Armenia - Banking Sector Policy Note (Vol. 2 of 2) : The Annexes

Document of The World Bank FOR OFFICIAL USE ONLY CONFIDENTIAL 15452-AM VOL. 2 REPUBLIC OF ARMENIA BANKING SECTOR POLICY NOTE Volume II: Annexes April 30, 1996 Enterprise and Finance Division G Q ?X Country Department IV . Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. о � Н � � � И � и W � и и � и Q � �С W Е� U �_ а`�. � �¢ � а гs, и а ° о � И � ы.Иr w � � н Z и � О � � � 3 w и � а � ° � � о � а г�д с�д а v --� N м ët vi � � � к � � � � ¢ ¢ ANNEX 1 page 1 of 5 ARMENIAN BANKS: A QUANTITATIVE ASSESSMENT 1. This Annex is based on in-depth interviews with Armenia's five former state-owned banks and with a sample of four private banks. Together these account for over eighty percent of all banking business. An attempt has been made to generalize from these meetings and the synthesis of findings is presented here. Annex 2 then provides more detailed but descriptive statements about the information obtained in each of the nine banks which were interviewed. 2. The main conclusion from these interviews is that the overall condition of the banks in Armenia is better than the quantitative information seems to suggest. There are two primary reasons. First, the loan portfolio figures require several qualifications, the most important of which is that the loan portfolios are said to be heavily collateralized'. Second, the management teams of these banks, on the whole, consist of motivated and intelligent individuals who are doing their best to cope with changing conditions in Armenia. Although there are many weaknesses in the Armenian banks, many of these are understandable given that the staff of these banks have had little formal bank training and have been working in an emerging market economy only for a very short time. 3. The Armenian banks uniformly claim that their loan portfolios are heavily collateralized, with a large margin of collateral value over loan value. The banks prefer to take liquid collateral, such as gold and jewelry, which they hold in their vaults. Real estate is also commonly accepted: Armenia apparently has a functioning real estate ownership registry system. The collateral realization process appears to be reasonably straightforward and the banks view the introduction of a new collateral law in June 1995 as a positive development. When there is no dispute between the bank and the borrower, the bank can obtain the collateral without any legal procedures. If there is a dispute, the bank undertakes an "arbitration" process, with estimates of the time required to complete the process and obtain the collateral ranging from two months to over one year. The majority of the banks stated that they rarely, if ever, utilized the arbitration process. 4. A definitive picture of the actual status of the banks' loan portfolios and the quality of their collateral will require a loan-by-loan review to check this information, but it does seem that the banks' loan portfolios as a whole are stronger than the off-site supervision figures in Table I in the main text indicate. It should be noted, however, that although the collateral valuations may be adequate for individual liquidations, they are highly unlikely to cover a crisis in a specific economic sector, when all of the banks would be simultaneously trying to liquidate similar collateral (e.g. construction equipment). ' The data on collateral collected by the Central Bank applies only to the small banks; accurate information concerning the large banks is not yet available. 2 A focused study would be required to confirm this information and to fully understand the issues and procedures related to collateral. It is particularly important to note that the banks provided inconsistent answers concerning whether or not state owned enterprises could provide loan collateral. If they can provide collateral, this potentially complicates the privatization process; a bank that forecloses on the property of a state-owned enterprise will acquire state property that had been intended for privatization. This could lead to suspicions about the banks or the enterprises circumventing the privatization process and to questions about adequate liquidation prices. ANNEX 1 page 2 of 5 Funding, Capital and Earnings 5. The former state banks are funded largely through "budgetary resources", which are budget funds allocated to ministries and state enterprises that are maintained in current accounts at the former state banks. Some of the banks pay no interest on current accounts, while some pay a modest 1 percent per month as a device to discourage the transfer of these funds to other banks. The proportion of current account funding held in the former state banks as of July 1, 1995 ranged from 42-57 percent of total assets. The reduced availability of these extremely inexpensive funds as the privatization process proceeds will put pressure on the profit margins of the former state banks. 6. The private banks rely on resources from interbank loans, funding from the CBA credit auctions, and household and enterprise current accounts and time deposits. Despite a widespread perception that the Armenian public does not trust banks, it is worth noting that even Armenia's small private banks have had some success in attracting household deposits: the amounts achieved in the aggregate now exceed the deposits in the Savings Bank. 7. Almost all the banks interviewed have recently increased their capital, through a combination of new equity issues and retained earnings. The smaller banks in particular have done so in order to respond to the new minimum capital requirements of 50 million dram. A number of banks have further plans to raise additional capital, in some cases before the end of the year. These capital expansion plans are particularly significant in the case of Armimpexbank. 8. Although precise figures were not available, most Armenian banks appear to rely largely on interest income as a source of revenue. The second most important source of revenue is typically fees for transactions, such as money transfers. Another source of revenue is related to foreign exchange: fees for foreign exchange sales as well as trading gains. However, foreign exchange speculation does not appear to be a significant source of income for the banks. The first two sources of income will come increasingly under pressure. In particular, increased competition, jump-started by the presence of Midland Armenia Bank, will put pressure on most service fees. 9. A breakdown of bank expenses was not available. However, judging by the experience of other CIS countries, increased competition will also raise salary expenses. The combination of these effects may cause the banks to turn more aggressively to foreign exchange trading as a source of profits, with the attendant risks. (Further financial information, on a bank by bank basis, is in Annex 2). Risk Management 10. The banks all have well-defined loan approval procedures, with some lending authority delegated to branch managers. All of the banks interviewed have a head office credit committee that approves larger loans. These credit committees make sense in the short term as a way of pooling information but they substantially mitigate individual accountability in the loan approval process. This is particularly a problem in post-Soviet countries, where individual accountability is not part of the historical heritage. Only individuals with specifically defined responsibilities will have the incentive to apply the time and effort necessary to adequately evaluate loan proposals; this incentive is dissipated by the group dynamics of credit committees. There is some limited evidence of competition for the low-cost budgetary funds. For example, Credit Yerevan seems to have succesfully poached deposits of some municipalities from Econombank. ANNEX 1 page 3 of 5 11. The analytical and approval process for loans focuses largely on the adequacy of collateral; meaningful financial analysis or economic sector analysis is essentially non-existent. The large banks all have teams of collateral experts, while the smaller banks either have a collateral expert on staff or they have a standing relationship with an outside specialized firm. 12. Taking a longer term view, the extremely heavy reliance on collateral in the loan approval process has several negative implications for the development of the banking sector. In particular, excessive reliance on collateral will prevent the banks from developing the skills, corporate culture and the internal organizational structures needed to identify, analyze, compare and price risk across a spectrum of banking products. Examples include regular enterprise credits as well as interbank loans, counterparty risk on foreign exchange, equity investments, credit cards and home mortgages. 13. Furthermore, because the Armenian banks are willing to lend to any individual applicant with acceptable collateral, they are not taking a strategic view of asset management as a whole. Such an approach would require deliberately building a portfolio of assets with different risk and return profiles that complement each other and that take into account changing conditions in the economy. 14. With the exception of state guarantees provided to the former state banks, guarantees are used much less frequently than collateral. The guarantees that are generally accepted are from the large former state banks; the banks accepting these guarantees assume that these are creditworthy guarantees because the guarantors are large banks with good reputations. There is minimal analysis of the financial condition of the guarpntors. As the earlier analysis has indicated this blind faith is not justified by the objective evidence. Ownership and Governance 15. The relationship between ownership and governance of many of the banks interviewed is extremely unclear. Even in cases where the level of state ownership is quite low, it seems likely that the potential influence of the state is high. It is also not always possible to immediately discern the degree of state ownership. In the case of one former state bank (Ardshinbank), for example, 73.5 percent of the bank's shares are held by enterprises. The critical point, however, is that the majority of these are state enterprises under the responsibility of the Ministry of Industry, which itself is a 10 percent shareholder. The Minister of Industry is also the chairman of Ardshinbank's board and several of the enterprises within the Ministry's authority have seats on the board. 16. Some of the banks may also face complications in the future related to the acquisition of state property. Two of the banks interviewed had acquired their buildings from government entities; in at least one case the building constituted the capital contribution to the bank from the government entity. Because these transfers did not take place within the framework of a privatization program, there may eventually be questions about the legitimacy of these asset transfers, as has occurred in Estonia. 17. The majority of Armenian banks are closed share holding companies: this is understandable given the underdevelopment of Armenia's securities markets. However, closed shareholding companies face constraints in raising additional capital, because all the shareholders must agree to any new equity issue and the admission of new shareholders. As ANNEX 1 page 4 of 5 Armenian banks attempt to develop their international business contacts, they will probably come under pressure to shift to a more transparent ownership structure. 18. It is not clear whether there is a direct and transparent relationship between the weight of a shareholder's shares and its influence on the bank's policies. It is also not clear how the chairman cum shareholders of the private banks would differentiate between the interests of shareholders and depositors in cases of severe distress. The extent of insider loans is also unclear. Most of the banks interviewed stated that loans to shareholders constituted a relatively small proportion of total loans4. However two of the large former state owned banks have significant loans to shareholders and given the history of the development of many Armenian banks as essentially captive finance companies for their founders, it seems unlikely that these are the only two banks in this situation. Strategy 19. The majority of banks with two noteworthy exceptions, do not have a clearly developed business strategy. When asked about their strategies, they frequently referred to how big they wanted to be relative to other banks and to their plans to acquire more computers. Nor have the banks developed the skills to target and evaluate specific economic sectors: this is another consequence of the tradition of heavy reliance on collateral. They also do not appear to be attempting to differentiate between themselves by identifying market niches (except for broadly defined niches such as small and medium sized businesses). None of the banks interviewed could articulate a strategy concerning the state-owned enterprises and whether the privatization process would positively or negatively affect its existing loan portfolio to these enterprises. Finally, the majority of the banks interviewed did not appear to have ideas for introducing new products and services, other than credit cards (cited by almost all of the banks) and privatization-related brokerage services. The former state banks in particular do have planning and economic departments that are ostensibly responsible for long range planning. However, these departments seem to be primarily involved in day to day issues such as reviewing the interest rates offered by other banks. Management Information 20. None of the banks had a completely integrated computer network that provided real time information to all relevant managers. Four of the five former state owned banks, however, have created information systems that appear to be workable in the short term. All of the banks interviewed said that they are in the process of upgrading their computer capacity but often without a strategy about how to apply the new capacity to improve management information. The general set up in the former state owned banks is for the different departments at head office to have their own computer systems, which are not part of a larger head office network. There is no direct access to branch information; this is provided on request by electronic mail (provided that the telephone lines are working). Not all of the branches, however, have computers and much of the consolidated information, such as that concerning the loan portfolio, is consolidated manually. 4 The Central Bank has recently established a requirement that total loans to shareholders can not exceed 25 per cent of the bank's capital. ANNEX 1 page 5 of 5 21. Three of the private banks that were visited have total staff of under one hundred each. Two of these banks have less formal management information systems because it is relatively easy for the bank chairman, who is the dominant decision-maker in these banks, to stay informed on an informal daily basis. Clearly if these banks expand they will need to develop more formal management information systems and procedures. 22. All of the banks interviewed follow the Gosbank chart of accounts for internal and external accounting and reporting purposes. One of the banks interviewed, which has a major foreign shareholder, is in the process of implementing a program that will convert its statements to western standard statements. This bank will continue to post items to the general ledger according to the Gosbank chart of accounts. With this one exception, all of the banks interviewed seem to be following the CBA's lead concerning any changes in accounting standards. The banks publish summary balance sheets in the Armenian press: although these appear to resemble the balance sheets of western banks, they are actually a consolidation of the accounts in the Gosbank system. Internal audit capabilities within many of the banks are under developed. Asset-Liability Management 23. This function is underdeveloped in the Armenian banks. However, the function does exist in at least the former state owned banks and is typically located in the economic and planning divisions. Asset-liability "management", however, appears to be a misnomer; the practice is more one of asset-liability monitoring. A positive aspect of this approach is that it appears to be conservative. With regard to maturity matching, for example, although none of the banks have enough three month deposits to match their three month loans, which poses an avoidable risk, it is rare for the banks to go out on a limb and make loans with maturities of one year or more. (Russian banks, by contrast, which face the same challenge of heavy reliance on short term funding, make longer term loans on a more routine basis.) 24. In general, the Armenian banks, and especially the smaller private banks, do not fully understand the concept of asset-liability management. The current conservatism of approach reflects more a lack of experience than awareness of the potential risks and rewards of more active asset-liability management. As the banks gain more confidence and as their profit margins shrink for reasons that have already been discussed, the banks may identify more aggressive asset-liability management as a potential source of increased income. This could prove to be a significant source of additional risk. It is particularly noteworthy that the banks seem to have a false sense of security about the stability of the dollar-dram exchange rate. 25. By way of summary, the positive characteristics noted from the interviews include conservative asset-liability management and primitive but adequate management information systems in some cases. The heavy reliance on collateral is also a strength in the short term in the light of the high ratios of over-due loans to total loans. However these characteristics, even when favorable in the short-term, do not position the banks to meet the challenges of the future. The challenges that the banks are poorly prepared to meet include corporate governance, the analysis and pricing of loan and other risk products, the development of a corporate culture that focuses on risk management and the creation of workable business strategies. ANNEX 2 Page 1 of 21 BANK PROFILES Note: This version omits the Schedule of Financial Results referred to in the text. This will be added later. This Annex provides descriptive statements and assessments on eight banks visited during the course of the mission. The eight banks together represent some eighty percent of the Armenian banking system as measured by total assets and so together provide a good indication of most of the problems facing the sector. These assessments represent the source material for the qualitative comments on the banking system presented in Annex 1. ARDSHINBANK Contacts: Karen Movsessian, Chairman Hakob Zadoyan, Head of Special Projects Division (former Head, Credit Div.) Boris Karapetian, Head of International Division Laura Vasilievna Eshauren, Deputy manager, Information Division Anosht M. Anonchenko, Head, Planning & Economic Analysis Division Olga M. Tasiarian, Deputy Manager, Planning & Economic Analysis Div. 1. Background/Future Business Strategy. Ardshinbank is the successor to the Armenian branch of Promstroibank, the Soviet era Bank for Industry and Construction. The bank's chairman observed that its current major challenge is to generate income and pay dividends. Although the majority of the bank's borrowers are state owned enterprises, he does not anticipate any major changes to occur as a result of the privatization process. 2. Ownership and Control. Ardshinbank is an open type shareholding company. The Ministry of Industry is a 10 percent shareholder and the minister is chairman of the bank's board of directors. 73.5 percent of the bank's shares are held by state owned enterprises, the majority of which are under the authority of the Ministry of Industry. Several of these enterprises are also members of the bank's board. The Ministry of Finance is a 9.5 percent (approximately) shareholder; this figure has declined from 20 percent. The Ministry also has a seat on the board. 3. Organization. The bank's senior management -consists of the chairman, three vice chairmen, the chief accountant, the manager of the information division, the manager of the credit division, the manager of the supervision division and the manager of the international division. Other significant divisions in the bank include accounting, economic planning and prognosis, and legal. Ardshinbank has 43 branches, of which 11 are located in Yerevan. 4. Government Involvement. Ardshinbank's business is tightly tied into the Government. Most notably, almost 80 percent of the bank's loans are to its shareholders. Because this figure exceeds the CBA's newly-established limitations on loans to shareholders (total loans to shareholders cannot exceed 25 percent of capital) this regulation applies to Ardshinbank only for new loans made after July 1, 1995. In addition, 57 percent of the bank's total footings consist of current accounts, the majority of which are presumably budgetary funds held by state enterprises. These represent an important source of inexpensive funding for the bank. Although precise information was not available, it is ANNEX 2 Page 2 of 21 evident that Ardshinbank sometimes provides financing at the government's request. The degree to which such loans are government guaranteed, explicitly or implicitly, was not clear. Ardshinbank did receive funding from the Government during August 1995; we understand that this funding represented payments for government guaranteed loans. Ardshinbank is also a member of the board of the CBA. 5. Financial Situation. See Schedule for further details. Ardshinbank accounts for 82.6 percent of the overdue loans of Armenia's 50 largest borrowers as of July 1, 1995. This amount is the equivalent of 79.7 percent of Ardshinbank's delinquent loans as of that date. Ardshinbank also accounts for 64.3 percent of the total PDI of Armenia's 50 largest borrowers; this amount in turn accounts for 34.9 percent of Ardshinbank's PDI. 93 percent of the bank's net income as of July 1, 1995 was due to net income on dram denominated loans. The bank's inexpensive dram funding is clearly very important for the bank's profitability. It should also be noted with regard to profits that the CBA is concerned about* the bank's high level of administrative and development related expenses. Ardshinbank's inter-branch transactions accounted for 85 percent of its total assets as of January 1; the bank is clearly smaller in terms of assets than Armenia's current accounting system suggests. 6. Management systems and related technology. Ardshinbank has an information division that consists of 4 departments and 28-30 people. This division's responsibilities include collecting financial information from the branches; software development; technical services for the bank; and other communications development. Information is collected from the branches by e-mail. On a weekly basis the division obtains the following information from each branch: balance sheet, amount of new loans, amount of overdue loans and past due interest, amount of dram and foreign currency resources. The division is responsible for collecting and compiling this information and providing it to other relevant departments of the bank, which it does through a local network system. The bank has developed its own "operating day" program, by means of which it is possible to look at the details of an individual client's account - average balances, loan outstandings, etc. This program appears to be available in some of the branches; it is not available at head office, nor can one branch access the operating day information of another branch. Ardshinbank does not appear to have any long term development plans with regard to management systems and technology other than to acquire more computers. Currently the bank has 300 computers. 7. Treasury Management. Ardshinbank has a division of planning and economic analysis, consisting of 11-12 people, that is responsible for ensuring that the bank is in compliance with the CBA's financial requirements and for monitoring the bank's funding resources. The division's major goal, as defined, is to avoid having to pay fines to the CBA. Although the division is responsible for monitoring the bank's foreign currency position according to the CBA regulation, this division is not responsible for managing the bank's foreign currency position; this is the responsibility of the foreign currency division. The division tries to maintain some balance between the maturity of the bank's loans and its deposits. The division is informed of the bank's upcoming loans and it is responsible for making recommendations on how to fund the loans. One option that is always ANNEX 2 Page 3 of 21 considered is to buy the funds from the CBA auctions or on the inter-bank market. The division head reports to senior management on a weekly basis. The division obtains weekly information from the information division about the branches. The division coordinates 'funding needs among the branches, by moving funds between those with surplus funds and those with insufficient funds. The branches do not have to pay for these resources. The division is also responsible for analyzing proposed inter-bank loans. Inter-bank lending is driven by requests from other banks; Ardshinbank doesn't proactively offer inter-bank loans if it has surplus funds. The division makes written recommendations regarding inter-bank loans to the Credit Committee, of which the division head is a member. Inter-bank loans can have maturities of up to 12 months; it was explained that banks can have longer maturity loans because it is easier to debit their accounts for interest payments (presumably because the banks have more money flowing through their accounts than does the average enterprise). The mission was told that the bank does not have a defined strategy for raising additional resources, because it is in no need of them. 8. Other Activities. There was no specific evidence of the bank's interest in non-lending activities. We were told that the bank is not interested in privatization related investment. However, the annual report mentions that Ardshinbank has a credit card project underway. 9. Staff Training. Ardshinbank's total staff is approximately 1500. Some of the staff has participated in EC-Tacis courses as well as seminars offered by correspondent banks, etc. Although most of the interviewees have been with the bank since the days of the Soviet Union, we were told that such people constitute under 10 percent of the total staff. The annual report mentions that the bank is undergoing a personnel certification process. The average age of the employees is approximately 34. 10. Automation. See comments under (6). 11. AccountingandAudit. NA. 12. Credit policy and procedures, risk management. The bank has approximately 800 borrowers, of which 200 are significant large borrowers. The loan portfolio is approximately equally in foreign currency and dram. Average loan maturities are 4-5 months. Approximately 4-6 percent of both dram and foreign currency loans are maturities of over one year. We were told that approximately 70 percent of the bank's loans are to state owned enterprises; this figure is low, because almost 80 percent of the bank's loans are to its shareholders, which in turn are largely state owned enterprises. The majority of its borrowers are to entities under the responsibility of the Ministry of Industry. All of the branch managers have the authority to approve loans to private companies up to the equivalent of $10,000, and loans to state owned enterprises up to the equivalent of $18,000. Proposals for larger loans are sent to the chairman, who assigns the proposed loan to the credit division for review. The credit division analyst makes a presentation regarding the proposed loan to the Credit Committee, which meets once a week. The credit division has a staff of 10-12 people. ANNEX 2 Page 4 of 21 (The bank's collateral experts, which are located in the administrative division, are responsible for checking and valuing the collateral as part of this analytical process. The international division is responsible for advising on international loan transactions, such as the client's contract, terms of payment, etc.) After the analyst's presentation, the client frequently meets with the Committee to answer further questions. The Credit Committee has 14 members, of which 2/3 have to be present. The Committee makes decisions by majority vote. If the Committee is not able to come to agreement, the proposed loan is subject to further analysis or it is referred to senior management. Once the loan has been approved by the Credit Committee, the bank's senior management reviews the loan again and makes the final decision. The division does not analyze inter-bank loans; this is the responsibility of the planning and economic analysis division. Branch managers have the right to prolong loans for one month if the borrower has made its interest payments. Decisions about subsequent prolongations are made by the head office Credit Committee. We were informed that the majority of the bank's loans are collateralized or guaranteed. As noted earlier, it was not possible to determine what proportion has explicit or implicit government guarantees. The bank also has a portfolio of loans to individuals, which we did not discuss. We were told that the bank has been lending to individuals for 3 years and that, because of their highly liquid collateral, they are considered good clients. The former head of the credit division is now going to be the head of a newly formed special projects division. This division's main function is to finance nonstandard large projects, such as for the Ministry of Industry, the Ministry of Energy, the Ministry of Construction, etc. In response to our question, we were told that private sector projects were not excluded from the division's potential clients. 13. Government strategy. The CBA is concerned about Ardshinbank's financial condition, and in particular its high level of overdue loans, its inadequate capital and loan loss reserves, its high level of loans to shareholders and its high level of expenses related to administration and bank development. The current strategy for strengthening the bank includes writing off the bad loans and increasing the reserve fund; reducing expenses; ceasing dividend payments until all bad loans have been written off; and increasing liquidity. The CBA is also planning to undertake a thorough portfolio review of the bank, such as has already been done for the smaller Armenian banks. The Government has also recently provided additional funding to Ardshinbank, apparently as payment for government guaranteed loans. ANNEX 2 Page 5 of 21 ARMAGROBANK Contacts: Armen S. Arzumanian, Chairman Harutian A. Ghazarian, Vice Chairman, Credit Division Grigor K. Konjeyan, Vice Chairman, International Division Arzik Suvarian, Manager, Resources department 1. Backgroundfuture business strategy. Armagrobank is the successor bank to the Armenian branch of the Soviet Agroprombank. The bank's long term goal, as described by one of the vice chairmen, is to be a universal bank, in the sense of a bank that offers a variety of services to a range of clientele, and is not just limited to the agricultural sector. The bank's plans include further capital increases; an expansion of its international business, including foreign currency transactions and trade finance; introduction of credit cards (these are already being advertised in the Armenian press - we were told that Armagrobank is the first bank to have an operative credit card); staff development; and strengthening of the branch network. The bank already has a computer system upgrade program underway. Several of the interviewees noted that the bank's new chairman, who was appointed last year, has encouraged the introduction of new products in the bank as well as a decentralization of responsibility. The bank is not concerned about competition from an agriculture cooperative, whose formation has been proposed, because Armagrobank is already extremely well established in the countryside. 2. Ownership and control. Armagrobank is an open type shareholding company which, according to the annual report, became a "private organization" at the beginning of 1994. Again according to the annual report, 95 percent of the bank's shares belong to individuals and private companies and 5 percent belong to state owned enterprises. The number of shareholders is 2441. The majority of shareholders are in the agriculture and food businesses. 2 shareholders hold shares exceeding 2 percent of the total and 2 shareholders hold shares exceeding 1 percent of the total. The Ministry of Finance holds an approximately 0.5 percent share. A total of 29 percent of the bank's loans are to shareholders. The bank has been making a concerted effort to reduce this figure, which has been reduced by almost 50 percent since March 1995. 3. Organization. Armagrobank has 42 branches and a total staff of over 1000. The bank's senior management consists of 8 people: the chairman; 5 deputies; the former chairman, who serves as an adviser; and the chief accountant. The six main divisions are: -Credit (analysis and methodology; loans; collateral foreclosure) -International (correspondent accounts, trading, stock exchange; loans & deposits; exchange offices) -Accounting (methodology; accounting center) -Economic analysis and planning (analysis, planning and taxes; bank liquidity and resources, CBA normatives; bank capital and shareholder issues) ANNEX 2 Page 6 of 21 -Automation and technology (services and utilization; software development; new payment technology) -Security (cash; security of bank property) There is also a "smaller" division responsible for human resources. 4. Government involvement. As noted above, the Ministry of Finance holds an approximately 0.5 percent share in Armagrobank. The deputy minister of finance, Sergei Bardosian, is chairman of the bank's board of directors. As of early August 1995, Armagrobank had not received any financial assistance from government, although some had been requested. In 1994 the bank received 280 million dram (slightly under 10 percent of total loans as of July 1, 1995) for onlending, at a margin of 18 percent. The borrowers used the financing to purchase products from farmers. - The bank has prepaid the loan, although it has not yet been repaid by all of the borrowers. Approximately 64 percent of the bank's dram loans are to state owned enterprises. According to the bank, approximately 20 percent of its funding is from budgetary resources. 5. Financial situation. Details are in Schedule. Other notes: In 1994 dram interest earnings accounted for 71 percent of total revenue; foreign currency transactions accounted for 12 percent; and foreign currency interest accounted for 7 percent of total revenue. It is not clear what proportion of income from foreign currency transactions is due to trading gains and what proportion from services. The bank clearly sees foreign currency transactions as a source of future income. Administration accounted for 28 percent of total expenses. As of July 1, 1995, NPL/TL accounted for 36.8 percent of total loans, which represents almost a doubling from the previous month. As of January 1, 1995 31.6 percent of the bank's total assets constituted inter-branch settlements. 6. Management systems and related technology. Armagrobank is currently upgrading its technological base; it has doubled the number of computers, is establishing direct computer links between departments, is putting in AT&T phone lines, and is negotiating with SWIFT. This upgrading process is currently ongoing: some division managers still rely on manually prepared reports and records. 7. Treasury management. Armagrobank has an economic planning and analysis division consisting of 16 people and 3 separate departments. These departments are analysis, planning and taxes; bank liquidity and resources, CBA normatives; bank capital and shareholder issues. The liquidity and resources department is responsible for managing the liability side of the bank's balance sheet. The head of the department is a member of the bank's Credit Committee, and in that function he advises on how loans are to be funded. To the extent possible, the bank tries to match loan maturities. Armagrobank appears to favor CBA funding, which is available for 28 days; this currently accounts for 10-15 percent of the bank's resources. Budgetary resources are also important; we were told that these account for 20 percent of the bank's funding. The bank also borrows on the inter- bank market. ANNEX 2 Page 7 of 21 The department is not responsible for managing the bank's foreign currency assets and liabilities; this is the responsibility of the international division. This division appears to take a somewhat aggressive approach to this responsibility; they noted that they try to keep their liabilities in dollars and their assets in DM. Note that the bank only began foreign currency operations in July 1994. The bank has been attempting to increase its funding base by opening more branches, including in cities (previously it focused on rural areas); attracting more foreign currency deposits (the bank pays 6 percent per quarter for dollar deposits); providing new services such as visa cards that will attract new clients; and providing polite counter service. 8. Other activities. As noted, Armagrobank is already advertising a credit card and claims to be the first bank in Armenia to be able to offer this service. The bank is also interested in privatization related investments. As noted elsewhere in this summary, the bank is also focusing on increasing its foreign currency related transactions, including foreign trade finance. 9. Staff training.. Armagrobank has approximately 1000 employees. Some bank employees have had some training through a USAID program and the bank has also sent some employees to Russia for training. The bank hopes to participate in some EC Tacis training initiatives as well as to organize training through its correspondent banks. 10. Accounting and audit. The bank has an internal audit function. 11. Credit policy and procedures, risk management. The credit division has 17 employees, of which 6 are responsible for loan analysis. Branch managers have authority to approve loans of up to 2 million dram. The vice chairman responsible for the credit division has authority to approve loans of up to 5 million dram. Larger loan proposals, if approved by this vice chairman, are reviewed by the Credit Committee. The members of the Credit Committee are the chairman, the vice chairman in charge of credit, the member of the economic department responsible for resource management, a staff member from the special services/security division (responsible for background checks on borrowers), and the manager of the credit analysis department within the credit division. (Input from the legal department is sought, if necessary, prior to review by the Credit Committee.) Loans that represent over 10 percent of the bank's capital are approved by the bank's board of directors. The branches have the authority to prolong loans once; subsequent prolongations have to be approved by the vice chairman responsible for the credit division. The credit division is also responsible for analyzing potential borrowers on the inter-bank market. Of the bank's dram loans, 64 percent are to state owned enterprises, and 36 percent are to private borrowers. 10 percent of the total amount of dram loans is to small farmers. The bank has approximately 15,000-17,000 loans to small farmers, with an average size of 100,000-200,000 dram. 20 percent of the total amount of dram loans is not related to the agriculture or food industry at all. Loan maturities range from 3 months to I year, with the average in the 6-8 month range. ANNEX 2 Page 8 of 21 In the international department, which is responsible for the bank's foreign currency loans, 50 percent of the loans are not related to the agriculture or food industry. The bank has found it difficult to lend to small farmers, because farmers have historically been accustomed to receiving grants from the government and not loans from a bank. However, because these loans are collateralized by the farmers' homes and other personal belongings, the farmers eventually understand that they have to repay the loans. Armagrobank intends to increase its farmer lending program, because it thinks that agriculture prices will be increasing. The vice chairman receives loan information from the branches once a month, by computer, but these records have to be compiled manually. The bank does not seem to track loans on a private vs. public borrower basis; this information was calculated from the manual records during our meeting. We were told that all of the bank's overdue loans are collateralized, with the collateral value exceeding the loan value by 2-3 times. One of the biggest problems is that large enterprises believe that they can default on their loans and not be penalized. The bank sometimes tries to get around this problem by requesting personal collateral from enterprise managers. Smaller borrowers are more afraid of losing their collateral. 12. Government strategy. The CBA is concerned about Armagrobank's financial condition and has proposed that the bank write off its bad loans, increase its loan loss reserves, cease paying dividends until the bad loans have been written off and the reserves created, and increase liquidity. The CBA will also conduct an in-depth portfolio review. ARMECONOMBANK Contacts: Vladimir S. Badalian, Chairman Varley H. Beglarian, Vice Chairman of International Operations Ludwig Megelian, Acting Manager, Credit department Akon Vartanovich Duvalen, Manager, Automated systems department Armen Iraelian, Manager, Control and audit department Souren Hambartsoumian, Manager, Economics department 1. Background/future business strategy. Armeconombank is the successor organization to the Soviet branch of Zhilsotzbank, the Soviet Bank for Housing and Social Affairs. The bank plans to increase its capital from its current level of 475 million to 2 billion dram by the end of the year, through a combination of dividend reinvestment and the addition of the bank's new premises to secondary capital. (The bank plans to move before the end of the year.) The bank has plans to open 4 new branches. It should be noted that Credit Yerevan, a recently formed private bank, has successfully won much of the municipal banking business that was under the purview of the former Zhilsotzbank. 2. Ownership and control. The bank is currently in the process of becoming an open type shareholding company. This change is being made because a closed shareholding structure limits the bank's ability to raise new capital. According to the annual report, the ANNEX 2 Page 9 of 21 bank's largest shareholders are the government of Armenia, the state insurance company, Yerevan Cognac Factory, Armagrobank, PO "Milk" and Armtobacco CO. The Ministry of Finance owns approximately 1-1.5 percent of the bank's shares; the Minister of Finance is chairman of the board of directors. The bank has over 400 shareholders. Specific information regarding loans to shareholders was not available. We were told, however, that the bank has a preference to lend to shareholders, because of their close ties. We were also told that the only advantage to shareholders is that they are charged a lower interest rate. 3. Organization. Armeconombank has approximately 1000 employees and 22 branches, of which 9 are located in Yerevan. There are four departments that report directly to the chairman - these are the economics department, the control and audit department, the legal department and the special department. The bank has four vice chairmen who divide up the other responsibilities. The first vice chairman is responsible for cash operations and automation, and the other vice chairmen are responsible for credit, international operations and investments. 4. Government involvement. As of January 1, 1995, 73.3 percent of the bank's loans were to government institutions and enterprises, particularly those enterprises under the authority of the Ministries of Light Industry, Trade, Supply and Provisions. (This figure had increased to 74.3 percent as of July 1, 1995.) As noted above, the Ministry of Finance owns 1-1.5 percent of the bank's shares (down from 35 percent in 1994) and the Minister of Finance is chairman of the board of directors. We were told that the bank readily finances government projects provided that the government is willing to provide a guarantee. Precise information about guarantees was not available. We were also told that the bank participates in the government's energy program by providing financing to light industry, so that products can be produced for the barter trade with Turkmenistan. It was not clear, however, how the bank's borrowers repaid their loans from the bank, since their output was used for barter. As of July 1, 1995, 51 percent of the bank's total funding consisted of current accounts, the majority of which is presumably provided by state owned enterprises, since they are the bank's major clients. 5. Financial Situation. See details in Schedule. Armeconombank accounts for 44 percent of the total prolonged loans provided to Armenia's 66 largest borrowers as of July 29, 1995. This is the equivalent of 49 percent of the bank's performing loans as of July 1, 1995. Therefore the bank's overdue loan figure, which was 16.4 percent as of July 1, has the potential to deteriorate rapidly. In 1994 the bank's net interest income of almost 1000 million dram accounted for over 100 percent of the bank's net profit of 854.4. million dram. 6. Management systems and related technology. Armeconombank is very proud of the accomplishments of its automation department, which consists of 16 people and has 3 functions. These are technology planning, software development, and repair services for the branches. Each of the branches has its own local network; the bank is in the process of connecting all of the branches to head office by e-mail. Currently 10 of the Yerevan branches are connected. The bank currently has no plans for a more elaborate arrangement that would give head office immediate access to branch information. ANNEX 2 Page 10 of 21 The department has created a program called "operating day," that is operative in 10 branches. This program enables the user to see detailed information about each client - loans outstanding, movement of funds in its accounts, etc. The department has also created software that provides the branch managers with overall data regarding branch performance. The department does not currently have the responsibility for creating overall management reports, but it expects to begin doing so in the future. 7. Treasury management. Armeconombank has an economics department of 12 people that is divided into 3 groups - one deals with issues related to the bank's capital (share issues, materials for board meetings, etc.), economic analysis (central bank financial ratios, asset-liability management), and a planning department that is responsible for branch related plans. The department is also responsible for analyzing potential borrowers on the inter-bank market. The economic analysis group is responsible for analyzing and reporting to the bank's senior management concerning the bank's central bank financial ratios and overall balance sheet dynamics. The group also monitors the resource base of the branches (information is provided bi-monthly) and shifts resources between the branches when necessary. (Branches pay for these shifted resources.) The manager of the department is a member of the bank's senior management and is therefore aware of the bank's ongoing funding needs. This department does not appear to be responsible for managing the bank's foreign currency position. 8. Staff training. The bank relies on correspondent relationships and seminars offered in Armenia. 9. Audits. Armeconombank has an audit and control department consisting of 7 people. Each branch is audited on-site once a year, as is head office. There are also unscheduled more frequent audits as necessary. The purpose of the audits is to ensure that the branches and head office departments are operating according to regulations. Items that are checked in the branches include cash operations, accounting procedures, the loan portfolio, and compliance with legal requirements. The department also analyzes the experience with overdue loans in order to avoid repeating past mistakes and to be able to recommend solutions. The department reports to the chairman and the bank's senior management at the conclusion of each audit. When the audit results are negative the branch manager receives a warning letter, or, when the situation is really serious, then the senior management decides what specific steps need to be taken. We were told that the bank does not usually have problems with the branches. 10. Credit policy and procedures, risk management. The department for dram loans has 9 people, of which 8 are economists with responsibility for analyzing loan requests. The bank has approximately 350 dram loans outstanding. Average maturities are 3 months, although loans for production purposes can be up to six months. The bank has recently centralized the loan decision making process. The branches make their recommendations to head office on the basis of their own analysis. The head office credit analysts review these recommendations, fine-tune them if necessary and then add their own comments and recommendations. The senior management of the bank meets ANNEX 2 Page 11 of 21 twice a week to consider these recommendations. The senior management team consists of the chairman, his first deputy, three other deputies, the head of the economics department and the head of the credit department. They make decisions by majority vote. After loans have been extended, the branches are responsible for monitoring the performance of their borrowers, under the supervision of the head office credit department. The branches are also responsible for managing problem loans, although the head office credit department gets involved if there are problems. Information is collected manually from the branches and consolidated at head office in the computer data base. Different information is obtained on different schedules, varying from daily to monthly. We were told that the bank has no non-collateralized loans. Another department within the bank values the collateral. We were told that the bank has a "very small" proportion of ministry guarantees, but specific information was not available. The international department, which has 5 credit analysts, is responsible for analyzing foreign currency loans. Approximately one third of the bank's loans are in foreign currency. The manager of the credit division reports to senior management at the biweekly credit meetings. ARMIMPEXBANK Contacts: Edward M. Arabkhanian, Chairman Ashot S. Mnatsakanian, First Deputy Chairman Gevorg H. Haroyan, Director, Credit and Deposit Department Tatyana V. Vardanian, Director, Department of Strategy, Methodology & Economic Analysis Anait Agaronovna Edigarova, Director, Accounting Department 1. BackgroundIfuture business strategy. Armimpexbank is the successor bank to the Armenian branch of Vnesheconombank, the Soviet Bank for Foreign Economic Affairs. Its goal is to maintain its position as one of the 3-5 largest banks in Armenia, including foreign banks. In order to do so, it has obtained its shareholders' commitment to increase the bank's capital by $7 million by the year 2000, half of which will be from retained earnings and half of which will be new capital contributions from shareholders. The shareholders have agreed to give up their dividends for the next two years as part of this program. Much of this increase will be spent on physical and technological upgrades of the bank, including opening 6 new branches (the bank currently has 6 branches). The bank plans to capitalize on its existing expertise in international transactions as well as to expand further in local currency financing and activities. Armimpexbank has taken the initiative to undergo an organizational diagnostic by KPMG. KPMG has also revised the bank's accounts according to international standards. However, the KPMG work did not include an audit of the bank's loan portfolio. It should also be noted that, although Armimpexbank demonstrated initiative in commissioning this work and appears to be taking the recommendations regarding internal organizational issues seriously, the bank appears to be under the impression that the government or some multinational organization might pay for the work. ANNEX 2 Page 12 of 21 2. Ownership and control. Armimpexbank is a closed type shareholding organization. 15 percent of its shares are owned by the Ministry of Finance and a deputy minister of finance is chairman of the board of directors. 35 percent of the bank's shares are owned by a foreign investor. We were told that the foreign investor has encouraged the Ministry of. Finance to retain its shareholding, because selling it would be a bad signal to the market. The foreign investor has also taken the lead in encouraging the bank to transfer to international accounting standards. 3. Organization. Armimpexbank has 6 branches, 3 of which are located in Yerevan. The bank also has representative offices in Moscow and Krasnodar. An external consultancy retained by the bank noted that the bank is currently highly centralized, with a lot of unnecessary details being decided by the chairman. This report also included other detailed comments regarding the bank's organizational structure and recommendations for potential changes. Currently the strategy and automation departments report directly to the chairman. The second deputy chairman is responsible for the vault, exchange offices and building related services. All of the other departments (financial transactions, export finance, deposits and credits, legal, accounting and internal control) report to the first deputy chairman. 4. Government involvement. As was noted, the Ministry of Finance is a 15 percent shareholder and a deputy minister of finance is chairman of the board. We were told that the bank has no government guaranteed loans. We were also told that the bank has no budgetary resources. 5. Financial situation. Details are in Schedule. In 1994 the bank's two primary sources of income were net interest margin (77 percent of profit before taxes) and fee and commission income (43.5 percent of operating income). 6. Management systems and related technology. The bank is currently in the test phase of automating the branches and has plans to integrate several system functions at head office. The bank has also introduced an operating day program, by means of which it is possible to view up to date information about client activity. 7. Treasury management. The bank is in the process of establishing an asset-liability function that will be located in the financial transactions department. It was mentioned that the bank is currently trying to attract more long term deposits, in order to stabilize its funding base. It plans to do so by offering superior service and attractive interest rates. 8. Other activities. Armeconombank has recently started to trade and invest in securities for its account. The consultant report noted that there does not appear to be an overall strategy for this activity. We were .also told that the bank has a factoring operation. According to the annual report, the bank is also planning to initiate trust operations. 9. Accounting and audit. The bank is in the process of establishing an internal control department that will be responsible for internal audits. The accounting department, which consists of 30 people, currently keeps all of the bank's internal accounts according to the Gosbank chart of accounts. (Some of these have been elaborated for internal management ANNEX 2 Page 13 of 21 purposes.) At the insistence of the bank's foreign shareholder, the bank is also planning to use a program, provided by the shareholder, that will convert its accounts to international accounting standards. Note that this is a conversion; items will still be posted to the general ledger according to the Gosbank system. The conversion will be done every two weeks. 10. Credit policy and procedures, risk management. As is the case in several Armenian banks, the loan and deposit functions are combined in one department; the consultant report recommended that this be changed. The credit department has a staff of 18 people; 3 are collateral experts while the rest analyze and process loans (with an emphasis on processing). Although the bank receives the borrower's financial statements, as well as business plan, if available, currently no independent written analysis is done, because the available collateral is the most important decision making factor. The borrower's reputation is also important. As of July 1 the bank's head office had 417 borrowers, of which 41 were legal entities. 11 of these were state owned enterprises and the rest were private. The total volume of loans outstanding was 1254 million dram, of which 58 percent of the outstandings were to enterprises. 70 percent of these loans were in foreign currency. The branches had a total of 249 million dram in outstanding loans, representing 307 borrowers. The majority of borrowers are in the consumer goods business - examples cited include machine tools, sewing machines and carpets. It was stated a number of times that all of the loans are fully collateralized, with a preference for gold and real estate, and with a high ratio of collateral to loan value. In 1994 the bank had 14 cases in which it seized collateral; there have been no such cases this year. We were told that the bank has won all of the collateral cases that it has taken to court. Armimpexbank does not lend on the inter-bank market, but this does not appear to be the result of any specific policies. The bank does accept third party guarantees from the big banks, because they are said to have good reputations. Average loan maturities are 3-6 months. The bank has only one loan with a maturity of over one year; this loan was made for humanitarian reasons. The bank has recently created a Credit Committee that consists of the chairman, the head of the credit division, the head of the methodology division and one deputy chairman. The Committee makes decisions by unanimous vote. Previously loan decisions were made by the bank's senior management. Branch managers can approve loans up to $5000. We were told that the manager of the credit division has the responsibility for monitoring the branch's loan portfolios. Note, however, that the consultancy report observed that branch supervision issues are not well defined at the bank. The head of the credit division has the authority to prolong loans of up to $1000. The chairman has the authority to prolong loans of up to $5000. All larger loans have to be reviewed by the Credit Committee. The maximum prolongation is 3 months. We were told that the bank increases the interest rate by 20 percent when a loan is prolonged. ANNEX 2 Page 14 of 21 The credit division produces a quarterly written report analyzing the bank's lending experience for the previous quarter, covering issues such as loan margins, loan prolongation issues, new borrowers, etc. The division head has agreed with the chairman on a new strategy whereby the bank will focus on developing a permanent base of clients. The division manager receives a daily computerized list of all of the bank's outstanding loans, including those in the branches. This list is also provided to the chairman. (The consulting firm recommended that an abbreviated report be provided to the chairman.) The division manager appears to have good access to information, through a combination of written records, computer records, and staff assistance. It was noted that the bank has doubled its loan portfolio since April 1; this is because there is more electricity in the spring and companies can therefore be more active. CREDIT YEREVAN Contacts: Martin S. Hovhannissian, Chairman Ara Edikovich Bardapetyan, First assistant to the chairman Abakyan Bagan, Manager, Factoring department Zazyan Vagramovna, Manager, Dept. of Planning, Economic Analysis & Prognosis Ms. Gerashen, Analyst, Credit department I. Backgroundfiture business strategy. Credit Yerevan was registered in March 1994 and was founded for the purpose of serving municipal and other budget organizations. It is a direct competitor of Armeconombank (the Armenian successor to Zhilsotzbank). The chairman of the bank, who was a motivating force in founding the bank, previously worked in the city government and was recently elected to the Armenian parliament. (He is the only Armenian banker with that distinction.) To date the bank has been quite successful; most notably, it is the only bank that has been officially authorized to handle the city's finances. The bank's strengths are its ties with the city government and its aggressive business development policy. Credit Yerevan can cite a number of firsts to its credit, such as being the first bank to obtain a depository license, the first bank to establish an investment fund, and the first bank to establish factoring operations. A key element of the bank's strategy, as described by the chairman, is to obtain a $3 million long term line of credit (7-8 years) from an international organization, under a CBA guarantee, to enable the bank to make more long term and investment type loans. Credit Yerevan does not currently have any branches, but it has plans to open three, including one in Yerevan. 2. Ownership and control. Credit Yerevan is a closed type shareholder company. 36 percent of its shares are held by the city of Yerevan and by other city and state organizations. The bank makes a point of having government and government related shareholders, because they represent its primary sources of funding and other business. ANNEX 2 Page 15 of 21 The most important of these shareholders are 5 municipal shareholders (the construction administration under the mayor's office, the administrative office for foreign economic contracts, the material supply administration, the water and sewer supply organization, and one other); and three state owned enterprises (the airline, the auto factory Yeras and the hotel association). The remaining 64 percent of shares is held by individuals. The largest "packets" of shares are held by the water and sewer supply organization and by 4 individuals. All of these packets are under 30%, in accordance with the bank's statutes. The chairman is a shareholder. There are 14 members of the bank's board of directors. They include the director of the water and sewer supply organization, the mayor of Yerevan, the vice mayor, the chairman and other major shareholders. According to the chairman, the degree of lending to shareholders is not significant. He noted that if these shareholders did have borrowing requirements, these requirements would be quite large and essentially beyond the means of Credit Yerevan. 3. Organization. The main departments in the bank are as follows: -Department for improving the municipal economy -Foreign exchange administration (exchange offices; stock exchange activities; foreign correspondent accounts) -Factoring (first bank in Armenia to provide factoring services) -Planning, economic analysis and prognosis -Bank development -Credit -Accounting and administration -Budget 4. Government involvement. The most relevant aspect of the government's involvement in the bank's activities is Credit Yerevan's deliberately close relationship with the city and state authorities, related to the original purpose of founding the bank. During the mission's meeting with the chairman, for example, he was called to the Central Bank to discuss a loan of $1-1.5 million to the electricity company. 76 percent of the bank's funding represents enterprise current accounts; although this information is not broken down further by public and private enterprises, it should be assumed, on the basis of the bank's business, that the majority of the funding is from public enterprises, which keep their budgetary resources at the bank. The bank also has a pilot factoring project with Yerkageltsants, the Yerevan City Electric Network, whereby Credit Yerevan advanced Yerkageltsants 50 million dram and is itself collecting the receivables from the company's corporate and individual borrowers. Yerkageltsants in turn pays its supplier, or essentially parent company, Electroenergo. Because Electroenergo has experienced severe payment difficulties, this project was very cleverly designed to address one of the government's major problems. Although this product provides the bank with a client information base that it is already using to provide billing (and non-credit) services to other utility companies, such as the water supply company, Credit Yerevan will ultimately lose money on this service if the discount is not quite steep. Yerkageltsants is Credit Yerevan's largest client, accounting for 20 percent of ANNEX 2 Page 16 of 21 the bank's total loans. (It appears that this factoring line is considered a loan to Yerkageltsants.) Approximately 65 percent of the bank's loans are to public entities. Note that Credit Yerevan's building, which is in a very central location, was provided to the bank as a shareholder contribution from the city government. (The land is still rented.) 5. Financial situation. Details are in Schedule . It is particularly noteworthy that as of July 1, 1995, loans/total assets were a relatively low 0.38, while ROA was a relatively high 0.122. These results appear to be due to the bank's low cost of funding as well as minimal costs related to premises, because the bank owns its building. NPL/TL of 0.287 is in the average range for the Armenian banks; furthermore, this figure is low on an absolute basis, because of the bank's relatively low proportion of loans to total assets. 6. Management information systems and related technology. This topic was not discussed in detail. The managers of some departments referred readily to information on their computers, while some did not. 7. Treasury management. The planning, economic analysis and prognosis department, with a staff of 5 people, is responsible for calculating the CBA required financial ratios; monitoring other aspects of the bank's daily financial performance, including rudimentary asset-liability management; attempting to strengthen the bank's deposit base; and monitoring areas of potential future interest for the bank, such as the securities markets. The head of the department noted that they pay particular attention to the Russian financial press, on the assumption that many of the banking market developments that have occurred in Russia will eventually occur in Armenia as well. The majority of the bank's funding is the budgetary resources of city and state organizations. Credit Yerevan is trying to expand its funding resources through factoring operations as well as straightforward billing services for city utilities (through which it can utilize payment float). Credit Yerevan currently provides a cash pick up service for Yerkhlebtorg, the city bread agency, whereby it picks up the cash from all of the city's bread outlets on a daily basis. (Approximately 18-20 million dram per day.) Credit Yerevan pays I percent per month on current accounts. Credit Yerevan has raised its deposit rates as high as 2.5% for foreign currency deposits and 3% for dram deposits, but has not been successful in attracting deposits. Another way that the bank attempts to attract depositors is by offering a range of free services for which other banks charge fees. It was explained that Credit Yerevan can afford to do this because its funding costs are low. Most of the bank's loans have 3 month original maturities. These are funded almost exclusively from the bank's current accounts. Credit Yerevan generally tries to keep an approximate balance between its foreign currency assets and liabilities. The bank's funding and lending is 80-90 percent in dram. Credit Yerevan staff did not indicate any particular interest in foreign exchange trading. 8. Other activities. Credit Yerevan has diversified into factoring, payment collecting for utilities, privatization voucher brokering, and investing in privatization vouchers. It should ANNEX 2 Page 17 of 21 be noted that the bank's investments are determined by the bank's senior management; it appears that there is not a department that is responsible for the preliminary analysis. 9. Staff training. The bank has 200 employees. Several of the department heads (factoring; planning and economic analysis) are university lecturers who also work full time at Credit Yerevan. 10. Automation. The mission was told that the bank has an integrated computer network, but it was not possible to confirm this information by observing the system in operation. For example, there was no sign of computers in the credit department. On the other hand, the factoring department has a computer data base of its clients, and the assistant to the chairman periodically referred to information available on his computer. Credit Yerevan has its own staff of software specialists. 11. Credit policy and procedures, risk management. Credit Yerevan has a credit department that analyzes loan proposals and makes recommendations in written form. "Big loans", which are those in the 40-50 million dram range, are approved by the bank's senior management. The chairman has the authority to approve smaller loans. As was noted, 20 percent of the bank's loans are to Yerkageltsants, the Yerevan City Electric Network. The credit department has a total of 5 people, one of whom will be on maternity leave for more than one year. Two of the people in the department are responsible for enterprise loans, including inter-bank loans, while two are responsible for loans to individuals. The bank has a collateral expert, but he is not a member of the credit department staff. Credit Yerevan only began lending to individuals in May, and has extended 55 such loans. (The loans outstanding figure was not available.) Some of these are consumer loans and some are business related loans to entrepreneurs. The loan portfolio is said to be heavily collateralized, with only a small proportion of -guarantees. As was noted, 65 percent of the bank's loans is to the public sector and 35 percent is to the private sector. The department staff does not have direct access to computer information about their clients, such as information about a client's account balances or loan outstandings. This information is obtained from the accounting department. No computers were visible in the department. The department provides a consolidated weekly report on the loan portfolio (new loans, repayments, etc.) to senior management, and the department manager also makes an oral report. ANNEX 2 Page 18 of 21 GLADZOR BANK Contacts: Gagik G. Amarian, President Armen Badalian, Manager, International Department 1. Background/future business strategy. Gladzor Bank was founded in July 1991 for the purpose of providing financing to Armenia's construction industry. Although the bank still has somewhat of a construction focus, given the president's experience in that industry, the original founders have left the bank, which is now 90 percent owned by individuals. The president described the bank's future strategy as depending on the economy. He is interested in making investments, if possible, both in individual businesses, as well as directly in construction (i.e. the bank would buy land, build houses and sell them). 2. Ownership and control. 90 percent of the bank's shareholders are individuals - these total approximately 6 people. The president is a shareholder of the bank. The remaining 10 percent of shareholders are 8 private companies. The bank is a closed type shareholding company. The bank was previously an open type shareholding company but it changed its ownership structure. The president explained that, because Armenia does not have a sufficiently developed securities market, it does not make sense to be an open type shareholding company. The company's shareholders are not significant borrowers. The only advantage that they receive is that their loans do not have to have third party guarantees. 3. Organization. The three primary departments in the bank are the credit department, the international department, and the accounting department. The bank has one branch, which it is closing down because of communications difficulties and because the branch is located in an economically depressed area of the country. The bank's total staff is approximately 60, of which 30 are in the branch that is being closed down. 4. Government involvement. The bank's relationship with the government is arms length. The bank has tried to get access to the government's budgetary resources, without success. Approximately 50 percent of the bank's loans are to state owned enterprises. Gladzor Bank originally obtained its premises as a capital contribution from a former shareholder that was a state-owned enterprise. When this enterprise was required to give up its shareholding, Gladzor Bank purchased the building from the enterprise. (Note that this is a circumvention of the privatization process.) 5. Financial situation. See details in Schedule. Note that Gladzor Bank has a low level of NPL/TL of only 0.096. The president said that interest accounts for over 50 percent of the bank's revenue. As with all of the private banks, the cost of funds is the highest expense. Gladzor has the advantage of not having to pay rent, because it owns its premises. 6. Management systems and related technology. The primary internal management information mechanisms are bimonthly meetings of senior management, review of the CBA required financial ratios, and quarterly visits to the branch. 7. Treasury management. The bank does not appear to have an economic and planning department, which exists in a number of other Armenian banks. Asset-liability ANNEX 2 Page 19 of 21 management appears to be passive; the bank attempts to match the currencies and maturities of its assets and liabilities. The bank does not try to raise funding if an attractive loan possibility surfaces; it also turns away deposits if it does not have adequate loan demand. The bank considers household deposits an important source of funding. (As of July 1, 1995 these constituted 15 percent of total footings. The bank pays 2 percent per month on dollar deposits and 6 percent per month on dram deposits.) Gladzor also raises funds on the inter-bank market (Sberbank was noted) as well as in CBA auctions. 8. Other activities. The bank is interested in direct investments, as noted above. The bank also considered trying to develop a foreign exchange futures product, but the market in Armenia is not sufficiently developed. 9. Staff training. Many of the staff are said to have training as economists. The bank also takes advantage of training opportunities provided by the CBA, EC Tacis, etc. 10. Automation. Currently every department in the bank has a computer, but they are not linked. The bank has an agreement with a computer firm to develop an internal network system. 11. Credit policy and procedures, risk management. Gladzor Bank has approximately 100 borrowing clients. The president and the head of the credit department both have the authority to approve "small" loans. Loans of over $50,000 are approved by the bank's board. The average loan maturity is 3 months, but clients are allowed to roll over their loans for up to one year. As noted, approximately 50 percent of the bank's loans are to the private sector and 50 percent are to state owned enterprises. Approximately 30 percent of the loans are in foreign currency; these loans are mostly to private companies. Approximately 40 percent of the bank's loans are related to the construction industry. The bank has no inter-bank loans. All of the bank's loans are collateralized. When it has been necessary to take possession of collateral, the bank has almost always been able to do so outside of the arbitrage process. BANK FOR RECONSTRUCTION AND DEVELOPMENT Contacts: Alexander A. Grigorian, Chairman Tigran Badanian, Manager, International Department 1. Background/future business strategy. The Bank for Reconstruction and Development was founded in November 1990 and became operative in March 1991. The bank was originally created as an organization through which to funnel the humanitarian aid that was being sent to Armenia. The bank was founded on the initiative of the Soviet government and its original founders were therefore all government organizations, including the Ministry of Finance, an institute of the Soviet Academy of Sciences, the Scientific Productive Union of Marble and Granite Production, a Russian enterprise called Kamea, etc. As it turned out, the bank received no humanitarian funding. Any funding that was sent went through the former state banks. Furthermore, the amount of humanitarian assistance was less than expected because of the collapse of the USSR and the war in Nagorno-Karabakh. ANNEX 2 Page 20 of 21 The bank has focused on serving a clientele of new small and medium sized businesses. The bank's operations are expected to expand dramatically in the fall, when it moves to new premises. Currently the bank has a staff of 15; this is projected to increase to 120. The bank will change its name to the Armenian Development Bank. 2. . Ownership and control. The bank has the same original shareholders, but their proportional shareholdings have decreased as the bank has increased its capital. The bank is an open type shareholding company. A third capital increase of $400,000 is scheduled for October. The bank has 34 shareholders in total. 90 percent of its most recent issue was purchased by individuals. The chairman of the bank's board of directors is the chairman of the Scherbakov Fund. The bank lends to shareholders, within the CBA limitations. After one shareholder defaulted on a loan, the bank has been using its dividends to liquidate the loan. (Note that several Armenian banks make loans using shareholder equity as collateral.) 3. Organization. Currently all of the bank's departments report directly to the chairman (total staff size is 15 people) because the chairman is trying to give them on the job training. 4. Government involvement. There does not appear to be any government involvement, other than the decreasing shareholdings noted above. 5. Financial situation. Details are in Schedule. 6. Management systems and related technology. Because of the bank's small size, it does not have developed management information systems. Computer technology is also extremely rudimentary; it is intended to upgrade this technology when the bank moves to its new premises. 7. Treasury management. The bank does not appear to have an active asset-liability management function. 8. Other activities. Currently the bank is not involved in non-lending activities. 9. Staff training. The chairman of the bank has formal training as an economist. His previous experience included work at Gosbank. He believes in close supervision and on the job training. His plans for training the bank's new staff in the fall include rotations between departments and assistance from retired western bankers. 10. Credit policy and procedures, risk management. The bank currently has 71 borrowers. Approximately 80 percent of the borrowers are in the consumer goods business and they are all in the private sector. We were told that in the life of the bank, it has made a total of 348 loans, of which 341 have been recovered. We were told that the bank has 7 problem loans, representing 41-43 percent of total loans; these are in the process of being recovered. (According to CBA data, the bank's NPL/TL were 92.5 percent as of July 1, 1995.) The bank has only appealed to the arbitrage court one or two times. ANNEX 2 Page 21 of 21 80-85 percent of the bank's loans are in foreign currency. We were told that Armenian businesses prefer dollar loans because, since interest rates are lower, they are considered less expensive. The bank charges 32 percent p.a. for dollar loans, and pays 24 percent p.a. for dollar deposits. We were told that all of the bank's loans are either collateralized or guaranteed by one of the large former state banks. Average loan maturities are 6-8 months. We were told that the bank has deposits of similar maturities. The bank has reduced its inter-bank lending because of growing difficulties in the banking market. The bank has an international department that is responsible for loan analysis and processing. Although collateral is the most important factor in the loan approval process, we were told that the bank also reviews the borrowers' business plans, financial statements, and management. Loans are approved by a Credit Committee that consists of the chairman, his assistant, the chief accountant, and the head of the international department. They decide by majority vote. The Committee also decides on loan prolongations. Aswin Kokilananda M:\ROE\ARMENIA\POLNOTE\ANNEX2.DOC 10/05/95 3:49 PM ANNEX 3 Page 1 of I I BANKING SUPERVISION AND PRUDENTIAL REGULATION 1. The supervision of banks is the responsibility of the Department of Bank Supervision, Regulations, and Licensing within the Central Bank of Armenia. The Department is also responsible for supervising banking transactions conducted by pawnshops and insurance companies, as well as the foreign exchange activities of non-banking companies. The system of prudential bank supervision in Armenia is still in its formative stages and is necessarily beset by the problems of creating an institutional capacity for effective supervision over banks and other institutions. These problems include: A. Inadequate staff skills to carry out and fully evaluate the more complex areas of examination interest and to resolve banking failures. The weaknesses in staff skills also contribute to a slower pace of development in supervisory initiatives, policies, and practices than might otherwise be achieved; B. The probable insolvency of a number of banks, including some large banks, that paralyze effective supervisory remedies pending a systemic solution to the distress in the banking system; C. Supervisory practices that are still evolving, including a need to strengthen the powers of supervisors to classify assets, mandate provisions, and force write-offs of bad debts; and; D. Weak enforcement tools and practices and an inadequate legal and institutional framework for dealing with bank insolvencies. 2. The result of the weaknesses noted above is that the supervisory process is not yet effective; supervisors are not yet prepared to deal with large bank insolvencies; there is an urgent need to accelerate the scope and depth of onsite examinations; and the analytical base for monitoring banks must be strengthened. However, these problems are not uncommon in transitional economies. It is essential that bank supervision be supported by adequate skilled staff, technical assistance, and strong political backing. The following narrative provides a description of the existing framework of prudential supervision and regulation, identifies weaknesses, and proposes remedies where appropriate. 3. Organization of Bank Supervision. The Department of Bank Supervision, Regulations, and Licensing was reorganized in September 1994 and now comprises two departments, having five divisions, and three stand alone divisions. The Department is managed by one of the CBA's three deputy chairmen. The main functions of the divisions are enumerated in Table I below. ANNEX 3 Page 2 of 11 Table 1A: Organization of the Department of Bank Supervision, Regulations & Licensing SDepartment . . Sub-Division Function Banking Supervision Department Division b On-site inspection Division IIOn-site inspection ....._ _ Division III On-site inspection Regulation & Analysis Department Division of Data Entry & Datinptitfrom prudential returns and Accounting Methodology formulation of accounting methods Division of Regulation & Off-site mohitoring of banks and the Analysis conduct of credit auctions Methodology Division Formulation of banking regulations, banking guidelines & examination tools LicnsngDivision Liesn of bank &. othe corporat..... Sactivitiesn financial enterprises 4. Staffing. Nearly seventy professionals are employed in the Department of Bank Supervision. More than one-third (26 persons) of this number is devoted to on-site examination, while off-site surveillance (16), licensing (10), regulatory policy (7), and foreign exchange supervision (7) make up the balance. Most staff have been recruited with prior work experience, either within the Central Bank or the commercial banking system. However, new trainees in the onsite examination divisions have recently been recruited direct from ranks of graduating university students--a practice which is considered reasonable since the work of bank supervisors is learned primarily on-the-job. On the whole, the existing number of staff is considered adequate for the department to fulfill its supervisory responsibilities. However, nominal increases may be necessary in specific functions such as onsite examination. More important, however, is the building of staff skills. In this regard, much work lies ahead. 5. Training and Career Development Training of staff is conducted largely on an ad-hoc basis, taking advantage of opportunities abroad provided by foreign central banks and multilateral donors. Otherwise, training has been conducted on-the-job. The IMF's advisor on bank supervision is currently preparing to conduct regular classroom sessions on a bi-weekly basis. However, over the medium-term, it will be necessary to develop a formal in-house training program to sustain and institutionalize the supervision function. Such a program need not be elaborate. Nonetheless, a basic core curricula, lesson plans, training materials, and instructional aids should be developed for use by Armenian instructors. 6. In the near-term, there is a pressing need to develop an effective on-site examination capability. This can be accelerated through training teams led by foreign advisors. Using a training team concept, the foreign advisors would mix classroom instruction with on-the-job coaching in the actual conduct of a bank examination. Each trainee would be given a major functional area of responsibility using written examination procedures as a step-by-step training ANNEX 3 Page 3 of 11 tool. The trainee would write-up his comments for the examination report when finished evaluating his area of responsibility. Once an examination is completed, the team moves to another bank where functional responsibilities are rotated. This process is repeated over the course of about six months until all trainees have had a chance to-examine each major functional area at least once. Completion of a training team cycle will not assure a cadre of competent bank examiners, but it will provide a solid base from which examiners may further their knowledge, skills, and experience. 7. Compensation. Bank supervisors are currently paid on a par with other central bank employees, but at rates below the salaries offered in the private sector. Over the medium-term, it is clear that the salary differential can only lead to the loss of the best and brightest supervisors to the commercial banks. To minimize this exodus, some countries have adopted a separate pay scale for examiners, based on the knowledge, skills, and judgment which must be exercised in the performance of their duties. Further, the bank supervision department should have the ability to maintain a pipeline of new recruits. In so doing, the ranks of departed, more experienced supervisors could be routinely filled by individuals who have only slightly less experience. A conscious effort should also be made to establish an esprit de corps within the bank supervision staff. Supervisory Practices and Methodologies 8. On-site Examination. Examination activities have primarily focused to date on banks' compliance with legal requirements and key prudential regulations. During 1994, comprehensive examinations were conducted of thirty banks (it is the intent of the bank supervision department to conduct comprehensive examinations of all banks at least once per year), but these did not include the major banking institutions in Armenia. Targeted examinations were performed in an additional eleven banks. The targeted examinations focused on verifying statutory capital and evaluating the loan portfolios of banks. The examinations, both comprehensive and targeted, did not include a classification of loans and other assets as to risk so that an appropriate determination of a bank's financial condition could be made. The fact is that, at present, the onsite examiners have neither the skills nor the authorization to classify assets and require proper provisions for problem loans. 9. Although a draft regulation has been proposed, the focus of the draft is on the assessment of a borrower's historic performance as indicated by past due status, renewal, extensions, or refinancing, and collateral. The draft pays insufficient attention to evaluating a borrower's capacity to repay. The proposed approach is mechanical and provides little room for judgment. Clearly, examiners must implement a credible program of asset classification and loan loss provisioning if discipline is to be instilled in the banking system. 10. For the most part, the present on-site examination process is transaction-oriented and is in the nature of audit and verification work. Furthermore, examiners visit all branches of a bank rather than only the head office and selected branches. In the absence of effective internal and external audit programs and internal controls in banks, a certain amount of work must be done at the transaction level. Nonetheless, over the medium-term, onsite examination activities should be re-oriented to: (a) the development within banks of appropriate written policies, systems, and controls for risk management; and (b) an evaluation of financial condition, performance, and ANNEX 3 Page 4 of II future prospects, with a special emphasis on those banking activities where losses may be incurred. Banks generally fail because of poor credit practices, concentrations of credit, and insider abuse. Supervisory methodologies that focus substantially on whether banks comply with "book" capital ratios, liquidity ratios, large exposure limits, and other sundry ratios, but which ignore adequate classifications of assets as to quality and provisioning for possible losses, evaluations of management, and an understanding of how banks provide for adequate liquidity and manage interest rate and foreign exchange risks are likely to fail. 11.- Examination activities must also be forward-looking rather than reactive and focus on banks' systems for identifying, measuring, and controlling risk. To achieve this, clearly formulated examination procedures should be developed. These procedures should encompass all activities within banks with an emphasis on those activities which subject banks to the greatest risk of failure. Written examination procedures provide a basis for training, consistency, uniformity, and documentation. There is also a need to define a standard examination report so that there is consistency in the coverage and presentation of major items of examination interest. At a minimum, the report should require a discussion of the following: * overall conclusions; * supervision and administration by the board of directors and management; * violations of law and regulations; * summary of classified assets; * loan portfolio management; * extension of credit to insiders and connected parties; * the reserve for loan losses; * earnings and capital; * liquidity, asset and liability management; * foreign exchange management; * internal and external audit-activities; * Internal controls; and * future prospects. 12. Examination conclusions are currently discussed with the bank's management, but are not routinely discussed with the bank's board of directors. In order to highlight the responsibilities of the board, the examiners should meet and discuss examination conclusions with the board at least once per year. 13. Off-site Surveillance. The Regulation and Analysis Department is responsible for the off-site monitoring of banks. The off-site surveillance system is based on periodic prudential returns submitted by the banks. The existing forms are outdated and a new reporting package is now being considered for adoption by the CBA management. This package will reduce the reporting burden on banks and provide a better basis upon which to monitor banks. Banks are currently required to submit 35 forms. However, this number will be reduced to a range between 18 and 20 depending on the decision taken by the senior management of the CBA. A further revision to the reporting package is envisioned in about a year as the transition of the banking system continues. The reports will be submitted by banks on diskette, thus reducing the time needed to input data. ANNEX 3 Page 5 of 11 14. Currently, the off-site analyses prepared on the basis of the reports submitted by the banks are more descriptive than analytical and do not demonstrate that a given bank's business activities are clearly understood. Deeper and more analytical evaluation of banks is necessary. The new report package will facilitate a deeper analysis. This is not enough, however, as data captured from prudential returns needs to be compiled in standard output reports that permit analysis in a logical format, not only of trends, but of ratios and comparisons to peers. The off-site analysis should focus more attention to a bank's income and expense components, yields, margins, costs, and sources and uses of funds to better enable an understanding of a bank's core business activities, its efficiency, and profitability. In addition, microcomputer modeling and sensitivity analysis should become a standard feature of the off-site analysis system so that analysts might better anticipate systemic problems as well as conditions within individual banks. 15. Treatment of Problem and Failed Banks. During 1994, licenses were revoked for 16 banks and two foreign branches. In addition, 41 pawnshops and six insurance companies were closed. In most of these cases, the revocation of license resulted from the inability of the institution to meet minimum prudential norms for capital. The CBA intervened in the case of the Bank of Armenia. However, this intervention was poorly handled and led to the arrest and incarceration of one of the Central Bank's employees when funds were subsequently embezzled by a bank employee. As a consequence of this, the CBA is not anxious to become involved in handling future insolvencies for which it is not, at present, adequately prepared. The weaknesses in the CBA's handling of bank insolvencies stem not only from inadequacies in the legal system, but also in the lack of formal policies for handling problem banks and bank failures, and skilled staff to carry out such policies. Given the current economic environment, the necessary policies and skilled staff for dealing with bank failures should be developed as soon as possible. 16. Formal policies for dealing with problem and failed banks should outline several key items: * The formal policy should outline the specific authorities and responsibilities of supervisors charged with handling problem and failed banks; * The policy should specify systems and methodologies for defining a problem bank. Many countries use the CAMEL rating system to designate problem banks. Under the CAMEL system, banks having a composite rating of "3", "4", or "5" are considered problem banks; * Mandatory corrective actions should be tied to problem bank status. These would include, for example, the use of enforcement measures such as cease and desist authority to outline the specific remedial actions to be undertaken by the bank. These actions could include a change in management, restricted lending and growth, prohibitions on dividends, requirements to increase capital, etc. Each cease and desist order would be unique and address those problems related specifically to the bank; * Problem banks should be required to submit frequent progress reports, usually monthly, to demonstrate their performance in correcting problems, particularly in collecting or otherwise strengthening classified assets where asset quality is a problem; ANNEX 3 Page 6 of 11 * The formal policy should require more frequent. visits and examinations of problem banks unless it can be demonstrated that the deterioration within the bank has stabilized; * The policy should require frequent meetings between the bank's board of directors and management and the CBA's supervisors so as to discuss the status of corrective measures being undertaken; * The formal policy should define when a bank has failed. Traditionally, banks are considered technically insolvent when the value of assets is less than liabilities. However, some supervisory authorities now intervene and close banks when capital, after first calculating the provisions to be made and losses to be recognized, has declined to 2% of assets. This provides a slightly larger cushion of assets to offset payments made to depositors; * When a bank fails, it should be closed. The formal policy should outline the basic steps in closure, the appointment of a receiver, and the alternatives for quickly resolving the failure. The latter would include a purchase and assumption transaction, depositor payoffs, liquidation, supervisory merger, etc. The conditions for each approach should be detailed; * Depositor preference rules should be established. The policy should outline who is to be protected and to what extent. 17. In order to build appropriate staff skills for dealing with problem and failed banks, it will first be necessary to develop good examiners. However, there is scope to transfer specific knowledge in the resolution and management of problem and failed banks. In this regard, technical assistance provided by foreign advisors experienced in problem bank management and failure resolution could be invaluable. The Banking Law and Prudential Regulations 18. The Banking Law. The Law on Banks and Banking was adopted by the Supreme Council of the Republic of Armenia in April 1993. In its present form, the Law contains many weaknesses and no longer provides an adequate framework within which banks can be expected to operate. The many deficiencies in the Law include aspects relating to the powers of supervisors, prudential controls and limits, sanctioning authority and enforcement measures, affiliates, corporate governance, licensing, and the treatment and handling of failed banks. The weaknesses are recognized within the Central Bank and work is proceeding on the formulation of a new law. The IMF has provided an excellent model for this which should provide the basis for a new law. However, the IMF model should be further expanded to include a more comprehensive treatment regarding the powers needed to deal with insolvent banks. The CBA intends to submit a new draft law, based largely on the IMF model, to the Parliament in the Fall. 19. Specific weaknesses in the present Law include the following: A. Article 2. Among other forms of ownership, this Article permits the organization of banks as limited liability companies and partnerships. As a result, owners can withdraw their invested funds at their option, thus undermining the purpose of capital which is to provide a cushion against unexpected losses for the protection of depositors and other liability holders. This form of ownership is not permitted in the new draft law. ANNEX 3 Page 7 of II B. Article 3. This Article permits the creation of specialized State-owned banks to finance national expenditure programs and other projects. In a market-oriented economy, the establishment of specialized banks with State ownership should be discouraged. The new draft does not recognize different forms of ownership. C. Article 6. The Law itemizes the permissible activities of banks. These activities include the buying and selling of precious stones and other valuables. Such activities are generally considered outside the traditional bounds of banking and should be prohibited. Further, equity participations are permitted but the Law fails to limit the amount of such participations. Appropriate limits should be established D. Article 8. With regard to licensing, information on professional skills is required only for the proposed President and the Chief Accountant. Information on professional skills should be provided for all proposed managers of the bank since incompetent managers at any position can cause the bank to incur losses. New banks are particularly at risk of failure and, therefore, the qualifications of all managers need to be carefully assessed. The new draft corrects this deficiency. E. Article 11. The current licensing application process requires the organizers to comply with all requirements for a license before the CBA renders its decision. This is unfair because it forces the organizers to incur the costs of premises, equipment, security devices, etc. before it is known whether the license will be granted. The CBA, on the other hand, is generally unwilling to decline a license after the organizers have incurred such costs. To prevent this problem, licenses should be granted in a two-step process: a preliminary approval and a final approval. The preliminary approval would be granted once all documents were thoroughly reviewed and assessed, including a determination of whether the bank could be viable based on an assessment of its feasibility and proposed trade area. The final approval would be granted once the organizers obtained premises and equipment and was prepared to commence operations. The new draft provides for a two-step approval and corrects the deficiency in the existing law. F. Article 12. The Law provides only two reasons for denying a banking license. These are: a) the failure of the by-laws or other documents to comply with legislation in force; and, b) a proven lack of professional skills on the part of the bank's management proposed president and chief accountant. The Law would appear to rule out the exercise of judgment by the CBA. There may be other reasons than these for denying a banking license, e.g., suspicion of criminal intent such as money laundering; or, simply, in the opinion of the CBA, the proposed trade area might not be able to support another bank. Thus, the Law needs to confer greater flexibility to the CBA with regard to licensing decisions. The new draft law corrects these weaknesses. G. Article 17. This Article is not sufficient for dealing with failed banks, nor does the new draft adequately cover the topic. Clearly, a broader range of legislation is required. The resolution of a bank failure is a difficult and complex issue in all countries and requires a broad array of discretionary powers. The experience of most countries ANNEX 3 Page 8 of 11 suggests that ad-hoc approaches do not work when attempting to resolve failed bank situations, thus the legal and practical modalities must be determined before-hand. If a failed bank is to be restructured, certain key principles apply: (i) the bank's management is removed; (ii) the rights of shareholders, who have lost their investment, are eliminated by the losses sustained; (iii) the bad assets are carved out of the balance sheet and replaced, preferably with government bonds; and (iv) the pricing of the bonds used in the financial restructuring must ensure that the bank returns to profitable operations. The legal framework must permit the CBA, or its designated restructuring agency/receiver, to undertake all these actions. In a liquidation situation, in order to maintain the stability of the banking system and avoid a banking panic, the CBA may find it necessary to finance the payoff of depositors or assumption of deposits by another institution. The usual rule in deciding whether to restructure or liquidate, and the methodology to be used is that the least cost alternative should be used, provided that stability in the banking system is maintained. Given the complexity of these issues, particularly during times of financial system distress, the law should be strengthened to provide for the resolution of bank failures in advance of the actual need. H. Article 18. Article 18 provides recourse through the courts, or arbitration, by banks against the decisions of the CBA. While the right of appeal is appropriate, the implementation of decisions made by the CBA should not be delayed pending a decision by the courts. It is important that urgent matters, particularly those involving unsafe and unsound banking practices, are acted upon promptly. Thus, the Law should not allow the appeals process to delay implementation of CBA decisions. Rules of procedure are required. The new draft law covers this. I. Article 19. This Article gives the CBA the power to issue prudential requirements. It would strengthen such requirements, however, if they were to be referred to in the Law. Therefore, the Law should enumerate the more important prudential requirements. These include limits on large exposures, limits on transactions involving insiders and connected parties, classification and provisioning requirements, limits on uncovered foreign exchange positions, and minimum capital adequacy requirements. J. Article 21. Article 21 discusses the seizure of assets deposited with a bank. In practice, it appears that the tax authorities have direct access to account information and can attach assets without due process. This leads to distrust and a lack of public confidence in banks. K. Article 24. Customers are permitted to open only one bank account unless permission is obtained from the CBA. This is unwarranted and anti-competitive. Customers of banks should be allowed to diversify their risks just as banks should do. The Law was apparently drafted in this manner for tax considerations. The new draft corrects this problem. L. Article 29. Article 29 addresses the supervision of banking activities. This Article should further define the powers of supervisors to include: the ability to mandate ANNEX 3 Page 9 of II provisions and direct the write-off of bad assets; and the power to close a bank which is technically insolvent. The new draft law adequately addresses this issue. 20. In addition to the weaknesses cited above, there are major gaps in the coverage of the existing law. These include the following topics on which the current law is silent: * Sanctions and enforcement measures. The Law should specify the range of measures that can be taken to enforce the Law and implementing regulations. These measures should not only include monetary fines, for specific violations of law, and revocation of the banking license, but also intermediate enforcement measures. The latter would include cease and desist authority, civil money penalties against individuals, restrictions on dividend payments, removal of management and directors, financial responsibility on the part of individuals for losses incurred by the bank from illegal acts, etc. Importantly, the range of enforcement measures should address unsafe and unsound banking practices. Such practices cannot always be defined in legislation, thus the supervisors should have the right and obligation to exercise judgment in determining whether sanctions should be applied. * Corporate governance. The Law should specify minimum corporate requirements such as the minimum and maximum number of directors, the manner by which directors are elected and vacancies filled on the board of directors, maintenance of a shareholders list, how shares are transferred, frequency of general meetings of shareholders, percentage of vote needed to amend the bank's statute, etc. The purpose is to establish a minimum framework within which banks must operate. The banks can, themselves, decide to adhere to more rigid standards. * Change-in bank controL The Law should require prior approval whenever a change in shares will lead to a change in control of the bank or whenever a minimum percentage of the shares is to change hands -- say 10% of the outstanding shares. * Affiliates. The Law should define different types of affiliates and other connected parties. Appropriate limits should be established on transactions .between affiliates and other parties connected to the bank. Limits should also be established on investments in equity participations. * Lending for the purchase, or on the security, of the bank's own shares. The Law should prohibit banks from lending for the purchase, or on the security, of the bank's own shares. To do so has the effect of weakening the capital base as a cushion for unexpected losses. The new draft law adequately covers the first four topics above. However, new clauses should be added to address the last topic. Prudential Regulations 21. A basic framework of prudential norms was established in April 1995 with the adoption of Resolution No. 78 on Prudential Economic Standards to Regulate Activities of Banks. Amendments to this resolution further define and strengthen the regulation. This framework establishes minimum requirements for capital, liquidity, large exposures, leverage, and reserve requirements. The basic requirements are: ANNEX 3 Page 10 of I1 A. Statutory CapitaL Effective January 1, 1996, banks are required to maintain minimum statutory capital, in nominal terms, of dram 50 million (approximately $100,000). Each branch requires 5 million drams in additional capital. The minimum requirement is to increase in a phased manner in accordance with the following schedule: * by January 1, 1997 - $350,000 equivalent; * by January 1, 1998 - $600,000 equivalent; * by January 1, 1999 - $800,000 equivalent; * by January 1, 2000 - $ 1,000,000 equivalent. By any measure, these nominal amounts are low in today's global financial system. Unfortunately, in Armenia today, most financial intermediation occurs outside the formal financial system. Thus, the assets of existing banks represent only a small portion of GDP1 and capital but a small fraction of assets. Clearly, fewer but stronger banks are required. Increase capitalization amounts appear warranted. B. Capital Adequacy. Effective July 1, 1995, banks are required to maintain a minimum capital to assets ratio of 6%. This minimum is to increase to 10% effective July 1, 1996. This minimum capital adequacy ratio is a simple ratio and not based on the risk weighting of assets as defined in the Basle capital adequacy guideline. While a simple ratio is useful as a floor, the CBA should move to the adoption of a risk-weighted system that better accounts for the inherent risk in different types of assets. C. Liquidity. Liquidity is defined as the ratio between liquid assets and total assets. As of July 1, 1995, the ninimum ratio is 20%. This is to increase to 30% as of January 1, 1996 and 35% as of July 1, 1996. The use of a liquidity ratio is misleading and its further use should be discouraged A bank can simply borrow long and invest short-term. In so doing, it will improve its calculated liquidity, but worsen its exposure to interest rate risk. Increasing the ratio from 20% to 30% will require more funds to be placed in lower earning assets, thus worsening.profitability. A better approach is for bank supervisors to understand how a bank provides for its liquidity needs and manages its exposures to liquidity, asset and liability, and foreign exchange risks. The use of a simplistic ratio is misleading and does a disservice to all. D. Large Exposures. The maximum exposure to a single borrower is currently 50% of capital. This percentage is to decline to 35% effective January 1, 1996 and 20% effective July 1, 1996. This phase-down is appropriate. However, there is also a need to define what constitutes an exposure and how loans to different borrowers may be combined for applying the single borrower limit. A separate regulation is suggested. E. Leverage. This ratio limits household deposits as a multiple of capital. The current limit on household deposits is 9 times capital. The intent of this ratio would seem to be to limit the exposure of household deposits to loss by ensuring a reasonable cushion of capital. Howe.ver, the risk for banks is in their assets. Household deposits provide a stable, core source of funding which can enhance a bank's safety by assuring reasonable, low cost funding. Thus, the supervisory focus should be on how the bank invests depositors funds in risk assets - not in ANNEX 3 Page 11 of 11 limiting household deposits. Most countries eliminated these types of ratios years ago. This ratio should be discontinued F. Reserve Requirements. Reserve requirements are presently 15%. This is on the high side and places a wedge between deposit and lending rates, i.e., increases the costs of financial intermediation. However, the current level should be viewed in the context of monetary policy and may be justified in that regard. The ratio should not be considered a prudential limit. A draft regulation has been prepared regarding the classification of assets and mandatory provisioning. However, the focus of the draft regulation is on the assessment of a borrower's historic performance as indicated by past due status, renewal, extensions, or refinancing, and collateral. Insufficient attention is paid to evaluating a borrower's capacity to repay. The proposed approach is mechanical and provides little room for judgment. Clearly, examiners must implement a credible program of asset classification and loan loss provisioning if discipline is to be installed in the banking system. .Further, the loan loss provisions made should be tax deductible. It is critical, for the sake of instilling such discipline, that bank managers are forced to disclose their true profits after absorbing all costs of banking. The provisioning of possible loan losses is a legitimate and important component of banking costs. Aswin Kokilananda M:\ROE\ARMENIA\POLNOTE\ANEX3.DOC 10/05/95 6:00 PM ANNEX 4 Page 1 of 5 PILOT LOAN WORK-OUT PROJECT 1. This Annex provides guidance about the establishment and operating methods of a pilot work out units for bad loans within one of the larger Armenian banks. Such a unit is a key component of the strategy for banks discussed in Section 7 of the main Report. This Annex discusses issues concerned with the organization, the responsibilities, the training needs, and the evaluation of the pilot unit. Organization 2. The pilot loan work-out unit within the bank should be a stand-alone unit that reports directly to the Chairman of the bank. The work-out project would initially have two foreign advisers. One adviser would temporarily manage the work-out unit while identifying an Armenian counterpart who could eventually take over the management of the unit.. This first foreign adviser would manage the unit throughout the pilot phase, to be replaced by the Armenian counterpart at the end of the pilot, assuming that the work-out unit is continued. The second adviser would be responsible for working with the bank's credit department and credit committee to strengthen the bank's procedures for analyzing, approving and monitoring new loans. The second adviser would also be responsible for supervising an intensive classroom training program for credit department staff and work-out staff, in close coordination with the work-out adviser. Once the credit adviser had completed his/her assignment, the work-out adviser would continue to monitor the ongoing implementation of the credit adviser's recommendations. The work-out adviser would also be a member of the bank's credit committee, with some form of enhanced authority: for example, a negative assessment by the work-out adviser could only be overridden by the unanimous vote of the other members of the credit committee. 3. The work-out department of the bank would comprise a number of work out teams each of which would have a leader. Team leaders in turn would report to the unit head (initially the foreign adviser). Each team would need to be staffed by 2-3 junior analysts. The department should also have a full-time staff of lawyers and collateral experts, with one lawyer and one collateral expert allocated to every two teams. 4. As a general approach for a developed and ongoing loan work-out department, each team would be expected to manage a portfolio of a total of 3-5 large borrowers per team as well as 5-8 small borrowers per junior analyst. The team manager would have direct responsibility for the large borrowers, with back up from the junior staff (research and analysis, routine contact with and monitoring of borrower, etc.). The junior staff would have responsibility for the small borrowers under the supervision of the team leader. This organizational structure assumes that only one of the large borrowers is likely to require an intensive restructuring process at any one time, with this process requiring a 100 percent time commitment from the team leader and one analyst for between 2-4 weeks. While intensive help is being provided to one borrower, the other large borrowers are assumed to be in holding patterns that require ongoing monitoring. 5. The work-out unit can be staffed by individuals who have previously worked in the bank's credit department although this is not absolutely necessary, because formal training will be available. However, none of these individuals should have work-out responsibilities for loans with which they were involved while in the credit department, because this prior experience makes it impossible to have the necessary objectivity to manage the work-out process effectively. ANNEX 4 Page 2 of 5 6. It will be necessary to make judgments on a bank-by-bank basis regarding the appropriate proportion of problem loan outstandings and the number of borrowers to include in a pilot work-out unit. This will depend on the bank's staff resources and its configuration of problem loans. In the case of Ardshinbank, for example, the bank's ten largest loans accounted for almost 76 percent of its non-performing loans as of July 1, 1995. This loan breakdown lends itself naturally to a 2 team structure, consisting of 11-13 professionals initially, which could eventually be reduced to 9-11. (1 unit manager, 2 team leaders, 2-3 analysts per team, and 1 collateral expert and lawyer per team at the beginning, to be reduced later to 1 collateral expert and I lawyer per each two teams.) Although it would be possible to cut the staffing down to I team and still cover a substantial proportion of the bank's problem loans, the experience o:F working with only 5 borrowers may not provide enough results and information to adequately assess the pilot program. These are the types of judgments that will have to be made for whichever bank is involved in the pilot project. Responsibilities of the work-out unit 7. The primary responsibility of each team leader is to design a loan restructuring program for each borrower under the supervision of the unit manager. The first aspect of such a program should be based on the company's realistic prospects for repaying all or part of the loan through its ongoing operations, supported, if necessary, by some combination of interest rate relief and extension of loan maturities. This part of the loan restructuring process is often the most demanding, because it requires a thorough understanding of the company and its prospects as well as successful negotiations with the company itself and its other creditors. Once the core of serviceable debt has been identified and agreed to by the borrower, the team leader should apply any collateral to the outstanding unserviceable-debt, (unless that collateral is required for the borrower's ongoing operations). The team leader should also consider other forms of loan strengthening or recovery, such as obtaining third party guarantees and converting part of the unserviceable debt to equity. However, debt for equity swaps should only be allowed once the major part of the workout process has already been completed (otherwise the swap may be seen as the solution to the problem which it is not). Once the borrower's obligations have been restructured in this way, any necessary write-offs of principal and past due interest should be made. Following this procedure the borrower's progress should be monitored on a regular basis by a team analyst, with the company providing specific information to the bank according to an agreed schedule. 8. In theory, once a borrower's obligations have been restructured, the borrower should need the attention of the work out team only for monitoring purposes until its debt is fully repaid. In practice however, further in-depth work may also be required. This is because loan restructurings maximize the cash flow and other assets that are available for debt service from companies that are already facing difficulties. It is not unusual for such companies to find themselves unable to meet their restructured commitments at some time before the loan is repaid, thereby necessitating further review and negotiations. 9. Another ongoing issue with regard to restructured loans concerns the access of the borrowers to new credit in order to keep their businesses alive. Any decisions about new credit, and indeed all issues related to the bank's business with a client whose loans are managed by the work-out unit, must be managed by the work-out team in the context of its overall strategy in dealing with the borrower. ANNEX 4 Page 3 of 5 10. It will be necessary to develop regulations concerning what decisions can be made by the team leaders and by the unit manager, and what decisions must be referred to the chairman or the credit committee. Training 11. Concurrently with the work being undertaken by the work-out unit, it is critical to train the bank's staff and revise the bank's ongoing loan analysis and approval procedures to minimize the emergence of new problem loans in the future. As has been noted, the pilot project would include a second shorter term foreign credit specialist who would analyze existing procedures, make recommendations to strengthen those procedures, and assist in implementing those recommendations. This adviser would also be responsible for supervising an intensive classroom training program for both credit and work-out staff. The training itself would be provided by another organization, such as EDI. The credit adviser would be responsible for advising on program content; modifying the program content as necessary for Armenian conditions; monitoring the quality of the training; and ensuring the active participation of the pilot bank's staff. 12. The initial courses, their approximate length, and the course participants are outlined below: * Fundamentals of accounting and financial statement analysis (2 weeks). Participation by every member of the credit department staff, including the credit department manager, and by every member of the loan work-out unit. * Responsibilities and functions of a credit committee (1 day). Participation by every member of the credit committee and the work-out unit team leaders. * Economic sector analysis (2 days). Participation by all credit analysts and work-out unit staff. * Loan work-outs (2-3 days). Participation by all work-out unit staff. To the degree possible, credit department staff should also participate. 13. With the possible exception of the credit committee course, all of these courses already exist in various forms and have been presented in different CIS countries. Therefore it would not be necessary to create the course content and materials from scratch. Some modifications would clearly need to be made to maximize the relevance of the courses to Armenia; the loan work-out course, in particular, would have to include considerable detail about the Armenian bankruptcy law, collateral procedures, etc. The credit adviser and the work-out adviser would be expected to supplement this classroom training with less formal workshops on topics that they identify in the course of their work. Completion of the project 14. The pilot project will be considered to have been completed when the following have been accomplished: * All of the transferred loans have been restructured according to a written agreement with each borrower and the loans have been written down to their appropriate value on the bank's balance sheet. ANNEX 4 Page 4 of 5 * All of the bank's staff members have completed training according to the above outline. * The bank's credit review, approval and monitoring procedures have been revised in accordance with the advisers' recommendations. * The foreign work-out adviser has identified one of the Armenian work-out team leaders to take over the work-out unit and has provided sufficient on-the-job training to that individual. (The possibility of retaining the foreign adviser for periodic "check-up" visits should also be considered.) OBJECIVES * The work-out unit is capable BOX Al: THE WORK-OUT PILOT HAS LIMITED OBJECTIVES e expan t manag of being expanded to manage The success of the work-out program will be seriously constrained by the bank's other problem two factors: the fundamental non-viability of many state-owned loans as well as problem loans enterprises whose production structure was orientated to the Soviet that are transferred from other system; and massive uncertainty over the future path of key determinants banks that are being of enterprise viability, including the blockade, real interest rates, the real exchange rate, international trading conditions and the pace of the liquidated. development of integrated and competitive domestic product and capital markets. Evaluation of the project These two constraints have important implications for the work-out 15. It is difficult to process. First, a significant proportion of the non-performing loans of the establish precise criteria for commercial banks will be non-recoverable. Second, in many cases it will whether or not the pilot project is be extremely difficult to determine whether the future value of any given successful, because criteria for enterprise (having discounted future cash flows) exceeds the current success that are related to the liquidation value. loans themselves are affected by a Given this, it is important not to define a specific recovery target (in number of factors beyond the percentage terns or drains) as a success criteria of the work-out control of the bank. In addition, process. Such a target is both impossible to define and may distort the quantification of results thalt incentives towards liquidation. The major justification for initiating the are related to the outcome of the work-out process is not a belief that there are large recoveries available. Rather it is based on the premise that one or more of the former state restructured loans will only banks has an important future role to play in the development of the become apparent over time. Armenian financial system. If the banks are to fulfill this role they will Therefore evaluations of the pilot need to clearly define their current capital and asset position, and develop project should be based less on the capabilities to analyze, assess and manage risks and to react appropriately to the emergence of non-performing assets. The initiation quantitative results and more on of a work-out process within the banks is directed in part at developing lessons learned that could be these capabilities. applied in a potential expansion of the project beyond the pilot stage. Critical information that should be derived from the project includes the following: * What are the laws, regulations and external infrastructural issues (such as court capacity, collateral registries, etc.), that would impede the successful expansion of this project? * What are the key issues related to other creditors (the government, suppliers, employees, etc.) that could impede banks from either taking a lead role in loan restructurings and/or achieving successful restructurings? ANNEX 4 Page 5 of 5 * Is there sufficient "political will" to support enterprise restructuring and liquidation to enable this project to expand successfully? * Is the limited use of foreign advisers, with a maximum of two foreign advisers per bank, workable? * Are the bank staff members sufficiently motivated and competent to take ownership of the loan work-out process in a relatively short period of time, with only rudimentary formal training? * Are the loan work-out unit and the bank's ongoing credit procedures sufficiently integrated with each other to minimize the uninformed creation of new problem loans in the future? 16. Clearly an important question related to the bank in which the pilot is conducted is whether, generalizing from the experience with this portion of the troubled loan portfolio, the bank itself is likely to be able to survive. Expanding the work-out unit within the pilot bank 17. If the pilot project is considered to be successful, the work-out unit should be expanded as necessary to accommodate all of the pilot bank's problem loans, with the exception of small problem loans in any of the bank's distant branches. The bank should develop explicit criteria for determining when borrowers are transferred to the work-out department. The bank should also seek to maximize the synergies available from the loan work-out and loan analysis experiences by developing career paths in which bank staff members periodically transfer between the work-out and credit departments. These career paths give loan analysts the important experience of working fully through the real life implications of a bad loan. They also enable work-out specialists to contribute to strengthening the loan analysis and approval processes of the banks. The overall result is a significantly strengthened bank with a corporate culture that is oriented toward risk identification and analysis. Aswin Kokilananda M:\ROETARMENIA\POLNOTE\ANNEX4.DOC 10/05/95 4:23 PM ANNEX 5 page 1 of3 CAPITAL MARKET ISSUES Current Situation I. The capital market is embryonic. As in other former Communist countries, Armenia's capital market activity is mainly a consequence of the mass privatization program. Many state- owned enterprises (SOEs) become Joint Stock Companies (JSC). After privatization the capital stock of the new JSC is equivalent to the amount subscribed by private investors, either in privatization certificates or in cash. Since the Government has succeeded in achieving the initial privatization targets, a large number of shares are now in private hands. However, this type of primary market is highly imperfect due to the lack of accurate information at the time of subscription. This information failure is carried forward to the potential secondary market. Apart from mass privatization, the only evidence of primary market activity has been the increase in capital stock made by three banks, through public offering. Nevertheless, these shares are not yet traded in the secondary market. 2. Many factors deter secondary market development. First, the Government decided to print physical shares, but has yet to print them. Second, there is no registry in place. The current proof of ownership is the receipt issued at the privatization center, and this receipt is not transferable. Thus, it is currently impossible to trade shares of the privatized JSC. In addition, there is no provision regarding clearing and settlement, no depository has been established yet, accounting information is inaccurate and scarce, and the few market intermediaries lack technical training and expertise. 3. Thus far, no corporate debt instrument has been issued and bond issues have been confined to the Government. On September 15, 1994, the Ministry of Finance issued 300 million drams in government bonds. The bonds have a one-year maturity, two coupons and a 144% annual interest rate. The last auction for this issue was held May 1995. The Central Bank has been the primary dealer for these bonds. Only banks were allowed to buy from the Central Bank. No secondary market transactions seem to exist. The auction of short- term government bonds (Treasury Bills) took place September 14, 1995. 4. Although the secondary market is non-existent, three stock exchanges are currently authorized to operate as trading floors. However, only the Yerevan Stock Exchange (YSE) is of any significance. Conducted with strong entrepreneurial drive, YSE currently houses the currency auctions. Thus far the only private company listed on YSE is the YSE itself. The YSE has a clearing contract with Armimpexbank and is planning to start its own depository for shares. Currently the YSE is also the only self-regulatory organization; it has internal regulations and listing requirements for companies. Any dispute between members of YSE is solved by an arbitration commission, which also imposes the due remedy. 5. The other legal and institutional arrangements to support the markets are also underdeveloped. The Congress approved, in 1993, the Law on Circulation of Securities. This law is very vague and delegates the authority upon an "authorized governmental body." To enforce the Law on Circulation of Securities, the Government created the commission for the "Inspection of Government Regulations and Securities Market Supervision" (SMS) on February 28, 1995. This agency is currently within the Ministry of Finance. The SMS is responsible for licensing brokers, brokerage houses, investment funds (also the management company and the depository) and all other market intermediaries. Thus far, the SMS has prepared regulations for brokers and investment ANNEX 5 page 2 of 3 companies, and has authorized 15 brokerage houses, 5 investment companies, and 1 consultant company. The SMS is incipient and most of its personnel lack formal securities market training. 6. Commercial banks do not require a special license to operate in the securities market and are regulated mainly by the Central Bank. For capital purposes, commercial banks are allowed to account only for liquid securities (government bonds and securities listed in international markets). A special account should be kept for securities in their portfolio. The banks are not allowed to use borrowed resources to buy securities. However, the banks can act as intermediaries or invest profits. 7. The main brokers are working for the commercial banks; the banks hire them to operate ir the currency market. The SMS does not provide for any distinction between broker and dealer. To receive a brokerage license, one must pass an exam required by the SMS. Training for the brokers is required to help them understand and deal with the forthcoming equity market. No other kind of intermediary is currently active. 8. The Government has issued Regulations on Share Registration and Investment Funds Under the share registry regulations, joint stock companies are allowed to set up their own registry. Although the Government has decided to create a centralized registry, it is not clear that this can be commercially attractive given the likely number of privatized enterprises and transactions. 9. Although the legal framework for Investment Funds is in place, no fund has started yet. The regulation provides for closed-end funds. The funds might be either cash funds or voucher funds. Serious concerns have been raised about the accounting procedures provided for investment in vouchers and taxation. A pilot investment fund was expected to start by the end of 1995 and a management company and a depository for investment funds have been licensed. A draft of accounting standards for investment funds has been submitted to the Government by the EU-Tacis funded advisors. Strategy 10. The main priority for the immediate future is to release the secondary market from the multiple constraints to which it is subjected. Armenia's capital market will not develop unless shares are tradeable. First, share ownership must be clearly stated, shares must be printed, and ownership must be legally recorded at a centralized registry. Such a registry should be started before shares are distributed. Since the centralized registry is not a commercially attractive idea, the Government should assume the responsibility for this service. Second, given the decision to print physical shares, the integrity and safety of the titles must be insured. The only way to operate a secondary market safely is by depositing the physical shares (in an authorized depository) and transferring ownership via the registry. The active mobilization of physical shares is inefficient. Third, after shareholders have their title, they must be able to engage in trading. The Government has to prepare the procedures for transfer, clearing and settlement. These procedures must contain a mandatory notification to the Centralized Share Registry. Clearing and settlement must be developed in direct relation with the Stock Exchanges. The Regulations on Investment Funds should be modified to solve the problems regarding accounting practices and taxation. 11. Once the basic infrastructure is in place, the Government should give particular attention to disclosure requirements. Basic standards for financial statements, based on international accounting standards must be issued. Currently, shareholders' rights are not protected and the need for disclosure is not well understood. For foreign investment to take place through the capital markets, it is necessary to standardize and make available the financial information of the public ANNEX 5 page 3 of 3 companies. The SMS should require periodically certain financial information and the information received should be made available to the public. The creation of a Securities Market Information Center would help to centralize public information and it might be a source of revenue for SMS. 12. Although the SMS is not very active at the moment, resources have to be devoted to build this institution. The SMS requires the advice of a foreign consultant, preferably with expertise in securities market regulation and enforcement to give shape to the SMS, define the scope of its powers and independence, and prepare the description of the different internal divisions. Special emphasis should be given to the information role of SMS. Legal advice is necessary for drawing up the legal boundaries among the SMS, the Central Bank and the Stock Exchanges. The Government has requested advice specifically for enforcement and supervision. However, to do effective supervision of the market, the SMS should have legal means to deter and punish misconduct in the capital market; a reform to the existing Law on Securities Circulation might be needed. 13. Another important requirement for Armenia's capital market is investment in education for both the Government and the private sector. Any program should include both local and foreign training. A viable alternative is to prepare an extension course, lasting one or two semesters, at a local academic institution, focused on the basic topics of financial markets. In addition, for a smaller number of participants a practical course might be designed to take place in a foreign securities market. The course should include practical issues and should be taught by officials from other securities market authorities and private firms working in the securities and banking sector (including stock exchanges). Aswin Kokilananda M:\ROE\ARMENIA\POLNOTE\ANNEX5.DOC 10/05/95 6:05 PM CATALOGUERS/FILE CONFIDENTIAL Report No: 15452 AM Type: SR