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    INTERNATIONAL MONETARY FUND

    Middle East and Central Asia Department

    Building Resilient Banking Sectors in the Caucasus and Central Asia

    Mercedes Vera-Martin, Tarak Jardak, Robert Tchoidze, Juan Trevino, and Helen Wang Wagner

    No. 18/08

    Caucasus and Central Asia Department

    Building Resilient Banking Sectors in the Caucasus and Central Asia

    Mercedes Vera-Martin, Tarak Jardak, Robert Tchaidze, Juan Trevino, and Helen Wang Wagner

    INTERNATIONAL MONETARY FUND

    Copyright ©2018 International Monetary Fund

    Cataloging-in-Publication Data

    Joint Bank-Fund Library

    Names: Vera-Martin, Mercedes. | Jardak, Tarak. | Tchaidze, Robert. | Trevino, Juan. | Wagner, Helen Wang. | International Monetary Fund.

    Title: Building resilient banking sectors in the Caucasus and Central Asia.

    Description: [Washington, DC] : International Monetary Fund, 2018. | The team was led by Mercedes Vera Martin, and included Tarak Jardak, Robert Tchaidze, Juan Trevino, and Helen Wang Wagner. | Includes bibliographical references. Identifiers: ISBN 9781484360774 (paper)

    Subjects: LCSH: Banks and banking—Caucasus. | Banks and banking—Asia, Central. | Caucasus—Economic conditions. | Asia, Central—Economic conditions.

    Classification: LCC HG3256.16.B84 2018

    The Departmental Paper Series presents research by IMF staff on issues of broad regional or cross-country interest. The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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    Acknowledgments

    This Departmental Paper from the IMF’s Middle East and Central Asia Department was prepared by a staff team under the guidance of Juha Käh-könen and supervised by Mark Horton. The team was led by Mercedes Vera Martin and included Tarak Jardak, Robert Tchaidze, Juan Trevino (all Middle East and Central Asia Department, MCD), and Helen Wang Wagner (from Statistics Department). Mansour Almalik and Jorge de Leon (both MCD) provided research assistance. The authors thank Nicolas Blancher, Padamja Khandelwal, Marina Moretti, Stephane Roudet, Wei Shi, country teams, and other staff members from MCD and MCM for their very helpful comments and suggestions. The authors are also grateful to Madina Toshmuhamedova for production assistance and to Peter Kunzel (MCD) and colleagues from the Communication Department for communication strategy assistance.

    Executive Summary

    External shocks since 2014—lower oil prices and slower growth in key trading partners—have put banking sectors in the eight Caucasus and Central Asia (CCA) countries under stress.1 Even before the shocks, CCA banking sectors were not at full strength. Asset quality was generally weak, owing in part to shortcomings in regulation, supervision, and governance. The economies were highly dollarized. Business practices were affected by lack of competition and, in most countries, connected lending, which undermined banking sector health. Shortcomings in financial regulation and supervision allowed the unsound banking practices to remain unaddressed. The external shocks exacerbated these underlying vulnerabilities. Strains in CCA banking sectors intensified as liquidity tightened, asset quality deteriorated, and banks became undercapitalized. These challenges have required public intervention in some cases.

    All CCA countries have taken policy actions in response to the shocks. Foreign exchange liquidity was provided at the cost of lower external buffers. Exchange rates were adjusted and, in most cases, became more flexible. Fiscal policy supported domestic demand. To address liquidity pressures in the financial sector, central banks eased monetary conditions and used buffers to limit the negative impact on lending. In countries in which banks were most affected, initial policy actions focused on ensuring that financial sectors remained operational, with more comprehensive programs for enhancing financial stability announced only later. In contrast, banking sectors in countries that better withstood the shocks have been able to support credit with the rebound in global economic activity. This reflects not only those countries’ stronger financial sectors before the shocks, but also the authorities’ proactivity in strengthening regulation and supervision.2

    But more needs to be done to restore the health of CCA financial sectors, so that CCA banking sectors are in strong shape to support much-needed economic diversification and more inclusive and sustainable economic growth over the medium term. Notwithstanding policy actions, credit growth slowed throughout the region, and it has remained subdued in many CCA countries. Indeed, in some cases there is still the risk that financial instability could trigger macroeconomic instability, with severe and persistent consequences, including a long-lasting loss of confidence in financial intermediaries. There-fore, further actions are needed.

    Fully addressing these vulnerabilities will require a comprehensive strategy and strong commitment from the authorities. The exact strategy will depend on country specifics and will require prioritizing objectives, depending on the financial health of banks.

    Countries in which risks to financial stability remain elevated should put immediate focus on accurately assessing banks’ health. A proper diagnosis will help the authorities formulate a strategy to address nonperforming loans, assess provisioning and capitalization needs, and prepare resolution strategies for nonviable banks. In this context, bank resolution frameworks need to be strengthened to ensure that support will be provided only to viable banks and under strict conditions, and that insolvent institutions will be closed in an orderly manner, while protecting retail customers through deposit insurance schemes. This strategy will facilitate timely intervention, help contain fiscal costs and support a swifter recovery in financial intermediation and economic growth.

    All CCA countries need to strengthen bank governance and regulatory and supervisory frameworks. A strong governance structure would emphasize transparency, include clear responsibility at the banks’ executive and board levels, limit public sector influence in banks’ operations, and establish independent risk management, compliance, and internal control units. The focus in making regulation and supervision more effective should be on improving risk-based and consolidated supervision, implementing macroprudential frameworks, and improving credit risk valuation. These actions would support development of a better functioning financial system and allow the financial sector to do more to promote greater and more inclusive economic growth.

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