Project Number: 42224 August 2011

Lao People’s Democratic Republic: Enhancing Financial Sector Supervision (Cofinanced by the Cooperation Fund for Regional Trade

and Financial Security Initiative)

Technical Assistance Consultant’s Report

This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project’s design.

Prepared by

Roger Kronenberg

For Bank of the Lao PDR The Bank Supervision Unit under the Banks and Financial Institutions Supervision Department (BFISD) of the BOL (Component 1) Microfinance Supervision Unit under BFISD (Component 2) AMLIU (Component 3)

TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................................................ 4 RECOMMENDATIONS AND CONCLUSIONS ............................................................. 8 I.  Introduction and Background ..................................................................................... 13 II.  The Macroeconomic Setting ....................................................................................... 15 III. Constraints to Financial Sector Development and the Strategy for Reform............... 19 IV. The Current Legal Framework and Composition of the Lao Financial System......... 20 V.  Principles for Good Supervision and Promoting Financial Sector Development....... 23 VI. Achievements of the Reforms and Areas Needing Further Attention ........................ 26 

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EXECUTIVE SUMMARY

The Lao PDR Government has been engaged in a nearly decade-long effort to strengthen the soundness, efficiency, and commercial orientation of the financial sector. The steps taken by the authorities have included far-reaching changes in the legal environment and a major restructuring of state-owned commercial banks (SOCBs). The reform process got off to a slow start, in part because some of the early efforts were overly ambitious in light of limited implementation capacity and insufficiently prioritized. However, refinements to the financial sector strategy that have been introduced since 2006, along with further training and experience, have helped achieve a better focus on the most critical—and doable—elements of the strategy and a stronger buy-in among the banks. Solid gains have been made across a broad front. The restructuring and recapitalization of the SOCBs resulted in the write off of a large stock of nonperforming loans (NPLs), and the NPL to total assets ratio for the banking sector as a whole has plunged from 13.9 percent at end-2005 to 1.8 percent at end-2009. Similarly, the recapitalization of state banks by the Government, along with more profitable operating results at many banks, has dramatically boosted the ratio of regulatory capital to risk-weighted assets (CAR) from 3.3 percent in 2007 to 13.3 percent in 2009. The entry of new foreign and private banks has brought in technical skills, expanded access to banking services, and helped create a more commercially oriented and competitive banking sector that could help mobilize savings and channel them to the most efficient uses. The depth of the financial system, as measured by the stock of broad money or the stock of banking system credit relative to the size of GDP, has increased significantly. External auditing requirements have been introduced, and a depositor protection system has been established. As a result—and despite the gathering storm of a global financial crisis--the Lao banking sector has been significantly strengthened by the reforms. The improved functioning of the financial sector has, in turn, contributed to Lao PDR’s strong economic growth performance, which averaged 7.7 percent per annum during 2005-09. Despite these impressive achievements, the building of a strong financial sector remains a work in progress. Some longstanding issues have not yet been fully addressed, while other new challenges have arisen, which will require the continued implementation of, and, in some cases, further refinements to, the financial reform strategy.

Although the ratio of broad money to GDP has increased my some 12 percentage points over the last five years, the level of financial intermediation in Lao PDR remains low by international standards. To promote greater intermediation, which strengthens incentives to save and helps ensure that resources are allocated to the most productive uses, the mission encourages the Bank of Lao PDR (BOL) to end its practice of lending directly to extra-budgetary public projects and state enterprises. The mission also recommends that the BOL

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significantly tighten its conditions for lending to commercial banks in order to reduce the overhang of excess liquidity in the banking system, which has the potential to fuel an acceleration in inflation, and in order to promote the development of a more active and efficient interbank market.

Maintaining macroeconomic stability is a precondition for long-term growth.

Significant strides have been made in this regard in recent years. Lao PDR’s economic growth performance has been very good, and inflation was brought down sharply in 2009. Looking forward, however, there are warning signs of potential macroeconomic imbalances. The continued rapid growth in monetary aggregates and the reemergence of inflation in 2010 suggest that the economy could be headed toward overheating. This rising inflation, along with a relatively large government deficit, a high level of government debt (62 percent of GDP) and a structurally low level of government revenue, means that the Government will need to contain its spending and slow the pace of credit expansion before higher inflationary expectations become entrenched.

Underlying the overall improvement in financial soundness indicators for the

consolidated banking sector, there have been large disparities in the performance of individual institutions. For example, while the largest of the state owned banks has raised its regulatory capital adequacy ratio to 12 percent, the other two state banks remain mired in low or even negative capitalization. To maintain confidence in the financial system, the Government needs to address the remaining problems in these banks. The mission believes that the authorities should give careful consideration to their privatization. However, it would likely be difficult to privatize these banks in their current condition, and a further recapitalization by the government would probably be needed before the banks could be put up for sale. Just as importantly, however, potential buyers will need to be convinced that the banks have good prospects, if managed skillfully, to operate profitably in the future. For this to occur, the banks will need to have the ability to trim unprofitable branches and rationalize staffing, actions that have been blocked by courts and local governments at times in the past. To ensure that the population in rural areas continues to have access to financial services, the authorities should give renewed emphasis to creating a sound legal environment for the microfinance sector and lower cost branchless banking alternatives.

Accounting standards also remain a problem. An independent auditor’s report

found that the standards set by the BOL for the reporting of prudential data by banks could, in some circumstance, portray a significantly different picture of the condition of the financial institution than if those reports had been compiled using internationally recognized standards. As a high priority, the mission believes that the BOL should adopt a loan classification system that more accurately gauges loan quality. Technical assistance is likely to be needed to assist the authorities in this area.

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Despite the establishment of a commercial court, the legal procedures for resolving disputes between creditors and debtors are still slow and lack transparency. Some banks contend that court procedures and rulings are so heavily biased in favor of borrowers that they no longer even consider filing legal charges in disputes. The authorities should take a fresh look at the regulations and procedures governing the handling of financial disputes with a view to improving their efficiency and timeliness. Technical assistance may be required.

Another factor inhibiting the development of a strong credit culture is the

lack of reliable information about the creditworthiness of borrowers. The World Bank’s Doing Business database gives Lao PDR a rating of zero on its six point index of credit information. The lack of good credit information and the weakness of the ability to enforce contracts are among the factors that contribute to the high cost of financial services in Lao PDR, as reflected in large spread between bank lending rates and the yield on government bills. Lowering the costs of financial intermediation through the establishment of better information and stronger legal institutions would strengthen the efficiency of markets and facilitate the achievements of Lao PDR’s developmental objectives.

While substantial improvements in operations are noted, the BOL faces

several challenges with regard to the longer term development of the financial sector;

The BOL faces potentially conflicting pressures in carrying out its joint

responsibilities: (i) to supervise the banking system (including state-owned banks); (ii) to conduct monetary policy so as to achieve the Government’s monetary policy targets; and (iii) to promote the achievement of the Government’s development objectives. To avoid such conflicts, the BOL should be given greater independence—and accountability--to run monetary policy in a way that will promote financial stability. Also, a strong firewall is needed to ensure that financial supervision does not become subordinated to either monetary or development policy. The authorities should explore various models, including the possibility of an independent supervisory agency.

The BOL’s technical ability and financial resources to carry out its

supervisory duties are thinly stretched. While the mission believes that the BOL should continue to conduct onsite and offsite examinations of all commercial banks, it should adopt a more risk-based approach to supervision, focusing most closely on institutions and issues of systemic importance. Supervision of banks should be given a clear priority over the supervision of non-deposit taking financial institutions, such as pawnshops. Closer collaboration with the home country supervisors of foreign banks operating in Lao PDR could help leverage the BOL’s resources while also providing an element of capacity building. Still, additional training to improve the skills and operating procedures of the BOL staff will be needed. An ADB consultant

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currently in Lao PDR has started the process, but further, ongoing support is likely to be needed.

The BOL lacks an adequate framework for the prompt resolution of

distressed banks. Supervisors should possess, and be willing to employ, a range of instruments to deal with weak banks, including the ability to assess penalties, restrict the range of the bank’s authorized activities, limit the size of the bank’s balance sheet, and require improvements in governance, internal controls, and risk systems.

A lack of transparency adversely affects the investment climate and remains

an important constraint to financial sector development.

Many banks do not disseminate their financial statements or annual reports to the public.

For its part, the BOL provides very little information about the condition of the financial sector. The mission encourages the BOL to publish financial soundness indicators in its quarterly statistical bulletin and to provide a comprehensive assessment of the condition of the financial sector and an analysis of the main risks it faces in its Annual Report.

Some banks, including some large banks, have stated that they have

considerable difficulty complying with the BOL’s data reporting requirements. Late or inaccurate reporting of prudential and monetary data by the banks can adversely affect the BOL’s ability both to supervise the safety and soundness of the banking system and to conduct sound monetary policy. The mission recommends that the BOL consult with the banks to develop reporting forms and procedures that they can be expected to implement, while also improving the accuracy and timeliness of the monetary and prudential data they provide to the BOL. This is also an area in which technical assistance could prove useful.

Greater transparency is also needed concerning the deposit insurance

system. To strengthen depositor and investor confidence, the BOL should provide more information about the operation of the system, the scope of its coverage, and its ability to handle large shocks to the banking sector. Technical assistance in this area might be useful.

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RECOMMENDATIONS AND CONCLUSIONS

Based on the issues raised above, the following recommendations are aimed at strengthening the safety and soundness of the financial system, mobilizing savings, promoting the efficient allocation of these resources to high productivity activities, and promoting the economic development of Lao PDR. Recommendation 1—Maintaining Macroeconomic Stability The pronounced pick up in inflation in the first half of 2010 and the overall strength of demand suggest that rapid pace of credit expansion should be slowed to preserve macroeconomic stability. This should be achieved through a general tightening of monetary policy and through the enforcement of more stringent loan underwriting standards for the banks. While the ratio of broad money to GDP is a useful medium-term indicator of financial intermediation, sharp changes in the money supply over a short interval can be a signal of financial instability. A rapid expansion in the money supply brought about simply by a relaxation of monetary policy is more likely to be an indicator of future inflationary pressures than of financial sector depth. Recommendation 2—Disseminating a National Financial Strategy Transparency at the BOL should also bring greater clarity about the authorities’ vision for the future of the financial sector. The mission found that most officials were either unaware of the existence of the National Financial Strategy document, which was prepared with the assistance of the World Bank, or they were unsure of its status or standing. If the document does reflect the authorities’ current strategy, this should be made known and serve as a roadmap for future reforms, along with the preparation of a detailed timetable. If the document is current, it should be updated and issued as the Government’s strategy. Recommendation 3—Next Steps for the Weak SOCB’ s and Access to Credit The severe undercapitalization of LDB and APB poses a risk to the stability of the banking system. Although the institutions may be marginally profitable at present, their cost structures are uncompetitive with other banks, and the amount of time that would be needed to reach an acceptable level of capitalization is too long and vulnerable to too many risks. The mission encourages the Lao authorities to consider privatization of these two banks. Bank privatization is a complicated undertaking, and the authorities should allow themselves the necessary preparation time. The authorities should also consider requesting technical assistance, possibly from the ADB. For any privatization to succeed, more government money will be needed to bring the banks’ capitalization to a minimum level that potential investors would be willing to consider. Policy changes will also be

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required to attract reputable foreign investors with strong track records of operating in low-income transition countries. The banks should be permitted to rationalize their staffs and branch networks, both of which have been blocked at times in the past. For APB, the partner should, if possible, have international experience in rural, small-scale lending. Pending privatization, the BOL should restrict the ability of APB and LDB to undertake new lending, and the BOL should cease extending credit of its own to the banks, other than temporary liquidity support fully backed by collateral. All profits of the banks should be retained to strengthen capital. In preparation for privatization, consideration must also be given to how access to credit will be maintained in rural areas given the branch rationalization that is likely to occur. One option would be to spin off regional branches as member-owned microfinance institutions, which would have a lower cost structure than banks. It might be possible for the rural finance component of the current ADB financial sector TA program to provide advice in this regard. Secondary options include the introduction on branchless banking for small payments and loans. Recommendation 4—Central Bank Credit The BOL should refrain from granting credit to nonbank entities other than the government. As noted above, current macroeconomic conditions warrant a tightening of credit conditions. Infrastructure and other projects that the government wants to promote should be financed through the budget, not directly by the central bank. The BOL should also clarify—and tighten--the conditions under which it will be willing to extend credit to banks. The rapid growth in BOL lending to banks over the past year raises concerns about future prospects for inflation, as well as the efficient allocation of financial resources. The large stock of bank deposits with the central bank also suggests that banks have the resources needed to make additional loans, if they believed the customers were creditworthy and the projects were financially viable. Any BOL lending to banks should be fully secured by sound collateral and should normally be on a short-term basis. Recommendation 5—Legal Procedures for Dispute Resolution Confidence in the financial system requires well-functioning institutions to protect the legal rights of both creditors and debtors. The establishment of a commercial court in Lao PDR was intended to expedite the settlement of claims in the event of a default. So far, however, it has not achieved this result, and some banks still consider it pointless to initiate legal proceedings against customers in default. Progress on this front is essential for the further development of the banking system and the future creation of capital markets. The authorities should give high priority to strengthening default and dispute settlement procedures, and they should consider requesting additional technical assistance, possibly from the ADB, if needed in this regard.

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Recommendation 6—Development of an Interbank Money Market Further efforts are needed to foster the development of a liquid and efficient interbank money market. The BOL should consider organizing a meeting with the commercial banks to learn more about how they are currently arranging interbank transactions and assess their willingness to develop a more efficient market infrastructure. The BOL might want to approach donors for technical assistance in such a program. Strong involvement of the banks will be needed to achieve successful results. Recommendation 7—Deposit Insurance The BOL should consider undertaking a thorough review of the deposit insurance system to confirm its viability in the event of a major shock. The review should include the adequacy of the contributions to the program, the deposit limits covered, and the types of deposits and depositors covered. The operations and accounts of the fund should be published and discussed in the BOL’s Annual Report. The coverage of the deposit insurance system should be limited to licensed commercial banks and should not, at present, be extended to any other deposit taking institutions. Recommendation 8—Improving Transparency of the Banks and the BOL Greater transparency is needed in the financial sector. All banks, regardless of their corporate structure, should be required to publish an annual report and audited financial statements. The report should include information about the bank’s activities, its business plan, its ownership and management, and an analysis of its financial condition. Greater transparency is also needed at the BOL, which should include data on financial sector indicators in its quarterly statistical reports and a thorough discussion of the condition of the financial sector in its Annual Report. Recommendation 9—Adoption of International Accounting Practices The BOL should implement a loan classification system that gives greater emphasis to elements of credit quality beyond just the past due status of existing loans. Such factors should include the borrower’s ability repay and strength of collateral. The BOL should announce a plan for phasing in internationally accepted accounting practices for the banks over a medium term (3-5 years) horizon. The BOL should request technical assistance, possibly from the ADB, if needed to implement the new standards. Recommendation 10—BOL Procedural Recommendations

Recommendation 10a—Coordination of Supervision and Translation into Concrete Recommendations

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The findings of bank examinations need to be translated into clear and explicit recommendations to bank management. This should include requirements, where needed, for prompt corrective actions. The quality of bank examinations could be strengthened through closer collaboration between the onsite and offsite teams. Recommendation 10b—Limits on Net Open Foreign Exchange Position The BOL should not relax regulations governing the net open foreign exchange position of banks. Doing so would expose the banking system to significant additional risks. Recommendation 10c—Supervision of NBFIs The BOL should give careful thought to defining its exact roles, responsibilities, and capabilities to supervise nonbank financial institutions. Once decided, it should disseminate this information widely to the public. Among other factors, the BOL should make clear that only banks, and not any other form of institution such as MFIs, are members of the depositor protection system. The BOL should not be required to supervise institutions if it is not given the resources necessary to do so. Consideration should be given to removing such institutions from the BOL’s supervisory responsibilities if no actual supervision is taking place or is feasible. On the other hand, the BOL or another competent government authority should supervise enterprises engaged in large cashed-based activities, such as casinos, where there are increased risks of money laundering.

Recommendation 10d—Procedures for Revising Laws and Regulations The procedures for revising banking laws and regulations should be done transparently. Whenever possible, there should be a process of consultation with the banks and other stakeholders to ensure that the proposed regulations are understood and can be implemented properly by the banks. Recommendation 10e—Reporting Requirements Reporting requirements for banks need to be streamlined to improve their timeliness and accuracy. It would be useful for the BOL to organize a seminar with the banks to evaluate the content and timetable for the submission of data. As part of the examination process, the BOL should work with the banks to ensure that data from their charts of accounts are correctly being translated into BOL reporting forms. Technical assistance from donors could be useful in revising reporting formats Recommendation 10f—Operation of Foreign Bank Branches The legal structure of foreign banks should be clarified. Foreign banks are currently classified as branches of foreign banks, but their capital structure appears to resemble that of subsidiaries.

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Strong cooperation between the BOL and the home country supervisors of foreign bank branches is essential for the maintenance of financial stability. The BOL should conduct their examinations of foreign banks in close consultation with the home country supervisors. Recommendation 10g—Banking Industry Association The BOL should encourage the strengthening of the banking sector industry association. The association could facilitate the implementation of some of the recommendations of this report, including the development of a money market, making improvements in the timeliness and accuracy of data submitted by the banks, providing feedback to the BOL on proposed changes in regulations, and creating institutions to expedite dispute settlement and default resolution.

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I. Introduction and Background

This report reviews the progress achieved by the Lao authorities over the past decade in their efforts to develop the financial sector and to strengthen its supervision. The report reviews the progress that the authorities have achieved, identifies a number of developmental constraints that have been encountered in this respect, and makes recommendations on options to address these issues so as to encourage the further deepening of the financial system and to enhance the prospects for strong, sustainable economic growth.

The Lao economy in the late 1990s was on the brink of a financial crisis. Inflation soared from 19 percent in 1996 to 128 percent in 1999, the exchange rate of the Kip depreciated commensurately, and real GDP growth slowed (Figures 1-3). In the banking sector, there was a marked increase in nonperforming loans (NPLs), and the risk-weighted capital adequacy ratios (CARs) of the state-owned commercial banks (SOCBs) turned sharply negative.

Source: ADB, Key Indicators

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

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As the magnitude of the crisis became clear, the Government responded with a far-ranging program of financial sector reforms, which was supported by the Asian Development Bank (ADB) and other donors. The ADB’s principal area of responsibility was to help the Government strengthen the banking system under a US$15 million Banking Sector Reform Program (BSRP). The program, which was approved by the ADB in 2002, aimed at improving the efficiency, financial soundness, and competitiveness of the banking system through the restructuring and recapitalization of the SOCBs and strengthening the supervisory capacity of the Bank of Lao PDR (BOL). The BSRP was completed in the first quarter of 2009. The program achieved headway in a number of important respects, including through a steep decline in NPLs and sharp improvement in the risk-weighted CAR of the banking system and the establishment of a clearer legal foundation for the operation and supervision of an efficient financial sector. The licensing of foreign and private banks was a crucial element of the Government’s reforms, which introduced greater competition in the banking sector, and, with it, helped bring about a wider array and higher quality of financial services and an increase in the level of financial intermediation. Despite this progress, important constraints continue to inhibit the development of deep and efficient financial markets capable of mobilizing savings and channeling them to productive uses by creditworthy customers. Perhaps the single most critical factor in this regard is the inadequate degree of transparency that exists at both the level of the individual banks and the BOL. Many banks, for example, do not publically disclose their financial statements or publish an annual report that would provide analysis of the bank’s past performance and commentary on the its future plans and priorities. The lack of such information can adversely affect both depositors and small shareholders. Like the banks, the level of disclosure of information by the BOL is very limited. The BOL does not, in general, publish financial soundness indicators in its quarterly statistical bulletins (which are quite comprehensive in their compilation of monetary data), and there is no commentary on the condition of the financial sector in the BOL’s Annual Report. Moreover, it appears that the BOL largely confines its analysis to the examination of the individual institutions and devotes relatively few of its supervisory resources to assessing the overall condition of the banking sector and identifying systemic risks. There are also other weaknesses in the supervisory regime:

Enforcement can be a problem. Even when problems are detected, the BOL may be unable to compel the financial institution concerned to take prompt corrective actions to prevent a worsening of the problem at that bank or its spread to other institutions.

Despite their recapitalization with public funds, two of the three restructured

SOCBs still have negligible or even negative amounts of capital. Their viability, in their current form, is uncertain.

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The loan classification standards used by the BOL differ in some respects from those used in most other countries. External auditors have stated that these differences could be significant enough, under certain circumstances, to lead examiners to draw incorrect conclusions about the condition of the bank or the actions needed to address them.

Some banks contend that framework for consultation between BOL and the banks

needs to be strengthened, particularly when it comes to the design and implementation of new regulations. As a result, they say, regulations have been introduced that the banks are incapable of implementing.

II. The Macroeconomic Setting A. Recent Economic Developments

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

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Lao PDR’s macroeconomic and financial performance has improved over the past decade, both relative to its own earlier performance and, in some respects, relative to the performance of other countries in the region. Real GDP growth averaged 7.7 percent during 2005-09, significantly higher than the 4.8 percent rate recorded by the ASEAN-5 countries, albeit from a much lower per capita income base (Figures 4-5). Lao PDR’s strong growth performance during the 2000s reflected a combination of exogenous and policy-driven factors. One such factor was a high rate of gross fixed capital formation, driven by large foreign direct investment inflows into the mining and hydroelectric sectors (Figure 6). The impact of the global financial crisis was contained by Lao PDR’s limited exposure to the immediate sources of financial instability, a 40 percent surge in copper and gold production following the opening of a major new mine in 2009, and a resilient tourism sector. The maintenance of broadly stable financial policies earlier in the decade also gave the authorities some scope to relax monetary and fiscal policies in the wake of the global downturn. Despite the vigorous growth in demand, the rate of inflation declined from 7.1 percent in 2005 to zero in 2009 (Figure 7), partly reflecting an appreciation of the Lao Kip. B. The Policy Response to the Global Crisis

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

Source: IMF World Economic Outlook

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Seen from the vantage point of mid-2008, however, policymakers could not discount the looming risks of global financial contagion, and they took actions to ease fiscal policy. The budget deficit, which had been cut earlier from 6.0 percent of GDP in 2003 to 2.6 percent of GDP in 2007, widened sharply to 6.8 percent of GDP in 2009, placing it well above the average levels in the ASEAN-5 and Developing Asia groups (Figures 8 and 9). The fiscal stimulus came in the form of higher Government spending, which rose from 21 percent of GDP in 2005 (well below the average of the ASEAN-5 countries) to 24.5 percent in 2009 (above ASEAN-5 levels) (Figure 10 and 11). As a result, the ratio of government debt to GDP, which had fallen from about 115 percent in 2001 to about 60 percent in 2008, changed course and edged up to 62 percent in 2009, some 20 percentage points higher than in the ASEAN-5 or Developing Asia.

Monetary policy was also eased. The Bank of Lao PDR cut its policy lending rate in several steps, bringing it down from 20 percent at the end of 2007 to 4 percent by the end of 2009, and the reserve requirement was modified to allow eligible bonds to cover up to 2 percent of the total. The BOL also significantly stepped up its lending to state enterprises and to commercial banks, both of which expanded nearly fourfold during 2008-09, as part of the central bank’s efforts to sustain economic growth (Figure 12).1 Although part of this central bank lending was reabsorbed through the issuance of central bank bills, net domestic assets of the BOL and reserve money continued to growth rapidly (Figure 13).

0.0

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20082009

Figure 13: Lao PDR‐‐ Growth in Monetary Aggregates

Monetary Base Broad Money Source: Bank of Lao PDR

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500

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2005 2006 2007 2008 2009

Figure 12: Lao PDR‐Domestic Assets of the BOL(billions of LAK)

BOL Credit to State Enterprises BOL Credit to Banks BOL Net Claims on Govt. Source: Bank of Lao PDR

1 Bank of Lao PDR, Annual Report 2009

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The increase in reserve money generated a surge in bank lending. Loans increased by 80 percent in 2008 and a further 101 percent in 2009, while growth in broad money picked up from 20 percent to 35 percent (Figures 14 and 15). For the period 2005-09 as a whole, broad money growth in Lao PDR was more rapid than in all regional comparators except Vietnam. As a result, the ratio of broad money to GDP in Lao PDR rose from 19.6 percent in 2005—when it was among the very lowest in all of Asia—to 31.9 percent in 2009, a level that is, nevertheless, still low by regional standards.

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Figure 14: Broad Money Growth Rate(percent)

Indonesia Thailand Vietnam Lao PDR Source: ADB

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100

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0

2005 2006 2007 2008 2009

Figure 15: Broad Money as Share of GDP(percent)

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Indonesia

C. Near-term Economic Outlook The economic outlook remains favorable, although downside risks persist. The projections made by the IMF staff in the October 2010 World Economic Outlook Report envisage that real GDP will increase by 7.7 percent in 2010 and 7.5 percent in 2011. However, after several years of rapid credit growth, inflation has picked up significantly during 2010, reaching 8.1 percent year-on-year in September. The monetary authorities recognize this risk and believe that a tightening of monetary policy is likely to start sooner rather than later. If successful, the authorities hope to be able to keep inflation to around 5 percent in 2010 and 2011, although they acknowledge that this could prove optimistic. Over the medium term, growth is expected to remain strong, supported by the coming on stream of new mining and hydro projects. However, maintaining strong, balanced and sustainable growth over the medium term will also depend on the authorities’ ability to avoid overheating and stem the build-up of inflationary pressures.

Thailand Vietnam Lao PDR Source: ADB

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III. Historical Constraints to Financial Sector Development and the Strategy for Reform

A. Historical Setting A decade ago, the Lao banking system was exceptionally shallow and dangerously weak. The ratio of broad money to GDP, at 17.4 percent in 2000, was lower than in all but a very few post-conflict and transition countries in Asia. Financial soundness indicators were not published, but it has been estimated that NPLs of the SOCBs reached 60-80 percent of total loans in 2004 and that their risk-weighted capital adequacy ratios ranged from minus 40 to minus 80 percent. Commercial banks were unable to mobilize the funds and extend credit effectively, and the provision of other financial services was limited. The Lao authorities recognized that the weakness of the financial sector was impairing prospects for the country’s economic development. Working with the ADB and other donors, they identified a number of key obstacles to financial sector development. These included:

The deep insolvency of the country’s largest banks; Laws and legal institutions that were not suited to the needs of a market-oriented

economy, including the timely enforcement of financial contracts; A shortage of individuals—both bankers and bank supervisors--with the training

and skills necessary to operate effectively in a market-oriented financial system. A weak accounting framework, which made the system non-transparent and

vulnerable to manipulation by individuals and business entities; A lack of public disclosure on the part of financial institutions and an absence of

credit history information about borrowers that severely reduced transparency and increased both the cost and risk of lending;

Poor loan monitoring procedures and capacity, which resulted in a high level of

nonperforming loans; Outdated and incompatible IT systems, which inhibited the BOL’s ability to

collect and analyze data; A high level of dollarization, which hampered the central bank’s ability to

conduct monetary policy effectively; The absence of a credible safety net to give bank depositors confidence to use the

financial system; and

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An underdeveloped interbank money market and an absence of capital markets, which reduced the scope of financial intermediation.

B. The Reform Strategy The Lao authorities recognized the need to restructure, reform, and recapitalize the banking sector in a manner that would promote strong, sustainable economic growth and contribute to the country’s long-term development. Their objective was to establish an efficient financial system for gathering wholesale and retail deposits and channeling them to borrowers capable of generating the highest risk-adjusted return. The focus of their strategy was on strengthening the legal framework to address impediments to the enforcement of commercial contracts and property rights, to create a level playing field for private and state banks, and to resolve NPLs in the state banks through an aggressive program of cash collection. The strategy also emphasized the need to strengthen the governance of financial institutions with staff that were well trained, motivated, and commercially oriented. The Banking Sector Reform Program (BSRP), which was approved by the ADB in November 2002, was intended to support these efforts with technical and financial assistance. The targets and objectives for the restructuring of each of the three SOCBs were spelled out in governance agreements (GAs), which were signed by the BOL, the Ministry of Finance, and the banks in 2003. The GAs set financial and operational targets and objectives and contained business plans and performance measurement systems against which progress could be measured. They also provided for a phased issuance of government securities that would enable the Government to recapitalize the institutions. To assist with implementation, the program provided for the placement of internationally recruited, full time consultants and external auditors at the banks. As time evolved, it became apparent that some of the targets and timetables in the initial GAs were overly ambitious, given the banks’ limited implementation capacity. Revised agreements were signed in July 2006, and compliance improved significantly. Three tranches of the program, eventually worth US$17.0 million, had been fully disbursed when the program was completed in March 2009.

IV. The Current Legal Framework and Composition of the Lao Financial System

A. Objectives and Functions of the BOL The BOL is mandated by the Central Bank Law and implementing regulations to supervise both banks and nonbank financial institutions. The stated objectives of supervision are to:

Maintain the internal and external stability of the Kip (i.e., maintain macroeconomic stability);

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Enhance the transparency of the monetary system; Improve the efficiency of the payments mechanism; Assure the solvency of the banking system; and Facilitate the achievement of the Government’s socio-economic development

objectives.

To achieve these objectives, the Law and regulations gives the BOL responsibility to inspect the commercial banks and other financial institutions under its jurisdiction and to collect, compile, and analyze data from the banks. The BOL is also expected to manage the nation’s foreign reserves, provide opinions to the Government on the economic, monetary, and financial situation of the country, and to act as the agent of the Government in negotiating monetary and financial agreements with foreign countries and multilateral institutions. B. Bank Licensing and Prudential Requirements The requirements for obtaining a banking license are contained in the Commercial Bank Law and BOL regulations. These stipulate that the applicant must have:

Registered capital of at least LAK 300 billion (LAK 100 billion in the case of foreign banks)2;

A sound shareholders’ agreement, feasibility study, and business plan; A transparent ownership structure, including a list of shareholders and their

proportion of shareholding; Satisfactory mechanisms for internal audit and control; and The facilities and equipment needed to conduct its operations.

BOL regulations also stipulate the prudential and reporting requirements for the operation of bank. These include:

A minimum capital to risk-weighted assets ratio of 8 percent;

2 “According to the covenant of BOL regarding the minimum registered capital for establishing a commercial bank or branch of a foreign bank in Lao PDR, commercial banks shall follow this instruction as amended by the BOL from time to time.”

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Ceilings on the amount of credit to any single person, group of interrelated persons, or persons related to the bank and on the amount of credit committed or outstanding to large clients;

A minimum level of liquid resources and limits on the maximum amount and

types of real estate investments a bank can make; Loan classification and provisioning standards and limitations on net open foreign

exchange positions; A prohibition against making a capital distribution to shareholders, if doing so

would leave the bank with less than the minimum regulatory capital; and Requirements to maintain accounting records and other documents which

correctly portray the bank’s transactions and financial condition. C. Current Composition of the Financial Sector

The Lao banking system currently comprises 24 institutions, which together account for an estimated 98 percent of total financial sector assets (Figures 16 and 17). These are:

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10

20

30

40

50

60

70

80

2007 2008 2009

Figure 16: Lao PDR‐Deposits by Type of Bank Ownership (percent of total deposits)

State‐Owned Commercial Banks Private and Joint Venture Banks Foreign Affiliated Banks Source: BOL Monetary Statistics 2009-IV

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Three full-service SOCBs—the Banque Pour Le Commerce Exterieur (BCEL), the Lao Development Bank (LDB), and the Agriculture Promotion Bank (APB). The SOCBs remain the largest players in the banking sector, together accounting for 73 percent of total bank deposits at end-2009. There is also a fourth state-owned policy bank (Nayoby Bank), which lends on soft terms to poor clients in rural districts, takes no deposits, and is not included by the BOL in consolidated monetary data;

1,000

000

000

000

000

000

000

000

2,

3,

4,

5,

6,

7,

8,

2006 2007 2008 2009

Figure 17: Lao PDR‐‐Currency Composition of Bank Deposits (billions of Kip)

Kip Forex Source: BOL Annual Report 2009

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Two joint venture commercial banks owned by the Lao Government in partnership with French and Vietnamese banks. These banks have a market share of about 5 percent.

Seven privately held commercial banks, with a current aggregate market share of 9

percent; and Ten branches of foreign commercial banks (from Australia, Korea, Malaysia,

Thailand, Vietnam and a small participation of IFC); these institutions have a current market share of 8 percent and tend to focus their business lines on serving trade and foreign investment customers from their home countries.

Nonbank financial institutions regulated by the BOL comprise a postal saving

institution, five deposit taking microfinance institutions, eight non-deposit taking NBFIs, 13 credit cooperatives and saving deposit institutions, two savings fund, eight other non-deposit taking NBFIs, and 22 pawnshops.

V. Principles for Good Supervision and Promoting Financial Sector Development

A. International Best Practices

The Basel Core Principles for Effective Banking Supervision (BCPs) and related documents provide very useful guidance on what supervision should do, and how supervisors should operate, to ensure the safety and soundness of a vibrant banking sector. Specifically, the BCPs establish that an effective supervisory regime should embody:

Comprehensive licensing procedures for the creation of new banks, changes in their allowed activities, or changes in their ownership;

Operational independence and sufficient resources for the supervisory authority

to conduct its work; Prudential rules governing such variables as capital, liquidity, connected

lending, and loan concentrations; Powers to enforce a range of penalties in the event of noncompliance with

prudential regulations; The means to ensure that there are strong internal controls and risk

management systems in place; The means to ensure that there is effective corporate governance;

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Regular data reporting by the bank and the ability for the supervisor to conduct onsite examinations to help ensure that problems can be detected as early as possible;

The availability of graduated and flexible corrective measure to address

difficulties in a timely manner; The use of internationally accepted accounting standards to help ensure that

asset impairment is recognized on a timely basis. A legal environment and insolvency regime that allow efficient resolution of

banks, expeditious liquidation of assets, and fair and equal treatment of creditors; and

A safety net to enhance public confidence in the banking system, which may

include lender of last resort and depositor protection arrangements. In 2002, the Financial Stability Forum (FSF) and the Basel Committee on Banking Supervision issued a set of recommendations on how supervisors should deal with weak banks.3 These were defined as banks whose liquidity or solvency would be impaired in the absence of a fundamental improvement in its financial resources, risk profile, strategic business direction, risk management capabilities and/or quality of management. Factors that can contribute to bank weakness include poor underwriting skills, an overly aggressive loan expansion program, or incentives for excessive risk taking, coupled with an absence of incentives to identify problem loans at an early stage and to take corrective actions. Problems can also arise from excessive loan concentration, when measured by industry, geography, or related borrowers, fraud or criminal activities, and other risks, such as interest rate risk, market risk, operational risk, and strategic risk. B. Implications for Strengthened Supervision and Financial Sector Development Comprehensive bank-by-bank analysis is essential for good supervision, but it is not sufficient to prevent problems at the systemic level. For that reason, supervisors need to have a clear understanding of the macroprudential risks that may affect the banking system as a whole. The current housing crisis in some advanced economies provides an example of how risks may be overlooked if supervisors focus too narrowly on the historical performance of a class of loans at an individual bank. Along with developing a view of macroeconomic conditions, supervisors need to deploy their resources where they are likely to have the greatest chances of detecting and avoiding serious problems. Unlike traditional compliance-based supervision, where supervisors focused on identifying any deviations from prudential ratios, risk-based supervision attempts to identify the riskiest business areas and to concentrate their 3 This section on principles for dealing with weak banks and the following section on corrective measures draw heavily on the analysis in the Basel Committee on Banking Supervision’s “Supervisory Guidance on Dealing with Weak Banks,” (March 2002)

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resources on the quality of management and internal controls in these areas. This requires regular contact between the supervisors and the managements of all banks. Onsite examinations are needed precisely because the supervisor must remain satisfied that bank management has the ability to identify, measure, monitor, and control the risks of the bank. In addition, there needs to be close communications between supervisors in host and home countries, where foreign branches or subsidiaries are present. When a bank breaches prudential requirements or otherwise engages in unsound banking practices, the supervisor must have the ability to compel the bank to take remedial actions. Supervisors should be empowered with a range of instruments for dealing with weak banks. These may include requiring the bank to improve governance, internal controls, and risk systems, by maintaining higher capital adequacy and liquidity ratios, placing restrictions on the lines of business conducted by the bank, enhanced provisioning for assets of doubtful quality, and, in extreme cases, the appointment of an administrator or conservator. Penalties for noncompliance with prudential regulations can range from warnings to fines of corporate officers for major violations. The dismissal of managers, directors, or shareholders can also be used in cases of noncompliance with prior supervisory orders. Poor asset quality usually reflects poor credit underwriting standards, but it can also reflect broader management and governance problems that can deteriorate rapidly. The global financial crisis has demonstrated that even large, sophisticated financial institutions may not have a complete awareness of the types or magnitude of risks they face, and there is now growing recognition that there are limits to the extent to which supervisors should rely on a bank’s own internal controls.4 When asset quality problems are discovered, the bank should elaborate a time-bound action plan that may include negotiating new arrangements with weak but viable debtors, taking possession of loan collateral, writing off nonrecoverable loans, and, in some cases, transferring bad assets to a special purpose debt management vehicle. The plan should show how the bank’s health can realistically be restored and should contain projections for the bank’s income, dividends, assets, liabilities, capital, nonperforming assets, and loan charge-off. Provisions should be based on the value of collateral that could be realizable in the short term, not under more favorable long-term circumstances.

4 See Jose Vinals, Jonathan Fiechter, et al., “The Making of Good Supervision: Learning to Say “No,” IMF Staff Position Note SPN/10/08 (May 18, 2010).

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VI. Achievements of the Reforms and Areas Needing Further Attention

This section reviews the achievements made over the past five years in strengthening financial supervision and identifies issues where the implementation of reforms has been incomplete or where new risks have arisen. A. Key Achievements Achievement 1—Strengthening the Banking Sector

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2005 2006 2007 2008 2009

Figure 18: Nonperforming Loans

Indonesia Philippines Thailand Lao PDR (BOL data) Source: AB and BOL

2005 2006 2007 2008 2009

Figure 19: Regulatory Capital to Risk‐Weighted Assets

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0

Indonesia

Although implementation of the BSRP took longer than initially envisaged, there is little doubt that the financial sector is stronger today than at any point in the past decade. Financial soundness indicators for the banking system as a whole have improved significantly (Figures 18 and 19). With the large-scale write-offs of bad assets made possible by the recapitalization of the state banks, aggregate NPLs of the banking sector plunged from 13.9 percent of total assets at end-2005—much higher than in Indonesia, Thailand, and the Philippines--to 1.8 percent at end-2009, which is comparable to, or better than, comparator countries, while NPLs as a share of capital have been cut from 6.6 percent to 1.2 percent. The ratio of regulatory capital to risk-weighted assets increased sharply from 3.3 percent at end-2007 to 13.3 percent at end-2009, bringing it close to the levels in regional comparators. BCEL, the largest SOCB, has reached the 12 percent target that the BOL has set for all banks. Achievement 2—Financial Deepening and Stronger Competition The size of the banking system and, with it, the extent of financial intermediation, has grown. Broad money as a share of GDP increased from 17.4 percent in 2000 to 31.9 percent in 2009, and the number of bank branches per thousand adults increased from 1.6 in 2005 to 2.4 in 2009. Importantly, the entry of new private and foreign banks has helped stimulate competition and set higher standards for customer service. Access to new financial services, such as ATMs, has expanded rapidly.

Philippines Thailand Lao PDR (BOL data) Source: IMF Global Stability Report and BOL

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Achievement 3—Better Legal Foundations The legal foundations for supervision and operation of a sound banking system have been enhanced by the enactment or amendment of laws and regulations that are much better suited to the needs of a market economy than those they replaced. Achievement 4—Improved Confidence The BOL has introduced a deposit insurance system to bolster confidence in the banking system. The existence of the system probably helped stem large withdrawals at a private bank in 2010 that otherwise might have spiraled into a full-scale run. B. Other Developmental Issues The authorities have accomplished much under the BSRP, but further work is needed to complete the restructuring of the SOCBs, further strengthen financial sector supervision, and enhance the safety and soundness of the financial system. . Developmental Issue 1—Central Bank Independence International experience demonstrates that central bank independence is an important condition for effective bank supervision and monetary policy management. In the case of Lao PDR, the BOL is tasked with strengthening the solvency of the banking system, facilitating the achievement of the Government’s money supply objectives, and supporting the achievement of the Government’s socio-economic development objectives. These objectives have to potential to create conflicting pressures for the BOL, which lacks the necessary degree of independence in these areas. In particular, the subordination of monetary policy to the Government’s monetary plan and the obligation of the BOL to pursue the attainment of the Government’s socio-economic objectives could conflict with its ability to maintain financial stability and banking sector soundness. In most countries, the Government establishes the broad objectives for the central bank, but translating these objectives into the conduct of monetary policy is usually the responsibility of the central bank. Other aspects of the BOL’s mandate could also create uncertainties. For example, the central bank’s obligation to ensure the solvency of the banking system could be interpreted as an obligation to prop up, rather than wind down, weak banks. Similarly, the central bank’s obligation to support the Government’s socio-economic objectives could influence decisions such as closing unprofitable branches or rationalizing staffing levels. The BOL’s supervisory effectiveness could also be undermined by the appearance of a potential conflict of interest inherent between its roles as owner and regulator of the SOCBs.

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Developmental Issue 2—Interpretation of Financial Soundness Indicators The improvements in system-wide financial soundness indicators need to be interpreted carefully in light of the of the rapid credit growth that has been taking place. In particular, rapid growth in lending tends to generate a declining NPL ratio, even if the stock of NPLs remains high or rising. This occurs for two reasons. First, the ratio falls because the stock of loans (the denominator of the ratio) is increasing rapidly, and, secondly, because those new loans are not old enough to be classified as nonperforming (the numerator of the ratio) under the BOL’s accounting procedures. It should also be noted that some system-wide financial soundness indicators, notably the CAR, deteriorated modestly in the first half of 2010. Although the extent of the deterioration to date has not been dramatic, the change in direction--from steady improvement to small deterioration—warrants close attention in light of the issues raised above. Developmental Issue 3—Evaluating the Condition of the Financial Sector Supervision must start at the level of individual banks. However, effective supervision also requires an ability to consolidate the data from individual banks and analyze their implications for systemic stability. The lack of consolidated information prevents the BOL from informing the public and advising the Government on the overall condition of the financial sector. Developmental Issue 4—Promoting a Strong Credit Culture Under the BSRP, the authorities established commercial courts and took other steps to expedite the resolution of defaults and other disputes between borrowers and lenders. Unfortunately, the results to date seem to have been limited. Indeed, some banks report that they are still unwilling to initiate judicial proceedings because the cases are invariably handled very slowly. They also maintain that the courts give excessive weight to the impact of foreclosure on the borrower and that borrowers are rarely required to relinquish or sell collateral in a reasonable time frame.

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Figure 20: Credit Depth Information Index

Source: World Bank

2004 2005 2006 2007 2008

Figure 21: Interest Rate Risk Premia(Bank lending rate minus t‐bill rate) 

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Philippines Thailand Vietnam Lao PDR Source: IMF Financial Soundness Indicators and BOL

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Another factor inhibiting the development of a strong credit culture is the lack of reliable information about the creditworthiness of borrowers. The World Bank’s Doing Business database gives Lao PDR a rating of zero on its six point index of credit information (Figure 20). The lack of good credit information and the weakness of the ability to enforce contracts are among the factors that contribute to the high cost of financial services in Lao PDR, as reflected in large spread between bank lending rates and the yield on government bills (Figure 21). Lowering the costs of financial intermediation through the establishment of better information and stronger legal institutions would strengthen the efficiency of markets and facilitate the achievements of Lao PDR’s developmental objectives. Developmental Issue 5—Condition of Individual Banks

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Regulatory capital to risk‐weighted 

assets     

Regulatory Tier 1 capital to risk‐weighted assets      

Nonperforming loans net of provisions  to 

capital      

Nonperforming 

loans tototal gross loans      

Figure 23: Financial Soundness Indicators 

"Indonesia (2008)" Philippines (2009) Malaysia (2009) Lao PDR (2009) Source: IMF Financial Soundness Indicators and BOL

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Capital Adequacy NPLs

Figure 22: Lao PDR FSIs by Type of Bank( end‐June 2010)

SOCBs Join Venture Banks Foreign Banks All Banks

Source: BOL

Although financial soundness indicators for the banking sector as a whole have improved in recent years, the condition of particular banks—notably the second and third largest state banks—remains precarious (Figures 22 and 23).

LDB, the second largest SOCB, remains heavily undercapitalized and handicapped by an uncompetitive cost structure. Although it has been slightly profitable since 2005, it will take several years, under the most optimistic of scenarios, for the bank to reach a CAR of 8 percent. There continue to be clashes in corporate cultures among staff coming from the six original banks that were merged into LDB. During the restructuring, LDB was required by local authorities in some districts to reopen some closed branches. Also, money from the Government to make redundancy payments to laid-off workers was never received, and the bank was obliged to rehire 145 staff.

Agriculture Promotion Bank, the third SOCB, is also undercapitalized but reports

a CAR at 5.9 percent as of year-end 2010. Management hopes to meet the BOL’s capital adequacy requirements by year-end 2014. Among other factors, the bank’s

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high cost structure reflects its mandate to maintain branches in largely rural areas and to provide loans to small-scale borrowers or groups of small borrowers.

Developmental Issue 6—Bank Resolution Framework The BOL lacks an adequate framework for the prompt resolution of distressed banks. Supervisors should possess, and be willing to employ, a range of instruments to deal with weak banks, including the ability to assess penalties, restrict the range of the bank’s authorized activities, limit the size of the bank’s balance sheet, and require improvements in governance, internal controls, and risk systems. The BOL has largely refrained from using such instruments and sanctions. Developmental Issue 7--Transparency There is a lack of transparency about the condition of individual banks and the banking sector, which impairs the public’s ability to understand and evaluate risks. Most banks do not publish annual reports or audited accounts, as they are required.5 In addition, the BOL does not publish consolidated financial soundness indicators in its statistical bulletins, nor does it systematically assess the condition of the banking system in its annual reports. Developmental Issue 8—Accounting Standards

KPMG Loan Classification IFRS principal IFRS provision BOL provision

Current 526,449 9,356 2,903Substandard 7,777 3,243 1,555Doubtfull 64,081 38,151 2,894Loss 12,773 12,484 12,773Total 611,080 63,234 20,125

Agricultural Promotion Bank - Loan portfolio classification and provisionTable 1

ClassificationBOL IAS 39 BOL IAS 39

Performing loans 584,742 526,449 2,903 9,356Non-performing loans 26,338 84,631 17,222 53,878Total 611,080 611,080 20,125 63,234

Principal (LK millions) Provision (LK millions)

Agricultural Promotion Bank - Loan loss provision; BOL compared to IAS39Table 2

Significant doubts remain about whether the accounting conventions established by the BOL present an accurate picture of a bank’s true financial condition. A recent

5 An exception is BCEL, which has posted its 2008-09 financial statements (but not an annual report) on its web site.

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External Audit Report for one of the SOCBs found that the differences between using IAS 39 and Circular 6 were large enough to produce an unreliable picture of the bank’s condition under certain (fairly extreme) situations. One particular problem area is the fact that the classification of loans places almost exclusive reliance on the number of days past due. A better basis for loan classification would also take into account other aspects of credit quality, such as the borrower’s ability to repay. Developmental Issue 9—Bank Reporting Requirements Some banks—including some large banks--contend that they are overwhelmed by the large quantity and high frequency of data they are required to submit to the BOL. Apparently, it is not uncommon for banks to miss deadlines for various reporting requirements. Developmental Issue 10—Supervision of Nonbank Financial Institutions The ability of the BOL to supervise NBFIs is limited by the shortage of financial resources and human expertise at its disposal. In these circumstances, it is not clear that the BOL has the capacity to supervise some entities, like pawnshops, which take no deposits and do not pose a systemic risk to the financial system.