FINANCIAL SECTOR ASSESSMENT REPUBLIC OF BELARUS

FEBRUARY 2006

EUROPE AND CENTRAL ASIA REGIONAL VICE PRESIDENCY FINANCIAL SECTOR VICE PRESIDENCY

BASED ON THE JOINT IMF-WORLD BANK FINANCIAL SECTOR ASSESSMENT PROGRAM

As part o f the jo in t IMF-World Bank Financial Sector Assessment Program (FSAP), two missions visited Belarus, one in September 2004 and the second in November 2004. The purpose o f the FSAP was to identi fy potential vulnerabilities and r isks in the financial system o f Belarus that could have macroeconomic consequences, to recommend measures to reduce those risks, and to identi fy appropriate areas for further development o f the financial sector. The team’ held meetings with the Ministry o f Finance (MOF), National Bank o f the Republic o f Belarus (NBRB), State Committee for Securities Supervision (SC), Belarus Currency and Stock Exchange (BCSE), commercial banks, insurance companies, and many other officials and market participants. The team produced several reports that were reviewed by and delivered to the authorities.’ A separate team visited Belarus in December 2004 to assess the preparedness o f Belarus for tackling money- laundering and combating the financing o f terrorism.

I. SUMMARY OF K E Y FINDINGS AND OVERALL STABILITY ASSESSMENT

1. The reform of the Belarusian financial system has been slow overall, with a centralized approach to managing the economy still predominant. Nevertheless, in its Banking Concept, the government has la id out its intention to move towards an efficient financial system with substantial private sector and foreign ownership over the coming years, and progress has been made in a few areas. The NBRB has stabilized the value o f the Belarusian ruble, and the technical infrastructure o f the financial system and its regulatory and supervisory framework has been significantly upgraded towards international standards.

2. desire for stability, mitigation o f the social costs of transition, and managed economic growth, but directed lending creates tensions and distortions. In this environment the norms for

The continuation of the present economic model in Belarus presumably reflects a

The FSAP team comprised Paula Perttunen (World Bank, Leader); Mark O’Brien (IMF, Deputy); Vassili Prokopenko, Jerome Vacher, Sibel Yelten, Veronica Bacalu (all IMF); Claire Grose and U l l e Lohmus (both Wor ld Bank); Arpad Kiraly, Walter Zunic, T o m Kokkola and Lorenzo Savorelli (all experts). The AMLEFT team comprised Terence Donovan, John Abbott and Antonio Hyman Bouchereau (all IMF), and Andrea Nicolai (Italian Guardia di Finanza) .

These were an Aide-MCmoire, Technical Notes, and Detailed Assessments o f Standards and Codes.

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analyzing a market-oriented financial system cannot always be directly applied. In the banking sector, moral hazard and adverse selection are inherent in the current framework whereby banks know that they will be recapitalized to cover losses, and thus have l i t t le incentive to assess r isk properly. Ma jo r banks are continually “recommended’y3 to lend to priori ty enterprises and sectors, irrespective o f whether or not they are profit-making. This has contributed to intermittent liquidity shortages and has undermined profitability, especially in the two largest banks.

3. swaps that do not provide fresh funds, thus increasing liquidity pressures. These banks have also received preferential supervisory treatment periodically, in the form o f forbearance f rom regulatory norms, to offset the impact o f recommended lending and rescheduling, and exemptions to contributions to the deposit insurance system. In 2004 the expansion o f credit accelerated, particularly by the two largest banks, under government-recommended lending programs to pr ior i ty sectors. Pressure o n liquidity was manifested by the sustained rise in interbank rates and the extraordinary measures taken to provide liquidity support to banks facing problems. In December 2004, the government completed another round o f recapitalization o f these two large banks.

The government has repeatedly recapitalized these two banks, at times by debt/equity

4. Fundamental restructuring of the financial system should start with a cessation, or at least a phasing out, o f directed lending. If this does not happen, i t will be impossible to develop a modern market-oriented banking system because incentives for the major banks to assess and price credit risk accurately will be absent. Whi le the ultimate goal should be privatization o f the major commercial banks, an early step should be to remove possible conflicts o f interest by excluding government ministers and NBRB officials f rom bank boards, and for the NBRB to dispose o f i t s shareholdings in banks.

5. o f the loss-making enterprises that are a source of many of the banking sector’s problems. A comprehensive program o f corporate sector reform i s needed to limit the role o f banks in supporting unprofitable sectors and enterprises. Any government funding o f enterprises, which i s currently provided indirectly in the form o f recapitalizing banks periodically to fund directed lending, should be shifted to direct and transparent enterprise subsidies only to those sectors that the government wishes to continue to support.

Financial sector reform needs to be implemented in coordination with restructuring

6. well as ad hoc administrative measures in the form of resolutions and decrees. Whi le the FSAP team’s assessment o f compliance with the Base1 Core Principles for Effective Banking Supervision (BCP) confirms that the banking supervision and regulatory framework has been significantly improved in recent years, there are a number o f areas where improvements can b e made. Most important will be to cease granting periodic supervisory forbearance to offset the negative impact o f the government’s recommended lending policies o n banks. The extensive tightening o f the golden share rule that deters private sector participation in state-owned companies should also be reversed.

The regulatory environment remains unpredictable owing to frequent changes, as

The presidential and governmental decrees on overall and sector and enterprise specific lending targets use the word “recommended.” I t i s unclear how mandatory these targets are to individual banks.

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7. Belarus has in place many elements o f Anti-Money Laundering and Combating the Financing o f Terrorism (AML-CFT). However for the A M L - C F T regime to be more effective, i t i s important that the authorities establish a clear distinction between the AML function and other controls applied to economic activity, such as taxes, customs and foreign exchange limitations.

8. In the near term, the structural liquidity shortage i s a key vulnerability fo r the banking system as long as banks continue to b e stretched by accelerating increases in recommended lending. This compounds problems in the implementation o f monetary and foreign exchange rate policies arising f rom targeted wage r ises and increased imports.

9. Owing to the low level o f international reserves, limited channels fo r foreign exchange liquidity, and significant levels o f foreign currency loans to unhedged borrowers, the banking sector i s also vulnerable to external shocks. These could include significant changes in the terms o f trade, a slow-down in the growth o f major export partners, contagion effects f rom possible banking sector uncertainty in Russia, or possible administrative measures by foreign governments.

10. I t i s doubtful whether the government can continue to provide support to large state banks without reversing the progress accomplished in macroeconomic stabilization, if the use o f the large banks for quasi-fiscal preferential lending to pr ior i ty economic sectors persists. Banks involved in such programs would need periodic large capital injections, whi le the structural liquidity problems would persist and probably worsen. Although important, technical improvements in the supervisory framework and capacity will not alone suffice to counter these problems.

1 1. The FSAP team has focused on the present situation o f the Belarusian financial system, but notes that currency unification w i th Russia would make it dif f icult fo r Belarus to continue i t s substantial support to the major banks. Strengthening and restructuring o f the banking system should take place pr ior to adoption o f the proposed currency union.

11. SUMMARY OF POLICY RECOMMENDATIONS

12. The key recommendations o f the FSAP team are summarized below.

H i g h Pr ior i ty Short-Term Recommendations

a Commence fundamental financial sector reform, with an essential first step o f stopping, or at minimum curtailing, recommended (Le. directed) lending.

Develop a comprehensive bank restructuring program, including the fol lowing key measures:

o Remove non-performing “recommended” loans f rom banks’ balance sheets; o Change the composition o f government banks’ boards; o Refrain f rom measures that create moral hazard and distort the financial markets, such

as ad hoc and non-transparent liquidity support measures; and o Eliminate caps o n lending rates and informal recommendations to banks to lend at un-

remunerative interest rates close to the refinance rate.

Increase the independence o f the NBRB, and give banking supervision greater autonomy.

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Enhance and better enforce the system o f bank supervisory remedial measures.

Increase bank borrowers’ awareness o f the r isks impl ied in un-hedged foreign currency lending.

Enact a draft AML law to provide for a Department o f Financial Monitor ing o f the State Control Committee (DFM) as the centralized Financial Intelligence Unit (FN) for the country, with adequate resources.

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Medium-Term and Developmental Recommendations

e Accelerate the transition to International Financial Reporting Standards (IFRS), especially in the banking sector.

Amend the deposit insurance system to limit moral hazard and create a level playing f ield for a l l banks, but exercise caution in i t s sequencing with other banking reforms given the structural liquidity shortage.

Reverse the recent expansion o f the golden share rule and consider i ts gradual abolition.

Consolidate a l l substantive legal provisions in the L a w o n Securities and Stock Exchanges and remove inconsistencies with other laws, such as the Civil Code.

Enhance shareholder protection and require full and t imely disclosure o f financial results.

Implement a phased opening o f the insurance sector to domestic and foreign private competition, reduce excessive regulation, relax licensing, tar i f f setting and controls, and implement a more level playing f ield for the taxation o f insurance premiums.

Strengthen the role and independence o f the insurance supervisory authority to ensure adequate on-site and off-site supervision.

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111. MACROECONOMIC ENVIRONMENT

13. Despite improvements in stabilizing its economy in recent years, the macroeconomic outlook for Belarus i s still difficult. In 2004 GDP growth o f 11 percent in real terms was fueled by a consumption boom and increased public spending, but such rapid growth appears unsustainable. Increased consumption has been driven by administrative wage increases exceeding the growth o f productivity and by strong credit growth, especially by channeling public funds to support several different sectors o f the predominantly state-owned economy, many o f which are unvi ab 1 e.

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Table 1. Belarus: Key Macroeconomic Indicators, 2000-2004 2000 2001 2002 2003 2004

Growth in real GDP (percent) 5.8 4.7 5.0 7.0 11.0 Consumer prices, end o f period (y-0-y), % 107.5 46.1 34.8 25.4 14.4 Ruble/US$ parity (end o f period) 1,180 1,580 1,920 2,156 2,170 General government

Revenue (percent of GDP) 45.7 44.9 44.6 45.8 46.2 Expenditure (cash), (percent o f GDP) 45.9 46.8 46.4 47.2 46.2

Banking System net domestic credit (12- 118.1 66.4 53.7 68.9 35.8 month growth in percent) Ruble Broad Money (1 2-month growth in %) 124.1 96.9 59.6 71.0 58.1

Balance (cash), (percent o f GDP) -0.2 -1.9 -1.8 -1.4 0.0

Current account balance: in US$ millions -323 -394 -311 -424 -1,043 as percent o f GDP -2.5 -3.2 -2.1 -2.4 -4.6

Off icial reserves (in months o f imports) 0.5 0.5 0.6 0.5 0.6 Source: Belarusian authorities and Fund staff estimates.

14. and the financial system. Inflation fe l l to a record low o f 14.5 percent for 2004 (fi-om 25.4 percent in 2003), and the NBRB refinance rate, which i s required to be used as the basis for pricing many financial assets, was decreased in parallel to 17 percent (from 28 percent in 2003). The reduction in inflation was supported by the cessation o f NBRB inflationary financing o f the budget deficit in 2004. Exchange rate stability in 2004 also contributed to the slowdown in inflation and some de-dollarization o f banking sector deposits. However the banking system remains substantially dollarized, with about half o f total bank deposits and loans to residents being denominated in foreign currencies. Furthermore government programs have pushed banks to lend for long-term housing construction and agriculture, contributing to a liquidity shortage in the system.

Current monetary and exchange rate policies pose some challenges to the economy

15. of risk for the financial system. Whi le traditional trade l inks with Russia, i t s main trading partner, have helped to maintain growth, the reliance on one trading partner renders Belarus susceptible to external shocks. Moreover, foreign reserves remain low at less than 0.6 months o f import cover, limiting the N B R B ’ s ability to maneuver, or to absorb shocks.

The trade concentration of the highly open Belarusian economy i s a potential source

16. remains difficult. The high share o f loss-making enterprises, high tax rates, and the scale o f arrears in the economy, cast doubt on the reported stable and low level o f overdue bank loans. The overall quality o f financial information on the enterprise sector i s poor, which undermines banks’ ability to assess borrowers’ capacity to repay loans.

Despite the recent economic growth, the financial situation of the enterprise sector

17. Administratively determined wage increases put additional pressure on enterprises and public finances. Real wages grew by 16.8 percent in 2004, compared to 2.9 percent for the previous year. Wage increases in 2004 were aimed at reaching the targeted equivalent o f US$190 by end-year. Realization o f the official wage target o f US$250 by end-2005 would create substantial pressures on the budget, as well as on enterprises. This could translate into higher non- performing loans (NPLs) for banks and a further need for recapitalization. The considerable share o f non-monetary payments between enterprises implies persistent illiquidity at least in some sectors.

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IV. FINANCIAL SECTOR OVERVIEW

18. total assets o f banks are equivalent to around 30 percent o f GDP, while the insurance sector and the capital market each accounts for less than 1 percent o f GDP (Table 2).

The Belarusian financial system i s dominated by banks, especially the six largest. The

Table 2. Belarus: Structure o f Financial Sector, 2000-2004

2000 2001 2002 2003 2004

Number o f licensed banks o f which state-controlled o f which with majority foreign participation

Number o f bank branches Assets o f commercial banks (percent o f GDP)

Number o f licensed insurance companies Gross Written Premiums (BYR billion) (%) Penetration Ratio: Gross written premiums/GDP

Number o f exchange bureaus

Value o f transactions in government securities (BYR billion)

Value o f transactions in shares in BCSE (BYR billion)

28 7 6

529 29.5

42 55

0.64

983

25 5 9

509 25.5

37 120.8 0.70

1427

1811

0.09

28 5

12 478 25.7

35 165.4 0.63

1998

3646

0.80

31 6

18 473 29.5

33 215.4

0.60

2443

5097

1 1.90

32 6

19 463 31.2

31 390.1

0.79

2914

81 19

0.18

Value o f transactions in shares on OTC (BYR billion) 10.79 9.57 12.10 29.75 Source: Belarusian authorities.

Banking Sector Overview

19. assets and about 90 percent o f the total capital o f the banking system. The largest domestic savings bank accounts for about 42 percent o f system assets and 62 percent o f retail deposits. The SIBS are authorized for participation in state programs, involving recommended lending to priority sectors, programs and companies on preferential terms. Such loans are often guaranteed by central or local governments and/or recommended by official decrees and resolutions.

The six systemically important banks (SIBS) constitute about 87 percent of the total

20. was 25.2 percent at end-2004, but Belarusian accounting and asset classification practices give an upward bias to the reported CARs. With the exception o f one small bank, all banks reportedly comply wi th the capital requirements. However the team estimated that adjusting for the distortions could result in reducing the average CAR o f the banking sector by a quarter, to around 19 percent, with several o f the largest banks potentially having CARs below 10 percent. An NBRB instruction issued in June 2004 lowered the required minimum CAR from present 12 percent to 8 percent for newly set up or reorganized banks after two years o f operations, effective starting January 2005.

The reported average capital adequacy ratio (CAR) [capital to risk-weighted assets]

21, recent years. Capital injections by the government in state banks (notably in Belarusbank and

Periodic government recapitalizations o f key state-owned banks have been large in

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Belagroprombank) rose f rom 0.7 percent o f GDP in 2000 to 1.6 percent o f GDP in 2003, and were 1 .O percent in 2004, consistently exceeding total loan write-offs in the banking system.

22. (debt/equity swaps) that do not provide fresh liquidity to the system. Typically, the government has converted into equity i ts refinancing o f recommended loans to recapitalize Belarusbank and Belagroprombank. Some recapitalizations have been made through government capital injections f rom proceeds o f i t s o w n securities placed in the same bank. These approaches do not add liquidity in the system and indeed may increase the liquidity demand going forward.

Many recapitalization schemes used by the government are de facto book transactions

23. end-2004). Other earning assets included government and NBRB securities (about 7 percent) and inter-bank assets (1 0 percent). On average, the balance sheets o f Belarusian banks are short-term - only 29 percent o f assets and 7 percent o f liabilities have maturities longer than a year. However, some state banks hold long-tern assets leading to liquidity problems and some interest rate exposure.

Banks’ balance sheets are dominated by customer loans (68 percent o f assets as of

24. o f deposits and lending denominated in foreign exchange has fallen since 2000. Between the end-2000 and end-2004, the share o f deposits denominated in foreign currencies dropped f rom 72 percent to 47 percent, whi le the share of foreign currency loans declined f rom 55 percent to 44 percent. Banks face indirect credit risk o n their foreign currency loans, since borrowers without foreign currency earnings might be unable to repay if there were to be a substantial depreciation.

The economy of the Republic of Belarus remains highly dollarized, although the share

25. Central government guarantees to support bank credits increased sharply in 2004 but were set to fall in 2005. The annual limit for central government guarantees o n loans extended by banks was raised f rom 0.3 percent o f GDP in 2003 over 1 percent o f GDP in 2004. A limit o f BYR 200 b i l l ion for central government guarantees (0.5 percent o f GDP) was envisaged for 2005.

26. concentrated in the agricultural sector (60 percent) and housing construction programs (40 percent). At the end o f 2003, loans extended by Belagroprombank and Belarusbank under government programs for housing and agriculture amounted to nearly 19 percent o f total credit to the economy. In 2004, recommended lending amounted to 4.3 percent o f GDP. A s o f October 1, 2004, recommended loans were estimated to account for about 70 percent o f Belagroprombank’s and for 23 percent o f Belarusbank’s credit portfolios respectively.

The practice of recommended lending prevails and such lending has been

27. loans by Belagroprombank are for agriculture, while loans to the industrial sector constitute about 70 percent o f Belpromstroibank’s and Belvnesheconombank’s loan portfolios. In addition, portfolio concentrations at the enterprise level also appear to be considerable, owing to regulations that restrict enterprises to holding local currency accounts in only one bank and numerous exemptions o n legal lending limits to one client. The periodic issuance o f exemptions by the NBRB to the maximum legal lending limit to a single client i s also indicative o f probable loan concentration.

Many banks have a high sectoral lending concentration. For example, 56 percent o f

28. The reported ratio of non-performing loans to total loans has been declining. The NBRB instructed banks to reduce their NpLs (defined as loans overdue) to below 5 percent by

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end-2003, a target which was reported to have been met. In December 2004, reported N P L s amounted to 4.6 percent, down from 13.4 percent in December 2001. According to the authorities the decline in NPLs partly reflected the rapid growth in the bank lending, and was facilitated by a mid-2002 amendment by NBRB to the loan classification rules, enabling banks to clear the stock o f the o ld NPLs more aggressively. Other contributory factors may also include (i) “evergreening” (rolling over) o f loans; (ii) issuance o f government guarantees which doubled in nominal terms in 2003 and increased rapidly in 2004; and (iii) recommended restructurings o f loans.

29. are likely to lead to higher levels o f NPLs as the loans fall due. Notably the reclassification o f a loan i s usually required only after the second roll-over. For loans over one year, only the overdue portion i s reclassified which i s contrary to sound practice. Presidential decrees that mandate lending or restructuring also appear to render substandard loans standard, and banks seem to have significant discretion for classifying as good various government-guaranteed loans. These factors, coupled with rapid loan growth in 2003 and 2004 raises concern about future NPL levels. Having doubled during the period 2000-02, bank loans grew by 58 percent in 2003 and by around 63 percent in 2004.

Lax loan classification regulations and practices, combined with rapid loan growth,

30. weak, enforcement being particularly difficult against state enterprises. Recent amendments to the existing legislation governing bankruptcy procedures and the enforcement o f creditor’s rights further complicate debt recovery. Moreover, the Housing Code prohibits seizure o f housing property, undermining the realization o f collateral for mortgage loans to households.

Legislation governing debt recovery and creditors’ rights i s complex and its execution

3 1. Lending rates are affected by administrative measures restricting the ability o f banks to price risk adequately, especially for longer term loans. Interest rates on loans in foreign currency are capped, and interest margins for ruble loans are limited by a general recommendation to lend at the refinance rate plus 3 percent. Banks compensate for these restrictions by charging fees and commissions, leading to non-transparent pricing that disguises the true cost o f funds.

32. 2004, but overall banking sector profitability i s low. In 2004, the average reported return on assets was 1.4 percent, and return on equity only 6.2 percent. The real position i s probably worse, as several banks appear to be under-provisioned.

Despite a contraction in interest margins almost all banks reported profits as of June-

33. The liquidity situation of several systemically-important banks i s o f concern. In 2004 the aggregate ratio o f liquid assets to very short term liabilities (both wi th a maturity o f less than one month) was only 63 percent, below the prudential minimum o f 70 percent. This average masked a wide variation in the liquidity o f individual banks, from only 37 percent to as much as 90 percent across the ten largest banks. While most banks reported comfortable liquidity ratios, the liquidity o f the largest bank in the country i s low, constrained by long-term government recommended credits.

Securities Markets

34. Belarus began in 1993 following the introduction o f a mass privatization voucher scheme, but shares received through vouchers and employment share schemes are subject to a moratorium on

The capital market i s in early stages of development. The securities market in the

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trading. The pace o f privatizations has been slow and strategically important state assets have not been included in the scheme. Whi le 836 national SOEs and 898 municipal SOEs have been fully or partially “privatized”, this means corporatization in the Belarusian context rather than sale to private investors, and the State Property Fund continues to ho ld a majori ty position in 931 companies.

35. licensed by the State Committee on Securities to operate in Belarus. I t i s an electronic market that conducts a currency exchange, primary auctions and secondary trading in securities. By law, securities listed on BCSE can only be traded o n BCSE. Secondary market trading includes ruble- denominated government securities, NBRB bonds, and shares and bonds in listed companies. The most active segment i s trading in government securities and there i s almost n o trading in corporate securities. Secondary trading i s very low, with only 45,000 transactions executed in 2003.

The Belarusian Currency and Stock Exchange (BCSE) i s the only stock exchange

Insurance Sector

36. The small insurance sector has a low volume of total premiums (around US$180 million at end-2004) and has been stagnating in real terms in recent years. The insurance penetration ratio (Gross Writ ten PremiumdGDP) in 2004 was only 0.8 percent (o f which 0.5 percent mandatory and 0.3 percent voluntary), compared with 2 percent in Ukraine, 3 percent in Russia, and double digit figures in OECD countries. Most insurance business i s placed with state- owned companies, notably Belgosstrakh which accounts for two-thirds o f a l l premiums and enjoys a virtual monopoly in Moto r Third Party Liabi l i ty (MTPL) and other compulsory insurance lines.

37. a small base and new products had been introduced, but recent measures to limit private and foreign participation in the insurance sector have arrested its growth. Private insurance activity developed quite rapidly f rom 199 1 to 1995 - the number o f companies exceeding 100 - but then consolidated, owing to stricter supervision and enforcement o f regulation, at about 30, including a small number o f foreign stakes. However per capita income levels are low, inf lat ion has been high and trust in insurance mechanisms was damaged by the 1991 default o n a l l outstanding insurance savings promises to citizens after the collapse o f the Gosstrakh centralized insurance system.

Until 1995 private companies’ share of the insurance market had been growing from

v. VULNERABILITIES AND DEVELOPMENT OPPORTUNITIES IN THE FINANCIAL SECTOR

Systemic Liquidity

38. Liquidity in the banking system tightened in the second half o f 2004, when the average ratio of liquid assets to short-term liabilities declined to below the prudential minimum established by the NBRB. The decline in systemic liquidity was largely centered in Belarusbank and Belagroprombank, which have a structural demand for liquidity to fund programmed lending to the economy. These two banks customarily pay higher rates o n deposits than other banks, despite their full state deposit guarantee at no cost. N o t surprisingly these two banks represent about two thirds o f interbank borrowing, with the remaining banks mostly acting as liquidity providers. The market i s very short term: o n average, more than 85 percent o f the transaction volume in 2004 was overnight or intraday. The shallow and fragmented market i s volatile and vulnerable to both domestic and international developments.

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45. and the central bank. The secondary market for government short-term bonds (GKOs) and government long-term bonds (GDOs) i s shallow, and the primary market for these instruments does not appear to respond to market signals or to banks’ liquidity needs. Foreign currency government bonds (VGDOs) are not tradable and cannot be used as collateral for operations with the NBRB.

Banks have limited possibilities to find liquidity quickly outside the interbank market

46. The conduct o f monetary policy i s complicated by the extended periods during which interbank rates exceed overnight credit rates and by increased recourse to central bank refinancing. Structural liquidity problems should be tackled through fundamental banking sector reforms rather than through ad hoc and non-transparent liquidity provision to individual banks. The authorities should refrain f rom measures that create moral hazard and distort the interbank market, such as exemptions o n mandatory reserve requirements, caps o n interest rates, and directing state-owned entities to make deposits with banks to improve their liquidity.

47. While interest rates on interbank foreign currency transactions have been less volatile and relatively lower than domestic currency rates, a high dependence on non-resident banks i s not without r i sks . Despite increased confidence in the domestic currency evidenced by a rapid growth o f ruble deposits, Belarus remains a highly dollarized economy. Demand for foreign currency has risen owing to several factors, notably increased imports in some sectors.

48. obtaining foreign currency liquidity are limited as well. A sudden withdrawal o f foreign currency liquidity could be disruptive. Foreign currency sources include savings deposits, export proceeds, a l imi ted number o f credit lines, and foreign banks operating o n the interbank market. NBRB m a y wish to consider building some buffer against sudden market movements by al lowing banks to maintain in foreign currency their mandatory reserves required for foreign exchange deposits.

Official foreign reserves are limited, at two weeks o f imports, and the channels for

Banking Sector Stability and Stress Tests

49. and profitable, though liquidity indicators represent a cause fo r concern. However reported data are based o n Belarusian Accounting Standards (BAS) that may significantly overvalue the amount o f regulatory capital and some other indicators compared to IFRS.

According to the reported data o f the NBRB, the Belarusian banking sector i s sound

50. The key systemic risk fo r the banking sector i s the government’s ability to continue providing support to the state banks, in the fo rm o f liquidity and equity. A s loans to pr ior i ty sectors or enterprises are of ien granted in accordance with government recommendations, banks may not adequately assess repayment capacity, especially when there i s an explicit government guarantee. Any deterioration in the government’s fiscal position would limit i t s abi l i ty to provide further such support to banks, potentially leading to a systemic financial unrest.

5 1. 31 commercial banks as o f end-June 2004, but there i s an over-capitalization bias in the data used, arising f rom local accounting and asset classification practices. Adjustments were made to offset the bias, resulting in a reduction o f the capital adequacy ratio o f the banking sector by a

The team conducted stress tests using balance sheet data provided by the NBRB for

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third, f rom almost 30 percent to around 18.5 percent. Whi le this lowers the accuracy o f the stress tests, they should st i l l give a fair indication o f the direction and size o f the impact o f a presumed shock.

52. Stress tests were performed for each individual bank and for five different overlapping groups of banks.4 The stress tests found that many o f the banks are vulnerable to credit and liquidity shocks, which could be amplified by features o f the economy such as the high proportions o f loss-making enterprises, foreign-currency-denominated loans, and long term banking assets. The reported and adjusted aggregate CAR for Group 1 (6 largest), Group 2 (state-owned), and Group 5 (all banks) as we l l as the aggregate stress test results for these banks are substantially affected by the capital position o f one bank, whose situation deserves special mention.

Securities Market and Insurance Sector

53. though there are some impediments to secondary market trading. A pre-depositing requirement for funds and securities i s inefficient and may hamper investment activity, although it l imi ts failed trades and prevents the need for a settlement guarantee. The overall regulatory environment for the protection o f property, contractual and other economic rights i s deficient and does not create solid foundations for building a well-functioning securities market.

The basic technical infrastructure for the nascent securities market i s quite good

54. Some of the current practices in government debt issuance are not conducive to capital market development. Transparency in the direct placement o f government bonds could be improved. Foreign exchange denominated government long-term securities are not tradable and they can be called at discretion before maturity, so their liquidity i s questionable.

55. The golden share rule, which was strengthened considerably in March 2004 by a presidential decree, represents a serious deterrent for investors. The golden share can be applied for an unl imited duration to any company (including those 100 percent privately owned) that was previously owned by the state. Reportedly the share would only be applied in case o f anti- competitive conduct o n the part o f a company, possible liquidation, failure to pay tax, and failure to pay employees’ salaries for a period o f 6 months, but this i s scant comfort to investors.

56. to the government from redemption of unused vouchers at present face value i s around US$ 400 million equivalent or about 12 percent o f the annual budget. N o strategically important state assets have been included in the slow paced privatization program. The state essentially controls the economy although approximately 35 percent o f state-owned assets have been corporatized, covering 40 percent o f state employees. By law, at the end o f the privatization program, unused vouchers may be redeemed for cash at face value. However, the end o f the program has been successively extended to end-2004 and end-2005, deferring crystallization o f the government’s liability.

The voucher privatization program has not been a success and the contingent liability

Group 1 comprised the six largest banks, accounting for 85 percent o f the market in terms o f assets as o f June 2004; Group 2 comprised state-owned commercial banks (6 banks); Group 3 comprised local private banks (7 banks); Group 4 comprised foreign banks (1 8 banks); and Group 5 comprised al l commercial banks (3 1 banks).

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57. A series o f policy measures implemented in 2002 by the government and presidential administration reversed earl ier positive trends in the insurance market, limiting competition and prompting private (especially foreign) companies to leave the market. Private insurers have seen their business dramatically reduced and many are seeking to sell their shares to the state. The measures effectively prevent private companies from accessing the largest and most profitable segment o f the market, namely compulsory lines o f insurance such as MTPL, as f rom 2004.

VI. THE POLICY FRAMEWORK FOR FINANCIAL STABILITY

Financial Safety Nets and Crisis Management

58. The system o f deposit insurance run by the Reserve Corporation i s characterized by preferential treatment o f authorized banks, especially Belarusbank and Belagroprombank, which benefit from a full guarantee on all their deposits without being required to pay contributions to the Guarantee Fund. Foreign currency deposits are fully guaranteed in the other four authorized banks: Belpromstroybank, Belinvestbank, Belvnesheconombank, and Priorbank - and local currency deposits in these four authorized banks are covered up to U S $ 1,000 equivalent. These other four banks pay to the Guarantee Fund a monthly premium equal to 0.1 percent o f their household deposits. All other banks are covered up to US$ 1,000 equivalent both for their local and foreign currency household deposits and they pay differential monthly premiums according to the level o f deposits f rom 0.1 to 0.3 percent o f household deposits.

59. by requiring al l banks (including state-owned banks) to pay a quarterly premium of 0.3 percent on their deposits. This level o f premium i s high by international standards, but can be just i f ied for a period whi le the Reserve Corporation builds up its resources f rom its present l o w base. Overhauling the deposit insurance scheme should reduce the government’s contingent liabilities by about U S $ 80 mil l ion.

Envisioned changes in the deposit insurance legislation would level the playing field

60. The bank resolution process should be made more efficient so that NBRB may react consistently and promptly to information indicating that a bank i s in violation o f prudential and regulatory requirements. Failure by a bank to rect i fy i ts situation without delay should lead to a threat o f increasingly onerous penalties. If a bank fails to take adequate action, the NBRB should be empowered to take corrective action, such as replacing management, seeking a take- over, or even closing the bank. Bank resolution should be guided by principles o f prompt corrective action, least-cost based reorganization, deposit safety, and systemic stability. Any recapitalization o f an under-capitalized bank should be accompanied by a solid restructuring program.

61. The NBRB should establish an early warning system and formalize contingency planning for handling problems in individual banks, focusing on (i) liquidity;(ii) stress testing; and (iii) bank insolvency. An effective solution could be to designate a separate unit within the NBRB for monitoring systemic stability. Accepted practice wou ld be to establish a clear sequencing o f actions and criteria for their application. Currently, liquidity provision for troubled banks i s ad hoc, often at below the refinancing rate, and o n occasion without collateral. Safeguards are needed to ascertain that liquidity provision i s l imi ted over t ime and does not impact monetary operations.

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VII. FINANCIAL REGULATION AND SUPERVISION

Bank Regulation and Supervision

62. strengthening of the banking system. Various provisions o f the Banking Code cover registering and licensing banks, regulating their activities, and exercising continuous control over banks’ observance o f the banking law.

The statute of the NBRB defines that among its objectives i s the development and

63. An assessment of compliance with the Base1 Core Principles (BCP) undertaken by the team found that the NBRB fulfills its responsibilities of authorization, regulation and supervision of financial institutions through its Banking Supervision Directorate (BSD). The B S D performs both offsite and onsite supervision and comprises 129 specialists, o f which 62 are at the head office and 67 in regional offices. The objective o f the B S D i s to ensure confidence in and the stability o f the banking system and to reduce the r isk o f loss for banks’ creditors and depositors.

64. The underlying regulatory framework for banking supervision i s reasonably comprehensive and also broadly consistent with international practice. Since being restructured in 2001, the B S D oversight process has been improved, and since 2003 the B S D has moved f rom the transaction testing supervision approach to a more risk focused approach based on a qualitative assessment o f the financial condition o f a bank and the prospects for i ts development. The B S D examiners use a CAMEL-type assessment in their on-site examinations.

65. Nevertheless, there are a number of areas where banking supervision could be improved. Market discipline i s currently weak owing to guarantees provided by the government to state-owned banks for loan losses, and the long-standing nontransparent disclosure o f banks’ financial condition. To compensate partially for fo l lowing the government’s recommended lending policies, the major banks are sometimes granted temporary supervisory waivers. The most important steps to be taken to improve supervision in the short term are:

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The B S D should introduce a comprehensive Manual o f Examination Procedures.

The current system o f remedial measures needs to be made more specific.

Banking supervision should be given more autonomy through strengthening the institutional standing o f the Director o f the Bank Supervision Directorate.

Licensing processes should be strengthened and the Banking Code amended in order to give NBRB the right to conduct a full analysis o f a bank’s ownership structure, to reveal the true beneficial owners o f a bank and to assess their potential influence on its activities.

To enhance transparency in the ownership structure o f banks, the limit for a significant ownership in a bank to be approved by NBRB should be decreased fi-om 10 percent to 5 percent. The NBRB should also be granted the power to analyze shareholdings in banks below the new 5 percent limit if needed. Until approval i s granted, voting rights and payment o f dividends to such shareholders should be suspended.

A separate division within the NBRB, but outside the BSD, should be created to handle the temporary administration and liquidation o f banks, thereby al lowing the B S D to focus on its core task o f supervising banks on an ongoing basis.

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0 Specific legislative provisions should be passed to protect NBRB supervisory staff against law suits for measures taken in good faith against a financial institution.

IFRS standards for banks’ financial statements should be introduced quickly. Accounts prepared under Belarusian Accounting Standards do not reflect the true financial condition o f the banks and could cause the banks to pay taxes on phantom profits.

66. Conflict o f interest issues are present as the NBRB i s both the supervisor o f banks and a shareholder in four banks. Senior ministers and members o f the Board o f NBRB are also seated on the boards o f the larger banks. T o limit actual or apparent conflicts o f interest, the NBRB should dispose o f i t s bank shareholdings, and government ministers and NBRB officials should cease sitting on the boards o f any commercial banks. Whi le the ultimate goal would be privatization o f the state banks, the near term objective should be that bank managements and boards comprise professionals with incentives to focus solely on viable banking activities.

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67. NBRB should introduce a new provisioning category between the Standard and Sub- Standard categories with a 10 percent provisioning and a general provision o f 2 percent fo r a l l loans. These changes would give banks more f lexibi l i ty in evaluating the financial condition o f the borrower, increase adherence to the prudential requirements and enable banks to safeguard against a general worsening o f the economy. These modifications would require additional provisioning at some banks, so an adjustment period o f two years i s suggested.

68. free trade zones o f Belarus should be repealed. Banks established in the free trade zones for the purpose o f conducting banking operations with free trade zone residents and non-residents o f Belarus should not be permitted to conduct banking operations with banks registered on i t s territory.

Recent regulatory amendments that liberalize the activities o f banks established in the

Securities Marke t Regulation and Supervision

69. constantly changing, which undermines the confidence o f investors, intermediaries and issuers. The market i s governed by a Securities L a w enacted in 1992 which was subsequently amended twice, most recently in 2002. A plethora o f other laws, ru les and regulations also apply.

The legal and regulatory regime fo r the securities market i s complex, and has been

70. (SC) which handles (i) government regulation and oversight o f the securities market; (ii) the issue, trading and registration o f securities; and (iii) licensing participants and intermediaries in the securities market. The SC licenses and supervises 129 legal entities, and examines and supervises around 4,000 attested individuals employed by market participants as a condition o f their license. The SC’s responsibilities extend to securities dealings by banks, the most active participants in both primary and secondary markets.

The pr imary regulator o f the securit ies market i s the State Committee on Securities

71. The SC lacks operational independence, has limited enforcement powers, and i t s staff do not have sufficient s k i l l s and resources to respond quickly to the regulatory requirements o f an active securities market. The Chairman o f SC (who i s a member o f the Counci l o f Ministers) is appointed (and can be removed) by the President o f Belarus. Whi le the Chairman has day-to-day responsibility for decisions taken by the SC, he appears to have l i t t le real autonomy and al l important matters are referred to the Counci l o f Ministers for decision.

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Insurance Sector Regulation and Supervision

72. partially modified by subsequent laws and presidential decrees. The L a w defines insurance notions, products and market participants; governs the establishment o f insurance companies, brokers and intermediaries. I t also establishes procedures for licensing, financial reporting, solvency criteria and sanctions. However the law limits foreign ownership o f Belarus insurance companies to 49 percent o f a company’s capital.

The Insurance Law issued in June 1993 i s comprehensive and modern, but it has been

73. duties. The supervisory authority was originally established as a separate body, but it was downsized in 2002 and converted into the insurance supervision department o f the MOF which was a step backwards. The ma in functions o f the insurance supervisor are: to register and license insurers, re-insurers, brokers, and intermediaries; to ensure compliance with the l aw o f a l l participants; to provide accounting and reporting rules; to supervise tar i f f rates and reserving levels; and regulate foreign insurance activity. Staff levels should be restored, and the department should be granted more autonomy again if i t i s to cope successfully with a developing market.

The Insurance Law created a supervisory authority and defined its powers and

74. The regulatory system includes most key norms foreseen by international practice, including a definition of solvency margin according to EU directives, but it lacks several important features. These include the application o f IFRS, corporate governance norms, asset safe custody and segregation rules, discount rates and mortal i ty tables for mathematical reserves calculation, and rules for group consolidated control and treatment o f derivative products. The regulations establish a strict licensing process for a l l new insurance products, and strict controls and guidelines for tariffs and commissions, which are set by law.

75. hands. The new C i v i l Code in 1998 and Decree No. 20 o f September 2000 “On Insurance Business” introduced some desirable changes such as the segregation o f l i f e and n o n l i fe business; and an increase in minimum capital requirements; but at the same t ime introduced several restrictions o n the operations o f foreign investors and companies. In 2002 a presidential resolution l imi ted MTPL compulsory insurance to state-owned companies, and differentiated the tax treatment o f insurance premiums as between state and non-state insurers.

Recent years have brought a concerted effort to move insurance activities into state

Prevention of Money Laundering and Combating the Financing of Terrorism

76. criminalized. Financial institutions must monitor and report financial transactions subject to special controls and take other measures to deter money laundering. Compliance supervision i s detailed with a strong culture o f on-site examination. T w o agencies exercise financial intelligence responsibilities. Money laundering offences are investigated and successfully prosecuted. Some capacity exists to cooperate internationally.

Belarus has many of the elements of a modern AMLEFT regime. Money laundering i s

77. implementation, undermine the full effectiveness of the AMLEFT effort. On several key points arrangements fa l l we l l short o f FATF Standards. Legislation needs to be updated; functions o f relevant agencies need to be streamlined and better coordinated; supervisors need to place more emphasis o n detection, deterrence, and reporting o f truly suspicious transactions; financial

However gaps in the current legal and institutional arrangements, and incomplete

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intelligence needs to be centralized in a single agency; and provisions for international cooperation need to be strengthened. The authorities are aware o f the need to update and reshape the present AMWCFT regime and they are wel l advanced o n a reform agenda.

Payments System

78. NBRB within the framework of the Automated System of Interbank Settlements. The system has two components: (i) the Belarus Interbank Settlement System (BISS), providing real-time gross settlement, in central bank money, primarily for high-value local currency transactions; and (ii) the N B R B ’ s clearing system for the net settlement o f large volumes o f low-value interbank transactions. The BCSE operates a clearing and settlement system for securities and card payments are handled by the BelCard scheme. Net balances arising in these two systems are settled in BISS.

The core elements of the interbank payments system are owned and managed by the

79. improvements in the following areas would be needed to achieve full compliance with the Core Principles for Systemically Important Payment Systems:

While BISS in general has proved to be a technically well functioning system,

e There i s currently a structural l imitat ion on liquidity available in the RTGS system, which could be resolved if the authorities were to al low a greater share o f reserve holdings to be used intraday for payment purposes, taking due care o f the potential risks.

e Unl imited intraday credit could also be granted to the participants. Payments discipline should be improved whi le at the same t ime substantially shortening the operating time.

e Effective and transparent governance needs to be established by introducing an oversight function for the NBRB, which should make public its objectives and policies for the payments system. The NBRB should also establish a time-bound action p lan for addressing the shortcomings identified in the assessment o f compliance with the Core Principles.

Transparency in Monetary Policy

80. NBRB i s not completely independent. As noted in the IMF safeguards assessment o f December 2003 “the NBRB i s accountable to the president, the chairman o f the board i s a member o f the government, the property o f the NBRB is owned by Belarus, and although ‘managed’ by the NBRB, such property cannot be disposed o f without permission o f the president; similarly, the approval o f the N B R B ’ s annual budget must be confirmed by the president. This impacts the transparency o f monetary policy.”

Belarus observes many aspects of transparency in monetary policy, except that the