7. With regard to sovereign risks, mandatory provisions are required to be established against 32 designated countries. These provisions are included in the loan loss experience of the bank and are to reach 10 to 15 percent of the total exposure to these countries by October 1986. The level of provisions within the prescribed range is to reflect the degree of concentration of exposure to individual countries. The allocation of provisions against each country or group of countries is left to the discretion of the banks based on their assessment of anticipated losses. The general provisions are charged to the income statement and are tax deductible in the same manner as specific provisions. 8. When keeping the accounts, the common principle of indication of value in the Danish bank and savings banks' legislation is that assets are to be estimated at their commercial value. In this way, it is prescribed that deprecations and provisions shall be made in consistence with proper accounting practice and valuation rules, which implies that assets should be shown at their actual value. Thus in order to avoid risks of loss in loan and guarantee engagements, provisions shall be made whenever there is a foreseeable loss. Provisions shall be made after having separately appraised the risk inherent in each engagement. Thus, provisions for bad debts shall be made for such claims as the responsible management of the bank or savings bank deems necessary. In the event of an actual loss, the asset shall be depreciated and the depreciation is to be booked as expenditure in the profit and loss account. In case the bank or savings bank wants to make a provision for a foreseeable loss, the provision is to be deducted from the asset item to which the provision belongs. In this way, the asset is shown at its actual value. The provisions shall be booked as expenditure in the profit and loss account. The Danish Supervision of Commercial Banks and Savings Banks requests performed provisions to be individualized. As regards loans and guarantees, general provisions are not permitted in the official accounts. Provisions do not form part of the bank's or savings bank's own funds. From the point of view of fiscal treatment, tax-free general provisions can only be made as long as the sum of the provisions of the current year and the preceding years is kept, after deduction of actual losses, below a maximum of 3 percent of outstanding loans and guarantees. Individual tax-free provisions can be made without any limit to the extent to which a loss is foreseeable. If individual provisions do not exceed 3 percent of the total amount of outstanding loans and guarantees, a fiscal supervision is not necessary. Individual and general provisions cannot be made simultaneously. Finland 9. Banks provisions for bad and doubtful debts are regulated by the Accounting Act and the Act on Companies' Taxation. According to the Accounting Act, a company may provide against bad and doubtful debts by a corresponding provision. The Act on Companies' Taxation regulates these provisions in a most specific way. Firstly, loan loss provisions are deductible in taxation provided that the corresponding amount has been made in the company's accounts. Secondly, the Act sets limits on the maximum amount of loan loss provisions. Banks are allowed to deduct annually as loan loss provisions a maximum amount of 0.6 percent of the total stock of debts provided that the total amount of loan loss provisions at the end of the accounting year does not exceed 6 percent of the total debts. No special provision for bad debts can be made. For supervisory purposes, banks have to inform the Bank Inspectorate of the amount of bad debts on their books and the foreseeable loan losses. The Inspectorate takes a positive stand and write-off bad debts. C-3 10. In accounting terms, there exist two different types of provisions: those set against the volume of assets and those used as an item on the liabilities side of the balance sheet. Provisions to write down the volume of assets are assimilated to changes for accounting purposes and include provisions for the depreciation of the value of securities held in the portfolio as well as provisions for claims which are expected to result in actual losses. On the liabilities side, provisions can be set up against the risk of latent losses as well as in the form of special provisions connected with specified operations such as medium- and long-term risks connected with the financing of international trade. These latter provisions are subject to a ceiling in terms of outstanding claims. With regard to provisions for doubtful assets, the tax administration applies strict rules for their deductibility. Thus, provisions must be "earmarked" in the sense that they must be clearly identified and the likelihood of a loss must be significant, which implies in practice that a legal procedure must have started against the debtor. Tax rules are applied in a more flexible manner with regard to claims on nonresidents, for which provisions are more easily accepted as tax-free charges against earnings. Germany 11. Three types of valuation allowances are available to banks in the Federal Republic of Germany to make contingency provisions for current asset items: individual valuation allowances (Einzelwertberichtigungen); overall valuation allowances (Sammelwertberichtigungen), and taxed overall valuation allowances ("undisclosed reserves"). Individual and overall valuation allowances are obligatory, while the formulation of "undisclosed reserves" is voluntary. However, provisions for liabilities and charges ("Riickstellungen") may as a rule be formed only to cover indeterminate commitments to third parties or impending losses from transactions in the course of settlement. Neither overall valuation allowances or undisclosed reserves nor provisions for liabilities and charges are taken into account when capital is being assessed for banking supervisory purposes. 12. Individual Valuation Allowances. In the Federal Republic of Germany, the value at which assets are entered in accounts may not exceed the cost of their acquisition or production. Current assets must be entered in accounts at their stock exchange or market price or-where such a price cannot be determined-at the relevant value on the balance sheet date, where such values do not exceed the cost of acquisition or production; in other words, current asset items may be shown only at their actual value (however, an asset that was entered at a lower value in preceding accounting periods may continue to be entered at this lower valuation even where the reasons for the valuation allowance no longer apply; this will lead to the formation of an undisclosed reserve). Individual valuation allowances serve to take account of factual depreciation in value arising from ;losses that have occurred or are likely to do so. This depreciation in value is written off in each case from the item in questions (which, however, does not exclude that since 1985 "earmarked" individual valuation allowances for individual country risks are added again in published aggregate statistical series in order to better identify the true flow movements). The valuation of each item must be reviewed at every balance sheet date. Banks and their auditors undertake the valuation of assets on their own responsibility. In doing so, they are obliged to observe the valuations stipulated under commercial law. The banking supervisory authorities prescribe neither individual valuation allowances for specific assets nor valuation allowance rates. Individual valuation allowances are admitted as correct for tax purposes where their formation is obligatory under commercial law. The above applies in principle also to the valuation of foreign claims, which besides the usual creditworthiness risk are also subject to special country risks. These country risks, in particular the transfer risks, can also lead to losses on foreign claims ad thus constitute grounds for the formation of valuation allowances. The authorities provide no pointers, such as official assessments of the countries concerned to help them in this task. Valuation allowances on foreign claims that are necessary in view of the exceptional country risks are also admitted as correct for tax purposes. C-4 13. Overall Valuation Allowances. These are general valuation allowances for which the Federal Building Supervisory Office has laid down mandatory minimum rates. They relate to specifically designated types of claims and are intended to cover the latent losses contained in total claims at the time of drawing up the balance sheet. (In the case of identifiable losses, an individual valuation allowance must be entered.) These are genuine and necessary adjustments to value that are intended to make provision for the risk of losses that cannot be catered for by individual valuation allowances. They are, however, lacking in so far as they have not up to now taken account of the specific country risks involved in foreign lending. As overall valuation allowances are a correction in value to meet the latent credit risk that is always present in a bank's total claims, they can as a rule be written back only insofar as the bank reduces the volume of the items in question. The total of overall valuation allowances must either be deducted from the appropriate asset or be shown separately on the liabilities side of the balance sheet. Overall valuation allowances conforming to the minimum rates laid down by the banking supervisory authorities will be admitted as correct for tax purposes. 14. Undisclosed Reserves (Taxed Overall Valuation Allowances). According to section, 26a, para. (1) of the Banking Act (KWG), banks may show claims and securities counted as part of their current assets at a value lower than that prescribed or permitted by the relevant commercial regulations. insofar as this is necessary according to reasonable commercial judgment as a safeguard against the particular risks of the banks' field of business. Auditors must notify the banking supervisory authorities in their reports on the annual accounts of banks of the type, volume, writing back and formation of undisclosed reserves. Taxed overall valuation allowances must be deducted from the appropriate asset item. Newly formed undisclosed reserves of this type cannot be deducted from taxable profits. Under banking supervisory regulations, banks must maintain a minimum ratio between their published capital and their lending volume; this precludes the unrestricted formation of undisclosed reserves up to arbitrary levels. Consequently, a bank wishing to expand the volume of its lending will have to make sizable allocations from its profits to its disclosed reserves (which are counted as part of its liable capital). Greece 15. Provisions relating to expected specific obligations falling due within the next fiscal year are treated on a case-by-case basis for tax'purposes. Furthermore, the law allow up to I percent of a bank's monthly average of total outstanding loans to be set aside each year as tax-free provisions for doubtful debts. Provisions are not included in the definition of capital. Ireland 16. Company Law is governed by the Companies Act 1963, and banks are obliged to comply with this Act in the presentation of their annual accounts. This legislation includes, inter alia, the requirement that company accounts present a "true and fair view." The meaning and interpretation of the "true and fair view" is continually evolving and includes compliance with accounting standards and generally accepted practices as well as the development of the appropriate accounting treatment to fit each particular circumstance. In accordance with accounting practice, the term "provision" means an amount written off or retained to provide for depreciation or diminution in value of assets, or retained to provide for a known liability, the amount of which cannot be ascertained with substantial accuracy, while a "reserve" represents undistributed profits or surplus assets. Provisions made against anticipated losses and contingencies are charges against profits, since the true profits can only be ascertained after such provisions are made, whereas reserves are appropriations of profit, the assets by which they are represented being retained to form part of the capital employed in the business. Provisions are usually C-5 shown in the balance sheet by way of deductions from the assets in respect of which they are made, whereas general reserves and reserve funds are shown as part of the proprietors' interest. Provisions therefore do not form part of a bank's capital. The calculation of provisions for bad and doubtful debts can vary from one institution to another. Such calculations would include both specific and general provisions, the latter being, in most cases, based on a percentage of the total outstanding advances. The overriding consideration is that the accounts should at all times be seen to give a "true and fair view." No special rules are applied by the Central Bank in relation to the overall valuation of their loan portfolios by banks. However, the Bank may from time to time require individual banks to maintain higher levels of provisions where it considers it appropriate following inspections by the Bank's examiners. No special treatment is applied to international loans. Finally, specific provisions backed by satisfactory evidence are accepted by the Revenue Commissioners as a charge against profits for tax purposes. General provisions are not generally accepted, however, and are written bank in determining taxable profits. Italy 17. With regard to the preparation of annual accounts the Civil Code does not lay down rigid "quantitative" rules, but only establishes the general principles of "clarity" and "accuracy" that directors must conform to when assessing the various items of the balance sheet and profit-and-loss account. As for credits, the Civil Code only establishes the principle that they should be assessed "according to their presumed realizable value/" In connection with the showing of the devaluation of asset items, the Civil Code only lays down the principle that such devaluation can be shown by separate entries on the liabilities side for each asset item, but does not indicate the manner in which these entries are created or used. From a civil law point of view, these regulations can be interpreted al allowing Italian companies to set up "credit risk reserves." Fiscal legislation, on the other hand, lays down precise quantitative parameters for the setting up and use of "reserves entered" on the liabilities side of the accounts in connection with the calculation with the calculation and taxation of company income. Tax deductibility applies to increases in reserves equal to 0.5 percent of the audits shown in the accounts when such reserves are less than 2 percent of the credits. Deductibility is reduced to 0.2 percent when the reserve exceeds 2 percent of the audits. When reserves are equal to or greater than 5 percent, further additions are fully liable to tax. Japan 18. The provision for bad debts is a general provision and is established in accordance with current accounting practice and tax law. The amount which is credited to the provision and satisfies the conditions in a tax law is tax deductible. No specific provision is allowed to be charged against taxes. But "the special provision for claims depreciated" is applicable in a manner similar to provisions for specific bad debts. For banking administrative purposes, the provision for bad debts is deemed to be a reserve subject to related laws and cabinet orders, thereby forming part of the bank's own funds. An "allowance for specific overseas claims" was introduced in 1983. The allowance is set against some 30 countries which have been rescheduled within the last five years, or have requested a rescheduling but have not reached agreement, or where payments of principal or interest are one month overdue. Per country allocations are up to the discretion of each bank, but the total reserve must be at least one, and not more than five, percent of them aggregate exposure to countries. Provisions must be made after tax, except that 1 percent of new loans advanced or rescheduling agreed to after April 1, 1984 is deductible, and that limited transfers of previously deductible provisions may be made from the general reserve for loan losses. The reserves are considered to be part of capital in a broad sense (e.g., for the application of lending limits, etc.) and are published. C-6 Luxembourg 19. There are two basic types of provisions: provisions against general risks relating to the business of banking (e.g., provisions set at an agreed rate-provisions forfeitures-against the risk nonreimbursement of claims) and provisions against depreciation and specific risks (e.g., doubtful claims, depreciation in the value of securities held in the portfolio). The aggregate amount of all provisions is shown on the liability side of the balance sheet and no offset on assets is permitted unless a special authorization is granted by the supervisory authority. General provisions are included in the computation of solvency ratios relating own fund to total payables. Specific provisions are allowable against tax while general provisions are not, with the exception of the "provision forfeiture" which is tax deductible within specific limits. 20. The Luxembourg Monetary Institute (LMI) considers that the responsibility for determining the level of provisions for doubtful loans rests with the credit institution concerned. However, the IML requires that provisions be established when a debtor is bankrupt or under supervised management and when a loan is not performing with regard to interest or amortization of principal. These general principles apply also to provisions against country risk, but the IML requires that a credit institution which envisages to distribute dividends should constitute provisions against its overall county risks up to an amount to the interest annually paid on the relevant outstanding claims. On the amount equivalent to the interest annually paid on the relevant outstanding claims. On the other hand, the IML regards as inappropriate the establishment of general provisions against doubtful sovereign debt which, in case of need, should be provided against/through specific provisions. Potential conflicts between tax authorities and credit institutions with regard to the treatment of provisions against country risk have been avoided through understandings reached by the parties involved. Netherlands 21. A distinction is to be made between provisions in the published annual accounts and in the confidential prudential returns. Although both are the primary responsibility of the banks themselves and its external against, De Nederlandsche Bank in its supervisory capacity checks-sometimes after consultation with the external auditor-whether adequate specific provisions for bad debts (both domestic and external) in the prudential returns are made. Regarding the published annual accounts, no detailed rules exist in the Netherlands with respect to specific provisions for bad loans. However, banks are explicitly allowed, pursuant to section 11 of the Act on the Supervision of the Credit system, to carry in their books a provision for general risks. In the balance sheet, this provision for general business risks may be combined with a group of liabilities in one item. In order to ensure that the provision for general business risks is used in accordance with its aim and as uniform a manner as possible, the Bank has included some instructions with regard to this provision in this model for the annual accounts. Thus, losses in respect of debtors and losses which are not foreseeable and, hence, not quantifiable in advance (e.g., losses on account of fraud and nationalization) may be charged to this provision. Additionally, transfers to the provision must be made systematically, and the credit institution must ensure that the minimum amount of the provision is in fair proportion to the risks to be covered. Under no circumstances may the provision be used to smooth out fluctuations in profit. The provision for general business risks is, for supervisory purposes, included in a bank's capital (own funds). The tax treatment of specific or general provisions in the Netherlands is based upon the principle that the valuation of assets ought to reflect the actual value of assets. Regional tax authorities are free, taking this principle into account, to decide whether and to what extent specific and general provisions are eligible for tax reduction. C-7 22. As far as transfer risk is concerned, a mandatory reserve has been established covering specified countries. Reserves are levied primarily on the basis of payment performance and are reviewed semi- annually. The reserves range from 5 to 100 percent, are country-specific and not part of capital. They are equivalent to write-offs, made against the general hidden reserves, and tax deductibility is permitted as such charges (as opposed to provisions of income) are made. New Zealand 23. There are no rules on provisioning. It is a matter for individual institutions to decide. Many institutions maintain both general and specific provisions although the practice is by no means universal. Provisions are not a deductible expense for taxation purposes. Only amount actually written off are allowed. Norway 24. In Norway, the tax authorities permit the individual bank to set aside, tax free, up to 5 percent of its overall loan volume to cover future losses on bad debts. In any single year, tax-free provisions for this purpose may amount to I percent of the bank's loan volume as at December 31 of the year in question. However, an amount equal to the aggregate actual losses in the year in their entirety may be set aside, even if this amount should exceed I percent of the loan volume. In the light of the wide scope for tax free, general provisions for bad debts, Norwegian banks do not usually make special provisions in connection with loss-making enterprises. Actual losses are written off against the general provisions. The banks therefore have an incentive to write off ample sums in order to make room for increased tax- free provisions. In cases where total provisions appear inadequate, the supervisory authorities may demand that further sums be set aside. So far this has not been necessary. In the banks' published accounts, provisions for future gad debts are written off against total advances. Both gross and net figures are shown in the balance sheet; moreover, banks must state in a note to the balance sheet the additions to and subtractions (actual losses) from the general provisions during the year. Holdings of bearer bonds must not be entered at a value higher than their actual value. Nevertheless, a bank is not obligated to write down the value of a bond below the redemption value if the bond is unquestionably good, and if interest and installments are paid in accordance with the loan conditions. Holdings of shares as current assets must not be entered at a value higher than their actual value, or higher than their purchase price. Banks are also permitted to set aside funds, tax-free, to an adjustment account for bonds and shares which are current assets and in this way can also build up reserves with which to meet a decline in the value of such current assets. Portugal 25. The Chart of Accounts of the Banking System which is in force since 1979-up to that year no chart existed, the several rules issued on the matter being scattered in different ordinances-provides for the setting up o provisions to be made by credit institutions for bad and doubtful debts, deprecations in financial participation, and sundry risks. Provisions made by credit institutions are considered as "costs of the fiscal year"- and, therefore, they are not taxable-up to an annual limit of 20 percent of interest from credit granted, plus 40 percent of commissions collected on accounts of guarantees and acceptances given. For tax purposes, the total balance of "provisions for other risks" shall not exceed 75 percent of the amount of bad and doubtful debts (recognized as such and entered on the books under "doubtful debtors") plus 5 percent of all other items of credit granted (including acceptances and guarantees) appearing in the balance sheet at year-end closing. The nontaxable "provision for overall credit risks" is intended to meet credit risks, including credits appearing in Memorandum Accounts; nevertheless, it C-8 does not cover "provisions for bad and doubtful debts. " According to the Charter of Accounts, the accounts relating to "provisions for sundry risks" may be included in the account group of the so-called "own funds." However, for supervisory purposes, own funds do not include provisions, but only capital, reserves and undistributed profits. Spain 26. Until 1978, no specific Bank regulation existed in relation with the write-off and provisions for bad and doubtful loans and shares. There only existed fiscal rules that determined the treatment given to this matter. In general, there were few provisions in the bank's balance sheets. In 1978, the Bank of Spain published a norm on compulsory provisions and write-offs, of loans that was later tightened in 1982. The rule established that: (a) All loans whose titulars have been declared in bankruptcy, or are clearly insolvent, and all unpaid loans that have been more than three years in that situation, are to be considered as very doubtful and should be written off from the balance sheet. (b) All loans, even before maturity, that could be appreciated of reduced probability reimbursement are to be considered as doubtful and should be provisioned at least 25 percent or according to paragraph (c). Loans reclaimed or subject to legation are included. (c) All loans that continue unpaid 90 days after maturity are to be considered in default and should be provisioned at least according to the following table, and depending on the amount of time they have been in this situation: More than 3 months and up to 9 months - 25 percent More than 9 months and up to 15 months - 50 percent More than 15 months and up to 18 months - 75 percent More than 18 months and until it is - 100 percent (d) written off according to paragraph (a) Guarantees and similar commitments that the bank will have probably to honor but whose repayment is doubtful must be provisioned up to 100 percent. (e) After including a loan in the situations of paragraphs (a), (b), or (c), it is forbidden to incorporate the interest earned and not received in the profit-and-loss account. (f) The provisions in the balance sheet, according to paragraph (c), should never be less than 1.5 percent of all loans and guarantees, excluding loans to the public sector and those with certain collateral. The banks that can justify lesser percentage by means of an auditing report are exempted from this rule. (e) The value of the shares cannot be greater than their quotation in the stock market and in other case, it cannot be greater than the value inferred from the balance sheet. 27. With some minor exceptions, the criteria set forth by the Bank of Spain are accepted from the fiscal point of view. 28. In October 1984, minimum provisions to be allocated by banking institutions against country risk were introduced, which were strengthened further in 1985 and 1986. Six groups of countries, ranking from the lesser to the greater risk, have been established. The minimum provisions for each C-9 group are as follows: (a) OECD countries with currencies listed on the Spanish foreign exchange market: nil; (b) unclassified countries: 1.5 percent; (c) countries with transitory problems: 1.5 percent; (d) doubtful countries: 20 percent for the first year and 35 percent from then onward; (e) very doubtful countries: 50 percent, up to 90 percent in three years; and (f) nonperforming country risks are considered as losses and are to be written off the bank's assets. Banking institutions are themselves required to classify each country in one of theses groups, though the Bank of Spain is empowered to suggest changes in the decisions adopted in this field. Country risks secured by residents in a third country or covered by a real guarantee that could be implemented in a third country can be allocated to the latter, provided that is rating is better than that of the final debtor. Banking institutions have been allowed to denominate in foreign currency provisions set against country risks. Provisions allocated in compliance with the above rules are deductible expenses for corporate tax purposes. Sweden 29. According to the Banking Companies Act, the banks shall set aside at least 15 percent of their annual profit to a legal reserve fund, until the fund has reached a sum corresponding to 50 percent of the share capital. The law stipulates further that assets may not be booked at a value exceeding either their true value or acquisition cost. Bonds may be booked at a value calculated on average issues rates during the least 10 years of bonds issued by the three largest mortgage institutions. Uncertain claims may be booked at a value not exceeding what can be expected to be repaid. The Banking Inspection Board requires the banks to maintain a general level of solvency in accordance with the provisions of the Bank Companies Act. This stipulates that banks must maintain certain asset/capital ratios which are different for assets with different risks. The capital ratio requirement can be met by the bank's own capital but also by up to 40 percent of the bank's reserves against loans, bonds, etc., the latter amount not to exceed the own capital. This general solvency ratio, however, understates the real position of a bank. Banks are also free to depreciate assets for taxation purposes up to limits which vary according to the types of latent tax liabilities, are substantial. Actual losses may be written off against these reserves. If reserves are converted to capital which increases the formal solvency ratio, taxes have to be paid. The tax authorities determine the maximum depreciation permitted, but the Banking Inspection Board does not prescribe which level these reserves should attain. 30. The Swedish National Tax Board has issued the following regulations. Depreciations of advances shall not exceed 4.5 percent of the amount granted. If the loans are tied long term with a fix interest rate, they may alternatively be written off according to the rules applied to bonds. Swedish bonds may be accounted for at the lowest at 85 percent of either their market value or their purchase value. This also applies to e.g., treasury bills and bonds, convertible promissory notes, capital market notes,, certificates of deposits, debentures. For foreign bonds, the limit is 70 percent. Depreciation of claims on foreign banks may be made at the most down to 70 percent of the amount granted in foreign currency or 85 percent in Swedish currency. If there is a risk of greater loss, the depreciation may be raised to an appropriate extent. Holding of shares may be depreciated to purchase at most 95 percent of market value. Switzerland 31. Banks are required to apply the general principles of commercial accounting a specified in the "Code odes Obligations" (CO). In addition, they have to draw up their accounts on the basis of the accounting plan established by the executive order of the federal law for banks and savings banks. The assessment of claims is to be based on the principle that the entry into balance sheet of any asset may not exceed its value for the company at the time when the balance sheet is drawn up. As a result, banks must C-10 assess the position of each debtor and if the value of a claim is assessed at a figure below the amount in the accounts, the bank must debt the item "losses, deprecations and provisions" of the profit-and-loss account and, correspondingly, reduce the value of the asset concerned or credit the difference on the item "other liabilities" of the balance sheet. The assessment of the value of assets must be verified by the external auditors of the bank. According to procedures established by the supervisors, the amendments to the accounts should take place as soon as serious doubt arises about the capacity of the debtor to meet its obligations. If the assessment and accounting treatment of deprecations and provisions are carried out in conformity with the principles of the Code des Obligations, they are admitted without difficulty by the tax authority. 32. As far as international lending operations are concerned, the banks have been informally advised that they are expected, in confirmation with their auditors, to establish adequate reserves for transfer risk exposures. As a practical matter, individual banks are expected to keep pace with the provisions of their peers. This means that the Federal Banking Commission's expectations are for an aggregate reserve of 20 percent of the combined exposures to countries facing payments difficulty (higher percentages for large concentrations). Reserves may be either general, or for specific countries. In neither case are they reflected as part of capital funds in banks' balance sheets, but provisions of up to the 20 percent guideline (whether specific or general) have thus far been afforded deductibility by the tax authorities. Turkey 33. Banks are required to have provisions for their cash, noncash and nonperforming credits, according to a decree of council of Ministers, dated December 11, 1985. Provisions to be kept by the banks, are of two types. One is the specific provisions directly related to nonperforming credits. These provisions should be allocated in a certain percentage of the credit in default within a definite period. The rates for secured credits are half of the rates fixed for unsecured credits. The other type of provision is a general provision which will be shown in the liability side of the balance sheet. The rates of provisions are determined as specified percentages of the total cash, noncash and nonperforming credits. The rates of provisions has been fixed as follows: (a) 1.00 percent for the year 1986, (b) 1.25 percent for the year 1987, (c) 1.50 percent for the year 1988, (d) 1.75 percent for the year 1989, and (e) 2.-00 percent for the years and thereafter. If the amount of the specific provisions is less than the above-mentioned rates for each relevant years, the difference will be recorded as general provisions. United Kingdom 34. In the United Kingdom, banks' provisioning policy is determined by standard banking and accounting practice. There are no directly related legal or regulatory requirements. Standard accounting practice requires that provision is made for all know losses whether the amount is known with certainty or is a best estimate. Accounts should be prepared on the basis that the bank will continue its operations for the foreseeable future and assets should be valued on that basis (the "going concern" concept). There are two balance sheet date. In addition to making specific provisions against individual loans, a bank may also make a general provision against that part of its loan book not covered by specific provisions. The general provision covers latent losses which are assumed to be present in any loan portfolio, but have not been, or are not capable of being, individually identified by the management, either because C-1 I they have not examined in detail each of a large number of small loans or because they believe there are further bad debts of which they are not aware. The general provision should not be confused with a reserve, which is part of the net worth of the business, and should not be used to smooth profits. Some banks have also made "earmarked" general provisions against their lending to countries or groups of countries experiencing debt-servicing difficulties. These provisions are general in that they are not made against particular individual loans, but are nevertheless earmarked in the minds of management against a particular portion of the loan book and are not available to cover losses generally. Banks also make provision against interest due on loans where there is doubt whether the interest will be received. Provision may be made either by "suspending" interest (i.e., not taking it to income) or by accruing the interest and providing against it. There is no difference between the two methods in their net effect on profits, although the latter results in a larger charge for provisions and the former has the effect of reducing gross income. 35. The responsibility for determining the level of provisions which is required rests with the directors of the company. In carrying out the audit of the company (which is a statutory requirement), its auditors will form a judgment on the adequacy of the provisions which have been made. In most cases discussions will take place between the company's directors and its auditors to agree on the necessary level of provisions. In the rare event of agreement not being reached, the auditors might be obliged to qualify their report on the company's accounts. During the regular meetings held in the course of its prudential supervision, the Bank of England discusses with each bank's management its approach to provisioning policy. The Bank will wish to satisfy itself that the management adopts a prudent and responsible approach to making provisions. Although a bank's auditors make an assessment of the level of provisions required in the course of their normal work in forming an opinion on the truth and fairness of the accounts, the bank reviews a bank's large and/or problematic loans regularly with management. The number of loans individually covered in this way will depend on the Bank's view of a bank's own system for reviewing its loan portfolio and making provisions and on the size and quality of individual loan within that portfolio. 36. The tax authorities consider that bad debt provisions are only allowable against tax where in their opinion a debt or a proportion of a debt may reasonably be said to be irrecoverable. These rules apply to both capital and interest. In effect, they mean that specific provisions are more likely to be allowable against taxable profits than general provisions. Provisions against sovereign and rescheduled debt are in principle allowable against tax provided that they meet the normal criteria. 37. For the purpose of assessing capital adequacy, general provisions are included in a bank's capital base where the Bank is "satisfied that a general provision is freely available to absorb future losses." This means that where part of the general provision is known to be "earmarked" against a particular category of loans, it will not be eligible for inclusion in the capital base. United States 38. The law specifically defines a bad debt as any loan where the principal or interest is delinquent six months or more and where the loan is not well secured and in the process of collection. Doubtful debts are defined in the supervisory policies, practices and procedures of the federal banking agencies as loans which have protracted repayment problems but the full or exact extent of a loss cannot be determined. Nonperforming and delinquent loans are defined under the regulations of the Sec and the bank agencies. Delinquent loans arise when interest or principal is due and unpaid for 30 days; nonperforming loans arise when the delinquency reaches 90 days. By statue, bad debts must be written off before any dividends are paid; convention and case law require loans to be charged off if so directed C-12 by prudential authorities; the banks may voluntarily write off any asset they believe warrant charge-off. There are no conflicts between prudential and fiscal authorities. Loans written off pursuant to the agencies' policies, practices and procedures are tax deductible. Deductibility of loans voluntarily charged off by the banks are always subject to challenge by the fiscal authorities as to whether the asset really was "worthless" and warranting tax deduction. The federal banking agencies, the Sec and GAAP require loan charge offs and recoveries occur through the ledger account "reserve for possible loan losses." Provisions which occur for actual losses are tax deductible. In addition, provisions necessary to maintain the reserve for possible loan losses a I percent of total loans also is tax deductible. 39. With regard to transfer risks, the International Lending Supervision Act of 1983 provided that the federal banking agencies require banking institutions to establish and maintain a special reserve whenever, in the judgment of the agency: (a) the quality of the banking institution's asset has been impaired by a protracted inability of public or private borrowers in a foreign country to make payments on their external indebtedness as indicated by such factors, among others as a failure by such borrowers to make full interest payments on external indebtedness; a failure to comply with the terms of any restructured indebtedness; or a failure by the foreign country to comply with any International Monetary Fund or other suitable adjustment program; or (b) no definite prospects exist for the orderly restoration of debt services. The principal elements of the rules are that: (a) banking institution shall establish an Allocated Transfer Risk Reserve (ATRR) for specified international assets when required under these rules; (b) at least annually, the agencies shall jointly determine which international assets are subject to risks warranting establishment of an ATRR, the size of the ATRR required for the specified assets, and whether an already established ATRR may be reduced due to the improved quality of the assets; (c) an ATRR is to be established by a charge to current income and shall not be considered as part of capital and surplus or allowances for possible loan losses for regulatory, supervisory or disclosure purposes. The initial year's ATRR normally will be 10 percent of the principal amount of the asset on which reserves must be kept as determined by the federal banking agencies, and, for subsequent years, normally will be 15 percent. These amounts may be adjusted, as the agencies determine. The respective banking agency will notify each banking institution it supervises of the amount of any ATTR and whether an ATRR may be reduced. A banking institution may written down an asset in lieu of establishing an ATRR. If it does so, it must replenish its allowance for possible loan losses to the extent necessary to provide adequately for estimated losses in its loan portfolio. C-13 I ANNEX D INTERNATIONAL ACCOUNTING STANDARD: DISCLOSURES IN THE FINANCIAL STATEMENTS OF BANKS AND SIMILAR FINANCIAL INSTITUTIONS Introduction 1. This Statement deals with disclosures in the financial statements of banks and similar financial institutions (subsequently referred to as banks). It also encourages the presentation of a commentary on the financial statements which deals with such matters as the management and control of liquidity and risk. 2. For the purposes of this Statement, the term "bank" includes all financial institutions, one of whose principal activities is to take deposits and borrow with the objective of lending and investing and which are within the scope of banking or similar legislation. The Statement is relevant of such enterprises whether or not they have the work "bank" in their name. 3. Banks represent a significant and influential sector of business worldwide. Most individuals or organizations make use of banks, either as depositors or borrowers. Banks play a major role in maintaining confidence in the monetary system through their close relationship with regulatory authorities and government and the regulations imposed on them by those governments. Hence there is considerable and widespread interest in the well-being of banks, and in particular their solvency and liquidity and the relative degree of risk that attaches to the different types of their business. The operations, and thus the accounting and reporting requirements, of banks are different from those of other commercial enterprises. This Statement recognizes their special needs. 4. This Statement supplements other International Accounting Standards which also apply to banks unless they are specifically exempted in an Statement. 5. This Statement applies to the separate financial statements and the consolidated financial statements of a bank. Where a group undertakes banking operations, this Statement is applicable in respect of those operations on a consolidated basis. Explanation 6. The users of the financial statements of a bank need relevant, reliable and comparable information which assists them in evaluating the financial position and performance of the bank and which is useful to them in making economic decisions. They also need information which gives them a better understanding of the special characteristics of the operations of a bank. Users need such information even though a bank is subject to supervision and provides the regulatory authorities with information that is not always available to the public. Therefore disclosures in the financial statements of a bank need to be sufficiently comprehensive to meet the needs of users, within the constraint of what it is reasonable to require of management. 7. The users of the financial statements of a bank are interested in its liquidity and solvency and the risks related to the assets and liabilities recognized on its balance sheet and to its off balance sheet items. Liquidity refers to the availability of sufficient funds to meet deposit withdrawals and other financial commitments a they fall due. Solvency refers to the excess of assets over liabilities and, hence, to the adequacy of the bank's capital. A bank is exposed to liquidity risk and to risks arising from currency D-1 fluctuations, interest rate movements, changes in market prices and from counterpart failure. These risks may be reflected in the financial statements, but users obtain a better understanding if management provides a commentary on the financial statement which describes the way it manages and controls the risks associated with the operations of the bank. Accounting Policies 8. Banks use differing methods for the recognition and measurement of items in their financial statements. While harmonization of these methods is desirable it is beyond the scope of this Statement. In order to comply with International Accounting Standard l, Disclosure of Accounting Policies, and thereby enables users to understand the basis on which the financial statements of a bank are prepared, accounting policies dealing with the following items may need to be disclosed: (a) the recognition of the principal types or income (see paragraph 9); (b) the valuation of investment and dealing securities (see paragraph 19); (c) the distinction between those transactions and other events that result in the recognition of assets and liabilities on the balance sheet and those transactions and other events that only give rise to contingencies and commitments (see paragraphs 20 to 23); (d) the basis for the determination of losses on loans and advances and for writing off uncollectable loans and advances (see paragraphs 35 to 39); and (e) the basis for the determination of charges for general banking risks and the accounting treatment of such charges (see paragraphs 40 and 41). Some of these topics are the subject to existing International Accounting Standards while other may be dealt with at a later date. Income Statement 9. The principal types of income arising from the operations of a bank include interest, fees for services, commissions and dealing results. Each type of income is separately disclosed in order that users can assess the performance of a bank. Such disclosure are in addition to those of the source of income required by International Accounting Standard 14, Reporting Financial Information by Segment. 10. The principal types of expenses arising from the operations of a bank include interest, commissions, losses on loans and advances, charges relating to the reduction in the carrying amount of investments and general administrative expenses. Each type of expenses is separately disclosed in order that users can assess the performance of a bank. 11. Income and expense items are not offset in the income statement except for those relating to hedges and to assets and liabilities which have been offset as described in paragraph 16. Offsetting in other cases prevents users from assessing other performance of the separate activities of a bank and the return that it obtains on particular classes of assets. 12. Gains and losses arising from each of the following are normally reported on a net basis: (a) disposals and changes in the carrying amount of dealing securities; (b) disposals of investments securities; and (c) dealings in foreign currencies. D-2 13. Interest income and interest expense are disclosed separately in order to give a better understanding of the composition of, and reasons for changes in, net interest. 14. Net interest is a product of both interest rates and the amounts of borrowing and lending. It is desirable for management to provide a commentary about average interest rates, average interest earning assets and average interest bearing liabilities for the period. In some countries, governments provide assistance to banks by making deposits and other credit facilities available at interest rates which are substantially below market rates. In these cases, management's commentary often discloses the extent of these deposits and facilities and their effect on net income. Balance Sheet 15. The most useful approach to the classification of the assets and liabilities of a bank is to group them by their nature and list them in a approximate order of their liquidity; this may equate broadly to their maturities. Current and non-current items are not presented separately because most assets and liabilities of a bank can be realized or settled in the near future. 16. The amount at which any asset or liability is stated in the balance sheet is not offset by the deduction of another liability or asset unless a legal right of set-off exists and the offsetting represents the expectation as to the realization or settlement of the asset or liability. Offsetting in other cases reduces the usefulness of balance sheet disclosures. 17. The distinction between balances with other banks and those with other parts of the money market and from other depositors is relevant information because it gives an understanding of a bank's relations with, and dependence on, other banks and the money market. Hence, a bank disclosure separately: (a) balances with the central bank; (b) placements with other banks; (c) other money market placements (d) other money market deposits; and (f) other deposits. 18. A bank generally does not know the holders of its certificates of deposit because they are usually traded an open market. Hence, a bank discloses separately deposits that have been obtained through the issue of its own certificates of deposit or other negotiable paper. 19. It is important to distinguish dealing securities from investment securities and from other investments. Dealing securities are marketable securities that are acquired and held for yield or capital growth purposes and are usually held to maturity. The market values of dealing securities and marketable investment securities are disclosed, in accordance with International Accounting Standing 25, Accounting for Investments, if these values are different from the carrying amounts in the financial statements. It is not appropriate in the financial statements of a bank to account for loans, advances and similar transactions as investments. D-3 Contingencies and Commitments Including Off Balance Sheet Items 20. International Accounting Standard 10, Contingencies and Events Occurring after the Balance Sheet Date, deals generally with accounting for, and disclosure of, contingencies. The Statement is of particular relevance to banks because banks often become engaged in many types of contingencies and commitments, some revocable and others irrevocable, whiclh are frequently significant in amount and substantially larger than those of other commercial enterprises. 21. Many banks also enter into transactions that are presently not recognized as assets or liabilities in the balance sheet but which give rise to contingencies and commitments. Such off balance sheet items often represent an important part of the business of a bank and may have a significant bearing on the level of risk to which the bank is exposed. These items may add to, or reduce, other risks, for example by hedging assets or liabilities on the balance sheet. Off balance sheet items may arise from transactions carried out on behalf of customers or from the bank's owIn trading position. 22. Off balance sheet items may take a number of different forms including the following: (a) direct credit substitutes including general guarantees of indebtedness, bank acceptance guarantees and standby letters of credit serving as financial guarantees for loans and securities; (b) certain transaction-related contingencies including performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions; (c) short-term self-liquidating trade-related contingencies arising from the movement of goods, such as documentary credits where the underlying shipment is used as security; (d) those sale and repurchase agreements not recognized in the balance sheet; (e) interest and foreign exchange rate relate items including swaps, options and futures' and (f) other commitments, note issuance facilities and revolving underwriting facilities. 23. The users of the financial statements iiee to know about the contingencies and irrevocable commitments of a bank because of the demands they may put on its liquidity and solvency and the inherent possibility of potential losses. Users also require adequate information about the nature and amount of off balance sheet transactions undertaken by a bank. Thus a bank discloses, in addition to any other contingencies required by International Accounting Standard 10, Contingencies and Events Occurring After the Balance Sheet Date: (a) the nature and amount of commitments to extend credit that are irrevocable because they cannot be withdrawn at the discretion of the bank without the risk of incurring significant penalty or expense; and (b) the nature and amount of contingencies and commitments arising form off balance sheet items. For the purpose of this disclosure, off balance sheet items are grouped according to their nature. Maturities of Assets and Liabilities 24. The matching and controlled mismatching of the maturities and interest rates of assets and liabilities is fundamental to the management of a bank. It is unusual for banks ever to be completely matched since business transacted is often of uncertain term and of different types. An unmatched position potentially enhances potentially enhances profitability but can also increase the risk of losses. D-4 25. The maturities of assets and liabilities and the ability to replace, at an acceptable cost, interest- bearing liabilities as they mature, are important factors in assessing the liquidity of a bank and its exposure to changes in interest rates and exchange rates. In order to provide information that is relevant for the assessment of its liquidity, a bank discloses, a minimum, an analysis of assets and liabilities into relevant maturity groupings. 26. The maturity groupings applied to individual assets and liabilities differ between banks and their appropriateness to particular assets and liabilities. Examples of periods used include the following: Up to I month From I month to 3 months From 3 months to 1 year From I year to 5 years From 5 years and over. Frequently the periods are combined, for example, in the case of loans and advances, by grouping those under one year and those over one year. When repayment is spread over a period of time, each installment is allocated to the period in which it is contractually agreed or expected to be paid or received. 27. It is essential that the maturity periods adopted by a bank are the same for assets and liabilities. This makes clear the extent to which the maturities are matched and the consequent dependence of the bank on other sources of liquidity. 28. Maturities may be expressed in terms of: (a) the remaining period to the repayment date; (b) the original period to there payment date; or (c) the remaining period to the next date at which interest rates may be changed. The analysis of assets and liabilities by their remaining periods to the repayment dates provides the best basis to evaluate the liquidity of a bank. A bank may also disclose repayment maturities based on the original period to the repayment date' in order to provide information about its funding and business strategy. In addition, a bank may disclose maturity groupings based on the remaining period to the next date at which interest rates may be changed in order to demonstrate its exposure to interest rate risks. Management may also provide, in its commentary on the financial statements, information about interest rate exposure and about the way it manages and controls such exposures. 29. Repayment maturities may be expressed in terms of the remaining period to either the contractual maturity date or the effective maturity date. In many countries, deposits made with a bank may be withdrawn on demand and advances given by a bank may be repayable on demand. However, in practice, these deposits and advances are often maintained for long periods without withdrawal or repayment; hence, the effective date of repayment is later than the contractual date. Nevertheless, a bank discloses an analysis expressed in terms of contractual maturities even though the contractual repayment period is often not the effective period because contractual dates reflect the liquidity risks attaching to the bank's assets and liabilities. 30. Some assets of a bank do not have a contractual maturity date. The period in which these assets are assumed to mature is usually taken as the expected date on which the assets will be realized. D-5 31. The user's evaluation of the liquidity of a bank from its disclosure of maturity groupings is made in the context of local banking practices, including the availability of funds to banks. In some countries, short-term funds are available, in the normal course of business, from the money market or, in an emergency, from the central bank. In other countries, this is not the case. 32. In order to provide users with a full understanding of the maturity groupings, the disclosures in the financial statements may need to be supplemented by information as to the likelihood of repayment within the remaining period. Hence, management may provide, in its commentary on the financial statements, information about the effective periods and about the way it manages and controls the risks and exposures associated with different maturity and interest rate profiles. Concentrations of Assets, Liabilities and Off Balance Sheet Items 33. A bank discloses significant concentrations in the distribution of its assets and in the source of its liabilities because it is a useful indication of the potential risks inherent in the realization of the assets and the funds available to the bank. Such disclosures are made in terms of geographical areas, customer or industry groups or other concentrations of risk which are appropriate in the circumstances of the bank. A similar analysis and explanation of off balance sheet items is also important. Geographical areas may comprise individual countries, groups of countries or regions within a country; customer disclosures may deal with sectors such as governments, public authorities, and commercial and business enterprises. Such disclosures are made in addition to any segment information required by International Accounting Standard 14, Reporting Financial Information by Segment. 34. The disclosure of significant net foreign currency exposures is also a useful indication of the risk of losses arising from changes in exchange rates. Losses on Loans and Advances 35. It is inevitable that in the ordinary course of business, banks suffer losses on loans, advances and other credit facilities as a result of their becoming partly or wholly uncollectable. The amount of losses which have been specifically identified is recognized as an expense and charged against income and deducted from the carrying amount of the appropriate category of loans and advances as a provision for losses on loans and advances. The amount of potential losses not specifically identified but which experience indicates are present in the portfolio of loans and advances is also recognized as an expense and charged against income and deducted from the total carrying amount of loans and advances as a provision for losses on loans and advances. The assessment of these losses depends on the judgment of management; it is essential, however, that management applies its assessments in a consistent manner from period to period. 36. Local circumstances or legislation may require or allow a bank to make charges against income for losses on loans and advances in addition to those losses which have been specifically identified and those potential losses which experience indicates are present in the portfolio of loans and advances. Any such charges represent appropriations of retained earnings and not expenses in determining net income for the period. Similarly, any credits resulting from the reduction of such charges result in an increase in retained earnings and are not included in the determination of net income. 37. Users of the financial statement of a bank need to know the impact that losses on loans and advances have had on the financial position and performance of the bank; this helps them judge the effectiveness with which the bank has employed its resources. Therefore a bank discloses the aggregate amount of the provision for losses on loans and advances at the balance sheet date and the movements in D-6 the provision during the period. The movements in the provision, including the amounts previously written off that have been recovered during the period, are shown separately. 38. A bank may decide not to accrue interest on a loan or advance, for example when the borrower is more than a particular period in arrears with respect to the payment of interest or principal. A bank discloses the aggregate amount of loans and advances at the balance sheet date on which interest is not being accrued and the basis used to determine the carrying amount of such loans and advances. It is also desirable that a bank discloses whether it recognizes interest income on such loans and advances and the impact which the non accrual of interest has on its income statement. 39. When loans and advances cannot be recovered, they are written off and charged against the provision for losses. In some cases, they are not written off until all the necessary legal procedures have been completed and the amount of loss is finally determined. In other cases, they are written off earlier, for example when the borrower has not paid in any interest or repaid any principal that was due in a specified period. As the time at which uncollectable loans and advances are written off differs, the gross amount of loans and advances and of the provisions for losses may vary considerably in similar circumstances. As a result, a bank discloses its policy for writing off uncollectable loans and advances. General Banking Risks 40. Local circumstances or legislation may require or allow a bank to make charges against income for general banking risks, including future losses or other unforeseeable risks, in addition to the charges for losses on loans and advances determined in accordance with paragraph 35. A bank may also be required for allowed to make charges against income for contingencies in addition to those for which accrual is required by International Accounting Standard 10, Contingencies and Events Occurring After the Balance Sheet Date. These charges may result in the overstatement of liabilities, understatement of assets or undisclosed accruals and provisions. They present the opportunity to distort net income and equity. 41. The income statement cannot present relevant and reliable information about the performance of a bank if net income includes the effect of undisclosed charges for general banking risks or additional contingencies, or undisclosed credits resulting from the reversal of such charges. Similarly, the balance sheet cannot provide relevant and reliable information about the financial position of a bank if the balance sheet includes overstated liabilities, understated assets or undisclosed accruals and provisions. Hence, any changes for general banking risks or additional contingencies are separately disclosed as appropriations of retained earnings. Any credits resulting from the reduction of such charges result in an increase in retained earnings and are not included in the determination of net income. Assets Pledged As Security 42. In some countries, bank are required, either by laws or national custom, to pledge assets as security to support certain deposits and other liabilities. This amounts involved are often substantial and so may have a significant impact on the assessment of the financial position of a bank. In these circumstances, a bank discloses the aggregate amount of secured liabilities and the nature and carrying amount of the assets pledged as security. D-7 Trust Activities 43. Banks commonly act as trustees and in other fiduciary capacities that result in the holding or placing of assets on behalf of individuals, trusts, retirement benefit plans and other institutions. Provided the trustee or similar relationship is legally supported, these assets are not assets of the bank and, therefore, are not included in its balance sheet. If the bank is engaged in significant trust activities, disclosure of that fact and an indication of the extent of those activities is made in its financial statements because of the potential liability if it fails in its fiduciary duties. For this purpose, trust activities do not encompass safe custody functions. Related Party Transactions 44. International Accounting Standard 24, Related Party Disclosures, deals generally with the disclosures of related party relationships and transactions between a reporting enterprise and its related parties. In some countries, the law or regulatory authorities prevent or restrict banks entering into transactions with related parties whereas in others such transactions are permitted. International Accounting Standard 24, Related Party Disclosures, is of particular relevance in the presentation of the financial statements of a bank in a country that permits such transactions. 45. Certain transactions between related parties may be effected on different terms from those with unrelated parties. For example, a bank may advance a larger sum of charge lower interest rates to a related party than it would in otherwise identical circumstances to an unrelated party; advances or deposits may be moved between related parties more quickly and with less formality than is possible when unrelated parties are involved. Even when related party transactions arise in the ordinary course of a bank's business, information about such transactions is relevant to the needs of users and its disclosure is required by International Accounting Standard 24, Related Party Disclosures. 46. When a bank has entered into transactions with related parties, it is appropriate to disclose the nature of the related party relationship, the types of transactions, and the elements of transactions necessary for an understanding of the financial statements of the bank. The elements that would normally be disclosed to conform with International Accounting Standard 24, Related Party Disclosures, include a bank's lending policy to related parties and, in respect of related party transactions, the amount included in or the proportion of: (a) each of loans and advances, deposits and acceptances and promissory notes; disclosures may include the aggregate amounts outstanding at the beginning and end of the period, as well as advances, deposits, repayments and other changes during the period; (b) each of the principal types of income, interest expense and commissions paid; (c) the amount charged against income in the period for losses on loans and advances and the amount of the provision at the balance sheet date; and (d) irrevocable commitments and contingencies and commitments arising from off balance sheet items D-8 International Accounting Standard 30 International accounting standard 30 comprises paragraphs 47-61 of this Statements. The Standard should be read in the context of paragraphs 1-46 of the Statement'8 Income Statement 47. A bank should present an income statement which groups income and expenses by nature and discloses the amounts of the principal types of income and expenses. 48. In additional to the requirements of other International Accounting Standards, the disclosures in the income statement or the notes to the financial statements should include, but are not limited to, the following items of income and expenses: Interest and similar income Interest expense and similar charges Dividend income Fee and commission income Gains less losses arising from dealing securities Gains less losses arising from investment securities Gains less losses arising from dealing in foreign currencies Other operating income Losses on loans and advances General administrative expenses Other operating expenses 49. Income and expense items should not be offset except for those relating to hedges and to assets and liabilities which have been offset in accordance with paragraph 52. Balance Sheet 50. A bank should present a balance sheet that groups assets and liabilities by nature and lists them in an order that reflects their relative liquidity. 51. In addition to the requirements of the International Accounting Standards, the disclosures in the balance sheet or the notes to the financial statements should include, but are not limited to, the following assets and liabilities: Assets Cash and balances with the central bank Treasury bills and other bills eligible for rediscounting with the central bank Government and other securities held for dealing purposes Placements with, and loans and advances to, other banks Other money market placements Loans and advances to customers Investment securities Liabilities Deposits form other banks Other money market deposits Is International Accounting Standards are not intended to apply to immaterial items (see paragraph 12 of the Preface). D-9 Amounts owed to other depositors Certificates of deposits Promissory notes and other liabilities evidence by paper Other borrowed funds 52. The amount at which any asset or liability is stated in the balance sheet should not be offset. Contingencies and Commitments Including Off Balance Slheet Items 53. A bank should disclose the following contingencies and commitments required by International Accounting Standard 10, Contingencies and Events Occurring After the Balance Sheet Date: (a) the nature and amount o commitments to extend credit that are irrevocable because they cannot be withdrawn at the discretion of the bank without the risk of incurring significant penalty or expense; and (b) the nature and amount of contingencies and commitments arising from off balance sheet items including those relating to: (i) direct credit substitutes including general guarantees of indebtedness, bank acceptance guarantees and standby letters of credit serving as financial guarantees for loans and securities; (ii) certain transaction-related contingencies including performance bonds, bid bonds, warranties and standby letters of credit related to particular transaction; (iii) short-term self-liquidating trade-related contingencies arising from movement of goods, such as documentary credits where the underlying shipment is used as security; (iv) those sale and repurchase agreements not recognized in the balance sheet; (v) interest and foreign exchange rate related items including swaps, options and futures; and (vi) other commitments, note issuance facilities and revolving underwriting facilities. Maturities of Assets and Liabilities 55. A bank should disclose an analysis of assets and liabilities into relevant maturity groupings based on the remaining period at the balance sheet date to the contractual maturity date. Concentrations of Assets and Liabilities 56. A bank should disclose any significant concentrations of its assets, liabilities and off balance sheet items. Such disclosures should be made in terms of geographical areas, customer or industry groups or other concentrations of risk. A bank should also disclose the amount of significant net foreign currency exposures. Losses on Loans and Advances 57. A bank should disclosure the following: D-10 (a) the accounting policy which describes the basis on which uncollectable loans advances are recognized as an expense and written off; (b) details of the movements in the provision for losses on loans and advances during the period. It disclose separately the amount charged to income in the period for losses on uncollectable loans and advances, the amount charged in the period for loans and advances written off and the amount credited in the period for loans and advances previously written off that have been recovered; (c) the aggregate amount of the provision for losses on loans and advances at the balance sheet date; and (d) the aggregate amount included in the balance sheet for loans and advances on which interest is not being accrued and the basis used to determine the carrying amount of such loans and advances. 58. Any amount set aside in respect of losses on loans and advances in addition to those losses that have been specifically identified or potential losses which experience indicate are present in the portfolio of loans and advance should be accounted for as appropriations of retrained earnings. Any credits resulting from the reduction of such amount result in an increase in retained earnings and are not included in the determination of net income. General Banking Risks 59. Any amount set aside in respect of general banking risks, including future losses and other unforeseeable risks or contingencies in addition to those of which accrual most be made in accordance with International Accounting Standard 10, Contingencies and events Occurring After the Balance Sheet Date, should be separately disclosed as appropriations of retained earnings. Any credits resulting from the reduction of such amounts result in an increase in retained earnings and are not included in the determination of net income. Assets Pledged as Security 60. A bank should disclose the aggregate amount of secured liabilities and the nature and carrying amount of the assets pledged as security. Effective Date 61. This International Accounting Standard becomes operative for the financial statements of banks covering periods beginning on or after I January, 1991. D- II ANNEX E METHODS OF BANK SUPERVISION BY COUNTRY To a large extent, this annex summarizes a survey published in 1987 by the OECD. In several instance, the authorities subsequently have enhanced their supervisory practices. Australia The reserve Bank's approach to prudential supervision places great reliance on the regular and timely supply of statistics of other information from banks. This information concerns banks' internal control systems and management limits on risks in foreign exchange operations, data on banks' large exposures to individual customers, and data on currency exposure, country exposure and maturity mismatching. Great importance is attached to the maintenance of high standards of financial accounting and reporting by banks, including the existence of appropriate controls and audit systems. The books of each bank are subject to periodic investigation by the Auditor-General, but the Reserve Bank does not carry out regular inspections. In April 1986, the Reserve bank announced that it would established links with banks' external auditors on prudential issues. In particular, the Reserve Bank will seek the external auditor's opinion whether a bank's internal management systems and controls are generally adequate and specifically: whether the prudential standards which the Reserve Bank has set for banks are being observed; whether the management systems to control exposures and limit risks outlined to the Reserve Bank by the bank are effective, and are being observed (policies in relation to provisions and the valuation of assets would be of particular importance); whether statistical data (both statutory and voluntary) provided to the Reserve Bank by the bank are reliable; and whether any statutory or regulatory banking requirements and conditions on the banking authority have been complied with. Auditors will be asked to bring to the attention of the Reserve Bank any matters which may have potential to prejudice materially the interests of depositors. [Source: Prudential Supervision in Banking, OECD, 1987]. Austria There are no on-site inspections carried out by the Austrian supervisory authority itself. The Minister of Finance may, however, have all required audits undertaken by auditors or by the auditing or accounting associations. The Minister of Finance may require at any time from every credit institution the presentation of interim financial statements, standardized returns, and auditing reports. It may require information concerning all business matters and inspect the books and records. The annual financial statements (balance sheet, profit and loss account, and the business report) are audited by external auditors who are appointed by the bank and report to it. The supervisory authority relies mainly on the work of external auditors. According to the amendment to the Austrian Banking Act of 1979, those external auditors need a special qualification to become "bank auditors" such as special experience, no participation in the examined bank, etc. The bank auditors are to submit a special auditing report for supervisory reasons without delay to the Ministry of France. Banks also have to establish an internal audit system. [Source: Prudential Supervision in Banking, OECD, 1987]. Belgium The methods of bank control have been modified significantly by the legislative changes of 1975 and 1980. Regular examination of banks is carried out by the certified auditor (reviseur agree) who is an independent expert appointed and paid by the Banking Commission. The main tasks of certified auditors are: (i) to verify the returns submitted by banks to be Banking Commission and to examine the adequacy E- I of accounting and internal control systems; (ii) to verify compliance with legal and regulatory provisions; (iii) to monitor solvency, liquidity and profitability, and to control the functioning of internal control system in order to ensure the solidity of the institution; and (iv) to report to the Banking Commission and to bank management. In addition to certified auditors, there are statutory examiners (commissaire-reviseurs) who are appointed and aid by the bank's shareholders. They are responsible for carrying out the auditing functions established by the law for any "societe commerciale". On-site examination of banks is also carried out by the Banking Commission through its own inspectorate. Such inspections are irregular and targeted to specific aspects of the organization and functioning of the bank. The Banking Commission examines on a regular basis the accounts and statistical returns submitted by the banks and the reports of certified auditors and inspectors. It maintains regular contacts with the management of the bank. [Source: Prudential Supervision in Banking, OECD, 1987]. Canada The Inspector General of Banks is required by law to make at least an annual examination into the affairs of each bank to ensure that the provisions of the Bank Act are being duly observed and that each bank is in a sound financial condition. Particular attention is paid to capital adequacy, liquidity, profitability, asset quality and management. The Inspector General has full access to the documents of a bank and of the corporations which are included in its consolidated statements. The Inspector General keeps ongoing contacts with senior management of each bank and its external auditors. The appointment and duties of the external auditors. Auditors are regulated by the Bank Act. At each annual meeting, the shareholders of a bank are required by law to appoint two qualified accounting firms as auditors until the next annual meeting. The same two firms cannot be appointed for more than two consecutive years and must be independent of the bank and its consolidated subsidiaries. The Minister of Finance has the power to revoke the appointment of an auditor. Auditors are required to exam a bank and report on the financial statements presented to the shareholders. Auditors may be required to report to the Minister of Finance on the adequacy of a bank's procedures regarding the safety of creditors and shareholders. The Minister may also expand or extend the scope of an auditor and may direct the auditors to make a particular examination or to establish a procedure required by public interest. Reports prepared by the externial auditors are provided to the supervisory authorities. [Source: Prudential Supervision in Banking, OECD, 1987]. China Supervision of banks and other financial institutions in China is carried out by the People's Bank of China through its Department of Bank Supervision and Audit. This department's staff of 5,600 is organized on a decentralized basis. It is responsible for supervision of more than 80,000 banking offices and financial institutions having assets in excess of Y I trillion. The department was only established in 1985. The supervision function is relatively new to China and its activities are still evolving. Unlike its counterparts in most market economies, the department has focused primarily on ensuring compliance with the developmental priorities of the national credit plan. Regular on-site inspections are scheduled once every three years for state-owned banks, foreign banks, and non-bank financial institutions. Collectively-owned financial institutions are inspected every two years. In some instances, for inspections of specialized banks, staff from the bank's own internal audit department assist in the inspection. In other cases, due to their own lack of resources and the huge number of banking offices, the supervisors rely totally on the results of the bank's own internal audit. In addition, PBC has delegated supervisory responsibility over some 60,000 rural credit cooperatives to the Agricultural Bank of China. In some provinces, urban credit cooperatives are supervised by the Industrial and Commercial Bank of China. Financial institutions are required to submit four different types of reports to PBC on a E-2 regular basis. These are: a) the institution's annual credit and resource mobilization plans; b) statistical returns which document the actual execution of the plans; c) a statement of payments and receipts; and d) for new institutions, a balance sheet and profit and loss statement. However, these reports are used primarily for consolidating financial institution and industry-wide statistics within a political boundary rather than compiling financial statements for individual banks. [Source: V. Polizatto]. France The Banking Commission is responsible for carrying out both on-site and spot examinations of credit institutions to verify prudential returns and internal control systems. On-site examinations may be extended to the affiliates of the institution and to bodies holding, directly or indirectly, a controlling interest in the credit institution. The results of the examination are transmitted to the Board of Directors and to the external auditor. Credit institutions must select external auditors from an authorized list. The appointment of external auditors is submitted to the Banking Commission which has authority for requiring additional information. [Source: Prudential Supervision in Banking, OECD, 1987]. Germany The Federal Banking Supervisory Office (FBSO) and the Deutsche Bandesbank are entitled to request information from a bank on its operation. This includes the data needed for a pro rata consolidation. This is a correlation of the specific exemption from legal regulations that restrict the transmission of data by domestic subsidiaries to their foreign parent banks for the purpose of bank supervision on a consolidated basis, provided that reciprocity is assured. The FBSO is also entitled to carry out inspections and on-site examinations of banks. In practice, the FBSO relies heavily on reports by external auditors, whose appointment and revocation is subject to FBSO control. The format and content of auditors' reports are specified in guidelines set by the FBSO, which has authority to request additional information on the conduct of business by the credit institution. [Source: Prudential Supervision in Banking, OECD, 1987]. India The authority to supervise, regulate, and control the activities of commercial banks in India is conferred on the Reserve Bank of India by the Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934. The Department of Banking Operations and Development within the Reserve Bank of India is charged with the responsibility for banking supervision. Institutions supervised include: a) the State Bank of India; b) the subsidiary banks of the State Bank of India; c) the nationalized commercial banks; d) the private sector commercial banks; e) foreign bank branches; f) the regional rural banks; and g) co-operative banks. To accomplish the task of supervisions, the Department of Banking Operations and Development employs a staff of approximately 2,500 persons. Approximately 300 are inspectors. These individuals are organized on a regional basis with the head office in Bombay and 16 regional offices located in most Indian states. Supervision over the banking system is carried out through periodic onsite financial inspections, annual financial reviews, and other investigations performed on an ad-hoc basis. Financial inspections of public sector banks are required once in four years. Those public sector banks which are E-3 experiencing special problems or whose financial positions or methods of operation are not satisfactory are inspected once in three years. An Annual Financial Review is also performed each year. For private sector banks, inspections are normally carried out every two years. Annual inspections are carried out when warranted or when the bank is under directions of the Reserve Bank. A key aspect of evaluation during the onsite inspection is the quality of management. In evaluating management, Reserve Bank of India inspectors consider the bank's solvency and earnings and its performance in achieving wider national objectives, maintaining adequate liquidity, and planning for the future. [Source: V. Polizatto]. Italy The Bank of Italy carries out regular on-site inspections to verify prudential returns and examine a bank's activities. The Bank has a right to inspect all documents, including customers' records. Since 1979, banks listed on the Italian Stock Exchange are required to be audited by certified auditing firms. The content and format of auditors' reports are not subject to guidelines by the Bank of Italy and such reports are not transmitted to the supervisory authorities. Auditors cannot be required to supply additional information or to carry out special examinations. The Bank of Italy, however, may receive information concerning joint-stock companies listed on the stock exchange through the Commissione Nazionale per le Sociaeta e la Borsa (CONSOB). [Source: Prudential Supervision in Banking, OECD, 1987]. Japan Banks are required by institutional laws, such as the Banking Law, to submit periodic returns on their business to the Ministry of Finance. The Ministry carries out regular on-site inspections under the Banking Law and other laws in order to maintain the safety and soundness of banking activities. On-site inspections concentrate on assessing asset quality, checking for inaccuracies or violations of legal and regulatory provisions, and for reviewing management policy. The Bank of Japan also requests its client financial institutions to submit periodic returns by the agreements between them. It also conducts regular on-site examinations. The Banking Law does not stipulate any special provision for auditing. Banks are subject to auditing requirements under the Commercial Code, the Securities Exchange Law and their respective special provisions (appointment of two or more auditors and one certified public accountant). Although auditors' entitled to request them to give information if necessary. [Source: Prudential Supervision in Banking, OECD, 1987]. Luxembourg Detailed statistical returns are submitted by credit institutions to the Luxembourg Monetary Institute (LMI) which has broad powers of inspection for verifying the accuracy of accounts and other information provided by the credit institutions. The LMI is entitled to ask credit institutions to provide any information it thinks necessary for an overall appreciation of the credit institution's financial policy. Periodic on-site inspections take place about once a year in most cases. Credit institutions are subject to compulsory auditing by an independent auditing firm and auditors' reports are made available to the LMI. [Source: Prudential Supervision in Banking, OECD, 1987]. Netherlands Regular on-site inspection is a major tool of supervision by the Nederlandsche Bank. Others include the examination of returns to be submitted monthly or, for some categories, quarterly by credit institutions and with discussions on policy matters with senior management. Bank auditors are requested E-4 to certify at least once a year the returns submitted by banks to the supervisory body. The Netherlandsche Bank holds regular discussions with external auditors, receives their audits, and may request any additional information it deems necessary for assessing the situation of individual credit institutions. [Source: prudential Supervision in Banking, OECD, 1987]. New Zealand Monitoring the financial condition and risk exposures of banks and supervised institutions will be undertaken by means of a range of statistical returns and through consultation with management. No direct relationship between the Reserve Bank and auditors is envisaged. Legislative authority is proposed for auditors to communicate to the Reserve Bank where serious concerns exist about the viability of financial institutions. [Source: Prudential Supervision in Banking, OECD, 1987]. Spain Since 1962, the supervisory focus of the Bank of Spain has continually evolved, from monitoring compliance with economic type regulations in the second half of the 1960's, to the acute realization at the end of the 1970s of prudential concerns. Today prudential supervision is entrusted to a single department which, with around 130 bank examiners, focuses its supervisory objectives on ensuring maintenance of a prudent balance among the risks assumed, the composition and quality of earnings, the sufficiency of the supporting capital, and the existence of adequate professional management. Since 1984, the Inspection Department has followed the CAMEL rating system to summarize conclusions about an institution's financial condition and viability. The focus on the identification and quantification of problems, a basic concern during Spain's banking crisis, has given way today to more systematic attention being paid to management quality related issues. Onsite examination of loan quality and market related risks continues to be the principal concern. Supervision and prudential regulation is carried out in a consolidated manner. Onsite examination is extended to branches and subsidiaries abroad. While prudential aspects are entrusted to the Bank Inspection Department, the monitoring of money markets, payment systems and forex activities are shared with other Bank of Spain departments. The Bank Inspection Department is organized in small groups of inspectors. Each is responsible for supervision of the whole range of activities of a given number of institutions. Banking conglomerates, including bank and non-bank financial subsidiaries and affiliates, are under the responsibility of a given inspection group. Depending on the condition and degree of problems perceived, onsite examination is performed on a one-to-two year basis. Ad-hoc targeted and follow-up onsite examinations are conducted when necessary, using contacts with senior management and discussions with external auditors as additional supervisory tools. A long-form audit report is submitted each year to the Bank of Spain. Auditors' working papers are reviewed in advance of an examination when judged advantageous. Permanent offsite surveillance is assured through the quarterly analysis of prudential information by the same group of inspectors responsible for onsite examination. The system for offsite surveillance is based on a flexible computerized model linked to the different Bank of Spain data bases, including the risk bureau center. This permits both trend and peer group comparison, variance and simulation analysis, and supports feed-back of onsite examination and market generated information. The maintenance of this model is entrusted to an inter-disciplinary core group of analysis, responsible also for global trend analysis, development of early-warning signals, and ad-hoc cross sectional studies. EDP specialists conduct onsite examinations of computer systems on a regular basis. [Source: J. Gutierrez]. E-5 Sweden On-site examinations are a major element of supervision. Such examinations are conducted by both the credit department (loan quality and portfolio administration) and the accounting department (verification of financial reports and internal control systems) of the Bank Inspection Board. The frequency of regular examinations is about once every third year. They are carried out at banks' head offices and their largest branches. Banks' accounts must be audited by at least two auditors appointed by shareholders and one auditor appointed by the Bank Inspection Board. In addition to verifying financial statements and accounts, auditors must examine large credits and property transactions, and review administrative directives and internal controls. The auditors appointed by the Board shall report back any observations of importance. He has also to take part in the auditing of the shareholders' auditors and answer any question from the Board. [Source: Prudential Supervision in Banking, OECD, 1987]. Switzerland The Federal Banking Commission does not normally carry out-on-site inspections. It relies primarily on reports by independent external auditors. These are appointed and paid by the bank. They are subject to the approval of the Banking Commission. Only licensed firms are eligible for bank auditing. Auditors must examine the annual accounts and organization. Their report must give a clear picture of the situation of the bank. Auditors must verify that the bank has observed the provisions of the banking law and regulations. The annual report of the auditors must be submitted to the board of directors of the bank and to the Banking Commission. In addition, external auditors are required to carry out unannounced interim audits and to ask for audits by a different auditor than those charged with regular auditing. The content of auditors' reports is determined by official guidelines. [Source: Prudential Supervision in Banking, OECD, 1987]. Thailand Thailand's Commercial Banking Act empowers the Minister of Finance to appoint inspectors to examine and report on the affairs of banks. In practice, supervision of financial institutions in Thailand is delegated to the Bank of Thailand. The actual performance of the supervisory function is carried out by the Departments of Bank Supervision and Examination and Financial Institution Supervision and Examination. Approximately 600 persons are employed within the two supervisory units where they are assigned to the tasks of supervision, examination, analysis, licensing, and administration. Supervisory coverage is extended to commercial banks, finance companies, securities companies, finance and securities companies, and credit foncier companies. A small number of specialized, government-owned institutions are under the direct control of the Ministry of Finance. These include the Government Savings Bank, the Bank for Agriculture and agriculture cooperatives, and the Government Housing Bank. Supervisory activities for banks and financial institutions are performed both onsite and offsite. During the past decade, the onsite examination process has evolved from one of determining compliance with laws to one which is designed to assess financial condition and solvency. The supervisory authorities had already begun to change their examination focus by the time the finance company crisis in 1983. However, the process was not yet not mature and the legal powers necessary to enforce corrective actions on the financial institutions were lacking. The Emergency Decree Amending the Commercial Banking Act (1985) substantially strengthened the powers of supervisors to act. Today, the overall framework for bank supervision and examination is highly satisfactory and ranks high among peers in developing countries. [Source: V. Polizatto]. E-6 Turkey The auditing of banks is mainly exercised by Sworn Bank Auditors and Assistants thereof associated with the Under secretaries of Treasury and Foreign Trade. Sworn Bank Auditors and Assistants control the application of the Banking Law and other relevant laws by the banks, the conduct of all types of banking operations, and the identification and analysis of relations and balances between bank assets, claims, capital stock and reserves, liabilities, profit and loss accounts, and of other factors affecting the financial structure of banks. They have authority to demand all information from banks, their participation and legal person having connections with them, and to examine all their books, records and documents. Banks, their participation and enterprises and persons connected with them, are obliged to supply the desired information and to submit their books, records and documents for examination. According to the Banking Law, banks are obliged to appoint at least two internal auditors. In addition to annual reports, these auditors are bound to submit quarterly reports to the Undersecretariat of Treasury and Foreign Trade showing the compliance of the activities of the bank with the Banking Law. Banks should also employ inspectors to control the compliance of their activity with the laws and banking principles. Banks are required to forward their annual balance sheets and profit and loss accounts to the Central Banks. It may require detailed information from banks about their deposits, foreign exchange positions and other operations. The Central Bank shall follow up and examine the financial standing of banks and shall submit its views thereon to the Prime Minister, together with its suggestions when necessary. According to the Central Bank Law, banks are obliged submit to the Central Bank the reports which are prepared by the independent auditing institutions determined by the Prime Ministry in order to provide for their surveillance and the auditing of their financial standing. [Source: Prudential Supervision in Banking, OECD, 1987]. United Kingdom The Bank of England does not carry out on-site inspections on a regular basis. Under the Banking Act, the Bank may appoint persons to investigate and report on an authorized institution (and on its holding company, subsidiaries and sister companies) where it appears desirable to do so in the interest of the depositors. The supervision of authorized institutions is based on the scrutiny of regular returns. It is supplemented by frequent wide-ranging interviews and discussion with senior management of the institution. Additional information not covered by the statistical returns is usually requested. The Bank also maintains close contacts with overseas supervisory authorities with whom it may discuss particular cases involving a shared supervisory responsibility. There are at present no particular auditing requirements apart from those applying to United Kingdom companies in general. Auditors have no duty to provide information to the Bank which has no direct power over their appointment or removal. The relationship between auditors and the Bank is, however, currently under discussion in the context of the proposed new banking legislation, with a view to extending the dialogue and co-operation between the two parties [Source: Prudential Supervision in Banking, OECD, 1987]. United States Regular on-site examinations have been the cornerstone of prudential surveillance in the United States. The primary objective of examination is to assess a bank's condition and management's quality, to verify compliance with laws and regulations, and to identify areas where corrective action is required. Examinations result in bank rating in five key areas (capital adequacy, asset quality, management, earnings and profitability, and liquidity) and in an overall composite rating. A Report of the Examination and/or supervisory communication is prepared. A copy is furnished to the board of directors for its information. Increasingly, the examination process is complemented by off-site E-7 monitoring through computerized systems of conditions in the bank as a means for early detection of potential problems. At present, the U.S. authorities do not require complete audits by Certified Public Accountants for all U.S. banks. However, every large U. S. Bank does have an annual audit by CPA's. In 1977, the federal banking agencies began relying more on the work of the CPA's rather than duplicate that work [Source: Prudential Supervision in Banking, OECD, 1987]. E-8 ANNEX F DRAFT LAW FOR COUPON INVESTMENT FUNDS AND MANAGEMENT COMPANIES CONSIDERING the importance of the orderly development of investment funds within the national territory to the overall success of the mass privatization program and that it is deemed expedient and appropriate to regulate the establishment and conduct of investment funds in order to ensure fair competition as between them, the protection of the public and good governance of privatized companies; NOW THEREFORE Parliament has agreed on the following provisions to govern investment funds which participate in mass privatization and their respective management companies: General Provisions I. Coupon Investment Funds and Management Companies regulated by this Act are legal persons engaged concurrently in the business of attracting Investment Coupons by issuing securities, investing Investment Coupons in the securities of other issuers, trading in securities, and owning securities.19 2. Coupon Investment Funds must be licensed in accordance with the provisions of Part V of this Act. 3. Coupon Investment Funds and Management Companies shall comply with the relevant requirements of the Commercial Code with due account for the provisions of this Act.20 4. Any other natural or legal persons engaged in the solicitation of Investment Coupons for the purpose of investment operations within the national territory shall acquire the status of a Coupon Investment Fund in accordance with the requirements of this Act and other applicable laws.2' 5. Banks and insurance companies shall not be Coupon Investment Funds but may own shares in a Coupon Investment Fund or Management Company.22 6. For the purposes of this Act, Investment Coupons shall be regarded as assets. 19 Explanatory Note: These should in fact be the only activities the Funds engage in, as the Fund should not be in a position to use the financial assets of the Fund to support other business activities -- see § 9 (c). 20 Explanatory Note: In other words, Coupon Investment Funds and Management Companies not only have to comply with the Commercial Code (for example, on matters such as voting levels, registration at the Court, disclosure in Prospectus etc.), but also this Act. If this Act places an obligation at a higher standard than the Commercial Code, then this Act is to be followed. 21 Explanatory Note: This provision is intended to ensure that this Act catches all persons who ask others to give them their coupons to invest. 22 Explanatory Note: This means that Banks or insurance companies have to set up a separate company to act as Coupon Investment Funds, which ensures separation of operations. F-I Coupon Investment Funds Structure of Coupon Investment Fund 7. Coupon Investment Funds must be legally incorporated as a joint stock company and registered as such pursuant to the requirements of the Commercial Code. 8. A Coupon Investment Fund can only issue registered shares23 and: a) all such shares shall carry the same voting rights and privileges;24 b) it shall be unlawful for the Management Company of a Fund, any shareholder in a Fund or any shareholder in the Management Company to have any right of pre-emption or preference over the shares held by any other person in that Fund;25 and, in each case, any provision to the contrary in the Articles of Association or any other agreement or arrangement between shareholders of that Fund shall be null and void.26 9. The Articles of Association of a Coupon Investment Fund shall, in addition to complying with the requirements of the Commercial Code: a) establish both a Supervisory Board and a Management Board; b) prohibit the Fund from borrowing, except for the purposes of § 14 below and for the acquisition of real estate within the limits established in § 12 below; c) prohibit the Fund from engaging in any other economic or commercial activity other than those specified in § I above; d) prohibit the Fund from granting loans or acting as guarantor whether for itself or for a third party; e) require approval by 50% or more of the votes in the Fund at each Annual General Meeting of the Fund of: i. the identity of the Management Company and the Depository; ii. the terms and conditions of the Management Contract and the Depository Agreement; and iii. the structure and level of fees to be paid to the Management Company and the Depository for the period of the next following financial year of the Fund; 23 Explanatory Note: A Fund therefore cannot issue bearer shares 24 Explanatory Note: This is intended to prevent abuse by sponsors in conferring special rights on themselves by making all shares except theirs non-voting etc. 25 Explanatory Note: Intended to ensure that the Fund cannot have a prior right to buy shares which a person wishes to sell to another person. 26 Explanatory Note: Therefore no private contractual arrangement or founding statute of the company can override these restrictions on the kinds of shares a fund can issue. F-2 10. The Supervisory Board referred to in § 9(a) above shall consist of not less than three persons and each member shall not: a) be employees of the Management Company or of an Affiliate of the Management Company; or b) own directly or indirectly securities in the Management Company or any Affiliate of the Management Company or any legal person which owns 5% or more of the voting rights in the Management Company. 11. The Management Board referred to in § 9(a) above shall only comprise of a single Management Company as regulated by this Act and no other person whatsoever. Portfolio Rules 12. Subject to § 13 below, the portfolio of a Coupon Investment Fund may consist only of: a) securities admitted to official listing on a stock exchange or dealt in on another securities market and shares made available through the mass privatization program; b) securities other than those referred to in (a) above; c) shares of other Coupon Investment Funds; d) an interest27 in land and buildings, but only in so far as is essential for the direct pursuit of the Fund's business; provided that investments in securities referred to in (b) may not exceed 10% and that investments in land and buildings referred to in (d) may not exceed 5%, in each case, of the Fund's aggregate assets. 13. Notwithstanding § 12 above, a Coupon Investment Fund shall not: a) own any securities whatsoever in: (i) its Depository or an Affiliate of its Depository; (ii) its Management Company or an Affiliate of its Management Company; or (iii) in entities which own more than 5% of the voting shares of the Management Company. b) invest more than 10% of its aggregate assets in securities issued by the same entity; except that the Fund may invest any amount up to the total of its aggregate assets in securities issued by the Government, its agencies or bodies guaranteed by the Government. 14. Subject to § 16 below, a Coupon Investment Fund shall be obliged to continuously issue and redeem its shares and any provision in the Articles of Association of the Fund to the contrary shall be null and void. In the event of an application for the redemption of its shares, the Fund shall purchase the shares promptly, but in any event not later than thirty (30) days from the date of receipt of the application. If the monetary assets of the Fund are insufficient to cover the price of the shares being redeemed, the Fund shall sell sufficient securities to cover the value of the redemption. For the duration of the period during which the securities are being sold, the Fund shall be entitled to accept short-term credit to pay for the shares being redeemed, except that short-term credit shall not be taken for a period 27 i.e. leasehold or freehold F-3 of more than ninety (90) days and the aggregate amount of such credits at any time shall be limited to 10% of the value of the Fund's assets. 15. For the purposes of redemption or sale of its shares, a Coupon Investment Fund shall value those shares on the basis of the Net Asset Value per share of that Fund at the time of sale or redemption. 16. Notwithstanding the provisions of § 14 above, a Coupon Investment Fund shall not be obliged to continuously or otherwise issue or redeem its shares during the Closed-End Period applicable to it. 17. A Coupon Investment Fund and its Management Company shall use all reasonable endeavors to exercise significant influence over the management of companies in which the Fund owns shares (or rights to shares allocated but not yet issued) commensurate with the rights conferred under the Commercial Code with respect to the level of shareholding owned by the Fund. The Fund and its Management Company shall exercise such influence with the objective of increasing the Net Asset Value of the Fund. Disclosure requirements 18. Any provision in the Articles of Association of a Coupon Investment Fund or any shareholders agreement or other arrangement to which the Fund is a party which restricts or otherwise limits the extent to which the Fund discloses information shall be null and void to the extent of that restriction or limitation. 19. No shares of any Coupon Investment Fund may be admitted for trading on any stock exchange or other market or offered for sale to the public in exchange for cash or Investment Coupons or any other consideration unless that Fund has published and makes freely available a prospectus which shall contain information which is necessary to enable investors and their investment advisors to make an informed assessment of the assets and liabilities, financial position, profits and losses and prospects of the Fund, and of the rights attaching to the shares of the Fund. 20. In addition to complying with the provisions of the Commercial Code in relation to the publication and content of prospectuses, the prospectus of any Coupon Investment Fund shall contain at least the information provided for in the Schedule to this Act, which Schedule shall form part of this Act. 21. A Coupon Investment Fund shall not, when advertising the sale of its shares, use false or misleading information or fail to disclose facts important for the decision-making of existing or future shareholders and, in particular shall not offer returns, gains or advantages the reliability of which cannot reasonably be assured of or guaranteed or which are contrary to this Act or the law, or to give incorrect or misleading information about personnel, technological or organizational assumptions regarding the activity of the Fund or its Management Company. 22. Every advertisement, publication or document issued or published by a Fund or its Management Company shall contain the following statutory warning in legible characters: 23. A Coupon Investment Fund shall, within 90 days after the end of each six month and twelve month period, publish a report on its results and activities which shall: F-4 a) list every purchase and sale of securities by or on behalf of the Fund giving details of the name of the entity in which the securities were bought or sold, the price for each security and the effective date of each transaction; b) where the purchase or sale is to an Affiliate of the Fund or its Management Company, the name of the person selling shares to the Fund or buying shares from the Fund shall also be disclosed; c) the amount of fees actually paid to the Management Company and the Depository during the period in question and the basis of calculation of those fees; d) details of any amounts paid to the members of the Supervisory Board of the Fund and the basis for any such payments; e) details of any claims against the Fund in excess of Manat xxx. 24. The issue and redemption price of shares in the Fund shall be published during the entire period that the Fund allows investors to acquire new shares, or redeem their shares, and at least twice a month. Notwithstanding the foregoing, a redemption price need not be published during the Closed-End Period (if any) applicable to that Fund. Management and Supervision 25. The management and supervision of any Coupon Investment Fund shall be subject to the laws applicable to joint-stock companies with due account for the provisions of this Law. 26. The highest managing body of any Coupon Investment Fund shall be the general meeting of shareholders, which shall have exclusive competence on the following matters: a) any amendment to the Memorandum and Articles of Association28 of the Fund; b) approval or any amendment of or addition to the Declaration of Investment Strategy, the Management Contract or the Depository Agreement, including the procedure for determining the amount of remuneration to be paid to the Management Company and the Depository; c) election of the members of the Supervisory Board; d) approval of the annual report and accounts on the results of the operations of the Fund; e) approval of the procedure for the calculation of dividends; f) decision-making on the establishment of Affiliates and branch offices that are not separate legal persons, and on the closure or liquidation thereof; g) appointment of the Auditors; h) decision-making on the liquidation of the Coupon Investment Fund. 27. The quorum at any shareholders' meeting shall require the presence in person or through authorized representative of no less than 50% of the Fund's shares. 28 i.e. the Fund's founding company statutes. F-5 28. In the presence of a quorum, any decision shall be taken by a simple majority of votes. In the absence of a quorum, the meeting shall be reconvened after 14 calendar days. Irrespective of a quorum, decisions at a reconvened meeting shall be taken by a simple majority of shareholders in attendance or their authorized representatives. 29. The first shareholders' meeting shall take place within 14 days from the date of licensing of the Fund under Part V of this Act. Irrespective of any other meeting, the annual general meeting of the Fund shall take place once a year. 30. The Supervisory Board shall be the highest managing body of a Coupon Investment Fund in between general meetings of the shareholders. 31. At the request of the Depository of a Coupon Investment Fund, representatives of that Depository shal I be entitled to attend meetings of the Supervisory Board of that Fund. 32. The Management Company shall be subject to the supervision of the Supervisory Board and the Depository. Profits and distribution of dividends 33. The profits of a Coupon Investment Fund shall derive from the dividends and interest receivable from the securities owned by the Fund as well as from trading in securities. 34. The Supervisory Board of a Coupon Investment Fund may decide to use part of the net profits of the Fund in a manner prescribed by the Articles of Association and the Declaration of Investment Strategy in order to increase the capital of the Fund prior to the distribution of net profits as dividends. 35. The conditions of and procedure for the distribution of dividends of a Coupon Investment Fund shall be governed by the Articles of Association of that Fund. Tax status 36. Any income received by a Coupon Investment Fund which ordinarily would be considered as income subject to corporate income taxes shall not be considered as such but shall be allocated pro rata amongst the shareholders of the Fund and considered to be income of the shareholders of the Fund for the purposes of their personal income tax. 37. Each Fund shall provide an annual statement to the shareholders of the Fund showing the amount of income allocated per share for the previous tax year. 38. The first sale of securities by a Fund or individual shall be exempt from any applicable capital gains tax provided that those securities where acquired in the course of mass privatization using Investment Coupons. Management Companies 39. Management Companies must be legally incorporated as either: a) a joint stock company, or F-6 b) a limited liability company; and, in each case, registered as such under the Commercial Code. 40. A Management Contract shall be the only basis on which a Management Company may provide services to a Coupon Investment Fund, which contract shall specify the fees to be paid to the Management Companies for its services. Any payment to the Management Company not provided for in the Management Contract shall be unlawful. 41. The Management Contract shall be ratified at the Annual General Meeting of the shareholders of the Fund, failing which it shall terminate on the appointment of another Management Company which appointment shall be not later than 60 days after the date of the Annual General Meeting. 42. The Management Company of a Coupon Investment Fund shall comply with the requirements of the Declaration of Investment Strategy of the Fund. 43. It shall be unlawful for any Management Contract to provide for fees to the Management Company in excess of 5% per annum of the value of the portfolio of the Fund; and any Management Contract which purports to provide a fee structure or amount which is greater shall be null and void. Depositories 44. Each Coupon Investment Fund shall have a Depository and all securities owned by a Coupon Investment Fund shall be deposited with the Depository of that Fund. 45. A Depository Agreement shall be the only basis on which a Depository may provide services to a Coupon Investment Fund and its Management Company, which contract shall specify the fees to be paid to the Depository for its services. Any payment to the Depository not provided for in the Depository Agreement shall be unlawful. 46. It shall be unlawful for any Depository Agreement to provide for fees to the Depository in excess of [0.5]% per annum of the value of the portfolio of the Fund; and any Depository Agreement which purports to provide a fee structure or amount which is greater shall be null and void. 47. A Depository shall maintain a separate list of shareholders of each of the Coupon Investment Funds for which it acts as Depository. 48. A Depository shall, at the request of any shareholder of a Coupon Investment Fund, circulate to all other shareholders of that Fund a request for a proxy in accordance with the Commercial Code. The shareholder making such a request shall pay of a fee to the Depository covering the reasonable costs of such circulation.29 29 Explanatory Note: This provision is intended to allow access to information about the identity of other shareholders in the Fund so that a shareholder may solicit proxies from other shareholders for use at a meeting of shareholders of the Fund. F-7 49. It shall be unlawful for any person to use a list of shareholders provided by a Depository under § 49 above for any purpose other than the solicitation of proxies from other shareholders for voting at any meeting of the shareholders of the Fund. 50. A Depository shall not be a creditor or guarantor of a Coupon Investment Fund for which is acts as Depository. Licensing 51. A License is required for the establishment or division of a Coupon Investment Fund, or a merger or amalgamation with another Fund. During division or mergers of Funds, only Funds which are in accordance with this Act may be created. 52. The License is granted by the Regulatory Authority on the basis of an application by the sponsors or founders to the Regulatory Authority. 53. In the application for a License, the applicant must state: a) the commercial name and seat of the proposed Fund; b) the paid-up share capital; c) the name of the Depository; d) the designation of the Management Company and information about the extent of the services to be provided; e) a full copy of both the Management Contract and the Depository Agreement; f) other particulars required by this Act; and must be supported by a document proving the founding of a joint stock company and its statutes of incorporation. 54. The application will be decided upon within 30 days of submission of the duly completed application with all the required supporting documentation. If the Regulatory Authority fails to respond to the application within 30 days, the application shall be deemed to have been approved. An application shall only be refused where the applicant has failed to comply with the requirements of this Act, other applicable laws or where § 58 below applies. 55. A License according to § 52 above is granted for an indefinite period and is not transferable, unless revoked in accordance with Part VII below or replaced by another license or authorization under another Act regulating securities and dealing in securities. 56. An election or appointment of new members of the Supervisory Board of the Fund or a new Management Company or a new Depository must be notified to the Regulatory Body within 14 days of the election or appointment. 57. For the purposes of this Act, a person who has been lawfully sentenced for a crime relating to property or any other premeditated crime shall not be considered as an applicant for a License. F-8 Anti-Monopoly Provisions 58. A Coupon Investment Fund shall notify the Commission for the Protection of Competition (hereinafter "the Commission") within 14 days of purchasing securities where, as a result of the purchase, that Fund directly or indirectly owns 5% or more of the voting rights attached to all securities issued by that company in two or more companies which, taken together, have more than 25% of the market for a good or service within the national territory. Reporting is also required on a disposal of voting securities as a consequence of which the holder, directly or indirectly, no longer owns voting rights of 5% or more of that company which it has previously reported. 59. The Commission shall be entitled to make an order directing a Coupon Investment Fund to sell within a stipulated period of time such quantity of securities carrying voting rights where the Commission is satisfied that, taken together with holdings of that Fund or a Related Entity of that Fund in other companies in the same market, that Fund's holding unduly restricts or distorts competition in that market. Enforcement And Liability 60. The members of the Supervisory Board shall be personally liable for statements contrary to § 22. 61. Failure to comply with § 23 shall render the Supervisory Board of a Coupon Investment Fund personally liable to a fine of between [ Manat and I. 62. Any person shall provide to the Regulatory Authority any information or document requested by the Regulatory Authority on the basis of the Regulatory Authority's reasonable belief that such information or document is relevant to a possible violation of the requirements of this Act. If any person refuses to provide any such document or information, the Regulatory Authority may impose an administrative penalty of not more than [Manat ] or seek relief to [the district court]. 63. If the Regulatory Authority finds, after notice and opportunity for hearing, that any person has violated, is violating or is about to violate any provision of this Act or any rule under this Act, the Regulatory Authority may make an order requiring such person to cease and desist from committing such violation and any future violation of the same provision or rule. Such an order may also: a) suspend the effectiveness of a Prospectus; or b) require such person to comply with such provision or rule on such terms and conditions and within such time as the Regulatory Authority may specify in such order; or c) suspend or revoke the License held by the Coupon Investment Fund. 64. In addition to making an order under § 64 above, the Regulatory Authority may impose an administrative penalty upon such person, payable to the Ministry of Finance, of up to [Manat ] for any violation involving fraud, deceit, or willful or reckless disregard of the legal requirement, or of up to [Manat ] for any other such violation. 65. Upon a showing by the Regulatory Authority that a person has violated, is violating or is about to violate any provision of this Act or any rule or order under this Act, and that there is a reasonable likelihood of a future violation by such person, [the district court] shall grant appropriate relief in the F-9 form of a temporary restraining order or temporary or permanent injunction and/or uphold the suspension or revocation of a License granted under this Act. 66. Upon a showing by the Regulatory Authority that a person has violated any provision of this Act or any rule or order under this Act, [the district court] may impose a penalty upon such person, payable to the Ministry of Finance, of up to the greater of: a) the amount by which the person profited from the violations; b) [Manat ] for any violation involving fraud, deceit or willful or reckless disregard of such provision, rule or order; or c) [Manat ] for any other such violation. 67. Any person who knowingly or recklessly violates any provision of this Act or any rule or order made under this Act shall be personally liable to any other person who has suffered loss or damage to the extent of that loss or damage. 68. Where two or more persons are liable for damages for the same act or omission, they shall be liable jointly and severally. As between or among such persons, the [district court] may, on request of such person, require contribution or allocate damages in proportion to relative fault. 69. [The district court] may: a) require the rescission of any vote, consent or proxy or consent obtained in violation of § 22; b) the termination of or rescission of any purchase in violation of the provisions of this Act. 70. Any person who provides substantial assistance to another person in a violation, with general awareness of the violation, shall be liable to the same extent as the primary violator. Definitions 71. For the purposes of this Act, the following words and expressions shall have the following meanings: "Affiliate" shall mean, in relation to a natural or legal person, its Management Company, its directors and officers, its founders or sponsors, shareholders owning more than 25% of its shares or an undertaking in which such a person owns more than 25% of the shares carrying voting rights. Affiliates of a Management Company shall include all Coupon Investment Funds with which that Management Company has concluded a Management Contract; "Auditor" shall mean, in relation to a Coupon Investment Fund and its Management Company, an auditing organization which is not an Affiliate of that Fund or Management Company; "Closed-End Period" shall mean that period during which a Coupon Investment Fund is not subject to the obligation to continuously issue and redeem their shares in that Fund, which period shall expire on the third anniversary of the date of incorporation of the Fund in question; "Coupon Investment Fund" or "the Fund" shall have the meaning given to it is § I above. F-10 "Declaration of Investment Strategy" shall mean a statement by the Supervisory Board of a Coupon Investment Fund of the investment policies and strategy which will be implemented by the Fund and its Management Company; "Depository" shall mean, in relation to a Coupon Investment Fund, a Bank or other legal entity which is not an Affiliate of that Fund or its Management Company and which performs operations with securities (including Investment Coupons) and cash assets of the Fund and which keeps accounts of the movement of such assets and performs the other functions as set forth in the Depository Agreement; "Depository Agreement" shall mean the written agreement between a Coupon Investment Fund and its Depository under which the Depository provides the services to the Fund and its Management Company as required by this Act. The Supervisory Board of the Fund shall sign the agreement as individuals acting for and on behalf of the Fund; "Investment Coupon" shall mean those coupons issued pursuant to Chapter 8 of the Transformation and Privatization of State and Municipal Enterprises Act 1992 (as amended) "Management Company" shall mean a company established in accordance with the provisions of this Act and which provides management services and which engages in those activities described in § 1 above; "Management Contract" shall mean a written contract between (a) the Management Company and (b) the Supervisory Board of the Fund for the provision of management services in relation to the assets of the Fund. The Supervisory Board shall sign the contract as individuals acting for and on behalf of the Fund; "Net Asset Value" shall mean, in relation to the redemption or sale of securities by a Fund, the value of the assets of the Fund less liabilities where the assets and liabilities are valued at the greater of the current market value or the value used for the purposes of the annual reports and accounts of the Fund; "Regulatory Authority" shall mean [the Center for Mass Privatization] or such other governmental agency as may be assigned this function by law; "securities" shall mean: a) shares in companies or other interests equivalent to shares in companies; b) bonds and other forms of securitized debt which are negotiable; c) any other interest or title normally dealt in giving the right to acquire any shares or interests equivalent to shares whether by subscription, exchange or giving rise to a cash settlement excluding instruments of payment. 30 refer to the amendment to the privatization law which empowers the Council of Ministers to make this Decree F-I I Schedule of Information Required for Prospectus31 72. Information concerning those responsible for Prospectus and auditing of accounts The Prospectus shall: a) set out the name and function of natural persons and name and registered office of legal persons responsible for the Prospectus or, as the case may be, for certain parts of them, with, in the latter case, an indication of those parts. b) A declaration by those persons responsible referred to in (a) above that, to the best of their knowledge and belief, the information given in that part of the Prospectus for which they are responsible is in accordance with the facts and contains no omissions likely to affect the accuracy of the Prospectus. c) The names, addresses and qualifications of the official auditors who have audited the company's annual accounts for the preceding financial year in accordance with the law or, in the case of company's which have not been so audited, the names, addresses and qualifications of the auditors who have been appointed to perform the next audit of that company's accounts. d) A statement that the a.nual accounts, where applicable, have been audited. If the audit reports on the annual accounts have been refused by the official auditors or if they contain qualifications,32 such refusal or qualifications shall be published in full in the Prospectus along with the reasons given. e) Where other information contained in the Prospectus has been audited by the auditors, it should be so indicated in the Prospectus. 73. Information concerning the shares and their public issue The Prospectus shall: a) describe the nature of the public issue, the price at which the securities are offered or, the procedure for fixing the price if it is not known when the Prospectus is issued; b) set out the period during which the offer is open; c) describe the shares in respect of which the public issue is being made; and in particular the number of shares and nominal value per share; d) indication of the resolutions, authorizations and approvals by virtue of which the shares have been or will be created and/or issued; e) the nature of the issue and the amount of shares that will be created and/or issued, if predetermined; f) in the case of an issue of shares in connection with a merger or division of a Coupon Investment Fund or transfer of all or part of the assets and liabilities, a takeover offer, or as 31 Explanatory Note: Consider what is necessary in addition to the requirements for the contents and form of a Prospectus under the Commercial Code. 32 For example, that the accounts do not represent a "true and fair view" of the financial health of the company. F-12 consideration for the transfer of assets other than cash, indication of where the documents describing the terms and conditions of such operations are available for public inspection; g) a concise description of the rights attaching to the shares and, in particular, the extent of voting rights, entitlement to share in the profits and to share in any surplus in the event of liquidation of the Fund and any privileges; h) tax on the income from the shares withheld at source (if any) and an indication as to whether the issuer assumes responsibility for the withholding of tax at source; i) arrangements for the redemption of shares and any restrictions that apply; j) date on which the entitlement to dividends arises; k) indication as to whether an application for official listing on any stock exchange is applied for or will be sought and details of any other markets for which application is being or is likely to be made; I) if the issue is being made simultaneously on two or more stock exchanges or other markets, or if a tranche of shares has been or is being reserved for one of these, an indication of the amount of such tranche; m) period of the opening of the issue or offer of shares, and the names of the financial organizations responsible for receiving the public's subscriptions. n) methods of and time limits for delivery of the shares, possible creation or provisional certificates. o) names, addresses and descriptions of the natural or legal persons underwriting or guaranteeing the issue for the issuer. Where not all the issue is underwritten or guaranteed, a statement of the portion not covered. p) indication or estimate of the overall amount and/or of the amount per share of the charges relating to the issue operation, stating the total remuneration of the financial intermediaries, including the underwriting commission or margin, guarantee commission or selling agent's commission. q) net proceeds accruing to the issuer from the issue and the intended application of such proceeds. 74. General information about the issuer and its capital The Prospectus shall: a) state the date of incorporation of the Fund and its Management Company; b) indication of the Fund's objectives and a reference to the clause in the Memorandum of Association in which they are described; c) the Declaration of Investment Strategy of the Fund; d) indication of the register and the entry number thereini; e) indication of where the documents referred to in the Prospectus concerning the Fund may be inspected; F-13 f) the amount of the issued share capital and the number of shares of which it is composed with details of their principal characteristics; the part of the issued capital still to be paid-up, with an indication of the number and total nominal value of the shares not yet fully paid-up; g) where there is authorized but unissued capital or an undertaking to increase the capital inter alia in connection with subscription options granted, an indication of: * the amount of such authorized capital or capital increase and, where applicable, the duration of such authorization; * the persons having preferential subscription rights for such additional portions of capital; * the terms and arrangements for the share issue corresponding to such portions. h) as far as they are known to the issuer, indication of the natural or legal persons who, directly or indirectly, severally or jointly, exercise or could exercise control over the Fund, and particulars of the proportion of the capital held giving a right to vote. Joint control shall mean control exercised by more than one company or by more than one person having concluded an agreement which may lead to their adopting a common policy in respect of the Fund. i) if the issuer belongs to a group of undertakings, a brief description of the group and of the issuer's position within it. j) number, book value and nominal value of any of its own shares which the issuer or another company in which it has a direct or indirect holding of more than 50% has acquired and is holding, if such securities do not appear as a separate item in the balance sheet; Information concerning the issuer's activities The Prospectus shall: a) accurately describe the issuer's activities; b) set out the Declaration of Investment Strategy; c) location and size of the issuer's principal establishments and summary information about land and buildings leased or owned; d) information on any legal or arbitration proceedings which may have or have had a significanit effect on the financial position of the issuer. F-14 ANNEX G MODEL ACT - CHILEAN INSURANCE LAW Authorization I. The insurance and reinsurance business in Chile requires the intervention of a regulatory agency (the Superintendency). To be legally constituted in Chile, an insurance company must be in compliance with the law for corporations, that is, it must be in possession of a legal constitution, have authorization from the Superintendency, be registered in the Commerce Registry and be published in the Official Gazette -- publication of the certificate issued by the Superintendency. Activity Reserved for National Entities 2. Present legislation limits the insurance and reinsurance activity in Chile to companies whose exclusive purpose lies in the insurance and reinsurance business. Although foreign insurance companies may not directly offer or contract insurance in Chile, wholly owned foreign subsidiaries control over 70 percent of the premiums. Yet defiance of the Governmental decree would constitute a criminal act. Unconstrained Insurance Abroad 3. Any individual or corporation may freely contract insurance abroad, subject to legislation on international exchange rates. Excluded from this are the mandatory insurance established by law and those mentioned in Pension Fund Law, disability and survivor insurance, and annuities fro retirement pension funds. 4. Characteristics of the Business a) All insurance and reinsurance companies must be Chilean companies with a minimum capital of 45,000 UF inflation-adjusted index (US$1,000,000) and 60,000 UF (US$1,300,000), respectively. b) No company may simultaneously carry out noni-life insurance busines and casualty) and life insurance business. c) insurance companies may only reinsure against risks of the group in which they are authorized to operate. d) Personal accident and health may be covered by both non-life and life insurance companies. e) Credit insurance (loss or damage to equity due to nonpayment of an obligation in money or credit) can only be insured by a non-life insurance company, which covers this type of risk along with guarantee and fidelity. The minimum capital required is the same as outlined under (a). 5. Indebtedness Limits a) The maximum equity indebtedness ratio is 5 times for non-life insurance companies and 15 times for life insurance companies. b) The total third-poverty debts incurred, which do not generate technical reserves, may not exceed the same amount of equity. G-1 6. Supervision a) The superintendency, at any time, may require from the insurer or reinsurer, reports on its offices; the superintendency may also examine records and books and dictate the norms for the preparation and presentations of balance sheets, financial statements and accountiig procedures. It may designate external auditors for carrying out specific activities within those companies being supervised. b) If an insurance or reinsurance company breaks the law or any regulations or statutes, the Superintendency may apply the following sanctions: censure or reprimand, fine, suspension of the administration up to six months, suspensions of all or some of the operations up to six months and revocation of the company's license. 7. Reinsurance The reinsurance of contracts drawn up in Chile must be effected between insurance and reinsurance companies constituted in Chile and foreign reinsurer authorized to operate in the country. Reinsurance entities constituted in Chile may only reinsure against risks of non-life and life business, although they may operate in both groups as long as they have the required capital for each business, with independent and separate accounting for each. 7.1 Reinsurance Entities Foreign entities that meet the following requisites are allowed to carry out reinsurance operations in Cliile: a) Registration in the Superintendency's Registry. b) Equity of over 300,000 UF (US$6,700,000 approximately). c) Legal constitution in the country of origin; the authority to operate in reinsurance ceded abroad; and the ability to pay in freely convertible currency. d) Possession of an authentic copy of current statutes, annual reports with audited financial statements and copy of power invested in a person residing in Chile who represents the company with ample authority, including someone who can be summoned to court. 7.2 Reinsurance Brokers Intermediaries or brokers either national or foreign, who meet the following requisites may operate in reinsurance: a) Registration in the Superintendency's Registry. b) Possession of a contracted insurance policy (E. and 0.) without deductible, for no less than 20,000 UF (US$445,000) or one third of the premium brokerage in the previous year, whichever is higher, to cover all obligations, correctly and completely, that emanate from their activity and any damages that may occur to those who contract through them. c) Foreign brokers must be legal entities, legally constituted in their country of origin, authorized to broker risks ceded abroad and pay obligations in freely convertible currency. G-2 d) Copy of current statutes, annual report with audited financial statements, company of power invested in a person residing in Chile who represents the company with ample authority, including someone who can be summoned to court. 8. Technical Reserves Insurance and reinsurance entities established in the country must constitute -- in compliance with procedures, mortality tables, technical interest rates and other aspects stated by the Superintendency -- the following technical reserves: a) Unearned premium reserve: in order for the company to meet its obligations with policy coming from premiums of short-term insurance contracts (one year or less). b) Net level reserves for long-tern policies: for the life insurance company to meet its obligations with policyholders, coming from premiums of long-term insurance contracts (more than one year). c) Loss reserve: to meet obligations for incurred losses pending payment and for unreported losses. d) Additional to unearned premium reserves: to meet obligations for risks whose level of disaster is not known, highly, cyclical or catastrophic; necessary for the development of the insurance activity. 9. Investment Norms 9.1 Eligible Investments According to the law, technical reserves and risks equity (that part of equity considered necessary to maintain equity indebtedness ratios must be backed up by the following investments: a) Certificates issued or guaranteed until their total extinction by the state or issued by the Central Bank of Chile. b) Time deposits or deposit certificates issued by banks or financial institutions. c) Letters of credit issued by banks or financial institutions. d) Bonds, commercial paper and debentures issued by state-owned companies or private corporations. e) Shares in bearer securities, real estate and risk capital investment funds, classified as first class. f) Stock shares in corporations, classified as first class investments in shares of pensioni fund companies, mutual funds, health insurance institutions, insurance and reinsurance entities, educational or sports-oriented institutions, or those entities whlose objective is providing benefits of a social nature to its shareholders is prohibited. g) Shares in real estate companies, classified as first class, that can be acquired with pension fund resources. G-3 h) Admitted receivables from credit on unearned premiums, given to policy holders with clauses for non-payment , only to back up unearned premium reserves and risk equity for non-life companies. i) Admitted receivables from claims deriving from transfers to reinsurer, only to back up loss reserves and risk equity. j) Nonresidential urban real estate, located in Chile, whose commercial value is apprised at least every 2 years, according to the norm dictated by the Superintendency. k) Life insurance companies, in admitted receivables from credit for premiums, deriving from disability and survivor insurance under D.L. 3,500, and in credit for the remainder of the individual account of affiliates with claims in the social security system, to back loss reserves. I) Advances granted to life insurance policyholders, up to the redemption value, as long as it is stated that loan capital can be deducted from the indemnization to be paid. m) Income-producing securities issued by international institutions of which the government of Chile is a member, and by the Central Bank according to its organic law, only to back up additional reserves for risks of disasters which are not well known, highly cyclical and catastrophic. n) In companies with reinsurance assumed, admitted receivables from credit for unearned premiums given to ceding non-life companies by virtue of reinsurance contracts, for backing up only unearned premium reserves. o) In companies with reinsurance assumed, admitted receivables from credit from unearned premiums given to ceding non-life companies by virtue of insurance contracts, for backing up loss reserves. p) Reinsurance companies, in unearned acceptance commission, product of transfers generated by reinsurance contracts, for backing unearned premium reserves, net level reserves for long term policies and risk equity. q) Endorsable mortgage loans. The law authorizes life insurance companies to give, through an administrative agent, endorsable mortgage loans to individuals only in order to acquire, construct, enlarge or repair urban dwellings, to refinance other endorsable loans or to prepay mortgage credits. These loans serve to back up equity, technical reserves and risk equity. 9.2 Limitations on Investments a) All time deposits or deposit certificates and letters of credit issued by banks and financial institutions; bonds, commercial paper and debentures issued by state-owned companies and private corporations; and investment fund shares, corporation and real estate company shares must be submitted to a process of risk classification, stipulated in the Stock Market Law. No investment may be made in securities classified as Categories D or E, nor in stocks classified as second class or lacking sufficient information to be classified. b) Time deposits or deposit certificates form banks and financial institutions that are seried, must be registered in the Securities Registry of Banks and Fiianicial lnstitutions Commission bonds, notes and debentures issued by state-owned companiies and private corporations, and G-4 stock shares of corporations and real estate companies must be registered in the Securities Registry of the Superintendency. c) The law establishes that investments representing technical reserves and risk equity must not be under liens, prohibitions, embargoes, litigations, preventive measure, suspensive or resolutory conditions, nor be the object of acts or contracts that impede free transfer or complete transparency. d) Furthermore, the law stipulates limits on investments concerning issuer and type of security (Articles 23 and 24). 10. Model Texts of Policies and Clauses Model texts of the policies and clauses that companies use for drawing up contracts must be pireviously registered in the Superintendency; to be registered they must be so written as not to lead to error or confusion, or in any way contradict the law. Registered policies and clauses may be used by any company. This registration procedure is not necessary for non-life insurance companies where policy holders and beneficiaries are corporations and the annual premium is 200 UF (US$ 4.400 approximately) or greater. 11. Prices. Premiums and Fees Freely Set Premiums for insurance policies are freely set by the insurers. Brokerage fees are also freely set between the insurer and the broker; fee is stated in the respective policy. 12. Transfer of Portfolio Between Companies The law states the possibility of partial or total transfer of business from one insurance company to another, subject to special authorization from the Superintendency, and any norm that the agency stipulates for such effect. 13. Classification of Insurance Companies' Obligations and Risks In order to improve information services for policyholders, the law requires that insurance companies contract continuous and interrupted classification of the obligations they have with their policyholders, with at least two different and independent risk classifiers, registered in a Superintendency's special registry. Classification will be made by category, from A (for companies with lowest risk) to D (for highest risk). Category E will be for insurers with insufficienit information to be classified. 14. Agents and Adjusters in the Insurance Business 15.1 Insurance Brokers The law authorizes insurance to be contracted either directly with a company or through an intermediary, called a broker. The broker's job is to advise potential policyholders; to point out what the contract covers and under what conditions; assist the insured as long as the policy is valid; and to assist when a loss occurs. Furthermore, the broker must verify the identity of the policyholder, vet the goods to G-5 be insured and inform the insurance company of the proposed risk. In order to carry out activity, the broker must meet the requirements listed in Article 58 of Law D.F.L No. 251 (1931) and D.S. No. 863 (1989). 15.2 Claims Adjustments The law states hat claims adjustments may be carried out by the companies directly or by a loss adjuster, a professional whose job is basically, to determine what occurred and the amount of indemnization to be paid out. The claims adjuster must meet the requirements stated in Articles 62 and 63 of the D.F.L No. 863 (1989). The regulations applicable to claims adjustments are established in the above-mentioned legal regulations. 16. Regulation of Insurance Companies The law covers certain situations in which insurance companies might find themselves during the course of their business, such as equity deficit, investment deficit or overindebtedness, and equity and investment deficit or over indebtedness, together. The following steps are outline for such circumstances, including the time frame for correction; infraction of these steps leads to revocations of the authorization to exist. 17. Liquidation of Insurance Companies Liquidation is carried out by the Superintendency, or by the person designated by this agency. The Superintendency may authorize the company to participate in its own liquidation, unless it is a life insurance company or has insurance contracts from the social security system regulated by D.L. 3.500 in its portfolio. 18. Settlements and Bankruptcy Special regulations determine insolvency and bankruptcy proceedings. G-6 ANNEX H SUPERVISION OF INSURANCE COMPANIES Introduction Insurance is a complex business and is plagued by information problems both from the point of view of the consumer and that of the provider of the insurance coverage. In addition, the nature of the product gives rise to risks such as adverse selection and moral hazard. For these reasons, experience has shown that the business of insurance is one which requires close supervision. From a purely practical point of view, it is necessary to establish an insurance regime that ensures that the game is the same for all players. Without this, one would have a market that included companies that attempted to adhere to all that is reasonable according to international practice, but also a few renegade companies that would ignore these rules and attempt to garner quick profits at the expense of the consumer, and the competition, with no real intention of ever paying out insurance benefits. An appropriate form of insurance supervision would be one which included each of the following aspects: (i) control over market entry and exit; (ii) rules to govern financial reporting, including the periodic filing of comprehensive returns with the supervisor; (iii) rules that govern the investment activities of the companies; (iv) rules that prescribe the valuation of elements of assets and liabilities that appear in the balance sheet; (v) prescribed minimum amounts of capital to start a company as well as minimum amounts to be maintained by a company once it is in operation; (vi) power of supervisor to have access to complete information regarding the insurance operations of companies; (vii) right of supervisor to conduct inspection of books and records at the premises of the company; (viii) requirement for independent audit of each company; (ix) requirement for periodic reports of an actuary; (x) procedures to govern intervention when companies are in financial difficulties; and (xi) a series of sanctions that are available to the supervisor when dealing with problem institutions. The following paragraphs comment on each of these aspects. However it should be stated at the outset that the success of the entire system depends on the effective functioning of the supervisor's office. The supervisory team must be ever vigilant for changing circumstances within the industry and in particular companies. The analysis of returns is only the first step to diagnosis of emerging problems. The system must be flexible so that reporting and other requirements can be adapted to meet these changing circumstances. It should also be noted that the focus of this discussion is the work of the supervisory agency in connection with the monitoring of the financial strengthi of companies. lInsurance supervisors are nornally also responsible for a variety of other functions such as the licensing of agents and brokers; the review and, where applicable, approval of policy forms; and the settling of disputes between policyholders and companies. Financial Strength Monitoring Control over market entry and exit. It should not be possible to sell insurance policies in Azerbaijan without first being authorized to do so by the supervisor. The decision to grant a license would be predicated on a review of the financial condition of the applicants, the amount of initial capital and an H-i analysis of a multi-year business forecast. It is also common today to apply a "fit and proper person" test to those who seek to be directors of companies or to serve as senior company executives. The admission of foreign insurers must be considered under this heading. It is helpful to the market to admit a certain amount of foreign competition. The large international companies can bring expertise to the market as well as considerable amounts of capital. Foreign applicants should be able to establish domestic subsidiaries -- this is a more substantial commitment for a foreign entrant than would be the opening of a branch or agency. The applicant would have to establish a local office, with a Board of Directors, and would have to meet the same capital requirements that are expected of local applicants. In addition, the Head Office of the foreign company could be asked to give an undertaking to support the financial condition of the new subsidiary. The supervisory system should include specific procedures for market exit. It must be borne in mind that obligations under insurance policies can run for many years after a premium is paid. Thus it is unacceptable that a company could just shut its doors and walk away from its obligations. In most jurisdictions there are rules that permit the transfer or merger of the business from a departing company to a continuing company. Such transfers must be subject to the approval of the supervisory agency. Terms governing the treatment of the interests of the transferring policyholders would be reviewed as part of the study of the proposal by the supervisor. Financial reporting. Unfortunately, there is no uniform international standard that has been generally accepted for financial reporting by insurance companies. Practices vary by country and each country has found it necessary to prescribe the way in which financial information is to be reported. It is quite common for supervisors to write a special summary of accounts (in Spanish "catologo de cuentas") that each insurance company is expected to maintain. The accounts are designed such that required statutory returns can be produced quite readily. In order to avoid confusion, it is also wise to specify that an insurance company may not publish its results, for use by shareholders and others in any other manner than that which was used in reporting to the supervisor. This is quite a conservative practice but is wise in a situation where the practice of reporting by insurance companies has not been well-established. The typical reporting period for an insurance operation is the calendar year. However, many regulators have found it necessary to collect interim reports, at least quarterly, to maintain a close eye on company results. The quarterly reports are less comprehensive than the annual ones. Annual filings are normally accompanied and supported by the reports of the auditor and actuary. Investment Rules. The rules that govern investmenit practices of insurance companies must bear il mind the long-term nature of some of the liabilities of such companies as well as the liquidity needs of other parts of the business. Modern regulatory practice involves a requirement that each company develop an investment policy. This would be a written document approved by the Board of Directors, whereby the Board would direct the management in its selection of investments. The policy would be filed with the supervisor who would monitor management's compliance with the policy, as would the Board. The policy would have to take into account the nature of the different categories of liabilities on the company's books to ensure the best possible matching of assets and liabilities by term and yield. The policy would also direct the management to remain in compliance at all times with the statutory rules governing investment. H-2 The supervisor would issue regulations to govern investment activities. The practice today is to urge companies to follow the "prudent management" rule. In other words, the company is free to select its investments as it see fit but it should invest them as a "prudent manager" would do. To supplement this, the rules would include specific quantitative limits to ensure there is adequate diversification by type of instrument and by issuer. There would also be limits per parcel of investment and there would have to be a limit on the aggregate of all investments of any type with a single counter-party. Valuation of assets and liabilities. The supervisor should prescribe the rules for valuation of liabilities. For example, it is common to require that a proportion of the unearned premium for policies that have not yet resulted in a claim, and where coverage is still "active", be set up as a liability. The rules would fix the percentage of premium to be included in this liability and describe the manner in which any reduction for reinsurance ceded is to be recognized. The rules would also specify that a reserve for claims that have been "incurred but not reported" (IBNR) should be established as well as the reserve for the amounts that are expected to be paid out under known claims. For life insurance policies, the rules would stipulate the tables of mortality and other contingencies that may be used. Depending on the sophistication of the actuarial work that is being done, greater discretion can be left to the actuary in selecting these tables. The maximum rate of interest that may be used in discounting liabilities is sometimes specified in the rules. This matter should be considered carefully in an environment where nominal rates of interest are very high. Once the decisions are made regarding valuation of liabilities, it would be appropriate to review the valuation of assets. In some jurisdictions, assets are carried at their original cost values. This approach may not be appropriate when inflation and nominal rates of interest are quite high. Market values may be more appropriate. This matter should be carefully reviewed by experts before the rules are written. Minimum Capital Requirements. The legislation should require a minimum amount of capital that must be invested in the company before a license to carry on an insurance business may be granted. In Canada, this minimum is now $10 million. In other countries, a minimum of $2 million is more common. For Azerbaijan, a minimum capital of $0.5 million may be appropriate (upgrading of capital of existing firms would have to be done over a period of time). While this is not a high standard, it may be adequate although it must be recognized that more business will have to be reinsured as a consequence. A company's capacity to retain risk for its own account is a function of the size of its capital. Of equal importance is the requirement for a standard that prescribes the capital to be retained by the company as it conducts its business and its obligations grow. The supervisor should prescribe a set of rules or formulas that fix the minimum as some function of the size of the companies business in force. Ideally these rules will be reflective of the degree of risk that the company is undertaken (i.e. be "risk- based", in the manner of the standard prescribed for banks by the Cooke committee working under the direction of the Bank for International Settlements in Basle, Switzerland). Very few jurisdictions have adopted rules for insurance with the degree of complexity seen in the BIS rules. However a sort of international standard is emerging, following work done in the European Union where a common standard is being adopted. The new EU standard specifies that for property/casualty insurance, the minimum capital to be maintained is the greater of two values: x% of one year's premiums or y% of one year's claims. In practice x and y vary between 16 and 20%. This rule has also been copied for Canada and is widely quoted in Latin H-3 America and in Africa. For life insurance business, the prevailing EU standard for life insurance calls for capital of 4% of liabilities plus 3.00 per 1,000 of insurance in force. As noted earlier, the supervisor would have to set the standard for valuation of assets and liabilities, and the capital test would compare the requirements (derived as described in the preceding paragraph) to the actual "net worth" of the company as determined from a balance sheet that is prepared using the supervisor's rules. In addition, the supervisor would reserve the right to disallow asset items, such as doubtful receivables, that the supervisor considers can not be relied upon for meeting capital requirements. This process of monitoring capital adequacy is part of the modern approach to supervision that is described as "solvency monitoring". It is becoming the universal approach and has replaced the former method of control of premiums. Supervisor's right to complete information. The legislation should make it clear that the supervisor has the right to complete access to information regarding the insurance business of a company. The supervisor should have the right to raise questions in writing or in person. If any information is withheld or denied, that should constitute automatic grounds for intervention in the company and withdrawal of its authority to carry on insurance business. Right to inspect. The law should also specify that the supervisor or his representative may at any time carry out an inspection of the books and records of the company at the premises of the company, without warning if the supervisor judges that to be appropriate. The law should also stipulate that the supervisor must cause such inspection to be carried out from time to time. For example, the law may state that the supervisor will carry out an inspection whenever he sees fit, but in no case shall such inspections be less frequent than once every three years. If the supervisor is denied access to the books and records of the company, that should also conistitute grounds for intervention and for automatic withdrawal of the authority to carry on an insurance business. Independent audit. The work of the supervisor will be largely based upon a review and analysis of the information presented by the company in its periodic statutory returns and the amounts entered into the books of account. It will not be possible, for practical reasons, for the supervisor to carry out a complete audit with all the detailed verification that implies, for every company under supervision. In fact, it is considered to be a waste of the supervisor's resources if a great deal of time is devoted to checking and verification of information filed. For this reason, it is the practice in most jurisdictions to rely upon the verification of these items by an independent auditor. The law could specify that each company must appoint a qualified auditor and that the supervisor should be notified of the appointment. The auditor would be obliged by law to report to the supervisor, as he does to the management, on the findings of the audit. In some jurisdictions, the auditor is now required to adopt a "whistle-blowing" role whereby he must make know to the supervisor any finding during the course of the audit that suggest that the financial condition of the company may be imperiled. This is particularly relevant when it comes to a planned course of action proposed or being considered by the management. The auditor becomes a private sector ally of the supervisor. Depending on the circumstances, the relationship between supervisor and auditor becomes a very positive force, based on mutual respect. The supervisor should have the right to reject an auditor's appointment if reputation or developments suggest that the auditor is not entitled to the confidence of the supervisor. H-4 Actuarial reports. The report of the actuary is essential for life insurance business. The actuary must comment upon the adequacy of the technical reserves established for long-term business. Also in the case of with-profits policies, the actuary will be expected to make a report on the plans for dividend distributions to policyholders. In some jurisdictions, an actuarial report on the adequacy of claim loss reserves under property/casualty business is also required. However this is still not a widespread practice. Our recommendation would be that there be no such requirement imposed as a general rule for Azerbaijan at this time. The supervisor could retain the right to require a special review of claims reserves, to be carried out by a qualified actuary, in any case where there is reason to doubt the adequacy of the reserves established. Intervention. The supervisor must be prepared to intervene when a company is not in compliance with the rules and is unwilling or incapable of rectifying the situation. For example, it is common to give a company some time to make up a shortfall in its capital. If the problem was not removed in the period specified, the supervisor would order the company to stop issuing new policies and to take control of the company's business. The supervisor would attempt to find another company to take over (100% reinsurance) the business in force of the troubled company. If such reinsurance is found, the business would be transferred along with the appropriate proportion of the company's assets. The remaining estate of the dormant company could then be turned over to the liquidators. Experience has shown that liquidation of an insurance company before all of its policies are transferred is a disaster for those persons with rights or expectations of any payment under their policies. The expenses of liquidation often consume all the assets of the company! In order to minimize the burden of this process on the supervisor's office, it would be advisable to provide the supervisor with the authority to retain an indepenidenit audit firm to act as his agent in the process of take-over, reinsurance and liquidation. It would be advisable if the expenses of this entire process be recoverable from the Qther companies still active in the industry by means of a special assessment. Sanctions. Experience has shown that the supervisor needs other tools beside outright intervention and take-over of a company. The rules should provide for the levying of fines for minor infractions and also for the possibility of temporary suspensions of the authority to write some or all of the types of business in the company's portfolio. Interim Measures In a perfect world, the supervisor would have prescribed the rules for financial reporting and there would be reason to have confidence in all the figures filed with the regulators by the companies. In the present circumstances, there may not be reason for such confidence. In order to arrive at the amount of available capital (or "net worth") for purposes of this test, one will have to rely upon the figures reported by the companies in their balance sheets. Since there may be doubt that these capital estimates are completely reliable, the conclusions of this preliminary study must be interpreted with great care. In any event, this test would provide a first screen regarding the capital position of the companies. Another very important test would be to look at the capital reported by the companies in light of the minimum amount that will be required to launch a new company. The proposal is to allow companies up to H-5 three years to meet the new requirements. Any company that does not appear at this tine to meet the minimum requirements could be asked to present a written proposal indicating what measures it proposes to take to get on-side. This proposal should include interim targets with monitor-able indicators of progress. Any company that fails to meet these capital tests and fails to supply a satisfactory response should be ordered to stop writing business. The most serious problem that will be faced is the method of dealing with the interests of policyholders of those companies that are deemed to have inadequate capital and where it has been decided that they must be ordered to stop writing business. The normal remedy for such situations is to have the supervisor take control of the business of the company and seek a reinsurer for its policies, unless the owners of the company can first arrange a merger with a stronger company. In summary, the first thing to do is to find a way to determine the degree of problems in the industry. The next thing in order of priority, would be to attempt to gain control of the financial reporting practices of the insurance industry, such that reliable information is being made available. Funding from external sources could perhaps be supplied to pay the cost of bringing experienced international experts to assist with the business of designing a summary of accounts and special statutory returns to be used by insurance companies in recording their transactions. The hope would be that after a year or so, more reliable data would be available from the returns filed by the companies and the supervisors would be in a position to make confident statements regarding the health of companies. During the course of the introduction of these measures, work could be progressing on the adoption of new legislation. Minimum capital standards and investment rules are key features that should be put into place as soon as possible. H-6 ANNEX I SUPERVISION OF PRIVATE PENSION SCHEMES Introduction Voluntary pension schemes could develop spontanieously, especially if workers and enterprises are not satisfied with the existing state program. As in OECD countries, private pension schemes should be regulated to protect the interests of contributors (especially employees in an employer-based program) and to ensure equitable and non-discriminatory treatment. Regulation is also needed -- in much the same way that governments regulate banks and insurance companies -- in order to protect the savings that consumers have entrusted to these institutions. Regulation should provide vesting and portability provisions as well as prudential, fiduciary, and custodial regulations. Legal and Regulatory Framework Setting up the needed regulatory framework will require the preparation and passage by Parliament of a framework law, and the creation of a supervisory agency empowered to enforce its provisions. The main task of the law should be to address the rules required to ensure that funds are managed prudently by competent institutions (Pension Fund Management Institutions or PFMIs). Moreover, the law should also give the regulatory agency sufficient enforcement powers, including: * granting and renewing of licenses for institutions seeking to manage pension funds; * monitoring compliance with the regulatory framework, including the minimum capital and reporting requirements and the investment portfolio limits; * reviewing the investment of pension fund assets; * conducting or ordering the conduct of inspections of the books and records of pension funds and management institutions to identify cases of non-compliance; and * assessing penalties and other sanctions, including withdrawal of authority for those management institutions found to be not in compliance where appropriate remedial actions is not taken. In order to minimize the direct costs of the supervisory agency, the pension plan will be expected to provide regular information returns at intervals to enable the supervisor to monitor its progress. In addition, regulatory reports showing assets owned by the plans will have to be filed with the supervisor accompanied by the report of a qualified auditor verifying the information contained in the reports. The supervisor should have the authority to order a pension plan to dispose of any asset that is not authorized. In addition, the supervisor should have the authority to order an independent evaluation of any asset that appears to be questionable and to order the company to use the value determined by the supervisor in any communication with plan members and with the general public. For reasons of economies of scale, it is recommended that the responsibility for supervision of pension plans be assigned to the same agency that will be charged with the supervision of insurance companies. In order to defray the costs of the supervisory body in adirninistering the laws and regulations applicable to pension plans, it is recommended that each plan must pay an aniual fee to the supervisory body. The fee should be established on the basis of estimated cost of supervisory activities. I-I The organization of the supervisory body typically requires at least the following functional groups: * Financial Division. This is in charge of ensuring compliance with all financial rules and regulations, including the maintenance of capital standards and respect for investment limitations. * Institutional Control Division. This is responsible for monitoring compliance with rules on advertising, information services to members, handlinlg of transfers between fund managers, limitation on commission and other expense charges. * Legal Advisor and Research Unit. These could be shared with the regulatory body for insurance companies, as would be the office of the chief executive officer of the agency. Most countries give tax advantages to contributions to encourage participation. This needs further study. Issues Wlho should be licensed to manage funds? At this time, only licensed financial intermediaries (insurance companies, licensed mutual funds, and banks) should be allowed to manage pension funds. Pension funds should not be managed by an employer. Financial intermediaries must set up a separate division, with separate financial assets, apart from the rest of their business in order to serve as a PFMI. They cannot mingle assets from other divisions. A legally established pension fund managed by a PFMI is a legal entity. Its assets are to be maintained and accounted for separately from those of a PFMI. Whlat should the minimum capital and reserve requirements be for a PFMI? Minimum capital and reserve requirements are needed to ensure that PFMIs have adequate resources to meet their fiduciary responsibilities and to meet any claims that may arise under the guarantees they provide. Minimum capital could also help meet any legal liability in the case of fraud or improper transactions. Finally, minimum capital will ensure that only those committed to the industry will establish themselves as PFMIs. An appropriate requirement would be that in order to be approved for participation as a PFMI, an insurance company or bank should have a minimum net worth that exceeds the minimum required for an insurance company or bank by at least $100,000. Failure to maintain this extra capital margin should result in forfeiture of the license to serve as a PFMI. At all times, the PFMIs must be required to have a special cash reserve of at least 1% of the value of the pension fund. This cash reserve may not be counted in satisfying the requirements for minimum capital. It is intended to cover those situations where the mi-nimnum return on investments of the pension fund falls below the specified minimum. Wlhere should the PFMI be allowed to invest the funds? Investment rules for pension plans should emphasize safety and profitability. A certain amount of diversification is required and maximum limits are imposed on portfolio shares in different types of investment instruments, as well as limits on investments in, or loans made to, specific users. Typically, pension plans are permitted greater latitude in investing in equities and real estate than are insurance 1-2 companies. This relates to the fact that the duration of liabilities of pension plans can generally be of much longer term than those of insurance companies, as well as the belief that the higher risk that is often perceived to exist in long term investment in equities is compensated for by the higher expected yields from such investments. In an immature market such as Azerbaijan, managers of asset portfolios for pension plans would not have a wide range of investment vehicles to choose from in the local market. It is likely that virtually all the initial investments would be in the form of bank deposits and, with the issuance of treasury bills, government debt securities. In the light of the situation, pension plans should be permitted to invest up to 10% of their assets in foreign securities. In order to provide the greatest latitude to fund managers, the investment regulations should focus primarily on quantitative tests that serve to prevent undue concentration by type of security and by issuer. However it will likely be necessary to provide some guidance by way of initial standards for quality in investments selected. For example, investments in securities should involve only listed and traded securities, since this will assist the fund manager to place an appropriate value on the holdings from time to time and also to ensure the liquidity of the portfolio. Especially in the initial period, care should be taken to ensure that the risk of conflict of interest is minimized. This should include the prohibition of related-party transactions. Further review is needed to determine the investment rules for PFMIs. Wlhat kind of disclosure requirements are needed? It is recommended that the administrator and manager of each pension plan establish a written investment policy for the plan. This will provide direction to the investment manager but will also serve as evidence to the plan members and to the regulator that the plan is investing appropriately having regard for its circumstances and also that it is in compliance with all the applicable laws and regulations. 1-3 ANNEX J 33 AZERBAIJAN -- SEIGNIORAGE AND INFLATION TAX Introduction The monetary authorities (the government and the central bank) can finance themselves by extracting resources from the public by means of creating base money. The authorities have to be careful, though, in deciding how much seigniorage they want to capture, as excessive base money creation will ultimately result in higher inflation, which will erode the real value of the seigniorage captured. The term inflation tax normally refers to the erosion of base money by inflation. Holders of base money (ultimately the public) will lose a portion of their stock of real wealth as part of their money holdings is taxed away by inflation. With relatively low rates of inflation, the authorities will be able to capture a certain level of seigniorage, as the public will remain willing to maintain a level of real money balances, despite the inflation tax. However, with high rates of inflation, the public will become reluctant to hold money denominated in local currency. They will seek ways to protect themselves from current and expected higher inflation rates by shifting into goods and foreign currencies. Thus, the base of the inflation tax will become smaller. To finance the same level of real expenditures the government will have to rely on an increasingly higher inflation tax to obtain the same real resources from seigniorage. Anyone who stays with the domestic currency will end up bearing a heavy inflation tax. Without a change in financial policies inflation will be bound to accelerate further, ultimately pushing the country in hyperinflation. Determining the size of seigniorage and the inflation tax Seigniorage is equal to the increase in base money: (1) S = AH where S is the amount of seigniorage and H is nominal stock of base money. The amount of real resources, S/P, which the authorities can extract by creating money can be determined in the following way, starting with Fisher's identity of exchange: (2) M6v = Pky or (3) Hkmkv = P6y where M is the nominal money stock, v is the velocity of money, P is the price level, y is real GDP, and m is the money multiplier (which is a function of the public's preference for cash relative to deposits, and the level of funds banks are required and/or willing to hold at the central bank). Differentiating equation (3) gives: (4) AH = AP)y/(mrv) + Ay&P/(mrn'v) - HtAv/v - HkAm/m with p = (Ap/p), y = (Ay/y), v = (Av/v), and mi = (Am/m) and with y/(rnkv) being equal to H/P, and P/(mrnv) to y/H, rearranging results in: (5) AH/P = pk&(H/P) + (y - v - m ) b ((H/P). The first part of the right- hand side of equation (5) is the inflation tax, T, which equals the product of the inflation rate (p) and real base money (H/P). The second part represents the demand for real money balances. Equation (5) shows that the authorities can extract more real resources from the public by raising the inflation tax. However, higher inflation will cause the public to move away from the domestic currency, resulting in a decline in the demand for real money balances and a higher velocity. This reduces the amount of real resources that can be captured. When the inflation rate is zero, revenue form the inflation tax is also zero. As inflation increases, the tax base--the demand for real money balances--goes down. Assuming a steady rate of inflation, there is a maximum amount of real 33 This note was prepared by the IMF European Department. resources S/Pmax the authorities can extract, with an inflation rate p max* Further increases in the rate of inflation bring about a drop in revenue, because the higher revenue from the inflation tax is more than offset by a fall in the demand for real money balances that are being taxed. However, the authorities may temporarily obtain resources higher than S/P,,ax, but at the cost of accelerating inflation. If the authorities persistently try to finance a deficit by creating money higher than S/Pnax , this will lead to hyperinflation. The inflation tax is often expressed as a percentage of real GDP: (6) T/y = p (H/P) /y Assuming that the GDP deflator and the consumer price deflator are equal, the result is the same if nominal base money and GDP are used. Seigniorage and inflation tax in Azerbaijan In Azerbaijan, during the period from 1992 until the end of 1994 the authorities were continuously extracting real resources from the public by creating money, in order to finance the public sector deficit. Given the relative inexperience of the public with high inflation, such an inflationary strategy was possible for some time. In the first half of 1993, with an average inflation tax of 25 percent of GDP, the amount of inflation tax was on average nearly 35% of GDP. However, as people developed their understanding of the inflationary process, they started to move away from the domestic currency in order to protect themselves from future inflation. Reflecting the declining confidence in the domestic currency, the velocity of Manat broad money tripled from mid-1993 to end-1994. Real money balances fell dramatically in late 1993 and in 1994 and shifted almost entirely to currency. The level of seigniorage that was captured by the authorities fell with it. As can be seen from the last quarter of 1993, the inflation tax had to be much higher than in the preceding quarters to still bring in an equal amount of resources. In 1994, with an average inflation tax nearly as high as in 1993, the amount of seigniorage that was captured nearly halved. At the end of 1994, real Manat balances had fallen by more than 80 percent since end-1992, while household and enterprise real deposit balances had fallen by more than 90 percent. Assuming that households hold most of the currency in circulation, households lost roughly 30 to 40 percent of their disposable income due to the inflation tax in 1993 and 1994. In early 1995, authorities dramatically changed their financial policies and reduced their reliance on inflationary financing. Inflation come down rapidly, and with it the inflation tax. This lead to a gradual recovery of the public's confidence in the domestic currency. Reflecting the public's growing willingness to hold Manat balances, the velocity of Manat broad money started to decline and real Manat balances began to increase. As a result of the increasing willingness to hold manatees, the level of seigniorage that could be captured in the first three quarters of 1995--on average 6.3 percent of GDP-- was actually higher than the inflation tax, whicih declined to an average of 3.8 percent of GDP. With a significant fall in inflation, if is estimated that only 3-5 percent of households' disposable income will be taxed away by the inflation tax in 1995. Experience in other countries Other countries in the region also used to rely heavily on inflationary financing of the budget, causing accelerating inflation and a loss confidence in the domestic currency. As a result, the amounts of seigniorage captured did not keep up with the inflation tax. An extreme example is Georgia, where the data for the past few years suggest a relatively modest inflation tax, compared to other countries. However, hyperinfaltion fueled by excessive monetary expansion sharply reduced the real demand for the Georgian coupon. Consequently , the authorities' ability to extract seigniorage dwindled. With less reliance on inflationary financinig, inflation rates have come down recently in these countries, resulting in a decline of the inflation tax, while--as confidence is gradually restored--the decline in the amounts of seigniorage that the authorities were able to capture was much lower. Figure 1: Azerbaijan Seigniorage and Inflation Tax Real Seigniorage s/Pms S/ n.. . .. .. .. .. . .. .z . A Inflation Pnux Table 1. Azerbaijan: Seigniorage and inflation tax (in million of Manat. unless indicated otherwise) 1992 1993 1994 1995 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3~ Manat base money 3,5 19 9,401 18.034 20,910 43,507 70,784 118,568 203,566 323,132 455,550 570,042 695,700 Seigniorage in Manat (quarterly) 5.882 8,633 2,876 22.597 27,277 47,784 84,998 119,566 132,420 114,490 125,658 Seigniorage in % of quarterly GDP 39.1 31.8 5.0 35.2 18.4 15.8 18.5 10.2 6.6 5.7 6.6 Inflation tax in Manat (quarterly) 3,472 7,346 7,965 36,211 48.671 74,596 44,676 437,950 153,066 42,230 30,178 Inflation tax in %of quarterly GDP 23.1 27.1 13.9 56.5 32.8 24.7 9.7 37.5 7.7 2.1 1.6 Real base money (index Dec 1992 = 100) 100.0 134.5 144.8 1,16.5 88.7 68.1 55.6 69.3 34.9 33.4 38.2 44.3 Manat broad money 9,358 14.817 29,348 40,397 73,541 111,622 161,095 264,162 431,036 580,179 750,155 863,480 CUrreuC\ outside banks 2,722 6,611 14.391 18,835 43.187 59,716 103,296 172,080 276,127 366,109 460,933 545,849 Nlaiat deposits 6.644 8,206 14,957 21,562 30,354 51,907 57,798 92,082 154,910 214,070 289,222 371,631 In-iterprise deposits 4,812 6,243 13,500 17.956 24,083 42,947 46,656 68,380 115,587 141,442 203,003 Ilousehold deposits l,824 1,963 1,457 3,606 6.270 8,960 11,142 23,702 39,323 72,628 86,219 Real Maniat broad moniey (index Dec 1992 - 100) 100.0 79.7 88.6 84.6 56.4 40.4 28.4 33.8 17.5 16.0 18.9 20.7 Real Maniat deposits (index Dec 1992 - 100) 100.0 62.2 93.6 63.6 32.8 26.5 14.3 16.6 8.9 8.3 10.3 10.7 Real enterprise deposits (index Dec 1992 = 100) 100.0 65.3 79.3 73.1 35.9 30.2 16.0 17.0 9.1 7.6 10.1 Real household deposits (ildcx Dec 1992 = 100) 100.0 54.2 22.6 38.7 24.7 16.6 10.1 15.6 8.2 10.3 11.2 Mcmiorandum items Nominh1al GDP (quarterls) Itillation (percenit. quarterly) 13,657 15.056 27,157 57,466 6,413 148,294 302,546 458,262 1.169,121 1.995,000 2,009,296 1,907,011 lilflatioi (iidcx Dec 1992 - 100) 133.4 98.7 78.1 44.2 173.2 111.9 105.4 37.7 215.1 47.4 9.3 5.3 V .latv (i.nde Dee 1992 .100) 100.0 198.7 353.9 510.2 1,393.8 2,953.1 6,065.1 8,350.4 26,315.5 38,781.1 42,376.0 44,619.4 MaVlat noiteo mnultiplier (ratio atio) 4.98 4.92 6.59 4.50 6.41 8.88 8.62 13.45 15.78 12.08 9.45 M .nat money multiplier (ratio) 2.66 1.58 1.63 1.93 1.69 1.58 1.36 1.30 1.33 1.27 1.32 1.24 Sourcc: A7crbaijan Nationial Bank. Azerbaijan State Committee of Statistics; and IMF staff estimates. Nialnat broad moniey anid GDP figures are estimates Table 2: Inflation tax and seigniorage in selected countries (in percent of nominal GDP) 1992 1993 1994 1995' Inflation Tax Seigniorage Inflation Tax Seigniorage Inflation I'ax Seigniorage - Inflation Tax Seigniorage Azerbaijan --- --- 28 24 37 13 5 6 Georgia --- 27 9 10 5 I I Arnmenia 265 38 15 7 14 7 Ukrainie --- --- 40 17 10 II 15 6 Russia 22 12 12 9 5 5 6 4 Source: IMF staff calculations. 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