78440 CONFIDENTIAL SecM200 l-0300 May 7,200l FROM: Vice President and Secretary Armenia: Financial Sector Assessment Attached, for your information, is the Financial Sector Assessment (FSA) for Armenia based on the joint IMF-World Bank Financial Sector Assessment Program (FSAP). Questions on this document should be referred to Mr. Slough (ext. 33010) or Ms. O’Connor (ext. 385 13). Distribution: Executive Directors and Alternates President Bank Group Senior Management Vice Presidents, Bank, IFC and MIGA This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CONFIDENTIAL For Restricted Use Only (Not for Use by Third Parties) FINANCIAL SECTOR ASSESSMENT: ARMENIA MAY 200 1 EUROPE AND CENTRAL ASIA REGION VICE PRESIDENCY FINANCIAL SECTORVICE PRESIDENCY BASED ON THE JOINT IMF-WORLD BANK FINANCIAL SECTORASSESSMENTPROGRAM BACKGROUND 1. As part of the joint World Bank-IMF Financial Sector Assessment Program (FSAP) two missions visited Armenia, one in August 2000, and another, larger mission from September 6 to 22,200O.l The missions focused on three broad areas: (i) the Armenian financial system’s short- term stability and its resilience to shocks; (ii) progress in meeting international standards and good practices in the regulation, supervision, and transparency of the financial system; and (iii) key medium-term and developmental issues in the financial system. The mission produced a number of reports that were reviewed by and delivered to the authorities.2 2. During the IMF Article IV mission in late January 200 1, discussions were held with the Armenian authorities on the main conclusions of the assessment. During those discussions the authorities requested help from the Bank and the IMF to facilitate the implementation of several recommendations,3 notably those regarding the strengthening of the legislative basis for CBA’s ’ The FSAP team was led by Mr. Ame Petersen (IMF, MAE - Mission Head) and Mr. Martin Slough (World Bank, ECSPF) - Deputy Mission Head). The team comprised Messrs. Alex Fleming, Noritaka Akamatsu, Gregorio Impavido, Charlie Garrigues, Peter Kyle, Yuri Boutaev (all World Bank); Messrs. Rogerio Zandamela and Thordur Olafsson and Ms. Priya Basu, Ms. Aliona Cebotari, and Ms. Joanna Meza-Cuadra (staff assistant) (all IMF-MAE); Mr. Clinton Shiells (IMF-EUZ); and Mr. Jan Rein Pruntel (Netherlands Bank). The mission was assisted in the field by Messrs. Garbis Iradian (IMF Resident Representative, Armenia) and Owaise Saadat (Manager, World Bank Office in Yerevan). * The September mission left a detailed Aide-Memoire. The team also prepared an FSAP report comprising three volumes: Volume I - the Main FSAP Report based on the Aide Memoire, Volume II - Background Information, and Volume III - Compliance with Standards and Codes. 3 The authorities reportedly found the FSAP valuable because it incorporated both institutional and macroeconomic factors and provided a comprehensive overview of not only the banking sector, but non-bank sectors as well such as (continued...) -2- enforcement powers, the creation of a retail payments system and the development of the infrastructure for the capital market. A small technical assistance program is presently being undertaken to respond to this request. STRATEGIC ASSESSMENT 3. The Armenian financial system is quite small, with the assets of the banking system (by far the largest component) accounting for only 15 percent of GDP. The whole financial system is vulnerable to several potential internal and external macroeconomic shocks, but a systemic crisis would have a limited effect on the rest of the economy given the sector’s present small size. However, unless the financial infrastructure is strengthened, the financial system will fail to deliver the growth-generating financial services that Armenia urgently needs. Furthermore, there is quite a high likelihood that weaknesses in the banking system would be sharply worsened by, and in turn could exacerbate, any macroeconomic crisis that might be caused by external or internal shocks. 4. The banking sector has not yet reached the level of consolidation and sophistication of the more advanced transition economies, and intermediation costs are high. This stems in part from, and contributes to, a lack of bankable projects able to service the high lending costs, a typical development trap in transition economies. Furthermore, the credit culture is generally weak. Further consolidation, enhanced resource mobilization, and increased efficiency of banks are required to allow successful banks to exploit economies of scale. This will need to be supported by a prompt exit strategy for failed banks. 5. While the data reported monthly by the Armenian banks to the CBA point to a relatively healthy financial system4 in aggregate and satisfactory growth during the last five years (see Table 1 below), the data must be interpreted with caution because of serious shortcomings in regulatory reporting, and the underlying situation contains severe weaknesses and vulnerabilities. Weaknesses relate especially to credit and foreign exchange risks owing to an under-developed credit culture, a fragile enterprise sector, inadequate risk identification, insufficiently rigorous monitoring and management practices, and large foreign currency exposure to borrowers without export earnings. The fragility of the loan portfolio of banks has been highlighted recently by the temporary slowdown in economic growth that occurred in late 1999 and early 2000, the sharp downturn in the real estate market, which has called into question the value of collateral, and the steep fall in interest rates, which has reduced banks’ income from Government securities. Unaudited financial statements for the year ending insurance, pensions and capital markets. The authorities also indicated that they have incorporated many of the recommendations into the work programs of the CBA, the Securities Commission and the Government. 4 In mid-2000, the reported ratio of total capital to risk weighted assets amounted to 26 percent and classified loans amounted to only 6 percent of banks’ portfolio. 2 -3- 12/3 l/2000 indicate that the banking system in aggregate registered only a small after-tax profit,5 and the number of banks failing to meet capital adequacy increased from three to seven. Moreover, a major bank, which had looked sound according to its audited 1999 financial statements, was found to be illiquid and insolvent. Finally, the high real rates of interest being paid by borrowers place stress on loan portfolio quality, since few projects can achieve such sufficiently high real rates of return to repay debt, unless the high cost of bank borrowing is substantially diluted by shareholders’ equity. Table 1. Selected Annual Indicators: Commercial Banks l/ Balance sheet items as of end of the 1995 1996 1997 1998 1999 Hl 2000 period Total Assets (in million. AMD) 42,324 69,327 108,575 162,143 194,128 225,773 (in million US$) 105.3 159.3 219.3 310.6 370.6 412.1 Total Capital (in million. AMD) 7,983 10,674 17,371 26,375 33,048 34,182 (in million US$) 19.9 24.5 35.1 50.5 63.1 62.4 After-tax Profits/Losses (in million 3,705 (886) (101) 2,377 4,496 (264) AMD) (in million US$) 9.2 (2.0) to4 4.6 8.6 (O-5) Exchange Rate AMDAJS$ 402 435.1 495.0 522.0 523.8 547.9 Source: Central Bank of Armenia and staff estimates. 6. The results of the stress tests show that the banking system is significantly exposed to a combination of credit and foreign exchange rate risks, but only moderately exposed to interest rate risks. However, the stress tests on banks must be interpreted with more than usual care in view of the data deficiencies noted above. The potential sensitivity to foreign exchange risks arises mainly from banks’ lending in dollars to domestic borrowers without export earnings and/or without revenues implicitly indexed to changes in the exchange rate. Consequently an exchange rate shock with a resultant significant secondary impact on the quahty of the loan portfolio would likely jeopardize the capital position of the banking system as a whole. Overall the system needs to be better capitalized and further consolidated to better withstand shocks to the quality of the loan portfolio, fluctuations in interest rates and/or sudden withdrawals of deposits. 7. The legal framework governing the financial sector in Armenia is reasonably sound and comprehensive, but decisions by the CBA to withdraw banking licenses and/or to initiate bankruptcy proceedings against banks have been successfully appealed in the ’ Indeed, even the small aggregate surplus for the banking system in 2000 was only achieved by dint of the good profits recorded by one large foreign bank, whose positive result slightly exceeded the aggregate loss of all the other 26 banks operating in Armenia. Among the latter group only a few banks achieved satisfactory results. -4- courts6 Therefore, it is apparent that although the Law on the Central Bank of Armenia and the Law on Banks and Banking both work fairly well, they should be improved, especially to strengthen the CBA’s enforcement powers to take remedial action to handle troubled banks without undue interference by the courts. In this regard appropriate amendments to the Law on Bankruptcy of Banks were approved by the Board of the CBA in March 2001 and sent to the Government of Armenia for review and submission to the Parliament. Significant work is also required to ensure consistency of financial sector legislation with the new Civil Code, which came into force in 1999. In addition, the legal and administrative procedures for enforcement of collateral (both foreclosure and subsequent sale by auction) need to be strengthened. Transparency in monetary and financial policies is generally good, although the very strong secrecy provisions of the Central Bank Law should be reviewed to ensure that they do not unintentionally provide a shield for money laundering activities. 8. The authorities have agreed that the Law on Joint-Stock Companies should he replaced as soon as possible, and supplemented by a Law on Limited Liability Companies. The amended law would address several key weaknesses, notably those relating to: (i) shareholder participation at the shareholders’ meeting: (ii) approval of large transactions by the Supervisory Board; (iii) approval of the auditor by the Supervisory Board; and (iv) new issues of shares. In addition the current statutory prohibition of debt for equity swaps will likely be repealed. Although the Law on Bankruptcy is generally well-regarded, there are shortcomings that will be addressed by amendments presently being drafted. A new Law on the Bankruptcy of Insurance Companies is also being drafted. Finally, to promote the development of the leasing industry, a Leasing Law needs to be enacted to allow speedy and efficient repossession of leased assets after default by the lessee. 9. Many of the Base1 Core Principles are largely complied with, but banking supervision needs to be strengthened to bring it more closely into line with international standards. There is an excessive reliance on adherence to formal rules and procedures, which should be supplemented by more judgment, especially by the on-site inspection teams, in order to achieve a better qualitative picture of banks undergoing inspection. Valuation methodologies used by banks need strengthening, particularly with regard to loans and collateral. This should be reinforced by improvements in the prudential rules for portfolio classification and loan loss provisioning. Much tighter regulations were approved by the CBA Board in March 200 1, but these have to be agreed by the Ministry of Economy and Finance (MFE) owing to the tax deductibility of specific loan loss provisions. 10. Other parts of the financial sector are relatively undeveloped. The securities market is small and thin. Supervisory authority was granted to an independent Securities Commission under a new Securities Law adopted in mid-2000, and a new centralized trading platform, the 6 In at least two cases, because such appeals against the CBA have been upheld by the presiding judge, the CBA has been prevented from taking further necessary action during a lengthy “rehabilitation� period established by the court. -5- Armenian Stock Exchange (Armex) was officially inaugurated in March, 2001, as a Self- Regulatory Organization (SRO). Systemic risks emanating from the insurance sector are negligible, given the small size of the sector (total assets US$5 million as of end-1999). Insurance companies are generally under-capitalized and under-reserved: there is a need for consolidation in the market. The Insurance Inspectorate is understaffed and under-funded, and its supervisory practices need to be strengthened to bring overall supervision in line with international standards. The pensions system in Armenia is also at a very early stage of development. Pensions are provided through a compulsory “pay-as-you-go� (PAYG), defined benefits, and state-managed system (“first pillar�). A strategy paper for reforming the state pension system prepared with World Bank assistance has recently been approved by the Social Security Ministry. The payments system is functioning relatively well and significant further modifications under consideration will take the system close to full compliance with the CPSS core principles. In all the above areas, the Bank is maintaining a close dialogue with the authorities to identify and implement appropriately targeted technical assistance. THEMACROECONOMICCONTEXT 11. Armenia continues to face a number of macroeconomic risks, but economic activity picked up in mid-2000, and real GDP grew by 6 percent in 2000, despite a severe drought during the summer that adversely affected most of the agricultural sector. Armenia is incurring a large, though declining, current account deficit (20 percent of GDP in 2000), financed mainly by remittances from the diaspora, official transfers, and official capital inflows. Exports grew by 15 percent in 2000, mainly owing to higher re-exports of polished diamonds and a recovery in mining and food processing exports. Foreign direct investment and private remittances remained stable in 2000 at about 6 percent and 8 percent of GDP respectively. While fluctuations in remittances and direct foreign investment have contributed to vulnerability, there has been little short-term borrowing. External debt stood at US$ 862 million at end-2000, which is modest in terms of the size of the economy (45 percent of GDP), although high relative to export revenues (195 percent).7 12. Inflation pressures have been virtually absent since the last quarter of 1998, and the CPI fell by 0.8 percent during 2000. The CBA contributed to the low inflationary out-turn by following a cautious monetary policy. Interest rates on three-month treasury bills fell back from around 50 percent at end-1999 to below 20 percent in May 2000, but have edged back up to around 25 percent in recent auctions. The exchange rate has remained broadly stable without significant CBA intervention, the dram depreciating by only 5 percent against the U.S. dollar during 2000. Fiscal performance has been disappointing over the past two years, reflecting mainly a slump in government revenues, only partially offset by cuts in spending. The stock of general government expenditure arrears, including carry-over, reached a total of 7 Armenia’s exports of goods and services were US$44 1 million in 2000. -6- AMD 54.5 billion by end-September, 2000 equivalent to 5.3 percent of GDP, but a modest improvement in revenue performance occurred during the last quarter of 2000. 13. In general, the Armenian economy faces a number of risks, including those related to macroeconomic instability, the high dollarization of the economy, and governance. The improved macroeconomic performance has reduced overall instability, but delays in addressing the weaknesses in the public finances could unravel the gains achieved on the macroeconomic front and indirectly cause banks’ portfolios to deteriorate. Increased dollarization has rendered the Armenian economy vulnerable, directly or indirectly, to significant exchange rate risk. In this context, for lack of alternatives, Armenian banks have relied heavily on deposits and credit lines in foreign currency to fund their operations or to make loans. Many of the banks’ loans have been made to domestic borrowers unable to hedge their exposure with either export earnings or revenues implicitly index-linked to changes in the exchange rate parity through the pricing mechanism. NEAR-TERM VULNERABILITIES IN THE FINANCIAL SECTOR Monetary Policy 14. The conduct of monetary policy is complicated by the variability of disbursements of loans and grants from international financial institutions and the attendant fluctuations in government spending. At the same time, the scope for an active monetary policy is limited by the high degree of dollarization and the low level of monetization in Armenia. Nevertheless, the CBA has succeeded in maintaining price stability, and the exchange rate has also been remarkably stable, even following the Russian crisis and the political instability in October 1999. Starting in 1999, the CBA announced a policy of maintaining base money within a corridor, using a well-defined set of instruments with which to smooth liquidity and implement monetary policy. It uses open market sales and purchases of government securities to manage longer-term trends in banking system liquidity, together with repo and reverse repo facilities. Yields on treasury bills have fallen substantially since end-1999, from about 50 percent in December 1999 to 20-25 percent in the second half of 2000. The CBA maintains a floating exchange rate policy but engages in limited exchange market intervention in order to smooth out significant exchange rate fluctuations that are expected to be temporary. The foreign exchange market in Armenia is liberal, reflecting open current and capital accounts. Transparency in Monetary and Financial Policies 15. In general, financial agencies in Armenia are transparent in their conduct of financial policies. The CBA fully observes virtually all the transparency practices in monetary policy, supervision of banks and oversight of the payments system, as defined in the Code. There are only 6 practices that are only partially observed, and there is no transparency practice that is not observed. The Insurance Inspectorate (INSI) and the Securities Commission (SC) are largely transparent in most important areas of the Code. However, coordination and information sharing among the various regulatory agencies could be improved. Banking System -7- 16. Considering the limited demand for banking services, further consolidation is needed to ensure the sustained profitability, efficiency and financial strength of the banking system. The number of Armenian banks has fallen from 74 in early 1996 to 30 licensed commercial banks (of which only 27 are operating) as of March 2001, including five branches / subsidiaries of foreign banks and one state-owned bank (Armenian Savings Bank), but a further reduction in the number of banks is likely to occur. Foreign participation in the banking system reached 45 percent of aggregate banks’ shareholders’ equity in 2000, but with one key exception, foreign investors are mainly Armenian expatriate individuals. 17. While reported data’ for the Armenian banking system point to a relatively healthy financial system, there are serious shortcomings in the regulatory reporting and supervisory practices that need to be taken into account in interpreting such data. The gradual increases in the minimum capital requirement have helped increase the reported capital adequacy ratio for the banking system from 22 percent in 1995 to 26 percent in mid-2000, which is significantly above the minimum required of 12 percent. Reported non-performing loans have declined considerably since 1995 and have remained relatively low over the past two years in the range of 6-8 percent of total loans. Provisioning has increased from virtually zero before 1996 to about 66 percent of classified loans in mid-2000. However, the implementation of tougher loan classification and loan loss provisioning regulations to be introduced by the CBA during 2001 will result in a substantial further increase in specific loan loss provisioning which will also have a negative impact on banks’ capital adequacy ratios. In this regard, a closer convergence between the banks’ financial condition as reported to the CBA and their annual IAS audits may be expected in the years ahead. 18. Most banks appear to have adequate liquidity, reflecting large placements with correspondent banks and investments in government securities in the absence of sufficient profitable lending opportunities elsewhere in the economy. The risk of default by the government in meeting its obligation with respect to Treasury bills is judged to be low. Due to the very short maturity of both assets and liabilities (three months, on average), banks also have sufficient current liquidity to meet their demand liabilities. 19. Despite improvements in the underlying picture of the banking system over time, there remain major shortcomings of regulatory reporting and supervisory practices that have resulted in an overstatement of the quality of banks’ assets, the adequacy of their provisioning and, consequently, their financial strength. These include: (i) undue reliance on often inflated collateral for lending decisions; (ii) poor loan classification practices based solely on past performance and collateral, rather than on borrowers’ ability to service loans; (iii) lending in foreign currency to borrowers without access to foreign currency earnings; (iv) widespread ’ This refers to the financial data reported monthly to the CBA by the commercial banks and the prudential ratios derived from that data. However year-end financial statements for most banks audited externally have customarily indicated the need for additional provisioning and other adjustments to meet International Accounting Standards (IAS). -8- rolling-over of overdue loans to same or third parties; and (v) non-transparencies in financial reporting and practices of enterprises. 20. Although CBA’s loan classification guidelines permit and indeed encourage banks to use subjective judgment on a case-by-case basis to evaluate the creditworthiness of their borrowers, many banks continue to classify loans based solely on the quantitative rules set out by the CBA, driven in some cases by a desire to show better results than are really warranted. These quantitative rules use payment history and quality of collateral as virtually the only determinants of the quality of a loan, and hence of the degree of provisioning, excluding factors related to borrower creditworthiness. Consequently, the reported data likely overstates the quality of bank loans and may leave banks seriously under-provisioned. Moreover, loan classification rules appear to be insufficiently stringent for a transition economy, especially with respect to the number of days overdue allowed for each category. 21. Most bank lending is carried out against real estate collateral, for which the market is weak, a properly regulated auction system lacking and the judicial system for enforcement slow and inefficient. Banks also find it hard to mark collateral to market in the absence of a well-established appraisal framework. Considerable procedural amendments to the legislation will be required in order to create an appropriate environment for secured lending. Banks are reluctant to initiate ordinary court procedures to collect their collateralized claims because of the slow process, preferring to enter into negotiations with borrowers to take over collateral in out of court settlements, even if losses are incurred. In the case of real estate, the cadastral system and real estate register have received extensive foreign assistance and are considered reasonably satisfactory. However, the day-to-day operation of the register is subject to bureaucratic delays. All real estate auctions must be conducted by the Department for the Enforcement of Judgments pursuant to a temporary Government decree, but a Law on Public Auctions is needed. For moveable property, such as vehicles, equipment, inventory, bonds and shares, it is strongly recommended that a register be established to record prior encumbrances 22. In a highly dollarized environment, foreign currency lending to borrowers without access to foreign currency earnings or FX-indexed revenues may seriously understate the risk exposure of the banks and overstate their capital adequacy. Many banks are highly dependent upon on-lending medium term donor funds, suggesting that donor lending programs should be modified to require accredited banks to make parallel contributions from their own funds. Another weakness is the practice of rolling over loans to the same or third parties, accounting for over 11 percent of gross loans. 23. An accurate evaluation of the quality of banks’ loan portfolios is seriously hampered by the non-transparent financial accounting rules and practices of enterprises. Unlike banks, most enterprises have not yet adopted the new accounting standards, which makes the assessment of the financial position of borrowers more difficult for banks and inhibits lending to the real sector. Enterprises are currently passing through a three-year period of conversion to IAS-compliant Armenian Accounting Standards (AAS). In theory the transition to AAS is due to end in 2002, but in practice the conversion period is likely to be longer. -9- Regulatory and Supervisory Framework and Compliance with Base1 Core principles 24. The regulatory and supervisory functions of the CBA are vested in the Banking Supervision Department (BSD), most of whose staff have good qualifications and receive regular training. Bank supervisors appear to be respected by the banks for their professionalism and integrity. CBA’s supervision is financed by the CBA’s normal budget process. The BSD has adequate information technology and training resources, which include some training abroad. Salaries are generally lower than in the commercial banks but substantially higher than in the civil service sector. 25. The CBA and the MFE issue jointly accounting norms and standards for banks, which are broadly compliant with IAS. A Decree on the Approval of Auditing Activities, Regulations and Licensing Procedures has recently been issued. The Accounting Methodology Department of the MFE is empowered to issue licenses to auditors who wish to practice as public auditors or chief accountants of open joint-stock companies. The MFE has yet to issue any general standards or guidelines on auditing, but special provisions for auditing of banks are contained in the banking laws and CBA regulations. The MFE is presently re-licensing auditors to undertake IAS audits of enterprises and banks. This re-licensing process is being conducted by MFE in a diligent manner, based on interviews and written examinations. 26. Guided by the Core Principles for Effective Banking Supervision that were issued by the Base1 Committee, several measures have been taken by the Armenian authorities to improve the quality of banking regulation and supervision in order to comply with international standards. However, one particular weakness of the Armenian supervisory system is its excessive reliance simply upon adherence to rules and procedures. Admittedly, an effective system of banking regulation and supervision cannot do without objective rules, but it should be recognized that not all aspects of banking can be captured by such rules. Therefore, the supervisory authority should have sufficient flexibility to make decisions at its discretion, based on its technical expertise and professional judgment. 27. Most prominent among the weaknesses that have been identified is the inadequacy of the authority of the CBA to follow up on conclusions it has reached during the supervisory process. Too many of its decisions are subject to court appeal or, in some cases, approval by the board of the bank concerned. The Code of Penalties does not appear to provide an effective deterrent against infractions of prudential norms. On many occasions, banks have chosen to pay the fine instead of correcting the infraction. There is currently no CBA regulation on internal controls in banks. The quality of banking supervision would benefit from a closer working relationship with the internal audit departments of banks who should be required to make available their reports. Market Discipline, Exit Strategy, and Lender of Last Resort Issues 28. As previously noted, the CBA’s position in the case of bank failures needs to be strengthened. Decisions to withdraw a banking license or to initiate bankruptcy proceedings against a bank can be appealed to the courts. The result is that great difficulty has recently been experienced in terminating the operations of insolvent banks. A further weakness is that when the 9 -lO- CBA appoints an administrator for a troubled bank, it usually chooses an executive director of the bank concerned. This is an undesirable practice and introduces an inherent conflict of interest since executive directors must normally be considered responsible for the fact that the bank has become mired in difficulties in the first place. 29. The Law on the Central Bank states that, in exceptional cases, in its role as lender of last resort, the CBA may provide unsecured or only partially secured loans to banks in order to secure the stability of the financial system. It is important that the CBA exercise restraint in this area, acting as a lender of last resort on an unsecured basis only when a bank is experiencing a temporary liquidity problem. Rescuing insolvent banks should not be contemplated since this would undermine market discipline and could cost excessive amounts of taxpayers’ money. MEDIUM TERM VULNERABILITIES IN THE FINANCIAL SECTOR Regulatory framework for the payments system, capital markets, insurance and pensions 30. Inter-bank payments transactions processed by the two paper-based systems (net and gross) are progressively shifting to a real-time gross settlement system (RTGS). However, there is a risk of overloading the RTGS. Therefore, CBA is studying a new infrastructure based on three major systems: (i) a new central bank accounting system, (ii) an upgrade of the functions of the RTGS, and (iii) the creation of an Electronic Net Clearing System for low value transactions. The legal main issues still to be addressed are: (i) finality of payment, particularly in case of bankruptcy; (ii) consumer protection; and (iii) the legal framework for electronic payment instruments (especially plastic cards). The commitment of commercial banks needs to be strengthened at the highest levels of management. It is recommended that a “Payments Council� be created with a mandate to draw up a long-term vision of Armenia’s payments system infrastructure. 31. The new Securities Market Regulation (SMR) Law provides adequate regulation of the securities market and established the Securities Commission as an independent regulatory authority with adequate enforcement powers. However, compliance with the IOSCO Principles can only be meaningfully assessed after the Commission becomes reasonably operational and the reshaping of the market architecture and the securities industry has taken place. Also, the required legal framework to regulate collective investment schemes and asset managers is not included in the Law and will have to be separately issued. The Central Depository of Armenia (CDA) is now functioning only as a central registry and is developing a system of dematerialization of securities which is to be achieved within one year. However, CDA’s system and functions need to be upgraded to become the integrated central depository, registrar, and clearing house as required by the SMR Law. 32. The systemic risk of the insurance market is negligible given its small size. The Insurance Inspectorate of the MFE supervises Armenia’s 25 insurance companies, 8 of which do not write premiums. Nevertheless, minimum capital requirements are too low and should be 10 -ll- increased in stages to at least the equivalent of US$500,000 for non-life insurance companies and US$750,000 to US$l ,OOO,OOO for life insurance companies. 33. Modest pensions are provided through a compulsory ‘pay-as-you-go’ (PAYG), defined benefit, and state managed first pillar. The Social Security Ministry has recently approved a strategy paper for reforming the state pension system, but these reforms do not yet foresee funding of pension liabilities in the financial markets. In the medium to longer term, it will be desirable for private pension plans to be developed, involving greater latitude in investment choices, at which time the attendant vulnerability of such plans to shocks in the financial sector will have to be addressed. . LONG TERM VULNERABILITIES Developmental Issues for the Financial Sector 34. Despite the progress of recent years, the Armenian financial sector remains at an early stage of development. This is due to two key issues: (1) a lack of depth in the financial sector, as measured by the low ratio of bank deposits to GDP, the high ratio of cash in circulation to bank deposits and the low level of average bank deposits per head of population, and (2) a lack of diversification in financial instruments and products. 35. Armenia’s economy is very retail-based, which explains the cash orientation of transactions. There are three other reasons why much financial activity takes place outside the formal financial system: (i) the prevalence of non-payments mechanisms that undermine the development of the formal financial sector; (ii) limitations on access to formal financing by small and medium enterprises; and (iii) the slow pace of banking sector consolidation. 36. Non-payments crowd out conventional banking by providing large amounts of cheap and wholly unregulated alternatives to the more conventional payment and credit arrangements through banks. The evidence in Armenia is that while barter is limited, tax and wage arrears appear to be significant, and delays in payments to utilities are also not uncommon, especially by state-owned enterprises. Armenia has not experienced the acute problems of non- payment that have afflicted some other CIS countries, but non-payments continue to undermine the formal financial sector in Armenia and contribute to its lack of depth. 37. In addition banks’ administrative costs are high and the planned increases in minimum capital requirements may cause the failure of some small banks. The weighted average operating costs for the Armenian banking sector were around 16 percent of total income- earning assets in 1998, and for nearly a third of banks, operating costs exceeded 25 percent. By contrast, in middle-income transition economies, operating costs are generally about 5 percent, and in a developed market economy, operating costs would be under 2 percent of income-earning assets. The high operating costs reduce the funds available to build capital. With the increases in capital requirements, surviving banks may prefer to attract the best clients (“cherry picking�) of the failed banks rather than to absorb the staff and portfolio of the failed banks. 11 - 12- 38. To better support SMEs, micro-enterprises and poorer households, the impediments to the development of new institutions and instruments should be removed. Leasing, for instance, can stimulate the development of the SME sector as it can often be arranged more quickly and simply than loan financing. The lessor focuses on the lessee’s ability to generate sufficient cash flow to service the lease payments and on the security provided by its ownership of the leased equipment, rather than relying on the lessee’s credit history, assets, or capital base. 39. Similarly credit unions and credit cooperatives are often important in transition economies and should be developed. These typically take deposits from and provide small loans to households or micro-enterprises that are signed up as members. However, it is crucial that an appropriate legal and regulatory framework be developed, including adequate safeguards to enable appropriate oversight either by a separate agency and/or by the Supervision Department of the CBA. KEY POLICY PRIORITIES FOR THE FINANCIAL SECTOR 40. The mission presented ten key recommendations for the Armenian financial sector in four broad areas: Institutional and legal framework for banking activities 1. Enact a new Law on the Bankruptcy of Banks to enhance the ability of the CBA to deal adequately with insolvent banks. 2. Modify the CBA Law to enhance the CBA’s authority to require implementation of remedial action and strengthen penalty provisions. Banking regulations and procedures 3. Increase minimum capital requirements for existing banks (presently at US$l million) in stages to the same level as new banks (US$5 million) by June 30,2005. 4. Revise the present loan classification system used by banks and the CBA to require more reliance by banks on an assessment of a borrower’s ability to service its debts. 5. Strengthen valuation methodologies on loans and collateral and introduce new provisioning rules, consistent with international best practices, yet better tailored to the high risks prevailing in the Armenian economy. 6. Introduce a new “watch� category to the loan classifications system and provision for loans in this category by 10 percent. 7. Issue guidelines to measure and manage credit, foreign exchange, interest rate and liquidity risks, drawing on the Base1 Committee Principles on Banking Supervision. Overall financial sector infrastructure 8. Create a Payments Council, with representatives from all major stakeholders, to develop a long term vision and implementation system for the payments system. Non-bank financial sub-sectors 12 - 13 - 9. Raise the minimum capital requirements for insurance companies in stages to US$ 500,000 for non-life companies and US$750,000 for life companies. 10. Develop an appropriate legal and regulatory framework for leasing, in order to support better the development of the SME sector. 13