Extended Annual Review Report

Project Number: 41911 Loan Number: 2343 September 2013

Senior Unsecured Loan Khan Bank (Mongolia)

This is an abbreviated version of the XARR which excludes commercially sensitive and confidential business information that is subject to exceptions to disclosure set forth in ADB's Public Communications Policy 2011.

CURRENCY EQUIVALENTS Currency Unit – togrog (MNT)

At Appraisal

At Project Review 15 April 2007 3 June 2012 MNT1.00 = $0.00086 $0.00070

$1.00 = MNT1,163 MNT1,437

ABBREVIATIONS ADB – Asian Development Bank CAGR – compounded annual growth rate EBRD – European Bank for Reconstruction and Development EROIC – economic return on invested capital FDI – foreign direct investment FMO – Nederlandse Financierings-Maatschappij voor

Ontwikkelingslanden IFC – International Finance Corporation IFI – international financial institution LIBOR – London interbank offered rate MSMEs – micro, small, and medium-sized enterprises NPL – nonperforming loan PSOD – Private Sector Operations Department rGMF – responsAbility Global Microfinance Fund ROIC – return on invested capital SMEs – small and medium-sized enterprises WACC – weighted average cost of capital

NOTE

In this report, “$” refers to US dollars.

Vice-President L. Venkatachalam, Private Sector and Cofinancing Operations Deputy Director General J. Yamagata, Private Sector Operations Department (PSOD) Director C. Engstrom, Private Sector Financial Institutions Division, PSOD Team Leader S. Hruschka, Principal Investment Specialist, PSOD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgment as to the legal or other status of any territory or area.

CONTENTS

Page BASIC DATA i EXECUTIVE SUMMARY ii

I. THE PROJECT 1

A. Project Background 1 B. Key Project Features 1 C. Progress Highlights 2

II. EVALUATION 2

A. Project Rationale and Objectives 2 B. Development Impact 3 C. ADB Investment Profitability 8 D. ADB Work Quality 8 E. ADB’s Additionality 8 F. Overall Evaluation 9

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS 9

A. Issues and Lessons 9 B. Recommended Follow-Up Actions 9

APPENDIXES 1. Project Related Data 10 2. Funding from International Finance and Government Institutions 14 3. Mongolia: Economic and Banking Sector Overview 16 4. Private Sector Development Indicators and Ratings: Financial Intermediaries 25 5. Comparative Financial Statements 27 6. Environment and Social Management System 28

BASIC DATA

Senior Unsecured Loan: Khan Bank (2343-REG Mongolia)

Key Project Data As per ADB Loan

Documents Actual

Total Project Cost ADB Investment:

Loan: Committed Disbursed Outstanding

$10 million

$10 million

$10 million

$10 million

Key Dates Expected Actual

Concept Clearance Approval Board Approval Loan Agreement Loan Effectiveness First Disbursement Loan Closing

2007 2007 2007 2007 2008 2013

3 Apr 2007 2 Aug 2007 19 Nov 2007 19 Nov 2007 4 Mar 2008

16 Nov 2013

Financial and Economic Rates of Return on Invested Capital (%) Appraisal XARR

Return on invested capital—real Economic return on invested capital—real

Project Administration and Monitoring Number of Missions

No. of Person-Days

Concept Clearance 1 Data not available Due Diligence Mission 1 5 Private Sector Credit Committee Meeting Board Approval

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EXECUTIVE SUMMARY

In August 2007, the Board of Directors of the Asian Development Bank (ADB) approved a senior unsecured loan of $10 million to Khan Bank, with a maturity of 6 years. The project aimed to provide wider access to longer-term loans denominated in US dollars to corporate borrowers in Mongolia. The objectives of ADB’s loan to Khan Bank were to (i) catalyze the growth of Mongolian enterprises by facilitating such funding, thereby contributing to further diversification in the Mongolian economy, and (ii) help improve finance sector efficiency and depth by enabling Khan Bank to offer loans with longer maturity and to grow its corporate banking business. The loan agreement was finalized in November 2007. The aggregate balance of the loan was $2.4 million as of September 2013, with the final payment and loan maturity scheduled for November 2013.

After being privatized in 2003, Khan Bank had become by 2007 Mongolia’s largest bank and the one with the biggest rural branch network. The bulk of its loans were to individuals and micro, small, and medium-sized enterprises. Khan Bank sought to expand its lending to corporations and larger firms in the small and medium-sized enterprise (SME) category in light of anticipated growth of the Mongolian economy. It planned to capitalize on its competitive edge in rural, micro and small business finance toward expanding its presence in corporate banking through the business links between its clients and larger corporations. However, Khan Bank’s dependency on short-term deposits constrained business expansion. ADB’s loan aimed to help fill this void by helping Khan Bank to grow its corporate banking business, thus enabling Mongolian enterprises to access needed financial services and achieve their optimal size.

The impact of ADB’s loan to Khan Bank on private sector development is rated satisfactory. The loan was successful in terms of helping Khan Bank extend additional loans, expand its corporate lending business, and diversify its business overall. The loan also contributed in some measure to enhanced competition and a more diversified banking sector. Considered alongside financial support provided by various international financial institutions (IFIs), ADB’s loan helped Khan Bank to diversify its loan book and thus weather the 2008–2009 global financial crisis better than its peers.

Khan Bank’s business and economic performance is rated excellent. As of year-end 2012, Khan Bank maintained its lead as the largest bank in Mongolia, with the highest share of loans, deposits, and capital in the country. The bank has maintained a strong capital position and recurring earnings better than most of its peers, and its performance demonstrates that a well-managed bank can be resilient and perform well despite difficult and volatile economic conditions. The success of Khan Bank emanates from professional management, responsible governance, the use of innovative technology, its introduction of new products, and its skill at building partnerships with the government, IFIs, and others. The financial parameters related to Khan Bank’s business success and profitability—e.g., real return on invested capital and economic return on invested capital—are considerably higher than the hurdle rates set in ADB guidelines for extended annual reviews and qualify to be rated excellent.

The investment profitability of the project is rated satisfactory. The margin ADB charged Khan Bank was in line with various US dollar-denominated loans extended by IFIs to Khan Bank in the same time period as ADB’s loan.

The project’s environmental, social, health, and safety performance is rated satisfactory. ADB’s loan to Khan Bank was in the financial intermediary category under ADB’s Environment Policy (2002). Khan Bank adopted an environmental and social policy consistent with the

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standards of ADB and other IFIs. The policy was integrated into Khan Bank’s loan appraisal process and included an exclusion list and processes to assess and mitigate environmental and social risks. ADB’s loan was category C for impact on indigenous peoples. No involuntary resettlement of indigenous peoples has resulted from Khan Bank’s activities.

ADB’s work quality is rated satisfactory based on its (i) screening, appraisal, and structuring; (ii) monitoring and supervision; and (iii) role and contribution. ADB’s loan was a collaborative effort with the International Finance Corporation (IFC), and both loans bore the same structure. The $47 million in US dollar loans raised by Khan Bank in late 2007 from IFIs, including $10 million from ADB, allowed it to diversify its lending and provided it with an additional buffer to weather the global financial crisis, maintain portfolio growth and profitability, and outperform its peers.

ADB’s additionality is rated satisfactory. The nature of ADB’s loan as a cooperative effort with IFC renders a precise assessment of the incremental effect of ADB’s loan difficult, given the overlapping benefits of similar facilities from other multilateral institutions that were utilized by Khan Bank in the same period. However, ADB’s loan had, in conjunction with those of other IFIs, a cumulative effect on Khan Bank and the Mongolian banking sector. It achieved the outcomes targeted in the transaction’s report and recommendation of the President, and built upon work previously begun by IFC. ADB’s Private Sector Operations Department approach to financial sector development includes supporting joint efforts with other IFIs where warranted by the anticipated development results and the lack of other sources of funding.

This extended annual review report rates ADB’s investment in Khan Bank successful overall. One lesson is that the Khan Bank model can be used as an example of best practice toward developing banking systems and access to finance in countries where bank penetration is low and in sparsely populated regions where financial services are unavailable.

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I. THE PROJECT

A. Project Background

1. In August 2007, the Board of Directors of the Asian Development Bank (ADB) approved a senior unsecured loan of $10 million to Khan Bank, with a maturity of 6 years.1 The project aimed to provide wider access to longer-term loans denominated in US dollars to corporations and larger small and medium-sized enterprises (SMEs) in Mongolia. The loan agreement was finalized in November 2007.

2. Privatized in 2003, Khan Bank had become by 2007 Mongolia’s largest bank measured by either assets or market share, and it had the most developed rural branch network in the country, providing financial services to more than half of Mongolian households. The bulk of its loan portfolio (89%) in 2007 was to individuals and to micro, small, and medium-sized enterprises (MSMEs). Only 11% of its loans were to corporate enterprises and large SMEs, a lending sector dominated by Trade and Development Bank and Golomt Bank.2

3. Khan Bank sought to expand its lending to corporations and large SMEs in light of the anticipated growth of the Mongolian economy and changes in regulations that encouraged corporate consolidation. The bank aimed to capitalize on its competitive edge in rural, micro, and small business finance to expand its presence in corporate banking, mainly in Ulaanbaatar, through the business links between its MSME clients and larger corporations. However, Khan Bank’s dependency on short-term deposits constrained business expansion. ADB’s loan aimed to help fill this void by helping Khan Bank to grow its corporate banking business, thus enabling Mongolian enterprises to access needed financial services toward achieving their optimal size.

4. In 2010, ADB’s East Asia Department provided a separate loan to Khan Bank, indirectly via the Mongolian Ministry of Finance, to finance value chain development in companies using agricultural raw materials to manufacture export-oriented products. The loan bears no interest, and its current balance is approximately $3 million. This review covers only the $10 million direct loan made to Khan Bank by ADB’s Private Sector Operations Department (PSOD).

B. Key Project Features

5. ADB collaborated on the project with the International Finance Corporation (IFC). IFC provided a $15 million, 6-year loan to Khan Bank, and the loans from both ADB and IFC were structured on similar terms. 3 Separately, the European Bank for Reconstruction and Development (EBRD) provided a $10 million, 6-year loan to Khan Bank. The agreements for all three loans, totaling $35 million, were signed in the fourth quarter of 2007, with the first drawdown on all three loans occurring in the first half of 2008. The proceeds of these loans were on-lent to corporate and large SME borrowers in 2008. Khan Bank also obtained $12 million funding in December 2007 from responsAbility Global Microfinance Fund (rGMF). In total, Khan Bank received $47 million in long-term loan commitments from ADB and other international financial institutions (IFIs) toward the end of 2007.

1 ADB. 2007. Report and Recommendation of the President to the Board of Directors. Proposed Loan—Mongolia:

Khan Bank. Manila. 2 Because Mongolian firms are relatively small, “corporate loans” in this context deviates from the standard definition.

They encompass loans made to corporations and large SMEs by Khan Bank’s Wholesale Banking Division for working capital and investment purposes. Such foreign currency loans exceed $1.0 million and entail highly complex customer service.

3 IFC has been a shareholder in Khan Bank since December 2004 and currently has a 9.3% stake in it.

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6. The project gave Khan Bank access to a long-tenor loan on attractive commercial terms, with commensurate structural features and covenants to mitigate risks for ADB. The 6-year loan to Khan Bank carried a 2-year availability period and priced at the 6-month London interbank offered rate (LIBOR) plus a credit margin.4 Khan Bank drew down $8 million of the loan in the first half of 2008, with the balance of $2 million disbursed in December 2009. The aggregate balance of both disbursements was $2.4 million as of September 2013, with the final payment and loan maturity set for November 2013.

C. Progress Highlights

7. Khan Bank’s large enterprise lending received a major fillip in 2008 from the $47 million in funding obtained from ADB and other IFIs. The bank’s foreign currency corporate loans increased by 150% from $35 million in 2007 to $88 million in 2008, reflecting the funds acquired from ADB and other IFIs.5 The number of corporate borrowers of foreign currency increased by 2.4 times in 2008 from 2007 levels. As a share of its overall portfolio, Khan Bank’s foreign currency corporate loans doubled from 8.6% in 2007 to 16.9% in 2008.

8. Khan Bank remained profitable throughout 2007–2012, though it was adversely affected by the 2008–2009 global economic crisis. A collapse in copper prices in the second half of 2008 triggered a drop in Mongolian exports, adversely affecting the economy and the banking sector.6 Flagship mining projects in Mongolia, such as the Oyu Tolgoi copper mine and the Tavan Tolgoi coalfield, are funded primarily by international commercial banks. However, domestic financial institutions like Khan Bank have indirect exposure to mining through the various supply chains that feed into the mining industry. The crisis prevented Khan Bank from building on the momentum of its initial surge in lending to corporations and large SMEs in 2008, causing the bank’s loan portfolio in this segment to remain flat in 2009 and 2010. Khan Bank’s lending to enterprises picked up again in 2011, aided by growth in foreign currency deposits, corporate deposits, and funding from IFIs and government bodies.

II. EVALUATION

A. Project Rationale and Objectives

9. The Mongolian economy saw rapid growth in the early and mid-2000s, aided by buoyant global demand for commodities. Increased demand for financial services from households and from construction, agriculture, and mining firms fueled strong growth in the banking sector. This was aided by relatively stable inflation and exchange rates. However, the deposit structure of Mongolian banks remained biased toward the short term, with almost no long-term deposits or funding that could facilitate longer-tenor lending. Much of the long-term lending resources in the country originated either from international development partners or directed credit initiatives from the Government of Mongolia. Banks focused primarily on short-term and collateral-based lending to retail and MSME borrowers. The lack of financial services constrained the growth of existing Mongolian enterprises and those potentially midwifed by brisk economic growth.

4 High volatility in LIBOR interest rates in the second half of 2008 prompted Khan Bank to request, and ADB to agree,

that the first disbursement of $8 million be converted to a fixed rate via an interest-rate swap. The second disbursement of $2 million carries a floating rate of 6-month LIBOR plus a credit margin.

5 The increase of $52 million in foreign currency loans to corporations and large SMEs is more than the total

received from ADB and other IFIs, as Khan Bank also obtained in 2008 program-based funds for on-lending from the Japan International Cooperation Agency and the World Bank through the Mongolian Ministry of Finance.

6 Refer to Appendix 1 for Khan Bank’s financial highlights and portfolio trends, Appendix 2 for Khan Bank’s borrowing

from IFIs, and to Appendix 3 for background on the Mongolian economy and finance sector.

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10. The objectives of ADB’s $10 million loan to Khan Bank were to (i) assist the growth of Mongolian enterprises by facilitating funding denominated in US dollars, thereby contributing to further diversification in the Mongolian economy, and (ii) help improve financial sector efficiency and depth by enabling Khan Bank to offer long-term loans and grow its corporate banking business.

B. Development Impact

11. The development impact of the investment is rated satisfactory in terms of (i) private sector development; (ii) business success; (iii) economic sustainability; and (iv) environmental, social, health, and safety aspects.

1. Private Sector Development

a. Assessment of Private Sector Development

12. The effect on private sector development of ADB’s loan to Khan Bank is rated satisfactory. The loan successfully helped Khan Bank extend additional loans, expand its corporate lending business, and diversify its portfolio. ADB’s loan of $10 million nearly doubled Khan Bank’s long-term funds at the time of commitment, providing a major boost to its long-term lending capability. The loan contributed in some measure to enhanced competition and a more diversified banking sector. The loan satisfactorily realized the outcomes specified in the project’s design and monitoring framework.

b. Beyond Company Impact

13. The Mongolian finance sector is dominated by three large commercial banks—Khan Bank, Trade and Development Bank (TDB), and Golomt Bank—which hold 70% of bank assets and 68% of all loans. The five largest banks hold 85% of loans. Khan Bank, TDB, and Golomt are of similar size in terms of assets and deposits but dissimilar in their business focus and approach. Khan Bank has traditionally focused on agricultural, retail, and MSME borrowers, while TDB and Golomt cater to larger Mongolian SMEs and corporations.

14. At the time of ADB’s loan, TDB and Golomt had well-established positions as leading lenders of foreign currency to corporate borrowers and trade-related businesses, with more than two-thirds of their portfolios comprising loans to larger enterprises. In contrast, loans to corporations and large SMEs made up only 11.4% of Khan Bank’s portfolio in 2007, and foreign currency loans to these entities accounted for 8.6%. ADB’s loan of $10 million, in conjunction with $37 million from other IFIs, significantly enhanced the bank’s lending capacity. Khan Bank’s foreign currency loans to corporations and large SMEs increased from $35 million in 2007 to $88 million in 2008, and the share of these loans in Khan Bank’s portfolio doubled to 16.9%. The bank’s lending tenors lengthened only marginally, as corporate loans carrying tenors of more than 5 years rose from almost none in 2007 to 9.0% in 2008.

15. To some extent, Khan Bank’s expansion into lending to corporations and large SMEs intensified competition in Mongolian banking, inducing TDB and Golomt to expand their retail and MSME product lines and their branch systems outside of Ulaanbaatar. Savings Bank and XacBank, the fourth and fifth largest banks, respectively, scaled up their lending to retail, MSME, and microfinance customers. The ensuing competition has benefited Mongolian borrowers through greater choice, additional financial products, better customer service, and a more

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diversified banking sector. With competition and economic growth, lending rates in Mongolia have come down steadily from 2007 to 2012 (Appendix 3, Figure A3.13).

16. Because of its small population and robust competition among top banks for borrowers and deposits, Mongolia has one of the world’s deepest banking penetration rates (Appendix 3, Section C). Competition and the resulting compression in lending rates has brought Mongolian banks’ net interest margins down to 4%–8% in 2012 from the extremely high 10%–14% before 2009. Market expansion by the top banks has lowered the cost of financial services for MSME and corporate borrowers. The World Bank estimates that half of all loans outstanding in Mongolia are to larger enterprises, 9% to SMEs, and 10% to micro-entrepreneurs (Appendix 3, Figure A3.18). Enterprise formation may have benefited from cheaper loans, as seen in the 10% increase year on year in the number of registered enterprises in Mongolia from 2007 and 2012 (Appendix 3, Figure A3.7).

17. Mongolian financial institutions rely mostly on foreign borrowings to support growth in long-term lending, due to the limited size and tenor of domestic deposits. Following the financial crisis of 2008–2009, Khan Bank’s prudently managed business and strong financial performance allowed it to increase its external borrowings. While Khan Bank’s success cannot be attributed entirely to ADB’s loan, its performance, along with that of the Mongolian banking sector in general, attracted more investors, as shown by significant increases in funding from IFIs and international investors, foreign equity participation in banks, and the economy’s ratio of debt to gross domestic product (GDP) over the past 10 years (Appendix 3, Section B).7

18. The banking sector is one of the main drivers of Mongolia’s economic growth. It finances a significant share of economic activity in the country such as mining, petroleum imports, construction, manufacturing, energy, transportation, communications, and trade. By some measures, Mongolia could be considered over-banked with too many bank branches, especially in the urban areas. Nonetheless, a strong banking system is essential to support the country’s growth and finance job creation through MSMEs and corporations. Despite meeting the objectives of ADB’s investment, Mongolia’s financial sector still requires support from IFIs to develop in accordance with international best practices, particularly in risk management, asset–liability management and hedging related to mortgage finance, the pricing of metals and other commodities, and foreign currency management.

c. Direct Company Impact

19. Khan Bank’s decision to enter the corporate and large SME market was hindered by a paucity of long-term US dollar funds, which prevented the bank’s establishing itself as a key player in that segment. At year-end 2007 the bank’s liabilities stood at about $500 million, but long-term borrowing accounted for just over $10 million (excluding rGMF’s $12 million funding in December 2007). ADB’s loan commitment of $10 million almost doubled Khan Bank’s long-term borrowings at the time. This loan and the $37 million from other IFIs quintupled its long-term funds.

7 All of Mongolia’s top banks received long-term funding from IFIs and/or other international development partners

after the global financial crisis abated. After a successful $75 million international bond offering in 2007, TDB issued $175 million in bonds in 2010 and $300 million in 2012, the latter oversubscribed by 4 times, demonstrating Mongolian banks’ growing maturity and credibility with international investors. Since 2010 Mongolian banks have attracted international investors from a host of countries; Eurasia Capital estimates that one-third of Mongolian bank equity is currently held by international investors.

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20. Funds from ADB and other IFIs successfully helped Khan Bank achieve significant outcomes as envisioned in the project’s design and monitoring framework. Khan Bank’s overall business loan portfolio grew by 37% from year-end 2007 to year-end 2008 (Appendix 1, Section F). 8 The funds provided a major impetus to the bank’s lending of foreign currency to corporations and large SMEs, which grew by 150% from $35 million in 2007 to $88 million in 2008, mirroring the $47 million infusion of long-term funds from ADB and other IFIs. The number of corporate and large SME borrowers of foreign currency loans increased by 2.4 times in 2008 from 2007 levels. Nonperforming loans (NPLs) in its corporate and large SME portfolio stayed below 5% during 2007–2012. While relatively low corporate NPLs may be a reflection of an unseasoned portfolio, the bank’s capital adequacy ratio remained above the central bank’s stipulated minimum throughout this period, and its return on equity was greater than 15% every year except 2009 (Appendix 1, Table A1.1).

21. The loans from ADB and other IFIs helped Khan Bank diversify its loan book and weather the financial crisis. Its MSME loan portfolio contracted by approximately 10% from 2008 to 2009, reflecting the short-term and cyclical nature of MSME loans (Appendix 1, Section F). By contrast, Khan Bank’s portfolio of lending to corporations and large SMEs remained stable during this period at $92 million, reflecting the longer-term nature of large enterprise loans originated by the bank using funds from ADB and other IFIs. These loans generated steady interest income at a time when raising funds and originating loans both became extremely difficult. The bank’s mixed exposure to retail, MSME, and corporate customers helped diversify its balance sheet compared with its corporate-focused peers, whose higher concentration of risk undermined portfolio performance, and with its microfinance-focused peers, whose higher operating costs and competitive pressures caused interest margins to narrow.9

22. The loans from ADB and other IFIs further enhanced Khan Bank’s reputation and helped it subsequently obtain additional IFI funding in 2009. In May 2009, the bank received a $5 million loan from Blue Orchard Microfinance. More significantly, Khan Bank was able to raise funds during the global financial crisis from Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden (FMO), with the Dutch bilateral as a first-time investor. In December 2009, FMO committed to lend $25 million to Khan Bank, of which $10 million was tier 2 capital in the form of a subordinated loan. Together with a $10 million subordinated loan that Khan Bank concurrently raised from a Japanese company controlled by Khan Bank’s chairman, the fund infusion helped augment the bank’s capital position at a critical juncture.

23. Khan Bank’s lending growth resumed in 2010 as the effects of the crisis waned, and its overall loan portfolio grew rapidly by 33% in 2010 and 76% in 2011. Corporate lending resumed in 2011, growing at 148% in 2011 and 25% in 2012. In part, this reflected additional funds raised from IFIs, international development partners, and the Government of Mongolia in 2011, as well as growth in Khan Bank’s foreign currency deposits arising from its strengthened franchise and profitability and the rapid growth of the Mongolian economy. From 2011 to the first quarter of 2013, Khan Bank raised $115 million in senior loans and $52 million in subordinated loans from IFIs.

24. With tight competition for deposits, Khan Bank’s relationships with a large network of IFIs have provided it with access to a competitively priced long-term funding structure. While Khan Bank’s reputation and growth cannot be credited solely to ADB, the presence of IFIs

8 The number of business borrowers remained unchanged from 2007 to 2008, as the bank includes working capital

loans to micro-credit entrepreneurs in its business loan category. 9 Khan Bank’s NPLs reached 8.0% in 2009, in contrast with 17.4% for the banking sector as a whole (Appendix 1,

Figure A1.5).

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including ADB has complemented the bank’s strategy of growing its loan book through superior pricing and flexible lending terms and in transitioning into a diversified financial institution from one focused on rural and MSME finance. This expansion has allowed it to address the needs of all segments of the Mongolian economy: households, small businesses, and large enterprises.

2. Business Success

25. Khan Bank’s business success is rated excellent. As of 2012 Khan Bank maintained its lead as the largest bank in Mongolia, holding the highest share of loans, deposits, and capital in the country (Appendix 1, Section C). It also has the most extensive branch network, with 85 branches in Ulaanbaatar and 427 in rural areas, making it largely responsible for high banking penetration and access to finance in Mongolia. It provides banking services to an estimated 80% of all Mongolian households, with 1.8 million customers in a population of 2.79 million. It has 286,000 borrowers, of which 80% are retail borrowers. Its achievements have been impressive given Mongolia’s very low population density and poor physical infrastructure.

26. The global financial crisis affected Khan Bank’s financial health, but the bank was quick to take mitigating measures. It reduced rates twice in 2009 to sustain loan demand, which prevented its loan portfolio from contracting substantially. Because of Khan Bank’s preponderance of small, short-term retail loans, it had a steady stream of repayments to relend and, unlike several of its competitors, continued to originate loans through the crisis. Compressed interest margins and a tripling of NPLs in 2009 over the previous year strained the bank’s capitalization. In response, it issued $3 million in common stock in August 2009 to its shareholders, and in December 2009 raised $20 million in tier 2 capital from FMO and a firm controlled by Khan Bank’s chairman. The infusion of funds helped augment its capital position, but profits in 2009 halved from 2008. With rapid economic recovery in 2010, Khan Bank rebounded, its loan portfolio growing by a third and net income tripling from that of 2009.

27. By 2009, Khan bank had completed a 9-year program of automation, and every branch in its network was connected in real time to the head office. The bank continued to invest heavily in information and communication technology, establishing a banking application system implemented by Tata Consultancy Services. After high growth and profitability returned in 2010, a management contract with Development Alternatives, hired to restore financial soundness to the bank in 2000, was not renewed, and Khan Bank bought out the former’s minority shareholding and performance-related equity options in 2012.

28. Khan Bank has maintained a strong capital position and recurring earnings better than most of its peers. Its performance demonstrates that a well-managed bank can be resilient and perform well despite difficult and volatile economic conditions. The success of Khan Bank lies in professional management; responsible governance; its use of innovative information and communication technology, its introduction of new products, and its skill in building partnerships with the government, IFIs, and others. The bank’s financial performance was robust during 2007–2012. Selected highlights from this period include the following:

(i) Total assets grew by a compounded annual growth rate (CAGR) of 36.0%. (ii) Net income increased 3.7 times from MNT19.4 billion to MNT71.5 billion. (iii) With increasing competition, its net interest margin declined from 12.9% to 8.0%,

which was still more lucrative than the average margin of peers focused on corporate clients, which was about 4.0% in 2012.

(iv) The loan portfolio grew at a CAGR of 29.8% despite marginal contraction in 2009. (v) Consumer lending grew at a CAGR of 40.3% while agricultural loans, a

traditional source of volatility, declined by a CAGR of 7.7%.

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(vi) Business loan growth reached a CAGR of 30.9%, with corporate loan growth standing at 51.3% and MSME loan growth at 20.3%, such that the corporate loan share of the business portfolio doubled from 25% in 2007 to 50% in 2012.

29. Project time-adjusted return on invested capital. This report used inflation-adjusted return on invested capital (ROIC) as an indicator for assessing Khan Bank’s business success against its cost of capital.10 Khan Bank’s weighted average cost of capital was derived using standard variables required to estimate Khan Bank’s cost of equity and its historical average cost of debt from 2007 to 2012. Khan Bank’s real ROIC exceeds its cost of capital by an adequate threshold to qualify for an excellent rating for business success based on ADB guidelines for preparing extended annual reviews.11

3. Economic Sustainability

30. Economic return on invested capital. This report used economic return on invested capital (EROIC) as a proxy to measure the contribution of ADB’s loan to Khan Bank toward economic development. ADB’s loan did not target specific capital investment or expansion projects, which would have allowed incremental costs and benefits to be separately quantified. Khan Bank’s real EROIC is sufficiently above the maximum hurdle rate to qualify for an excellent rating.

31. The economic sustainability rating is further exemplified in Khan Bank’s lending mix. In 2007 corporate loans comprised only 11% of all loans and 25% of business loans (Appendix 1, Section F). By 2012, these numbers had improved, with corporate loans accounting for 25% of all lending and 50% of business loans. The shift toward financing large enterprises with higher productivity and greater economies of scale is expected to contribute to more sustained economic impact. In 2012, 31% of Khan Bank’s corporate loans were for construction, 27% for wholesale and retail trade, and 24% for mining and manufacturing (Appendix 1, Section G).

4. Environmental, Social, Health, and Safety Performance

32. The project’s environmental, social, health, and safety (ESHS) performance is rated satisfactory. ADB’s loan was in the financial intermediary category under ADB’s Environment Policy (2002) and category C under its Involuntary Resettlement Policy (1995) and Policy on Indigenous Peoples (1998).12 Khan Bank established an environmental and social policy in 2009 that was designed with the assistance of EBRD and refined further with input from IFC. The policy aligns with the social and environmental requirements of the Government of Mongolia and IFI standards (Appendix 6). Adherence to these standards was stipulated in the ADB loan agreement, but the agreement did not require the submission of annual environmental and social policy reports to ADB.13 The annexure to the report and recommendation of the President of an indicative ESHS framework specified that Khan Bank would send at least one senior representative to ADB-sponsored or -approved ESHS training. Khan Bank staff attended ESHS training at ADB-approved institutions.

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The real ROIC of Khan Bank’s business is determined by calculating the return on all invested capital (share capital and long-term loans), net income generated, and the present value of its terminal valuation derived from a 5-year earnings forecast for 2013–2017.

11 ADB. 2007. Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Manila.

12 A financial intermediary project involves a credit line or an equity investment to a financial intermediary and requires an environmental management system unless no subprojects will result in significant environmental impact. Category C means the project entails no involuntary resettlement or impact on indigenous peoples.

13 Khan Bank submitted to other lenders annual environmental and social policy reports for 2010–2012, which ADB subsequently received.

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C. ADB Investment Profitability

33. ADB’s investment profitability is rated satisfactory. Its loan was priced at the 6-month LIBOR plus a credit spread, for a period of 6 years. Pricing was in line with loans made to Khan Bank by other IFIs during the same period.

D. ADB Work Quality

34. ADB’s work quality is rated satisfactory based on its (i) screening, appraisal, and structuring of the project; (ii) monitoring and supervision; and (iii) role and contribution.

1. Screening, Appraisal, and Structuring of the Project

35. ADB’s work in screening, appraisal, and structuring the loan to Khan Bank is rated satisfactory. ADB’s loan was a collaborative effort with IFC, both loans having the same structure. IFC’s existing equity investment in Khan Bank facilitated the flow of relevant information to ADB, including the financial, operational, and management profiles of Khan Bank. The information helped qualify Khan Bank as a commercially viable and sustainable financial institution under the parameters set forth during the concept clearance stage. The collaboration was acceptable from the perspective of risk management. It accelerated loan negotiation and processing, thus reducing transaction costs and facilitating speedier access to long-term funding for both Khan Bank and its sub-borrowers.

2. Monitoring and Supervision

36. Khan Bank was monitored regularly in line with the annual and semiannual review schedule of PSOD. In connection with waiver requests, particularly in 2012–2013, the PSOD Project Administration Unit interacted promptly and smoothly with the client, and Khan Bank’s responses were cooperative and succinct throughout. ADB’s monitoring and supervision is rated satisfactory.

3. ADB’s Role and Contribution

37. ADB’s role and contribution is rated satisfactory. The $47 million in loans raised by Khan Bank in 2007–2008 from IFIs, including $10 million from ADB, allowed it to diversify its lending and provided it with an additional buffer with which to weather the global financial crisis and maintain portfolio growth and profitability. The timing of the loan was helpful to Khan Bank, as alternate fund sources such as short-term deposits and international loans began to contract during the financial crisis and the costs of such funds began to escalate.

E. ADB’s Additionality

38. That ADB’s loan was a joint effort with IFC renders it difficult to precisely assess incremental effect, especially considering the overlapping benefits of similar facilities from other IFIs used by Khan Bank in the same period. However, it is among PSOD’s strategies to support suitable financial institutions with the potential to achieve satisfactory developmental results even if other IFIs are present. ADB’s loan, in conjunction with those of other IFIs, had a cumulative effect on Khan Bank and the Mongolian banking sector that achieved ADB’s goals targeted at project conception. The absence of ADB’s loan would have weakened these achievements. This is highlighted by Khan Bank having raised $139 million in IFI loans in 2012 and Q1 of 2013 and its ongoing negotiations with various IFIs for long-term loans. These

9

developments indicate that demand for long-term funds still exceeds supply. ADB’s additionality is thus rated satisfactory.

F. Overall Evaluation

39. ADB’s loan to Khan Bank is rated successful overall (table).

Evaluation of the Senior Unsecured Loan to Khan Bank

Item Unsatisfactory Less than

Satisfactory Satisfactory Excellent

A. Development Impact √

1. Private sector development √

2. Business success √ 3. Economic sustainability √ 4. Environment, social, health, and safety √ B. ADB's Investment Profitability √ C. ADB's Work Quality √

1. Screening, appraisal, and structuring √ 2. Monitoring and supervision √ 3. ADB's role and contribution √ D. ADB's Additionality √

Overall Rating Successful

ADB = Asian Development Bank.

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS

A. Issues and Lessons

40. Khan Bank’s extensive branch network and integrated technology has allowed it to provide banking coverage to almost all Mongolian households, and in many towns it is the only financial services provider. It is largely responsible for higher banking penetration and access to finance in Mongolia than in other countries in emerging Asia (Appendix 3, Section C). The bank’s model can be used as an example of best practice for developing banking systems and access to finance in countries where banking penetration is low and in sparsely populated regions where financial services are unavailable.

B. Recommended Follow-Up Actions

41. None.

10 Appendix 1

PROJECT-RELATED DATA

A. Five-Year Financial Highlights

Table A1.1. Khan Bank Financial Highlights Indicator 2007 2008 2009 2010 2011 2012

Gross loans (MNT million) 497,533 624,896 608,043 802,809 1,405,396 1,756,360

Total assets (MNT million) 600,605 838,972 1,087,917 1,555,736 2,235,743 2,796,470

Total liabilities (MNT million) 542,791 758,841 992,983 1,434,235 2,047,205 2,564,693

Shareholders’ equity (MNT million)

57,813 80,130 94,935 121,501 188,539 231,778

Net income (MNT million) 19,399 22,254 10,522 30,528 58,379 71,495

Gross NPL ratio (%) 1.50 2.80 8.00 4.50 2.30 1.20

Net interest margin (%) 12.90 12.79 8.90 8.82 8.73 8.00

Cost–income ratio (%) 46.54 48.39 57.52 52.57 44.23 48.40

Return on average total assets (%)

4.10 3.09 1.09 2.31 3.08 2.84

Return on average equity (%) 42.96 32.26 12.02 28.21 37.66 34.02

Tier 1 capital ratio (%)a 10.85 11.96 14.38 13.50 10.81 10.76

Total capital ratio (%)b 11.44 12.45 19.32 16.70 15.41 16.59

NPL = nonperforming loan. a The regulatory minimum tier 1 ratio was 5% in 2007–2008, 6% in 2009–2011, and 8% in 2012.

b The regulatory minimum capital ratio was 10% in 2007, 12% in 2008–2011, and 13% in 2012.

Sources: Khan Bank, Asian Development Bank.

B. Ownership Structure

Figure A1.1: Ownership Structure of Khan Bank, 31 December 2012 (%)

a Public Japanese financial holding company controlled by Hideo Sawada, chairman of Khan Bank.

b 100% subsidiary of Sawada Holdings in Hong Kong.

c Mongolian conglomerate with 14 affiliated companies, founded in 1995.

d Executive vice president of the Tavan Bogd Group and cofounder of Tavan Bogd Trade Company.

Source: Khan Bank.

Sawada Holdings a

41.3

H.S. International

(Asia) b

13.1

Tavan Bogd Trade c

23.0

D. Hulan d

13.3 International Finance

Corporation

9.3

Appendix 1 11

C. Competitive Position

Figure A1.2: Banking Market Share, 2012

Figure A1.3: Branch and ATM Network, 2012

TDB = Trade and Development Bank. Note: 2012 figures are preliminary. Sources: Khan Bank, Bank of Mongolia.

TDB = Trade and Development Bank Sources: Khan Bank, bank websites.

Figure A1.4: Banking Competitive Performance, Q3 2012

Figure A1.5. Asset Growth and NPL Trends, 2007-2012

TDB = Trade and Development Bank. Sources: Khan Bank, bank websites.

Note: 2012 figures are preliminary. Source: Khan Bank.

D. Funding and Deposits

Figure A1.6: Funding Sources, 2012 (%)

Figure A1.7: Deposit Composition, 2012 (%)

Source: Khan Bank. Source: Khan Bank.

340

78

146

238

295

0

50

100

150

200

250

300

350

400

0

5

10

15

20

25

30

Khan Savings Xac Golomt TDB Others

MN

T b

illio

n

%

Asset share (left scale) Loan share (left scale)

Deposit share (left scale) Capital (right scale)

ATMs303

171

48

163

125 Branches

512

489

97

88 45

Khan

Savings

Xac

Golomt

TDB

14.8

18.9

14.3 14.1

22.5

19.2

15

19.6

2.7

1.5

1.9 2

1.3 1.3

2.3

1.3

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0

5

10

15

20

25

Khan Xac Golomt TDB

%%

Capital adequacy (left scale)

Return on equity (left scale)

Return on assets (right scale)

Nonperforming loan ratio (right scale)

1.5

2.8

8.0

4.5

2.3 1.2

3.3

7.1

17.4

11.5

6.1

4.2

0

2

4

6

8

10

12

14

16

18

20

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012

%%

Asset growth, Khan Bank (left scale)Asset growth, Banking Sector (left scale)Nonperforming loans, Khan Bank (right scale)Nonperforming loans, Banking Sector (right scale)

Retail54

Business27

Others19

Time deposits

41

Demand deposits

21

Current accounts

27

Others11

12 Appendix 1

E. Overall Portfolio Growth

Figure A1.8: Loan Volume Outstanding by Segment, 2007–2012

Figure A1.9: Loan Volume Outstanding by Currency, 2007–2012

Source: Khan Bank. Source: Khan Bank.

Figure A1.10: Consumer Loan Purpose, 2012 (%)

Source: Khan Bank.

F. Business Loan Portfolio Growth Business Loan Definitions:

(i) Corporate loan. Loans made by the Wholesale Banking Division for working capital and investment purposes to corporations and large SMEs. Most loans denominated in foreign currency are for more than $1 million and entail complex customer service.

(ii) MSME–WC loan. Short-term business loans for up to 24 months to finance working capital for micro, small, and medium-sized enterprises (MSMEs). This class includes different types of MSME loan products such as import loans, credit lines for business, and contractor’s loans. It also Includes express micro loans of up to MNT2 million or $2,000 with terms up to 18 months, mostly to finance working capital for micro traders and business owners.

(iii) MSME–term loan. Investment loans to MSMEs with terms of 12–60 months to finance equipment, construction, leasing, and commercial property purchase. This class includes loan products such as investment loans, construction loans, and financial leasing loans.

221 304 289

362

699 851

101 89 64

48

59

68

154

215 244

382

635

840

477

608 597

791

1,394

1,758

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2007 2008 2009 2010 2011 2012

MN

T b

illio

n

Consumer loans

Agriculture loans

Business loans

85 150 138 116 285

401 391

458 458 675

1,108

1,357

477

608 597

791

1,394

1,758

0

5

10

15

20

25

30

35

40

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2007 2008 2009 2010 2011 2012

%

MN

T b

illio

n

Local currency loans (left scale)

Foreign currency loans(left scale)

Foreign currency loan share (right scale)

Salary loan52

Pension loan10

Mortgage19

Others19

Appendix 1 13

Figure A1.11: Business Loan Volume Outstanding by Sub-segment, 2007–2012

Figure A1.12: Share of Business Loans in the Portfolio, 2007–2012

Source: Khan Bank. Source: Khan Bank.

G. Corporate Loan Portfolio

Figure A1.13: Corporate Loan Purpose, 2012 (%)

Source: Khan Bank.

79 83 72 95 177 196

88 107 98

145

200 225

54

114 119

121

322

429

221

304 289

362

699

851

0

100

200

300

400

500

600

700

800

900

2007 2008 2009 2010 2011 2012

MN

T b

illio

n

Corporate loan

MSME–WC loan

MSME–term loan

46.4

49.9

48.4

45.7

50.2

48.4

43

44

45

46

47

48

49

50

51

2007 2008 2009 2010 2011 2012

%

Agriculture2.4

Mining11.1

Manufacturing13.4

Construction31.4

Wholesale and retail

26.7

Transport and warehouse

7.0

Real estate3.3

Other4.8

14 Appendix 2

FUNDING FROM INTERNATIONAL FINANCE AND GOVERNMENT INSTITUTIONS

Table A2.1. Senior Loans Extended to Khan Bank by IFIs

Institution

Loan Amount ($ million)

Current Balance ($ million)

Agreement Date

First Drawdown

Date Maturity Date

EBRD 10.0 1.1 30 Oct, 2007 17 Apr, 2008 06 Sep, 2013

ADB 10.0 2.4 17 Nov, 2007 27 Mar, 2008 16 Nov 2013

IFC 15.0 1.7 19 Dec, 2007 02 Jun, 2008 15 Jun, 2013

rGMF 6.0 0 07 Dec, 2007 07 Dec, 2007 07 Dec, 2010

rGMF 6.0 0 07 Dec, 2007 07 Dec, 2007 07 Dec, 2012

Blue Orchard 5.0 0 12 May, 2009 12 May, 2009 14 May, 2012

FMO 15.0 12.5 15 Dec, 2009 29 Dec, 2009 15 Oct, 2017

rGMF 6.0 6.0 29 Dec, 2010 29 Dec, 2010 29 Dec, 2013

rGMF 3.0 3.0 29 Sep, 2011 29 Sep, 2011 29 Sep, 2014

BlueOrchard 5.0 3.8 15 Sep, 2011 15 Sep, 2011 15 Sep, 2014

FMO, DEG a 37.0 37.0 14 May, 2012 31 May, 2012 15 May, 2017

EBRD syndication 25.0 25.0 15 May, 2012 31 May, 2012 16 May, 2017

rGMF 4.0 4.0 20 Jun, 2012 20 Jun, 2012 22 Jun, 2015

rGMF 5.0 5.0 20 Nov, 2012 20 Nov, 2012 20 Nov, 2015

rGMF 6.0 6.0 10 Dec, 2012 10 Dec, 2012 10 Dec, 2015

Blue Orchard 5.0 5.0 04 Feb, 2013 08 Feb, 2013 08 Aug, 2016

rGMF 5.0 5.0 12 Mar, 2013 13 Mar, 2013 14 Mar, 2016

IFC 20.0 20.0 26 Mar, 2013 tbd tbd

Total 188.0 137.4 ADB = Asian Development Bank, DEG = Deutsche Investitions- und Entwicklungsgesellschaft, EBRD = European Bank for Reconstruction and Development, IFC = International Finance Corporation; FMO = Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden, IFI = international financial institution, rGMF = responsAbility Global Microfinance Fund, tbd = to be determined. a

FMO-led syndication.

Source: Khan Bank.

Table A2.2: Subordinated Loans Extended to Khan Bank by IFIsa

Institution

Loan Amount

($ million)

Current Balance ($ million)

Agreement Date

First Drawdown

Date Maturity

Date

Sawada Holdings 2 2 28 Jul, 2003 28 Jul, 2003 31 Jul, 2013

FMO 10 10 15 Dec, 2009 29 Dec, 2009 15 Jan, 2015

HIS 10 10 29 Dec, 2009 29 Dec, 2009 15 Jan, 2015

IFC 10 10 15 Jun, 2011 30 Jun, 2011 15 Jun, 2017

IFC 10 10 15 Jun, 2011 23 Aug, 2011 15 Jun, 2018

FMO, DEG b 32 32 14 May, 2012 15 Nov, 2012 16 Aug, 2017

Total 74 74 DEG = Deutsche Investitions- und Entwicklungsgesellschaft, FMO = Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden, HIS = Japanese travel agency controlled by Hideo Sawada, chairman of Khan Bank, IFC = International Finance Corporation, IFI = international financial institution. a All subordinated loans are classified as tier 2 capital for regulatory purposes.

b FMO-led syndication.

Source: Khan Bank.

Appendix 2 15

Table A2.3: Loans Extended to Khan Bank by Government Bodies

Institution

Current Balance

(MNT million)

Maturity or Program

Termination

Ministry of Food, Agriculture, and Light Industry (i) SME Investment Fund 35,824 1 Dec 2015

(ii) SME Development Fund 12,393 31 Oct 2016

IFIs via Ministry of Finance

(i) JICA: SME Development & Environmental Protection

20,385 Sub-borrower

based (ii) ADB: Agriculture & Rural

Development Project 3,215

Sub-borrower based

(iii) World Bank: Private Enterprise Development Fund

1,033 Sub-borrower

based (iv) IFAD: Rural Poverty

Reduction Program 735

1 Aug 2021

Bank of Mongolia

(i) Fuel & Food Price Stabilization Projects

33,172 1 year,

renewable

(ii) Term Loan III 126 1 Dec 2031

Local Government Organizations (Aimags)

(i) SME Loans for Local Governments 930 Various

Ministry of Labor

(i) Labor Support Fund 0 17 Nov 2012

Others

(i) World Bank: Microfinance Development Fund

2,429 Sub-borrower

Based (ii) UNDP: Enterprise Mongolia

Program 168

Dec 31, 2012

(iii) EBRD: Co-Financing Facility 3,470 Sub-borrower

Based

Total 113,880

ADB = Asian Development Bank, EBRD = European Bank for Reconstruction and Development IFAD = International Fund for Agricultural Development, IFI = international finance institution, JICA = Japan International Cooperation Agency, SMEs = small and medium-sized enterprises, UNDP = United Nations Development Programme. Source: Khan Bank.

Table A2.4: Trade Finance Loans Extended to Khan Bank by IFIs

Institution Current Balance

(MNT million) Maturity

Various 28,191 3 year revolving

Total 28,191 IFI = international financial institution.

Source: Khan Bank.

Appendix 3

16

MONGOLIA: ECONOMIC AND BANKING SECTOR OVERVIEW 1 A. Economic Overview 1. The Mongolian economy was hit by the global financial crisis of 2008–2009 but recovered strongly by 2011. The sharp collapse of commodity prices in 2008, notably for copper, triggered Mongolia’s economic crisis. After averaging gross domestic product (GDP) growth of almost 9% per annum from 2003 to 2008, the economy contracted by 1.27% in 2009. This was attributable to a drop in copper prices by more than 60% in the latter half of 2008 (Figure A3.1). Exports and GDP growth picked up again after 2009, with the economy growing by 6.37% in 2010 and 17.51% in 2011—among the highest growth rates in the world. GDP growth decelerated to 12.5% in 2012 primarily due to a 9% drop in exports in 2012 (Figure A3.2).

Figure A3.1: Economic Growth and Copper Prices, 2003–2012

Figure A3.2: Merchandise Exports, 2003–2012

Note: 2012 figures are preliminary. Sources: World Bank, International Monetary Fund.

Note: 2012 figures are preliminary. Source: ADB estimates based on International Trade Center compilation of UN Commodity Trade statistics.

1 Sources for this section include the following reports and databases:

Reports: (i) ADB. 2013. Asian Development Outlook. Manila. (ii) Bank of Mongolia. Annual Reports, 2009–2011. Ulaanbaatar. (iii) Economist Intelligence Unit. 2012. EIU Mongolia Country Report. London (May). (iv) National Statistical Office of Mongolia. Statistical Bulletins, 2009–2012. Ulaanbaatar. (v) World Bank. 2012. Mongolia Quarterly Economic Update. Washington, DC (October). (vi) International Monetary Fund. March 2011. Mongolia: Financial System Stability Assessment.

Washington, DC. (vii) International Monetary Fund. November 2012. Mongolia Staff Report for the 2012 Article IV

Consultation and Third Post-Program Monitoring. Washington, DC. (viii) Standard and Poor’s. March 2012. Banking Industry Country Risk Assessment: Mongolia. Hong Kong. (ix) Fitch. October 2012. Mongolian Banks: Mining-Related Growth Continues. Hong Kong. (x) ADB staff research.

Databases: (i) World Bank. World Development Indicators Database. (ii) International Trade Center. Trade Map Database. (iii) ADB. Statistical Database System. (iv) International Monetary Fund. International Financial Statistics Database. (v) International Monetary Fund. Financial Access Survey Database. (vi) CEIC. Global Database. (vii) ADB staff calculations.

0

2,000

4,000

6,000

8,000

10,000

12,000

-5

0

5

10

15

20

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

$ per ton%

Gross domestic product growth year on year (left scale)

Copper price, monthly average (right scale)

-30

-10

10

30

50

70

90

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

%

$ m

illio

n

Coal

Copper

Iron & other metals

Other exports

Export growth year on year (right scale)

Appendix 3 17

2. Copper is traditionally Mongolia’s largest single export, accounting for more than a third of exports from 2003 to 2008. With the collapse in copper prices, Mongolia’s exports contracted by 19% in 2009 (Figure A3.2). Simultaneously, increased demand for coal from the People’s Republic of China (PRC) saw a surge in Mongolia’s coal exports, which accounted for more than a third of Mongolia’s exports from 2010 to 2012 and outpaced copper exports in all 3 years. Larger coal exports have created greater dependency on the PRC, where a slowdown in coal demand in the second half of 2012 caused Mongolian exports to decline. 3. In the midst of the crisis, since late 2008, the Mongolian togrog depreciated by almost 20% against the US dollar and Mongolia’s international reserves dropped sharply (Figure A3.3). The decline of revenue, especially for mining in 2008, weakened key fiscal indicators. The resulting export slowdown led to a current account deficit, while foreign direct investment (FDI) remained broadly stable (Figure A3.4). With economic recovery and large coal and copper development projects, FDI flows surged in 2011, equaling 54% of GDP. Mongolia continues to import more than it exports, primarily capital equipment for extracting its mineral reserves, with the current account deficit reaching 31.5% of GDP in 2011. However, this deficit remained fully funded by FDI inflows (Figure A3.4).

Figure A3.3: Gross Reserves and Exchange Rates, 2003–2012

Figure A3.4: Current Account Balance and Foreign Direct Investment Flows, 2003–2011

Sources: Asian Development Bank Statistical Database System, International Monetary Fund.

FDI = foreign direct investment, GDP = gross domestic product. Sources: World Bank, Bank of Mongolia.

4. A primary driver of double-digit growth has been infrastructure and construction spending related to the mining boom, and in particular to the Oyu Tolgoi copper and gold mine and the Tavan Tolgoi coalfield, both among the world’s largest. These have been the largest mineral extraction projects in Mongolia and are expected to quadruple both copper and coal exports by 2018. Spending on these projects is reflected in gross fixed capital formation, which encompasses capital expenditures on machinery, equipment, and buildings. After declining by 30% in 2009, gross fixed capital formation grew by 33% in 2010 and 65% in 2011, reaching 50% of GDP in 2011 (Figure A3.5). Most of the MNT6.5 billion invested in Mongolia in 2011 has been for machinery and construction (Figure A3.6), with foreign sources of capital accounting for 70% of investments, mirroring FDI flows into the country.

1,000

1,100

1,200

1,300

1,400

1,5000

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

MNT/$$ m

illio

n

Reserves including gold (left scale)

Togrogs per $, period average (right inverted scale)

-40

-30

-20

-10

0

10

20

30

40

50

60

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2003 2004 2005 2006 2007 2008 2009 2010 2011

%

$ m

illio

n

FDI net inflow (left scale)

Current account balance to GDP (right scale)

FDI net inflow to GDP (right scale)

Appendix 3

18

Figure A3.5: Gross Fixed Capital Formation, 2006–2012

Figure A3.6: Investment Usage and Sources, 2004–2011

Source: World Bank. Sources: CEIC Database (accessed 17 May 2013), National

Statistical Office of Mongolia.

5. The growth of private enterprise in Mongolia has been robust, with the number of active enterprises increasing from 26,552 in 2003 to 51,940 in 2012 (Figure A3.7). Registered and active enterprises both recorded cumulative annual growth rates (CAGRs) of 12% in the 3 years to 2012. The sectors witnessing the largest increase in active enterprises from 2009 to 2012 were construction (43% CAGR); manufacturing (24%); transport, storage, and communication (20%); real estate (20%); and agriculture (18%). However, wholesale and retail services continues to be the dominant sector, with 38% of all active firms in 2012 (Figure A3.8), followed by real estate, education and health, and manufacturing.

Figure A3.7: Number of Registered Enterprises, 2003–2012

Figure A3.8: Active Registered Enterprises by Sector, 2012

(%)

Sources: CEIC Database (accessed 17 May 2013), National Statistical Office of Mongolia.

Sources: CEIC Database (accessed 17 May 2013), National Statistical Office of Mongolia.

6. The domestic stock market’s capitalization grew from 3.3% of GDP in 2006 to 18% in 2011 (Figure A3.9). However, trading has been thin, as there are only 332 listed companies, and volatile, with the index plunging by 45% in 2009, growing by 3.5 times from 2009 and 2011, and witnessing an 18% decline in 2012. Toward increasing market breadth and liquidity, the Government of Mongolia has been considering legislation that would allow overseas firms dual

-45

-30

-15

0

15

30

45

60

75

0

10

20

30

40

50

60

2006 2007 2008 2009 2010 2011 2012

%%

Year-on-year growth (right scale)

% of gross domestic product (left scale)

1,580 1,538

463

745

1,802

4,263

588716 881

1,253

1,7852,146

3,846

6,546

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2004 2005 2006 2007 2008 2009 2010 2011

MN

T b

illio

n

MN

T b

illio

n

Machinery & equipment

Construction

Others

Domestic sources

Foreign sources

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

2003200420052006200720082009201020112012

Number of registered enterprises

Number of active registered enterprises Agriculture5.5 Manufacturing

8.6

Construction6.0

Wholesale & retail services

38.1

Hotels & restaurants

3.8

Transport & communication

3.5

Financial services

3.0

Real estate & other business

9.5

Public administration

& defence3.9

Education, health & social

work9.7

Mining0.8

Other7.4

Appendix 3 19

listing on the stock exchange. Several large Mongolian companies, including Trade and Development Bank, Mongolian Mining Corporation, and the Development Bank of Mongolia have successfully tapped overseas bond markets to raise capital. In November 2012, the government sold $1.5 billion of debt, equivalent to nearly one-fifth of the country’s GDP, to overseas investors in its first sovereign bond offering. The yields obtained on the government bonds reflected pricing available to more developed nations.

Figure A3.9: Equity Market Performance, 2006–2012

Figure A3.10: Population and Unemployment, 2007–2011

GDP = gross domestic product, MSE = Mongolia Stock Exchange. Sources: Mongolia Stock Exchange, World Bank.

Source: Asian Development Bank Statistical Database System, National Statistical Office of Mongolia.

7. A significant risk facing the Mongolian economy in the longer term is susceptibility to the so-called Dutch disease, when extractive resources attract revenue inflows that push up the national currency and undermine manufacturing and export competitiveness. Typically, the phenomenon stymies employment, as resource industries are capital intensive but need little labor. Despite strong growth unemployment remains high (Figure A3.10). Although 2011 saw a substantial decline in poverty, 30% of Mongolia’s people still live in poverty (Figure A3.11) and inequality has been rising more severely than in most of Mongolia’s peers in Asia (Figure A3.12).

Figure A3.11: Poverty Headcount, 2010–2011

Figure A3.12: Change in the Gini Index of Inequality

Source: World Bank. Lao PDR = Lao People’s Democratic Republic, PRC = People’s

Republic of China. Source: World Bank.

3.3

14.5

7.2

9.4

17.6 18.0

12.6

2,031

10,256

5,5836,190

14,760

21,68817,715

0

2

4

6

8

10

12

14

16

18

20

0

5,000

10,000

15,000

20,000

25,000

2006 2007 2008 2009 2010 2011 2012

%

Index

MSE market capitalization to GDP (right scale)

MSE top 20 equity market index (left scale)

6

7

8

9

10

11

12

2.50

2.55

2.60

2.65

2.70

2.75

2.80

2007 2008 2009 2010 2011

%

mill

ion

Population (left scale) Unemployment rate (right scale)

39.2

47.8

32.229.8

33.3

26.6

0

10

20

30

40

50

60

National Rural Urban

%

2010 2011

-10 -5 0 5 10

Kazakhstan (1996-2009)

Thailand (1994-2010)

Nepal (1996-2010)

Cambodia (1994-2009)

Bangladesh (1996-2010)

Azerbaijan (1995-2008)

Viet Nam (1993-2008)

Philippines (1994-2008)

Sri Lanka (1994-2010)

Pakistan (1997-2008)

India (1994-2010)

Mongolia (1995-2008)

Indonesia (1996-2010)

Georgia (1996-2010)

Lao PDR (1992-2008)

PRC (1996-2008)

Change in Gini Points

Appendix 3

20

8. Although ADB estimates that the Mongolian economy is expected to grow at 16.5% in 2013 and 14% in 2014, the 2008–2009 global economic crisis highlighted certain vulnerabilities. The economy is constrained by its small population of 2.79 million and its undiversified structure heavily reliant on commodity exports, especially to the PRC, which receives more than 90% of Mongolia’s exports. The country has obtained financial assistance from the International Monetary Fund (IMF) five times since 1991, most recently when it was extended an 18-month IMF standby arrangement in April 2009 to facilitate economic adjustment in the midst of the global financial crisis. Inflation continues to be a major concern, as it exceeded 10% for much of 2010–2012 partly because of severe winter weather in 2009/10, when Mongolia lost 22% of its livestock and meat prices doubled (Figure A3.13). More recently, the government's expansionary fiscal policies have contributed to high inflation, with 14.3% headline inflation recorded in 2012. According to the IMF, the Mongolian economy currently exhibits signs of overheating, raising concerns of a hard landing if external shocks hit the country in the form of a significant drop in copper or coal prices.

Figure A3.13: Inflation and Interest Rates, 2003–2012

Figure A3.14: Bank Nonperforming Loans and Liquid Reserves, 2007–2012

Sources: Bank of Mongolia, World Bank. Sources: Bank of Mongolia, World Bank.

B. Banking Sector Overview 9. Mongolia has 14 commercial banks, 195 small nonbank financial institutions, 162 savings and credit cooperatives, and 17 insurance companies. The finance sector is dominated by the largest three commercial banks—Khan Bank, Trade and Development Bank, and Golomt Bank—which hold 70% of the total assets and 68% of loans. In recent years, Mongolian banks have attracted considerable interest from foreign investors in Japan, the United States, the Russian Federation, and the United Arab Emirates. Eurasia Capital estimates that international investors own about one-third of the Mongolian banking sector. 10. The financial crisis of 2008–2009 was a significant setback for banks and highlighted the worsening vulnerability of their balance sheets. In the aftermath of the crisis, banking system profitability fell, real interest rates became negative as inflation touched 28% (Figure A3.13), and nonperforming loans more than doubled (Figure A3.14). The deterioration in credit quality was strongest in construction, manufacturing, and agriculture. Agriculture was further adversely affected by the severe winter of 2009/10. Bank credit increased annually by an average of 47% in 2006–2008 (Figure A3.15), before banks all but stopped lending in late 2008 because of the crisis. Credit growth resumed in late 2009 as the economy rebounded strongly, and in 2011 and

0

5

10

15

20

25

30

35

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

%

Lending interest rate

Annual consumer price inflation

0

2

4

6

8

10

12

14

16

18

20

0

5

10

15

20

25

30

35

40

45

50

2007 2008 2009 2010 2011 2012

%%

Bank liquid reserves to bank assets ratio (left scale)

Bank nonperforming loans to total gross loans (right scale)

Appendix 3 21

2012 credit grew to 40% and 31% of GDP, respectively. Credit to the private sector in Mongolia accounted for 49% of GDP in 2011, comparing favorably with peers in Asia (Figure A3.16).

Figure A3.15: Banking Sector Domestic Credit, 2003–2012

Figure A3.16: Domestic Credit to the Private Sector, 2011

GDP = gross domestic product. Source: World Bank.

GDP = gross domestic product, PRC = People’s Republic of China. Source: International Monetary Fund.

11. Growth in lending to households and firms (from micro to large) was rapid between 2006 and 2011 (Figure A3.17). Household loans decreased by 11% in 2009, as banks stopped lending because of the crisis, but have since grown rapidly, recording 79% growth in 2011 driven by high demand for mortgages and salary loans. More than a quarter of loans are to households: 13% mortgages and 15% consumer, salary, and pension loans (Figure A3.18). Growth in corporate loans slowed substantially in 2009 to 7%, followed by no growth in 2010. As with household loans, corporate lending has increased substantially, by more than 70% in 2011 (Figure A3.17). Almost half of loans are to large enterprises, 10% to entrepreneurs and micro-enterprises, and 9% to small and medium-sized enterprises (Figure A3.18).

Figure A3.17: Credit to Households and Firms, 2006–2011

Figure A3.18: Lending Composition, 2011 (%)

GDP = gross domestic product. Source: World Bank.

SMEs= small and medium-sized enterprises. Source: World Bank.

15

20

25

30

35

40

45

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

%

MN

T b

illio

n

Net domestic credit (left scale)

Domestic credit provided by banking sector relative to GDP (right scale)

0 20 40 60 80 100 120 140

AzerbaijanPakistan

CambodiaSri LankaIndonesia

PhilippinesGeorgiaArmenia

KazakhstanBangladesh

IndiaMongolia

NepalViet NamMalaysia

PRCThailand

(% of GDP)

0

5

10

15

20

25

30

-20

-10

0

10

20

30

40

50

60

70

80

90

2006 2007 2008 2009 2010 2011

%%

Household credit year-on-year growth (left scale)Corporate credit year-on-year growth (left scale)Household credit to GDP (right scale)Corporate credit to GDP (right scale)

Loans to large enterprises

47 Consumer, salary &

pension loans

15

Mortgage loans

13

Loans to enterpreneurs

& micro-enterprises

10

Loans to SMEs

9

Other 6

Appendix 3

22

12. While lending spreads remain extremely attractive in Mongolia compared with its peers (Figure A3.19), most bank loans in Mongolia have short maturities, as banks face chronic constraints on providing longer-term finance because of the short maturity of their deposits and the shortage of other funding sources with longer maturity. Most loans finance working capital, with maturities mostly 1–3 years.

Figure A3.19: Interest Rate Spread (Lending Rate Minus Deposit Rate), 2011

Figure A3.20: Deposits of Households and Corporations, 2006–2011

PRC = People’s Republic of China. Source: World Bank.

Sources: Bank of Mongolia, World Bank.

13. Deposits increased rapidly from 2006 and 2011. Households hold more than half of all deposits, and corporations 25%. Deposit growth has been driven primarily by growth in corporate deposits, which have shown average growth of 56% year on year from 2006 to 2011, compared with 34% growth for household deposits in the same period. In 2011, household deposits outpaced corporate deposits (Figure A3.20). About 53% of deposits are demand deposits, and 43% time deposits. A blanket deposit guarantee law enacted in 2008 during Mongolia's banking crisis expired at the end of 2012 and was replaced by a mandatory deposit insurance scheme in January 2013.

14. The operating environment for banks has improved along with strong growth in mining. The benefits of the Oyu Tolgoi and Tavan Tolgoi projects are potentially transformational for the economy, but the historic boom–bust cycle adds to the volatile operating environment for banks. The new Fiscal Stability Law will come into force in 2013, compelling the government to save during commodity up cycles to ensure that it has funds to spend during commodity down cycles. This should help stabilize the economy, which should be positive for the banking sector. 15. Mongolia’s relatively high private sector credit can be viewed as moderately high relative to the country’s income levels. A number of factors potentially heighten credit risks, including aggressive lending and weak underwriting standards with high concentration in volatile sectors such as agriculture and mining, as well as single-name concentration. High dollarization exposes the financial system to an additional dimension of risk. About a third of deposits and loans are denominated in foreign currency. Such dollarization limits the Bank of Mongolia’s ability to act as a lender of last resort during periods of distress and constrains its capacity to manage systemic liquidity. Moreover, in the event of a sharp correction hitting the togrog, the banking system may be exposed to credit risks associated with borrowers that lack adequate

0 2 4 6 8 10

Malaysia

Viet Nam

Sri Lanka

PRC

Bangladesh

Philippines

Thailand

Indonesia

Mongolia

Pakistan

Azerbaijan

Armenia

%

0

5

10

15

20

25

30

-20

0

20

40

60

80

100

120

140

160

180

2006 2007 2008 2009 2010 2011

%%

Household deposit growth year on year (left scale)

Corporate deposit growth year on year (left scale)

Household deposits to GDP (right scale)

Corporate deposits to GDP (right scale)

Appendix 3 23

US dollar incomes. To control lending growth, the Bank of Mongolia undertook a host of measures in 2011 and 2012 to strengthen the banking system (table).

Regulatory Changes in Banking System Prudential Ratios Ratio Changes

Liquidity ratio Increased to 25% from 18%

Minimum reserve requirement Increased to 12% of total deposits from 9%

Total capital adequacy ratio 12.5% by 31 July 2012 13.0% by 31 December 2012 14.0% by 31 July 2013

Tier 1 capital adequacy ratio for the five largest banks

a

7.0% by 31 July 2012 8.0% by 31 December 2012 9.0% by 31 July 2013

a Khan Bank, XacBank, Trade and Development Bank, Golomt Bank, and Savings Bank.

Sources: Fitch, Bank of Mongolia.

C. Banking Penetration 16. Access to financial services in Mongolia is high when measured by branch penetration per head of population, which is one of the highest in the world (Figure A3.21). However, due to its large territory, Mongolia’s geographical branch penetration is one of the lowest in the world, at 0.67 branches per 1,000 square kilometers (Figure A3.22). Low population density makes the provision of traditional banking services outside of the large cities costly. There are about 1,300 bank branches in Mongolia, with Khan Bank and Savings Bank accounting for 75% of all branches in the country and having the most significant presence in rural areas. Most of their branches are located outside Ulaanbaatar. Bank lending in rural areas is limited due to the low population density, riskiness of agricultural loans, lack of financial information on borrowers, and lack of real estate collateral in rural areas.

Figure A3.21: Commercial Bank Branches per 100,000 Adults, 2011

Figure A3.22: Commercial Bank Branches per 1,000 Square Kilometers, 2011

Source: International Monetary Fund financial access survey.

Source: International Monetary Fund financial access survey.

0 10 20 30 40 50 60 70

Kazakhstan

Viet Nam

Cambodia

Tajikistan

Nepal

Kyrgyz Rep.

Bangladesh

Philippines

Indonesia

Pakistan

Azerbaijan

Malaysia

India

Thailand

Sri Lanka

Armenia

Georgia

Uzbekistan

Mongolia

0 10 20 30 40 50 60 70

Kazakhstan

Mongolia

Kyrgyz Rep.

Tajikistan

Cambodia

Malaysia

Viet Nam

Indonesia

Azerbaijan

Nepal

Georgia

Thailand

Pakistan

Armenia

Philippines

Uzbekistan

India

Sri Lanka

Bangladesh

Appendix 3

24

17. Loan and deposit penetration in Mongolia is significantly high when compared with peers. There are more than 3,000 deposit accounts per 1,000 adults, compared with just over 1,000 in Kazakhstan and 400 in Azerbaijan (Figure A3.23). There are also more than 300 bank loan accounts per 1,000 adults, compared to 250 in Thailand and 70 in Bangladesh. Deposit and loan penetration is higher than most of its comparator countries.

Figure A3.23: Depositors with Commercial Banks per 1,000 Adults, 2011

Figure A3.24: Borrowers from Commercial Banks per 1,000 Adults, 2011

Source: International Monetary Fund financial access survey.

Source: International Monetary Fund financial access survey.

18. Financial intermediation in Mongolia has grown significantly in recent years, bringing credit and deposit levels as a percentage of GDP higher than in most other developing countries in Asia and closer to percentages in higher-income countries such as Malaysia and Thailand. In 2011, outstanding deposits equaled 80% of GDP (Figure A3.25) and credit equaled 65% of GDP (Figure A3.26), considerably higher than for Mongolia’s peers.

Figure A3.25: Outstanding Deposits with Commercial Banks, 2011

Figure A3.26: Outstanding Loans from Commercial Banks, 2011

GDP = gross domestic product, PRC = People’s Republic of China. Source: International Monetary Fund financial access survey.

GDP = gross domestic product, PRC = People’s Republic of China. Source: International Monetary Fund financial access survey.

0 500 1,000 1,500 2,000 2,500 3,000 3,500

Kyrgyz Rep.

Pakistan

Bangladesh

Azerbaijan

Philippines

Tajikistan

Georgia

Armenia

Uzbekistan

Kazakhstan

Thailand

Mongolia

0 100 200 300 400

Tajikistan

Pakistan

Kyrgyz Rep.

Uzbekistan

Bangladesh

Azerbaijan

Thailand

Armenia

Malaysia

Indonesia

Mongolia

Georgia

0 20 40 60 80 100 120 140 160

Azerbaijan

Tajikistan

Kyrgyz Rep.

Armenia

Georgia

Uzbekistan

Kazakhstan

Pakistan

Cambodia

Philippines

Indonesia

Sri Lanka

Nepal

Bangladesh

India

Thailand

Mongolia

Malaysia

Viet Nam

PRC

(% of GDP) 0 20 40 60 80 100 120 140

Kyrgyz Rep.

Tajikistan

Pakistan

Philippines

Azerbaijan

Uzbekistan

Indonesia

Cambodia

Armenia

Georgia

Sri Lanka

Nepal

Kazakhstan

India

Bangladesh

Mongolia

Thailand

Malaysia

PRC

Viet Nam

(% of GDP)

Appendix 4 25

PRIVATE SECTOR DEVELOPMENT INDICATORS AND RATINGS: FINANCIAL INTERMEDIARIES

Indicators Ratingsa Justifications

Monitoring indicators can be partly derived from RRPs. Several indicators are essentially judgmental. Their use and ratings should consider the operating context and ADB aims, strategies, and project proportions.

1. Beyond Intermediary and Sub-borrower Impacts

1.1 Private sector expansion and institutional impact

1.1.1. Contributes to an increased private sector share and role in the economy, and to sustainable jobs or self-employment

1.1.2. Contributes to expanded SME lending with good portfolio and sub-borrower performance

1.1.3. Contributes to institutional change by

(i) improving SME access to formal credit and banking service and

(ii) influencing a more enabling environment for SMEs via lobby activity, policy dialogue, or otherwise in which the bank(s) become more engaged

Satisfactory The loan is rated satisfactory for private

sector development. The loan contributed to a greater supply of loans denominated in US dollars for Mongolian corporations and large SMEs. ADB’s loan, in conjunction with loans from other IFIs, contributed to the growth and expansion of Khan Bank’s corporate and business loan portfolio and lending activities (including new products, staff training, and investments in credit and information technology systems).

1.2. Competition. Contributes to new competition for

SME business among local banks (including new product and service offerings and local currency products) and/or contributes to increased competition in key sub-borrower markets

Satisfactory The loan, in conjunction with loans from other IFIs, spurred significant competition among the top banks in Mongolia, as Khan Bank was not traditionally involved in corporate lending. Competition has benefited Mongolian borrowers through additional choice, more financial products, better customer service, and a more diversified banking sector.

1.3. Innovation. Contributes to new ways of offering

effective banking services to SMEs (including new products, services, and technologies) in ways that are replicated by other banks and in the financial system (item 2.2)

Satisfactory Khan Bank is well known in the market for continuous innovation and quickly offering new products that cater to its customers’ evolving needs.

1.4. Linkages. Contributes to local savings and

deposits mobilization via networks of participating bank(s) and/or relative to size of sub-portfolios; contributes to notable upstream or downstream link effects to sub-borrowers’ businesses in their industries or the economy.

Not applicable ADB and other IFI funding in 2007–2008 has supported Khan Bank’s access to additional international funding in 2009–2012.

1.5. Catalytic element. Contributes to mobilizing other

local or international financing to SMEs, and to a positive demonstration to market providers of debt and risk capital to SMEs

Satisfactory All top banks in Mongolia have subsequently received increased funding from IFIs in 2007–2012; most of these loans received from IFIs were for relending or onlending to SMEs or corporations.

1.6. Affected laws, frameworks, regulation.

Contributes to improved laws, regulation, and inspection affecting formal SME banks and banking services to SMEs in the local financial system

Not applicable The loan is too small to have impact on laws, frameworks, or regulation.

1.7. Wider demonstration of new standards.

Contributes to raised standards in the finance sector or in sub-borrower industries and sectors in corporate governance, transparency, and stakeholder relations

Not applicable Given the loan’s limited size, this report does not claim impact on wider demonstration of new standards. However, banks working successfully with several IFIs tend to do so by adopting accounting, reporting, risk, and

Appendix 4

26

Indicators Ratingsa Justifications

management standards that appeal to IFIs and satisfy their standards. This is emulated in turn by competitors, who adopt similar procedures and hire staff trained by the bank in question to improve their own competitiveness. Khan Bank is a successful example of this trickledown effect, as are a number of other banks in PSOD’s portfolio.

2. Participant Banks and Sub-borrower Impacts

2.1. Skills with wider impact potential. Contributes

(i) to an improved SME credit approach at all stages in the participant bank(s) in ways that will be replicated by other providers of SME finance and banking services and (ii) via the participating bank(s) to improved sub-borrower skills in operating their businesses, e.g., via good appraisal and monitoring by the bank(s)

Satisfactory Khan Bank’s strong financial performance, healthy interest margins, and moderately low percentage of nonperforming loans provide a good example that diversification in lending can be attractive for business, by reducing volatility in earnings and excessive exposure to any single sector. In addition, during the 2007–2012, Khan Bank continuously invested resources to expand its corporate lending, including new product development, staff training, and improvements to credit processes and systems as well as to information technology systems. The loan provided by ADB played a limited but important role in Khan Bank’s funding strategy and, therefore, contributed to the development of lending to corporations and large SMEs in Mongolia.

2.2 Demonstration and new standards-setting potential. Demonstrates potential through

improved and achieved standards in corporate governance and transparency, stakeholder relations, and ESHS spheres

Not applicable Khan Bank adopted an ESHS policy consistent with the standards of ADB and other IFIs. The policy was integrated into Khan Bank’s loan appraisal process and included an exclusion list and processes to assess and mitigate environment and social risks.

Overall Rating Satisfactory

ADB = Asian Development Bank, ESHS = environmental, social, health and safety, IFI = international finance institution, PSOD = Private Sector Operations Department, SMEs = small and medium-sized enterprises, RRP = report and recommendation of the President. a Ratings scale: excellent, satisfactory, partly satisfactory, unsatisfactory. The rating is not an arithmetic mean of the individual indicator ratings, which have no fixed weights. Manifest actual impact (positive or negative) is considered, as is potential impact and risk to its realization.

Appendix 5 27

COMPARATIVE FINANCIAL STATEMENTS

Table A5.1: Khan Bank Statement of Financial Position, 2007–2012 (MNT million)

Balance Sheets 2007 2008 2009 2010 2011 2012

Customer loans, net 490,101 608,654 580,708 776,710 1,377,266 1,731,042

Other earning assets 27,857 77,614 246,490 440,756 290,684 353,149

Fixed assets, net 28,621 40,194 37,512 38,999 59,230 69,825

Other nonearning assets 54,027 112,510 223,208 299,271 508,564 642,455

Total Assets 600,605 838,972 1,087,917 1,555,736 2,235,743 2,796,470

Total deposits & money market funding

513,639 681,771 868,923 1,316,571 1,826,799 2,148,978

Other liabilities 3,854 4,012 4,218 7,015 12,958 23,100

Long-term borrowings 25,298 73,058 119,841 110,649 207,448 392,614

Total Liabilities 542,791 758,841 992,983 1,434,235 2,047,205 2,564,693

Common stock (including capital surplus)

22,493 22,577 26,860 26,860 26,860 27,339

Retained earnings 34,391 56,740 67,349 94,016 146,394 189,753

Reserves 929 812 726 625 15,285 14,686

Total equity 57,813 80,130 94,935 121,501 188,539 231,778

Total Liabilities and Capital 600,605 838,972 1,087,917 1,555,736 2,235,743 2,796,470

Source: Khan Bank audited financial statements.

Table A5.2. Khan Bank Statement of Comprehensive Income, 2007–2012

(MNT million)

Profit and Loss Statements 2007 2008 2009 2010 2011 2012

Net interest income 51,386 77,026 67,304 90,137 125,848 149,973

Net fee and commission income 6,691 7,957 9,407 6,556 11,753 16,006

Other operating income 1,481 3,111 4,082 6,921 21,064 18,225

Total Operating Income 59,558 88,094 80,794 103,614 158,665 184,204

Less operating expenses (31,210) (48,365) (54,168) (62,869) (77,439) (97,130)

Pre-provision Income 28,347 39,729 26,626 40,744 81,226 87,074

Loss provisions (2,826) (10,077) (12,726) (701) (2,982) 539

Income after Loss Provisions 25,521 29,652 13,900 40,044 78,244 87,612

Net non-operating income 0 0 0 0 0 0

Pre-tax Income 25,521 29,652 13,900 40,044 78,244 87,612

Taxes (6,123) (7,399) (3,378) (9,516) (19,865) (16,117)

Net Income 19,399 22,254 10,522 30,528 58,379 71,495

Source: Khan Bank audited financial statements.

Appendix 6

28

ENVIRONMENT AND SOCIAL MANAGEMENT SYSTEM 1. In the course of each loan analysis, Khan Bank loan officers and credit specialists review the environmental assessment and guidelines provided by the relevant authorities on the business and assess whether the business can operate normally. Moreover, when decided on loan approval, the credit committee reviews the environmental assessment, housekeeping evaluations, and special licenses to ensure that the borrower’s business will not be suspended for environmental reasons. 2. Pursuant to Khan Bank’s loan policy, the bank complies with Mongolia’s environmental protection laws in all its activities and will not finance any activity that could adversely affect the environment. For instance, starting in April 2007, business executives circulated information from the Ministry of Environment to all branches and sub-branches regarding the mandatory inclusion of environmental assessments and conclusions into the loan file. Moreover, it was made mandatory to include environmental assessment as a factor for all loan decisions that met the following criteria:

(i) Applicants requesting a loan exceeding MNT50 million were required to have an environmental impact assessment carried out.

(ii) Borrowers with more than MNT50 million in loans outstanding were required to have an environmental impact assessment performed annually and report the results to Khan Bank.

3. Key customer service responsibilities of the bank’s loan officers include (i) analyzing the outcome of the environmental assessment on the borrower or customer’s business and analyzing assessments provided by professional agencies, (ii) explaining how any business risk is being mitigated, and (iii) coordinating work such that documentation required from the borrower does not hinder the borrower. Credit specialists exercise onsite review of loans disbursed by the credit department and deal appropriately with environmental, safety, and financial issues. 4. The updated Khan Bank Environmental Policy and Procedures, which defines Khan Bank’s strategy and approach regarding environmental procedures, was approved in November 2009 and amended in December 2011. These procedures are followed in the course of all lending, from receiving the loan application to analyzing, approving, and monitoring the loan thereafter. For instance, if the proposed loan impinges on the list of excluded activities, the proposal will immediately be refused. When the loan is presented to the credit committee for approval, the loan officer presents all the documentary proof on environmental compliance such as (i) the borrower’s template-guided letter confirming compliance with Khan Bank and European Bank for Reconstruction and Development requirements and Mongolian law and (ii) assessments and conclusions for projects that require them.

5. Pursuant to these procedures, if the assessment states that the project can be carried out subject to certain terms and conditions, the bank shall disburse the loan once those terms and conditions are met. The environmental impact of a project is scored according to a three-tiered risk-rating system for loans exceeding MNT50 million, introduced in April of 2008. The risk rating of any loan is reviewed by credit departments and the Credit Risk Division prior to credit committee presentation. Khan Bank’s loan portfolio classified by the risk rating system is in Figure A7.1.

Appendix 6 29

Figure A6.1: Loans Outstanding Classified by Environmental Impact, 2010–2012

Source: Khan Bank.

6. Some results from 2012 are as follows:

(i) Loans to retail and wholesale traders and vehicle and motorcycle maintenance businesses accounted for 16.0% of Khan Bank’s portfolio. Those businesses have relatively low environmental impact.

(ii) Loans to processing industries, which include wool and cashmere scouring and de-hairing, tanneries, bakeries, flour mills, and brick and cement factories, accounted for 6.0% of the portfolio. As these businesses have relatively high environmental impact, the bank proceeds with loan analysis only after it has reviewed evidence of the borrower’s activities to mitigate environmental impact and improve the environment, ensuring business continuity.

(iii) Construction loans, at 10.9% of the portfolio, were mainly in Ulaanbaatar, allowing the bank to monitor sites regularly.

(iv) Loans to administrative and support services, at 0.1% of the portfolio, include rental businesses, employment services, office administration, and other support activities. Those sectors have a relatively low environmental impact.

7. Monitoring after disbursement is performed by the loan officer, credit committee, credit departments, and internal audit department through onsite visits to ensure the normal operation of the business and ensure that relevant permits are current and all necessary fees are paid. The officers and credit specialists check all documentary proof that the business complies with necessary environmental, social, and health requirements to ensure continuity of business. Copies of these documents are held in the loan files. The documents include workplace evaluations, special operating permits, environmental assessment materials, and environmental impact assessment results, as well as reports on any necessary follow-up action. 8. Ongoing monitoring and review is strictly required for those projects with high environmental impact risk to ensure regulatory compliance. The environmental officer of the bank determines, over the term of the loan, the timing and frequency of reviews made by Khan Bank on the environmental compliance of borrowers’ projects. The review establishes whether the borrower fully or partly complies with its environmental management responsibilities. In the event that a borrower’s activity is proved to affect the environment or not comply with environmental requirements, the loan is called in and recovery action begun as per the loan agreement.

54.50 50.00 53.02

27.30 29.26 23.89

12.10 14.62 15.92

6.10 6.12 7.17

0

10

20

30

40

50

60

70

80

90

100

2010 2011 2012

%

High impact

Medium impact

Low impact

Consumer and Herder Loans (No Impact)