On 11 January the
International Monetary Fund issued a highly-detailed “Financial System Stability
Assessment” for Armenia
II. VULNERABILITY ANALYSIS
A.
Key Macroeconomic and Financial Risks
9. A possible downturn in the Russian economy and a
drop in commodity prices are key risks to the real economy. Armenia is a
small open economy with a significant dependence on remittances, primarily from
Russia, and is vulnerable to a shock to the Russian economy that could be
caused by a drop in oil prices and spillover from the euro area (Appendix III).
As exports consist largely of raw materials such as minerals and metals, a drop
in commodity prices for the exporting Armenian mining industry is also a risk.
10. Direct spillover effects from any future
financial sector distress in the euro area would likely be limited.[2] Second-round effects of a downturn in Europe
and, in particular, Russia, might have a greater impact on banks through
increased credit risks in the real sector, including through lower remittance
inflows, which, however, to a considerable extent are channeled directly into
other investments or consumption rather than saved in banks.
[2] There are no wholly owned subsidiaries of eurozone
banks and little relation between Armenian banks and eurozone banks. Wholly
owned subsidiaries have parents outside of the eurozone that are more likely to
face second round effects than direct effects of the eurozone crisis.
11. The large external current account deficit is a
potential vulnerability. The current account deficit fell by nearly 4
percentage points in 2011, but remains high at 10.9 percent of GDP. In
addition, at the time of the Third Review in December 2011, Fund staff
estimated that the real effective exchange rate was overvalued by 10–15
percent. While capital inflows have remained
strong (foreign direct investment (FDI), official financing, banking flows),
risks of pressures on the dram remain.
B.
Banking Sector Risk Assessment
12. Since the onset of the global financial crisis,
Armenia’s vulnerabilities have intensified in a number of ways:
– The shares of foreign currency in both deposits and
lending have increased significantly (Figure 3).
– While banks have weathered
the worst of the crisis, their capital buffers have declined from pre-crisis
levels (in part due to increased risk weights on foreign currency assets). Loan
portfolios are somewhat weaker, as evidenced by nonperforming loan (NPL)
ratios. Borrowers are also likely to be weaker than before the downturn began,
though there is little data available (e.g., on household and corporate balance
sheets) to make a firm assessment
– As in many other countries, policy buffers
have been reduced since 2008. Public debt to GDP has increased. Gross
international reserves, which were used to defend the currency in 2008 and 2009
(before it was allowed to fall), are on par with pre-crises levels. The current
account deficit, despite a narrowing, remains sizeable and total external debt
to GDP has increased from less than 30 percent in 2008 to a projected 65
percent in 2011.
– The level of credit is higher and growth is
accelerating. These trends imply a bigger effect on the economy of a similar
shock and more severe feedback effect through weaker balance sheets.
One positive factor
in the post-shock environment is a greater awareness of exchange rate risks among
banks and borrowers. For example, it appears that some commercial banks have
stepped up their risk management regarding credit risks stemming from exchange
rate volatility.
Asset quality
Although NPLs remain
somewhat above pre-crises levels, they are moderate (Figure 4, and Appendix
Table 3).
NPLs are defined by the CBA to include watch, substandard, and doubtful loans,
but not loss loans (i.e., more than 270 days past due). Much of the sudden
increase in 2009 (Figure 4) was quickly
reversed as the economy started to recover. Banks did not have much exposure to
the construction and real estate sectors, which were severely hit by the
crises. Importantly the government provided AMD60 billion in guarantees for
lending to small-and medium sized enterprises oriented towards exports or
production for the domestic market. As of end-December 2011 NPLs stood at 3.4
percent of gross loans, up from 3.1 percent at end-2010. There is no
significant qualitative difference across sectors, although NPLs in loans to agriculture
increased less than in other sectors.
13. Provisioning against
NPLs, according to the local definition, was only 41 percent at end-September
2011 (Figure 5). This is somewhat below pre-crises levels, but well above
the low point of 26.5 percent in 2009. The picture is similar when considering
provisions for NPLs including write-offs and excluding watch category loans (a
more standard definition) which were covered by 103 percent at end-September
2011. This level of provisioning compares favorably to other countries in the
region, partly reflecting Armenia’s relatively low level of, and moderate increase
in, NPLs. Loan-to-value ratios are prudent—CBA data shows an average
loan-to-value of 34 percent for loans registered in the credit registry.
14. NPLs levels are, however, elevated in some
banks. As of end December 2011, NPLs, including write-offs, in five banks
exceeded 10 percent. A key factor behind the asset quality deterioration in
these banks is the concentration of their credit portfolio with large exposures
to just a few borrowers. These banks do, however, remain adequately
capitalized.
15. The ratio of NPLs in
foreign currency loans has been similar to domestic currency NPL ratios (Figure
6). Levels of nonperformance for foreign currency loans could be expected to
be somewhat higher since the exchange rate depreciation of 2009 has not
reversed. However, the negative effects of depreciation are mitigated by the
lack of foreign currency lending to households (banks cannot lend in foreign
currency to households except for a small amount of mortgage lending).
16. The lack of foreign currency income for many
foreign currency borrowers adds to credit risk. There is no systematic
collection of information to the extent to which foreign currency borrowers are
naturally hedged through a corresponding income stream, and hedging is not
taken into account for capital requirements, although some banks do incorporate
this analysis into internal risk management.
Capital adequacy
17. Banks appear to be well
capitalized (Figure 7). Banks are subject to Basel II requirements for
calculation of capital. The capital adequacy ratio (CAR) declined from 27.5 at end-2008
to 19.6 at end September 2011. Leverage increased from 435 percent to 540
percent, possibly reflecting a general trend of increasing risk appetite within
the banking system. Tier 1 Capital accounts for about 90 percent of total
capital, and there are only a couple of banks where Tier 2 capital accounts for
more than 20 percent of the total. An analysis of balance sheet data suggests
that all banks would meet Basel III capital levels should those be implemented.
Resilience to shocks: stress testing results
18. Solvency stress tests conducted during the
mission suggested that Armenian banking system is robust enough to withstand
significant shocks (Appendix V and VI). The stress tests simulated the
impact of a baseline and two recession scenarios: a moderate and a severe
slowdown in economic activity paired with a significant AMD depreciation
vis-à-vis the USD. The stress tests suggest that only a few banks would face
capital strains, but also illustrate that in the face of shock, banks will be
severely constrained in their abilities to generate additional capital as an
increase in interest rates would worsen their income streams. This reflects the
fact that Armenian banks’ portfolios are dominated by fixed interest rate
loans, limiting the possibility for pass-through of funding cost increases to
their customers. Banks that largely rely on domestic funding sources would face
negative net interest income margins, which, combined with additional loan loss
provisions would further erode capital buffers. Still, 2009. However, these
historic experiences may not capture more recent vulnerabilities, including an
increase in dollarization, increased competition among banks, and relatively
high credit growth.
Concentration risk
20. Concentration of
individual banks’ exposures constitutes a further vulnerability. Although
concentration in the banking system is low (HHI index is only 0.66), banks’
loan portfolio concentration is fairly high and warrants particular vigilance
from the authorities (Figure 8). Concentration risk is not unexpected in a
small financial sector and concentration risk is especially important for small
banks that have small loan portfolios with a number of bigger clients. Stress
tests assuming that the largest borrower will fail reveal that several small
and midsized banks would need additional capital; although as in the case of
macro scenarios, these amounts are very limited.5 Failure of the four largest
borrowers would have a more significant impact; however the amount of
recapitalization needs in terms of GDP would still be limited on account of the
relatively small size of the Armenian banking system and the small size of the most
vulnerable banks.
Profitability
21. Banks’ profitability has
recovered, but is below pre-crises levels (Figure 9). Banks reported that
competition both for attracting deposits and to lend has stiffened recently,
and this can also be seen in tighter lending to deposit interest rate spreads
(Figure 10), especially in foreign currency. Such competition may put pressure
on profitability in the future.
Funding and liquidity
22. Armenian banks are
largely deposit funded (Figure 11). The customer deposit to noninterbank loan
ratio has been fairly stable in the last four years. Banks have increased
funding from foreign banks, including parents, international organizations, the
government, and the CBA. The interbank market is fragmented and does not
constitute a significant source of bank liquidity or funding.
23. Banks are generally
quite liquid, in particular in domestic currency (Figure 12). Most banks
are well above the regulatory minimum ratios for liquid assets over total
assets and demand liabilities. Foreign currency liquidity is lower than that of
dram. The overall foreign currency liquidity ratio over total foreign currency
assets is 21 percent, and 83 percent over demand liabilities, but there are
significant differences across banks and several banks have substantially lower
ratios.
24. Liquidity stress tests highlight that banks
would be able to cope with large liquidity outflows although an outflow in
foreign currency would be more challenging. The banks maintain fairly large
liquidity buffers in both domestic and foreign currency. The CBA imposes strict
liquidity requirements, although no differentiation among various currencies is
made. Banks are not exposed to market funding risk, as main sources of funding
for majority of banks are domestic deposits and IFI deposits. Foreign-owned
banks indicated that in the case of a systemic liquidity event they expect
support from parent institutions. The failure of a foreign parent would
therefore be a risk for these banks. For other foreign owned banks, the effect
of the failure of the parent would be reputational only.
25. While a majority of
banks have fairly diversified structures of liabilities, in a few small banks
the largest deposits account for a substantial share of all deposits (Figure
13). Notably, banks that have high
level of loan portfolio concentration also tend to have higher concentration of
funding, and the underlying stability of such banks could be in question, suggesting
a need for improved risk management in banks and supervision of risk management
by the CBA.
Risk management
26. Risk management in banks
has improved since the onset of the crisis, though there appears to be
significant variation across banks. Several banks have created separate
risk management departments, which report directly to management. Risk
management departments have also in some cases been given a strengthened key
role in decisions on larger loans. Awareness of exchange rate risk seems to
have increased, and has resulted in intensified loan monitoring, including
clients’ revenue streams. Stress-testing by banks has increased, in line with
recently issued CBA regulations. Stress tests are, moreover, the basis for
mandatory contingency plans prepared by banks. Still, there is room for
improvement, in particular in smaller banks where capacity is lower. CBA’s
regulations regarding risk management (including, e.g., for indirect foreign
exchange risk) can also be enhanced to promote further improvement. Banks
acknowledge that credit risk is important and challenging to manage, and in keeping
with this, emphasize that they demand a high degree of collateral and internal provisioning
in their lending.
Source:
Mark Pleas
[contact]
