TRADE, FINANCE AND INVESTMENT COMPETITIVENESS iStock Naypong FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Readiness for Resolving Nonperforming Loans in Central Asia Emiko Todoroki Ismael Ahmad Fontan Fernando Dancausa Maksym Iavorskyi © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be construed or considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. Cover photo: iStock Naypong >>> Contents Acknowledgments 5 Acronyms 6 Executive Summary 7 Chapter 1. Nonperforming Loan Trends in the Central Asian 10 Banking Systems Chapter 2. Asset Classification and Coverage 13 Chapter 3. Workout Techniques for Reducing Nonperforming 19 Loans in the Central Asian Region Chapter 4. Supervisory Measures to Encourage NPL Reduction 22 Chapter 5. Insolvency Frameworks and Creditors’ Rights in NPL 24 Resolution Chapter 6. Recommendations 28 Bibliography 32 >>> Figures Figure 1. Evolution of NPL Ratios in Central Asian Countries 11 Figure 2. Evolution of NPL Coverage Ratios 11 Figure 3. Evolution of Solvency Ratios in Central Asia Countries 12 Figure 4. Foreign Currency–Denominated Liabilities to Total Liabilities 17 Figure 5. Foreign Currency–Denominated Loans to Total Loans 18 Figure 6. Insolvency Options in the Four Central Asian Economies 25 >>> Boxes Box 1. Loan staging and credit coverage under IFRS-9 15 >>> Tables Table 1. Key Recommendations 9 Table 2. Loan loss classification and coverage framework in Central Asia 14 Table 3. Mechanisms to reduce NPLs in the Central Asian Region 21 Table 4. Insolvency Data 26 >>> Acknowledgments Building on ongoing technical assistance projects in four Central Asian countries, this report was prepared by Emiko Todoroki (Senior Financial Sector Specialist, EECF1); Ismael Ahmad Fontan (Senior Financial Sector Specialist, EECF2); Fernando Dancausa (Senior Financial Sector Specialist, EFNFI); and Maksym Iavorskyi (Operations Analyst, DECSN) under the guidance of Task Team Leader Martin Melecky (Lead Economist, EECF1) and Ilias Skamnelos (Practice Manager, EECF1). The authors are grateful for the feedback received from peer reviewers David Knight (Lead Economist, EECM1); Matei Dohotaru (Senior Financial Sector Specialist, EFNFS); Miquel Dijkman (Lead Financial Sector Specialist, ESAF1); and Mario di Filippo (Senior Financial Sector Specialist, EMNF1). The review meeting was chaired by Sascha Djumena, Country Program Coordinator ECCCA, in June 2022. The report reflects, to the extent possible, new developments since the review meeting. In addition, the authors would like to thank the World Bank Country Management Unit for Central Asia led by Tatiana Proskuryakova (Country Director), Equitable Growth, Finance and Institutions (EFI) Regional Director, Lalita M. Moorty and other colleagues whose support and assistance made it possible to publish this report: Andres Federico Martinez (Senior Financial Sector Specialist, EFNFI), Tim L. De Vaan (Senior Financial Sector Specialist, EECF1) and Davit Babasyan (Senior Financial Sector Specialist, EECF1). Abolanle Surakat provided administrative support, Daryl Martin and Marcy Gessel of Publications Professionals LLC, editorial assistance, and Bruna Sofia Simoes, design and layout assistance. The authors would also like to thank authorities in four Central Asian countries (Kazakhstan, the Kyrgyz Republic, Tajikistan, and Uzbekistan) for their ongoing collaboration in strengthening financial stability and insolvency regimes. >>> Acronymns Agency for Financial Regulation and the Development of AFR the Financial Sector (Kazakhstan) AMC asset management company AQR asset quality review DPD days past due EBRD European Bank for Reconstruction and Development IFRS International Financial Reporting Standard LGD loss given default MSMEs micro, small, and medium enterprises NPL nonperforming loan PD probability of default PLF Problem Loans Fund SME small and medium-sized enterprises SREP supervisory review process UTP unlikeliness to pay >>> Executive Summary The COVID-19 crisis combined with the global repercussions from the Russian invasion of Ukraine exacerbated the stress on financial systems around the world. More than 150 countries introduced policy measures to support the financial sector amid the COVID-19 pandemic.1 Such measures included debt moratoria, loan forbearance, and the relaxation of classification and provisioning rules—a truly unprecedented response in its scale and speed. Central Asia is no exception.2 Policy makers in the region introduced temporary measures to support the financial sector during the COVID-19 pandemic. But even before one crisis is contained, the region faces another crisis stemming from the repercussions of the Russian war in Ukraine. Central Asian countries have strong economic and financial ties with Russia, which have, in turn, affected trade, remittances, the subsidiary operation of Russian banks, corresponding banking relationships, payment channels, among other systems. The compounded effect of the two crises has increased the pressure on both the repayment capacity of borrowers and the financial management of banks and other creditors. Under the current uncertainties, regulators and supervisors in the financial sector are faced with the difficult policy decision of whether to reintroduce or extend temporary COVID-19 measures intended to contain the shocks to the financial system in general and to borrowers in particular, including shocks from the Russia-Ukraine war. Financial regulators in Europe and Central Asia have been withdrawing regulatory forbearance measures since 2021, but the response to this action has varied, and new support measures may be needed to address the fallout from the war in Ukraine. In Central Asia, however, because some of the financial sector regulators and policy makers withdrew regulatory forbearance and other support measures only recently, the pressure on the quality of asset can intensify. In contrast, if support measures stay in place for too long, zombie firms can linger in the economy and reduce productivity and growth in the medium to long term, which, in turn, negatively affects the financial sector. Rising borrower distress is widely expected to translate into an increase in nonperforming loans (NPLs). The unprecedented COVID-19 crisis measures have masked the real health of the banking sector, particularly in the recognition of NPLs.3 The lingering effect of the COVID-19 1. FCI Global Practice COVID-19 Financial Policy Response Compendium (dataset) as of March 2022. 2. This report covers four Central Asian countries: Kazakhstan, the Kyrgyz Republic, Tajikistan, and Uzbekistan. 3. World Bank Group, World Development Report 2022: Finance for an Equitable Recovery (Washington, DC: World Bank Group, 2022). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 pandemic, coupled with the new wave of risks arising from for debtors and creditors to resolve insolvency. For instance, the spillover of the war in Ukraine, rising inflation, tightening reorganization allows viable but financially distressed monetary policy, and significant economic uncertainty have companies to gain some breathing room to restructure. contributed to reversing the economy recovery in 2022 and However, this option is rarely used in Central Asia. At the same the forecast for 2023 in Central Asia. A new wave of defaults time, reorganization through the judicial system is not always a on bank loans and other debt could be expected. fast or economically reasonable solution, especially for micro, small, and medium enterprises (MSMEs). In these cases, out- Supervisors in the region’s financial sector need to of-court workouts present multiple advantages, allowing for be prepared for a potentially sharp rise in NPLs. Close flexible and confidential alternatives to formally addressing monitoring of asset quality—especially the forward-looking insolvency. Furthermore, while corporate insolvency has considerations of the borrowers’ likelihood to repay— drawn significant attention in Central Asia—especially after continues to be critical. Supervisors in the region will need the Global Financial Crisis—consumer insolvency remains an to upskill in order to understand and assess forward-looking underdeveloped area where only Kazakhstan and Uzbekistan developments in credit quality. Enhanced measures for banks have recently taken initial steps to adopt a legal framework. that are dealing with high NPLs should be introduced. This report assesses the NPL resolution framework in The efficiency of NPL workouts and the readiness of four Central Asian countries (Kazakhstan, the Kyrgyz systems that address insolvency co-determine the Republic, Tajikistan, and Uzbekistan) and provides resilience of the financial system and its ability to cope recommendations for improving it. Chapter 1 discusses with NPLs. Banks in Central Asia have limited options for the current trend in NPLs in Central Asia. Chapter 2 assesses reducing their NPLs because the practices of court-based how assets are classified and covered. Chapter 3 reviews settlements, alternative out-of-court workout mechanisms, and the NPL reduction workout techniques practiced in Central NPL portfolio sales are not readily available. Instead, banks Asia. Chapter 4 looks into supervisory measures that can primarily work out their NPL portfolios by actively seeking to be adapted to reduce NPLs. Chapter 5 reviews the role that maximize loan repayments through collateral enforcement. the insolvency and creditors’ rights framework plays in this process. The report concludes in Chapter 6 with specific Insolvency systems in Central Asian countries offer recommendations for enhancing the readiness of banks and a variety of procedures for addressing the problem. insolvency regimes for dealing with NPLs. Table 1 summarizes Corporate insolvency laws—although outdated in some these recommendations. countries— have made available a wide array of procedures >>> Table 1. Key Recommendations for Improving the NPL Resolution Framework in Central Asia (a) Enhancing banking supervision, regulatory frameworks, and the capacity of bank supervisors 1. Prepare bank supervisors to implement International Financial Reporting Standard 9 (IFRS 9) through the following actions: a. Set up specialized credit risk modeling teams in banking supervision. b. Develop methodologies and tools to effectively supervise IFRS 9, such as IFRS 9 assessment methodologies and IFRS 9 challenger models. c. Provide training on IFRS 9. 2. Improve credit risk classification and coverage in Central Asian countries as follows: a. In the Kyrgyz Republic and Uzbekistan, consider expanding the list of eligible collateral. b. In the Kyrgyz Republic, consider the impact of collateral not only in credit classification but also in credit risk coverage. c. In Tajikistan, consider restricting the definition of NPLs in line with international standards by including only the credit risk exposures that are 90 days past due (DPD) (currently 30 DPD) or that have been assessed as unlikely to pay. d. In the Kyrgyz Republic and Tajikistan, consider defining the loss category with credit exposures that are 360/5 past due instead of the current conservative 180 DPD. e. In Tajikistan and Uzbekistan, consider the higher reserve requirements for certain foreign-currency loans. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 3. Introduce a specific regulation to manage high-NPL banks that includes the following: a. A definition of “high-NPL banks” b. General requirements that banks need to meet when managing NPLs c. Enhanced requirements applicable to high-NPL banks, such as (a) strategic and operational plans for NPL reduction, (b) standardized information templates that force banks to report the expected (forward-looking) NPL trend during a plan’s the time horizon, and (c) independent and well-resourced workout units (b) Improving insolvency regimes 4. Improve insolvency legal frameworks, particularly to address the following: a. Including state-owned enterprises under the scope of the insolvency law b. Allowing the debtor to obtain new financing c. Allowing essential contracts to continue d. Promoting the adoption of reorganization plans through “cram-downs” e. Introducing out-of-court workout mechanisms 5. Develop consumer insolvency frameworks (initial work has started in Kazakhstan and Uzbekistan) EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 1. >>> Chapter 1. Nonperforming Loan Trends in the Central Asian Banking Systems 1. Countries in Central Asia have suffered a significant rise in nonperforming loans (NPLs) in the aftermath of the Global Financial Crisis. After years of quick economic expansion facilitated by the easing of financial conditions and inflows of foreign direct investment, the Global Financial Crisis triggered a large increase in NPLs. The crisis also resulted in large bank failures in the region, especially in Kazakhstan. A few years later, the Russian Financial Crisis in 2014–15 renewed the pressure on asset quality in the banking sector. In Tajikistan, for example, a deterioration in asset quality affected by weak governance and related party lending, among other factors, resulted in the failure of two systemic banks and two smaller institutions, shaking the financial stability of and the overall trust in the banking sector. Kazakhstan, too, faced further systemic bank failures. 2. Facing these crises in the banking sector, the countries in Central Asia implemented significant reforms to ensure adequate loan classification and coverage and sound risk management. Following the Global Financial Crisis and especially after 2015, financial regulators and supervisors in Central Asia implemented significant reforms in two important areas, among others: (a) the rules for asset classification and coverage and (b) new standards for credit. 3. The reforms, coupled with economic growth and more prudent policies, have resulted in the reduction of NPLs. NPL ratios saw a sharp downward trend owing to economic growth that caused robust loans to grow faster than new NPLs and write-offs. The most significant trend was a reduction in the NPL ratio in Tajikistan, where the ratio dropped from about 47 percent in 2016 to 13–15 percent during 2021. This change is largely explained by drastic actions taken in the financial system (that is, the liquidation of several banks), the strengthening of the regulatory regime for NPLs, and the improvement of the economy. 4. Despite these gains, the COVID-19 crisis has stopped the NPL downward trend in some countries. In the Kyrgyz Republic and Uzbekistan, the NPL ratio has increased because of recessions induced by COVID-19, although in Uzbekistan, the rise comes from a low base. In EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 Tajikistan, the NPL level in the banking sector has stabilized of the NPL level across the Central Asian countries exhibits after it had already dropped, whereas in Kazakhstan, the significant variation (figure 1). ratio continued its decline in 2021. Interestingly, the evolution >>> Figure 1. Evolution of NPL Ratios in Central Asian Countries Source: International Monetary Fund data. For Kazakhstan, the 2021 data are from the second quarter. 5. On a more positive side, the banking sector’s ratios continue to be at very high levels in all the Central capacity for absorbing losses remains largely sound. Asian countries (figure 3). Adequate bank capital and NPL NPL coverage ratios are at robust levels, especially in provisioning are the first lines of defense against further Kazakhstan and Tajikistan (figure 2). In addition, capital losses from NPLs. >>> Figure 2. Evolution of NPL Coverage Ratios Source: International Monetary Fund data. For Kazakhstan, the 2021 data are from the second quarter. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 >>> Figure 3. Evolution of Solvency Ratios in Central Asia Countries Source: International Monetary Fund data. For Kazakhstan, the 2021 data are from the second quarter. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 2. >>> Chapter 2. Asset Classification and Coverage 6. Countries in Central Asia significantly enhanced their regulatory standards on credit classification and coverage in the past several years, but some gaps remain. The central banks in the Kyrgyz Republic, Tajikistan, and Uzbekistan have maintained their respective loan classification and coverage standards, which are largely based on the days past due (DPD) of a delinquent loan and on predetermined fixed rates linked to those categories. In Tajikistan and Uzbekistan, there are five categories of loan classification, and in the Kyrgyz Republic, there are six. At the same time, these three Central Asian countries have rolled out new rules on the following three classification issues, among others: (a) forborne loans, including the definition of restructuring and refinancing, and the classification of forborne loans; (b) the requirements for reclassifying a loan that is not overdue but for which there is evidence that the borrower may be unable to pay; and (c) how collateral is considered when determining the loan-loss reserves. In these three countries, banks are currently subject to a dual regime in which credit losses are calculated for financial reporting based on the International Financial Reporting Standards (IFRS), but the regulatory reserves, relevant to regulatory reporting and the calculation of loan-loss reserves for prudential standards,4 follow the central bank’s regulations. Whereas supervisors are largely focused on prudential calculations, concern is naturally growing over the soundness of the estimations of expected losses that banks use for calculating the loan-loss provisions for their financial reporting. 7. In 2018, Kazakhstan’s National Bank introduced a regime that requires banks to quantify their loan losses for prudential purposes according to IFRS 9 expected losses, becoming the first country in the region to do so.5 Under this policy, banks must estimate their loan reserves using their risk parameters, including probability of default (PD), loss given default (LGD), and exposure at default (EAD). The introduction of these rules has been accompanied by the amendment of the Risk Management Regulation6, which requires banks to develop their own credit risk models and integrate them into their credit risk underwriting and monitoring standards. 4. Including solvency, leverage ratios, or large exposure limits, among others. 5. See Regulation 269, approved by resolution of the Board of the National Bank of the Republic of Kazakhstan, dated December 22, 2017. 6. See Regulation No 188, approved by resolution of the Board of the National Bank of the Republic of Kazakhstan, on “Rules for Formation of Risk Management and Internal Control Systems for Second Tier Banks” EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 The framework was strengthened in 2021 with new rules that when quantifying the expected losses. There are, however, require the use of certain indicators to reclassify assets to outstanding gaps in this framework, and the World Bank team stage 2 and 3, bringing the classification criteria broadly in has provided advice to the National Bank of Kazakhstan to line with IFRS standards. The framework has also introduced eliminate them and enhance the regulatory framework. Table backstops on the calculation of expected losses, such as 2 summarizes the loan classification and coverage framework minimum expected losses coverage by stage or minimum in Central Asia. haircuts that banks must consider for collateral valuations >>> Table 2: Cost of Housing (IQD, millions) Kazakhstan Kyrgyz Republic Tajikistan Uzbekistan 3 stages 6 5 5 Loan categories (IFRS 9) (3 NPL) (3 NPL) (3 NPL) > 90 DPD > 30 DPD > 30 DPD > 90 DPD Definition of NPLs + UTP + UTP + UTP + UTP Comprehensive rules Comprehensive rules Comprehensive rules Comprehensive rules Loan forbearance on identification and on identification and on identification and on identification and coverage coverage coverage coverage 180 DPD as 180 DPD as 365 DPD as As per the bank threshold for the loss Losses/write-offs threshold for the loss threshold for the loss policy classification, two classification classification years for write-offs Dependent on the Minimum loan-loss provisions Fixed and increasing Fixed and increasing Fixed and increasing expected losses Embedded in Broad recognition in Very limited the calculation of the asset coverage, Limited recognition in Treatment of collateral recognition in the expected losses, including minimum the asset coverage asset classification haircuts defined haircuts Note: DPD = days past due; IFRS = International Financial Reporting Standards; NPL = nonperforming loan; UTP = unlikeliness to pay. 8. Kazakhstan’s NPL regime strikes a good balance 9. Regulators in the Kyrgyz Republic, Tajikistan, between fostering the development of credit risk modeling and Uzbekistan need to consider aligning the asset capabilities and estimating credit losses conservatively. classification and coverage standards that they use for Although there is a room for improving this regime, particularly regulatory reporting with an IFRS 9 approach to expected with respect to reinforcing the criteria for unlikeliness to pay losses. However, the timing of the introduction should be (UTP) and to identifying and reporting of forborne loans, the carefully planned. Regulators will need to assess whether the regulatory regime provides a good starting point in these areas, banking sector has capabilities for estimating expected losses and the National Bank of Kazakhstan should focus on oversight and whether their own supervisory capacity is prepared to of the sound implementation of this policy by the banking sector. challenge these estimates, especially to avoid losing control In doing so, the bank should build the capacity of its supervisory over the loan-loss reserves of banks, potentially by maintaining staff by enhancing their skills in assessing credit losses and a parallel calculation during the first few years. The loan staging developing tools that can equip them to challenge the models and credit coverage under IFRS 9 are explained in box 1. developed by banks in estimating expected losses. These tools may include challenger models and supervisory guidance on assessing expected credit losses. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 BOX 1. LOAN STAGING AND CREDIT COVERAGE UNDER IFRS-9 Stage 1 corresponds to fully performing loans. Stage 2 loans (underperforming) are those for which there has been a significant increase in credit risk since they were originated, whereby the pricing of the loan may be no longer sufficient to compensate for the credit risk that the loans carry. Stage 3 loans (nonperforming) are those that have defaulted (understood as having overdue amounts for more than 90 days) or that are otherwise unlikely to pay. Banks should calculate the expected losses for one year only; however, they should set aside loan-loss reserves for those classified in Stage 2 or 3 that cover the lifetime expected losses of those loans. Therefore, a classification from Stage 1 to Stage 2 commonly results in a material increase in loan-loss provisions. One of the main challenges of implementing a loan classification and coverage regime based on IFRS 9 is that banks should develop their capacity to calculate their expected losses, as this is essential not only for asset coverage but also for asset classification. The most relevant trigger for classifying loans from Stage 1 to Stage 2 is usually an increase in a loan’s probability of default since inception. Therefore, banks should be able to evidence their capability for calculating, for every loan, the risk parameters required to estimate the loan’s expected losses, particularly the probability of default (PD), the loss given default (LGD), and the exposure at default. Banks are expected to estimate these parameters by using historical data on the defaults and on losses for the defaulted loans that can feed into their own models for estimating the PD and the LGD, which will be used to calculate the expected losses on a loan-by-loan basis. Ideally, banks should use their own historical data from their loan portfolios and develop their own model capabilities to estimate the relevant risk parameters. Nevertheless, this may not be completely possible—especially for small, unsophisticated banks—because they may have neither the requisite data nor the modeling capabilities. Experience has shown that in such cases, banks are likely to “buy” both the data and the modeling capabilities from third parties (that is, Big 4 audit firms, private credit bureaus, and consulting companies), resulting sometimes in limited ownership of both the inputs and outcomes of the process. 10. The IFRS 9 regime for expected loss-based 11. However, an IFRS 9-based regime for prudential asset classification and coverage has undeniable advantages. classification and coverage requires both the banking The implementation of this regime encourages banks to industry and its supervisors to enhance their capacity. develop their own internal credit risk capabilities, potentially First, less sophisticated banks may not have access to the resulting in a more accurate measurement of credit risk, a data and modeling capabilities that the calculation of expected more risk-based loan pricing, earlier action against delinquent losses requires, and they may end up effectively outsourcing loans, and, overall, a better understanding of the dynamics the full process to third parties, resulting in lack of ownership and risks of their loan portfolios. Furthermore, banks that use of the process, a poor awareness of their credit risk, and the IFRS rules in their financial reports, including banks in the inability to integrate the expected losses into their credit risk four Central Asian countries, align their supervisory reporting underwriting, monitoring, and workout processes. Second, with financial reporting, making it easier for them to integrate allowing banks to fully apply the IFRS 9 for asset classification the loan-loss provisions into their credit risk management and coverage may bring significant challenges for banking framework. Furthermore, accounting for expected losses supervisors, who would need to develop their own capabilities can also force the early recognition of problems in the loan to verify and, if necessary, to challenge the banks’ estimated portfolio, as the change in credit risk in the loan should quickly losses. Supervisors in the Kyrgyz Republic, Tajikistan, and translate into higher expected losses, enabling banks to take Uzbekistan have little experience in statistics because credit early actions against delinquent borrowers. risk modeling has been largely absent in these countries.7 7. Unlike most European countries, none of these countries allows banks to calculate their credit risk-weighted assets by using internal models, because capital requirements regimes are usually based on a mix of Basel I, II, and III. Nor have they used bottom-up stress testing to estimate future losses for the banks’ loan portfolios. Therefore, the experience in credit risk modeling at this stage in the central banks is rather limited to financial stability top-down basic credit loss forecasting. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 12. The current level of capacity in the banking sector requirements applicable to banks, and so forth). Furthermore, and its supervisors in these three Central Asian countries these countries should continue their engagement with the necessitates accelerated reforms in order to introduce banking sector and with audit firms to gather evidence on the and implement an IFRS 9 approach for asset classification main challenges that the implementation of these regimes and coverage. Both banks and supervisors are not well may bring and the gaps that may remain after implementation. prepared or equipped to migrate to an IFRS regime. However, Since 2018, second-tier banks in Kazakhstan have already central banks in the Kyrgyz Republic and Uzbekistan are been subject to a loan classification and coverage regime taking measures to train their supervisors in overseeing that is largely based on IFRS 9. The challenges for them are expected-loss accounting models. This is a step in the right to continue to build capacity and equip supervisory staff with direction because sooner or later, they will have to adopt an appropriate supervisory tools. expected-loss regime. 13. During the transition period, central banks in the USE OF THE UNLIKELINESS TO PAY CRITERIA Kyrgyz Republic, Tajikistan, and Uzbekistan may consider introducing backstop measures. Some countries, 15. UTP criteria are universally used to classify assets including Kazakhstan, have implemented regimes that force into the nonperforming categories. UTP criteria ensure banks to estimate expected losses while preserving some that banks classify assets into the substandard or doubtful rules (“regulatory backstops”) that impose certain limits on categories based on criteria other than DPD. This is particularly features such as minimum loan stage coverage or collateral relevant in the context of a bank’s forbearance practices and haircuts. Bosnia and Herzegovina banking agencies have may be even more relevant in the current context of tightening implemented a regime that imposes additional criteria for global monetary policy conditions that threaten the balance reclassifying loans in stages 2 and 3, imposing minimum sheets of households and corporations. expected losses for loans classified in stages 1 and 2 that are higher for banks that are unable to estimate their expected losses and laying out minimum haircuts for collaterals TREATMENT OF LOAN FORBEARANCE when estimating their expected losses. The Bank of Spain has created a two-tiered regime. Sophisticated banks are 16. To cope with shocks induced by COVID-19, the allowed to calculate their own expected losses with their own Central Asian countries introduced measures for models if they can meet the qualitative requirements laid out the classification and coverage of restructured and in the regulation. Less sophisticated banks that are unable to refinanced loans (forborne loans); hence the term calculate their own risk parameters must determine their loan “forbearance measures.” Weak forbearance measures can reserves by using standardized percentage losses that have easily undermine loan classification and coverage standards, been calculated by the supervisors on a portfolio basis using allowing a loan to be restructured several times to rehabilitate historical information on credit losses. While these regimes it or to avoid reclassifying it into one of the nonperforming may strike a balance between aligning the regulatory regimes categories. All four Central Asia countries have the following and the accounting rules, central banks should be aware simple, but mostly effective, rules for accounting for forborne that the stricter the backstops, the higher the risk that the loans: (a) defining forborne loans largely on the basis of regulatory regimes may be considered noncompliant with the the provision of a credit concession, (b) the mandatory IFRS 9 accounting regime. reclassifying of forborne loans to worse categories, and (c) defining probation periods for reclassifying a loan to a better 14. Central Asian countries should examine relevant category and for not identifying it as forborne. All four countries international experience in migrating to expected loss in this report have abolished the special forbearance rules, models to understand what tools supervisors can use with the Kyrgyz Republic being the last country in the region to to challenge banks’ estimates (for example, challenger lift the measures, after renewing them several times. models, guidance in assessing expected losses, minimum EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 COLLATERAL TREATMENT OTHER RELEVANT ASPECTS IN ASSET CLASSIFICATION AND COVERAGE: LOANS 17.The four Central Asian countries treat collateral DENOMINATED IN FOREIGN CURRENCY AND differently for both asset classification and coverage. ASSET QUALITY REVIEW The Kyrgyz Republic and Uzbekistan accord very limited recognition to collateral for the purpose of asset classification 19. The banking sectors in the Central Asian countries and coverage. In the Kyrgyz Republic, only high-quality are heavily dollarized. Providing loans denominated in a collateral8 is eligible for classifying a loan as “normal.”9 In foreign currency can expose borrowers to market risk that can Uzbekistan, eligible collateral is likewise restricted to high- translate into credit risk for the banks, especially for unhedged quality liquid assets10 for the purpose of calculating the loan borrowers who do not receive their revenues in the currency coverage. In Tajikistan and Kazakhstan, on the other hand, in which the loan is denominated. The share of liabilities there is a broad recognition of collateral, including not only denominated in a foreign currency to total liabilities in Central high-quality liquid assets, such as government securities or Asia has somewhat decreased over the past decade, but it bank deposits, but also guarantees or residential real estate. has been persistently high at 35 to 60 percent depending on In both countries, the regulations prescribe minimum haircuts the country (see figure 4). On the other hand, the share of for the eligible collateral. In Tajikistan, the haircut collateral is foreign-currency loans to total loans has decreased sharply deducted from the loan exposure to determine the unsecured in the last years in Kazakhstan, the Kyrgyz Republic, and portion of the loan, whereas Kazakhstan considers the haircut Tajikistan, although in the latter two countries, the ratio is still collateral in estimating the expected credit losses. high (see figure 5). The Kyrgyz Republic assigns a higher risk weight when the loan has been provided in foreign currency 18. If collateral was recognized more broadly, banks to a borrower who does not have a material portion of its might feel encouraged to more actively pursue credit revenues denominated in the foreign currency. Tajikistan has risk mitigation techniques, including, for example, providing also defined rules to establish an add-on for the coverage of mortgage loans that consider loan-to-value ratios, potentially foreign-currency loans. Neither Kazakhstan nor Uzbekistan resulting in lower credit losses for the banking sector. has established rules for imposing higher provisioning levels Uzbekistan and the Kyrgyz Republic may broaden the eligible for foreign-currency loans. While banks in Kazakhstan may collateral, subject to prudent haircuts and appraisal rules. well consider the currency of the denomination of the loan when Furthermore, the Kyrgyz Republic may also consider collateral estimating expected losses, not all banks in Uzbekistan are when calculating the applicable credit reserves. likely to do so, but the supervisors may consider the possibility of setting specific rules for covering foreign-currency loans. >>> Figure 4. Foreign Currency–Denominated Liabilities to Total Liabilities Source: International Monetary Fund data. 8. Eligible collateral is limited to government securities issued by the Kyrgyz Republic, pledged deposits in the bank, other securities in the Kyrgyz Republic Stock Exchange, and pledged gold. 9. “Normal” means the safest category and the one with the lowest minimum provisioning levels (0 percent). 10. These assets are government securities; pledges of deposits in the bank; or guarantees by central banks, governments, or international organizations. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 >>> Figure 5. Foreign Currency–Denominated Loans to Total Loans Source: International Monetary Fund data. 20. Kazakhstan has been using an asset quality review CREDIT RISK MANAGEMENT STANDARDS (AQR) as part of its supervisory review process. In 2019, the country launched an independent AQR that was based 21. The Central Asian countries have been strengthening on the European Central Bank’s methodology and covers 14 the credit risk management standards in their risk banks, or 87 percent of all banking assets. The exercise was management regulations. In all four countries, the coordinated by Oliver Wyman, and the participants were the regulations require sound credit risk management, including main international audit firms as well as about 70 appraised close involvement of the bank’s board of directors and the companies. As a result of the exercise, the Kazakh supervisor, preparation of a credit risk strategy, policy, and appetite. the Agency for Financial Regulation and the Development of Furthermore, banks are asked to institute sound underwriting the Financial Sector, defined supervisory plans and measures standards that include an assessment of the affordability for the 14 participating banks. It is expected that the regular of the loans and the solvency of the borrower. In particular, AQR will be conducted on a yearly basis, although the full- Kazakhstan,11 Tajikistan,12 and Uzbekistan have recently scale independent AQR will be implemented only every five tightened their requirements for credit risk management. years. The other three Central Asian countries have not Kazakhstan’s new standards require banks to apply sound conducted any type of AQR. credit risk underwriting standards for the clients who, among other requests, ask for the expected losses to be calculated when the loan is originated. 11. See the amendments to Regulation 188 of the National Bank of Kazakhstan on the rules for the formation of risk management and internal control systems for second-tier banks. 12. See Regulation 247 of the National Bank of Tajikistan in the Risk Management and Internal Control System (2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 3. >>> Chapter 3. Workout Techniques for Reducing Nonperforming Loans in the Central Asian Region 22. Banks can use any of the following common mechanisms to reduce NPLs: (a) rehabilitating loans through the successful collection of repayments, loan restructuring or refinancing, or other amicable settlements involving debt forgiveness or court settlements of the amounts due; (b) foreclosing on collateral through either court-based foreclosure procedures or voluntary, out-of-court debt-to-equity swaps; (c) writing off loans that have been classified as nonperforming over a long period of time, (d) selling NPLs or NPL portfolios to third-party investors; and (e) selling NPLs or NPL portfolios to a state-owned asset management company (AMC) or bad bank. 23. Banks in Central Asia primarily work out their NPL portfolios by maximizing loan repayments or restructuring defaulted loans. For borrowers who have seen their repayment capacity adversely affected but who are still willing and able to make loan repayments, the preferred solution is to restructure or refinance the loan to adjust to the new repayment capacity of the borrower. For example, the maturity of the loan can be extended, grace periods can be given, debts can be consolidated under a new single loan, and payments can be reduced for a specific period of time. Loan restructuring has been widely used to accommodate repayments during the COVID-19 pandemic, especially in the Kyrgyz Republic. Overall, bank supervisors should be vigilant to ensure sound registration of restructured loans and to safeguard that this option is not used to avoid reclassifying loans as NPLs. Nevertheless, when a borrower is uncooperative or has seen its repayment capacity severely impaired to the extent that it may be no longer viable, the banks should avoid restructuring the loan and try instead to maximize their chances of recovering the debt first through amicable settlements, potentially with debt forgiveness, and when this is not possible or desirable, through court settlements. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 24. For certain secured portfolios, such as mortgage 26. NPL portfolio sales are currently not a viable lending, banks can maximize recoveries through collateral alternative in Central Asian countries. NPL portfolio sales foreclosures or debt-to-equity swaps. For secured/ can be used to swiftly reduce the NPLs, as their ownership and mortgage borrowers who have seen their revenues reduced management is transferred to a third-party investor. Portfolio to a level that makes their loan unaffordable, restructuring sales have other benefits, such as allowing a bank to focus is not a viable alternative. In these circumstances, amicable on its core business, which frees up resources that are tied settlements can involve debt-to-equity swaps, in which to bad loans workouts. The existence of a secondary market the borrower voluntary agrees to transfer the property of for NPLs requires several preconditions, such as a credible the collateral to the lender in exchange for debt relief. This framework for court-based recoveries, third-party recovery approach could also cover debt forgiveness when the borrower agencies to which banks outsource the loan workout for certain is cooperative and has no other means to repay the loan. portfolios, and, finally, investors with sufficient capacity and However, when the borrower is uncooperative, the lender may knowledge to value and bid for the NPL portfolios. There are seek to recover the debt by initiating foreclosure procedures in no NPL markets in any of the Central Asian countries to date, courts, with the target of gaining control of the collateral in the although Kazakhstan is taking measures to create the legal process. Secured lending to individuals, especially mortgage and economic conditions to develop a viable NPL market.14 lending, is rather limited in Central Asian countries. Ineffective and slow national court procedures can also undermine both 27. The transfer of NPLs to publicly owned AMCs could be voluntary and court-based settlements, as borrowers see their a mechanism for rapidly cleaning up the balance sheets legal position strengthened by the lack of alternatives through of the private sector; however, the use of AMCs in this which lenders can enforce the terms that govern collateral. way has many well-known risks. Among other factors, risks determine the transfer price, the use of public funds to buy 25. Loan write-offs are another way to actively reduce private assets, the inefficiency in the recovery process, and NPL levels. Writing off an NPL removes it from a bank’s the political risks embedded in the management of NPLs. The balance sheet, so it is no longer reflected as an NPL. While the use of AMCs in the region during the past few years has been regulations in Central Asian countries do not include specific limited to Kazakhstan,15 where the Problem Loans Fund (PLF), thresholds for loan write-offs,13 they facilitate and encourage first owned by the National Bank of Kazakhstan and then them, as per the definition of losses (that is, the loans that by the Minister of Finance, has been used to remove large should be written off). The Kyrgyz Republic and Tajikistan amounts of NPLs from the problem banks’ balance sheets.16 are very conservative in using 180 DPD as the threshold for writing off a loan, while Uzbekistan uses 365 DPD. Because loans classified as losses should be fully covered with loan- loss reserves, banks have a clear incentive to write them off. Although write-offs are a common way to reduce NPLs, this measure does not in any way imply stopping the actions for recovering a loan. 13. Nevertheless, in Tajikistan, banks should provide a clear explanation for retaining in their balance sheets loans that are beyond two years past due. Although this rule cannot qualify as a threshold for loan write-offs, it informally signals the expectation that banks should write off the loans that have been past due for more than two years. 14. Kazakhstan has prepared a draft Law on Distressed Assets that (a) expands the possible types of organizations that can acquire distressed assets, allowing private investors to participate in the acquisition of small and medium enterprise and corporate portfolios but excluding retail portfolios, and (b) establishes a regime for servicing companies such that the management of NPLs can be outsourced by banks and other financial institutions, and AMCs and debt collection agencies can be eligible as servicing companies. 15. The Kyrgyz Republic has used a state-owned bad bank (DEBRA) to acquire bad loans from failed banks. Although DEBRA still continues to operate, it has not been used in the past 10 years to buy assets from any failed banks. 16. In 2020, the PLF also provided guarantees to parts of the NPL portfolio of several banks. Through this approach, the banks can continue managing the NPLs, whereas the credit risk is transferred from the banks’ balance sheets. This “synthetic” approach has several benefits over the outright purchase of the loans, such as avoiding the large amount of funding needed to acquire the assets and ensuring that the bank continues to manage NPLs. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 >>> Table 3. Mechanisms for Reducing NPLs in the Central Asian Region Availability in Central Asia and key Definitions Relevance success drivers • Defaulted loans can be actively • Broadly available and used managed toward rehabilitation. throughout the region • Successful restructuring/refinancing • Availability of workout units, 1. Repayments/cures Very high can help to accommodate a restructuring, and other amicable borrower’s installments to the new settlements tools are the key drivers payment capacity. of success • Applicable to mortgage/secured portfolios only • Banks can recover an NPL by • The ineffectiveness of the court 2. Foreclosures/debt- foreclosing on collateral or by foreclosure procedures influences Low to-equity swaps accepting debt-to-equity swaps. the possibility of achieving successful settlements through foreclosures. • Absence of secondary developed markets for NPL portfolios • Banks can quickly reduce the • Kazakhstan is making strides number and amount of their NPLs 3. Portfolio sales toward developing active markets Low by selling them to third-party for NPL transactions investors • Other countries remain largely undeveloped • Countries in Central Asia impose strict rules on fully provisioning • Banks can reduce the number and NPLs (that is, as soon as 180 4. Write-offs amount of their NPLs by writing off DPD in the Kyrgyz Republic and High loans. Tajikistan) • Loan write-offs can contribute to quickly reducing NPLs • Significant use in Kazakhstan in the past few years (PLF), largely absent in the Kyrgyz Republic, Tajikistan, • Banks may be able to reduce their and Uzbekistan 5. AMCs NPL levels by transferring them to Low • Huge implications for fiscal an AMC. sustainability, market incentives, and long-term management of problem loans Note: AMC = asset management company; DPD = days past due; NPL = nonperforming loan; PLF = Problem Loans Fund. 28. In summary, banks in Central Asia have limited options often unprepared judges. The secondary market for NPLs has for reducing their NPLs because two of the main avenues been hardly developed across the region. Whereas efforts are for doing so—court-based settlements and NPL portfolio being made in Kazakhstan to create an active market for NPL sales—are not readily available (see table 3). Court- sales, the current situation is hardly promising in the other assisted recoveries are affected by protracted legal processes three countries. in clogged courthouses and by usually overwhelmed and EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 4. >>> Chapter 4. Supervisory Measures to Encourage NPL Reduction 29. Banking supervisors have been paying more attention to the negative effects of NPLs on the solvency and the viability of banks. Regulators have launched several initiatives for banks identified as outliers based on their NPL levels. Among other actions, regulators have issued guidelines that detail the expectations that banks need to meet when managing NPLs.17 The guidelines are comprehensive and cover all aspects of the process related to workout, from setting the strategy for managing NPLs, to ensuring the availability of sufficient human and technical resources to work out the delinquent loans, and to setting the rules for recognizing and measuring NPLs for valuating collateral. 30. Supervisors apply enhanced measures to banks that have high levels of NPLs. These banks are automatically subject to mandatory enhanced measures,18 including the following: a. Annual strategic and operational plans for reducing NPLs. Banks are asked to set their targets for reducing NPLs on a short- and medium-term horizon, with the breakdown by portfolios (for example, corporate, small and medium enterprises [SMEs], retail, and so forth) and by workout mechanism (for example, repayments, cures, write-offs, portfolio sales, and so forth). The banks’ plans are expected to be approved by their boards of directors, and the performance must be reported to the supervisor several times throughout the year. b. Dedicated workout units. Banks need to create a workout unit that reports directly to the management of the bank and is functionally separated from both the lending unit and the risk management unit. The workout unit should have sufficient technical, human, and financial resources to actively manage the NPL portfolio and reduce it to the level set by the bank’s board in its strategy. c. Regular reporting. Banks need to report their projections of NPLs with additional templates that break down the evolution of their different portfolios. 17. See, for example, European Banking Authority, Final Report—Guidelines on Management of Non-performing Loans and Forborne Exposures (EBA/GL/2018/06, Paris: EBA, October 31, 2018); and European Central Bank, Guide to Banks on Non-performing Loans (Frankfurt, Germany: European Central Bank, March 2017). 18. Some supervisors of banks with high and persistent levels of NPLs have required the banks to reduce these levels below a predetermined point over a specific time horizon. For example, certain Cypriot, Greek, and Italian banks have taken this approach when the levels of NPLs were well above 10 percent of their total loan portfolios. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 31. The use of these supervisory tools has been uneven 32. Against the current macroeconomic backdrop, across Central Asia. The Central Bank of Tajikistan has bank supervisors in the region should speed up their issued, with the support of the World Bank, a guideline that preparations for a potential sharp rise in NPLs. In light of requires banks to prepare action plans for NPL reduction the lingering effect of the COVID-19 pandemic coupled with together with specific, forward-looking NPL reporting templates the new wave of risks arising from the spillover of the war in that banks need to periodically complete and submit to their Ukraine, tightening global monetary conditions, and significant supervisor. Banks prepared the plans for the first time in 2017 economic uncertainty, bank supervisors in the region need and have updated them recurrently through 2020. The plans to be prepared for a potential sharp rise in NPLs. Financial may have been essential in reducing NPL levels in Tajikistan regulators and supervisors can take the following immediate from as high as close to 50 percent in 2017 to a low of about 14 actions: (a) prepare detailed regulations on the management percent as of this writing. Likewise, Kazakhstan’s AFR agreed of NPLs, (b) request supervised banks with high levels of NPLs with 14 banks in 2020 to prepare actions plans for reducing to prepare strategic and operational plans for reducing them, NPLs; this agreement was an outcome of the AQR exercise (c) require supervised banks to strengthen their workout units, conducted in 2019.19 Supervisors in the Kyrgyz Republic and and (d) enhance supervisory capacity to ensure a readiness Uzbekistan have not requested banks with high levels of NPLs to assess the workout capabilities across the banking sector. to prepare strategic or operational plans. 19. In 2019, the NBK conducted an AQR of the top 14 banks in Kazakhstan. The selected banks accounted for 87 percent of the total banking assets in the country and 90 percent of the total loan portfolio of the banks. The review sought to ensure that the bank was adequately capitalized after fully reviewing the credit classification and coverage of the main loan portfolios. In accordance with the AQR results published on December 30, 2019, no capital shortfall was observed at the banking system level (aggregating results of the participating banks). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 5. >>> Chapter 5. Insolvency Frameworks and Creditors’ Rights in NPL Resolution 33. Effective insolvency and creditor rights (ICR) regimes facilitate the expeditious resolution of NPLs. Growing empirical evidence shows that the effective protection of creditors’ rights mitigates the risk of banks’ exposures, which, in turn, promotes financial sector resilience and access to financing at more affordable rates.20 Once banks and financial institutions have exhausted their internal debt recovery procedures, they rely on the legal framework to assist them in either restructuring or recouping defaulted loans. Two sets of laws are particularly critical to expediting the resolution of NPLs: (a) enforcement laws, which protect the claims of individual creditors by allowing them to ensure they are repaid through access to collateral, and (b) insolvency laws, which provide an organized collective enforcement regime designed to protect the entire pool of creditors, as well as the debtor, and to maximize this collective recovery. In a post-COVID-19 environment, the role of robust insolvency systems is even more critical in freeing up capital so that it can be applied to more productive uses.21 34. ICR systems in the four Central Asian countries provide for a variety of insolvency procedures. All four countries have adopted corporate insolvency laws, although only Kazakhstan’s law can be characterized as reasonably modern.22 In contrast, the insolvency laws of the Kyrgyz Republic, Tajikistan, and Uzbekistan23 were adopted shortly after they achieved independence or in the early 2000s and have been subject to only cosmetic improvements since they were enacted. One feature that stands out in these laws is the wide array of procedures made available to debtors and creditors for addressing insolvency (figure 6). The laws of Kyrgyz Republic and Uzbekistan, in particular, provide for multiple procedures, many of which can be characterized as reorganization procedures. This development can be considered a 20. See World Bank Group, How Insolvency and Creditor-Debtor Regimes Can Help Address Nonperforming Loans (Washington, DC: World Bank Group, 2021). 21. See World Bank Group, Insolvency Systems and Zombie Firm Proliferation in High- and Middle-Income Economies (Washington, DC: World Bank Group, 2022). 22. Law on Rehabilitation and Bankruptcy, March 7, 2014, No. 176-V, https://online.zakon.kz/Document/?doc_id=31518958. The law in Kazakhstan includes more advanced practices (compared with the laws in the Kyrgyz Republic, Tajikistan, and Uzbekistan) that align with international standards. The practices include, for instance, the treatment of state-owned enterprises and the confirmation of essential contracts. 23. A new Law on Insolvency of Uzbekistan took effect on April 13, 2022, replacing the Law on Bankruptcy, No. 1054-XII, May 5, 1994. The Law on Insolvency is available at https://lex.uz/ru/docs/6352957 . This report has, however, assessed the 1994 Law on Bankruptcy, as it was the law applicable when the report was being prepared, and not all chapters of the 2022 law were in force by the end of 2022. We recommend conducting a follow-up study to analyze the effects of the newly adopted provisions on the insolvency regime in Uzbekistan. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 positive one in the region, as it is generally considered good that best suits their needs. However, these procedures can practice for the ICR system to offer a “menu of options” to potentially overlap and create unnecessary complexities that debtors and creditors so that they can choose the procedure may discourage their use.24 >>> Figure 6. Insolvency Options in the Four Central Asian Economies Kazakhstan Kyrgyz Republic Tajikistan Uzbekistan Bankruptcy procedure, Special administration Pre-judicial sanation Pre-judicial sanation which leads to liquidation procedure, which leads to liquidation Bankruptcy procedure, Insolvency procedure, which leads to liquidation Rehabilitation In court or Out of court which leads to liquidation Debt restructuring Bankruptcy procedure, Special administration which leads to judicial Insolvency procedure, procedure, which leads sanation Amicable settlement which leads to external to restructuring management (judicial sanation) Bankruptcy procedure, In court or Out of court which leads to external management Amicable settlement Rehabilitation Amicable settlement In court or Out of court Sanation Amicable settlement Note: World Bank Group staff research based on the insolvency laws of the four Central Asian countries. 35. Despite the availability of reorganization procedures, liquidations were open in 2020, whereas only 52 rehabilitation they are rarely used in the four Central Asian economies. cases were observed in that year, amounting to 4 percent Country-specific statistics in this respect show clear evidence of cases recognized as bankrupt.26 Similarly, 96.2 percent of weak reorganization culture and a strong focus on of cases open in the Kyrgyz Republic as of December 2020 liquidation in the countries’ insolvency systems (table 4).25 were liquidation proceedings. In Uzbekistan, reports indicate Indeed, reorganization cases are scarce and sometimes that only four cases have avoided liquidation in the 2018–20 anecdotal across Central Asia. Different factors explain this period, all of which were sanation cases submitted by debtors development, including poor implementation of reorganization and that led to recovery.27 The insolvency statistics from procedures as well as a strong sigma toward bankruptcy, these four countries showcase the common ineffectiveness which triggers very few applications for reorganization from of the ICR systems in these Central Asian jurisdictions, where debtors. In contrast, liquidations are widespread as they piecemeal liquidations are the norm. are typically initiated by creditors. In Kazakhstan, 1,296 24. European Bank for Reconstruction and Development, EBRD Insolvency Assessment on Reorganisation Procedures (London: EBRD, 2022). 25. Country-specific statistics are available for Kazakhstan, the Kyrgyz Republic, and Uzbekistan only. The authorities in Tajikistan do not publish statistics on insolvency cases, and the World Bank Group’s requests for data were not successful. The lack of insolvency data is a concern that has also been highlighted recently by the EBRD. 26. According to the Law on Rehabilitation and Bankruptcy of Kazakhstan, rehabilitation is a court-supervised reorganization procedure under which the debtor is subject to organizational, economic, managerial, and financial measures through a plan intended to restore the debtor’s solvency. 27. According to the Law on Bankruptcy of Uzbekistan, court sanation is the judicial reorganization procedure that is intended to restore the debtor’s solvency and repayment of debts to the creditors without transferring the powers to manage the debtor’s property and business operations to an external organization or individual. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 >>> Table 4. Insolvency Data Kazakhstan Kyrgyz Republic Uzbekistan Rehabilitations Sanation cases Restructurings Liquidations of Rehabilitation legal entities Settlements Bankruptcy bankruptcy cases cases cases Total 2017 1,248 131 80 8 1 — n.a. n.a. 2018 1,633 119 80 10 1 1 n.a. 2 2019 1,654 33 56 11 3 — 8,659 1 2020 1,296 52 96.2% liquidation casesa 7,302 1 Source: Kazakhstan: Ministry of Justice of the Republic of Kazakhstan; Kyrgyz Republic: Ministry of Economy and Commerce of the Kyrgyz Republic and the Council on De- velopment of Business and Investments under the Government of the Kyrgyz Republic, presented in European Bank for Reconstruction and Development, EBRD Insolvency Assessment on Reorganisation Procedures—Kyrgyz Republic (Economy Profile) (London: EBRD, 2022); Uzbekistan: the Supreme Court of Uzbekistan and the State Asset Management Agency of Uzbekistan. Note: — = no reported cases; n.a. = not available. a. Data for 2017–19 come from the Council on Development of Business and Investments under the government of the Kyrgyz Republic as presented in the EBRD report. Data for 2020 are available from the Ministry of Economy and Commerce of the Kyrgyz Republic, but the information is not disaggregated (http://mineconom. gov.kg/ru/direct/8/83). 36. Besides the overall ineffectiveness in resolving there should not be a distinction between types of debtors insolvency cases, there are specific, critical legal based on ownership.31 deficiencies in the countries’ frameworks for addressing insolvency. Such flaws negatively affect the countries’ b. New financing. New financing and its protection are reorganization culture, and it is essential to address them in critical aspects of an effective insolvency framework. A order to increase the effectiveness and importance of ICR struggling company that may yet be viable in the long systems. These legal deficiencies relate to the following six run might urgently need additional financing to pay its categories: employees, suppliers, and operating expenses. However, in the Kyrgyz Republic and Tajikistan, the insolvency law a. Treatment of state-owned enterprises. State-owned does not provide for the possibility of the debtor obtaining enterprises in the Kyrgyz Republic,28 Tajikistan,29 and credit after insolvency proceedings begin.32 New financing Uzbekistan30 are explicitly excluded from the countries’ provisions are available in Kazakhstan and Uzbekistan, insolvency laws and proceedings. This negatively affects although they are not protected from being voided or the fundamentals of the ICR system and prevents it from declared unenforceable after the reorganization has been being applied to a significant share of each country’s completed.33 Thus, the protection of new financing for the economy. This approach should be revised and aligned subsequent avoidance of insolvency is an area that might with international best practices, which recommend that need more attention from legislators. 28. Article 1 of the Bankruptcy Law, http://cbd.minjust.gov.kg/act/view/ru-ru/574?cl=ru-ru and http://cbd.minjust.gov.kg/act/view/ru-ru/574. 29. Article 2 of the Law on Insolvency (Bankruptcy). 30. Article 2 of the Law on Bankruptcy, https://www.lex.uz/acts/955393. 31. According to the World Bank’s ICR principles, “The insolvency proceeding should apply to all enterprises or corporate entities, including state-owned enterprises. Exceptions should be limited, clearly defined, and should be dealt with through a separate law or through special provisions in the insolvency law.” World Bank, Principles for Effective Insolvency and Creditor/Debtor Regimes, 2021 Edition (Washington, DC: World Bank, 2021), 22. 32. While the Kyrgyz Republic allows the administrator to obtain unsecured loans to finance the ongoing operations of the debtor, this provision has limited applicability and is not available in all stages of the reorganization procedure, which is not aligned with leading practices. 33. European Bank for Reconstruction and Development, EBRD Insolvency Assessment on Reorganisation Procedures. In particular, the EBRD report examined whether relevant local legislation includes express protection from avoidance actions for new financing provided in connection with a reorganization procedure—that is, whether judicial actions can be brought against legal entities and individuals who provide new financing to an insolvent debtor. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 c. Essential contracts. The assets of any given debtor are in a formal way. They can save viable firms by giving very likely to be closely tied to its commercial contracts. In the them much-needed breathing room at much lower costs Kyrgyz Republic, Tajikistan, and Uzbekistan, the insolvency than does a court-based process. However, the legal frameworks do not explicitly allow the continuation of regimes in Kazakhstan, the Kyrgyz Republic, Tajikistan, contracts that supply essential goods and services to the and Uzbekistan do not feature any procedures through debtor. Appropriate provisions that explicitly allow essential which a substantial part of the restructuring process is contracts to continue are available in Kazakhstan only. And conducted informally.37 even there, protection against the termination of contracts is available in bankruptcy (liquidation) proceedings only.34 f. Creditors’ priorities. For the efficient flow of secured Protection for essential contracts is not explicitly provided credit in an economy, creditors must be certain that they for rehabilitation or debt restructuring.35 If contracts were will be able to receive the proceeds arising from the sale permitted to be retained or assigned, it is likely that more of collateral if a debtor defaults on a loan. When secured value would be generated, and reorganization would creditors cannot be sure that they will be given priority with be more effectively promoted. This approach should be respect to collateral, they demand lower loan-to-value ratios considered by the four countries. from borrowers, thereby restricting access to financing. In Central Asia, only Uzbekistan does not give absolute priority d. Adopting a reorganization plan. Approving a to secured creditors when a business is liquidated. reorganization plan should be as efficient as possible while ensuring that the different interests of creditors 37. Consumer insolvency frameworks are yet to emerge are properly managed. For voting purposes, the best in Central Asia. While corporate insolvency has recently practice is to create several classes of creditors based drawn significant attention in Central Asia, especially after on their similarity and enable these classes to vote the Global Financial Crisis, consumer insolvency remains an separately on the proposed plan. However, in the Kyrgyz underdeveloped area except in Kazakhstan and Uzbekistan, Republic and Tajikistan, creditors are not divided into which are the only countries that have recently passed laws classes for voting purposes. Another important aspect on this area.38 The absence of such laws is a significant of reorganization proceedings is allowing the debtor to impediment to the resolution of consumer loans, as some select which creditors will be affected by the plan, leaving countries have seen very strong growth in consumer lending some of them unaffected, such as employees or trade in recent years (Uzbekistan, for example). A legal framework creditors. In Kazakhstan, the Kyrgyz Republic, Tajikistan, for dealing with consumer insolvency allows an overly and Uzbekistan, the debtor does not have the freedom indebted borrower to offer its creditors a repayment plan, either to choose which creditors are affected by the after which the remaining debts are canceled or “discharged.” reorganization plan or to leave out certain creditors whose When implemented properly, this framework can have several rights would not be affected. Providing for the possibility positive personal, social, and economic effects. Consumers to conduct a reorganization in which only some creditors get a fresh start while creditors’ recoveries are maximized. In are affected makes it easier to adopt a more flexible and turn, consumers can remain in the formal sector where, no effective reorganization plan.36 longer under pressure from creditors, they are more eager to be entrepreneurial. This increase in entrepreneurship enhances e. Out-of-court workouts. Reorganizing a loan in court is economic activity and maximizes government revenue via tax not always a fast or economically reasonable solution, collections. Despite specific ongoing initiatives in Kazakhstan especially for MSMEs. Out-of-court workouts, however, and Uzbekistan,39 the four Central Asian countries overall present multiple advantages, as they allow for flexible should focus on this aspect of ICR space. and confidential alternatives to addressing insolvency 34. In particular, according to Article 8 of the Law on Rehabilitation and Bankruptcy, the initiation of proceedings cannot be a basis for a unilateral refusal to perform a contract concluded before the proceedings and may not result in termination of the agreement. 35. See, for example, EBRD’s findings in EBRD Insolvency Assessment on Reorganisation Procedures, Kazakhstan (Economy Profile). 36. European Bank for Reconstruction and Development, EBRD Insolvency Assessment on Reorganisation Procedures. 37. Until 2020, a partly informal procedure was available in Kazakhstan. 38. A consumer insolvency law in Kazakhstan was enacted in December 2022, after the preparation of this report. The text of the draft law is available at https://legalacts. egov.kz/npa/view?id=13983794. The draft applies exclusively to “consumers” and explicitly excludes individual entrepreneurs, contrary to the World Bank Group’s latest ICR principles applicable to insolvency of micro and small enterprises. The law will enter into force in March 2023 and its provisions and impact are yet to be analyzed. 39. In Uzbekistan’s 2022 Insolvency Law, Chapter 14 is dedicated to individual insolvency. This chapter took effect on January 1, 2023 (per Article 249 of the law), after the preparation of this report. Its provisions and impact are yet to be analyzed. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 6. >>> Chapter 6. Recommendations 38. In light of the current economic situation, countries in Central Asia should step up their NPL reform agenda. The uncertain economic conditions stemming from global inflationary pressures, rising geopolitical tensions, the negative spillover from sanctions on Russia resulting from close economic ties between Russia and Central Asian countries, and the lingering effects of the COVID-19 pandemic all point to the importance of continuing the NPL reform agenda with the following goals in mind: a. Avoid an increase in NPLs by ensuring that banks have the tools to actively manage their delinquencies early on and that the bank credit risk underwriting standards remain sound. b. Ensure (a) that banks do not delay the reclassification and coverage of NPLs through restructuring or other approaches to avoid implementing the regulation and (b) that they comprehensively report their NPLs. c. Ensure that banks engage in sound restructuring practices only, which should include (a) a thorough, upfront, systematic assessment of the borrower’s viability; (b) a comprehensive assessment of the borrower’s debt-shouldering capacity if it is determined that restructuring the loan is worth the effort; and (c) repayment obligations that are arranged in a way that matches the borrower’s expected cash flows. d. Force banks that report high levels of NPLs to prioritize the quick reduction of these loans by ensuring that they allocate sufficient managerial, technical, human, and financial resources to this effort. e. Equip banks with enough of the right tools to manage their NPLs, including facilitating the sale of NPLs or speeding up court-based recoveries. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 39. Bank supervisors in Central Asia should build enough i. Supervisory IFRS9 assessment methodologies. capacity to effectively oversee the asset classification and This guidance focuses not only on the issues coverage under IFRS 9. Although the benefits of introducing that supervisors should consider at a minimum a regulatory regime based fully on expected losses may need when reviewing credit risk models but also on the to be weighed against costs in the short term, bank supervisors definition of the minimum tests and procedures for should upskill their capacity to ensure that they are able to comprehensively reviewing the banks’ quantifications, assess and challenge the banks’ calculations of expected among other areas. These methodologies are losses. Bank supervisors in the region can take several fundamentally qualitative, since they include a set of measures to improve their capacity, such as the following: criteria on all the issues relevant to supervising IFRS 9 models.41 a. Setting up specialized credit risk modeling teams in banking supervision. Modeling credit risk is becoming i. IFRS 9 challenger models. Supervisors can use common not only in the banking business but also in in-house models to develop their own alternative the regulatory and supervisory framework. Although calculations of the banks’ expected losses. This supervisors may not allow banks to calculate their credit enhancement of the supervisory toolkit would allow risk–weighted assets by using their internal models, they supervisors to quantitatively challenge the banks’ should be able to challenge the banks’ credit risk models internal credit risk models. in loan-loss provisioning (IFRS 9), in credit risk stress testing, and when supervising credit risk underwriting 40. The credit risk classification and coverage need models. To effectively challenge the banks’ credit risk to be further improved. First, in the Kyrgyz Republic models, supervisors should have a strong statistical and Uzbekistan, the limited recognition of collateral may background or be supported by the complementary skills discourage or not sufficiently encourage the development of an expert team/unit. Hence, it is important to create a of credit risk mitigation techniques. These countries could modeling unit composed of experts in statistics and credit consider expanding the list of eligible collateral to residential risk modeling who have the expertise to support line real estate, particularly if there is evidence that the collateral supervisors when reviewing the credit losses estimated can reduce the losses of the secured loans and that the assets by banks.40 can be subject to sound risk management actions. Likewise, the Kyrgyz Republic may start to consider the impact of b. Training on IFRS 9. The Kyrgyz Republic, Tajikistan, and collateral not only in credit classification but also in credit risk Uzbekistan face the same challenges regarding IFRS 9 coverage. Second, Tajikistan may consider restricting the implementation. They may provide common trainings on definition of NPLs to bring it in line with international standards IFRS 9 to build the bank supervisors’ capacity to effectively by including only the credit risk exposures that are 90 DPD challenge the banks’ credit risk models. (currently 30 days past due) or that have been assessed as unlikely to pay.42 Third, the loss category that forces banks to c. Developing methodologies and tools to effectively fully cover the loan exposure is currently set at 180 DPD in the supervise IFRS 9. Supervisors require tools that enable Kyrgyz Republic and Tajikistan. This very conservative practice them to effectively engage with banks in the supervision may discourage banks from recovering loans that have been of their credit risk models. Building on the experience overdue beyond that date. These two countries may consider of other supervisors, the four countries could consider identifying the loss category with credit exposures that have developing the following tools: been 360/5 past due, as Uzbekistan has done recently. Fourth, given the dollarization of the banking sectors in Central Asia, 40. One of the common challenges for establishing these units is finding the staff who have the right set of skills and knowledge to model credit risk. Many supervisors are attempting to address these challenges by doing the following: (a) upskilling employees of the central bank, which has traditionally been the most successful approach, but it is contingent on the availability of these staff members in the banking supervision department; (b) hiring an individual with the right skill set and building the team around him or her with new hires; or (c) hiring a consultant with experience in supervising credit risk models to train supervisors in this area. 41. For example, the guidance may include minimum standards on the governance of credit risk models (the role of the board, internal validation, risk management, and so forth); on the pooling of exposures by the same risk category; the supervision of models for estimating the PD and LGD; the minimum standards required to manage overlays; the minimum frequency of internal validations of models; the standards to be expected on information and data quality. 42. For example, Armenia has done so recently. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 the practice of using higher reserve requirements for certain their NPL exposures. The templates also act as a foreign-currency loans in the Kyrgyz Republic can be applied control tool through which supervisors can discuss in Tajikistan and Uzbekistan. with banks how they are performing in their NPL reduction plans.44 41. To manage high-NPL banks, the four countries in Central Asia could issue a regulation with the following features, iii. Independent and well-resourced workout units. among others: High-NPL banks should set up workout units with a clear mandate for managing the NPL. The units should a. A definition of “high-NPL banks.” The countries should be independent of the business and risk management consider laying out criteria to identify banks that should be units, and report directly to senior management. The considered as outliers and therefore subject to enhanced workout units should be responsible for executing the measures for reducing NPLs. Such measures would seek strategic and operational plans defined by the banks’ to ensure that these banks actively and decisively work boards, and they should be provided with enough out their NPLs to quickly reduce them while maximizing financial, human, and technical resources to reduce recoveries.43 their NPL. b. The general requirements that banks need to meet 42. Central Asian countries should address specific, when managing NPLs. The regulation should set the critical, legal deficiencies in their insolvency frameworks requirements that banks need to meet in identifying, in the following five categories: managing, covering, controlling, and reporting NPLs. These requirements should be applicable to all banks, not a. Including state-owned enterprises. State-owned only to those classified as having high NPLs. enterprises in the Kyrgyz Republic, Tajikistan, and Uzbekistan should be subject to insolvency laws and c. The specific enhanced requirements applicable proceedings. There should not be a distinction between to high-NPL banks. The regulation should set the types of debtors based on ownership. requirements that banks above the threshold should meet at all times, including the following: b. Allowing new financing. New financing after the commencement of insolvency proceedings and its i. Prepare strategic and operational plans for NPL protection are critical aspects of an effective insolvency reduction. In these plans, banks should define their framework because they allow a struggling but viable main quantitative and qualitative targets for NPL company to continue to operate. The Kyrgyz Republic and reduction in the short and medium term. The targets Tajikistan should allow debtors to obtain new financing. should be approved by each bank’s board and subject While this is possible in Kazakhstan and Uzbekistan, to constant challenge and control. Kazakhstan and new financing should be protected from being voided Tajikistan are already doing this, but making the or declared unenforceable after the reorganization has practice a regulatory requirement will allow bank been completed. supervisors to more easily enforce it. c. Allowing essential contracts to continue. The Kyrgyz ii. Use standardized information templates that Republic, Tajikistan, and Uzbekistan should explicitly force banks to report the expected, forward- allow essential contracts to continue during insolvency looking NPL trend during the plan’s time horizon. proceedings. Kazakhstan does this, but contracts are The information templates force banks to elaborately protected in bankruptcy (liquidation) proceedings only. identify the mechanism through which and the Protection for essential contracts should be extended to portfolios in which they are expecting to trim down rehabilitation or debt restructuring. 43. In some European countries, the threshold has been set as low as 5 percent. Therefore, all banks reporting NPL ratios above 5 percent are considered high-NPL banks and are subject to enhanced supervisory measures. 44. As mentioned previously, the templates were already introduced, albeit informally, in Tajikistan in 2019. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 d. Adopting a reorganization plan. One best practice for ensuring that the different interests of creditors are properly managed is to create several classes of creditors based on their similarity. This also enables the classes to vote separately on a proposed reorganization plan. The Kyrgyz Republic and Tajikistan should introduce creditors’ classes for voting purposes. In addition, all four countries should accord the debtor the right to choose which creditors are affected by the reorganization plan and to leave out certain creditors whose rights are unaffected. This approach results in a more flexible and effective reorganization plan. e. Creating alternative mechanism: out-of-court workouts. Out-of-court workouts present multiple advantages, especially for MSMEs, as a flexible and economically more viable mechanism for addressing insolvency. Complex insolvency systems and high legal fees deter MSMEs from using formal procedures to tackle financial distress. MSMEs are also frequently operated by natural persons as sole proprietors, potentially putting both the business and the personal affairs of the debtor- entrepreneur at risk. However, none of the four Central Asian countries has detailed procedures for out-of-court workouts, so they should develop these procedures and introduce special simplified procedures for MSMEs. 43. Finally, Central Asian countries should develop consumer insolvency frameworks. Some of the Central Asian countries have recently seen very strong growth in consumer lending. A consumer insolvency framework would allow an over- indebted borrower to offer its creditors a repayment plan, after which the remaining debts are canceled or “discharged.” As a result, the consumer would have a fresh start and be able to remain in the formal banking sector while creditors are repaid. While initial work along these lines has begun in Kazakhstan and Uzbekistan, all four Central Asian countries should focus on developing consumer insolvency frameworks. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 >>> Bibliography European Bank for Reconstruction and Development. EBRD Insolvency Assessment on Reorganisation Procedures. London: EBRD, 2022. European Banking Authority. Final Report—Guidelines on Management of Non-performing Loans and Forborne Exposures. Report EBA/GL/2018/06. Paris: EBA, October 31, 2018. European Central Bank. Guide to Banks on Non-performing Loans. Frankfurt, Germany: European Central Bank, March 2017. World Bank Group. How Insolvency and Creditor-Debtor Regimes Can Help Address Nonperforming Loans. Washington, DC: World Bank Group, 2021. World Bank Group. Insolvency Systems and Zombie Firm Proliferation in High- and Middle-Income Economies. Washington, DC: World Bank Group, 2022. World Bank. Principles for Effective Insolvency and Creditor/Debtor Regimes, 2021 Edition. Washington, DC: World Bank, 2021. World Bank Group. World Development Report 2022: Finance for an Equitable Recovery. Washington, DC: World Bank Group, 2022. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32