Information about Asia and the Pacific Asia y el Pacífico

Chapter 7. Addressing Financial Sector Vulnerabilities

Alfred Schipke
Published Date:
April 2015
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Information about Asia and the Pacific Asia y el Pacífico

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Financial sector development and deepening are broadly seen to be essential to long-term growth because they enable saving and facilitate investment (see Chapter 6 on Financial Sector Deepening). Although the nexus and direction of causality between growth and financial deepening are subject to debate, the two are clearly linked. Few, if any, of today’s dynamic emerging markets—the frontier and developing economies of the 1980s and 1990s—experienced high and sustained levels of growth without an accompanying increase in financial deepening. Virtually all of today’s Asian emerging markets boast highly developed banking and financial intermediation, effective capital and foreign exchange markets, and close links to global financial systems.

With change and growth come new risks. Financial innovation and development—when poorly supervised or unregulated—can, in some cases, negatively affect macroeconomic stability. Perhaps more than any other sector, finance brings with it a potent mix of opportunity and risk. The Asian financial crisis of the late 1990s underscored the critical vulnerabilities to which rapid (and unsupervised) growth in banking and capital markets can give rise. Poor risk management, overexposure to cyclical economic activity, weak governance, and directed and connected lending are only some of the potential hazards. These problems and associated risks can also be exacerbated as cross-border linkages grow, and can ultimately prove costly to output, international reserves, and public finances in the event of a crisis (see Chapter 2 on the Recent Experience of Emerging Markets).

Some of the risks facing frontier and developing Asian economies have parallels with the Asian emerging market economies of the 1990s.1 These similarities include rapid financial sector growth in the context of low supervisory capacity; poor risk management; nonbank financial activity (shadow banking), which may or may not be appropriately licensed and supervised; and, although still at an early stage, growing links with global financial markets (Ostry 1999). Also, state banks have a significant presence in many frontier and developing Asian economies, and often have ties to state enterprises. Some economies, as part of a development strategy, also engage in directed credit operations, which can impose quasifiscal liabilities and impinge on the profitability of private banks.

This chapter provides a snapshot of financial sector developments and risks in frontier and developing Asian economies. It focuses primarily on banks and bank-related activities. The next section reviews the structure of financial sectors in frontier and developing Asian economies, highlighting some common characteristics. The following sections describe the state of the financial sector and look at some of the key financial sector risks in frontier and developing Asia, including domestically generated risks, external spillovers, and governance and supervisory risks. The subsequent section reviews country authorities’ progress in meeting these challenges, and policy recommendations are discussed in the final section.

Structure of Financial Sectors in Frontier and Developing Asia

Financial intermediation and services have grown quickly in frontier and developing Asia since early in the 2000s. The nature of growth in assets, number of institutions, and types of financial services reflect country-specific conditions, but the common trend clearly points to significant and rapid expansion. The impetus behind financial sector growth has varied—activity has sometimes been fueled by such factors as commodity booms, remittances flows, or market liberalization. Despite significant country-by-country differences, important structural characteristics of financial sectors in frontier and developing Asia include the following:

  • Bank-centric systems: Financial systems in frontier and developing Asia are predominantly bank-centric (Figure 7.1). In Mongolia and Maldives, for example, banks account for nearly 100 percent of total financial system assets. In other frontier and developing Asian economies, the ratio seldom drops below 70 percent. Commercial banks (as opposed to development banks) typically represent the largest share of financial sector assets.
  • Oligopolies: In many frontier and developing Asian economies, a few large players often dominate the market. Although concentration has gradually lessened, for 8 out of 12 frontier and developing Asian economies, 50 percent or more of total banking sector assets are concentrated in five or fewer institutions (Figure 7.2).
  • Concentration of lending in particular sectors (real estate, extractive industries, and others): Some 50 percent of bank assets in Bangladesh are in industry and trade. In Nepal, real estate exposure (either directly or through real estate as collateral) is high—about 70 percent of commercial bank assets in Nepal are directly or indirectly exposed to the real estate sector. In Cambodia, real estate prices can have a significant impact on bank balance sheets. In Mongolia, the banking system is particularly sensitive to shocks to real estate, construction, mining, and trade.
  • Rapid institutional growth: For some frontier and developing Asian economies, financial growth has been manifested in an increase in the number of financial institutions. In Nepal, for example, the number of financial institutions climbed from 85 to nearly 200 between 2002 and 2012—largely on the back of a steady rise in remittances inflows, a property boom, greater opportunities for financial intermediation, and a relatively lax licensing regime. In Bangladesh, the number of financial institutions has increased during the past decade as the result of a shift in government policy on licensing. However, in other countries, such as Mongolia, the number of banks has not increased substantially, although financial sector assets have grown. Papua New Guinea, Cambodia, and Lao P.D.R. have similarly seen only a moderate rise in the number of institutions compared with the increase in assets.

Figure 7.1The Banking Sector in Frontier and Developing Asia

Sources: National authorities; and IMF staff estimates.

Note: Latest available data used.

Figure 7.2Number of Banks Holding Large Sector Share of Banking Assets

Sources: Central banks; and IMF country desk data.

Note: Latest available data used.

  • State-owned banks: State-owned commercial banks are most prevalent in south Asia and the larger frontier and developing Asian economies. For instance, they constitute 30–60 percent of the banking system assets in such countries as Lao P.D.R., Maldives, Sri Lanka, and Vietnam (Figure 7.3). They frequently have the weakest balance sheets and asset quality, often encouraging regulatory forbearance (Box 7.1). In Nepal, two of the three state banks have had net negative capital for over 10 years (from the early 2000s to mid-2014); in Bangladesh and Lao P.D.R., a number of state-owned commercial banks are well below established minimum adequacy. State-owned commercial banks in frontier and developing Asia typically have weaker asset quality compared with private commercial banks (Figure 7.4)—consistent with experiences in other countries. In some cases, state-owned commercial banks with negative capitalization or high nonperforming loans (NPLs) can contribute to the weakening of confidence in the overall banking system.
  • Limited foreign presence or links to international markets: Many frontier and developing Asian economies host no more than two or three foreign banks as part of the financial system. Cross-border financial flows with correspondent banks are limited. Funding structures in frontier and developing Asian banks show little or no dependence on cross-border wholesale funding. However, there are notable exceptions: in Cambodia and Papua New Guinea, for example, foreign banks have a strong presence, reflecting the relatively underdeveloped state of domestic institutions and the authorities’ approach to financial liberalization.

Figure 7.3Frontier and Developing Asian State Banks’ Share of Banking System Assets

Sources: Central banks; and IMF, Article IV Reports, and Financial System Stability Assessment Reports.

Figure 7.4Relative Performance of State-Owned Banks in Asian Low-Income Countries

(Percent, 2010 or latest available)

Sources: IMF, Article IV Reports, Financial System Stability Assessment Reports, Selected Issues Papers, and technical assistance reports.

  • Nonbank financial institutions: Credit cooperatives and other shadow banking firms are not as common as banks. However, in some frontier and developing Asian economies, these institutions have gained significance, and they are less regulated than commercial banks and other larger entities (Box 7.2). Nepal, for example, has some 26,000 credit cooperatives. Although each is small, they collectively represent assets of more than 7 percent of GDP and are largely unregulated. Other countries in which the nonbank sector has been or is emerging as a concern include Papua New Guinea and Sri Lanka.
  • Weak supervisory capacity: Supervisory capacity has not always kept pace with financial sector growth. The steady increase in financial assets, activities, and instruments has been one challenge. In some frontier and developing Asian economies (where licensing has been more liberal) the sheer number of new institutions has outstripped supervisory resources. Most central banks have been hard-pressed to attract and adequately train supervisory staff. In Nepal, the number of bank supervisors has remained relatively steady since 2000, while the number of institutions (commercial banks, development banks, and finance companies) regulated by the central bank has more than doubled. Many countries also need to strengthen capacity (resources as well as technical skills) for adequately regulating and supervising a growing number of nonbank financial institutions (NBFIs).

Box 7.1State-Owned Commercial Banks: Issues and Challenges

The relative share of state banks in frontier and developing Asian economies is varied and has been gradually declining in many countries, but assets often continue to grow in nominal terms (Figure 7.1.1). In Vietnam, the share of state-owned banks in banking system assets dropped to less than 40 percent (from more than 60 percent) between 2006 and 2012, but total assets of these banks grew by about 10 percentage points of GDP to more than 85 percent of GDP before declining amid financial stress (Figure 7.1.2).

Figure 7.1.1Frontier and Developing Asian State-Owned Banks’ Share of Banking Sector Assets

Sources: Central banks; and IMF, Article IV Reports, Financial System Stability Assessment Reports, and technical assistance reports.

Note: 2010 or latest available.

Figure 7.1.2Vietnam: market share and asset size of state banks


Source: State Bank of Vietnam.

Although state banks can, in some cases, encourage financial access, in practice they often provide subsidized lending and directed credit, and frequently demonstrate poor collection from connected individuals or state enterprises—giving rise to a negative relationship between economic growth and state ownership of banks. Relative to their private counterparts, state banks tend to be less well capitalized and less profitable, and have thinner core earnings. Several studies show the way in which state ownership of banks can impact economic growth, bank performance, financial sector reform, and monetary policy transmission.

Growth: State ownership of banks has been linked to lower economic growth through its impact on productivity resulting from the inefficient allocation of resources. Studies have shown that this relationship depends on a country’s financial development and political institutions (La Porta, Lopez-de-Silanes, and Shleifer 2002; Körner and Schnabel 2010). In industrial countries, no correlation appears between state ownership and growth, but state ownership of banks in developing economies can weaken growth when accompanied by low financial development and institutional quality: an increase in public ownership of banks by 10 percentage points is associated with a reduction in the annual growth rate of per capita GDP of 0.12 of a percentage point.

Bank performance: Studies suggest a negative relationship between public ownership of banks and indicators of banking sector development and performance. One study, based on about 50,000 observations from 119 countries during 1975–2002, demonstrated that state-owned banks in developing economies are significantly associated with lower profitability and higher costs, even after controlling for other variables (Levy-Yeyati, Micco, and Panizza 2007).

Quality of financial sector reform: Government ownership can also affect financial sector reform and liberalization. Research has focused on how bank ownership can affect credit to the private sector after reform. One study, using bank-level data for 1991–2007 in India, explores whether public and private banks used resources freed up by reduced state preemption (measured by the requirement to hold government securities as a share of assets) to increase private credit (Gupta, Kochhar, and Panth 2011). The study finds that public banks allocated a larger share of assets to government securities than private banks because of the distortion in the incentive structure and moral suasion.

Monetary policy transmission: State ownership may complicate weak monetary policy transmission in developing economies. Research suggests that at lower levels of financial development, transmission is generally dominated by bank lending (Mishra, Montiel, and Spilimbergo 2010). However, weak institutions and high levels of bank concentration may undermine the transmission of central bank monetary policy actions to bank lending rates. Where state banks lend to state enterprises, political economy considerations can also complicate implementation of monetary tightening, implying the need for a more pronounced tightening of private credit. Bangladesh and Vietnam have faced such challenges in the past.

Box 7.2Rise of Nonbank Financial Institutions and Accompanying Challenges

Nonbank financial institutions (NBFIs) are important complements to mainstream banking in many frontier and developing Asian economies.1 In most of these economies, NBFIs in aggregate are still small relative to the size of the commercial banking sector and in comparison with the NBFI sector in major emerging market economies in the region, except in the case of the island nations of Papua New Guinea and Sri Lanka (Figure 7.2.1). Given limited access to commercial banking for some segments of the population and underdeveloped financial markets, finance companies (Bangladesh, Maldives, Mongolia, Nepal), microfinance institutions (Bangladesh, Cambodia), and contractual savings institutions (Bhutan, Papua New Guinea, Sri Lanka) play important roles in providing financial services. Insurance penetration, however, remains low across the frontier and developing Asian economies. Since 2000, NBFIs have also undergone consolidation, and in some instances, a few of these institutions were converted to banks (Bhutan, Mongolia, Nepal).

Figure 7.2.1Size of the Nonbank Financial Sector

(Percent of assets of commercial banking sector; latest available data)

Sources: Asian Development Bank (2011); country authorities; and IMF, Financial System Stability Assessment Reports.

Supervision and regulation of NBFIs are fragmented across regulatory bodies. In countries with a single supervisor for the NBFIs, central banks are assigned the role (Bhutan, Maldives, Papua New Guinea), except in Mongolia, where the Financial Regulatory Commission, set up in 2006, regulates the sector. In other frontier and developing Asian economies, central banks supervise and regulate some of the deposit-taking NBFIs, and there are often regulatory bodies for the insurance sector, microfinance institutions, rural banks and cooperative societies, and merchant banks and stock brokers. Supervisory capacity remains limited and often does not keep pace with growth in the NBFI sector. However, new laws have further empowered the supervisory authorities (Bangladesh, Maldives, Mongolia, Sri Lanka), but scope still remains for improving prudential and risk-based supervision in all frontier and developing Asian economies. The rapid proliferation of NBFIs has also raised concern about the effective supervision of their internal control processes. To the extent that not all deposit-taking institutions are supervised and regulated by the central bank, attempts should be made to establish a joint supervisory council to assess and minimize the risks to financial stability. Bangladesh and Mongolia, for example, have such joint supervisory bodies.

Credit and operational risks remain the biggest vulnerabilities for the NBFI sector. Undiversified economic structures, underdeveloped legal frameworks related to credit information bureaus and collateral registries, and inadequate internal controls at these institutions pose big risks. Vulnerabilities in the banking industry could potentially spill over to the NBFI sector given that these institutions are often heavily reliant on the banks for funding and investment purposes. Weak regulation of the sector in some countries makes it an easy conduit for risky investment by banks and for money laundering.

1 The definition of the NBFI sector varies by country. In this box, the NBFI sector is defined to comprise specialized development finance institutions, rural banks, leasing companies, investment and brokerage companies, housing finance companies, merchant banks, thrift and cooperative credit societies, contractual savings institutions (provident funds and insurance companies), and microfinance institutions.

Banking Sector Performance

Banking sector performance in frontier and developing Asia has varied, depending, in part, on how the financial sector in each economy has evolved. In many cases, rapid growth has resulted from market liberalization, economic growth, and increasing trust in financial institutions. In others, external factors (such as capital flows, remittances, or surges in commodity earnings) have helped to fuel a boom in financial institutions.

Many frontier and developing Asian economies have experienced strong growth both in bank deposits and in assets. Deposit mobilization and credit growth have been rapid, rising at an average annual rate of 31 percent between 2003 and 2013. As a share of GDP, private sector credit more than doubled in a number of frontier and developing Asian economies (Bhutan, Cambodia, Lao P.D.R., Maldives, Mongolia, Vietnam) and showed strong growth in most others (Figure 7.5). Vietnam’s rapid financial sector growth has been the most visible, with growth in private credit more than double the next most significant case (Maldives—Figure 7.6).

Figure 7.5Ratio of Private Credit to GDP, 2002 and 2013

Sources: IMF, country desk data, and World Economic Outlook database.

Figure 7.6Average Annual Growth of Private Sector Credit, 2003–12

Sources: IMF, country desk data, and World Economic Outlook database.

Note: ASEAN-4 = Indonesia, Malaysia, Philippines, and Thailand.

Profitability in frontier and developing Asian banks has varied—being largely idiosyncratic and subject to key domestic developments (such as commodity booms and busts, housing bubbles, and others—Figure 7.7). Average return on assets, for example, hovered around 1.6 to 1.7 during 2001–12, although there have been notable fluctuations for individual countries.

Figure 7.7Bank Profitability

Sources: Central bank data; and IMF, Article IV Reports, and Financial System Stability Assessment Reports.

Rapid credit growth has raised the risk of poor quality of investment, as evidenced by shifts in asset quality. NPLs climbed in most frontier and developing Asian economies during the years of the global financial crisis (Figure 7.8).2 For a few, this increase in NPLs reflected exposure to global markets and interconnectedness with foreign financial institutions (Ree 2011). For most others, the impact of the crisis was indirect—for example, through declining remittances or a slowdown in such sectors as trade, tourism, services, or construction and real estate. The most dramatic increases were seen in Maldives and Mongolia. The former was linked to declines in the tourism sector (in which loan concentration was heavy), and the latter reflected a downturn in commodities (particularly gold).

Figure 7.8Frontier and Developing Asia Banks: Nonperforming Loans as Share of Total Loans

Sources: Central bank data; and IMF, Article IV Reports, and Financial System Stability Assessment Reports.

Capital adequacy has also varied among frontier and developing Asian economies. The differences partly reflect existing prudential regulations (some countries simply demand a higher capital adequacy ratio, CAR, than others). Other factors, such as corporate governance, experience with state banks, regulatory forbearance, and a history of systemic shocks (and banks’ use of reserve cushions) also play a role. CARs have improved in many frontier and developing Asian economies in the postcrisis years, but the data often mask underlying problems. Strong capital adequacy in Maldives, for example, might be overstated because of regulatory forbearance given to NPLs. In Nepal, capital adequacy among commercial banks as a group has only recently recovered to the minimum CAR of 10 percent, reflecting the insolvency of two large state-owned commercial banks (Nepal Bank Limited and Rastriya Banijya Bank—which are in the process of being recapitalized). Even in countries with CARs in line with regulatory requirements, capital might be overstated if accounting standards are not yet in line with international best practices, implying that banks might have less capacity to absorb shocks.

The quality of reported financial soundness indicator data remains an issue. Data quality concerns have been raised during surveillance in most frontier and developing Asian economies. Classification of NPLs is the most common weakness, with a direct bearing on provisioning, profitability, and bank capital. In some countries, even the officially reported data vary significantly, and market expectations range from 4 percent to 20 percent. Nepal’s banking system, with its heavy exposure to a challenging real estate market and overstretched supervisory capacity, is another case for which reported data may not accurately reflect banks’ balance sheet stress.

Risks and Vulnerabilities

Rapid financial sector growth in frontier and developing Asia is indicative of financial deepening, but such rapid expansion also comes with risks. Frontier and developing Asian economies could be facing risks and might want to learn from the lessons of today’s Asian emerging markets prior to the Asian financial crisis of 1997–99 (Box 7.3). As in these countries, supervisory bodies in most of frontier and developing Asia have faced many challenges—even with relatively intensive technical assistance from the IMF, the World Bank, and other international financial institutions and bilateral donors. Financial sectors in these countries remain subject to a number of vulnerabilities, which can be categorized broadly into domestic (homegrown), spillover, and governance and supervisory risks. Appendix 7A provides a qualitative benchmarking of vulnerabilities and the policy response. The next section discusses some of these risks in more detail.

Domestic Risks

Risky lending

Many studies suggest that changes in the ratio of private credit to GDP have the best predictive power for banking crises and asset price busts because rapid credit growth is often associated with excessive risk taking (Borio and Lowe 2002, 2004; Borio and Drehmann 2009; Alessi and Detken 2009; Gerdesmeier, Reimers, and Roffia 2009).3 Two factors are most common:

  • In frontier and developing Asian economies, rapid credit growth was associated with excessive loan concentration in particular sectors—primarily real estate. In Nepal, this concentration contributed to a liquidity squeeze and fears of a potential banking crisis in 2011, when a sharp drop in real estate prices was accompanied by a slowdown in remittances growth. In Vietnam, booms and busts in the real estate market were a key factor behind credit cycles and rising NPLs.

Box 7.3Parallels between Frontier and Developing Asia and the Asian Crisis Countries of the 1990s

Rapid financial sector expansion in frontier and developing Asia bears some important similarities to that of the ASEAN-4 (Indonesia, Malaysia, Philippines, Thailand) in the 1990s. The parallels are most striking with respect to the growth of credit, asset concentration, and weak supervision. Nevertheless, important distinctions are the degree of integration with international financial markets, the use of foreign funds to finance domestic lending, and growth models—including governments’ involvement in resource allocation.

As credit growth in frontier and developing Asia rapidly increased, nonperforming loan (NPL) ratios became elevated. Similar to the ASEAN-4, frontier and developing Asian countries experienced rapid credit growth, with annual growth rates hovering above 25 percent (Figure 7.3.1, panel 1). Although credit growth in frontier and developing Asia has eased—which contrasts with the accelerated credit expansion in the ASEAN-4 leading up to the crisis of the late 1990s—NPL ratios remain elevated (Figure 7.3.1, panel 2), comparable to those of the ASEAN-4 in 1996. Heavy exposure to a few sectors was also a key vulnerability in the ASEAN-4 (such as excessive real estate investments in Thailand) during the precrisis period, which echoes conditions in frontier and developing Asian economies such as Bangladesh, Cambodia, Mongolia, and Nepal. In tandem with credit booms, investment booms are also underway (Figure 7.3.1, panel 3).

Figure 7.3.1Comparison of Frontier and Developing Asia with ASEAN-4

Note: FD Asia = frontier and developing Asia; ASEAN-4 = Indonesia, Malaysia, Philippines, and Thailand.

Amplifying these growing financial risks, the financial systems are poorly supervised in frontier and developing Asia. The financial systems in the ASEAN-4 during the precrisis years were not well positioned to deal with credit shocks alongside external shocks following capital liberalization. Banking sectors in the ASEAN-4 were poorly regulated with loose enforcement and compliance, which resonates with current frontier and developing Asia. Country authorities showed a preference for mergers and consolidation to deal with insolvent institutions instead of addressing root problems—much as in Nepal, Vietnam, and other frontier and developing Asian economies today.

Nevertheless, international claims by foreign banks are still limited for most frontier and developing Asian economies. In the run-up to the crisis of the late 1990s, the ASEAN-4 came to be heavily dependent on short-term foreign bank loans, with the amount reaching about 40 percent of GDP. In contrast, international claims to frontier and developing Asia remain low, at about 10 percent of GDP (Figure 7.3.1, panel 4). Apart from Cambodia and Mongolia, foreign currency lending also remains small in frontier and developing Asia, limiting currency mismatch risks. Still, some countries have large exposures to international claims—particularly Maldives (about 20 percent of GDP) and Vietnam (about 25 percent of GDP). International claims on the nonbank private sector have also increased during the past decade (Figure 7.3.1, panel 5).

More important, the key difference is in contrasting growth models and the concomitant degree of government involvement in bank lending. The governments in the ASEAN-4 were heavily engaged in managing the allocation of financial resources—partly financed from overseas at low cost following capital account liberalization. Emphasizing economic growth, the governments adopted various investment-conducive policies, such as government guarantees, which facilitated private inflows to finance investment. A large amount of the funds, however, was channeled to unproductive, unprofitable businesses—in some cases to those with close political connections. In contrast, frontier and developing Asian economies have not yet shown such heavy, systemic government involvement in financial resource allocation, thereby mitigating systemic risks, although some countries, such as Vietnam, have very large state-owned banking sectors and rely on directed lending to state enterprises and favored sectors.

Frontier and developing Asian economies also exhibit limited openness and capital account liberalization, although they have become increasingly open since 2000. The ASEAN-4 countries were relatively open—imports and exports as a share of GDP exceeded 110 percent in 1997. With the exception of Malaysia, capital accounts were also relatively liberalized to facilitate higher levels of investment. In contrast, frontier and developing Asian economies are generally less open as measured by trade flows, and some maintain capital account restrictions. Still, de facto openness of frontier and developing Asia is steadily rising, and trade flows have also jumped (Figure 7.3.1, panels 6 and 7). Similar to the ASEAN-4, which had large current account deficits in the mid-1990s, some frontier and developing Asian economies have posted widening underlying current account deficits (Figure 7.3.1, panel 8).

  • Concerns about concentration risk also arise from large exposures to single borrowers or to related parties—sometimes in breach of prudential regulations. In Papua New Guinea, banks have high loan exposures to single large borrowers whose fortunes, in turn, are largely dependent on volatile commodity prices. In several countries—Bhutan, Lao P.D.R., and Mongolia—excessive credit growth has also heightened external stability risks: credit-fueled domestic demand increases import growth and puts additional pressure on foreign exchange reserves while accentuating currency mismatches on banks’ balance sheets.

Interbank linkages

Interbank contagion and multiple gearing: In a number of frontier and developing Asian economies (most notably Mongolia, Nepal, and Vietnam) rapid credit growth has been accompanied by an increase in cross-ownership in the banking system. These relationships consist of both mutual ownership among banks and cross-ownership between enterprises and banks. Although conglomeration offers advantages, such as greater financial capacity to withstand shocks and wider diversification of activities, it also poses special challenges for prudential regulation and supervision. In particular, cross-ownership makes it more difficult to detect and correct (1) multiple uses of existing capital (double or multiple gearing); (2) group risks (contagion, concentration, management complexity, and conflicts of interest); and (3) regulatory arbitrage (the shifting of certain activities or positions within a conglomerate to avoid stricter prudential rules and supervision by one set of supervisors compared with another, or to avoid regulation and supervision altogether by transferring the activities or positions to an unregulated entity).

The lack of transparency of cross-ownership among banks, and between enterprises and banks, is a particular area of concern. This lack of clarity could undermine lending standards and increase the risks of interbank contagion. Cross-ownership also raises concerns about conflicts of interest and about banks imprudently channeling funds to related companies or unrelated speculative ventures. An example of this could be that some shareholders may fund their share purchases via bank loans, including loans from the same banks in which they have invested. Such multiple gearing would make capital a circular relationship that poses an asset risk to the relevant bank or to the banking system as a whole, and could undermine the loss-absorption capacity of bank equity.

Governance Risks

Virtually all countries in frontier and developing Asia witnessed rapid credit growth in the context of weak corporate governance in banks. A significant number of domestic banks have inadequate internal audit and control systems and lack sound risk-management frameworks and practices to monitor and control the risk profiles of their loan (or, more generally, asset) portfolios. For example, banks in Myanmar (and to a lesser extent in Bhutan) have little experience with international standards of accounting and risk management. Political interference in banks’ lending decisions in some countries—for example, Bangladesh—is a related governance risk, particularly in state-owned commercial banks. The result is that operational risks in the banking system are high in many of these countries; for example, the IMF’s Financial System Stability Assessment of Papua New Guinea (IMF 2011b) notes that operational risks, including security and fraud risk, are material in a country in which violence and crime are significant.

Supervisory Risks

Supervisory agencies in most frontier and developing Asian countries face common challenges. These challenges include a shortage of qualified staff, a lack of technical capacity, and data weaknesses that severely impair the quality of surveillance and supervision. Partly as a consequence, risk-based supervision is at an early stage of implementation in many of these countries. Banking supervision could be strengthened, since the emphasis is often on compliance with laws and regulations, particularly those related to attaining monetary policy objectives (such as interest rate controls or lending limits) at the expense of a clear focus on sound risk management of banking activities. Notable examples include Lao P.D.R., Mongolia, and Myanmar, where compliance-based supervision continues to be the norm, with limited efforts to move toward risk-based and forward-looking supervision.

Fragmentation, weak mandates, and lack of independence are also common supervisory challenges. In a number of frontier and developing Asian economies, semiautonomous bodies have overlapping jurisdictions and lack independence and clear mandates. Cooperation and exchange of information are often limited. In Cambodia, for example, a memorandum of understanding among supervisory agencies for coordination across supervisors and for exchange of information on cross-cutting issues is not yet fully developed. Multiple central bank objectives can also undermine supervision. In Vietnam, the law does not give the central bank a clear and unambiguous mandate to guard the safety and soundness of the banking system, which could have presented some challenges to supervision and enforcement in the past.

Work also needs to be done with regard to consolidated supervision and cross-border cooperation on regulation and supervision of financial institutions. None of the countries in frontier and developing Asia has a robust framework for conducting consolidated supervision. A Financial System Stability Assessment for Mongolia highlights implementation of consolidated supervision (as well as risk-based supervision) as a key priority for strengthening banking supervision and regulation (IMF 2011a). With the expansion of cross-border banking, another priority in several countries is to strengthen cross-border supervisory cooperation. Some frontier and developing Asian economies do not have memoranda of understanding with bank supervisors of all home countries of foreign banks with a large presence in their domestic financial markets.

Legal and Regulatory Risks

In a number of frontier and developing Asian economies, banking regulation and supervision frameworks have not kept pace with international standards; for example, the capital adequacy requirement in Vietnam might be based on Basel I but is not fully consistent with it, and the country has not yet adopted international financial reporting standards. Potential underreporting of NPLs is an important challenge in several countries.

Enforcement of existing prudential rules lacks teeth in some frontier and developing Asian economies. The problem is particularly notable with regard to single-borrower limits and related-party lending. In Papua New Guinea, for example, the central bank lacks legal authority to impose administrative sanctions on banks that fail to comply with prudential regulations. In Maldives, regulatory forbearance extended by the central bank since June 2012 has led to an artificial boost in capital adequacy and provisioning, and several commercial banks remain out of compliance with prudential norms on single-borrower exposures and net open foreign exchange position limits. In Nepal, strengthening of prudential regulations by the central bank following the near-crisis in April–May 2011 gave way to some regulatory forbearance. IMF (2011a) notes that strict enforcement of regulatory requirements in Mongolia is lacking and that the central bank permits regulatory forbearance.

Few countries in frontier and developing Asia have formal and effective crisis-management and bank resolution frameworks, including for the provision of liquidity and solvency support. Instead most of them have some components of a crisis-resolution framework, including an established means of providing short-term liquidity support, longer-term solvency support, deposit insurance, and a legal and regulatory framework that can facilitate the restructuring or resolution of a problem bank or financial institution. In many cases, however, large gaps remain to be filled. Deposit insurance schemes are frequently in the early stages, and have limited resources. Liquidity and solvency support is provided on an ad hoc basis. And the legal framework supporting restructuring or liquidation of financial institutions is in need of strengthening or of separation from the general insolvency framework. Prompt corrective action frameworks, which would take much of the discretionary element out of intervention, are also frequently absent or not always observed.

External and Spillover Risks

Most frontier and developing Asian economies have relatively underdeveloped links with international financial markets. As in many low-income countries, the lack of direct links between frontier and developing Asia and advanced and emerging markets provided a buffer during recent global crises. In contrast with regional emerging market economies (particularly precrisis Asia in the 1990s), debt markets in most frontier and developing Asian countries remain largely unexplored by global investors (see Chapter 8). High and difficult-to-price sovereign risks and heavy reliance on concessional financing and foreign direct investment leave limited room for a market for external sovereign bonds to thrive. Moreover, domestic bonds attract few foreign investors, given stringent capital controls and uncertain exits, reflecting in particular a dearth of secondary trading as well as high repatriation risks. Banks’ security holdings consist mainly of government and central bank debt, which is generally held to maturity. Cross-border ties (proxied by foreign bank claims—Figure 7.9) illustrate the comparatively weak links to international markets in a number of frontier and developing Asian economies (for example, Lao P.D.R, Mongolia, Myanmar, Nepal) compared with some emerging market economies. Other frontier and developing Asian economies (Cambodia, Maldives, Sri Lanka, Vietnam), which have a larger foreign bank presence, tend to have stronger links comparable to other Asian economies.

Figure 7.9Consolidated Foreign Claims on Banks, as Share of GDP, 2012

(Percent of GDP)

Source: Bank for International Settlements.

Comparatively insulated banking systems in many of these countries emerged from the crisis relatively unaffected by direct financial contagion. This outcome is markedly different from developing market counterparts during the Asian crisis of the late 1990s (see Box 7.3), in which a high degree of openness and weak oversight of nonbank activity facilitated rapid transmission of financial contagion. IMF surveillance in 2009–10 for virtually all of the frontier and developing Asian economies reported little or no direct financial contagion from the global crisis. Rather, indirect channels (commodities, remittances, and accompanying effects on property markets where banks were heavily exposed) were more common conduits for negative pressures.

The absence of direct financial links does not mean that frontier and developing Asian economies are completely immune to spillovers. Empirical work suggests an important difference between the largest banks in frontier and developing Asia, which show some sensitivity to international market turbulence (mainly through cross-border funding) and smaller banks that remain insulated and dependent primarily on domestic conditions (Box 7.4).

Box 7.4Impact of the Global Financial Crisis on Frontier and Developing Asian Financial Sectors

An IMF study (Ree 2011) examined the impact of the global financial crisis on a subset of frontier and developing Asian countries (Bangladesh, Cambodia, Lao P.D.R., Mongolia, Sri Lanka, Vietnam). Most frontier and developing Asian economies were insulated from the direct effects of the crisis by their isolation and sparse links with international financial markets (even more so for Bhutan, Myanmar, Nepal, Papua New Guinea, and Timor-Leste). However, despite this low level of integration, there is evidence of pass-through to frontier and developing Asian banks—particularly to large ones. And the effects of the global crisis were most strongly transmitted through a loan-to-cross-border-funding nexus—most visibly for the 20 largest banks.

Market risk showed little measurable impact, with frontier and developing Asian banks continuing their strong mark-to-market gains despite the global financial crisis. The lack of spillover through exposure to market risks is likely due to frontier and developing Asia’s comparatively low degree of financial market integration. By contrast, Asian emerging market banks’ balance sheet linkages to global financial markets proved significant. Philippine banks took the hardest hit, with 0.6 percent of the value of their average assets eroded by mark-to-market loss, followed by Indonesian banks (mark-to-market losses at 0.2 percent of average assets) and Malaysian banks (mark-to-market gains slipped 0.1 percent of average assets).

The impact on funding and lending is less clear. On the funding side, frontier and developing Asian banks as a whole did not appear to be affected—especially compared with Asian emerging market banks. On a more disaggregated level, however, some evidence indicates that wholesale funding sharply decelerated in 2008 in the 20 largest banks in the frontier and developing Asian economies reviewed, followed, however, by a strong rebound in 2009. Smaller banks in the Asian low-income countries continued to expand their wholesale funding in 2008 and 2009, although at an increasingly slower pace than in 2007. The proportion of the deceleration in wholesale funding that can be attributed to global capital flow factors is not obvious, and the cycle of cross-border interbank capital flows to these countries was less uniform than in emerging market counterparts. With respect to lending, the aggregate data are again split—the top 20 banks allowed lending growth to plunge by 21 percentage points to 8 percent in 2008, while smaller banks maintained their lending growth at 20 percent. By contrast, the top 20 Asian emerging market banks strove to sustain their lending growth despite a sharper drop in deposit growth. The difference in initial liquidity buffers appears key to determining the vigor with which banks leaned against the wind in this period.

With respect to asset quality, the median nonperforming loan (NPL) ratio of frontier and developing Asian banks stayed unchanged from the previous year at 3.6 percent in 2008, before shedding 0.9 percentage point in 2009, despite significant deceleration of economic growth. However, a disaggregated view of the data suggests that the Asian low-income country banks may have suffered a somewhat greater spillover from the crisis on NPLs. NPL ratios for the top 20 low-income country banks were far less likely to rise in 2008 than those of all frontier and developing Asian banks and more likely to decline in 2009. This dichotomy may reflect better credit risk management on the part of these banks, or a greater tendency toward regulatory forbearance of delinquency based on their more favorable liquidity.

These findings caution against understating frontier and developing Asian banking systems’ vulnerability to international liquidity and capital flow cycles. Even though vulnerabilities appear to be significant and to be growing, macroprudential supervision is generally nascent or nonexistent. As a starting point, compiling and disseminating data on interbank capital flows can be stepped up to inform the use of countermeasures, including prudential regulations or capital controls, as needed. Currently, Bank for International Settlements (BIS) capital flow data are the only regularly disseminated information on this front, but the data gap may be particularly significant for frontier and developing Asian economies given their large exposures to Chinese and other intraregional capital flows, which are not captured well by the BIS statistics.

As frontier and developing Asian economies liberalize, make progress in macroeconomic management, and generate greater interest from investors, external links will invariably grow. This interconnectedness brings opportunities, but will also heighten risks from the preexisting vulnerabilities reviewed above. Therefore, the entry of foreign banks into a developing market economy raises both opportunities and risks (Box 7.5). Foreign bank entry in various forms can help transfer technology and managerial expertise and can foster competition, thereby improving financial services and promoting more rapid development of the financial sector. However, foreign bank entry—if premature—risks overwhelming weak supervisory capacity and may force out of business some domestic institutions that are at a financial, technological, or managerial disadvantage, even if they have superior local knowledge. Foreign banks may also attract the stronger clients (firms and individuals), leaving the domestic banking sector with weaker clients. Different approaches to foreign bank entry are possible with regard to speed and models of entry (Box 7.5). Regardless of the approach, however, a number of regulatory and supervisory conditions are needed to ensure that foreign bank entry is consistent with financial sector stability (see Appendix 7C for a review of bank entry conditions).

Country Progress in Addressing Challenges

Frontier and developing Asian economies have made progress in improving the key pillars of financial sector supervision since the mid-2000s. The rate of progress has varied, with some making a more concerted effort to deal with vulnerabilities and challenges. Others have taken a more gradual approach, reflecting a mix of capacity constraints and preferences with respect to oversight of financial institutions (Barth, Caprio, and Levine 2004). But generally, interest in improving oversight and reducing financial sector risks is clear in most frontier and developing Asian economies.

Proxy data are indicative of frontier and developing Asian economies’ levels of interest in and commitment to addressing financial sector vulnerabilities. For example, most of these countries have financial sector reform plans—homegrown initiatives to address vulnerabilities or move financial sector supervision and regulation closer to international standards. Nearly all frontier and developing Asian economies are intensive users of IMF technical assistance: financial sector technical assistance is the leading form of assistance in about half (Appendix 7A). Assistance from the World Bank also figures prominently in most of these countries’ financial sector reform efforts.

Most frontier and developing Asian economies have made improvements in the quality and timeliness of supervision—often by tightening existing prudential criteria or restructuring supervisory processes. Many have also undertaken reforms to the legal framework (usually through central bank or commercial bank laws) with a view to clarifying mandates, roles, and supervisory powers. Some have also sought to improve financial sector infrastructure, such as deposit insurance and credit registries.

Box 7.5Cross-Country Experience with Foreign Bank Entry

Asian economies have followed various approaches to foreign bank entry with respect to speed and model, suggesting several considerations for frontier and developing Asia. (For a detailed description of these approaches, see Appendix 7B.)

Speed: Indonesia, the Republic of Korea, and Thailand quickly initiated reforms to allow foreign bank entry in the aftermath of the Asian financial crisis of the late 1990s as part of a comprehensive set of liberalization efforts. The Philippines also liberalized foreign bank entry substantially after the Asian crisis, but at a somewhat slower pace. China and India pursued a more gradual approach. For China in particular, the timing and manner of foreign entry were mostly driven by World Trade Organization accession obligations.1Among frontier and developing Asian economies, Lao P.D.R. and Vietnam pursued a gradual approach; Cambodia allowed foreign bank entry with few restrictions during the comprehensive conversion from the monobank system.

Model of entry: Gradual increases in foreign equity shares in banks have been common, but ceilings range from 30 percent in Malaysia to 100 percent in Korea. Market access for branches differs from that for subsidiaries. Malaysia allows subsidiaries only, while other countries allow both branches and subsidiaries. Korea allowed foreign branches and ownership stakes in local banks first, followed by subsidiaries. China allowed foreign equity in local banks before subsidiaries and branches. Thailand allowed ownership by foreign banks followed by subsidiaries and branches simultaneously. In frontier and developing Asia, Cambodia permitted all forms of foreign participation simultaneously, while Vietnam followed an approach similar to China’s. Lao P.D.R. allowed joint venture (JV) banks and branches simultaneously, but not subsidiaries. Maldives allowed four foreign branches starting in the mid-1970s and subsidiaries later.

Level of financial liberalization: Some Asian economies maintained substantial financial restrictions even after foreign bank entry. Among frontier and developing Asian economies, Lao P.D.R. and Vietnam had relatively low levels of financial liberalization, while Cambodia, which followed a “big bang approach,” liberalized the financial system and allowed foreign bank entry at the same time. Bangladesh nationalized domestic banks following independence, but permitted existing foreign branches to continue to operate.

Advantages and Disadvantages of Different Strategies

Joint ventures followed by foreign subsidiaries and branches: The advantages of this approach include (1) “breathing room” to develop and upgrade skills at domestic banks and to prepare for foreign competition; (2) technology and skills transfer, especially if JV requirements include a critical mass of foreign executives and specialists; and (3) a less onerous and gradual overhaul of regulations and supervision. Disadvantages may include potentially less deployable capital and credit compared with fully owned branches or subsidiaries, slower diffusion of technology, and lack of interest by foreign banks if ownership control is not sufficient.

Big bang—fully owned foreign branches or subsidiaries and JVs: The advantages to the big bang approach can include faster progress in modernizing financial services through competition and potentially greater access to credit for borrowers. Potential disadvantages include the inability of some domestic banks to withstand foreign competition and concentration of relatively safer business at foreign banks, leaving domestic banks to focus on riskier activities.

Branches or subsidiaries? Although there is not a significant difference with regard to financial stability,1 the operational modalities of branches versus subsidiaries could have implications. For instance, foreign bank branches rely on the parent’s balance sheet for funding and service provision on an ongoing basis, while subsidiaries’ dedicated local capital may affect their capacity to expand or contract operations. If not domestically permitted, foreign bank branches may find it easier to transfer certain activities to parents in offshore markets, thereby limiting domestic banking development. In addition, by ring-fencing their local capital, subsidiaries could be better shielded from potential problems of the parent if the parent were to face an adverse shock.

1 For more details see IMF (2011d).

Areas for further reform center largely on the timeliness and quality of financial soundness indicators, supervisory capacity, prudential frameworks, and countries’ ability to deal with financial sector crises. The most pressing areas for reform include the following:

  • Improving the quality of financial soundness indicators and the capacity of financial supervisory bodies to collect this data.
  • Strengthening loan classification practices and enforcement of prudential standards.
  • Bolstering supervisory capacity—both the absolute levels of manpower needed to oversee growing financial sector activity and the capacity of financial supervisors to assess and effectively act when it comes to risky or problematic institutions.
  • Building capacity to monitor macroprudential indicators and financial system stress, as part of a broader effort to bolster supervision and provide for earlier action to circumvent crises; considerable headway has been made in this regard in emerging and more advanced economies, but such efforts could also be pursued in frontier and developing Asia (Box 7.6).
  • Enhancing surveillance of nonbank financial institutions, particularly where NBFIs are not subject to sufficient oversight or regulation.
  • Establishing effective crisis-management and bank resolution frameworks, including for prompt remedial action.

Box 7.6Predicting Financial Sector Distress

Early recognition of financial sector vulnerabilities and stress is key to avoiding crises. Several macro-financial indicators can help highlight the buildup and realization of phases of systemic risk. Based on a sample of 40 countries with 76 instances of financial sector distress (IMF 2011d), these indicators include the following:

  • Increases in the credit-to-GDP ratio (either bank credit or a broader measure that also includes cross-border loans to domestic nonbanks) of more than 3 percentage points, year over year, could serve as early warning signals one to two years before a financial crisis. Postdistress, this measure falls sharply.
  • Credit-to-deposit ratios higher than 120 percent are associated with crises within the following year.
  • Private sector foreign liabilities typically accelerate rapidly before a crisis. External borrowing by banks and the nonbank private sector grows from about 10 percent to 25 percent in the run-up to financial stress.
  • Banks’ foreign liabilities as a fraction of domestic deposits increase from about 32 percent to 38 percent two years before a crisis.
  • Real effective exchange rates tend to appreciate rapidly in the run-up to a crisis in emerging market economies.
  • House prices, on average, tend to rise by 10 to 12 percent for two years before financial sector stress.

These indicators are based largely on a sample of advanced and emerging market economies. Their applicability to developing economies is not entirely clear—particularly where market forces are weaker and the evolution of financial crises tends to move more slowly. A more precise set of benchmarks geared to low-income countries is needed, but using the above indicators yields some findings of note for frontier and developing Asia.

All frontier and developing Asian economies have seen at least one year of credit-to-GDP growth in excess of 3 percent (Figure 7.6.1, panel 1). In Vietnam (which has faced some difficulties since 2009) this growth is the most pronounced, with an average increase of 6 percent a year between 2002 and 2012.

Figure 7.6.1Signs of Potential Distress in the Financial Sector

Sources: IMF, country desk data; and World Economic Outlook database.

With the exception of three countries, frontier and developing Asia has not seen credit-to-deposit ratios breach 120 percent. Vietnam’s credit-to-deposit ratios were well in excess of this threshold between 2002 and 2012—followed by Maldives, Mongolia, and Sri Lanka in the 80–90 percent range.

Private sector liabilities remain limited compared with Asian emerging market economies (as discussed earlier).

Real effective exchange rates have varied. During the past decade (since 2002), virtually every country in frontier and developing Asia has seen significant real effective exchange rate appreciation (Figure 7.6.1, panel 2). Since 2007, however, appreciation has been more moderate for most.

Real estate booms have been seen in Bhutan, Cambodia, Mongolia, Nepal, and Vietnam. In most of these countries, surges in housing and real estate prices and bank exposure to these sectors have been cited as factors in financial sector distress or as a potential vulnerability.

Policy Recommendations

Policy recommendations for financial sector reform need to be country specific and tailored to meet both needs and existing capacity. The countries examined in this chapter cross the spectrum of financial sector development. Common threads of vulnerability in frontier and developing Asian economies suggest a few areas for which policy focus is particularly warranted.

Enhancing data collection and analysis: Virtually all frontier and developing Asian economies have significant shortcomings in the quality and timeliness of data for financial soundness indicators. A focused effort to improve financial soundness indicator data collection, backed by a more rigorous application of international financial reporting standards, is essential. Initiatives in support of such efforts are critical if data and accounting are to improve to a degree sufficient not only to ensure effective supervision and prevention (or mitigation) of financial crises, but to instill the confidence needed for successful deepening of financial intermediation.

Building effective supervision: Supervisory resources appear inadequate relative to the size and growth rate of the financial sectors in many frontier and developing Asian economies. Capacity—the ability to undertake effective on- and off-site supervision and to accurately assess the level of risk in financial institutions or the financial system as a whole—also appears weak despite notable improvements in a number of these countries and intensive technical assistance from the IMF, the World Bank, and other international financial institutions and donors. Looking ahead, foreign bank entry and presence will also require additional supervisory skills and resources. The issue of enforcement—bringing noncompliant institutions in line with prudential standards—also remains. Enforcement is often undermined by political economy considerations; forbearance can be a product of relatively weak supervisory authorities facing powerful vested interests (including state-owned commercial banks).

Bringing prudential standards in line with international good practice: Weak or antiquated prudential standards are a common problem in frontier and developing Asia, particularly where the growth of banking activities and financial markets has outpaced supervision and regulation. This problem is not specific to frontier and developing Asia, but is compounded by strong economic growth and rapid financial sector deepening. In a number of these countries a quantum leap is needed to address existing weaknesses.

Establishing an effective framework for crisis resolution: The global financial crisis has highlighted the importance of establishing strong financial safety nets, but few countries in frontier and developing Asia have done so as yet. The norm has instead been to rely on mergers and ad hoc measures to deal with problem banks, as has been the case, for example, in Vietnam. In Cambodia, work on key elements of a crisis-management framework has not yet been initiated, and agreements on the delineation of responsibilities among different supervisory agencies are still pending. And even though the bank resolution regime in Sri Lanka has been effective, a comprehensive institutional and legal framework for tackling a systemic banking crisis has yet to be developed. Finally, most countries in frontier and developing Asia do not have financially viable deposit insurance schemes.

Creating or strengthening the supervisory framework for NBFIs: In many frontier and developing Asian economies, the nonbank financial sector remains small but has the potential to expand quickly and outside the supervisory umbrella. Thus, oversight of this sector needs to be significantly enhanced. Equally important, the supervision regime needs to be adequate to effectively oversee and evaluate the risks associated with banks’ participation in “nonbank” activities.

Another priority in many frontier and developing Asian economies is to strengthen the monitoring of systemic risks and to enhance the framework for macroprudential supervision. This is particularly important for countries with significant cross-ownership issues, and almost all IMF Asian Financial Sector Assessment Programs highlight the importance of developing a sound framework for macroprudential supervision and the monitoring of systemic risks as financial institutions grow in size, complexity, and interconnectedness.


Financial sector growth in frontier and developing Asia has been rapid since the early 2000s, with credit-to-GDP ratios rising quickly in virtually all the countries under review. Most systems in the region are bank-centric and are concentrated (measured by either the number of institutions or the sectors to which they lend). Also common are state-owned commercial banks—many with relatively poor balance sheets. Links to international financial markets are limited for most, given their state of financial development. But the growth of financial intermediation and financial institutions has generally outstripped supervisory capacity in virtually all frontier and developing Asian economies—including for the supervision of the nonbank financial sector in several of these economies.

Several risks arise from this rapid growth, and some echo the risk elements present in Asian emerging market economies before the financial crisis of 1997–99. Key challenges include a shortage of qualified staff, a lack of technical capacity, and data weaknesses that severely impair the quality of surveillance and supervision. Risk-based supervision is at an early stage of implementation in virtually all of these countries. Fragmentation, weak mandates, and lack of independence are also common supervisory challenges. Enforcement of existing prudential rules lacks teeth in some frontier and developing Asian economies—particularly notable with regard to single-borrower limits and related-party lending. Few countries in frontier and developing Asia have formal and effective crisis-management and bank resolution frameworks, including for the provision of liquidity and solvency support. Most frontier and developing Asian economies have some components of a crisis-resolution system, but fully operational frameworks are not in place.

Policy recommendations need to be tailored to country circumstances—the rate of change and development of financial sectors in different frontier and developing Asian countries varies widely. Enhancing data collection and analysis is a critical step for virtually all the countries reviewed in this chapter because supervisory authorities cannot be effective unless they know the true condition of the institutions (including NBFIs) under their purview. Closely related is the need for supervisory resources and a steady increase in supervisory capacity to keep pace with financial sector growth and diversification. Effective prudential frameworks are another key element of successful risk management, thus it is critical that the supervisory structure be supported by independent institutions and a fully developed crisis-resolution framework. As frontier and developing Asian economies continue to develop, additional resources may also need to be devoted to macroprudential frameworks, which are more common in emerging market and middle-income countries.

Frontier and developing Asian economies have made progress in improving the key pillars of financial sector supervision since 2000. For some, the onset of financial sector difficulties (in the bank or nonbank sector) served as a catalyst for reform. For others, supervision has gained greater attention because of the perception that risks are on the rise, the need to ensure that financial intermediation can contribute to sustained economic growth, and the prospect of entry into the market by foreign financial institutions. Most frontier and developing Asian economies have financial sector reform plans, and virtually all are intensive users of IMF technical assistance in this area, as well as of assistance from the World Bank. The areas that have improved most visibly focus on the quality and timeliness of supervision, reforms to the legal framework (usually through central bank or commercial bank laws), and the bolstering of financial sector infrastructure such as deposit insurance and credit registries.

Appendix 7A: Assessing Vulnerability, Preparedness, and Policy Response
Table A7.1Authorities’ Responses to Financial Sector Vulnerabilities
Domestic Financial Sector Reform ProgramFSAP Completed or in ProcessAverage Intensity of IMF Technical Assistance, 2010–13Share (%) of Financial Sector TA out of Total TA Hours, 2010–131World Bank Technical AssistanceAreas of ProgressAreas for Further Improvement
BangladeshYes2003, 2010High54.7YesBank supervision; risk and capital management; stress testing; prudential standards.Loan classification and provisioning; enforcement of prudential standards; nontraditional banking; credit information; state banks.
BhutanNoNoLow0.0NoCentral bank act; regulatory regimePrudential standards; supervisory capacity; rapid credit expansion.
CambodiaYes2010High46.8YesFSI compilation; asset classification and provisioning; capital requirementsLow supervisory capacity and human resources; weak financial data quality; concentration of assets; weak oversight of foreign firms; emergence of NBFIs.
Lao P.D.R.NoNoMedium0.0NoState bank restructuringRapid credit growth; weak risk management capacity; data gaps in financial reporting; quality of FSIs.
MaldivesNoNoHigh61.7YesDeposit insurance; AML/CFT legislationWeak supervision; regulatory forbearance; state banks
MongoliaYes2008, 2011High10.1YesPrudential requirements; deposit insurance; credit registry.FSI data; forbearance, weak governance; cross-ownership and asset concentration.
MyanmarYesNoHigh40.5YesCentral bank law; improved supervisory and regulatory framework; NPL and bank capital definition.Weak supervision; rapid credit growth; shadow financial system.
NepalYes2014High22.2YesCentral bank law; supervision; prudential standards; deposit insurance; financial institutions legal framework; bank resolution.Insufficient supervisory capacity; weak FSI reporting; capital adequacy; shadow banking; forbearance.
Papua New GuineaYes2011Low50.0YesSupervision; central bank act and financial institutions law.Prudential standards; legal framework for problem bank management; insufficient funding and staffing for supervision.
Sri LankaYes2002, 2008, 2013Low9.1YesSupervisory capacity; state bank reform; NBFI oversightPrudential standards; crisis management framework; bank resolution framework; macroprudential policy coordination.
VietnamYes2013High41.9YesCapital adequacy.Supervision; prudential standards; FSI data; resolution framework; licensing framework.
Sources: IMF, Monetary and Capital Markets Department and Office of Technical Assistance Management; IMF technical assistance and staff reports; and World Bank.Notes: AML/AFT = Anti-Money Laundering/Combating the Financing of Terrorism; FSAP = Financial Sector Assistance Program; FSI = financial sector indicators NBFI = nonbank financial institution; NPL = nonperforming loan; TA = technical assistance.

Does not include resident advisers in Bangladesh, Cambodia, Myanmar, Nepal, and Vietnam.

Sources: IMF, Monetary and Capital Markets Department and Office of Technical Assistance Management; IMF technical assistance and staff reports; and World Bank.Notes: AML/AFT = Anti-Money Laundering/Combating the Financing of Terrorism; FSAP = Financial Sector Assistance Program; FSI = financial sector indicators NBFI = nonbank financial institution; NPL = nonperforming loan; TA = technical assistance.

Does not include resident advisers in Bangladesh, Cambodia, Myanmar, Nepal, and Vietnam.

Appendix 7B
Table A7.2Foreign Bank Entry
CountryTimelineModelLevel of Financial Liberalization when Entry Is Allowed1
Asian Emerging Market Economies
KoreaBranches of foreign banks allowed since end-1967, although not allowed to engage in retail banking.

1992—Foreign security companies authorized to do business. Only branches allowed.

1993—Announcement of a five-year plan aimed mainly at interest rate deregulation and abolishing the limits on maximum maturity loans and deposits.

1996—Korean government announcement of a blueprint to remove barriers from foreign portfolio investment and foreign direct investment.

1998—Foreign banks and securities firms from Organisation for Economic Co-operation and Development (OECD) countries allowed to establish subsidiaries in Korea.

2000—Aggregate foreign investment ceilings for investors from OECD countries to be phased out.

Ceilings on foreign equity ownership increased from 49 percent in 1996–97 to 100 percent (no limits) after the financial crisis of 2007–08.

If foreign equity participation in domestic banks exceeds 10, 25, and 33 percent up to 100 percent, it needs to be approved by the Financial Supervisory Committee.
Allowed foreign branches and foreign investment in domestic banks first. Fully owned subsidiaries were allowed later. Substantial financial liberalization in 2000s following the Asian financial crisis.Relatively low when branches were allowed in 1967, with substantial interest rate controls.

Exchange restrictions present.

Relatively high during period when subsidiaries were allowed.

Article VIII—November 1988.
ThailandBefore 1997, foreign commercial banks were limited to a single branch with no automated teller machines and focused primarily on trade financing, with little emphasis on retail banking. Foreign banks could operate in a more limited capacity under an offshore license as an international banking facility. Following the 1997–98 financial crisis, up to 100 percent foreign ownership of domestic financial institutions on a case-by-case basis for a 10-year period was allowed, after which the foreign banks would not be able to take up additional equity unless they held less than 49 percent of equity.

2004—Foreign banks allowed to open branches or subsidiaries.
Ownership in local banks, then fully owned branches and subsidiaries. However, fully owned branches and subsidiaries restricted in the number of offices allowed.

A foreign bank subsidiary allowed to open one branch within Bangkok and three branches elsewhere. A full branch of a foreign bank cannot open any branches.
Relatively high. Some interest controls (deposit ceilings present).

No exchange restrictions during 1997 liberalization.

Article VIII—May 1990.
IndonesiaForeign bank branches allowed in 1967. Subsidiaries and joint ventures (JVs) allowed in 1988.

Before 1998, foreign ownership in local banks was limited to 49 percent.

1998—Foreigners allowed to directly acquire or purchase bank shares through stock exchange and own up to 99 percent of listed and private banks and JVs.
Bank branches first, subsidiaries and JVs later. Similar regulations for subsidiaries and branches.

Big push for liberalization (implemented during the Asian crisis).
Relatively low when bank branches were allowed in 1967. Interest controls present.

Relatively high during “big bang” episode of 1998.

Exchange restrictions in place when bank branches were allowed. No exchange restrictions during big bang of 1998.

Article VIII—May 1988.
MalaysiaFull foreign bank presence allowed for many years in the form of subsidiaries. Ownership of local institutions limited to 30 percent. In 2011, limit on foreign ownership of local Islamic banks raised to 70 percent.Limited foreign subsidiary and foreign ownership allowed in local banks. No branches allowed.Relatively high. Some interest controls in place when bank presence was allowed.

No exchange restrictions.

Article VIII—November 1968.
ChinaDuring 1980s and 1990s, operations of foreign banks restricted mostly to special economic zones. The timeline was, to a large extent, influenced by commitments under the entry to the World Trade Organization (WTO) in 2001.

2003—Foreign ownership limit in local banks raised to 25 percent from 15 percent.

2007—Foreign banks allowed to establish branches, subsidiaries, and JVs after establishing a representative office. Limits on foreign ownership of 20 percent for individual investors and 25 percent overall.
Only foreign commercial banks with a representative office in China for at least two years before the application, and with total assets of at least $10 billion at the end of the year preceding the application allowed to apply for establishment of a wholly foreign-funded subsidiary, with higher restrictions for branches. Banks that do not incorporate locally must take individual deposits of at least 1 million renminbi, which limits their ability to compete.Limited, with interest rate controls.

No exchange restrictions during post-WTO reforms.

Article VIII—December 1996.
IndiaIn the early 1990s, foreign banks allowed to acquire stakes in local banks, initially at 10 percent, growing to 47 percent by 1996 and 75 percent after 2007.

2005—new-entrant foreign banks allowed to open 100 percent owned subsidiaries or branches outright and the limit on the number of branch offices abolished.
Allowed investment in foreign banks first, subsidiaries and branches later.Significant financial liberalization measures undertaken simultaneously with allowing bank entry, including liberalization of interest rate.

No exchange restrictions.

Article VIII—August 1994.
Asian Emerging Market Economies
Singapore1999—Five-year liberalization program allowed qualified foreign banks to conduct operations with residents on a broad scale.

2012—announcement that some qualifying full banks deeply rooted in the economy would be required to incorporate locally.
Foreign banks operating with Singapore residents need to acquire special license.

Branches are required to maintain minimum level of assets in proportion to their liabilities. Limits on foreign equity ownership in foreign banks (40 percent).

No interest controls.

No exchange restrictions.

Article VIII—November 1968.
Frontier and Developing Asia
BangladeshAfter nationalization of the banking system in 1972, foreign banks allowed to operate as branches. Nine foreign commercial banks are operating in Bangladesh as branches of banks that are incorporated abroad.Foreign banks in Bangladesh are exclusively branches and are broadly subject to similar prudential requirements, although the licensing process for opening new branches is less stringent for foreign commercial banks than for Bangladeshi banks.Low.
BhutanThe Bank of Bhutan established in 1968 as a JV with Chartered Bank of India, Australia, and China. In 1973 it was reconstituted as a JV with the State Bank of India (SBI), which held a 40 percent stake. SBI’s share was reduced to 20 percent in 1987. Druk PNB entered the market as a JV with Punjab National Bank holding more than 51 percent.Branches, subsidiaries, and JVs allowed by law. Joint venture foreign ownership limited to 51 percent.Low. Financial liberalization increasing since 2010 as a result of reforms.
CambodiaIn the early 1990s, private banks allowed during the transition away from the monobank model. Domestic and foreign banks treated equally and required to start as JVs with the National Bank of Cambodia (NBC). The reform initially created four commercial banks (two domestic, two foreign). Within two years, the government eliminated the JV requirement with NBC. All commercial banks—domestic and foreign—could start with 100 percent private equity. Thus, beginning in 1993, 100 percent foreign ownership allowed. Unlike in neighbors (such as Vietnam), foreign banks allowed to mobilize domestic deposits from the beginning. No special approval needed for foreign banks to open new branches (but some capital requirements for domestic banks and new branches).Big-bang approach. The banking system was liberalized to include both domestic and foreign investors with comparable treatment.

No difference in regulatory treatment between branches and subsidiaries.
Mostly liberalized (big-bang approach), including with regard to interest rates.

Exchange restrictions present.

Article VIII—January 2002.
Lao P.D.R.JV banks and foreign bank branches allowed since the early 1990s.JV banks and foreign bank branches allowed simultaneously. No subsidiaries allowed.

No upper limit on foreign equity in JV, lower limit of at least 30 percent.

Exchange restrictions present. Article VIII—May 2010.
MaldivesFour branches of foreign banks opened since mid-1970s:
  • State Bank of India, Malé branch established in 1974
  • Habib Bank Limited, Malé branch established in 1976
  • Bank of Ceylon, Malé branch established in 1981
  • HSBC, Malé branch established in 2002
One subsidiary of a foreign bank: Mauritius Commercial Bank, Maldives, established in 2008.
Legally, no restrictions on foreign ownership, but the authorities exercise discretion. The Maldives Monetary Authority (MMA) encourages and welcomes foreign entrants to the Maldivian banking and financial industry and considers proposals from foreign and local applicants. MMA encourages increased participation by local investors because of the benefits of retention of profits and attentiveness to the needs of the local economy; however, paramount importance placed on the overall quality and competence of the proposed owners, board of directors, and executive management. MMA indicates that it makes no distinction between nor has a preference for whether a foreign bank applies to establish a presence in Maldives as a branch or subsidiary. Foreign banks may apply for license to operate in either capacity. Critical factors for MMA are whether there are any constraints or requirements posed by the group or organizational structure of the applicant or the applicant’s home country regulator and whether operations in Maldives will help or hinder MMA’s ability to properly supervise and regulate the new entrant.Low.
MongoliaForeign participation in the banking sector currently limited to “representative offices” of Standard Chartered, ING, and Bank of China. In 2012, new bank regulation allowed establishment of subsidiaries. Foreign banks may establish local subsidiaries no earlier than one year after establishment of their Mongolian representative offices. Initial capital requirements for foreign subsidiaries significantly higher than for domestic banks.No explicit restrictions in the law on operating branches, subsidiaries, or banks with joint participation. Bank may open after establishment of representative offices.Current level relatively high.
Frontier and Developing Asia
MyanmarNo foreign bank presence yet.Not decided. Authorities considering allowing JVs first.No foreign bank entry allowed yet. Banking system subject to various restrictive controls.
NepalFirst foreign JV bank set up as Nepal Arab Bank Ltd (now Nabil Bank Ltd) in 1984. Two foreign JV banks, Nepal Indosuez Bank Ltd (now Nepal Investment Bank) and Nepal Grindlays Bank Ltd (now Standard Chartered Bank Nepal Ltd) established in 1986 and 1987, respectively. Currently 17 commercial banks in operation: 6 foreign JVs and 11 fully domestic banks.JVs.Relatively high.
Papua New GuineaBranches of ANZ and the National Bank of Australia opened in the 1950s. In the 1970s, foreign branches converted into subsidiaries. In 1983, Papua New Guinea invited the banks to open affiliates (JVs) on the condition that the foreign parent could own only 49 percent and the central bank would buy the portion of the remaining shares that foreign investors did not pick up. Today, out of four major banks, three are foreign owned: ANZ, Westpac, and Maybank.No official limits; currently all foreign banks operate as subsidiaries.Relatively low.
Sri LankaBranches of foreign banks allowed in 1979.

Limits on foreign ownership by foreign banks raised to 90 percent from 60 percent in 2000.
No restrictions on foreign shareholdings or opening branches and subsidiaries. However, there are restrictions on the number of expatriates employed by foreign banks:

  • 3 for banks with fewer than 75 staff
  • 5 for banks with staff of 75 to 400
  • 10 for banks with more than 400 staff

Employment of expats by local banks on a case-by-case basis.

Discretionary considerations for opening of branches of foreign banks.
Relatively low.
Vietnam1990—Representative offices of commercial banks allowed.

1994—Foreign banks allowed to take minority stakes in local banks as JVs.

2008–100 percent foreign owned foreign bank subsidiaries allowed.

Limits on foreign equity ownership in foreign banks of 30 percent.
Foreign banks initially could enter Vietnam through purchase of minority stakes in local banks. Foreign ownership share of JV banks limited to 49 percent of capital. At least 20 percent of managers, executives, and specialists must be foreign nationals in the JV bank. Onshore foreign bank branches initially not allowed to open entry points other than their head offices. Fully owned subsidiaries allowed later. Additional restrictions on branches to open local offices.Relatively low. Various restrictions, including interest rate ceilings.

Exchange restrictions present.

Interest rate ceilings reimposed in 2008.

Article VIII—November 2005.
Sources: Country documents and research papers; and IMF country teams.

Notations for Article VIII indicate when the member country accepted the obligations of Article VII under the IMF’s Articles of Agreement. Obligations of members under Article VIII include avoidance of restrictions on the making of payments and transfers for current international transactions, avoidance of discriminatory currency practices (including multiple currency practices) and providing necessary information to the IMF.

Sources: Country documents and research papers; and IMF country teams.

Notations for Article VIII indicate when the member country accepted the obligations of Article VII under the IMF’s Articles of Agreement. Obligations of members under Article VIII include avoidance of restrictions on the making of payments and transfers for current international transactions, avoidance of discriminatory currency practices (including multiple currency practices) and providing necessary information to the IMF.

Appendix 7C: Conditions for Foreign Bank Entry

Regardless of the model of bank entry used, a number of regulatory and supervisory conditions need to be in place to ensure that foreign bank entry is consistent with financial sector stability:

  • Criteria for foreign bank entry: The foreign bank should be a reputable financial institution from a country with a strong regulatory and supervisory regime. The applications should not discriminate by region or domicile of the bank.
  • Necessary supervisory and regulatory elements: A strong regulatory and supervisory framework is essential for maintaining financial stability during any liberalization of the financial system, regardless of foreign entry. However, the minimum regulatory and supervisory elements that should ideally be in place include the following:
    • Establishing contact and coordination with home-country supervisors of foreign banks that are applying to enter the market: Coordination should follow best principles outlined by the Basel Committee.4 Regular and well-defined relations and information sharing between home and host country supervisors are essential for effective consolidated bank supervision of foreign branches and subsidiaries.
    • Enhancing bank governance to ensure arm’s-length relations between bank management and bank customers, including through strengthened connected-lending limits and fit-and-proper requirements.
    • Establishing a level playing field between state and private banks by subjecting the former to the same regulations and supervision: Identical regulation is especially relevant for countries in which certain banking activities (for example, international banking and sectoral lending) are subject to some degree of government control and state banks are not subject to the same requirements as private banks.

The regulations should accommodate cross-border financial flows and dividend payments essential for foreign investment and financial operations. At a minimum, clear guidelines on dividend policy, repatriation of profits, and transfer of foreign shares to third parties should be established. For example, there may be a need to liberalize borrowing from abroad (for branches, predominantly from the parent; for subsidiaries, this may include the broader market, at par with domestic banks) and payment of interest on such borrowing, extension of financial credits from residents to nonresidents (for domestic bond issuance, for instance), and other related restrictions.


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This chapter covers Bangladesh, Bhutan, Cambodia, Lao P.D.R., Maldives, Mongolia, Myanmar, Nepal, Papua New Guinea, Sri Lanka, Timor-Leste, and Vietnam. Given the limited availability of data, Myanmar is not included in some analyses.


Cross-country comparison of NPLs is hampered by varying accounting standards and quality of enforcement and is here meant to be illustrative.


The credit-to-GDP ratio works well partly because it behaves countercyclically; most risk measures underestimate risk during the upswing and overestimate it during the downswing. However, a study covering 107 countries finds that neither private sector domestic credit as a share of GDP nor domestic bank credit as a share of GDP provided an early warning of the 2008 crisis (Rose and Spiegel 2009).


The Basel Committee on Banking Supervision advises that all international banking groups and international banks be supervised by a home country authority that capably performs consolidated supervision. The creation of a cross-border banking establishment should receive the consent of both the host supervisor and the bank’s supervisor, and if different, the banking group’s home country supervisor. Supervisors should possess the right to gather information from cross-border banking establishments of the banks or banking groups for which they are the home country supervisors. If a host country supervisor determines that any one of these minimum standards is not met to its satisfaction, it could impose restrictive measures or prohibit the establishment of banking offices.

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