38397 FOR OFFICIALUSEONLY FINANCIALSECTORASSESSMENT GEORGIA JANUARY2007 EUROPECENTRALASIA REGION VICE PRESIDENCY & FINANCIALANDPRIVATE SECTORDEVELOPMENT PRESIDENCY VICE BASED THEJOINTIMF-WORLDBANKFSAPUPDATE ON The FinancialSystemAssessment (FSA) is basedonthe work of the joint IMF-World Bank Financial Sector Assessment Program(FSAP) Update missionto Georgia during February 15-28,2006.' The principalobjective of the FSAPUpdate was to assist the authorities in evaluating the potential vulnerabilities and development priorities of the Georgianfinancial system. Following reviews within the IMFand the World Bank, an Aide-MCmoire, Detailed Assessment of Compliance with Basel Core Principles and Technical Notes on Banking System Development and Risks, Insurance and ContractualSaving Sector, Securities Markets, and FinancialIntegrity have been submitted to the authorities. This report provides a summary of the main findings and recommendations. 1The FSAP Update team was headedby Steven Seelig (IMF)and was composed of Sonja Brajovic-Bratanovic (deputy, World Bank), Andreas Billmeier, MaliChivakul, Terry Donovan, MalineeRamiscal (all IMF),Goran Lind(IMFexpert), Peter Kyle, Rodney Lester, SusanRutledge (all World Bank), Keith Bell and Jesper Dockir (both World Bank experts). The accounting and auditing aspects were covered inJanuary 2006 by the Report on Observanceof Standardsand Codes (ROSC) for Accounting and Auditingheadedby Frederic Gielen (World Bank). 2 I. OVERALLASSESSMENT 1. Despiterecent rapidgrowth, Georgia'sfinancialsystemremainssmalland dominatedby banks. Withtotal assets of 22 percent of GDP, the bankingsector is still small, even by the standards of transitioneconomies. While the insurance and securities sectors are growing rapidly, they still account for a small fraction of the system. The structure of the banking sector is evolving towards greater concentration and formation of financial conglomerates led by banks. Many banks now have insurance and securities subsidiaries. 2. The financialconditionof the bankingsector hasimproved,as comparedwith 2001. The sector is reasonably capitalized and the nonperforming loanratio has fallen to 3.8 percent. However, some important sources of risk, particularly credit concentration and connected lending, are not yet adequately supervised. The current capital requirements inthe banking sector cover credit and foreign exchange risks, but not interest rate, market risks, and operational risks. The capital requirements are set on a bank-only basis and do not reflect the consolidated risks of bank subsidiaries. As the use of subsidiaries grows, this will become a more significant weakness. There are several weak institutions, and the NBG should make sure that these are recapitalized, or subject them to an orderly exit. 3. The stresstests revealcriticalvulnerabilitiesto economicshocks and to sharp fluctuationsof exchangerates, pricesandoutput. Stresstests suggestthat the banking sector is vulnerable to large currency devaluation and liquiditypressures. Rapid credit growth as experienced in2005, coupled with highly dollarized balance sheets, could pose risksto financial stability. An economic scenario similar to the events experienced duringthe Russian debt crisis, accompanied by a liquidity run, would result inmost o f the largest banks becoming undercapitalized and one becoming insolvent. 4. The authoritieshaveimplementedmany of the 2001FSAP recommendations. (Attachment 1provides a more detailed summary.) Inthe banking supervisionarea, amendments to the NBG law and introduction of an AML/CFT regime were implemented as recommended. The NBG addressedthe most pressing supervisionissues and dealt with problembanks, but progress was slower inimproving the relations with external auditors or inestablishing acontingencyplanandacrisis managementgroup. Indevelopinggovernment securities markets, the agreement to securitize government debt to the NBGwas an important step. 5. While there was significant progress,many issuesremain. Regular, systematic coordinationand the exchange of information among regulatory and supervisory authorities are lacking, and there are differences inprudential standards and inenforcement practices. The Law on Licensing and Permits, passed last year, aims to eliminate barriers to entry. However, its formulations have created legal uncertainties and questionthe capacity to effectively apply the "fit and proper" standards for intermediaries inthe financial sector. Other key issues include the inability of non-bank supervisory agencies to get information about shareholders and affiliated structures and activities or to identify sources of funds; the lack of tools to mandate improvement of corporate governance of entities under their supervision and the lack o f authority to impose adequate penalties and fines. There were 3 major improvements inthe legal framework, but the court procedures and execution o f judgments remainproblematic. 6. During the past several years, significant progress has been made indeveloping a legalframework for AMWCTF and establishing a financial intelligence unit.While there may be roomto streamline some aspects of the AML law, any changes should be carefully considered inorder to avoid negative internationalpublicity and reputational damageto Georgianfinancial institutions and markets. A full AMLKFT mutualevaluation will be undertaken bythe regional FATFbody later this year. 7. Progress was also made in introducing internationalaccounting andfinancial reporting standards, especially in banks. However, weaknesses inthe applicationof accounting and financial reporting standards inthe corporate sector and the lack of appropriate audit standards undermine confidence incorporate financial statements. This, in turn, leadsto an increase in loanspreads andnegativelyaffects access to credit. Similarly, the lack o f confidence inaudited corporate financial statements discourages equity investments inbusinessesandhinders the development of capital markets. 8. Weak institutions and the widespread lack of technical knowledge and of principles and practices ina market economy are serious problems. The difficulties are further complicatedby low salary levels, especially incivil service institutions, the lack of moderntechnology-based tools, and inadequate access to training. Corporate governance reform and introductionof accounting and financial reporting standards consistent with good practices are the key reformpriorities. Building staff and management skills are also important priorities. 9. Access to financial services and to credit is inadequate, especially in rural areas. Access to banks is a problem. O f the 12regions inGeorgia, half have less then one bank branch per 100,000 citizens. Privatebanks are unlikely to open a branch, unless they are sure that the branchwould be able to operate profitably. The interest rates are high incomparison with other more developed transition economies.2The risks associated with collecting against collateral, and the lack o f good credit information, contribute to highlending spreads. Facilitiesthat would assist with appraisal and management of credit risk, including improved capacity to use and collect on collateral, would greatly improve chances for SME access to finance. 10. Development of a nationalstrategy to address the lack of financial services and credit in large partsof the country, especiallyin ruralareas, should be a high priority. Banks have little interest inimproving services insmall urban and rural areas, giventhat it will take too long for them to recover their investment. The credit portfolios of microfinance institutions (MFIs) and credit cooperatives are still disproportionately concentrated inor near major cities and hence are not serving rural constituencies. The NBGwas slow to implement the nationalpayment systems strategy and did not take the lead indeveloping other elements 2 Inthe first quarter of 2006, nominal interest rates were inthe 17-25percent rangewith (annualized) inflation of around 5 percent. Both interest rates and inflation were slightly higher in 2005. 4 of the financial sector infrastructure, including settlement and clearing systems and other items necessary for the creation o f a nationalplatform and widespread use of electronic payment instruments inall parts o f the country. Enterprise and credit risk registry and registries of mortgages and pledged movableproperty are absent. Yet, such registries would facilitate credit risk management and, thus, access to credit. 11. Beyondstability,there is a developmentalissueinthat foreigninvestmentsinthe financialsector are unlikelyinan environmentthat significantlyfailsto meet internationalstandards. A list ofpriority recommendations is presented inBox 1.A more detailed summary o f recommendations is provided as Attachment 2. Box 1.Priority Recommendations CrisisManagementandBankResolution 0 Establish formal crisis managementteam and develop a crisis managementstrategy and contingency plan. 0 Develop clear rules as to whether and when it i s appropriate to use NBG resources when banks experience difficulties. FinancialSector Supervision Amend law to give the NBGauthority to establish fit and proper criteria for bank owners, to determine the sourceof the owners' capital, and to mandate changes ina bank's ownership. The same power should also be given to insurance and securities supervisors. 0 Amend regulations to apply capital and other prudential requirements on a consolidated basis. 0 Adopt legislationto stimulate cooperation and allow for the sharing of information among domestic financial sector supervisors. 0 Amend the Law on Licensing and Permits to ensurethat financial sector supervisors have full powers over issuanceandrevocationof licenses. 0 Consolidate the supervision of pension system management firms into the insurance supervisory agency. FinancialSector Development 0 Develop, under the lead of the NBG, elements of the financial sector infrastructure, including low the value payments system and widespread use of electronic payment instruments throughout the country. 0 Develop a national strategy to address the lack of financial services inlarge partsof the country, especially inrural areas. 0 Allow insurance companies to diversify their investments. 0 Improve the quality of financial statementsby adopting financial reporting standards and develop clear standardsfor audits. 0 Undertake necessarylegal reforms to improve enforcement ofjudgments. 11. OVERVIEW OF THE FINANCIAL SYSTEMAND INTERMEDIATION 12. The financialsector hasgrown since the 2001FSAP, though it remainssmallby internationalstandardsand is stilldominatedby banks. Since 2001, bank assets have grown at an annual rate of 30 percent to reach 22 percent of GDP at end-2005. Moreover, 5 while still low, deposits have grownto 11.3 percent of GDP up from 6.3 percent in2001. Similar growthhas been experienced inthe insurance and securities sectors. Insurance company premiumincome has increasedthreefold inthe five-year period ending2004. The securities market has grown from virtually nilto an annual turnover of GEL 62 million in2005. 13. The commercialbanking,insurance,andsecuritiesmarketshavebecome interconnectedinways that mayincreasethe increasethe risksof contagionand,hence, vulnerabilityof the system. There are an increasing number of financial conglomerates, with commercial banks having acquired both insurance and securities firms.Insurance companies hold the bulk of their assets as deposits incommercial banks, and many insurance subsidiaries hold a portion o f their assets as deposits intheir parent banks. Such inter- linkages with parent banks pose supervisory challenges and create vulnerabilities to inter- industry contagion. Similarly, the securities markets have become linked to the fate of banking. Over 50 percent of the value and volume of shares traded onthe Georgian stock exchange in2004 were shares of banks. Inaddition, innominee name, the securities affiliate of one of the banks is one of its larger shareholders. 14. For the financialsystem, the mainmacroeconomicrisks arise from potential capitaloutflowsandsharp fluctuationsinexchange rates,prices, and output. Continued progress inprivatizing the remaining state-owned enterprises is not certain, and privatization receipts are volatile. Georgia continues to be a highly-dollarizedeconomy. While the NBG intends to avoid a substantial further appreciation of the lari due to competitiveness concerns, interventions on the foreign exchange market cannot be fully sterilized due to the lack of monetary policy instruments. Hence, large-scale interventions would have a direct effect on liquidity, posing a challenge for inflationwith negative effects onbusiness environment. A weakening business environment could trigger a shortfall of privatizationreceipts, a depreciated exchange rate, and a reduction inoutput. 111. THEBANKINGSYSTEM 15. As of February28,2006, there were 18licensedcommercialbanksoperatingin Georgia.Foreignparticipation inthe banking system is significant, with majority ownership inten banks, including private foreign investors, banks fromthe former Soviet Union, and international financial institutions and development agencies. The six largest banks control more than 85 percent of the total assets, with the largest two banks controlling 40 percent of assets. Loans to the private sector are dominant banking assets (67 percent), while securities holdings are negligible (1percent). Onthe liabilities side, deposits account for 62 percent of total liabilities. Both credit and deposits inforeign currencies account for well over 70 percent of the banking sector balance sheet. 16. Bankperformancehasimprovedsignificantlysince the 2001FSAP. To a large extent, these results have been achieved through a combination o f loan growth, highmargins, and a declining nonperforming loanratio. Returns on assets and equity were 3.1 percent and 14.9 percent in2005, respectively. Credit to the private sector increased dramatically in2005, to anestimated 15percentofGDP, withthe numberof loanshavinggrownby 34 percent and the total value by 83 percent. 6 17. The condition of the system as a whole is generally sound, though several weak institutions remain and continued rapid credit growth raises some concerns. The banking sector reporteda capital to risk-weightedassets ratio of 17.5 percent, well above the 12percent requirement of the NBG.3The excessive credit growth in2005 raises a number of concerns, includingthe pressure for banks to raise capital to keep up with lending growth and the capacity of the banking system to expand intermediationat such a rapid pace without significantly underminingcredit standards. 18. Stress test results suggest that the banking system as a whole is vulnerable to a combination of large depreciation, increasing interest rates, credit shocks and deposit o ~ t f l o wThe highdegree of dollarization (over 70 percent of loans and deposits) makes the . ~ Georgianbanking sector vulnerable to changes inthe exchange rate. The booming realestate sector magnifies the credit risk, since over 30 percent of total loans have real estate collateral. For liquidity, most banks would fall below the minimum30 percent liquidity requirement with a 10percent withdrawal of deposits. 19. The regulatory and supervisory framework for bankshas improved, but some issues remain. Since 2001, the Banking Law and the Central Bank Law have beenamended andthey are currently close to international practices. The NBGhas issuedregulations introducing capital requirements for foreign exchange risk, limits on connected lending, a double risk weight on loans inforeign currency to borrowers who only have cash flows in lari, and requirements for internalaudits. Among remaining issues, the most pressing are the lack of cooperation among Georgianfinancial sector supervisors, no capitalrequirements for interest rate risk, absence of consolidated supervision, and no regular contact betweenNBG management and individual bank managements, directors, and external auditors. 20. The Base1Core Principles (BCP) assessment of bank supervision notes significant progress since 2001, but also found a number of weaknesses, including: (i) inability to identify the true owners of banks, to obtain information about shareholder and affiliated structures and activities, or to identify sources of funds; (ii) the lack of consolidated supervision of banks, subsidiaries, and affiliates and absence of consolidated capital rules; (iii) constraintsthathindercooperationandinformationsharingamongdomestic secrecy financial sector supervisors; and (iv) effectiveness and efficiency o f NBG supervisory staff. (The same deficiencies affect the insurance and securities sector.) The quality of prudential reportinghas to be further improved. For example, banks do not regularlyreport details on The realcapital ration is lower, as capital requirements include credit and foreign exchangerisks, but do not cover interest rate and market risks. Also, improper reporting of loan quality and under provisioning of problem assets, reported as a problem by the NBG, result inhigher capital ratios. Stress tests were performed for the 10largest banks individually and for all banks aggregated, on the basis of the banks' end-2005 data. Sensitivity analyses were performed separately for exchangerate, interest rate, liquidity, and credit quality deterioration shocks. The relationships between the macroeconomic shocks and credit quality, and between credit quality and expected losses were assumed, as there are no consistenthistorical data on such relationships. 7 credit concentration and exposures to connected parties. The information on interest rates, foreign exchange and market risks should be improved. 21. The efficiency and effectivenessof the supervisory process can be further improved. The lack of a consolidated supervisory framework for risk assessment is a pressing deficiency given the trend to form financial conglomerates. An excessive amount of time and effort inthe off-site and on-site examination work is devoted to documenting financial details (compliance checks), rather than on assessingthe underlying risks and condition o f banks. Although NBGmay not be ready for fullrisk-based supervision, some steps inthis direction could be taken now, such as spending less time and effort onthe systemically insignificant small banks and the nonbank depository institutions; reallocating freed resources to the monitoring of the major banks; and developing supervisory tools which will make future supervision more effective. The supervisory processes within the NBG could also be simplified, e.g., by a higher degree of delegation of decision-making powers. 22. The lender-of-last-resort function (LOLR),especially for large banks experiencing difficulties, needsto be better clarified. The NBGperforms the LOLR function for banks experiencing financial difficulty or to facilitate a bank resolution. Clear rules as to whether and when the use of NBG resources or government funding, as well as what is acceptable collateral, should be established. While the recent failure of a bank deemed systemically important involved coordinationof the NBGwith the MOF, there is a needto formalize the process, establish an intra-governmental crisis management capacity and introduce more formal contingency planning. As part of this effort, it would be helpfulto establish a more formal crisis management team and develop a crisis management strategy and contingency plans. 23, Explicit government-backed deposit insurance would not be advisable untilall outstanding problem banks are resolved. A precondition for deposit insurance is the establishment of a healthy banking sector and a strong disclosure and supervisoryregime. IV. NONBANK FINANCIAL SECTOR 24. Insurancesector, while still very small, has been characterizedby rapid growth, especially in the nonlife industry. Insurance and contractual savings still has a very low penetrationrelative to peer countries (as measuredby GDP per capita). Although growing from a low base, gross premium income increased more thanthreefold inthe five years ending 2004, to GEL 45.1 million (0.4 percent of GDP). There are 16 licensed insurers and one authorized private pensionplan operating inthe country. 25. The licensing and supervision responsibility for the insurance sector is vested with the State Insurance Supervision Service of Georgia (SISSG). The SISSG made steady progress since 2001, but its skill set needs to be further improved. The SISSG should adopt a risk-based supervisionmodel and improve its focus. The supervisory effort should be concentrated on the six to seven largest institutions, given the concentrationinthe industry. This could be supplemented with a gradualincrease inminimumcapital (with the EU requirements as a final objective) to further encourage a rationalization o f the industry's structure. 8 26. Since the 2001FSAP, there have been major legislative advances inthe insurance sector and further improvements are on the way. Among the most important are: (i) introduction o f a levy on insurers, making the supervisor financially independent the and (ii) giving the SISSG the power to withdraw license^.^ The amendments under preparation include definitions of the actuarial profession and its role, requiring that all insurers be registered asjoint stock companies, introducing whistle-blowing responsibility for auditors and specifying financial sanctions inthe Administrative Offenses Code. 27. However, a number of deficienciesstill need to be addressed. The Insurance Law does not adequately supplement the minimal licensing requirements mentioned inthe LicensingLaw. At the very least, some basic "fit and proper" rules and a three-year solvency planshould be added. The SISSG is not able to cooperate and share informationwith other supervisors. Brokers do not need a license. Insurers are not liable for the actions of their agents. The current multi-institutional regulatory structure for insurance and pensions is unnecessarily broad, especially since there is no genuine supplementary pensionsystem, and the pensionsystem supervisionfunction could be consolidated into the SISSG. 28. There is substantial scope for further growth of the insurance sector. Insurance market offers few compulsory products and continues to be dominatedby property insurance. The 2001 suspension of mandatory third party liability insurance for motor vehicles has negatively affected premiums, and its (proposed) reintroduction in2007 should substantially raise the premiumincome. The contractual savings sector (life insurance and supplementary pensions) is currently small, accounting for less than3 percent of total premiums, but has a significant growth potential. Health insurance i s also becoming a significant component of nonlife premiums, although coverage is still limited to the larger employers and targeted social programs. 29. Inorder to reachits growth potential, insurance sector should be providedwith additionalinvestment options. The growth potentialof the contractual saving sector is especially sensitive to the capacity of insurers to safely and productively invest the funds they receive. Currently, they are barred from investing inequities and constrained to a maximumo f 15 percent investment incorporate bonds. Inthe absence of a deep and well functioning capital market, insurers should be able to invest abroad. Without such options, insurers' assets are increasingly concentrated ina small number of banks and inreal estate. Securities Market 30. The legaland regulatory framework for capital markets is based on the Securities Market Law, which is generally inline with international practices. There are, however, still a number o f open issues, and some of the 2001FSAP recommendations have not yet been addressed. Of the open issues, especially important are those related to the However, with the new Law on Licenses and Permits, the power of the SISSG to revoke a licensehas become unclear. Also, licensingrequirements for insurance companies are minimal. 9 inadequate enforcement powers of the NationalSecurities Commissiono f Georgia (NSCG), the quality of oversight of self-regulatory organizations (SRO), the transparency in operations of the Georgia Stock Exchange (GSE) and the lack of cooperation between domestic supervisory authorities inthe financial sector. 31. The NationalSecurities Commission of Georgia(NSCG) is a regulator and supervisor of all market participants including brokerage companies, stock exchanges, securities depositories, and share registrars. The commissioners are appointed directly by the president and confirmedby Parliament. The NSCG is legally, but not financially, independent. Its dependenceon the state budget negatively affects its effectiveness, but the volume and turnover inthe capital markets are too small to be able to generate sufficient income for the NSCG. 32. Since 2003, the NSCG has become a (de facto) registry for joint stock companies' (JSCs)financial reporting.6 A criticalreview of NSCG functions would indicatewhich functions are important to strengthen and which shouldbe removed because they are unrelated to its primary mission. Collection and review of financial statements (of unrelated companies) has become the NSCG's primary responsibility, which places a heavy, but unnecessary, burdenon its staff. Moreover, the NSCG is unable to impose any sanction on JSCs that fail to report or provide inaccurate information. The NSCG appears to be ineffective and is overstaffed, as compared to the regulatory and supervisory agencies inthe banking and insurance sectors. 33. The institutionalframework for the securities market includes Georgia Stock Exchange (GSE) and Georgia Central Securities Depository (GCSD). There are currently 17 specialized brokerage firms, many ownedby commercialbanks. The GSE, with the self- regulatory (SRO) status, is the only organized securities exchange inGeorgia with market capitalizationof about GEL 580 million or 5 percent of GDP. It was established in 1999 as a not-for-profit organizationowned by its members. Trades made at the GSE are settled via the GCSD. The GCSD is a majority-ownedsubsidiaryof the GSE and an SRO inits ownright. There are seven licensed security registries. Companies with fewer than 50 shareholders are allowed to keep their own shareholders' register. 34. The GSE offers two forms of listings(fulllisting and admission to trading). Neithercategory requires companies to publishfinancial and other informationthat might have a substantial impact on the price of shares. The GSE has one JSC with fully listed shares, and 279 companies have their shares admittedto trading. Only two JSCs have issued corporate bonds. The low turnover of individual shares makes it virtually impossible for brokers to rely on market prices as an indicator of current share values. This has led to a practice where, although the actual trade takes place on the GSE, the conditions for a trade are agreed bilaterally outside the market prior to the trading session. Over 80 percent of the trading value is comprised of the shares of five companies. An amendment to the Securities Market Law in2003 increased the number of reporting companies from about 400 to 1,850. 10 35. Proposedlegislation to abandoncompulsory trading on the stock exchange for securities admitted to trading or listing,ifenacted, would result ina serious setback to the integrity of the nascent stock market. At the least, permission to trade off the exchange should be accompanied by anobligationto promptly report the terms and prices to the respective exchange, inorder to assure market transparency. The reopening o f the market for government securities would be another important step to stimulate development of securities markets inGeorgia. Without government bond issuance, there is currently no benchmark to develop a yield curve that would facilitate pricing of other private issuers of bonds. Inthis regard, the securitization of the government debt to the NBGcould help revitalize the market. Microfinance Institutions 36. Microfinance Institutions (MFI)are small and have not yet reached the stage of long-term sustainability. The sector is currently funded at below market rates by NGOs, who also provide various types of operational support. There were 11larger MFIs with loan portfolios of about GEL 38 millionas of September 2005, serving about 37,000 clients in about 54 locations mostly inurban areas. The sector is highly concentrated, with the two largest M F I s accounting for about 64.5 percent of the total credit portfolio. The MFI geographical coverage echoes the banking sector patterns. MFIs are concentrated inthe same regions as banks and leave most rural areas uncovered. 37. The microfinance sector is at a turning point inthe processof changing its nongovernmental organization(NGO) status. The development of MFIs started with a number of projects runby internationalcharities, registered either as Georgianbranches of international nongovernmental organizations or as localnot-for-profit organizations. The new MFIlaw is currently beingdiscussed. While there are stillsome disagreements onthe details regarding their legal status, the M F I s will not be allowed to take deposits. The long-term sustainability o f the MFIsector is yet unclear. Credit Unions 38. Credit Union sector is small and plays a negligible role in the economy. There are 40 active credit unions inGeorgia, mostly inurban areas, with the total assets of about GEL 1.8 million. The two largest credit unions located inthe two largest cities account for 56 percent of total assets. Credit unions are nonbank depository institutions licensed and supervised by the NBG. The legal and supervisory framework for the credit unions is modern and prudentialrequirements are fully enforced. The NBGreports serious compliance problems affecting a large number o f CUs, and resulting infrequent suspensions o f licenses. The C U sector is not likely to play a significant role inproviding access to finance for the poor and inrural areas, at least not inthe near future. Access to Finance 39. Access to financial services and credit is inadequate, especially in rural areas. O f the 12 regions inGeorgia, halfhave less then one bank branchper 100,000 citizens. Access to credit is also inadequate, althoughthere seems to be a potentially strong loan demand.A number of S M E surveys found that about 70 percent of registered micro- and small- 11 enterprises would like to be able to borrow. Yet, only about 15-20 percent (mostly from urban areas) actually applied for a loan, and less then 10percent of those have been able to get a At 16-20 percent, the interestrates are rather high. The lack of goodcredit information and the risks associated with collecting against collateral contributeto high lending spreads. Inaddition, banks mentionoperational inefficiencies and the high cost of compliance to NBGliquidityrequirements. 40. Developmentof a nationalstrategy to addressthe lack offinancialservices and credit inlargepartsof the country, especiallyin ruralareas, shouldbe a highpriority. Bankshave little interest inimproving services insmall urbanand rural areas, giventhat it will take too long for themto recover their investment. The credit portfolios of microfinance institutions (MFIs) and credit cooperatives are still disproportionately concentrated inor near major cities and hence are not serving rural constituencies. The NBGwas slow to implement the nationalpayment systems strategy anddidnot take the lead indevelopingother elements of the financial sector infrastructure, including settlement and clearing systems and other items necessaryfor the creationof a national platformand widespread use of electronic payment instruments inall parts of the country. Facilities that would assist with appraisal and management of credit risk, including improved capacity to use and collect on collateral, would greatly improve chances for the S M E access to finance. V. FINANCIAL INFRASTRUCTURE Legal Framework 41. The legalframeworkhassubstantially improvedsince the 2001FSAP. The Law onthe NationalBank of Georgia and the Law onthe Activities of CommercialBanks have been significantly revised inaccordance with internationally accepted practices and other financial sector legislationhas been updated and modernized. At the same time, a number of issues noted in2001 are yet to be addressed. 42. Sincethe 2001FSAP,there havebeenimportantadvances, includingchanges to thejurisdiction of the courts, significant increases insalaries for judges, a substantial increase inthebudget allocationfor the sector, andcreationofanewtraining facility. Whilepetty corruption seems to be a thing of the past, political intervention seems to be as pervasive as ever, andjudicial independence remains at a low level. The public perceptionof the judiciary remains poor. The continuing backlog of cases, poor infrastructure, and serious problems with the execution o fjudgments has resulted ina lack of confidence inthe ability o f the courts to enforce contracts and to administer justice ina fair and impartial manner. 43. Ofthe remainingissuesto be addressed, bankruptcyproceduresand the executionofjudgments are particularlyimportant.While there were some improvements, 'In addition to problems with physical proximity, the reportedreasons for difficulties inaccess includelow profitability of business and/or high interest rates- 69.5 percent; lack of information about banks' credit appraisalrequirements or inability to collect the necessarydocuments, or lack of credit history - 35 percent; lack of trust informal credit institutions- 38 percent; and incapacity to provide collateral -25 percent. 12 the concept o f bankruptcy is still not well understood, and the procedures are regarded as complicated and outdated. A new modernInsolvencyLaw should be promptly completed and enacted. For the execution ofjudgments, a study should be carried out to examine options for the related Law and a new Law on Arbitration should be enacted. Accounting and Auditing 44. International Accounting Standards (IAS) andInternational Financial Reporting Standards (IFRS) were introduced,* but the actual practices do not result in reliable, timely, and useful financial information. The NBGdoes not enforce compliance with IFRS incommercial bank financial statements. It was suggestedthat aneffective and practical way to address the IASDFRS noncompliance issues is to adopt a differential approach to financial reporting requirements using a three-tiered reporting structure' so the cost of compliance will be proportional to the public interest inthe respective enterprises. 45. Statutory audit requirements cover banks, insurance, andjoint stock companies. However, the quality of audits has not been adequate, and the obligation to comply has not been effectively enforced. Inmid-2005, the qualificationrequirements for firms that carry out statutory audits were abolished (most likely as a consequence of the new Licensing Law). Evenwithout adequate technical expertise, an audit firm is now permittedto audit a bank, an insurance company, or a public interest entity, and this can have serious negative consequences. Recognizing that banks' financial statements are different from those of other businesses, the NBG should be empowered to establish minimal experience and knowledge requirements for auditors assignedto bank audits. The same mandate should also be given to other supervisory authorities. And the audit requirements should be effectively enforced. Financial Integrity 46. Georgian AMWCFT framework, developed inresponse to the FSAP 2001 recommendations, is largely consistent with international practices. The financial intelligenceunit has become operational and because of its locationwithin the NBG, it enjoys both industry and public confidence that the information it collects will remain confidential. The effectiveness of the AMLKFT framework will be assessedby the upcoming MONEYVAL evaluation. The FSAP team assessed only issues critical to financial integrity. The most critical issue inGeorgian corporate governance is the low transparency o f ownership and control structures -banks and other financial institutions should be required to disclose to the supervisory agency the identities of all significant shareholders and the control relationships. Supervisory boards should be mandatedto take more direct * Until2006, the Georgian accounting standards were basedon the InternationalAccounting Standards (IAS) 2000 version and, from 2006, on the IAS2004 version. However, some of the more recent changes to IFRS have not been applied in Georgia, nor has IAS 39 been applied to banks. Systemically important entities (also known as "public interest entities") should be requiredto present their (consolidated) financial statements inconformity with "full IFRS." Small andmedium enterprises should conform to simplifiedfinancial reporting requirements. Very small and micro enterprises should apply simple tax-basedrules. 13 responsibility for financial reporting, risk management, and internal controls, including establishment of an audit committee. Payment Systems 47. The NBGshould be given a formal mandate for oversight of or accountability for the integrity of the nationalpayment systems infrastructure. The NBGled the development of a nationalpayment systems strategy inresponse to the findings of the 2001 FSAP.A NationalCommittee for the Development ofPayment Systems (National Committee) was created and a nationalpayment systems strategy was defined and agreedto at the conceptual level. Yet, many o f the important development aspects have not been addressed, and progress inactually implementingthe strategy has been rather slow. 48. The only existing element of the national payment systemsinfrastructureis a real-time-gross-settlement (RTGS) system operated by the NBG. The RTGS does not have operating problems, but several areas require improvements, including the legal framework (e.g., clear rules regarding the irrevocability and the finality of settlement); operating procedures (especially concerning liquidity, such as more effective liquidity support for intra-day settlements, or flexible use of mandatory reserves); and accepting, in additionto the commercial banks, other key players inthe financial sector (National Treasury and Central Securities Depository) as direct participants inthe system under adequate legal and institutional arrangements. 49. The NBGinitiative to develop a low value clearing and settlement (LVCS) system is long overdue. The LVCS should be usedto clear and settle, on a net basis, recurringpayments such as salaries, pensions, and utility bills. This will increase the efficiency of the payments system as a whole. 50. The NBGshould also provide leadership to develop nationalinfrastructure for electronic payment instruments, which would contribute to improving access to financial services. The lack o f leadership onbuilding the infrastructure needed for card systems has resulted inmultiple (and seemingly incompatible) processing centers and increased costs. As a minimum, the NBG should support the necessary regulation(related to acceptance, irrevocability and finality o f settlement, the legal basis for electronic documents and electronic-digitalsignatures), establish the technical parameters ensuring effective interfaces with the low value payment system and sharing of the e-payments related infrastructure (such as the automated teller machines and point-of-sale devices). 14 ATTACHMENT 1:GEORGIAFSAP2001 PROGRESSONIMPLEMENTATIONOFTHEKEY - RECOMMENDATIONS 2001FSAPRecommendations Progress Bank Supervis nand Regulations Parliamentary approval of the proposed amendments to the The new NBGlaw came into effect inNovember 2001. NBGLaw and to the BankingLaw by October 2001. A consistent analytical framework for resolving insolvent NBGissueda decreein2002 that outlines the framework for banks shouldbe developed and implemented. problem bank resolution. Implementationstarted. A strategy andprogramto be developed and put inplace Basic elementsneededfor an effective W C F T regime are with rules, policies and statues againstmoney laundering. inplace, andit is movingcloser to effective implementation. The NBGshould be able to obtain information from banks' N o progress. NBGhas no power to imposerequirements, or external auditors; reject audits that are unsatisfactory; opposethe appointment of an unsuitable or incompetent specify minimumrequirements for the scope of the audit; auditor (CP 19-materially noncompliant). The new Licensing and sanction auditors who do not performto accepted Law hasresulted in significant deterioration of the quality of professional standards. audit profession. The BSD should develop procedures for special supervision NBGissued a decree in2002 that outlines the framework for for banksidentified as likely to have their licenses revoked supervising and resolving problem banks. to protect against asset stripping. NBG should establish a crisis managementgroup, including No progress NBG and MOF should establish a strategy of strengthening Someprogress. T-bill market was developed, but disappeared public debt managementand developingthe government since mid-2005 as the Government has no financing needs. A securitiesmarket. M O Ubetween MOFand NBGwas signedinMarch 2006 addressingthe issue of securitization of government debt at the NBG. NBG monetary management should be strengthenedto Some improvement. Need more tools for monetary operations. reducethe high liquidity and reserve requirement ratios. overseeinga modern payment and settlement system, National Committee for the Development of Payment including low value or batch payment system. Systems). However, the low value payment system i s not in place. The NBGstill has no oversight responsibility or formal accountability for the national payment system iniastructure. NBGshould facilitate the introduction of alternative II Littleprogress. Initiativeleft to banks. - - mediums of exchange (such as checks and debit and credit cards) to facilitate noncash transactions. LegalFramework A comprehensivereview of Georgia's law and practice Someprogress. A working group to review the bankruptcy law ~~~ ~ ~~ ~~ ~~ ~~~ ~~ relatingto bankruptcy should be carried out. framework established inMay 2003 (EBRD). Nodraft proposal has yet been tabled. A law on collateral needs to be adopted. The enforcement Someprogress. Collateral law substantially revised inJune regime should bereviewed. 2005, effective inMarch 2006. However, enforcement of security remains a serious problem, as the court execution procedures are slow and unpredictable. NBG should review court procedures that affect the II To a limitedextent, court proceduresrelated to contract enforcement of contracts and the recovery of debts, with a enforcement and debt recovery were addressed inthe reformof view to simplifying the process and reducingthe related Georgia's collateral law provisions. However, execution of direct and indirectcosts. iudgments remains difficult. 15 ATTACHMENT2: GEORGIAFSAPUPDATE 2006 RECOMMENDATIONS - Issues Recommendations Banking supervision needs further improvements. Implement therecommendations inthe BCP assessment. A trend for banksto establish or acquire nonbank Implement consolidated supervision. Increasecoordination with firms. other financial sector supervisors. Problem bank resolution slow and ineffective. Develop crisis managementstrategy. Establish crisis management team, including the MOFrepresentatives. Take timely actions on weak banks. Use of Lender Of Last Resort (LOLR)facility Clarify rules for the use of NBGfunding inbank failures. Clarify unclear. what i s acceptablecollateral. Issue NBGguidelines on principles andrules for the use of its LOLR facility. OECD passportallows any insurer to enter Georgia, "Satisfactory financial condition" and "time inactive business" regardlessof its financial positionand track record. criteria should be the minimum.The SISSG should confirm with the home supervisor that the parent company is in"good standing." Current licensing criteria do not include "fit and Require minimal "fit and proper" licensing for management and proper" or financial viability. supervisory board and evidence that solvency can bemaintained duringthe initialoeriod. Brokers are not licensed. Insurers are not I Introduce adequatelicensing- criteria andresponsibility. responsible for actions of their agents. The SISSG has limitedpowers of Introduce a simple regulatory ladder. intervention-between doing nothing and withdrawing a license. Unhealthy concentration of insurance companies. Allow insurers (and pension schemes) to invest inforeign assets indomestic banks and real estate. securities that are highlv rated. subiect to orudential limits. The NSCGhas some systemic responsibilities, but Transfer the supervision responsibility from the NSCGto the does not effectively overseethe nonstate pensions. SISSG. Establisha separate unit for this function. SISSG's skills are not adequatefor the emerging Apply risk-based supervision. Minimumskills criteria for future consolidated market and increasing risk levels. recruits should be defined. Existing staff should be required to improve technical skills. NonstatePensions The law requires that a specialized depository be Allow the central depository to handle pension scheme assets. usedfor pensions. A specialized depository has not been created. The NSCGhas inadequateenforcement tools. Amend legislation to allow the supervisory authority to enforce the prudential rules. The NSCGhas heavy but unnecessaryburden to Reducethe number of reporting companies basedon reasonable review balancesheets of alljoint stock companies. criteria. Reviews should be meaningful, including reprimand. Off-exchange trading leads to market distortions Oblige companiesto report off-market trading to the GSE. unless promptly reported to the stock exchange. NSCGdoes not appear to have adequate Reorganize the NSCG. Improve financial independenceof independence.It appears overstaffed and securities supervisor. ineffective. Despite of increasing ownership of brokerage firms Improve coordination between banking and insurance sector by banks, no adequatecoordination. supervisors. Sign a Memorandum of understanding explaining 16 gal Framework NBGdecisions to revoke a license overruled bythe Limitby legislationthe ability of the courts to review the courts-resulting intechnically insolvent banks substantivetechnical aspects-as opposedto the procedural continuing to operate. aspects-f NBGdecisions. The fit and proper criteria for bank administrators Adopt amendmentsto the Banking Law to strengthenthe fit and and significant shareholdersneedto be proper criteria for bank administrators and significant shareholders. strengthened. There is no legal basis inGeorgia for the creation of Consider introducing aLaw on Credit Information Bureaus. credit information bureaus. Microfinance institutions (MFIs) are not adequately Adopt acomprehensive Law on Microfinance Institutions and regulated. consequential amendmentsto the Civil Code and Tax Code to facilitate the operation of MFIs. The Law on Entrepreneurs (Georgia's company Consider revising the Law on Entrepreneurs to bringit more into law) i s outdated. The law lacks modern corporate line with the provisions of a modern company law. governance safeguardsand provisions necessaryto allow for more complex commercial transactions. There is considerableuncertainty regardingthe Clarify the scope of the new Law on Licenses andPermits and the application of the new Law on Licenses and Permits extent to which it applies to the issue, amendment, transfer and to the banking, securities, and insurance sectors. revocation of licenses issuedrespectively by the banking, securities and insuranceregulatory authorities. Amend the respective laws according to international (BIS. IOSCO', standards. Consider enacting anew modern Law on Bankruptcy Proceedings. Y Enforcement ofjudgments is a major problem, Commission a study to examine options for improving the scoue which discourages the use of courts. and operation of the Law on Execition of Judgments.- Georgia's Law on Public Arbitration needsrevision. Enact anew Law on Public Arbitration basedon the UNCITRAL A good arbitrationregime is a useful alternative to Model Law on Arbitration. court-related dispute settlement. F ancial Integrity Corporate governanceis very basic. Encourage supervisory boards to take greater responsibility and accountability for the firm's financial statementsand have an audit committee that deals with internal and external auditors. Lack of transparencyof ownership. Improve transparency of who are the beneficial owners of financial Qualification requirements for firms which carry out Promptly introduce "veto" rights by supervisory authorities to statutory audits abolished inJuly 2005. ensure qualified audits. Require professional associations to set standardsand police the technical knowledge of their members. The NBGhas no responsibility for oversight or Amend legislation to make NBGaccountable to supervise and accountability for the integrity of the national ensure integrity of the national payment systems infrastructure. payment infrastructure. Missing important elements of the national payment Buildalow valuehatch payment system andnational infrastructure system infrastructure, which negatively affects for the use of electronic payment instruments. access and increasescost and risk inpayment Establish national technical standardsand ensure interoperabilityof payment system infrastructure incomplete. settlements. Provide legal basis for electronic documentsand electronic-digital signatures, and generallyelectronic-payment instruments.