ASIAN DEVELOPMENT BANK Operations Evaluation Department

PROGRAM PERFORMANCE EVALUATION REPORT

FOR

MONGOLIA

In this electronic file, the report is followed by Management’s response.

Performance Evaluation Report

Reference Number: PPE:MON 2007-37 Project Number: 30101 Loan Number: 1743-MON December 2007

Mongolia: Second Financial Sector Program

Operations Evaluation Department

CURRENCY EQUIVALENTS (as of 30 June 2007) Currency Unit MNT1.00 $1.00 – = = togrog (MNT) $ 0.000852 MNT1,173.70

ABBREVIATIONS ADB BIS BOM CAR CIB CDS FRC FSAC FSPL FSRP FX GDP IAS IDA IMF ISU JSC MARA MIS MOF MSE MSEC NBFI NPL OED OEM PCR PPER PRGF PRO ROA ROE SCC SCS SCHCDS SME SML SOE SPC SSIGO TA TDB – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – Asian Development Bank Bank for International Settlements Bank of Mongolia capital adequacy ratio Credit Information Bureau Central Depository System Financial Regulatory Commission financial sector adjustment credit Financial Sector Program Loan financial sector reform program foreign exchange gross domestic product International Accounting Standards International Development Association International Monetary Fund Insurance Supervision Unit joint-stock company Mongolian Asset Restructuring Agency management information system Ministry of Finance Mongolian Stock Exchange Mongolian Securities and Exchange Commission nonbank financial institution nonperforming loan Operations Evaluation Department operations evaluation mission project completion report program performance evaluation report poverty reduction growth facility Property Registration Office return on assets return on equity savings and credit cooperative Securities Clearing System Securities Clearing House and Central Depository System small and medium-sized enterprise Securities Market Law state-owned enterprise State Property Committee State Social Insurance General Office technical assistance Trade and Development Bank

NOTES (i) (ii) The fiscal year (FY) of the Government and its agencies ends on 31 December. In this report, "$" refers to US dollars.

Keywords asian development bank, banking sector, bank of mongolia, capital market, development effectiveness, financial regulatory commission, financial sector reform program, financial sector program, impact, nonbank financial institutions, operations evaluation, privatization, program loan, technical assistance

Director

:

Ramesh Adhikari, Operations Evaluation Division 2, Operations Evaluation Department (OED) C. Kim, Senior Evaluation Specialist, Operations Evaluation Division 2, OED J. Dimayuga, Evaluation Officer, Operations Evaluation Division 2, OED R. Perez, Senior Operations Evaluation Assistant, Operations Evaluation Division 2, OED Operations Evaluation Department, PE-708

Team Leader Team Members

: :

CONTENTS
Page BASIC DATA EXECUTIVE SUMMARY I. INTRODUCTION A. Evaluation Purpose and Process B. Program Objectives DESIGN AND IMPLEMENTATION A. Rationale B. Formulation C. Cost, Financing, and Executing Arrangements D. Application of Counterpart Funds E. Consultants F. Outputs PERFORMANCE ASSESSMENT A. Overall Assessment B. Relevance C. Effectiveness D. Efficiency E. Sustainability F. Institutional Development G. Impact OTHER ASSESSMENTS A. ADB and Executing Agency Performance B. Technical Assistance ISSUES, LESSONS, AND FOLLOW-UP ACTIONS A. Issues B. Lessons Identified C. Follow-Up Actions ii iii 1 1 2 2 2 3 4 4 4 4 9 9 10 10 10 11 11 12 13 13 14 15 15 16 17 19 24 29 42 43 44 45

II.

III.

IV.

V.

APPENDIXES 1. Program Framework: Second Financial Sector Program 2. Progress in Compliance with Second Tranche Release, Program Monitoring, and End-Of-Program Conditions 3. Progress Made in the Second Financial Sector Program Outputs 4. List of Banks in Operation as of July 2007 5. Key Banking Sector Indicators 6. Summary of Stock Market Operations (2002–2006) 7. Macroeconomic Indicators (1999–2006)

Attachment:

Management Response

The guidelines formally adopted by the Operations Evaluation Department (OED) on avoiding conflict of interest in its independent evaluations were observed in preparing this report. The fieldwork was undertaken by consultants Sarath Thalakada (Financial Sector Specialist) and Baasanjav Tsolmon (Financial Analyst) under the guidance of the Mission Leader. To the knowledge of the management of OED, the persons preparing, reviewing, or approving this report had no conflict of interest.

BASIC DATA Second Financial Sector Program (Loan 1743-MON) PROGRAM PREPARATION/INSTITUTION BUILDING:
TA No. 3459 TA Project Name Strengthening Financial Sector Development Type ADTA PersonMonths 28 Amounta ($) 600,000 Approval Date 22 Jun 2000

KEY PROGRAM DATA ($ million): Total Program Cost ADB Loan Amount/Utilizationb KEY DATES: Fact-Finding Appraisal Loan Negotiations Board Approval Loan Agreement Loan Effectiveness First Disbursement Loan Closing Program Completion Review Months (effectiveness to loan closing) BORROWER: EXECUTING AGENCY: MISSION DATA: Type of Mission Fact-Finding Appraisal Program Administration - Inception - Review - Consultation - Program Completion - Operations Evaluation
b

As per ADB Loan Documents 15.0 15.0 Expected

Actual 15.8 15.8 Actual 24–30 Mar 2000 24–30 Mar 2000 none 15 May 2000 22 Jun 2000 21 Sep 2001 11 Dec 2001 12 Dec 2001 22 Mar 2004 07-11 Mar 2005 27

21 Dec 2001 31 Aug 2000 30 Jun 2002 6

Government of Mongolia Bank of Mongolia

No. of Missions 1 0

Person-Days 7 0

9 1 1

42 5 15

ADB = Asian Development Bank, ADTA = advisory technical assistance, n.a. = not available, TA = technical assistance. a Represents approved amount of technical assistance. b Equivalent to SDR11.5 million.

EXECUTIVE SUMMARY The financial sector reforms implemented during 1991–1999 facilitated restructuring and transformation of the financial sector from a Soviet-style mono-banking system into a two-tier system with a central bank and a number of state-owned commercial banks. These reforms were supported by the Asian Development Bank (ADB) through technical assistance (TA) and the Financial Sector Program Loan, approved in December 1996. The reforms helped develop an environment conducive to private sector-led development supported by a relatively small and fragile financial system. However, those positive developments were short-lived. The difficult political environment in the late 1990s and the 1999 financial crisis adversely affected the banking system and interrupted the ongoing reform process. In addition, intermediation costs remained high and the reach of the financial system continued to be limited. As a result, a need arose to develop the nonbank and capital market subsectors, in order to diversify and deepen the financial sector to offer alternative mechanisms and institutions for depositors and borrowers, and to facilitate a drop in high intermediation costs. These circumstances spurred the Government of Mongolia (the Government) to formulate a long-term vision and medium-term strategy for financial sector development. The Government asked ADB and the World Bank’s International Development Association (IDA) to support the second phase of financial sector reforms. In response, they developed a comprehensive financial sector reform program (FSRP) that was supported by ADB’s Second Financial Sector Program (the Program) loan of $15 million and IDA’s Financial Sector Adjustment Credit (FSAC) of $32 million, both approved in 2000. The program loan and an associated TA grant of $600,000 for strengthening financial sector development were intended to promote the development of a competitive, stable, and broad-based financial system to support enhanced resource mobilization and sustainable economic growth. Such a financial system was considered necessary to efficiently respond to both the growing market-based economy and the demands of the private sector, and thereby contribute to accelerating economic development for employment generation and poverty alleviation. The improvement in financial intermediation was to be achieved by (i) strengthening corporate governance of the banks in line with international best practices, improving the loan collateral system, implementing a management information system for banks, and developing interbank markets; (ii) strengthening prudential regulations and the supervisory framework for the nonbank financial subsector; (iii) developing capital market infrastructure, including separating and privatizing the Mongolia Stock Exchange, Central Depository System, and Securities Clearing System; (iv) developing the pension system by transforming it to a partiallyfunded system; and (v) strengthening the legal and regulatory framework for the insurance system. Overall, this program performance evaluation report rates the Program “successful”. The Program is rated “highly relevant”. It was in accordance and consistent with the sector strategies and programs of the Government and ADB. It was a core part of the financial sector reform program that was put together in coordination with the Government, IDA, and International Monetary Fund, with ADB playing a lead role, based on joint diagnostic analyses. The Program’s positive response to changing circumstances, such as the volatile economic conditions in the late 1990s, was regarded imperative at that time. It remained focused and encompassed a balanced approach to assisting the development of all three constituent subsectors of the financial sector—the banking, nonbanking, and capital market subsectors— with satisfactory results. Government ownership of the reforms was relatively strong and there was adequate harmonization with other development partners.

iv The Program is rated “effective”. The Government and ADB were of the view that an efficiently functioning financial sector was the key to achieving a market-based economy for promoting rapid economic development, with the private sector as the engine of growth. That objective was achieved successfully, in so far as the country now has (i) a small but relativelywell regulated, vibrant and efficient banking system that is fully owned by the private sector, and is responding to the market-based economy; and (ii) nascent nonbank and capital market sectors that show prospects for future growth. There was a lack of progress in regard to the laws on trusts, investment funds, and private pension plans. However, the new Financial Regulatory Commission (FRC) has begun to reexamine the draft laws prepared by ADB’s consultants, with the view to having them passed by the Parliament and Cabinet as soon as possible, and implemented without further delay. The Program is rated “efficient”. The Program’s funds and the counterpart funds were used for the reform process and structural adjustments as planned. The banking system has now been entirely privatized. The 16 banks now in operation are performing autonomously and efficiently; growth rates in deposits and loans, returns on assets and equity, and decreases in nonperforming loan ratios are all satisfactory. The data show that the banks are providing efficient services to the public, while growth rates in deposits and loans reflect the increasing confidence by the public and investors in the banking system. The program was processed efficiently utilizing experiences from the preceding ADB program loan. There were some inefficiencies, however, with respect to delays in complying with conditions for release of the second tranche, which caused a two-year delay in completion of the Program. The sustainability of the program outcomes is considered “likely”. The Bank of Mongolia has set up a sound regulatory, supervisory, and accounting/auditing framework for the banking system. It is being enforced effectively and the banking system is functioning well. In addition, the FRC established in 2005 is in the process of developing the full complement of required legal, regulatory, supervisory, and accounting/auditing frameworks for the nonbank and capital market sectors. This work is progressing satisfactorily with substantial achievements expected by about the middle of 2008. Those frameworks in place at present are being enforced effectively. The authorities are aware of the fragility of the three financial subsectors, particularly in the face of financial crises similar to those that occurred in the late 1990s, and are taking the following steps to increase the resilience of the subsectors: (i) strengthening and enforcing regulatory frameworks; and implementing (ii) good governance practices, internal controls, and measures to increase investor confidence in the nonbank and capital market sectors. In addition, the Ministry of Finance, Bank of Mongolia, and FRC recently established a Financial Stability Board that will jointly research, assess and analyze developments in the financial sector and jointly recommend actions to be taken by the appropriate agencies. The overall favorable macroeconomic setting will help increase the sustainability of the reform process. The FSRP contributed substantially to human resource and institutional development in the financial sector. Institutional strengthening was undertaken of (i) the Bank of Mongolia’s regulatory and supervision departments, with a focus on prudential norms and bringing accounting and auditing standards into line with international standards; (ii) the Credit Information Bureau; and (iii) the Asset Restructuring Agency. Under the Program, institutional capacities relating to supervision of nonbank financial institutions, capital markets, and insurance industry were strengthened. The Program also strengthened the institutional frameworks for developing the capital markets and contractual savings institutions. The capacity building momentum is now being maintained by these beneficiary institutions, with the support of their own budgets and other donor assistance. The FRC, however, needs considerable donor assistance for skills and institutional development. In the area of corporate governance in the

v sector, Mongolia has made a good start. The Bank of Mongolia has introduced a code of good governance with a range of penalties for any contraventions. It also closely supervises the implementation of that code. The 16 private banks have their own independent boards appointed by the shareholders; credit decisions are made independently by credit committees using risk-management techniques; and operations are closely controlled and supervised, with independent internal auditors reporting directly to their respective boards. Through the Program and the FSAC, the FSRP’s contribution to development of Mongolia’s financial sector is rated substantial, based on a four-category scale of high, substantial, modest, and negligible. The FSRP helped Mongolia complete the transformation of its formerly mono-banking system to a two-tier system that is fully privately-owned and efficiently providing the banking services demanded by the general public and investors. It is now capable of responding to market signals and assisting in the efficient operation of a marketbased economy. Financial intermediation improved significantly over the 5-year period (2002– 2006), led by banking sector growth. The ratio of broad money (M2) to gross domestic product (GDP), an indicator of the depth of the financial sector, increased from 38% in 2002 to 48% in 2006, while the total assets of the banking sector increased from 40% of GDP in 2002 to 68% in 2006. The private sector has benefited most from this transformation. The loans given by the banking system have been predominantly for private sector development, averaging about 97% of its total loans outstanding over 2002–2006. As a result, the private sector’s contribution to GDP increased from only 3.0% of GDP in 1989 to 70% in 1999, and to about 78% in 2006. The GDP growth rate increased from 3.2% in 1999 to 8.4% in 2006. The performance of both ADB and the executing agency (the Bank of Mongolia) was mixed. ADB’s performance was less than satisfactory. While it promptly undertook the design and formulation of the Program to meet the urgent demand, its performance during implementation was inadequate. This complex program had multiple facets—such as policy reform, development of new laws and/or amendment of existing laws, as well as institutional capacity enhancement aspects in three different subsectors of the financial sector—and required above average supervision to ensure effective implementation and overall success. ADB’s supervision was not commensurate with that level of complexity, however, and problems encountered led to delays in implementation and second tranche release, and shortcomings in some TA outputs. Similarly, the performance of the executing agency was mixed, being satisfactory with respect to program loan implementation, but less than satisfactory in TA implementation. It remained fully committed to implementing the reform program, particularly those aspects connected with the commercial banking system. It successfully introduced legal, regulatory, supervisory, internal control, governance, and accounting/auditing frameworks for the commercial banking system, which meet international standards. However, its performance in dealing with the vital TA component was not entirely satisfactory. The TA addressed development of non-banking and capital market subsectors; the executing agency was not directly responsible for these areas, which may account for their less than satisfactory treatment during TA implementation. Had the implementing agency been the Mongolia Stock Exchange Commission, which is the agency responsible for these two subsectors, the treatment would have been more positive, resulting in more successful implementation.

vi Several lessons are evident from the program design and manner in which ADB supervised program implementation. The key lesson identified and worthy of replication in future ADB operations in similar situations was that the success of the Program was a result of continued Government commitment and ownership of the FSRP, which was formulated and implemented through a combined effort involving the Government and key donors, with ADB playing the lead role. A second lesson is that the success in banking sector restructuring was a result of the Government’s emphasis on privatization of banks rather than restructuring them under the same government ownership, which enabled establishment of a more efficient and effective financial intermediation system. A third lesson is that reform program formulation should not overestimate the capacity and political will of the Government to formulate and implement reforms and new laws, and/or amend existing ones. The overall reform process was dependant on actions undertaken in a multitude of other sectors. Both the Cabinet and Ministry of Justice are overburdened, meaning that proposed new reforms, laws and/or amendments to existing laws should have been better sequenced and phased, and presented in a more convincing manner with additional research and analysis, so as to improve the chances they would be considered and approved by the appropriate authorities. Fourth, ADB’s due diligence should be carried out more carefully. ADB staff and consultants should have collaborated more closely and ensured that necessary procedures, such as those outlined in the previous paragraph, were followed in cases where ADB encountered implementation problems. Fifth, the choice of appropriate executing agencies for implementing different components of a program is essential. The agencies directly responsible for handling different components in the existing organizational arrangement should be selected as the executing agencies for those components, rather than having one umbrella executing agency for all components. Lastly, in order to improve ADB’s supervision of complex financial sector program loans—particularly those that entail policy reforms, development of new laws and/or amendment of existing laws, and human resource and institutional development elements—the supervision budgets, staff skills, and staff incentives in responsible ADB programs should be improved, so as to enable staff to maintain their program supervision roles for longer periods, thereby improving implementation.

vii The report recommends the following follow-up actions.
Recommendation (i) Request the Financial Regulatory Commission to have the two draft laws on trusts and investment funds passed by the Parliament and Cabinet, respectively. Request the State Social Insurance General Office to present the draft law on private voluntary pension plans for consideration and approval by Parliament. Consider providing further assistance and policy support to the Government, with more emphasis on development of the nonbank and capital market sectors and less emphasis on the banking sector, to address the issues mentioned under paras. 34–35 above, plus the establishment of the proposed deposit insurance system. Look into possibility of privatizing MSE, Credit Information Bureau, and Mongolia Asset Restructuring Agency within 2–3 years. Consider assistance for strengthening some of the smaller banks, including one of the banks operating mainly in the rural sector, through equity and loan investments in the banks. Consider assistance to help the banks undertake nonbank and capital market activities (e.g., fund placement, initial public offerings, and underwriting) as being proposed by the Government. Consider assistance for introducing new financial products into the market, such as mortgage securitizations through equity and loan investments in the Mongolia Mortgage Corporation, medium to long-term bonds, medium to longterm deposit and lending instruments for banks to promote the development of small and medium-sized enterprises and rural sectors, financial leasing, and cross-border leasing and insurance products. Consider broadening ADB’s private sector involvement into support for the corporate sector, particularly small and medium-sized enterprises, for diversification of the economy. Private Sector Operations Department, East Asia Department Responsibility East Asia Department Timing As soon as possible

(ii)

As soon as possible

(iii)

During the preparation of the next country partnership strategy

(iv)

MSE within 2008; others beginning from early 2008 Beginning from early 2008

(v)

(vi)

Beginning from early 2008

(vii)

Beginning from early 2008

(viii)

Beginning from early 2008

ADB = Asian Development Bank, MSE = Mongolia Stock Exchange. Source: Operations Evaluation Team.

Ramesh Adhikari Officer-in-Charge Operations Evaluation Department

I. A. Evaluation Purpose and Process

INTRODUCTION

1. The Loan for the Second Financial Sector Program1 (the Program) and the associated technical assistance (TA) grant2 were selected for evaluation for three main purposes. First, this program performance evaluation report (PPER) evaluates and takes stock of the performance and impact of the Program and TA on development of the financial sector. Second, it strengthens policy dialogue, ensuring the continued achievement and sustainability of program outcomes and enhancing any further assistance to the sector by the Asian Development Bank (ADB). Third, by highlighting important lessons, it provides inputs to future ADB financial sector strategies and programs, with the goal of achieving greater economic and social impact. The assessment was based on the following core criteria, as defined in the evaluation guidelines:3 (i) relevance, (ii) effectiveness, (iii) efficiency, and (iv) sustainability. International standards were adopted in making the assessments in terms of financial performance of the commercial banks,4 and frameworks for their regulation, supervision, accounting, auditing, and governance practices. The other assessments included institutional development, impact, and ADB and executing agency performance. An operations evaluation mission5 (OEM) visited Mongolia from 20 June to 4 July 2007 and reviewed program-related documentation and other background materials, interviewed key stakeholders 6 in Mongolia, and ADB officials associated with the Program. 2. The Program was intended to carry forward reforms that were successfully implemented under the First Financial Sector Program Loan (FSPL I).7 Appendix 1 summarizes the program framework. A program completion report (PCR), prepared by the Regional Cooperation, Governance, and Finance Division of the East Asia Department, rated the Program “successful”, but the TA “partly successful” (due mainly to delays in passing laws for establishment of trust and investment fund operations, and for improvements in the insurance and pension systems).8 Another key feature of the Program was the close coordination between ADB and the International Development Association (IDA) of the World Bank. It complemented IDA’s Financial Sector Adjustment Credit (FSAC), and the progress of the Program and the FSAC was monitored through joint review missions. Under the agreed arrangements, FSAC focused on privatization of state-owned commercial banks and banking reforms such as prudential regulations, while the Program focused on reforms in financial sector governance and promotion of nonbank financial institutions (NBFIs), including capital markets and contractual savings. Another feature of the Program was the adoption of a more holistic approach to
1

2 3

4

5

6

7 8

ADB. 2000. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance to Mongolia for the Second Financial Sector Program. Manila. (Loan 1743-MON, for $15 million, approved on 22 June 2000). TA grant (3459-MON) of $600,000 for strengthening financial sector development. ADB. 2006. Guidelines for Preparing Performance Evaluation Reports for Public Sector Operations Addendum 1. Manila. The 16 commercial banks now in operation in Mongolia are all privately owned, and include three previously stateowned banks that have been restructured and are now fully privately owned (i.e., Khan Bank [previously Agriculture Bank], Trade and Development Bank, and Mongol Post Bank). The OEM was staffed by Cheolghee Kim (Senior Evaluation Specialist/Mission Leader), Sarath Thalakada (International Financial Sector Specialist), and Tsolmon Baasanjav (Domestic Financial Analyst). Including representatives of the Ministry of Finance, Bank of Mongolia, Financial Regulatory Commission, State Property Committee, Mongolian Asset Restructuring Agency, privatized commercial banks, the Chamber of Commerce, Mongolia Bankers’ Association, the Mongolia Stock Exchange, Securities Clearing House and Central Depository System, the International Monetary Fund, and the World Bank. ADB. 2003. Program Performance Audit Report on the Financial Sector Program. Manila. (Loan 1509-MON-[SF]). ADB. 2005. Program Completion Report on the Second Financial Sector Program. Manila. (Loan 1743-MON).

2 financial sector development through promotion of nonbank and capital market sectors, which extended its focus for diversification and deepening of the financial sector. B. Program Objectives 1. Program (Loan 1743-MON)

3. The primary objective of the Program was to promote the development of a competitive, stable, and broad-based financial system to support enhanced resource mobilization and sustainable economic growth. Such a financial system was considered necessary to efficiently respond to both the growing market-based economy and the demands of the private sector, and thereby contribute to the acceleration of economic development for employment generation and poverty alleviation. The improvement in financial intermediation was to be achieved by (i) strengthening corporate governance of the banks in line with international best practices, improving the loan collateral system, implementing a management information system (MIS) for banks, and developing interbank markets; (ii) strengthening the prudential regulations and supervisory framework for the nonbank financial subsector; (iii) developing capital market infrastructure, including separating and privatizing the Mongolia Stock Exchange (MSE), Central Depository System (CDS), and Securities Clearing System (SCS); (iv) developing the pension system through transformation to a partially funded system; and (v) strengthening the legal and regulatory framework for the insurance system. Further details are in Appendix 1. 2. TA Grant 3459-MON: Strengthening Financial Sector Development

4. The TA was expected to strengthen the legal and regulatory framework for (i) supervision of NBFIs, (ii) secured collateral, and (iii) development of capital markets and contractual savings institutions. The program loan and the TA were implemented over June 2000–March 2004. II. A. Rationale DESIGN AND IMPLEMENTATION

5. The financial sector reforms implemented during the period 1991–1999 facilitated the restructuring and transformation of the financial sector from a Soviet-style mono-banking system to a two-tier system, with a central bank and a number of state-owned commercial banks. These reforms were supported by ADB’s FSPL I, comprising a program loan and its associated TA grant and a TA loan, approved in December 1996. Together, they made significant impact on the progress of reforms, and development of both human resource and institutional capacity. The Operations Evaluation Department (OED) rated FSPL I “successful”, the TA grant “highly successful”, and the TA Loan “less than successful” (due mainly to problems associated with the selected consulting company), based on their relevance, effectiveness, efficiency, sustainability, and impact. The reforms helped develop an environment conducive to private sector-led development supported by a relatively small and fragile financial system. The overall impact of the reforms led to an average real gross domestic product (GDP) growth rate of about 3.9% during the 5-year period 1995–1999. Inflation was brought down from over 50% in 1996 to below 10% in 1998 (although it increased to 10% in 1999). 6. These positive developments were short-lived, however. The difficult political environment in the late 1990s and the 1999 financial crisis caused by the severe drop in the prices of major commodity exports adversely affected the banking system and interrupted the

3 ongoing reform process. The commercial banks, faced by increasing deposit interest rates and mounting bad debts, once again began to face profitability, liquidity, and solvency problems, and required recapitalization as well as strengthening of their governance practices and internal controls. In addition, intermediation costs remained high and the reach of the financial system continued to be limited. The weak financial sector, which lacked diversification and played only a limited role in the economy, negatively affected Mongolia’s growth and macroeconomic prospects. The reform process therefore needed to be revamped and carried forward to put the bank transformation process back on track. Specifically, there was a need to develop the nonbank and capital market subsectors to diversify and deepen the financial sector, so as to offer alternative mechanisms and institutions for depositors and borrowers, and to facilitate a decrease in intermediation costs by providing greater competition and alternatives in the marketplace. B. Formulation

7. Such circumstances and the need to carry forward the first phase of financial sector reforms prompted the Government, with the assistance of the IDA, to formulate a long-term vision and medium-term strategy for financial sector development.9 This included the pace and sequence of overall financial sector reforms over the medium term. To implement this strategy, the Government asked IDA and ADB to support the second phase of financial sector reforms. In response, ADB and IDA developed a comprehensive financial sector reform program (FSRP) that included a common development policy letter and policy matrix, and covered the various subsectors of the financial sector for parallel financing of the associated structural adjustment costs. 8. The umbrella reform program was supported by (i) ADB’s Second Financial Sector Program Loan (FSPL II) of $15 million and the associated TA, approved in June 2000; and (ii) the FSAC of $32 million approved by IDA in April 2000. Under the agreed arrangements between ADB and IDA, the FSAC focused on (i) restructuring and privatizing state-owned banks; (ii) banking reforms such as prudential regulations; (iii) strengthening banking institutions, namely, the Mongolian Asset Restructuring Agency (MARA), and the Credit Information Bureau (CIB); and (iv) supporting capacity building and skills upgrading through a TA credit. The banking reforms under ADB’s program loan complemented those under FSAC, focusing on (i) reforms in financial sector governance; and (ii) promotion of NBFIs, capital markets, and contractual savings. These combined policy actions were expected to develop a broad framework for the creation of a stable and competitive financial sector. That was an important focus and agenda of the FSAC and built on the progress made under past ADB operations. To facilitate coordination, ADB and IDA jointly monitored implementation progress within FSRP. 9. The second phase of reform package was developed jointly by the Government, ADB, and IDA, as is evident from paras. 7–8. Given the circumstances, ADB presumably considered that a separate project preparatory TA (PPTA) was not necessary for formulation of the Program and the TA. These were formulated relatively quickly, with about 5 months elapsing between the first reconnaissance mission, fielded in January 2000, to Board approval in June 2000. This was possible as a result of the experience gained from (i) the ongoing reform process, which began in 1991; (ii) outcomes of advisory TA grants, the First Financial Sector Program, and associated TA projects; and (iii) the joint program formulation work done under the FSRP.
9

World Bank. 1999. Mongolia Financial Sector Strategy. Washington D.C.

4 C. Cost, Financing, and Executing Arrangements

10. The cost of structural adjustment under the FSRP was estimated at about $100 million,10 financed through (i) the Program (covering adjustment costs, up to $15 million equivalent), (ii) the IDA loan of $32 million equivalent (supporting the balance of payments gap of $30 million over 2001–2002), and (iii) the Government’s budgets (covering financing gaps in the structural adjustment costs). The Program comprised (i) a policy loan of $15 million equivalent (SDR11,448,000) to be disbursed in two tranches, and (ii) a TA grant of $600,000 to support strengthening financial sector development. The first tranche was disbursed on the day the loan became effective (12 December 2001). The second tranche was released on 8 December 2003, about 24 months later than planned. The Bank of Mongolia (BOM) was the Executing Agency for the Program and the TA, with overall responsibility for program implementation. It was assisted by a steering committee, which was chaired by the deputy governor of BOM and included senior representatives of the Ministry of Finance (MOF), Ministry of Justice, and other appropriate agencies. D. Application of Counterpart Funds

11. Loan proceeds were withdrawn according to ADB’s standard disbursement procedures and were used to finance structural adjustment costs under the Program. The counterpart funds of about $53 million equivalent for structural adjustments under the FSRP—comprising costs arising from restructuring problem banks, establishing the MARA, and managing the inherited directed loan—were included in the national budget and used in line with the Program. Bonds were issued beginning in 1996 to finance these costs. E. Consultants

12. The Strengthening Financial Sector Development TA was an integral part of the Program. It assisted the Government in developing a more competitive, stable, and broadbased financial system by increasing the efficiency of financial intermediation and supporting the development of financial infrastructure. An international consulting firm with relevant experience in banking and capital market development, in association with domestic consultants, was engaged to provide the TA services required. The firm was recruited by ADB using the simplified proposal format in accordance with ADB’s Guidelines on the Use of Consultants, and other arrangements satisfactory to ADB for the engagement of domestic consultants. The consultants provided 18 person-months of international consulting and 10 person-months of domestic consulting services.11 F. Outputs

13. The Program reforms were to be implemented for 3 years from loan effectiveness, with the Program planned to end in December 2004. Although the loan was approved on 22 June
10

The estimated cost of structural adjustment of about $100 million consisted of the following components: (i) bank restructuring, including liquidation, restructuring, recapitalization, and settlement of severance payments ($51 million equivalent); (ii) transition to a partially funded pension scheme ($28 million equivalent); (iii) institutional strengthening of BOM, MARA, the Mongolia Securities Exchange Commission, State Social Insurance General Office, and Insurance Supervision Unit ($13 million equivalent); and (iv) others including privatization of MSE, MIS development, and liberalizing guidelines for pension and insurance funds ($8 million equivalent). 11 The international consulting services were provided as follows: (i) supervisory framework for NBFIs (2 personmonths); (ii) the framework for secured collateral (2 person-months); (iii) the legal, regulatory, and institutional framework for developing capital markets (8 person-months); and (iv) the legal, regulatory, and institutional framework for developing contractual savings institutions (6 person-months).

5 2000, its effectiveness was delayed to allow negotiations to conclude between IMF and the Government on IMF’s poverty reduction growth facility (PRGF) as (i) macroeconomic stability was a condition for effectiveness of the FSAC, and (ii) the FSRP intended effective coordination between the FSAC and the Program. The IMF and the Government reached agreement in September 2001; following the necessary ratification by the Parliament, loan effectiveness occurred on 12 December 2001. The first tranche of the loan was released on that date. Release of the second tranche was conditional on 13 policy actions, and was originally targeted for December 2001 (i.e., 18 months after the intended effectiveness).12 The Program included 12 other monitorable conditions and eight end-of-program conditions. Release of the second tranche occurred on 8 December 2003, following confirmed progress on overall program implementation and compliance with all second tranche release conditions. The PCR, completed in July 2005, found that at the end of the Program, one monitorable condition and four end-of-program conditions had not yet been fully complied with, although positive progress had been made in that regard. 14. OEM’s field work, undertaken in June and July 2007, revealed that the monitorable condition pertaining to the target set for the sale of shares of privatized companies through the MSE 13 was not fully complied with. In regard to the four end-of-program conditions, one pertaining to the introduction of good governance practices into banks had been met,14 but the other three—pertaining to (i) introduction of a legal, regulatory, supervisory, and accounting/ auditing framework for the insurance industry meeting international best practices; (ii) the privatization of the MSE; and (iii) submission to Parliament for approval of a draft law on voluntary private pension plans—remained not fully complied with. In regard to the other program conditions, the PCR reported that the needed amendments to the Law on Cooperatives were proceeding, and therefore the covenant requiring them was “largely complied with”. The PCR also reported that the two covenants that required two new laws on trusts and investment funds were “complied with”, as they were drafted by ADB/TA consultants meeting ADB requirements. However, the OEM found that in practice these three covenants remained not fully complied with. Appendix 2 gives the present status of compliance of program conditions as verified by the OEM. Also, Appendix 3 elaborates on progress made thus far in the respective output areas assisted by the Program; a summary of progress is presented below. 1. Improving Financial Intermediation

15. The FSAC (undertaken by IDA) and ADB’s Program were integral and complementary parts of the FSRP, and therefore in the following discussion the key outcomes of the overall FSRP are discussed together, in order to present a comprehensive picture of the combined outputs for financial sector development. The FSRP has been implemented satisfactorily and has achieved significant results. The previous mono-banking system has been completely transformed into a two-tier banking system, which is privately-owned, well regulated and supervised, and established on a stable basis with good growth prospects. The following
12

Given the initial delay, second tranche release would have been expected by June 2003 (i.e., 18 months after effectiveness). 13 That condition required the State Property Committee to sell at least MNT200 million worth of shares of privatized state-owned enterprises through the MSE. According to the PCR, such sales exceeded the target in 2001 (MNT281 million), but did not reach that target in 2002 (MNT167 million) and 2003 (MNT107 million). The target was not met during the subsequent years (nil in 2004, MNT94 million in 2005, MNT115 million in 2006), while the number of listed companies on the MSE fell from 402 in 2003 to 387 in 2006. In 2006, about 100 privatized limited liability companies remained to be listed on the MSE. 14 BOM adopted the corporate governance regulation in 2006, and it has been effectively enforced since then. Among other requirements, it delineates the codes of corporate governance that the board of directors, management, internal auditor and external auditor need to observe.

6 outputs were made with assistance of the ADB Program: (i) Strengthening Corporate Governance in Banking Institutions. All the banks practice good governance principles. BOM adopted the corporate governance regulation in 2006 and it is being enforced. Improving the System of Collateral. The debt-recovery process needs to be further expedited and the associated costs reduced. Doing so would bring down loan transactions costs, contribute to enhancing the efficiency of banking services, and further strengthen the financial intermediation process. A new law on immovable property is now in Parliament for approval before end 2007. Implementing an MIS in Banks. The banks continue to install and improve their MISs. These were first introduced with ADB TA, and improvements are now funded from bank profits. Developing an Interbank Market. BOM’s liquidity support to banks has stopped, largely to encourage banks to manage liquidity among themselves. The operations of the interbank market remains small in comparison to overall banking sector operations but the framework for operating an interbank market satisfactorily is now in place. The efficiency of the interbank operations is improving.

(ii)

(iii)

(iv)

16. In parallel, the following related outputs—made with the assistance of IDA’s FSAC— formed part of the Government’s overall sector reform program, which was supported by ADB: (i) (ii) Privatization of the Commercial Banks. The banking system has now been entirely privatized. Prudential Regulations. The Basle Committee requires that about 25 core principles relating to banking supervision be implemented by central banks. BOM has implemented 23 that meet the requirements; one principle, pertaining to overseas branch operations, is considered inapplicable to Mongolia. Accounting and Auditing Standards. International accounting standards (IAS) have been introduced. Bank Supervision. The basic framework for bank supervision is now in place, which should help BOM to examine banks and enforce regulations more effectively. BOM conducts full onsite examinations of all 16 banks every year, based on the “CAMELS” principles, as well as adherence by the banks to prudential regulations and international accounting standards. Autonomy of Commercial Banks. The banks operate independently and without any government involvement in their policy-making, management and operations. Competition, Efficiency, and Viability. Private enterprise has led to intense competition among banks for both deposits and loans, resulting in benefits to the public in terms of greater efficiency in meeting public demand for various banking services. Deposits and Loan Growth. Deposits with banks have been growing significantly, reflecting increasing public confidence in the banking system. Loan Portfolio Diversification. The loan portfolios of the 16 commercial banks are fairly well diversified. Interest Rates on Deposits and Loans and Interest Spread. Interest rates for both deposits and loans are now fully liberalized, with the banks being free to charge interest on a risk-reward basis. Market interest rates show a declining trend with the increasing competition.

(iii) (iv)

(v)

(vi)

(vii) (viii) (ix)

7 (x) Status of Non-Performing Loans. The aggregate nonperforming loans (NPLs) increased from MNT11.7 billion to MNT60.0 billion over the 5-year period 2002– 2006. The ratio of NPLs to total loans outstanding increased from 5.1% in 2002 to 6.4% in 2004 and decreased to 4.9% in 2006. These ratios indicate that they are at a manageable level. Banking Skills Upgrading. Banks are placing a high priority on skills upgrading for (i) capacity enhancement, (ii) to cope with competition and possible slowdowns in economic expansion, and (iii) to increase the efficiency of service provision. Strengthening Prudential Regulations and Supervision of NBFIs

(xi)

2.

17. The Program supported the introduction of appropriate legal, regulatory, supervisory, and accounting/auditing frameworks for the orderly development and viability of the nonbank sector. Their previous fragmented regulatory and supervisory framework has now been brought under one umbrella with the establishment of the Financial Regulatory Commission (FRC) in November 2005, as recommended by ADB. FRC has begun to fill the gaps in the required legal, regulatory, supervisory, and accounting/auditing frameworks, with completion scheduled for 2007 or 2008 at the latest. It has also begun to enforce these frameworks effectively, and is taking positive steps that promote a stable, competitive, and viable nonbank sector in the country. However, it would require capacity enhancement in order to more effectively perform its functions and carry out its plans. The nonbank sector is open for foreign investment. There are about 300 institutions in operation, comprising 141 NBFIs, 118 savings and credit cooperatives (SCCs), 27 securities companies, and 14 insurance companies. The present status of the nonbank sectors is given below. (i) Nonbank Financial Institutions. NBFIs are engaged mainly in giving short-term loans for small businesses using their own funding resources. This subsector is the most stable of all the nonbank sectors. The Law on Nonbank Financial Activities enacted in December 2002 provides the legal basis for their operation. The regulatory framework in place includes specifications for minimum capital requirements, asset classification, liquidity, foreign exchange (FX) exposure, accounting/auditing meeting IAS standards, and provisioning. There is an increasing interest by foreign investors in the nonbank sector. The total assets of NBFIs show an increasing trend.15 Savings and Credit Cooperatives (SCCs). A new law to govern the operation of SCCs will be submitted for the approval of Parliament before end 2007. It will give the legal basis for SCC operations and will cover various issues, including membership, share-capital, loan operations, and obligations in respect of taking and repaying deposits from members and non-members. FRC is now the sole authority regulating, supervising and controlling the SCC system. Securities Companies. Securities companies are engaged in brokerage, dealing in stocks and bonds, funds placement, underwriting, and initial public offerings. The Securities Law, Company Law, and the Civil Code provide the legal basis for their operations. Prudential regulations and accounting/auditing procedures meeting international standards are in place. FRC is preparing further prudential regulations for implementation in 2007, while re-licensing of securities

(ii)

(iii)

15

The total assets have increased from MNT12,459 million in 2002 to MNT69,262 million in 2006, for an annual growth rate of just over 50%. The total assets in 2006 equaled about 2.2% of GDP, slightly larger than the insurance sector (0.7% of GDP), but much smaller than the banking sector (68.4% of GDP in 2006).

8 companies is proceeding satisfactorily. FRC is taking steps to improve the viability of the subsector by increasing investor confidence in stock market operations and market liquidity through more public listings of good quality stocks. Insurance Companies. The private insurance companies are engaged in general insurance business. The Law on Insurance and the Law on Insurance Professional Participants passed by Parliament in April 2004 provide the legal basis for their operations. These laws were prepared with the support of ADB TA and comply with the standards and principles set by the International Association for Insurance Supervisory Agencies. The required accounting/auditing framework meeting international standards is now in place and is being effectively enforced. Another new law on compulsory insurance covering the liability of automobile drivers is now being drafted by FRC for the approval of Parliament in 2007. The need to introduce life insurance and other forms of compulsory insurance schemes is also being examined. Developing Capital Market Infrastructure

(iv)

3.

18. The Program promoted the development of capital markets for diversification and deepening of the financial sector. It supported improvements in (i) governance structure of the MSE, (ii) the Securities Market Law (SML) and related regulations, and (iii) the legal status of trust relationships and investment funds. It also assisted in the institutional strengthening of the Mongolia Securities Exchange Commission (MSEC), now known as the FRC under the TA associated with the Program. These reforms have been implemented satisfactorily, with some gaps that are to be filled in 2007, or at the latest in 2008. Their implementation status is given below. a. Separating MSE Functions and Privatizing MSE

19. MSE’s functions were divided in October 2003, with MSE made responsible for securities trading, and a separate state-owned limited liability company (the Securities Clearing House and Central Depository Co. Ltd. [SCHCD])16 given responsibility for securities clearing, settlement and depository functions. Both are now well established and operating independently on a profitable basis. Privatization of MSE was included in the Government’s overall privatization program for 2005–2008, but privatization has not yet occurred, apparently due to a lack of political will. The list of institutions to be privatized in 2008 will be finalized before the end of 2007. OEM impressed upon the State Property Committee (SPC) and FRC the need to follow that procedure and finalize privatization no later than end 2008. Various options for privatization of MSE are being discussed, and it is probable it will be completed by then. It is OEM’s current opinion that the recommendation by ADB to privatize MSE may have been premature, as the prospects for successful privatization would improve following an increase in the viability17 of and public confidence in MSE’s operations.

16

The SCHCD was created by the amalgamation of the previous Securities Clearing System (SCS) and Central Depository System (CDS). It was licensed by FRC in October 2006 to conduct these functions. 17 Two options being considered are (i) local privatization with involvement by the management and staff of MSE and other securities market players, and (ii) privatization on a joint-venture basis. OEM indicated that a third option would be privatization on a two-stage basis: initial privatization of management with foreign participation to introduce international best practice, followed by full privatization subsequent to an improvement in MSE’s viability, thereby improving the price obtained by the Government.

9 b. Strengthening the Securities Markets Law (SML)

20. The Program called for amendments to SML to improve financial governance and restore public confidence in the securities markets. The amended SML was passed by Parliament in December 2002 and became effective in January 2003. The amended SML included (i) increased penalties for violation of the SML; (ii) stricter audit requirements for listing of companies; and (iii) higher minimum capital requirements for brokers. The Law on FRC Legal Position (dated 17 November 2005), which established the FRC, adequately covers other shortcomings, such as (i) the inadequate legal basis for (a) the regulatory, supervisory, and enforcement powers previously held by MSEC, and (b) for self-regulation; and (ii) the need for clarity of some technical terms being used. Based on experience and the evolving nature of the market, FRC proposes to amend the SML again and renew existing rules and regulations for the securities market before the end of 2007. 4. Strengthening the Pension System

21. The Program aimed to support (i) the Government’s efforts to formulate a suitable legal and regulatory framework for partial funding of the state pension system, which was an unfunded, pay-as-you-go system; (ii) the improvement of the administrative capacity of the State Social Insurance General Office (SSIGO); and (iii) the development of non-state voluntary pension systems. Properly managed and regulated pension funds could act as an impetus for development of an institutional investor base and a diversified financial sector. The required legal and regulatory frameworks for development of these pension schemes are now in place as described below. To build on this foundation, ADB approved additional TA,18 which is now being implemented in coordination with the World Bank. 5. Strengthening the Insurance System

22. The Program supported the drafting of amendments to the insurance laws and the development and adoption of a sound regulatory framework. As discussed under item F.2.(iv) above, the legal and accounting/auditing frameworks are now in place. Most of the needed regulations are also now in place, and work on the balance needed is proceeding satisfactorily. III. A. Overall Assessment PERFORMANCE ASSESSMENT

23. The PPER rates the Program as “successful” based on its assessment rating of the Program as “highly relevant”, “effective”, and “efficient”. The Program’s output and outcomes are “likely sustainable”.19

18

19

TA 4910-MON: Strengthening the Pension System, approved in December 2006. The performance ratings in this report were prepared following the Guidelines for Preparing Performance Evaluation Reports for Public Sector Operation.

10 Table 1: Overall Performance Assessment Criteria 1. Relevance 2. Effectiveness 3. Efficiency 4. Sustainability Total Rating B. Relevance Weight (%) 20 30 30 20 Rating Value 3 2 2 2 Rating 0.6 0.6 0.6 0.4 2.2

Source: Asian Development Bank estimates.

24. The Program is rated “highly relevant”. It was in accordance and consistent with the sector strategies and programs of the Government and ADB. It was a part of the FSRP developed in coordination with the Government, IDA/World Bank and IMF, with ADB playing the lead role, and was based on joint diagnostic analyses. The main focus was support for banking sector reforms, as proposed in the Government’s FSRP and worked out in conjunction with the IDA/World Bank and ADB. A secondary focus involved support for development of the nonbank and capital market sectors as (i) alternative sources of funds for the private sector, and (ii) to provide competition to the banking sector. The Program responded positively to changes in circumstances, such as the volatile economic conditions in the late 1990s; this was regarded as imperative at the time. The Program remained focused and encompassed a balanced approach to assisting the development of the three constituent subsectors of the financial sector—the banking, nonbanking, and capital market subsectors—with satisfactory results. Government ownership of the reforms was relatively strong and there was adequate harmonization with other development partners. The outcomes in both those sectors confirm the Program’s “highly relevant” categorization. C. Effectiveness

25. The Program is rated “effective”. The Government and ADB were of the view that an efficiently functioning financial sector was the key to achieving a market-based economy for promotion of rapid economic development, with the private sector as the engine of growth. That objective was achieved successfully, and the country now has a small but relatively-well regulated, vibrant and efficient privately owned banking system that is responding to the marketbased economy; the nascent nonbank and capital market sectors show prospects for future growth. The latter have contributed positively to private sector development and overall economic stability and growth in the country (see paras. 29–30 for details). Limited progress was made in regard to the laws on trusts, investment funds, and private pension plans, but FRC is re-examining the draft laws prepared by ADB’s consultants, with a view to having them approved by Parliament and Cabinet as soon as possible and implemented without further delay. D. Efficiency

26. The Program is rated “efficient”. The Program’s funds and the counterpart funds were used for the reform process and structural adjustments as planned. The efficiency can be judged by the present performance of the banking system that it sought to improve and strengthen. The banking system has now been entirely privatized. The 16 banks now in operation are performing autonomously and efficiently with satisfactory growth rates in deposits and loans, return on assets and return on equity, and decreasing NPL ratios. These data show

11 that the banks are providing efficient services to the public, while the growth rates in deposits and loans reflect increasing public and investor confidence in the banking system. The real interest rates continue to be high, but show a downward trend. They should decline further with greater competition among the banks, and with further diversification and deepening of the financial sector, supported by the expanding nonbank and capital market subsectors. The program was processed efficiently utilizing the experience from the preceding ADB program loan, although some inefficiencies were experienced as well; specifically, the 2-year delay in the completion of the Program due to delays in complying with conditions for release of the second tranche. Overall, however, the Program is considered to have been efficient. E. Sustainability

27. The sustainability of the outputs and outcomes of the Program is considered “likely”. The BOM has set up a sound regulatory, supervisory, and accounting/auditing framework for the banking system. It is being enforced effectively and the banking system is functioning well. In addition, the FRC that was established in 2005 is in the process of developing a full complement of the required legal, regulatory, supervisory, and accounting/auditing frameworks for the nonbank and capital market sectors. This work is progressing satisfactorily, with substantial achievements expected by about the middle of 2008. Those frameworks presently in place are being enforced effectively. The authorities are aware of the fragility of the three subsectors, particularly should financial crises similar to those of the late 1990s reoccur, and are taking the following steps to increase the resilience of the subsectors: (i) strengthening and enforcing the regulatory frameworks; and implementing (ii) good governance practices, internal controls, and measures to increase investor confidence in the nonbank and capital market sectors. In addition, MOF, BOM and FRC recently established a Financial Stability Board that will jointly research, assess and analyze developments in the financial sector and jointly recommend action to be taken by the appropriate agencies. That is being done with the view to taking proactive action on likely developments that might adversely affect the operations of the financial sector. The recommendations are made on a quarterly basis. Furthermore, the overall favorable macroeconomic setting will help increase the sustainability of the reform process. F. Institutional Development

28. The FSRP contributed substantially to human resource and institutional development in the financial sector. FSAC’s TA credit supported (i) skills upgrading and capacity building in the commercial banks, particularly in risk assessment and asset-liability management; (ii) BOM’s regulatory and supervision departments in the areas of prudential norms; and (iii) bringing accounting/auditing standards in line with international standards in the CIB and MARA. In addition, under the Program the Strengthening Financial Sector Development TA (TA 3459MON) strengthened the capacity of the MSEC (now FRC) for supervision of NBFIs, capital markets and the insurance industry. It also developed a business plan for MSE, and a code of ethics and guidelines for MSEC and MSE employees. The TA also strengthened institutional frameworks for development of capital markets and contractual savings institutions. These beneficiary institutions are now maintaining the capacity-building momentum with the support of their own budgets (in the case of commercial banks) and other donor assistance (e.g., GTZ support for the BTC). The FRC needs further donor assistance for skills and institutional development, however.

12 G. Impact

29. Through the Program and the FSAC, the FSRP’s contribution to development of Mongolia’s financial sector is rated substantial, based on a four-category scale of high, substantial, modest, and negligible. The FSRP helped Mongolia complete the transformation of its mono-banking system to a two-tier system that is now fully privately-owned and efficiently providing the banking services demanded by the general public and investors. The banking system is now capable of responding to market signals, and is contributing to the efficient operation of the country’s market-based economy. Financial intermediation improved significantly over the 5-year period (2002–2006), led by banking sector growth. The ratio of broad money (M2) to GDP, an indicator of the depth of the financial sector, increased from 38% in 2002 to 48% in 2006, while total banking sector assets increased from 40% of GDP in 2002 to 68% in 2006. These banking sector developments are illustrated in Appendix 5. The private sector has benefited most from this transformation. The loans given by the banking system have been predominantly for private sector development, and these average about 97% of the total loans outstanding over the period 2002–2006. As a result, the private sector’s contribution to GDP increased from only 3.0% in 1989 to 70% in 1999, reaching about 78% of GDP in 2006. The private sector’s significant contribution to GDP also helped accelerate overall economic growth in the country. 20 GDP growth increased from 3.2% in 1999 to 8.4% in 2006. The nonbank and capital market sectors are contributing to diversification and deepening of the financial sector, but are at an incipient stage of development—they account for about only 10% of the total assets of the financial sector—with the result that their impact is hard to discern at present. The impact on development of the stock market is given in Appendix 6, and overall economic indicators are in Appendix 7. 30. Mongolia has made a good start with respect to corporate governance in the sector. BOM has introduced a code of good governance with a range of penalties for any contraventions, and closely supervises implementation of the code. The 16 private banks have independent boards appointed by their shareholders, with credit decisions made independently by credit committees using risk-management techniques; operations are closely controlled and supervised, with independent internal auditors reporting directly to their respective boards. The accounts are also audited by independent auditors on an annual basis. The NPLs are kept under control (the NPL ratio in 2006 was 4.9%) and all the 16 banks are operating profitably. As pointed out in the PPER two banking scandals are being investigated by BOM, but these did not adversely affect public confidence in the overall banking system. The progress made by the NBFIs and the other capital market institutions at this incipient stage of their development is impressive. A specialized regulatory body has been established and has begun to operate successfully. Data on the progress being made by the NBFIs and capital market institutions are given above (paras. 17–22) and in the appendixes.

20

Exports increased from $454.2 million in 1999 to $1,545.2 million in 2006; current account balance turned a surplus of $63.4 million in 2004 increasing to $306.3 million in 2006; total foreign reserves increased from $155.9 million in 1999 (representing 14.3 weeks of imports) to $718 million in 2006 (representing 25.2 weeks of imports); inflation dropped from a high of 11% in 2004 to 6.0% in 2006; unemployment remained at a reasonable level of around 3.5%; and the exchange rate has remained steady around MNT1,200 per US dollar.

13 IV. A. OTHER ASSESSMENTS

ADB and Executing Agency Performance

31. ADB’s performance was mixed. While it promptly undertook the design and formulation of the Program to meet the urgent demand, its performance during implementation was inadequate. The design remained largely valid at entry as well as during implementation and up to the completion date. It was formulated, in a relatively short period of time, in conjunction with the other donors in the sector and took into account the key issues that needed to be addressed for further development of the financial sector. It was also coordinated well with the Government’s strategies and plans, thus ensuring Government ownership of the Program. The Program was complex, involving many facets including policy reform, development of new laws and/or amendment of existing laws, as well as human resources development and institutional capacity enhancement aspects in three subsectors of the financial sector. It therefore required enhanced supervision to ensure effective implementation and success. Oversight was further complicated when implementation of a key component (i.e., the TA project) experienced problems due to deficiencies associated with the selected consulting firm. However, ADB’s supervision was not commensurate with (i) the level of complexity; and (ii) the problems encountered, which led to delays in implementation and second tranche release, and shortcomings in some TA outputs. During the entire 3-year implementation period only 42 staff person-days (equal to 6 staff person-weeks, or 2 staff person-weeks per year) were allocated for supervision of the Program. This appears to have been insufficient. The staff skills selected for supervision also appear to have been inappropriate, as no counsel visited the field to provide assistance during the 3-year implementation period, despite problems experienced with delays in covenants compliance and drafting of needed laws. Also, lack of continuity of staff dealing with supervision of the Program further weakened the effectiveness of supervision. Overall, the performance of ADB is rated less than satisfactory. 32. Similarly, the performance of the executing agency (BOM) was mixed, being satisfactory with respect to program loan implementation but less than satisfactory as regards TA implementation. It remained fully committed to implementing the reform program, particularly those aspects connected with the commercial banking system. It successfully introduced legal, regulatory, supervisory, internal control, governance, and accounting/auditing frameworks for the commercial banking system that meet international standards, and which are being enforced satisfactorily. This facilitated the bank transformation process, and Mongolia now has a privately owned and stable banking system that provides efficient services for private sector-led economic growth. However, its performance in dealing with the vital TA component was not entirely satisfactory. The TA appears not to have received the level of attention it required during implementation, with the consulting firm reporting difficulties in arranging a workshop for discussion of its findings and recommendations, and delays in reviewing and discussing the draft final report at a tripartite meeting. This resulted in part from the selection by ADB of an unsuitable consulting firm to undertake the TA (see para. 33), and led to a significant delay (of about 3 years) in completion of the TA. The TA focused on development of the nonbank and capital market sectors, and it is possible that implementation would have been more successful if the executing agency had been the MSEC rather than BOM. As the main regulatory body, MSEC was directly responsible for development of the nonbank and capital market subsectors, and would therefore have had greater ownership for the TA objectives.

14 B. Technical Assistance

33. The OEM confirms the PCR rating of the Strengthening Financial Sector Development TA (TA 3459-MON) as “partly successful”. The TA was well formulated and adequately provided for the areas identified as in need of assistance (e.g., development of the legal, regulatory, and institutional framework for the supervision of the nonbank and capital market sectors). The terms of reference were in accordance with the scope of the TA. The TA helped to strengthen (i) the legal and regulatory framework for NBFIs; (ii) the framework for secured collateral; (iii) the legal, regulatory, and institutional frameworks for development of capital markets; and (iv) the legal, regulatory, and institutional framework for development of contractual savings institutions. However, the overall performance of the TA was adversely affected by the placement of the firm selected by ADB to undertake the TA under receivership of another firm. This occurred in the middle of the project, and led to a change in the team leader, and the need to recruit other consultants to complete his work. The quality of the work was also less than satisfactory, as some work did not appear to be properly researched, necessitating redrafting and/or rejection of some of the draft laws that were prepared (e.g., the draft laws for trust, investment funds, and for voluntary private pension plans). These events adversely affected TA implementation and delayed TA completion by about 3 years. Table 2: TA Performance Assessment Strengthening Financial Sector Development (TA 3459-MON) Weight (%) 20 30 30 20

Criteria 1. Relevance 2. Effectiveness 3. Efficiency 4. Sustainability Total Rating (i)

Rating Value 3 1 1 1

Rating 0.6 0.3 0.3 0.2 1.4

Source: Asian Development Bank estimates.

(ii)

(iii)

Relevance. The TA is rated “highly relevant”. It had a dual focus, providing assistance in implementation of the Program, and helping to develop the nonbanking and capital market sectors, which were considered essential for diversification and deepening of the financial sector as a whole, in order to expand the range of financial services for private sector development and economic growth. Effectiveness. The TA is rated “less effective”. It did not fully assist in implementation of the Program within the originally specified program completion period of 3 years, and failed to establish the full complement of legal, regulatory, supervisory and accounting/auditing frameworks that were needed for development of the nonbank and capital market sectors, leaving gaps in the frameworks that needed to be filled. ADB took subsequent action to fill those gaps by approving another program loan and associated TA in December 2005.21 Efficiency. The TA is rated “less efficient”. Problems associated with the selected consulting firm delayed implementation of the TA and Program. Also, some work performed was considered less than satisfactory, leading to the

21

ADB. 2005. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance Grant to Mongolia for the Financial Regulation and Governance Program. Manila.

15 redrafting of some laws, and rejection or postponed approval of others. Thus, the full outcome of the TA was not realized. Sustainability. The TA is rated “less likely”. A considerable amount of additional work would have had to be done to complete the full complement of legal, regulatory, supervisory and accounting/auditing frameworks needed for proper development of the nonbank and capital market sectors. That work is now being undertaken by the FRC but will not be finished for some time. In addition, the FRC’s capacity would require enhancement to enable it do the work in an efficient and effective manner. V. A. Issues 1. Commercial Banking Sector ISSUES, LESSONS, AND FOLLOW-UP ACTIONS

(iv)

34. The commercial banking system faces many challenges and issues, including (i) coping with a rather volatile economy based on a few commodity exports; (ii) a relatively large number of fully privatized banks; (iii) the marginal profitability of some of the smaller banks, because of intense competition for deposits and resulting reduced margins; (iv) rapid expansion of banking operations, in terms of deposits and lending; (v) the need to keep NPLs at a manageable level under expanding loan portfolios; and (vi) the need for enhancement of staff skills and capacity, driven by the expanded operations and increasing sophistication of business activities. In addition, private banks are placing less emphasis on small and medium enterprises (SMEs) and rural development (by means of appropriate lending instruments and mechanisms for employment generation and poverty alleviation), due to (i) the risk factor and short-term nature of their deposit structures, (ii) continuing high real interest rates in the market, and (iii) the need to become conversant with the nonbank and capital market activities that the Government will allow them to undertake in the future. The authorities (mainly MOF, BOM and FRC) are aware of these challenges and issues, in particular the marginal viability of the five smaller banks, and are constantly reviewing developments and taking steps to deal with these as appropriate, through actions such as (i) strengthened regulatory, supervisory, and accounting/auditing frameworks; (ii) corporate governance requirements; (iii) internal controls; and (iv) diversification and deepening of the financial sector through strengthened and expanded nonbank and capital market sectors. MOF is addressing the need to pay more attention to development of financing schemes for promotion of SMEs and rural sectors. 3. Nonbank and Capital Markets Sectors

35. The FRC is faced with the challenge of filling the remaining gaps in the legal framework and strengthening the regulatory, supervisory, governance, internal control, and accounting/auditing frameworks in the nonbank and capital market sectors. It has a tremendous workload in this regard, but is severely constrained by limited resources (physical infrastructure, organization and management, staff capacity and knowledge, and capital and operational budgets). It is also faced with the challenge of increasing public confidence in the operations of the nonbank and capital market sectors, as well as helping guide their future growth prospects. To do that it would need to address the need for (i) listed companies to prepare their financial statements accurately and on time, with full accountability and transparency, and to have them published on a timely basis and include all company information that needs to be in the public domain; (ii) training of local audit companies to enable accurate and timely auditing of their financial statements, in accordance with the responsibilities laid down in the IAS; (iii) prevention

16 of insider trading and off-exchange trading, which require close vigilance from the FRC to maintain the significant reductions that have resulted from the specialized operations of MSE and SCHCD; (iv) education of the general public and market players on their respective rights and responsibilities and the need for and mutual benefits of self-regulation; and (v) rapid introduction of laws for promotion of trust, investment fund, and private voluntary pension plan operations as required by ADB. The FRC, MSE, and SCHCD are aware of these challenges and issues and are taking steps to adequately address them. B. Lessons Identified

36. Several lessons can be identified from the program design and manner in which ADB supervised program implementation. The key lesson identified and worthy of replication in future ADB operations in similar situations is that the Program’s success resulted from (i) continued Government commitment and ownership of the FSRP; and (ii) the formulation and implementation of the FSRP through a combined effort of the Government and the key donors, with ADB playing the lead role. 37. The success in banking sector restructuring resulted from the Government’s decision to privatize banks and establish a more efficient and effective financial intermediation system, rather than restructuring them under the same government ownership. 38. The other lesson identified was the need to not overestimate the Government’s capacity and political will to formulate and implement reforms and pass new and/or amend existing laws. The overall reform process also involved many other sectors (e.g., health and education), and therefore institutions such as the Parliament, Cabinet and Ministry of Justice were overburdened with reform-related requests. Under the circumstances, the chances of new reforms and laws and/or amendments to existing laws being considered and approved by the respective authorities would have improved had they been better sequenced and phased, and presented more convincingly following additional research and analysis. The 2-year delay in completion of the Program was caused mainly by delays in complying with second tranche release. 39. ADB’s due diligence should have been done more carefully. ADB staff and consultants should have worked more closely and ensured the reform measures were better sequenced, phased and presented, as detailed in para. 38. These procedures appear not to have been followed in those cases where ADB encountered implementation problems. Thus, (i) the privatization of MSE should have been scheduled only after it had become viable (e.g., had met profitability targets), when it would have been a more attractive prospect for privatization, and attracted a better price; (ii) following the sale and listing on the MSE of the more viable SOEs, the remainder were more difficult to privatize, making compliance with the covenant that required a minimum of MNT200 million in shares of privatized SOEs to be sold through the MSE per year difficult; (iii) two draft laws on trusts and investment funds prepared with ADB TA were rejected, on the grounds that they were unnecessary as existing laws already provided for them; and (iv) parliamentary consideration of the draft law on private voluntary insurance plans prepared with ADB TA was postponed, on the grounds that prevailing conditions in the country did not warrant its passing at that time. 40. Another lesson relates to the choice of appropriate executing agencies for implementing different components of a program. The agencies with direct responsible for handling various components in the existing structure should be selected as the executing agencies for those components, rather relying on one umbrella executing agency for all components. Coordination could be undertaken by the steering committee that is typically appointed. This approach may

17 help avoid situations in which implementation of components for which the selected executing agency is not directly responsible in the existing structure receive less attention. Based on this reasoning, the TA component should have been executed by the MSEC (now FRC), rather than BOM. 41. With respect to deficiencies in ADB’s supervision work, complex financial sector program loans—particularly those involving policy reforms, new laws and/or amendment of existing laws, and human resource and institutional development goals—require consistent, long-term program supervision to ensure effective implementation. Such programs should be provided with enhanced supervision budgets and staff incentives, and staffed by individuals who have with the skills required to enable them to undertake the needed supervision. C. 42. Follow-Up Actions The following follow-up actions are recommended.
Recommendation (i) Request the Financial Regulatory Commission to have the two draft laws on trusts and investment funds passed by the Parliament and Cabinet, respectively. Request the State Social Insurance General Office to present the draft law on private voluntary pension plans for consideration and approval by Parliament. Consider providing further assistance and policy support to the Government, with more emphasis on development of the nonbank and capital market sectors and less emphasis on the banking sector, to address the issues mentioned under paras. 34–35 above, plus the establishment of the proposed deposit insurance system. Look into possibility of privatizing MSE, Credit Information Bureau, and Mongolia Asset Restructuring Agency within 2–3 years. Consider assistance for strengthening some of the smaller banks, including one of the banks operating mainly in the rural sector, through equity and loan investments in the banks. Consider assistance to help the banks undertake nonbank and capital market activities (e.g., fund placement, initial public offerings, and underwriting) as being proposed by the Government. Consider assistance for introducing new financial products into the market, such as mortgage securitizations through equity and loan investments in the Mongolia Mortgage Corporation, medium to long-term bonds, medium to longterm deposit and lending instruments for banks to promote the development of small and medium-sized enterprises and rural sectors, financial leasing, and cross-border Private Sector Operations Department, East Asia Department Responsibility East Asia Department Timing As soon as possible

(ii)

As soon as possible

(iii)

During the preparation of the next country partnership strategy

(iv)

MSE within 2008; others beginning from early 2008 Beginning from early 2008

(v)

(vi)

Beginning from early 2008

(vii)

Beginning from early 2008

18

Recommendation leasing and insurance products. (viii) Consider broadening ADB’s private sector involvement into support for the corporate sector, particularly small and medium-sized enterprises, for diversification of the economy.
ADB = Asian Development Bank, MSE = Mongolia Stock Exchange. Source: Operations Evaluation Team.

Responsibility

Timing

Beginning from early 2008

Appendix 1

19

PROGRAM FRAMEWORK: SECOND FINANCIAL SECTOR PROGRAM
Performance Targets/Indicators
A sound, well-functioning, and resilient banking system Strengthened and enhanced role for nonbank financial institutions (NBFIs) in financial intermediation Capital market development

Design Summary
Goal/Impact Develop a competitive, stable, and broad-based financial system to strengthen financial intermediation, and enhance domestic and external resource mobilization

Assumptions
The Government’s financial sector strategy is implemented Macroeconomic adjustments and stabilization measures are adhered to There is political resolve to deepen reforms. Vested interests are contained

Results
The banking system was substantially strengthened. The NBFIs’ role in financial intermediation was enhanced.

Capital market remains underdeveloped Total bank assets increased Credit and deposits have grown rapidly. Bank profits (amount) increased but profitability (return on assets) declined Nonperforming loan (NPL) ratio declined but the outstanding amount increased.

Increased total bank assets Credit and deposit growth

Increased bank profits

Fewer nonperforming loans in banking system

Prudential regulations for NBFIs developed M2/gross domestic product (GDP) M1/M2 Loan tenure profile

Prudential regulations for NBFIs developed M2/GDP increased

Loan tenure profile more diversified but still mostly short Interest rate spread narrowed NBFIs and SCCs have grown rapidly. SCCs are in financial trouble and a new law has been proposed for financial strengthening, supervision and control. Market capitalization in the MSE declined The number of listed companies in the MSE declined Pension system reform not yet completed Insurance sector assets increased

Interest rate spread Growth of NBFIs including finance companies and savings and credit cooperatives (SCCs)

Market capitalization in the Mongolian Stock Exchange (MSE) Increased number of listed companies in the MSE Decreased share of unfunded liabilities in pension system Increase in insurance sector (assets/GDP)

20

Appendix 1

Design Summary

Performance Targets/Indicators

Assumptions
The World Bank’s restructuring program is in tandem with this Program The Government is committed to reform

Results
Banking regulation and supervision strengthened

Purpose/Outcome Improve the soundness and efficiency Strengthen regulation and of the banking system supervision in the sector

Improve corporate governance in the banking system

Corporate governance in banks improved but still seen to be weak The use of collateral substantially increased

Improve and facilitate use of collateral

Strengthen management information systems (MISs) Develop the interbank market Improve efficiency in resource allocation

Commitment to reform by stakeholders, including the Bank of Mongolia (BOM), Mongolian Securities and Exchange Commission (MSEC), MSE, Central Depository System (CDS), State Property Committee (SPC), State Social Insurance Office, Insurance Supervision Agency, the commercial banks involved, Association of Brokers.

MISs in banks strengthened

Interbank market developed Efficiency in resource allocation improved but needs further improvement Regulation and supervision of NBFIs strengthened but SCC regulation and supervision remains weak

Enhance role of NBFIs in financial intermediation

Strengthen regulation and supervision of NBFIs

Support and facilitate capital market development Promote and strengthen contractual savings institutions

Improve governance in equity markets Establish a legal infrastructure to facilitate resource mobilization in capital markets Improve the operations of the pension system, and prepare for transition to a reformed system Improve regulations and supervision of the insurance industry Legal infrastructure for capital markets improved but needs further improvements Operations of the pension system improved

Regulation and supervision of the insurance industry improved but the supervisor’s capacity needs further strengthening

Outputs 1. Banking system Strengthen corporate governance in the banking system Issue guidelines for corporate governance, in line with Bank for International Settlements (BIS) guidelines (Dec 2001) The Government is committed and supports the reforms Corporate governance guidelines in line with those of BIS issued

Appendix 1

21

Design Summary

Performance Targets/Indicators
Strengthen internal control mechanisms (Dec 2001)

Assumptions
The Government facilitates coordination between the various government agencies involved

Results
International control mechanism in banks strengthened but still seen to be weak Model charter developed and issued

Develop a model charter for banks (Dec 2001) Increase secured collateral Prepare plan to expand types of property that can be used as loan collateral (Dec 2001) Simplify collateral registration and administration procedures (Dec 2001) Strengthen MIS in commercial banks Develop and implement an integrated MIS at a pilot commercial bank (Dec 2000) MIS operating in other banks participating in MIS program (Dec 2001) Develop an interbank market Develop a legal, regulatory, and institutional framework for an interbank market (Jun 2001) Issue and document risk-based prudential regulations for NBFIs (Dec 1999) Issue accounting standards for NBFIs (Feb 2000) Provide institutional strengthening for the Supervision Department, including organizational structure and procedures, to enable it to effectively monitor and enforce compliance with prudential regulations (Jun 2000). Pass amendments to the Law on Cooperatives to provide for the regulation of second- and highertier credit associations by BOM (Dec 2001). Develop prudential regulations for second-and higher-tier credit associations (Mar 2002). 3. Capital markets Improve governance in equity markets, by improving the legal and regulatory framework. Increase supply of equities Enhance reporting and disclosure requirements related to trades in the securities market (May 2000). Increase capital requirements for brokers and dealers (Dec 2001). Parliament supports reform proposals, and draft laws to be passed Progress reports Review missions The quality of consulting services is appropriate Counterpart agencies have adequate capacity to manage the reforms

Types of property expanded but movable properties are not often used as collateral Procedures simplified

MIS developed and operating in a pilot bank

MIS operating in some of Counterpart support is available, and consultants and the other banks counterpart staff cooperate fully Interbank market framework developed

2. Enhance the role of NBFIs

Prudential regulations for NBFIs issued

Accounting standards for NBFIs issued Capacity to supervise NBFIs strengthened

The law was passed but does not provide adequate basis for effective supervision. New law expected to be approved in 2007. Prudential regulations issued but compliance is not adequately monitored.

Reporting and disclosure requirement strengthened but needs further strengthening. Capital requirements increased

22

Appendix 1

Design Summary
Build public awareness and confidence in capital markets

Targets
Prepare and submit to parliament laws on trust funds and investment funds, and amendments to the Securities Law (Dec 2001). Establish the MSE as a separate legal entity and the depository, settlement, and clearing systems as a separate legal entity or entities (Dec. 2001). Privatize the MSE, CDS, and the settlement and clearing system (Dec 2001) Enhance regulations at the MSE and provide for sanctions against unauthorized trading and noncompliance with regulations (Jun 2003). Make the Dealers and Brokers Association a separate entity from MSE (Mar 2001) Strengthen audit and inspection functions of MSEC (Jun 2001) Strengthen: regulations for brokers, dealers, and subbrokers; insider trading rules; appeals regulations; and code of ethics for staff of MSEC and the MSE (Jun 2002) Sell MNT200 million worth of shares through the stock exchange annually (Jun 2001).

Assumption and Risks

Results
All the draft laws prepared, but only the amendments to the Securities Law adopted MSE separated into two entities

Privatization not yet achieved

Regulations to restrict offexchange trading issued

The association is a separate entity from MSE FRC’s (MSEC) functions strengthened Regulations strengthened

Shares worth over MNT200 million sold only in the first year (2001) Campaign launched but public knowledge and confidence remain weak

Provide public information campaign to raise public knowledge of equity markets (Dec 2001) 4. Contractual savings Strengthen administrative processes within the pension system (Sep 2001) Draft a plan for transition to notionally defined contributions system (Dec 2001). Improve collection of pensions (Sep 2001)

Promote the pension system to increase savings

Administrative processes strengthened Plan issued but not yet completed Collection capacity strengthened Financial management strengthened Basic draft law prepared but not submitted to parliament

Strengthen the financial management of the pension system (Sep 2001). Prepare and submit law on voluntary pensions, including procedures and terms for the establishment of such plans, and a proposed regulatory framework (Jun 2002).

Appendix 1

23

Design Summary
Promote insurance and strengthen regulation and supervision

Targets
Draft amendments to the Law on Insurance to introduce risk-based solvency requirements, increased minimum capital requirements, and increased minimum income percentage that can be invested (Dec 2001). Insurance Supervision Unit to develop and introduce prudential norms; investment guidelines; and reporting, accounting, and disclosure requirements in line with international best practices (Jun 2002). Amount: $15 million. Maturity: 24 years, including 8-year grace period. Annual interest: 1% during grace period, 1.5% during the amortization period. Executing Agency: Bank of Mongolia TA piggybacked onto the loan: Strengthening Financial Sector Development Consulting services: under ADB’s Guidelines for the Use of Consultants

Assumption and Risks

Results
Revised insurance laws adopted but not yet effective

Regulations developed but not yet issued

Inputs Program Loan

Source: Operations Evaluation Team.

24

Appendix 2

PROGRESS IN COMPLIANCE WITH SECOND TRANCHE RELEASE, PROGRAM MONITORING, AND END-OF-PROGRAM CONDITIONS
No. I.A.1. Program Conditions Status of Compliance

Bank of Mongolia (BOM) to prepare and issue Complied with. In May 2003 BOM issued revised guidelines on best practices in corporate guidelines to the commercial banks, based on governance in banking institutions in comments on an earlier set by ADB. Mongolia, including measures to strengthen internal control mechanisms, based on international practices such as the guidelines issued by the Bank for International Settlements.a BOM to prepare a model charter for banks that Complied with. In December 2002, BOM issued a is acceptable to the Asian Development Bank model charter for banks. (ADB). BOM to issue guidelines recommending that all banks have charters in accordance with the model charter (End-of-Program Condition: March 2002). Banks to adopt best practices in corporate governance under the BOM Guidelines on Best Practices in Corporate Governance in Banking Institutions (End-of-Program Condition: December 2003). Government and BOM to prepare a plan acceptable to ADB on the expansion of types of property that can be used as loan collateral.a Complied with. In December 2002, BOM issued a governor’s order requiring all banks to amend their charters in line with the model charter and applicable laws. Complied with. BOM adopted the corporate governance regulation for banks in 2006, which has been enforced since then.

I.A.2.

I.A.3.

I.A.4.

I.B.1.

Complied with. BOM has issued a regulation outlining the types of collateral that commercial banks may accept. The regulation will be advisory in nature. The Office of Immovable Property Registration can now register movable assets as collateral. A new law on immovable property will be presented to Parliament for approval in 2007 to allow for non-judicial foreclosure of collateral. Complied with. Government Resolution 40 of 26 February 2001 introduced a new tariff structure reducing the costs of registering collateral by 34.5% (currently $2–$8 per registration). The procedure has been simplified by making valuation and loan agreements the only required documents. Since its adoption, registration time has been considerably reduced. Complied with. TDB has implemented an integrated accounting package that has automated all accounting functions.

I.B.2.

With respect to the Office for Immovable Property Registration, Government to reduce the cost of collateral registration and simplify the administrative procedures for registering collateral in a manner acceptable to ADB.

I.C.I.

Implementation, in a manner acceptable to ADB, of integrated banking (management information system [MIS]) software at a pilot commercial bank (i.e., Trade and Development Bank [TDB]). Progress acceptable to ADB has been achieved in the implementation of the program to introduce and operationalize integrated banking MIS software in the Mongolian banks participating in the program.a

I.C.2.

Complied with. Half of the 17 banks have made satisfactory progress in this area. The 16 private banks in operation have introduced MISs that are being regularly updated.

Appendix 2

25

No. I.D.5.

Program Conditions

Status of Compliance

Government to submit to Parliament for approval Not complied with. See condition I.D.6. draft amendments to the Law on Cooperatives and any other necessary legislation to provide for the regulation of second- and higher-tier credit associations by BOM. Enactment of amendments to the Law on Cooperatives and any other necessary legislation to provide for the regulation of second- and higher-tier credit associations by BOM.a Not complied with. Loopholes in the existing Law on Cooperatives caused the demise and bankruptcy of many SCCs, resulting in significant losses by depositors and the failure to repay many loans to SCCs. A new Law on Cooperatives being presented to Parliament for approval in 2007 will cover those loopholes and strengthen the legal, regulatory, supervisory, governance, internal controls, and accounting/auditing frameworks for SCCs. Also, their previous fragmented supervision framework has now been brought under one supervisory agency i.e., the Financial Regulatory Commission (FRC). Complied with. In November 2003, BOM issued prudential regulations for SCCs based on the PEARLS monitoring system developed by the World Council of Credit Unions.

I.D.6.

I.D.7.

BOM to issue prudential regulations governing second- and higher-tier credit associations based on capital adequacy standards and best practices in corporate governance (End-of-Program Condition: March 2002). Ministry of Finance (MOF) and BOM to prepare a plan acceptable to ADB for development of an interbank market, including establishment of the legal, regulatory, and institutional framework.a

II.A.1.

III.A.2.

Complied with. With ADB technical assistance (TA) support, in August 2002 BOM finalized an institutional and regulatory framework acceptable to ADB to guide the interbank market. A market for interbank credit has been operating since September 2002. The interbank market has been growing since then. Mongolian Securities and Exchange Commission Complied with only technically and not in practice. (MSEC) to prepare a draft law on trusts to See condition III.A.4. provide for the requirements of establishing trusts, including investment trusts, and the fiduciary duties of a trustee. MSEC to prepare a draft law on investment funds Complied with only technically and not in practice. to stipulate procedures for the formation and to See condition III.A.5. govern the operations of investment funds. The Government to submit a draft law on trusts acceptable to ADB to Parliament for approval.a Complied with only technically and not in practice. A revised draft law on trusts was submitted to parliament by the Cabinet on 13 November 2003. However, the law was not passed. The FRC is considering revising that law for resubmission to Parliament for approval.

III.A.3.

III.A.4.

26

Appendix 2

No. III.A.5.

Program Conditions The Government to submit a draft law on investment funds acceptable to ADB to Parliament for approval.a

Status of Compliance Complied with only technically and not in practice. A draft law has been prepared, and ADB has provided TA in this area. However, the Cabinet of Ministers decided that there are appropriate provisions in the Company Law and the Securities Market Law (SML), with amendments passed on 12 December 2002, to provide the necessary legal basis to govern the operations of investment funds, and that no separate law is needed. ADB believed that a separate law would be highly desirable, but is willing to accept the provisions in the Company Law and LSM, as adequate provisions were included in the investment fund regulations issued by the Mongolian Securities and Exchange Commission (MSEC) in June 2003. The FRC is looking into revising that law for resubmission to Cabinet for approval. Complied with. A draft plan was furnished to ADB in May 2003, based on a resolution by Cabinet on 26 March 2003 requiring the reorganization of the MSEC, CDS, and SCS. The State Property Committee (SPC) has adopted separate corporate charters for the stock exchange and the securities settlements and depository center (SSDC). In October 2003, two separate institutions, MSE and SSDC (now called the Securities Clearing House and Central Depository Co. Ltd. [SCHCD]), were formally established.

III.A.6.

The Government to prepare a plan to establish the Mongolian Stock Exchange (MSE) as a separate legal entity, and the Central Depository System (CDS) and Securities Clearing System (SCS) as a separate legal entity or entities, with each entity having separate financial and accounting records and no MSE officials on its staff, in preparation for their eventual privatization.a

III.A.7.

MSE and MSEC to increase the minimum capital Complied with. The SML, amended in December requirements for securities brokers and dealers to 2003, stipulates minimum capital requirements of at least MNT20 million.a MNT50 million. MSEC to issue regulations (i) requiring that all Complied with (compliance delayed). MSEC issued trades be undertaken on the MSE through such regulations in March 2005, after completion of licensed securities dealers, brokers, subbrokers, the program. and salespersons; and (ii) providing for sanctions for unauthorized trading. Association of Mongolian Dealers and Brokers to prepare revised articles of association reflecting its independence from the MSE and governance by its internal rules. Complied with. MSE has written to ADB expressing its opinion that the Association of Mongolian Dealers and Brokers is entirely independent. The association may consider new articles of association in its annual general meeting. In 2006, the first conference of professional organizations in securities market “Capital market development – Broker Dealer Companies Current Challenges and Strategies” was organized and participants discussed future plans. Complied with. Its external audit and on- and offsite inspection functions have been considerably strengthened. This applies to issuers of securities as well as market intermediaries.

III.A.8.

III.A.9.

III.A.10. MSEC to strengthen its audit and inspection functions pursuant to a plan acceptable to ADB.

Appendix 2

27

No. Program Conditions III.A.11. The State Property Committee to sell MNT200 million worth of shares from the privatization of state-owned enterprises (including most valued and second-tier companies) annually through the MSE.

Status of Compliance Partly complied with. The sale of shares through MSE exceeded this target in 2001 (MNT281 million). However, the sales of shares through MSE did not reach this target in 2002 (MNT167 million), 2003 (MNT107 million), 2004 (nil), 2005 (MNT94 million), and 2006 (MNT115 million).

III.A.12. MSEC, in collaboration with the MSE, to develop Complied with. MSEC and MSE developed and a marketing and public awareness campaign to implemented a marketing and public awareness increase public knowledge of equity markets.a campaign. However, public confidence in the capital markets remains low. III.A.13. The Government to submit to Parliament for approval a draft amended and restated Securities Law acceptable to ADB, with provisions to improve financial governance (including protection of minority shareholder rights, increased penalties for Securities Law violations, stricter auditing requirements for companies to be listed, and broader representation among MSEC members) in line with the international best practices.a Complied with. The SML amendments passed in December 2003 contain explicit provisions regarding increased penalties for LSM violation and stricter audit requirements for companies to be listed. A proposed increase in the number of MSEC members from five to seven, to increase representation, was deleted in the parliamentary review. However, current members include two representatives from listed companies. Minority shareholder protection provisions are mainly found in the Company Law, in addition to the SML. ADB reviewed the Company Law and SML and agreed that minority shareholders are afforded generally adequate protection in line with international practice. Complied with. Subsequent to the passage of SML, MSEC issued supporting regulations, which included regulations on securities market intermediaries, insider trading prevention regulations, and appeals regulations. In June 2003, MSEC and MSE adopted the code of ethics based on the model code provided under TA 3459-MON.

III.A.14. MSEC to review and strengthen the existing (i) Regulations on Brokers, Stock Dealers, and Subbrokers; (ii) Insider Trading Regulations; (iii) Appeals Regulations; and to prepare and issue a code of ethics and guidelines for MSEC and MSE employees (End-of-Program Condition: June 2002).

III.A.15. Government to privatize the MSE, CDS, and SCS Compliance expected to be delayed. The Cabinet in a manner acceptable to ADB (End-of-Program passed a resolution to privatize MSE in 2004. While Condition: June 2003). there is overall agreement to privatize the MSE, there are concerns about the potential for privatization. IV.A.1. State Social Insurance General Office (SSIGO) to prepare a plan acceptable to ADB setting forth measures to be taken to (i) strengthen administrative processes within the existing pension system, (ii) facilitate the change to a notionally defined contribution system, (iii) improve capacity in pension payments collection, and (iv) strengthen financial management of the pension system. Complied with. SSIGO, with support from MOFE, has finalized a plan that envisages full termination of all subsidies from the state budget to the State Social Security Fund by 2005. The plan contained measures to (i) strengthen administrative process within the pension system, (ii) facilitate the change to a notionally defined contribution system, (iii) improve capacity in pension payments collection, and (iv) strengthen financial management of the pension system.

28

Appendix 2

No. IV.A.2.

Program Conditions SSIGO to prepare a plan acceptable to ADB for introducing partial funding to the pension system.a

Status of Compliance Complied with. The Government issued a decree on social security in June 2002, outlining reforms up to 2020, comprising a plan for reducing deficits gradually, by increasing the pension base to enhance premium contributions. SSIGO, with support from MOFE, has finalized a plan that envisages full termination of all subsidies from the state budget to the State Social Security Fund by 2005. To support this, amendments to relevant legislation are being proposed. Partly complied with. With ADB TA support, SSIGO has drafted a basic law, but SSIGO considers the draft too basic. The TA consultant recommended that legislation be put on hold because the conditions in Mongolia are currently not adequate for establishing a voluntary private pension plan. No work has been done to develop any regulatory framework. Compliance expected to be delayed. See IV.A.3.

IV.A.3.

SSIGO to (i) prepare a draft law on voluntary private pension plans, setting forth the procedures and terms and conditions for establishment of, and participation in, such plans; and (ii) establish an appropriate regulatory framework to govern voluntary pension plans (End-of-Program Condition: (June 2002). Government to submit draft law on voluntary private pension plans to Parliament for approval (End-of-Program Condition: December 2002). MOF to prepare and issue investment guidelines for the insurance industry, including (i) types of investment instruments, and (ii) minimum share of reinvestable resources under the reserve fund.

IV.A.4.

IV.B.1.

IV.B.2.

Compliance under way. Insurance industry regulations are being drafted with ADB support. The regulations will be issued by the proposed Nonbank Financial Regulatory Commission (NBFRC), which will be in charge of regulation and supervision of the insurance sector. Target Date: June 2005. MOF to draft and submit to Parliament for Complied with. A draft insurance law, incorporating approval draft amendments to the Law on sub-conditions (i) to (iii) and prepared with the help Insurance to (i) introduce risk-based solvency of ADB TA, was submitted to parliament in requirements in the industry, (ii) strengthen November 2003. The law was passed in April 2004 the minimum capital requirements, and (iii) and will take effect in June 2005. increase the percentage of premium incomes that can be invested by the insurance companies.a The Insurance Supervisory Unit to develop and establish, pursuant to MOF regulations and guidelines, a sound regulatory framework acceptable to ADB and based on prudential norms and with adequate guidelines and standards, reporting and disclosure requirements, accounting, auditing and prudential norms, investment guidelines and other requirements in accordance with international best practices (End-of-Program Condition: June 2002). Compliance underway. The regulation and supervision of the insurance sector will be transferred to the proposed NBFRC when it is established. A sound regulatory framework has been prepared with ADB support. NBFRC will issue regulations after its establishment. Target date: June 2005.

IV.B.3.

a

Second tranche release condition. Source: Operations Evaluation Team.

Appendix 3

29

PROGRESS MADE IN THE SECOND FINANCIAL SECTOR PROGRAM OUTPUTS A. Improving Financial Intermediation

43. The Financial Sector Adjustment Credit (FSAC) undertaken by the International Development Association (IDA) and the Second Financial Sector Program (the Program) undertaken by the Asian Development Bank (ADB) were integral and complementary parts of the financial sector reform program (FSRP). Consequently, the key outcomes of the overall FSRP are discussed together below in order to present a total picture of their combined outputs for financial sector development. The FSRP has been implemented satisfactorily and has achieved significant results. The previous mono-banking system has been completely transformed into a two-tier banking system that is privately owned, well regulated and supervised, and established on a stable basis with good growth prospects. 1. (i) The IDA Financial Sector Adjustment Credit Outputs Privatization of the Commercial Banks. The banking system has now been entirely privatized (see Appendix 4 for present list of banks). Only 5 of the 16 banks are survivors of the 1996 banking crisis and restructuring, and the balance of 13 banks are new ones. Three banks have a majority share of foreign investors, while six have various proportions of foreign investment. The privatization of one of the banks, the Trade and Development Bank (TDB), was supported by loan and equity investments by ADB’s Private Sector Operations Department (PSOD). Four of the banks are categorized informally as large, seven as medium-sized, and five as small. Mongolia has liberal rules relating to operation in the country by foreign banks, but none have shown interest to date. The banking sector continues to dominate the financial sector, accounting for over 90% of the sector’s total assets. Prudential Regulations. The Basle Committee requires about 25 core principles for banking supervision to be implemented by central banks. The Bank of Mongolia (BOM) has implemented 23 of these in compliance with the requirements; one, pertaining to overseas branch operations, is considered inapplicable, as no Mongolian banks currently have overseas branch operations. The remaining principle relating to supervision of consolidated accounts of group businesses will be included in the proposed amendments to the central banking and banking laws. The banks are also subject to legal lending limits (for example, single and group borrower limits). BOM’s organization and staff skills have been upgraded, enabling it to rigorously enforce the regulations and legal limits. Accounting and Auditing Standards. International accounting standards (IAS) have been introduced. These are being implemented in a transparent manner with respect to the preparation of accounts and audit statements by the large and some of the medium-sized commercial banks, and to a lesser extent by the smaller banks. The noteworthy features are: a more differentiated approach towards credit risk assessment for calculation of minimum capital requirements; stronger supervision of the adequacy of credit risk management processes and policies of commercial banks; additional bank information disclosure requirements that enhance market transparency and market discipline; adequate loan provisioning against stringent rules for bad loan assessments and classification; and the calculation of the capital adequacy ratio (CAR) based on the risk-weighted assets formula. The CAR measures the ability of banks to cover credit and foreign exchange (FX) losses. Based on this formula, BOM

(ii)

(iii)

30

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(iv)

(v)

(vi)

insists on a minimum CAR of 10% for banks as against the minimum Basle II requirement of 8%. BOM requires three banks to meet a CAR of 12% in view of their higher loan asset risks. If the CAR falls below 10% BOM recommends measures to improve the quality of assets and/or increase capital. The CARs of all banks are above the specified minimum limits. The risk-weighted CAR of all banks declined from 18.5% in March 2006 to 16.5% in March 2007 despite an increase in minimum capital required to MNT8 billion (about $7 million) in April 20061. That decline occurred due to rapid credit growth outpacing the growth in capital. Nevertheless, the relatively high CARs, well above the minimum set by BOM, reflect the sound capital structures of the banks on an overall basis at present. BOM considers the penalties for infringement too low, and amendments to the central banking and banking laws are being prepared to increase them. Bank Supervision. The basic framework for bank supervision, which should help BOM examine banks and enforce regulations more effectively, is now in place. Article 31 of the Banking Law specifies the actions that could be taken (such as revoking licenses and termination of the services of the chief executive officer) against commercial banks that violate the prudential regulations, accounting and auditing standards, legal lending limits and other applicable rules and regulations. BOM conducts on-site full examinations of all 16 banks every year based on the “CAMELS” principles 2 and their adherence to prudential regulations and international accounting standards, as outlined above. These examinations are performed independently of internal and external audits of the banks. Offsite monitoring and surveillance of banks is conducted by BOM on a monthly basis. In addition, more sophisticated examination methods are now being adopted, in which attempts are made to forecast the future financial and operational positions of the banks based on market sensitivity. Procedures are being developed to conduct consolidated supervision of varied business interests of banks and their owners. Two violations of the regulations have come to light recently.3 Although they did not adversely affect public confidence in the banking system, they nevertheless revealed deficiencies in BOM’s supervision capability and inadequate internal control and audit at specific banks. These would need to be considerably improved to prevent similar situations from arising in the future. Autonomy of Commercial Banks. The banks operate independently and without any government involvement in their policy-making, management and operations. The “directed” credit and interest rate fixing regimes no longer exist. The shareholders now appoint their respective boards of directors and they in turn appoint their key management personnel. Six of the banks have foreign management. Competition, Efficiency, and Viability. Private enterprise has led to intense competition among banks for both deposits and loans, with the public benefiting

1

2

3

The minimum capital requirement has been increased three times: first from $0.5 billion MNT to $1.0 billion MNT, then to $4.0 billion MNT, and finally to 8 billion MNT (about $7 million) in April 2006. The “CAMELS” principles entail examining and auditing banks on the basis of capital, assets, management, earnings, liquidity and sensitivity to market risks. One violation relates to the misappropriation of cash at the Savings Bank, amounting to about $12 million in respect of an inter-branch/interbank transaction that was discovered by BOM during an onsite visit. It is understood that the new private owners of the bank have placed responsibility for meeting that loss with the Government, as the privatization agreements assigned responsibility for covering any liabilities prior to privatization to the Government. BOM has since improved its software for online checking of interbank settlements/balances within a few days of the transactions. The case is said to be now under investigation by the police department. The other violation relates to an alleged scam relating to a letter of credit opened by a local bank for import of about $70 million in goods. No details are available at present.

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31

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from greater efficiency in meeting their demand for various banking services. The banks have developed some niche markets and specializations to cope with this competitive environment. Of the 16 banks, three specialize in rural areas, two in microfinance and the balance in general banking activities. They have also increased their branch network from 682 in 2004 to 832 in 2006 to spread their outreach systems and develop business in rural areas. 4 The four large banks handle most of the corporate accounts, with total market share of about 40% for loans and about 72% for deposits, while the remaining 12 banks focus on consumer and retail banking services, controlling 60% of the market for loans and about 28% for deposits. The attractive average spread of about 11.6% during the 5-year period 2002–2006 has enabled banks to be very profitable, with a return on equity (ROE) of 20.8% in 2002; this decreased to 12.1% in 2005, and then increased again to 14.3% in 2006. Similarly, the return on assets (ROA) decreased from a high of 4.3% in 2002 to 2.2% in 2005, and then increased to 2.7% in 2006. These returns are much higher than those achieved in some industrialized countries. 5 The smaller banks are less profitable, with ROAs of around 1.0–1.5% as a result of having to pay higher deposit rates to attract deposits. These returns are on an after-tax basis (the banks are subject to an effective tax rate of about 20%).6 The profitability of the banks would have been even higher if not for the BOM reserve requirement of 5% on all deposits (reduced from 14% in March, 2007), on which no interest is received. The high returns may not be sustainable in the medium to long term, and some decreases can be expected. The banks have set up specialized departments and/or divisions for risk management (e.g., credit risk and FX risk) and for asset-liability management, in order to reduce risks and maintain high profitability levels. Deposits and Loan Growth. Deposits with banks have been growing significantly, reflecting increasing public confidence in the banking system. This growing trend is due to the expanding economy, increased foreign worker remittances and foreign direct investment inflows. Time and term deposits have been increasing by about 30–40% per annum since 2002. Deposits as a percentage of gross domestic product (GDP) increased from 17.6% in 2002 to 31.4% in 2006. The increasing deposits have enabled the banks to expand their lending considerably, mainly to the private sector, recording an annual credit growth of over 50% during 2002–2005. The other factors that led to the sharp credit expansion are the robust economic growth and competition among the banks. Bank loans to the public sector (mainly utilities) have been negligible, averaging only about 2.7% of the total loans outstanding over the 5-year period 2002–2006; this signifies a complete shift7 from the lending structure under the previous system, in which bank loans to the public sector predominated. Similarly,

4

5

6

7

The 832 branches and other units at the end of 2006 comprised 118 branches, 662 payment and settlement centers, 31 cash offices, one money-changing unit, two representative units, and 18 others (advisory and other units all belonging to the Khan Bank). According to the International Monetary Fund’s twice-yearly publication “Global Financial Stability Report”, the ROAs in 2006 were: Korea (1.3%), USA (1.4%), Czech Republic (1.4%), Hong Kong (1.7%) and Australia (1.8% in 2005). The present income tax rate on profits is 10% for the first MNT100 million of taxable income, and 25% on the excess of taxable income over MNT100 million. Interest income on government bonds is not taxable. BOM regulations allow banks a net-open position not to exceed 15% of capital for one currency and 40% for all currencies. If the total foreign exchange exposure is measured in terms of the value at risk (VAR) method, the VAR cannot exceed 10% of capital. Only one bank calculates the risk on this basis, using a management information system model. Other banks calculate the net-open position on the basis of total foreign exchange liabilities and assets.

32

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(viii)

(ix)

(x)

loans outstanding as a percentage of GDP increased from 18.7% in 2002 to 38.6% in 2006. Loan Portfolio Diversification. The loan portfolios of the 16 commercial banks are fairly well diversified. In 2006, the industrial sector/processing took up the largest portion (34%), followed by trade (27%), agriculture (11%), construction (11%), mining (3%), transportation (1%) and others (13%). Thus, a downturn in any particular sector would not adversely affect the viability of the banking sector as a whole. However, in 2006, most of the loans were short term (57%), followed by medium-term (38%) and long-term (over 5 years; 5%) loans. This heavy bias towards short-term lending results from the short-term nature of the deposit structure. There appears to be an urgent need to develop more long-term deposit and lending instruments, in particular to promote the development of more small and medium-sized enterprises (SMEs) for employment generation and poverty reduction. Also, with only three banks servicing the rural areas, including one specializing in rural credit, there appears to be a need to spread banking into rural areas to provide competition and to improve services in rural areas. Another characteristic of the loan portfolio is the fairly large content of FX-denominated loans. The FX-denominated loan portfolio increased from 37.6% of total portfolio in 2002 to 43% in 2006. The borrower and the banks are exposed to a FX risk in the event of a depreciation of the togrog. To guard against this risk, the FX risk is carefully assessed by banks and covered either through FX in-flows and/or FX deposits of the borrower, or through higher interest rates that reflect the risk factor. Interest Rates on Deposits and Loans and Interest Spread. Interest rates for both deposits and loans are now fully liberalized, with the banks free to charge interest on a risk-reward basis. Market interest rates are showing a declining trend with the increasing competition and gradual decrease in the inflation rate, with lending rates dropping faster than those on deposits. Lending rates have dropped from 26.6% in 2002 to 20% in 2006,8 while deposit rates have dropped from about 14% in 2002 to 13.5% in 2006.9 The interest spread has dropped from 15.4% in 2002 to 8.9% in 2006, but nevertheless remains attractive.10 The interest rates are positive in real terms, with inflation running at about 6% at the end of 2006. Similarly, the weighted average interest rates on central bank (CB)bills increased from 9.9% in 2002 to 15.75% in 2004, decreased to 4.75% in 2005, and then increased again to 6.42% in 2006. These high spreads may not be sustainable in the medium to long term, and a further drop could be expected with the rapid sophistication and expansion of the financial markets. Status of Non-Performing Loans. The aggregate nonperforming loans (NPLs) increased from MNT11.7 billion to MNT60.0 billion over the period 2002–2006. The ratio of NPLs to total loans outstanding increased from 5.1% in 2002 to 6.4% in 2004, and decreased to 4.9% in 2006. These ratios indicate that the NPLs are at a manageable level. The larger banks show a better NPL ratio. This scenario raises concerns about the prospects of the continued viability of the smaller

8

The lending interest rate is the arithmetic average of the weighted averages of domestic currency loans and FX loans. 9 The deposit interest rate is the arithmetic average of the arithmetic averages of domestic currency deposits and FX deposits. The weighted averages on deposits cannot be calculated as yet due to the preponderance of deposits at different interest rates in the 16 different banks. BOM will calculate them in the near future with improvement in their MIS. 10 The interest spread has been calculated as follows: interest income on loans/total loans x 100 – interest expenses on deposits/total deposits x 100

Appendix 3

33

(xi)

(xii)

(xiii)

banks in the event of an economic slowdown and/or unexpected external shocks. The banks appear to be aware of this concern and are taking steps to meet the challenge through strategic planning, strengthening of policies and procedures to meet international standards, product and customer diversification, development of niche markets, selective marketing, efficiency improvements in the provision of their services, and skills upgrading and capacity enhancement (see sections xi and xii, below). The ratio of public sector NPLs to total loans outstanding was negligible, averaging about 0.3% during 2002–2006. Banking Skills Upgrading. Banks are placing a high priority on skills upgrading for (a) capacity enhancement, (b) to cope with competition and any slowdown in economic expansion, and (c) to increase efficiency in service provision. Staff training that supplements the training provided by the Bankers Training Center (BTC) is being done using four methods: on-the-job training; classroom-type training on a structured basis; training provided by BTC; and the use of foreign training on an ad hoc basis, particularly by the larger banks. Staff training presently focuses on customer relations, MIS, credit and other forms of riskmanagement, and asset-liability management. The banks with foreign management have an advantage in skills upgrading, particularly in the more sophisticated and modern methods of banking. Also, the smaller banks seem to recruit staff trained by the larger banks to quickly upgrade their skill base, particularly in the relatively weaker areas of risk management in a competitive environment, corporate governance practices, and introducing greater transparency in the preparation of their accounting statements. Bankers Training Center (BTC). First established within BOM in 1993, BTC became dormant and was re-established in 1999 with ADB TA for furniture, equipment, MIS and training of trainers and bank staff. It is performing a useful purpose by training Mongolian bank staff and thereby positively contributing to the stability of the banking system through improvement in the quality and efficiency of banking services in the country. Well-structured programs and training required on a case-by-case basis cover a wide range of subjects: basic entry-level training for new staff, training of loan officers including risk and assetliability management, human resource development, and MIS. The yearly training program is designed in conjunction with the commercial banks and regularly updated based on market requirements. A BTC trainer, BTC-trained trainers from commercial banks, and BOM conduct the training. Currently, the German GTZ, with support from BOM and local trainers, has taken the lead role in training of trainers from commercial banks and commercial bank staff over a four-year program (2005–2008). Training packages have been prepared for training of commercial bankers in three stages (basic, medium, and advanced). Of the estimated total staff of about 6,800 currently in the banking industry, about 3,000 have been trained thus far (at the rate of about 1,500 per year); the balance of 3,800 are to be trained over the next 2.5 years, ending in 2010. Plans are also underway to train trainers and prepare training modules to provide training in (a) mortgage financing based on the experience of the ADB Housing Finance Loan, (b) property valuation, (c) securitization, and (d) in the macroeconomic environment. Credit Information Bureau (CIB). BOM established the CIB in 1997 to provide credit status information on prospective bank borrowers. The banks are using the facility, which is helping them reduce exposure to potential bad debts, and reduce loan transactions costs and the need for recourse to the judicial system for recovery of bad debts. Its operations are being upgraded with the support of

34

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the World Bank. In addition, the Mongolia Bankers Association is working with the IFC, United States Agency for International Development (USAID), and GTZ to form another credit information bureau to further strengthen credit information operations in terms of expanding the information database, and the speed and efficiency of information dissemination. It is questionable whether there is room for two credit information bureaus to operate in the country’s small financial system. A compromise may be privatization of the existing CIB within BOM, with upgrading of its operations through private management. 2. (i) The ADB Second Financial Sector Program Outputs Strengthening Corporate Governance in Banking Institutions. All the banks practice good governance principles. BOM adopted the corporate governance regulation in 2006 and it is being enforced. That law very clearly delineates the various codes of corporate governance that boards of directors, senior management, internal auditors and external auditors need to observe. All the banks have internal auditors and audit committees that report directly to their respective boards of directors, and their annual accounts are audited by independent external auditors, based on IAS standards. Well-known and internationally reputed auditing firms audit the large and medium-sized banks, while the accounts of the small banks are audited by local firms. Based on BOM requirements, all the banks now publish summaries of their financial statements, and adherence to prudential ratios and legal lending limits on a quarterly basis in the country’s major newspapers. These actions demonstrate the transparency of their financial positions and operations, and have also served to enhance the confidence of the general public and international business community in Mongolia’s banking system. The five small banks appear to lag behind the others in terms of good governance practices. BOM is aware of their shortcomings in this regard and is taking steps to address the issue. All the banks are also registered as companies under the National Registration Office that requires them to observe the various rules and regulations, as prescribed by the Law on Company 1999. Improving the System of Collateral. The debt-recovery process needs to be further expedited and the associated costs reduced. This would reduce loan transaction costs, enhance the efficiency of banking services, and further strengthen the financial intermediation process. A new law on immovable property that is before Parliament for approval before end 2007 would allow for non-judicial foreclosure of collateral, and allow banks to go directly to the Marshall’s office to seize immovable property for auction without going through a lengthy court process, during which time the loan does not accrue interest. There is also a need to have a registration process for movable property (as exists for immovable property), and a means developed of registering property and liens more rapidly. At present there is only one property registration office for immovable property. Regionalization of property registration in and outside Ulaanbaatar, with appropriate electronic communication and access, would accelerate the property registration and searching process. Two other new laws are also being processed with support from USAID, one to provide for assetbacked security, and the other for mortgage bonds. The ongoing staff training programs in credit and risk management, proper appraisal of property values, and legal documentation should reduce the need for litigation.

(ii)

Appendix 3

35

(iii)

(iv)

Implementing MISs in Banks. The banks continue to install and improve their MISs, first introduced under ADB TA. Improvements are now being financed by banks from their own profits. Considerable information is produced on a regular basis on loans, deposits, cash balances, income, expenses and NPLs, assisting management to take effective decisions on various business matters. Branch offices are being continuously linked with head office operations. Staff members are being trained to cope with the expanding use of MISs, but systems in the smaller banks appear to need further strengthening, particularly to improve their internal controls. Developing an Interbank Market. BOM has largely stopped providing liquidity support to banks, so as to encourage banks to manage liquidity among them. The two remaining support schemes comprise an overnight facility with a very high interest rate (as a penalty, to encourage banks to utilize other banks rather than BOM for overnight liquidity), and a repurchase facility. In tandem, the auctioning of CB-bills has now been made the main policy instrument for monetary management and for development of the money market. Banks have responded positively to this facility and it has proven to be a successful and effective monetary policy instrument. 11 The operations of the interbank market remain small in comparison with overall banking sector operations, mainly because of the excess liquidity kept by the banks to meet emergencies, and the general reluctance to rely on the interbank market for liquidity support, but the latter will improve with the growing sophistication of the financial markets). However, the framework for satisfactory operation of an interbank market is now in place.12 The efficiency of interbank operations is improving, although only a small number of products are transacted among the banks. Investment products include interbank deposits, interbank loans, CB-bills, 7 and 91 day repos on CBbills, and the recently introduced overnight product. BOM will soon introduce changes to their bill products to three maturity dates (7, 84 and 364 days), and revise the process for running auctions to further develop the interbank market. BOM has also recently decided to change their monetary management strategy, moving to a focus on inflation targets rather than the money supply. The target inflation rate for each year would be announced in advance and the Government would take steps to achieve that target through appropriate action related to monetary instruments.

B.

Strengthening Prudential Regulations and Supervision of NBFIs

44. The Program supported the introduction of appropriate legal, regulatory, supervisory, and accounting/auditing frameworks for the orderly development and viability of the nonbank sector. The previously fragmented regulatory and supervisory framework has now been brought under one umbrella with the establishment of the Financial Regulatory Commission (FRC) in November 2005, as recommended by ADB. The FRC has begun to fill the gaps in the required
11

Based on assessments of excess liquidity in the market, BOM announces every Tuesday the volume, maturity and maximum interest rates on CB-bills to be auctioned the next day. The volume of CB-bills auctioned has increased rather erratically, from 61,000 million MNT in 2002 to 125,700 million MNT in 2005 due to increased excess liquidity in the market, followed by a drop to 70,800 million MNT in 2006. The weighted average CB-bill rate increased from 9.9% in 2002 to 15.75% in 2004, dropped to 4.75% in 2005, and increased again to 6.42% in 2006, based on the excess liquidity in the market (from December 2004 onwards, data are shown at market price). 12 Interbank operations totaled 74.9 billion MNT as of 31 December 2005 but decreased to 58.2 billion MNT as of 31 December 2006. The decrease was due to the reduced excess liquidity in the market in 2006.

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legal, regulatory, supervisory, and accounting/auditing frameworks, with completion slated for 2007, or 2008 at the latest. It has also begun to enforce them effectively, and to take positive steps for the promotion of a stable, competitive and viable nonbank sector in the country. However, it would need to enhance its capability further for more effective performance of its functions and plans. The nonbank sector is open to foreign investment. There are about 300 NBFIs are in operation, made up of 141 NBFIs, 118 savings and credit cooperatives (SCCs), 27 securities companies, and 14 insurance companies. The present status of the nonbank sectors is given below. (i) Nonbank Financial Institutions. There are 141 NBFIs in operation, engaged mainly in making short-term loans to small businesses, using their own funding resources. This subsector is the most stable of all the nonbank sectors. All NFBIs are profitable; one is large, while 50 are very active, and 90 not very active. About 20 specialize in rural areas, 10 focus on Ulaanbaatar city and have branches in rural areas, and 111 have operations only in Ulaanbaatar. The Law on Nonbank Financial Activities enacted in December 2002 provides the legal basis for their operation. The regulatory framework in place specifies the minimum capital requirement, asset classification, liquidity, FX exposure, the need for accounting/auditing to meet IAS standards, and provisioning. Some new regulations have been completed recently to strengthen existing regulations with respect to licensing of NBFIs to conduct their activities, prudential ratios, accounting, and offsite supervision. Their governing law will be amended shortly to allow them to undertake financial leasing operations. As required, the NBFIs publish their audited statements in major newspapers. There is increasing foreign investment interest in the nonbank sector. The trend in total assets is increasing.13 Savings and Credit Cooperatives. There are 118 licensed SCCs in operation. A new law to govern their operation will be submitted to Parliament for approval before end 2007. This will provide a legal basis for SCC operations and will address many issues, including membership, share capital, loan operations, and obligations with respect to taking and repaying deposits from members and nonmembers. Loopholes in the previous SCC Law will be covered adequately in the new law. Those loopholes14 led to irregularities in the cooperatives system that caused the demise of many SCCs, with depositors losing considerable amounts of money. The FRC is now the sole authority regulating, supervising and controlling the SCC system. The FRC has introduced four regulations on licensing, SCC operations, accounting (a joint United Nations Development Programme/MOF project), and onsite examinations. Four additional regulations will be introduced before end 2007 pertaining to performance evaluation of SCCs, strengthening of accounting and auditing regulations, strengthening of operations regulations, and establishment of a special credit information bureau for NBFIs, including SCCs. The legal, regulatory and accounting/auditing framework has

(ii)

13

The total assets have increased from 12,459 million MNT in 2002 to 69,262 million MNT in 2006, with an annual growth rate of just over 50%. The total assets in 2006 equaled about 2.2% of GDP, slightly more than the insurance sector (0.7% of GDP), but much smaller than the banking sector (68.4% of GDP of in 2006). 14 Those loopholes were: lack of proper legal environment and implementation; lack of public awareness of financial and legal aspects and principles of the cooperative system; weak internal controls; and inadequacy of training, guidelines and general information on the operations of the cooperatives system (such as responsibilities of the management of the SCCs, depositors and loan borrowers).

Appendix 3

37

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been prepared with the assistance of the Canada Cooperative Association (CCA) and the Canada International Development Agency (CIDA). Within this framework, the Union of SCCs was established in December 2006 for the present 118 members. A code of conduct for the Union is now under preparation. Some SCCs are not complying with the new accounting/auditing framework, and this is being addressed by the FRC. As with the other nonbank subsectors, the FRC is planning to provide training to cooperative administrators, members and auditors on their respective rights and obligations, backed by awareness programs and dissemination of information and knowledge. Securities Companies. There are 27 securities companies in operation, engaged in brokerage, dealing in stocks and bonds, funds placement, underwriting, and initial public offerings. The Securities Law, Company Law, and the Civil Code provide the legal basis for their operation. Prudential regulations and accounting/auditing procedures meeting international standards are in place. The accounting procedures are those set forth by FRC and the Company Law. Rules for licensing and onsite examination are also now in place and are being enforced. The FRC is preparing further prudential regulations for implementation in 2007, while re-licensing of securities companies is proceeding satisfactorily. All 27 are limited liability companies, but only one (the largest) is listed on the MSE. Control of most of the accounts and stock market operations is in the hands of just a few companies, and profitability is limited to those companies. Some market consolidation and rationalization may take place in the future, and the FRC will need to be vigilant regarding the performance of the relatively small companies to maintain public confidence in the system. The FRC is taking steps to improve the viability of the subsector by increasing investor confidence in stock market operations and market liquidity through more public listings of good quality stocks. Insurance Companies. There are 14 private insurance companies in operation, all engaged in general insurance work. The Law on Insurance and the Law on Insurance Professional Participants passed by Parliament in April 2004 provides the legal basis for their operations. They were prepared with the support of ADB TA and comply with the standards and principles set by the International Association for Insurance Supervisory Agencies. However, the full complement of regulations needed to regulate the industry has yet to be put in place. About 21 regulations are required under the Law on Insurance. Of these, only 10 are currently in place, while the balance of 11 will be completed by the FRC before end 2007. Eight additional regulations are required under the Law on Insurance Professional Participants; none are in place at present, but these will be completed by the FRC in 2008. The required accounting/auditing framework meeting international standards is now in place and is being effectively enforced. In an encouraging development, quarterly accounts are published in the major newspapers of the country to increase public confidence in the insurance industry. Another new law on compulsory insurance of the liability of automobile drivers is now being drafted by FRC for the approval of Parliament in 2007. The need to introduce life insurance and other forms of compulsory insurance schemes is also being examined. The insurance industry is relatively very small at present, with total assets amounting to just 0.7% of GDP in 2006, versus 10– 12% of GDP in more developed countries; Mongolia’s banking sector equaled 68% of GDP in 2006. Because of its present small size, the insurance

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industry as a whole does not appear to be viable,15 but an improving trend could be seen as of 2006. The FRC will need to be vigilant regarding the performance of the marginal companies in terms of operations and profitability to prevent failures and adverse impacts on the public’s confidence in the industry. C. Developing Capital Market Infrastructure

45. The Program promoted the development of capital markets for diversification and deepening of the financial sector. It supported improvements in (i) governance structure of the Mongolian Stock Exchange (MSE), (ii) the Securities Market Law and related regulations, and (iii) the legal status of trust relationships and investment funds. It also assisted in the institutional strengthening of the Mongolia Securities Exchange Commission (MSEC), now known as the FRC under the TA associated with the Program. These reforms have been implemented satisfactorily, with the gaps that remain to be filled in 2007 or 2008 at the latest. Their implementation status is as follows. 1. Separating MSE Functions and Privatizing MSE

46. Beginning in October 2003, MSE’s functions were separated, with MSE responsible for securities trading, while securities clearing, settlement and depository functions became the responsibility of a separate state-owned limited liability company (the Securities Clearing House and Central Depository [SCHCD] Co. Ltd).16 Both are now well established and operating on a profitable basis. Privatization of MSE was included in the Government’s overall privatization program for period 2005–2008, but privatization has not yet occurred, apparently due to a lack of political will. The list of institutions to be privatized in 2008 will be finalized before the end of 2007. OEM impressed upon the SPC and FRC the need to complete privatization prior to the end of 2008 at the latest. Various options for its privatization are under discussion, and it is likely it will be done by that date. With hindsight, OEM considers that ADB’s recommendation regarding privatization of MSE may have been premature, as the prospects for privatization would have improved with increased viability17 and public confidence in its operations. 2. Strengthening the Securities Markets Law (SML)

47. The Program called for amendments to SML to improve financial governance and restore public confidence in the securities markets. The amended SML was passed by Parliament in December 2002 and became effective in January 2003. The amended SML included (i) increased penalties for SML violations, (ii) stricter audit requirements for listing of companies, and (iii) higher minimum capital requirements for brokers. The Law on FRC Legal
15

The whole system recorded a profit of MNT82.3 billion in 2004 but has since become unprofitable, with losses of about MNT789 billion in 2005, decreasing to MNT129 billion in 2006. The largest insurance company, which is foreign owned, is said to the most profitable, mainly because of its Mongol Airlines account; another four are marginally profitable, while the balance of nine are barely profitable or are loss-making. The total assets of the industry increased from MNT15.1 billion to MNT22.1 billion in 2006, at an average annual rate of about 22%. The reserve fund stood at MNT12.1 billion in 2006 with a net addition (income less claims) of MNT2.41 billion in that year. The largest company controls about 41% of the insurance business (because of the Mongol Airlines account), four others about another 39%, with the nine smallest companies accounting for the remaining 20%. 16 The SCHCD was created by the amalgamation of the previous Securities Clearing System (SCS) and Central Depository System (CDS). The FRC licensed it in October 2006 to conduct these functions. 17 One option being considered is local privatization with involvement of the management and staff of MSE and other securities market players; a second is privatization on a joint-venture basis. OEM indicated that a third option would be to privatize MSE on a two-stage basis: initial privatization of management with foreign participation to introduce international best practice, with full privatization following subsequent to an improvement in MSE’s viability, thereby improving the price obtained by the Government.

Appendix 3

39

Position dated 17 November 2005, which established the FRC, adequately covers other shortcomings, such as (i) the inadequate legal basis for (a) the regulatory, supervisory, and enforcement powers previously held by MSEC, and (b) for self-regulation; and (ii) the need for clarity of some technical terms being used. Based on experience and the evolving nature of the market, FRC proposes to amend the SML again and renew existing rules and regulations for the securities market before the end of 2007. (i) Penalties for SML Violations. The revised SML increased penalties for SML violations. 18 However, they are still considered too low and therefore the proposed amendments to the SML will include penalty increases high enough to eliminate malpractice and maintain public confidence in the system. The penalties will be differentiated for each type of violations and repeat violations. In addition, FRC will reduce the incidence of violations through training and awareness programs for investors, securities companies, MSE, and SCHCD. Stricter Audit Requirements for Listed Companies. The FRC proposes to approve the “Governing Code of Mongolian Companies” that would contain a special set of requirements for audits of listed companies. Listed companies are required to submit audited annual and half-yearly financial reports to FRC and MSE on a timely basis. Minimum Capital Requirements for Brokers. The revised SML set a minimum capital requirement of MNT50,000 for both broker and dealer companies. The project completion report19 (PCR) stated that there were complaints that that limit was too high, and forced many small brokers, especially those from rural areas, to exit the market. The FRC does not consider the limit to have been excessive, based on the risk factor, the need to maintain public confidence in the system, and the demand for new licenses by prospective brokers and dealers. However, the proposed amendments to the SML will specify different capital requirements for brokers and dealers based on (a) the risk factor; (b) the percentage of the capital that should be earmarked for fixed and current assets; and (c) prudential, reserve, and provisioning requirements that need to be observed by brokers, dealers and other professional entities. Regulations to Prevent Insider Trading. Following the revised SML, MSEC issued regulations, including regulations to prevent insider trading. The PCR stated that the controls on insider trading were not effective, as insiders carried out a large part of the securities transactions, and that MSEC faced difficulties in enforcing some of the regulations because (a) the term “insider” was not clearly defined, (b) there were no reporting requirements on trading done by insiders, and (c) disclosure requirements for listed companies were generally weak. The FRC is preparing a new regulation based on international standards called “Activities of the holders of internal information and supervision of market manipulation”, which should help overcome these problems. The proposed amendments to the SML will include increased penalties for violations of clauses relating to participation in trade while holding internal information, and for factitiously increasing or depressing securities prices. The other areas to be strengthened are: clearer definition of the term “insider”, establishment of clear and effective procedures for tracking insider trading, ways to disclose how

(ii)

(iii)

(iv)

18

The penalties were increased from MNT20,000 to MNT40,000 for individuals and from MNT100,000 to MNT200,000 for legal entities. 19 ADB. 2005. Program Completion Report on the Second Financial Sector Program. Manila. (Loan 1743-MON).

40

Appendix 3

(v)

insider trading occurs, and strengthened internal control systems of market participants. Regulations on Off-Exchange Trading. In March 2005, after completion of the Program, MSEC issued regulations that require all transactions on MSE to be undertaken through licensed securities companies. Negotiated transactions between buyers and sellers outside MSE had been allowed since 1998 and were widespread. Changes to the current regulation are not contemplated. Offexchange trading has decreased considerably with strengthened supervision under the FRC, MSE and SCHCD, and awareness programs conducted by the FRC and MSE for securities companies and investors. Legal Framework for Investment Funds

3.

48. As required by ADB, two new laws on trusts and investment funds were drafted by ADB TA consultants. They were not passed, however (the former by Parliament and the latter by Cabinet), as the existing Securities Market Law and the Company Law were seen to be providing adequately for those requirements, with passage of new laws considered unnecessary. Preparation by the consultants of briefing notes to convince the politicians as to the need for the laws would have increased their prospects for approval. A working group set up by FRC is looking into the draft Law on Trusts, while another that is soon to be established will look into the draft Law on Investments. The FRC is confident that prospects for approval are much improved, as a result of having a new government in power and increased awareness of the usefulness of developing the capital market. D. Strengthening the Pension System

49. The Program aimed at supporting (i) the Government’s efforts to formulate a suitable legal and regulatory framework for the partial funding of the state’s unfunded, pay-as-you-go pension system; (ii) improvement of the administrative capacity of the State Social Insurance General Office (SSIGO); and (iii) the development of non-state voluntary pension systems. Properly managed and regulated pension funds could act as an impetus for development of an institutional investor base and a diversified financial sector. The required legal and regulatory frameworks for development of these pension schemes are now in place, as described below. To build on this foundation, ADB approved additional TA,20 which is now being implemented in coordination with the World Bank. (i) Developing a Partially Funded System. A decree on social security issued by the Government in June 2002 outlined the needed reforms up to 2020, including a plan to gradually reduce deficits by increasing the pension base to increase premium contributions. A social security sector strategy developed under the Strengthening Policy for Social Security Reform TA21 and issued in 2004 by the Ministry of Social Welfare and Labor also included several planned changes in the Law on Social Insurance to strengthen the financial position of the state pension system. According to the strategy, the measures would be adequate to eliminate the pension plan deficit and place the program on the path to partial reserve funding. The changes to the law are being developed for submission to Parliament for approval.

20 21

Strengthening the Pension System (TA 4910-MON), approved in December 2006. ADB. 2001. Technical Assistance to Mongolia for Strengthening Policy for Social Security Reform. Manila (TA 3709-MON). The TA was provided in conjunction with Loan 1836-MON (footnote 22).

Appendix 3

41

(ii)

(iii)

Improving Administrative Process in SSIGO. The SSIGO has adopted measures to (i) improve capacity in pension payments collection, (ii) strengthen the financial management of the pension system, (iii) exchange information about payment declarations with the tax authorities, (iv) improve technical capabilities of social insurance inspectors, and (v) set up a professional management structure for the pension fund in the transition to a partially funded system. Investments in MIS and training programs for inspectors under ADB’s Social Security Sector Development Program loan strengthened SSIGO’s capacity to manage social insurance programs.22 Developing Non-State Voluntary Pensions. The social security sector strategy stated that the long-term policy for social insurance was to encourage private supplementation of the benefits provided under the state-managed system. A new law on voluntary private pension plans was drafted by ADB TA consultants, but on their advice not submitted to Parliament for consideration, as it was considered premature to do so in light of the difficult economic conditions prevailing at that time (i.e., 2003). The matter currently remains in abeyance.

E.

Strengthening the Insurance System

50. The Program supported the drafting of amendments to the insurance laws and the development and adoption of a sound regulatory framework. The legal and accounting/auditing frameworks are now in place. Most of the needed regulations are also now in place and work on the balance needed is proceeding satisfactorily.

22

ADB. 2004. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance to Mongolia for the Social Security Sector Development Program. Manila. (Loan 1836-MON).

42

Appendix 4

LIST OF BANKS IN OPERATION AS OF JULY 2007 Number of Branches

No.

Name

Foreign Investment

Management

Area

Large Banks (Assets over MNT100 billion) 1 2 3 4 Golomt Bank Trade & Development Bank Khan Bank Anod Bank Yes Yes Foreign Foreign Urban Urban Rural Urban 42 20 440 21

Medium Banks (Assets MNT30 billion–MNT100 billion) 5 6 7 8 9 10 11 Mongol Post Bank Chinggis Khan Bank Savings Bank Zoos Bank Kapitron Bank Xac Bank Ulaanbaatar Bank Small (Assets below MNT30 billion) 12 13 14 15 16 Capital Bank National Investment Bank Credit Bank Transport Bank Erel Bank Total Yes Yes Yes Yes Foreign Urban Urban Urban Urban Urban 27 1 7 3 5 934 Yes Foreign Yes Yes Yes Foreign Foreign Rural Urban Urban Urban Urban Rural Urban 227 2 43 32 16 39 9

MNT = Mongolian togrog, No. = number. Note: Classification of banks as large, medium, and small done on an informal basis for analytical purposes only. Source: Bank of Mongolia.

Appendix 5

43

KEY BANKING SECTOR INDICATORS (%) Indicator M2/GDP Loans/GDP Deposits/GDP Total bank assets/GDP Total bank loans (MNT billion) Total loan growth Total NPL (MNT billion) NPL/Total Loans Banks’ lending-weighted average interest rates Banks’ interest rates on deposits (non-weighted)a CB-bills weighted average rate 2002 37.9 18.7 17.6 40.1 231.4 71.3 11.7 5.1 26.6 14.0 9.9 2003 47.5 29.9 24.6 60.6 442.1 91.1 21.1 4.8 25.6 14.0 11.5 2004 43.5 31.2 26.6 59.5 606.8 37.3 39.1 6.4 24.0 13.2 15.8 2005 45.2 34.1 27.5 60.4 859.9 41.7 49.5 5.8 21.6 12.6 4.8 2006 48.4 38.6 31.4 68.4 1,223.3 42.3 60.0 4.9 20.0 13.5 6.4

CB = central bank; GDP = gross domestic product; M2 = broad money (money in public circulation plus business and household time and savings deposits); MNT = Mongolian togrog; NPL = nonperforming loan. a The weighted average interest rate on deposits is not available from Bank of Mongolia’s Statistical Bulletin. Sources: Bank of Mongolia, National Statistics Office.

44

Appendix 6

SUMMARY OF STOCK MARKET OPERATIONS (2002–2006)

Item 1. Listed companies (fully and/or partially state-owned) 2. No. of trading days 3. Market capitalization: - in MNT million - in $ million 4. Trading value: - in MNT million - in $ million 5. Trading volume: - in million 6. Bond trading (MNT million) - Government - corporate 7. Index (top 20) 8. No. of companies paying dividends 9. No. of member broker/dealer companies 10. No. of accounts of stock owners

2002 403 — 255

2003 402 (68) 250

2004 395 (67) 255

2005 392 (66) 253

2006 387 (60) 253

35,848 31.9

49,513 42.4

29,832 24.7

55,701 131,179 45.6 112.6

1,373 1.2

896 0.8

654 0.5

2,547 2.1

12,604 10.8

9.8

8.1

9.1

25.9

74.5

41,691 2,958 934 16

21,723 2,988 896 20

12,464 2,777 586 12

6,768 2,664 1,019 17

4,462 961 2,031 23

34

26

25

24

25

— 281,150 287,835 292,712 309,145

— = not available, MNT = Mongolian togrog, No. = number. Source: Mongolian Stock Exchange Fact Book 2006.

Appendix 7

45

MACROECONOMIC INDICATORS (1999–2006)
Year Item Income and Growth GDP per Capita ($) Nominal GDP (MNT billion) GDP Growth (constant prices) Industrial Production (% change) % of GDP Agricultural Production (% change) % of GDP Unemployment Rate (%) Money and Inflation Consumer Prices (%) Implicit GDP Deflator (%) Broad Money (M2, % change) % of GDP Exchange Rate: year-end average Government Finance Overall Budgetary Deficit (% of GDP) Balance of Payments Balance of Goods ($ mn) Exports ($ mn) % change Imports ($ mn) % change Current Account Balance ($ mn) % of GDP Foreign Direct Investment ($ mn) External Payments Indicators External Debt (% of GDP) External Debt Service ( % of Exports)a Gross Official Reservesb ($ mn) 1999 366.1 925 3.2 1.6 20.7 4.4 37.0 4.7 2000 2001 2002 447.1 1,237 3.8 4.3 22.8 (12.4) 20.5 3.4 2003 2004 2005 2006

388.5 417.5 1,019 1,116 1.1 1.0 0.3 15.5 21.9 22.0 (15.9) (18.3) 29.1 24.9 4.6 4.6

508.8 639.0 1,480 1,946 6.1 10.8 5.9 14.4 25.4 29.7 4.9 17.7 20.6 21.7 3.5 3.6

811.5 1,056.0 2,524 3,172 7.1 8.4 1.4 7.9 35.0 40.4 9.6 9.7 20.8 18.8 3.3 3.2

7.5 9.7 31.6 23.8 1,072 1,022 (11.6) (56.5) 454.2 (1.8) 510.7 (2.6) (51.3) (5.7) 30.4 100.9 3.9 136.9

8.1 8.9 17.6 25.4 1,097 1,077 (7.7)

8.0 8.4 27.9 29.7 1,102 1,098 (4.5)

1.6 6.9 42.0 37.9 1,125 1,110 (5.8)

4.7 11.0 12.7 18.7 49.6 20.4 47.5 43.5 1,168 1,209 1,147 1,185 (4.2) (2.1)

9.5 21.1 34.6 45.2 1,221 1,205 2.9 (28.8)

6.0 15.9 34.8 48.4 1,165 1,180 3.9 188.5

(72.5) (100.6) (156.2) (227.1) (28.9) 535.8 523.2 524.0 18.0 (2.4) 0.2 608.4 623.8 680.2 19.1 2.5 9.0 (69.9) (61.7) (105.0) (7.4) (6.1) (9.4) 53.7 63.0 77.8 95.4 6.1 202.1 87.2 6.7 256.6 93.1 6.7 399.4

627.3 872.1 1,068.6 1,545.2 19.7 39.0 22.5 44.6 854.4 901.0 1,097.4 1,356.7 25.6 5.5 21.8 23.6 (95.9) 63.4 84.2 314.0 (7.4) 3.9 4.0 11.7 131.5 92.9 182.3 166.5 116.6 29.5 94.8 2.9 72.5 – – –

242.7 250.4

430.3 1,060.6

– = not available, ADB = Asian Development Bank, GDP = gross domestic product, mn = million, MNT = Mongolian togrog. a Exports of goods and services. b Includes foreign exchange, gold, special drawing rights, reserve position in the International Monetary Fund. Sources: ADB. 2007. Key Indicators of Developing Asian and Pacific Countries. Manila.

MANAGEMENT RESPONSE TO THE PROGRAM PERFORMANCE EVALUATION REPORT FOR LOAN 1743-MON: SECOND FINANCIAL SECTOR PROGRAM IN MONGOLIA

A.

General Comments

1. We appreciate OED's Program Performance Evaluation Report (PPER) on the Second Financial Sector Program (the Program). We find it analytically sound and well-prepared. We agree with its overall satisfactory rating of the Second Financial Sector Program. We note that the findings of the PPER are useful and the issues and lessons identified in the PPER will provide a better approach in preparing similar programs in the future. 2. We note that ADB has supported the development of Mongolia's financial sector throughout the course of the country's transition to a market economy. As the PPER observes, the Second Financial Sector Program was a core part of the financial sector reform package that was put together in coordination with the Government, the World Bank, and International Monetary Fund (IMF). The Program formed one part of a consistent package of ADB's support, which has also included two other program loans, significant amounts of technical assistance, a technical assistance (TA) loan and two private sector operations. 3. Working in close coordination with other key development partners, notably the World Bank and the IMF, we have supported a process of institutional building, development of the legal framework, and sector privatization. Key outcomes of the Program are a fully-privatized commercial banking system capable of supporting the further development of Mongolia's private sector-led economy and an appropriate regulatory and supervisory framework. B. Comments on Lessons Learned

4. The PPER has identified some key lessons which we agree should be fed into the design and implementation of ADB’s future interventions in Mongolia’s financial sector. We note that a number of lessons from the Program have been already incorporated into the design of later projects, including Loan 2218-MON (SF): Financial Regulation and Governance Program. 5. Importance of Government Ownership. We fully agree with the PPER observation that the Program's success was the result of continuous Government commitment to and ownership of financial sector reform. However, we do not believe that ADB overestimated the political will to reform. In fact, uninterrupted government support for market-oriented reform, despite frequent changes of government, has been a notable feature of Mongolia’s transition. 6. Government's Capacity. We agree with the PPER observation that the lack of capacity often became a constraint on Government when it endeavored to move forward simultaneously on a wide range of reforms and the reform agenda should have been matched by capacity in the key government agencies, which even today needs further strengthening. 7. Choice of Executing Agency. The PPER's observations about the choice of executing agency are generally valid. However, we note that in the case of Mongolia in 1999, the Bank of Mongolia (BOM) was the only institution in the financial sector with any real capacity. Choosing the Mongolian Stock Exchange to implement the capital markets aspects of the Program, as recommended in the OED report, was not a viable option at that time.

C.

Comments on Follow-Up Actions

8. We generally support the follow-up actions proposed by the PPER. However, we offer the following comments on the individual follow-up actions. 9. Follow-up Action (i). We fully support the suggested follow-up action. We note that the draft laws on trusts and investment funds are being redrafted by the Financial Regulatory Commission (FRC). Staff will dialogue with the FRC and the Government on the timetable for their planned adoption. 10. Follow-up Action (ii). We support the follow-up action. We note that TA 4910-MON: Strengthening the Pension Reform, approved in December 2006, is already assisting the Government in its review of pension legislation. 11. Follow-up Actions (iii) and (iv). We agree with the PPER's suggestions related to nonbank and capital markets. We note that these issues will be addressed in a proposed TA for Capital Market Development to be processed in 2008. 12. Follow-up Action (v). The marginal viability of some of the smaller banks due to intense competition for deposits has been an important policy issue in Mongolia. We note that the BOM and the Government encourage consolidation of the commercial banking sector through mergers and acquisitions rather than seeking to strengthen smaller banks through equity participation. 13. Follow-up Action (vi). We note that the suggestion would be applicable for the larger banks, subject to the review of the current legal framework. 14. Follow-up Action (vii). We agree with the importance to support innovations in financial products. However, we believe that given the current development stage of the financial market in Mongolia, ADB should continue to place emphasis on the development of the emerging primary mortgage market. Securitization of mortgages will develop as gaps in the legal framework are remedied and the primary market demonstrates financial performance. 15. Follow-up Action (viii). In general, Mongolian enterprises are often too small to receive direct support from ADB's private sector window. However, ADB will continue to support the corporate sector through our operations in the banking sector. 16. We will remain engaged with Mongolia’s financial sector in a proactive manner. In addition to the ongoing TAs and loans supporting financial sector development, ADB stands ready to respond to the emerging needs of the country and will continue to support the reform and capacity building process through a combination of policy dialogue and advisory technical assistance.

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