## Financial System Stability Assessment, Republic of Armenia (cr18361)

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**Canonical URL:** [Financial System Stability Assessment, Republic of Armenia (cr18361)](https://www.imf.org/-/media/files/publications/cr/2018/cr18361.pdf)

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### Banking sector recovery and core vulnerabilities
- Banking sector recovering from the 2014 slowdown, aided by additional capital injections, several mergers, and improved regulation and supervision.
- Major vulnerability: high financial dollarization exposing banks (including largest ones) to FX-related credit and liquidity risks.
- Explicit mitigants suggested:
  - adoption of a stressed debt service to income ratio limit;
  - gradual introduction of reserve requirements in foreign currency for liabilities denominated in foreign currency;
  - adoption of the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) in domestic currency and in United States dollars (USD);
  - introduction of the capital surcharge for domestic systemically important banks.

### Cyclical risks, profitability, and capital/liquidity measures
- Cyclical outlook and credit:
  - Credit-to-GDP gap estimated to be closing; credit expanded over 21 percent (y-o-y) at end-June 2018.
  - Total credit remained moderate at 45 percent of GDP at end-2017.
  - Credit to manufacturing grew about 40 percent (y-o-y) at end-June 2018; consumer loans grew about 25 percent (y-o-y) at end-June 2018.
- Profitability and incentives:
  - Total profits of Armenian banks remained broadly constant at about $60 million per year on average between 2007 and 2017.
  - In 2017: average return on assets (ROA) less than 1 percent; average return on equity (ROE) about 6 percent.
  - Estimated cost of capital about 10–16 percent; ROE appears on average below the cost of bank capital.
- Recommended actions:
  - Implement the planned Basel III’s capital buffers starting from next year, including countercyclical capital buffer framework and ability to increase capital for higher-risk banks.
  - Consider remunerating reserve requirements.
  - Use Pillar II to mitigate consequences from excessive risk-taking.

### Funding, liquidity, and dollarization
- Funding and liquidity facts:
  - FX funding was about two thirds of total funding between 2012–2017.
  - Loan to deposit ratio in FX about 1.4 in 2017; in AMD about 1.
  - As of February 2018, about 30 percent of contractual outflows have a residual maturity of less than 30 days.
  - CBA’s net international reserves as of end-2017 were about $1.7 billion — about 40 percent of bank liabilities in foreign currency.
- Dollarization metrics:
  - Over 60 percent of household deposits denominated in FX.
  - Remittance inflows represented 8.5 percent of GDP in 2017.
  - 80 percent of corporate loans and about 30 percent of household loans are denominated in FX.
- Liquidity management and ELA:
  - CBA has limited capacity to provide emergency liquidity assistance in FX.
  - Recommendation: operationalize ELA with conditions for access, collateral framework, monitoring and exit criteria; permit ELA in FX only after prudential FX HQLA buffers are adopted.

### Large exposures, concentration and solvency
- Large exposures represent about 25 percent of total exposures.
- Direct exposure to the government (excluding the CBA) amounted to 10 percent of bank assets at end-June 2018, or 65 percent of regulatory capital at end-June 2018 (up from 53 percent at end-2015).
- Solvency indicators as of end-June 2018:
  - Capital adequacy ratio about 18 percent (with 16 percent leverage) for the system.
  - System’s NPL ratio around 6 percent of total loans; about 48 percent of NPLs covered by provisions.
  - Restructured loans estimated about 3 percent of total loans.
- Solvency stress-test (adverse scenario key assumptions):
  - Remittances decline by about 24 percent.
  - Copper prices decline by about 27 percent.
  - Nominal exchange rate depreciates by 22 percent.
  - Policy rates double to about 12 percent (from the current 6 percent).
  - Sovereign yields increase by about 400 basis points.
  - Under adverse scenario: capital shortfalls relative to the minimum required 12 percent remain contained at some 1 percent of GDP, occurring in banks with combined share of 58 percent of system assets.
  - Note: solvency stress testing may underestimate results due to insufficient data on large exposures and restructured loans.

### Liquidity stress testing and FX-specific gaps
- Liquidity stress tests (cash-flow approach, up to one year) — aggregate results:
  - Banks seem well positioned to confront liquidity shocks in aggregate (all currencies).
- FX-specific results:
  - Most banks would not have sufficient liquid assets denominated in U.S. dollars to confront U.S. dollar outflows in adverse scenarios, even allowing euro assets to be converted to USD.
  - For the most severe scenario, the system’s open funding gaps in foreign currency would amount to 24 percent of the CBA’s international reserves as of May 2018.
  - Counterfactual: if reserves for liabilities in foreign currency were required to be held in the currency of the liability, FX buffers would be sufficient to cover FX gaps in all scenarios.

### Supervision, regulatory framework and microprudential oversight
- Progress:
  - CBA adopted Risk-Based Supervision (RBS) in December 2017 and addressed many gaps from the 2012 FSAP.
  - RBS provides forward-looking assessments, use of risk teams, and improved off-site/on-site balance planned for 2018.
- Remaining supervisory priorities:
  - Refine RBS to differentiate capital levels more granularly using stress testing and ICAAP.
  - Develop standardized criteria to review/evaluate banks’ stress testing and ICAAP.
  - Consistently enforce large exposure limits and develop plans to bring down breaches.
  - Amend definitions of nonperforming and restructured loans to align with BCBS April 2017 guidance.
  - Incorporate review and understanding of IFRS 9 expected loss methodologies into supervisory practice.
  - Develop a non-discretionary regime of supervisory actions (Prompt Corrective Action) for deteriorating positions.

### Financial safety net, crisis management and resolution
- Weaknesses:
  - Flaws in bank resolution approach; absence of a special bank resolution regime that prevents court reversal of CBA actions.
  - DGF is a pure paybox with narrow functions; DGF governance allows active bankers on its board by law (MOU prohibits this in practice).
  - Absence of a true interagency high-level crisis management committee (CMC).
- Recommended reforms:
  - Amend banking law to establish a special bank resolution regime to make CBA resolution actions irreversible.
  - Expand DGF mandate to “paybox plus” to permit use of funds in resolution transactions (e.g., P&A), while decision to use funds remains with resolution authority.
  - Establish a high-level CMC including CBA Governor, Minister of Finance and Director of DGF (CMC not decision-making but coordination-focused).
  - Require all banks to complete Recovery Plans; CBA to prepare Resolution Plans for systemically important banks and update RRPs at least annually.
  - Expand supervisory MOUs to include Recovery and Resolution Planning; request commitments/letters of support from foreign parent banks for Armenian subsidiaries.

### Macroprudential toolkit, liquidity ratios and FX measures
- Legal authority allows wide range of macroprudential instruments including Basel III buffers.
- Planned Basel III phase-in (exact schedule preserved):
  - 2019 2020 2021 2022 2023 2024
  - Minimum total capital: 12% 12% 12% 12% 12% 12%
  - Capital conservation buffer (CCoB): — 0.5% 1% 1.5% 2% 2.5%
  - Minimum plus CCoB: 12% 12.5% 13% 13.5% 14% 14.5%
  - Countercyclical capital buffer: 0-2.5% (in effect within 6 months following the decision date)
  - D-SIB surcharge (systemic bank only): — 1% 2% 2% 2% 2%
- Measures to address dollarization:
  - Introduce a stressed debt service to income (DSTI) limit for unhedged FX borrowers (stress e.g., 20% depreciation).
  - Collect borrower income information to implement DSTI; until DSTI feasible adopt a stressed loan-to-value (LTV) limit.
  - Adopt LCR and NSFR in AMD and USD; set a higher LCR requirement in USD than in AMD in the medium term to promote de-dollarization.
  - FX reserve requirement should cover at least 20 percent of the deposit base (it is 18 percent at present).
  - Enhance liquidity stress tests with cash-flow methodology, maturities beyond 30 days, behavioral components, and currency breakdowns.

### Financial development, insolvency, pensions, MSME finance and transparency
- Financial sector structure and indicators:
  - Banking sector assets rose from 58 percent of GDP in 2012 to 78 percent in 2017.
  - Nonresidents account for about 20 percent of deposits and 8 percent of loans.
  - Nonbank credit sector doubled in 6 years to 8.5 percent of GDP at end-2017.
  - Pension funds: by end-2017 six funds with assets equivalent to 2 percent of GDP under a defined-contribution scheme administered by two private management companies under CBA supervision.
- Insolvency and enforcement shortcomings:
  - Bankruptcy law reformed in 2016 to increase rehabilitation potential; further reforms needed to ensure insolvency maximizes creditor recovery and is not used as a debt collection tool by individual creditors.
  - Recommendations include allowing secured creditors to vote on restructuring plans, introducing time limits for relief from automatic stay, and revising tax authority’s position in insolvency cases.
- MSME finance:
  - Access constrained by informality and unreliable financial reporting, leading to excessive collateral requirements and limited product offerings (lack of factoring, invoice financing, leasing).
  - Recommendation: consolidate government MSME support programs, improve targeting, and create financial capability programs.
- Pension reform and capital markets:
  - Full implementation of pension reform in July 2018 important for capital markets development; mandatory pension system should be maintained.
  - Government commitment needed to create a pipeline of AMD-denominated issuance to absorb pension inflows.
- Transparency:
  - Lack of transparency in reporting and accounting by corporations, sub-national entities and SOEs hampers capital markets development and trade finance products.
  - Advance accounting and auditing reform and introduce simplified financial reporting for SMEs.

### Key recommendations (selection with prioritized timing)
- Financial Stability (selected, timing preserved as in source):
  - Implementation of Basel III capital buffers as planned (CBA, ¶29). ST-MT
  - Start collecting income information for the adoption of a stressed debt service to income ratio limit for unhedged FX exposures (CBA, ¶30). ST
  - Until ready for DSTI implementation, adopt a stressed loan to value ratio limit (CBA, ¶30). ST
  - Prepare an action plan to reform the reserve requirement regime in the medium term. Include a clear timeline of implementation (CBA, ¶19-21; ¶32). ST
  - Adopt the LCR and NSFR in AMD and USD (CBA, ¶31-32). MT
  - Strengthen the liquidity management framework (CBA, MoF, ¶18). ST
  - Operationalize the emergency liquidity assistance (CBA, ¶23-25). ST
  - Use Pillar II to mitigate consequences from excessive risk-taking (CBA, ¶34). ST
  - Develop and implement a plan to bring down gradually exposures exceeding limits (CBA, ¶36). ST
  - Adopt a definition of nonperforming loans and restructured loans in line with international best practices (CBA, ¶37). ST
  - Adopt a special bank resolution regime to ensure that no court or other body can reverse any CBA resolution action (CBA, Parliament, ¶42). MT
  - Expand the DGF’s mandate to “paybox plus” (Parliament, ¶43). MT
  - Establish a high-level crisis management committee including DGF and MOF (CBA, MoF, DGF, ¶44). ST
  - Ensure that all banks develop acceptable recovery plans and the CBA to prepare resolution plans for systemically important banks (CBA, ¶45). ST
  - Start expanding supervisory MOUs to include Recovery and Resolution Planning, requesting them from parent supervisors. In the absence of proper arrangements, prepare domestic resolution plans (CBA, ¶46-47). ST-MT
  - Strengthen AML/CFT measures aimed at detecting the laundering of proceeds of corruption (Parliament, MoJ, CBA, ¶41). MT
- Financial Development (selected):
  - Continuing support for pension reform (Parliament; MOF, CBA, ¶48). I
  - Amend the bankruptcy law to strengthen the protection of secured creditors rights. Introduce further measures to expedite and improve the efficiency of court enforcement of debt-related cases (Parliament, ¶49). MT
  - Consolidate government programs and institutions for MSMEs support to enhance efficiency and targeting (MoF, CBA, ¶49). ST
  - Advance accounting and auditing reform to foster corporate and SOE transparency; introduce simplified financial reporting requirements for SMEs (Parliament, ¶50). ST

### Risk Assessment Matrix — principal risks (high-level)
- Weaker economic growth due to internal and external factors: Relative likelihood Medium; impacts include exchange rate pressure, deposit conversions, liquidity runs, higher NPLs and funding costs.
- Tighter global financial conditions: Relative likelihood High; impacts include stronger U.S. dollar pressures on a highly dollarized system, higher NPLs in USD loans, elevated volatility, higher funding costs.
- Significant financial stress from external shocks: Relative likelihood Medium; impacts include reduced access to international capital markets, liquidity pressures from depositor behavior, cyber-attack risks.

### Stress testing framework and contingency planning
- Banking Sector Solvency STeM:
  - Scope: all 17 individual banks (100 percent of assets).
  - Risk horizon: 5 years; last historical information December 2017.
  - Behavioral assumptions: iterated static balance sheet; no portfolio rebalancing; maturing assets replaced by same-type exposures; no dividends; losses recognized same year as impairment.
  - Hurdle: regulatory minimum CAR of 12 percent.
- Domestic and international contagion analyses:
  - Domestic: scenarios include single-counterparty and pairwise insolvencies across 17 banks.
  - International: insolvency scenarios for banking systems of 31 countries (30 non-Armenian scenarios described).
  - Finding: interconnectedness within domestic and global networks not large enough to threaten system solvency under modeled scenarios; capital buffers over regulatory minimum absorb losses due to thin links.

*Source: International Monetary Fund — Financial System Stability Assessment, Republic of Armenia (cr18361).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 6

### EXECUTIVE SUMMARY

### Banking sector recovery and core vulnerabilities
- The Armenian banking sector is recovering from the 2014 economic slowdown, aided by additional capital injected by shareholders, several mergers, and improved regulation and supervision.
- Banks, including the largest ones, are vulnerable to external shocks because high levels of dollarization expose them to FX-related credit and liquidity risks.
- Suggested mitigants explicitly identified:
  - adoption of a stressed debt service to income ratio limit;
  - gradual introduction of reserve requirements in foreign currency for liabilities denominated in foreign currency;
  - adoption of the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) in domestic currency and in United States dollars (USD);
  - introduction of the capital surcharge for domestic systemically important banks.

### Cyclical risks and capital/liquidity measures
- From a cyclical perspective, with the credit to GDP gap estimated to be closing, the recent pick-up in credit growth warrants close monitoring of bank risks.
- Observed incentives and concerns:
  - Banks’ low profitability levels, coupled with current abundant liquidity, seem to be providing incentives to adopt excessive risk-taking behavior.
  - Credit quality has not yet fully recovered from the 2014 slowdown.
- Recommended actions:
  - Implement the planned Basel III’s capital buffers starting from next year, including the framework for the countercyclical capital buffer, and the possibility for supervisors to increase capital requirements for banks with higher risks.
  - Consider remunerating reserve requirements.

### Supervision and regulatory framework
- The Central Bank of Armenia (CBA) has made significant progress, including adoption of the Risk-Based Supervision (RBS) framework and addressing gaps identified in the previous FSAP.
- Remaining supervisory priorities:
  - Refine risk-based differentiation in capital levels using stress testing and the internal capital adequacy assessment process (ICAAP).
  - Consistently enforce large exposure limits.
  - Amend the definition of nonperforming and restructured loans to reflect international best practices.
  - Incorporate understanding of International Financial Reporting Standard (IFRS) 9 methodologies in supervisory practices to enable a more comprehensive assessment of a bank’s credit risk management capabilities.

### Crisis management and resolution
- The crisis management framework is weakened by:
  - flaws in the approach to bank resolution;
  - narrow functions of the Deposit Guarantee Funds (DGF);
  - absence of a true interagency high-level crisis management committee.
- Given the significant presence of foreign subsidiaries:
  - supervisory Memoranda of Understanding (MOUs) should be expanded to include resolution planning of foreign subsidiaries in Armenia;
  - in the absence or inadequate resolution provisions, authorities should develop contingency plans to deal with stress in foreign banks.
- Recovery and resolution planning:
  - Recovery and resolution plans should be implemented for domestic banks, particularly when systemically important.

### Financial development, insolvency, pensions, and transparency
- Since the 2012 FSAP there have been substantial improvements in the legal framework and key policy decisions that led to further development of the financial sector; further efforts are needed to fully reap benefits.
- Insolvency framework:
  - Bankruptcy law reformed in 2016 to increase potential for rehabilitation, but further improvements are necessary to ensure insolvency maximizes return to creditors through reorganization or collective debt collection.
  - Current shortcomings mean insolvency is often used as a debt collection tool by individual creditors; rights of secured creditors in insolvency proceedings are not sufficiently protected.
- MSME finance:
  - Access to finance for micro, small and medium enterprises (MSME) remains constrained by informality and unreliable financial reporting, resulting in excessive collateral requirements, high costs, and non-diversified product offerings.
  - Efficiency of fragmented government support programs should be enhanced by consolidation, improved targeting, and better coordination among stakeholders.
- Pension reform and capital markets:
  - Full implementation of pension reform in July 2018 was an important step toward development of capital markets.
  - Administration of the pension system has been set up on a cost-effective basis and is working well.
  - The mandatory pension system should be maintained.
- Transparency:
  - A cross-cutting issue is lack of transparency in reporting and accounting by corporations, sub-national entities and state-owned entities (SOEs).
  - Measures to increase transparency, including improved accounting standards and audit requirements, are crucial to support financial stability surveillance and to enable pension funds to channel resources into the real economy.

### Financial sector structure — selected facts and indicators
- Banking sector size and growth:
  - Banking sector’s assets rose from 58 percent of GDP in 2012 to 78 percent in 2017.
  - A large proportion of banking assets are of subsidiaries of foreign banks; nonresidents account for about 20 percent of deposits and 8 percent of loans.
  - Higher capital requirements announced in 2014 and implemented in 2017 led to merger/acquisition of four banks since 2015.
- Nonbank sector:
  - The nonbank credit sector (non-deposit taking institutions) doubled in 6 years to 8.5 percent of GDP at end of 2017.
  - Insurance sector assets remain broadly constant at about 1 percent of GDP since 2013; nonlife insurance premia collected are low and there are no life insurance services.
- Pension funds:
  - Pension reform introduced a defined-contribution scheme run by two private management companies under CBA supervision; by end-2017 there were six funds with assets equivalent to 2 percent of GDP.
- Markets and interbank activity:
  - Issuances in the primary market remain dominated by government bonds and by three commercial banks.
  - Almost all repo and reverse repo transactions in the secondary market involve government bonds.
  - As of December 2017, interbank transactions in AMD represented 8 percent of banks’ funding.

### Structural vulnerabilities — dollarization and exposures
- Armenia is highly dollarized:
  - Over 60 percent of household deposits, including most of their saving accounts, are denominated in FX.
  - Remittance inflows represented 8.5 percent of GDP in 2017 and underpin FX deposits.
  - On the lending side, 80 percent of corporate loans and about 30 percent of household loans (mainly mortgages) are denominated in FX.
- Market behavior and risk manifestations:
  - Competition for market share encourages banks to remunerate FX deposits at rates higher than those consistent with remuneration of high quality liquid assets (HQLA) holdings; to avoid negative carry, banks lend to hedged and unhedged customers.
  - Nonperforming loan (NPL) ratios are higher for dollar-denominated loans and sensitive to currency depreciation.

### Key recommendations (prioritized timing: I/ST/MT)
- Financial Stability (selection of recommendations with timing):
  - Implementation of Basel III capital buffers as planned (CBA, ¶29). ST-MT
  - Start collecting income information for the adoption of a stressed debt service to income ratio limit for unhedged FX exposures (CBA, ¶30). ST
  - Until ready for DSTI implementation, adopt a stressed loan to value ratio limit (CBA, ¶30). ST
  - Prepare an action plan to reform the reserve requirement regime in the medium term. Include a clear timeline of implementation (CBA, ¶19-21; ¶32). ST
  - Adopt the LCR and NSFR in AMD and USD (CBA, ¶31-32). MT
  - Strengthen the liquidity management framework (CBA, MoF, ¶18). ST
  - Operationalize the emergency liquidity assistance (CBA, ¶23-25). ST
  - Use Pillar II to mitigate consequences from excessive risk-taking (CBA, ¶34). ST
  - Develop and implement a plan to bring down gradually exposures exceeding limits (CBA, ¶36). ST
  - Adopt a definition of nonperforming loans and restructured loans in line with international best practices (CBA, ¶37). ST
  - Adopt a special bank resolution regime to ensure that no court or other body can reverse any CBA resolution action (CBA, Parliament, ¶42). MT
  - Expand the DGF’s mandate to “paybox plus” (Parliament, ¶43). MT
  - Establish a high-level crisis management committee including DGF and MOF (CBA, MoF, DGF, ¶44). ST
  - Ensure that all banks develop acceptable recovery plans and the CBA to prepare resolution plans for systemically important banks (CBA, ¶45). ST
  - Start expanding supervisory MOUs to include Recovery and Resolution Planning, requesting them from parent supervisors. In the absence of proper arrangements, prepare domestic resolution plans (CBA, ¶46-47). ST-MT
  - Strengthen AML/CFT measures aimed at detecting the laundering of proceeds of corruption (Parliament, MoJ, CBA, ¶41). MT
- Financial Development (selection):
  - Continuing support for pension reform (Parliament; MOF, CBA, ¶48). I
  - Amend the bankruptcy law to strengthen the protection of secured creditors rights. Introduce further measures to expedite and improve the efficiency of court enforcement of debt-related cases (Parliament, ¶49). MT
  - Consolidate government programs and institutions for MSMEs support to enhance efficiency and targeting (MoF, CBA, ¶49). ST
  - Advance accounting and auditing reform to foster corporate and SOE transparency; introduce simplified financial reporting requirements for SMEs (Parliament, ¶50). ST

*Source: International Monetary Fund — Financial System Stability Assessment, Republic of Armenia (EXECUTIVE SUMMARY, cr18361).*

### 4.      There are also funding and liquidity

### 4.      There are also funding and liquidity 

### Funding and liquidity risks associated with dollarization
- FX funding was about two thirds of total funding between 2012–2017.
- Loan to deposit ratio in FX was about 1.4 in 2017 while this ratio was about 1 in AMD.
- As of February 2018, about 30 percent of contractual outflows have a residual maturity of less than 30 days (the bulk of the short-term liabilities is concentrated on corporate demand deposits and retail deposits).
- Reserve requirement policy: requirement to maintain reserve requirements in AMD for liabilities denominated in foreign currency results in lower liquid assets in foreign currency (about 6 and 18 percent of total assets respectively).
- The central bank has limited capacity to provide emergency liquidity assistance in FX.
- CBA’s net international reserves as of end-2017 were about $1.7 billion—i.e., about 40 percent of bank liabilities in foreign currency.

### Low profitability
- Between 2007 and 2017: total assets of the banking sector increased from 24.3 to 78.2 percent of GDP and banking capital more than doubled, while total profits of Armenian banks remained broadly constant at about $60 million per year on average.
- In 2017:
  - Average return on assets (ROA) of Armenian banks was less than 1 percent.
  - Average return on equity (ROE) was about 6 percent.
- Low profitability appears driven by:
  - High volume of nonperforming loans.
  - Declining interest spreads.
- Bank size indicators (2017):
  - Average bank assets about $0.53 billion in Armenia.
  - GDP per bank amounted in 2016 to $0.62 billion.
- Herfindahl-Hirschman concentration index by assets: 8.7 percent.
- Since 2014:
  - Economic slowdown increased provisions for nonperforming loans.
  - CBA’s 2014 decision to raise minimum absolute capital requirements six-fold from 2017 induced an inflow of new capital; minimum absolute capital (effective January 2017) is AMD 30 billion, equivalent to $62 million.
  - The capital increase promoted expansion of deposits to preserve leverage and returns, spurring competition and compressing interest spreads as funding costs increased in real terms.
- Bank profitability trends and indicators (2007–17 figures shown in source): declining ROAA and ROAE, rising NPLs (percent of total loans), narrowing spread between loans and deposits, rising real interest rates on deposits and loans, and expanding total funding and deposit volumes as percent of GDP.
- Cost of capital: estimated at about 10–16 percent.
- Yields on government securities (contextual figures from source):
  - Yields on one-year bonds were 6.8 percent on average.
  - Yields on 10-year bonds were 10.6 percent.
  - Yields on Treasury bills (maturities up to 9 months) were, on average, below or equal to the average ROE (6.1 percent).
- Risks: ROE appears on average below the cost of bank capital, potentially encouraging excessive risk-taking and short-term risk acceptance by bank managers if yields remain modest.

### Large exposures
- Large exposures represent about 25 percent of total exposures.
- Armenian regulation of large exposures is more conservative than Basel guidance, but enforcement is poor; banks tend to breach local statutory limits.
- Total direct exposure to the government (excluding the CBA) amounted to 10 percent of bank assets at end-June 2018, or 65 percent of regulatory capital at end-June 2018, up from 53 percent at end-2015.
- Concentration of banks’ exposure to the sovereign is low but rising while government borrowing is also rising.

### Cyclical vulnerabilities
- 2014–15 shock: fall in price and volume of copper exports, weakening of Russian economy, and low remittance receipts.
- Dram depreciation by almost 15 percent in 2014; monetary policy tightened to ease depreciation pressure and contain inflation.
- High financial dollarization plus depreciation and lower FX inflows resulted in increased debt burden for unhedged FX borrowers and high NPLs.
- Credit-to-GDP:
  - Remains moderate at 45 percent at end-2017.
  - Total credit expanded over 21 percent (y-o-y) at end-June 2018.
  - Credit to manufacturing sector grew about 40 percent (y-o-y) at end-June 2018.
  - Consumer loans grew about 25 percent (y-o-y) at end-June 2018.
- Some banks describe current phase as a “borrowers’ market”, suggesting inadequate pricing of credit risk and/or some relaxation of credit standards.
- Household and corporate debt:
  - Loans to households represent about 19 percent of GDP (slightly down from a peak in 2014).
  - Mortgages account for about 30 percent of total household loans; credit card loans account for about 25 percent.
  - Real estate market: market prices of residential apartment buildings in Yerevan broadly stable after a fall by 3 percent in 2017.
  - Loan-to-value ratios lie in the 60 to 80 percent range on aggregate; some high values exist in the distribution of mortgage loans in foreign currency.
  - At end-2017:
    - Nonperforming consumer loans amounted to around 6 percent of total consumer loans.
    - Nonperforming mortgage loans amounted to around 4 percent of total mortgage loans.
- Corporate debt about 25 percent of GDP, dominated by trade credit and loans to energy and agricultural sectors.
- Hedging instruments not widely available; banks manage open currency positions within regulatory limits by balancing on-balance sheet positions.
- Corporate leverage analysis hampered by lack of transparency in corporate financial reporting.

### Risk assessment and stress-testing results
- Financial soundness indicators as of end-June 2018:
  - Capital adequacy ratio about 18 percent (with 16 percent leverage) for the system.
  - All banks had achieved the new CBA-mandated minimum capital (AMD 30 billion, equivalent to $62 million).
  - System’s NPL ratio had fallen to around 6 percent of total loans; about 48 percent of NPLs were covered by provisions.
  - NPLs remain above 10 percent in some banks; trade, construction and industry segments together account for 30 percent of loans.
  - Restructured loans are estimated to be about 3 percent of total loans.
- Solvency stress test (mission’s analysis):
  - Adverse scenario assumptions:
    - Sharp oil price fall prompting a significant downturn in Russia, affecting remittances by about 24 percent.
    - Armenia’s exports further negatively affected by a decline of copper prices of about 27 percent.
    - Policy reaction: 22 percent depreciation of the nominal exchange rate and policy rates doubling to about 12 percent (from the current 6 percent).
    - Sovereign yields increase by about 400 basis points.
    - After two years of economic contraction, the economy starts to recover.
  - Under adverse scenario:
    - Bank losses materialize due to higher NPLs, interest rate risk (prevalence of fixed interest rates on asset side), and higher capital requirements driven by exchange rate changes.
    - Capital shortfalls (relative to the minimum required 12 percent) remain contained at some 1 percent of GDP, although these shortfalls occur in banks with a combined share of 58 percent of the assets of the banking system.
  - Solvency stress testing may underestimate results due to insufficient data on large exposures and restructured loans.
- Liquidity stress tests:
  - Based on cash-flow analysis with time buckets up to one year under several adverse scenarios:
    - 30-day run based on idiosyncratic risks for each bank.
    - Three 12-month scenarios characterized by system-wide deteriorating macro-financial conditions.
    - Combined (idiosyncratic and severe market) 12-month scenario for each bank.
  - Stress parameters applied to cash-flows derive outflow rates for maturing liabilities, roll-over rates for maturing assets, and haircuts on liquidity buffers; tests undertaken on aggregate liquidity and by currency.
  - Aggregate results: banks seem well positioned to confront liquidity shocks in aggregate (all currencies).
  - FX-specific results:
    - Most banks (including the largest ones) would not have sufficient liquid assets denominated in U.S. dollars to confront U.S. dollar outflows in the adverse scenarios.
    - Result holds even when euro-denominated foreign assets are allowed to be converted to U.S. dollars.
    - For the most severe scenario, the system’s open funding gaps in foreign currency would amount to 24 percent of the CBA’s international reserves as of May 2018.
    - Counterfactual assessment: if reserves for liabilities in foreign currency were required to be held in the currency of the liability, FX buffers would be sufficient to cover the FX gaps in all scenarios.
- Vulnerability note: large Armenian banks remain vulnerable to adverse external shocks due to low capital buffers as signaled by the solvency stress test.

*Source: Central Bank of Armenia; and IMF staff calculations.*

### 17.      Interconnectedness within the domestic interbank network and within the global

### 17.      Interconnectedness within the domestic interbank network and within the global

### Interconnectedness and solvency stress-test findings
- Interconnectedness within the domestic interbank network and within the global network of banking systems is not large enough to threaten the solvency (of individual banks or of the system), even under adverse scenarios.
- Capital buffers over the regulatory minimum are sufficient to absorb losses in both cases due to thin links.
- Armenia’s largest direct banking system counterparties are Russia and the United States.
- Banking systems whose distress could most significantly affect Armenia are France and the United Kingdom because they are connected to counterparties in Armenia that have large cross-border exposures relative to their capital.
- Most cross-border risk would come from potential credit losses, but losses from potential funding shocks and asset fire-sales would not be negligible.
- Solvency stress-test dynamics:
  - Regulatory capital ratios fall and then rise under the adverse scenario, and the total capital ratio remains above the regulatory minimum.
  - The capital shortfall is 1 percent of GDP in the first year, and this shortfall reduces over time as capital ratios improve over the projection horizon.
  - The main contributions to the fall in capital ratios in the first year are losses due to interest rate and credit risk, and rising capital requirements.
- Note: T1 denotes Tier 1 capital and T2 denotes Tier 2 capital.

### Financial Stability Policy Framework — A. Systemic Liquidity Management
- Overall assessment:
  - Management of systemic liquidity has improved since the last FSAP; however, there are still in need of improvement.
- Recommendations for Ministry of Finance and CBA coordination:
  - Ministry of Finance should improve the quality of its short-term forecasts and provide to the CBA daily cash flow projections at the beginning of each week as well as a 12-month horizon forecasts (with monthly breakdown).
  - The CBA should improve transparency of its operations by disclosing the formula to determine the allotment of its open market operations, and more liquidity data. (This includes: the previous day’s balance of banks’ account at the central bank; realized autonomous factors; autonomous factors forecasts; the reserve requirement amount and the average of banks’ accounts at the CBA up to the publication date.)
  - CBA should determine the range for the liquidity deficit (i.e., a maximum and a minimum outstanding amount of open market operations), which should be preserved with structural liquidity operations (such as reserve requirements) to maintain a firm grip on short-term interest rates.
- Reserve requirements and FX/domestic distinction:
  - Reserve requirements in domestic and foreign currencies should be adjusted to reflect their different roles.
  - Role of reserve requirement in AMD: create enough refinancing needs in the market to keep the CBA’s control on short-term interest rates (monetary policy implementation tool).
  - Role of reserve requirement on FX liabilities: primarily a prudential tool.
- Specific reserve requirement recommendations:
  - Set AMD reserve requirement at the level that provide enough room for averaging to stabilize short-term rates and remunerating it. This level should be consistent with the targeted liquidity deficit for monetary policy implementation and should provide enough room for averaging to absorb autonomous factors liquidity shocks.
  - The criterion would suggest increasing the reserve requirement to at least 5 percent (currently it is 2 percent). It should be fully remunerated at the CBA policy rate to mitigate its impact on banks’ cost of funds.
  - Banks should be gradually required to fulfill the reserve requirement on FX liabilities in FX to correct the distortion arising from the requirement to fulfill it in AMD.
    - Rationale: current requirement causes the stock of banks’ AMD HQLA (which includes the reserve requirement) to be disproportionately large, while the stock of FX HQLA is insufficient.
    - Transition should be gradual to avoid destabilizing the FX market; the CBA could help via U.S. dollar sales in the market (this sale would not change its gross reserves).
- Initiatives to support funding and market liquidity:
  - Government debt strategy should include a market development component, focusing on maintaining AMD-denominated securities for some benchmark maturities.
  - CBA should encourage market development of a reference for short-term interest rate compliant with international principles for computation of financial benchmarks.
  - CBA should gradually transfer to the market the swap of external funding that it executes for the banks.
- Emergency Liquidity Assistance (ELA):
  - CBA is allowed to provide ELA but does not have the operational framework.
  - Law allows the CBA to provide refinancing for maturities of up to six months and, in exceptional cases, five years, including without collateral (which should be avoided).
  - Making ELA operational requires: defining conditions for access (restricted to solvent banks with temporary liquidity problems), establishing appropriate collateral framework, monitoring use of resources, supervising steps for prompt reimbursement (remedial measures), and setting criteria for the exit strategy.
  - Financial dollarization raises the issue of what sort of liquidity assistance could be provided in FX:
    - ELA has to be secured with illiquid FX credit claim.
    - CBA could extend ELA in FX with AMD collateral, as it operates a swap facility allowing banks to access FX funding against AMD reserves at the CBA.
    - ELA in foreign currency should be in place only when and after prudential liquidity regulations ensuring banks keep prudent buffers of FX HQLA have been adopted.
- Collateral framework:
  - CBA collateral framework should be defined clearly and extended beyond government securities to address liquidity stress.
  - Extending framework requires introduction of appropriate risk management measures to maintain same level of residual risk after haircuts across classes of eligible collateral.

### Financial Stability Policy Framework — B. Macroprudential Oversight
- Mandate and governance:
  - Financial stability mandate is appropriately one of the CBA’s main objectives; CBA is an integrated supervisor overseeing all financial sectors.
  - In December 2017, the CBA formally adopted financial stability as a primary objective in its law in parallel with price stability.
  - CBA Board adopts macroprudential policies based on assessments and proposals by the Financial Stability and Special Regulation Committee (FSSRC).
  - Recommendation: CBA would benefit from summarizing its macroprudential policy implementation strategy in a public document, setting out policy objectives, instruments and transmissions, decision-making process, communication strategy, and accountability.
  - CBA’s financial stability reports should provide more forward-looking perspectives to guide markets’ expectations.
- Safeguards for dual objectives:
  - Dual mandates can complicate accountability and reduce credibility; having separate committees on monetary and macroprudential policies helps and should be strengthened by clearly assigning policy instruments to the two committees and improving communication.
- Current macroprudential toolkit and FX-focused measures:
  - Law allows CBA to select and use a wide range of macroprudential instruments including Basel III buffers.
  - Current tools in use are focused on FX risks: higher risk-weights (150–200 percent) and higher loan loss provisions (20 percent higher) for exposures denominated in foreign currency; prohibition to grant loans to households in foreign currency, except mortgages; requirements for banks to assess whether borrowers should be considered hedged or unhedged for monitoring purposes.
- Basel III capital requirements and phase-in (Table 5):
  - Current capital adequacy requirements are based on the standardized approach of Basel II with a minimum ratio of 12 percent.
  - Almost all capital of Armenian banks is CET1.
  - A draft regulation addresses the phase-in schedule for three buffers (conservation, countercyclical and systemic).
  - Lowest level of the leverage ratio in the banking system is 5.3 percent, which is still above the Basel minimum.
  - The framework for setting countercyclical capital buffer (CCyB) should be introduced from January 2019 as planned, and a positive buffer requirement should be adopted if the current credit growth trend continues.
- Planned phase-in table (exact values preserved):
  - 2019 2020 2021 2022 2023 2024
  - Minimum total capital: 12% 12% 12% 12% 12% 12%
  - Capital conservation buffer (CCoB): — 0.5% 1% 1.5% 2% 2.5%
  - Minimum plus CCoB: 12% 12.5% 13% 13.5% 14% 14.5%
  - Countercyclical capital buffer: 0-2.5% (in effect within 6 months following the decision date)
  - D-SIB surcharge (systemic bank only): — 1% 2% 2% 2% 2%
- Measures to address vulnerabilities from dollarization:
  - Introduce a stressed debt service to income (DSTI) limit:
    - For unhedged FX borrowers, debt-service would be calculated under a stress scenario of a depreciation that matches historical large depreciations (e.g., 20 percent).
  - Implementation of DSTI requires borrower income information to be collected by the CBA; guidance needed on including income from informal sources (including remittances) if appropriate.
  - DSTI limit can be first introduced as an indicative limit to assess quality of banks’ reporting, refine parameters, and allow adjustment time.
  - Until DSTI feasible, a stressed loan-to-value (LTV) limit assuming certain depreciation for unhedged FX loans can be imposed; the distribution of LTV should be analyzed to determine the threshold.
- Liquidity ratios and foreign currency adequacy:
  - Two prudential liquidity ratios adopted as follow up to 2012 FSAP are not adequate to mitigate liquidity and funding needs in foreign currency.
    - The total liquidity ratio (high liquid assets to total assets) and the current liquidity ratio (high liquid assets to demand liabilities) should be satisfied on aggregate and for individual currencies.
    - Requirements for foreign currency are lower and neither measure captures stressed assumptions.
  - Basel III liquidity ratios (LCR and NSFR) have been monitored since 2015 for all banks but are not yet implemented.
  - Specific FX liquidity recommendations:
    - The FX reserve requirement should cover enough of the deposit base, e.g., at least 20 percent (it is 18 percent at present).
    - The LCR and NSFR in USD, in addition to those for all currencies, should be adopted and set a higher requirement for the LCR in USD than in AMD in the medium term to promote de-dollarization.
    - Enhance regular liquidity stress tests by using a cash-flow methodology, maturities beyond 30 days, and behavioral components, both in aggregate and in foreign currency.
  - Current ratios mentioned for context: Ratios are 15 and 60 percent for the aggregate and 4 and 10 percent in FX.

### Financial Stability Policy Framework — C. Microprudential Oversight
- Progress and remaining gaps:
  - CBA has made significant progress by adopting a risk-based supervision (RBS) framework and addressing regulatory gaps identified in the 2012 Basel Core Principles assessment.
  - RBS framework provides forward-looking assessment of banks’ risk profiles and assigns resources proportionately to risk; use of risk teams contributes to identification and monitoring of system-wide risks.
  - Improvements have been made in risk management, stress testing, corporate governance, country risk and consolidated supervision.
- Areas needing enhancement:
  - RBS program should be refined for more granular assessments of banks’ capital needs.
  - Stress testing and internal capital adequacy assessment process (ICAAP) conducted by banks are important but standardized criteria for their review and evaluation should be developed.
  - Stress testing and ICAAP processes in banks have not led to differentiation in capital levels based on risk; this limitation should be addressed.
- Supervisory resources:
  - Supervisory resources to conduct RBS should be re-evaluated annually.
  - Number of staff has not changed in five years while RBS expectations have increased; resource planning exercises are recommended.
  - Consider hiring individuals with previous experience/training in risk analytics, stress testing, and risk management.
- Enforcement and large exposures:
  - Use of discretionary enforcement powers to address risk management concerns has not been consistent.
  - Since 2013 several banks have breached large exposure limits regularly; sanctions/fines have not been sufficient to prevent further violations.
  - Recommendation: develop a plan to bring down current exposures exceeding limits under the regulatory framework.
- Definitions and accounting:
  - Definition of nonperforming loans (NPLs) and restructured loans need amendment to reflect international best practices.
    - CBA uses a non-standard definition of NPLs (one day past due); reported NPL ratios are influenced by mandatory write-off of loans past due 270 days or more.
    - Definition of restructured loans is not well supported by examples or detailed supervisory explanations.
    - CBA does not provide detailed guidance on evaluating performance periods for restoring restructured loans to performing status and instead assesses adequacy of banks’ internal regulations on a case by case basis.
    - Recommendation: align definitions for non-performing and forborne (restructured) loans with the BCBS guidance issued in April 2017; initiate more detailed reporting and monitoring of restructured loans by banks.
  - CBA assessment of credit risk management should incorporate a review of International Financial Reporting Standard (IFRS 9) expected loss estimation practices required for all banks in 2018.
    - As Armenian banks adapt to IFRS 9 methodologies, supervisors need to enhance their review and understanding of IFRS 9 methodologies to accurately assess banks’ credit risk management capabilities.

*Source: IMF staff calculations.*

### 39.      The CBA needs to develop a non-discretionary regime of supervisory actions in

### 39.      The CBA needs to develop a non-discretionary regime of supervisory actions in

### Supervisory actions for deteriorating bank positions
- The CBA needs to develop a non-discretionary regime of supervisory actions in response to a bank’s deteriorating capital or liquidity position.
- Potential supervisory responses include:
  - submission of remediation plans,
  - ceasing dividends and discretionary compensation,
  - limits on growth, types of activities, or funding sources.
- While the CBA currently has authority to use these supervisory limits at its discretion, a clearer framework outlining the incremental use of these limits for banks is missing.

### D. Financial Integrity — AML/CFT assessment and follow-up
- Findings from Armenia’s 2015 AML/CFT assessment against the 2012 Financial Action Task Force standard:
  - broadly sound legal and institutional framework, albeit with some deficiencies.
  - low level of effectiveness of measures related to criminal sanctions against money launderers and to the confiscation of proceeds of crime.
  - recommended enhancing understanding of ML risks and vulnerabilities with respect to corruption, abuse of legal persons, the shadow economy and the extensive use of cash.
  - risk-based approach to AML/CFT supervision should be further developed.
  - domestic politically-exposed persons should be subject to relevant AML/CFT requirements.
  - requirements for targeted financial sanctions in relation to proliferation financing need to be brought more explicitly into the AML/CFT law to avoid legal challenges to sanctions.
- Progress since 2015 and remaining deficiencies:
  - Steps taken: revising some sections of the ML/TF national risks assessment; introducing a risk-based approach to AML/CFT supervision; amending the AML/CFT law to clarify requirements for targeted financial sanctions in relation to proliferation financing.
  - Further steps recommended:
    - deepen the understanding of risks and disseminate findings to the private sector,
    - continue to improve risk-based supervision,
    - strengthen measures to detect laundering of proceeds of corruption by enacting and implementing enhanced due diligence requirements for domestic politically-exposed persons,
    - ensure financial institutions and other obliged entities report suspicious transactions.

### Financial safety net and crisis management
- Banking law and resolution regime:
  - The banking law should be amended to establish a special bank resolution regime (SRR).
  - Although the CBA is the sole authority that can recommend license revocation, there is still the opportunity for the court to reverse the resolution action.
  - The new framework should provide, inter alia, authority for CBA to perform irreversible resolution actions, and introduce expanded resolution tools in line with the Key Attributes of Effective Resolution Regimes.
- Deposit Guarantee Fund (DGF) and deposit insurance law:
  - Recent amendments to the DGF Law specify a gradual reduction in the timeframe for reimbursing insured depositors to meet international best practices of 7 days by January 1, 2023 (current payout timeframe is 15 days).
  - Armenia’s DGF is a pure paybox and doesn’t play a role in the resolution process; the DGF’s mandate should be expanded to permit use of its funds in resolution transactions such as a Purchase and Assumption (P&A).
  - The decision to use funds for resolution transactions will be made by the resolution authority—i.e., the mandate expansion should not confer additional powers to the DGF.
  - The DGF law allows active bankers or members of the banking union (Armenia’s bankers association) to be members of the DGF board, which is not in line with best international practices.
    - Note: An MOU between DGF, CBA and MOF prohibits active bankers or members of the banking union from being on DGF’s management board; however, this should be included in amendments to the DGF Law.
  - The DGF covers only individual deposits; there is an international trend toward also covering deposits of legal entities (at the same limited level as for individuals), which is recommended to protect spillovers to the broader economy.
- Crisis management coordination:
  - The Financial Stability and Special Regulation Committee (FSSRC) is an effective coordination platform; however, a true interagency high-level crisis management committee (CMC) is recommended, comprised of the CBA Governor, Minister of Finance and Director of DGF.
  - The FSSRC is contained within the CBA and representatives from MOF and DGF can attend by invitation only; formally including the other safety net members in a high-level CMC is important.
  - The CMC would not be a decision-making body; each member would still retain statutory responsibilities and obligations:
    - DGF: prompt and effective resolution including swift repayment to insured depositors can help prevent contagion and avoid that resolution of a non-systemic bank create a systemic crisis.
    - MOF: any systemic crisis will likely require outlays of public funding for recapitalization or guaranteeing certain depositors and creditors.
  - CBA has drafted a Crisis Management Guide and safety net members have conducted several simulations, primarily with DGF regarding resolution of a non-systemic bank; authorities—especially MOF—are recommended to continue this effort.
- Recovery and Resolution Planning (RRP):
  - Not all banks have completed their Recovery Plans and those that have are often deficient.
  - CBA has not prepared Resolution Plans for any bank.
  - Recommendations:
    - Every bank should be required to complete adequate and reasonable Recovery Plans, based on proportionality.
    - CBA should develop Resolution Plans for all systemic banks.
    - RRPs should be updated at least annually.
- Cross-border cooperation and resolution planning:
  - CBA has supervisory MOUs with home regulators for every foreign subsidiary except for the United Kingdom (reportedly there is an informal agreement for coordination and information sharing with U.K. supervisors); extant supervisory MOUs are thin and should be improved.
  - Armenia participates in two supervisory colleges.
  - Armenia is not a member of any Crisis Management Group (CMG) for any of the foreign subsidiaries since the foreign subsidiaries are not material for the parent banks.
  - Recommendations for home-host framework:
    - CBA should be proactive in requesting Resolution Plans from the home supervisory/resolution authority.
    - CBA should ensure that the Armenian subsidiary is included and treated equitably in the plan.
    - CBA should request letters from foreign parent banks committing to support their Armenian subsidiaries, including capital and liquidity support.
    - If Resolution Plans for entities systemic in Armenia are inadequate or discriminatory to the favor of home country creditors, or no Resolution Plan is forthcoming, the authorities should develop national recovery and resolution plans to deal with stress in foreign subsidiaries.

### Financial Development — reforms, shortcomings, and recommended actions
- Progress since the last FSAP:
  - Substantial improvements in legal and regulatory frameworks that matter for financial development.
  - Reformed credit infrastructure: establishment and operation of a movable collateral registry and introduction of a new secured transactions regime.
  - Progress in improving the bankruptcy law.
  - Measures being taken to address cyber risks in payment systems.
  - The well-designed new pension system has mobilized a growing supply of long-term domestic capital that can be channeled through the local capital market to fund the economy.
  - Recommendation: Support for the pension reform should continue.
- Remaining shortcomings and recommendations:
  - Insolvency regime and enforcement:
    - Strengthen the regime on insolvency of corporate and individual debtors, and related institutional framework to better balance creditors’ rights and strengthen secured creditors’ rights in the context of insolvency.
    - Aim to increase numbers of successful rehabilitation cases and maximize creditors’ recovery within liquidation.
    - Recommended steps include:
      - Allowing secured creditors to vote on restructuring plans.
      - Introducing a time limit for relief from the automatic stay on enforcement for secured creditors.
      - Revising the tax authorities’ position in insolvency cases by allowing them to compromise debt and vote on restructuring plans.
      - Extending post-commencement financing beyond approved restructuring plans.
    - Reform measures should direct insolvency to be used only as a collective proceeding among multiple creditors, rather than as a collection tool by individual creditors against delinquent debtors.
    - Improve effectiveness of civil enforcement of individual debts through formal processes and potentially increased use of alternative dispute resolution (ADR) mechanisms.
  - MSME access to finance and market functioning:
    - Strengthen corporate transparency, financial capability and the efficiency of government support programs to provide MSMEs with affordable access to finance.
    - Informality and unreliable financial reporting reduce banks’ ability to ascertain a company’s ability to generate revenues, leading to very high collateral requirements and lending rates for MSMEs.
    - Product diversification is poor; in a largely collateral-based lending environment, products such as factoring, invoice financing, leasing are key for SMEs to access working capital.
    - Recommended actions:
      - Introduce targeted financial capability programs focused on improving MSMEs’ financial reporting and management.
      - Promote cash-less payments to alleviate some demand-side constraints.
      - Consolidate and improve targeting and coordination of fragmented government support programs.
      - CBA should consider creating a new unit to take over tasks related to financial inclusion.
  - Capital markets development:
    - A high-level commitment from government is required to create a pipeline of capital markets issuance and demonstration projects to absorb the inflow of pension contributions.
    - CBA has been proactive in introducing frameworks for new instruments and the overall regulatory framework for capital markets is sound.
    - The key constraint is the supply side due to limited issuance pipeline across issuers and products.
    - Government action is needed to promote municipal, SOE and infrastructure projects.

*International Monetary Fund — Republic of Armenia (excerpt).*

### 50.      Sustained financial sector development requires improvements in transparency across

### 50.      Sustained financial sector development requires improvements in transparency across all sectors of the economy

### Transparency and financial development
- Lack of transparency in reporting and accounting by corporations, sub-national entities and SOEs:
  - Hampers possible issuances on the capital markets.
  - Inhibits growth of products such as factoring and invoice financing that facilitate trade finance and are key for MSME access to finance.
- A failure to improve these standards will jeopardize the progress made so far and limit the ability of the financial sector to play an effective role in the economy.

### Baseline and adverse scenarios (Table 6) — selected series (2017–2022)
- Output gap
  - WEO baseline scenario: -0.04 -0.02 0.00 0.02 0.04 0.04
  - Adverse scenario, deviations from baseline: 0.00 -1.53 -4.27 -3.31 -1.35 -0.32
  - Adverse scenario variable path: -0.04 -1.55 -4.27 -3.29 -1.31 -0.28
- GDP growth, year-on-year seasonally adjusted
  - WEO baseline scenario: 7.48 3.40 3.50 3.50 3.70 4.00
  - Adverse scenario, deviations from baseline: 0.00 -2.97 -8.74 -0.83 1.42 0.59
  - Adverse scenario variable path, year-on-year: 7.48 0.43 -5.24 2.67 5.12 4.59
- Russian real GDP growth, year-on-year
  - WEO baseline scenario: 1.55 1.71 1.49 1.50 1.50 1.50
  - Adverse scenario, deviations from baseline: 0.00 -10.08 3.05 3.34 1.08 0.25
  - Adverse scenario variable path, year-on-year: 1.55 -8.37 4.53 4.84 2.58 1.75
- Policy rate
  - WEO baseline scenario: 5.79 5.79 5.79 5.79 5.79 5.79
  - Adverse scenario, deviations from baseline: 0.00 5.85 5.05 2.12 0.52 0.13
  - Adverse scenario variable path: 5.79 11.64 10.84 7.91 6.31 5.92
- Effective long-term rate
  - WEO baseline scenario: 11.54 12.29 12.29 12.29 12.29 12.29
  - Adverse scenario, deviations from baseline: 0.00 4.72 3.46 1.55 0.52 0.20
  - Adverse scenario variable path: 11.54 17.01 15.75 13.84 12.81 12.49
- Country spread (premium)
  - WEO baseline scenario: 2.38 2.38 2.38 2.38 2.38 2.38
  - Adverse scenario, deviations from baseline: 0.00 3.58 1.87 0.98 0.51 0.27
  - Adverse scenario variable path: 2.38 5.97 4.26 3.36 2.89 2.65
- CPI inflation, period average, year-on-year
  - WEO baseline scenario: 0.91 3.50 4.00 4.00 4.00 4.00
  - Adverse scenario, deviations from baseline: 0.00 1.48 3.71 1.71 0.36 -0.11
  - Adverse scenario variable path, year-on-year: 0.91 4.98 7.71 5.71 4.36 3.89
- Rate of change in nominal exchange rate, year-on-year (1/)
  - WEO baseline scenario: 0.03 4.01 2.00 2.20 1.17 1.17
  - Adverse scenario, deviations from baseline: 0.00 18.29 -2.59 -2.84 -1.42 -1.02
  - Adverse scenario variable path, year-on-year: 0.03 22.29 -0.59 -0.64 -0.24 0.15
- Price of Oil, USD per barrel
  - WEO baseline scenario: 52.81 62.31 58.24 55.55 54.08 53.55
  - Adverse scenario, deviations from baseline: 0.00 -34.32 -21.44 -19.38 -18.91 -18.75
  - Adverse scenario variable path: 52.81 27.99 36.80 36.17 35.17 34.80
- Copper prices, US dollar per metric ton
  - WEO baseline scenario: 6,169.94 7,131.67 7,228.02 7,242.00 7,237.25 7,232.00
  - Adverse scenario, deviations from baseline: 0.00 -2,631.95 -1,830.18 -1,750.78 -1,753.05 -1,753.91
  - Adverse scenario variable path: 6,169.94 4,499.72 5,397.84 5,491.22 5,484.20 5,478.09
- Remittances, millions of US dollars
  - WEO baseline scenario: 1,765.50 1,736.72 1,728.21 1,718.04 1,714.97 1,720.48
  - Adverse scenario, deviations from baseline: 0.00 -392.00 -299.26 -71.19 46.45 87.35
  - Adverse scenario variable path, year-on-year: 1,765.50 1,344.72 1,428.94 1,646.85 1,761.42 1,807.83
- (In percent unless otherwise noted) — Sources: Central Bank of Armenia; Haver Analytics; and World Economic Outlook database.
- 1/ Increase equals depreciation.

### Selected economic indicators (Table 7) — highlights (2015–21)
- Real GDP (percent change): 3.2 0.3 7.5 6.0 4.8 4.5 4.5
- Final consumption expenditure, Contrib. to Growth: -5.2 -0.3 7.5 4.5 2.6 2.8 3.2
- Gross fixed capital formation, Contrib. to Growth: 0.5 -2.4 1.5 3.6 2.9 2.7 1.7
- Net exports of goods and services, Contrib. to Growth: 6.1 3.1 -1.1 -1.3 -0.7 -1.0 -0.4
- Gross domestic product (in billions of drams): 5,044 5,067 5,569 6,143 6,683 7,249 7,868
- Gross domestic product per capita (in U.S. dollars): 3,529 3,526 3,847 4,190 4,447 4,705 4,982
- CPI (period average; percent change): 3.7 -1.4 0.9 3.1 4.4 3.8 3.9
- Investment (in percent of GDP): 20.9 18.9 20.7 22.5 23.3 23.8 24.2
- National savings (in percent of GDP): 18.4 16.6 17.8 18.4 19.6 19.8 20.2
- Revenue and grants (in percent of GDP) 1/: 21.5 21.4 21.2 21.8 22.2 22.5 22.7
- Expenditure (in percent of GDP) 1/: 26.3 27.0 26.0 24.5 24.4 24.5 24.6
- Overall balance on a cash basis 1/: -4.8 -5.6 -4.8 -2.7 -2.2 -2.0 -1.9
- Public and publicly-guaranteed debt (in percent of GDP): 48.7 56.7 58.7 57.1 56.2 54.4 53.3
- Exports of goods and services (in millions of U.S. dollars): 3,136 3,500 4,268 4,830 5,140 5,333 5,557
- Imports of goods and services (in millions of U.S. dollars): -4,418 -4,516 -5,720 -6,425 -6,772 -7,058 -7,311
- Current account balance (in percent of GDP): -2.6 -2.3 -2.8 -4.1 -3.7 -4.0 -4.0
- Gross international reserves (in millions of U.S. dollars): 1,771 2,204 2,314 2,212 2,311 2,361 2,385
- Import cover 3/: 4.7 4.6 4.3 3.9 3.9 4.0 3.7
- Memorandum: Population (in millions): 3.0 3.0 3.0

### Financial soundness indicators for the banking system (Table 8) — selected metrics (levels and ratios)
- Capital adequacy
  - Total regulatory capital to risk-weighted assets (decimals shown across periods): 14.5 16.2 17.3 17.4 18.4 20.0 20.0 19.5 19.1 18.6 18.7 18.2
  - Capital (net worth) to assets: 14.0 14.7 15.0 15.7 15.9 16.2 16.3 16.1 16.1 15.7 16.0 16.0
- Asset composition (sectoral distribution of loans, in billions of drams) — selected sectors:
  - Industry (excluding energy sector): 266.3 225.9 219.7 228.2 228.5 227.1 229.6 230.8 244.9 256.3 270.3 322.3
  - Trade/commerce: 386.3 345.5 373.0 369.2 376.4 335.8 343.9 355.6 390.4 419.6 419.9 432.3
  - Consumer credits: 451.5 423.1 429.2 426.1 419.6 434.2 451.2 466.6 472.6 511.4 548.6 585.7
  - Mortgage loans: 172.4 179.0 177.3 178.6 181.1 183.7 182.4 186.2 191.3 209.0 210.5 219.9
  - Foreign exchange loans to total loans: 64.7 66.7 67.9 67.1 67.3 64.6 64.6 64.4 64.6 63.5 63.3 62.1
- Asset quality
  - Nonperforming loans (in billions of drams): 149.9 166.0 218.1 202.7 213.1 162.2 166.0 155.6 184.7 146.7 146.7 181.8
  - Loss (>270 days past due, in billions of drams): 173.4 288.4 292.5 312.3 331.4 354.3 372.4 390.8 404.1 442.5 448.2 453.0
  - Nonperforming loans to gross loans (percent): 6.8 7.8 10.0 9.2 9.7 6.7 6.8 6.3 7.3 5.5 5.4 6.3
  - Provisions to nonperforming loans (percent): 41.3 42.9 40.6 46.0 47.5 52.0 52.5 54.6 51.3 51.5 53.9 47.6
- Earnings and profitability
  - ROA (profits to period average assets): 1.0 -0.5 0.2 0.5 0.5 1.1 1.1 1.3 1.2 1.2 1.4 1.5
  - ROE (profits to period average equity): 6.4 -3.5 1.0 3.3 3.2 7.0 6.4 7.9 7.6 7.7 8.7 9.6
- Liquidity
  - Liquid assets to total assets (percent): 25.1 28.0 29.2 28.0 29.9 32.5 32.0 32.2 32.2 32.1 30.8 27.0
  - Liquid assets to total short-term liabilities: 129.4 142.4 157.7 153.5 159.7 170.8 164.6 157.1 144.5 141.7 148.7 132.1
  - Customer deposits to total (non-interbank) loans: 98.0 112.5 112.9 110.1 113.2 115.0 115.6 115.0 117.5 117.0 118.3 107.3
- Sensitivity to market risk
  - Gross open positions in foreign exchange to capital: 14.6 6.5 5.2 5.6 5.6 6.9 4.9 4.9 4.2 3.8 4.0 2.7
  - Net open position in FX to capital: -11.1 -2.8 -2.3 0.0 -3.3 -3.3 -1.2 -2.5 -1.8 -1.4 -0.4 0.8
- Source: Central Bank of Armenia

### Risk Assessment Matrix (Table 9) — key risks, relative likelihood, and transmission channels
- Weaker economic growth due to internal and external factors
  - Relative likelihood: Medium
  - Impact: Medium / Medium / High / High / High (table lists multiple impact cells)
  - Possible triggers:
    - Significant economic downturn in the key trading partner, Russia, through remittances and exports.
    - Lower commodity (especially copper and oil) prices.
    - Regional conflict, given sharp, renewed Nagorno-Karabakh-related tensions.
    - Intensification of sanctions to Russia and conflicts in the Middle East.
    - Higher risk premia.
  - Transmission channels and impacts:
    - Substantial pressure on the exchange rate to devalue, accentuated by the high degree of financial dollarization.
    - Deposit conversions into foreign currency widening banks’ net FX open position; marked devaluation could negatively impact banks’ profits.
    - Runs to convert deposits into hard currency in cash could impose substantial liquidity shortage.
    - Interest rate increases leading to higher NPLs, higher provisioning, lower profits, and reduced capital; duration mismatches and valuation losses on financial assets.
    - Increased funding costs for sovereign, banks, and private sector; reduced credit growth; potential for banks to engage in riskier lending and investment.
- Tighter global financial conditions
  - Relative likelihood: High
  - Impact: Medium
  - Possible triggers:
    - A rise in global interest rates and term premia associated with Fed normalization and tapering by the ECB.
  - Transmission channels and impacts:
    - Stronger U.S. dollar could harm Armenia’s highly dollarized banking system.
    - Higher NPLs in U.S. dollar-denominated loans from unhedged borrowers.
    - Elevated volatility in FX and financial markets; higher risk premia and funding costs; weaker banks losing market funding.
    - Liquidity problems as customers try to exchange DC deposits for FX deposits; impact on profit related to banks’ NOP; lower profitability as provisions rise and demand for credit abates.
- Significant financial stress triggered by external shocks
  - Relative likelihood: Medium
  - Impact: Medium / Low
  - Possible triggers:
    - Capital outflows from large EMs and/or reemergence of financial stresses in Euro Area.
    - Cyber-attacks on interconnected financial systems with subsidiaries in Armenia.
  - Transmission channels and impacts:
    - Direct impact on subsidiaries of foreign banks under financial stress in the Euro area.
    - Reduced access to international capital markets, particularly given the expected $500 million Eurobond roll-over in 2020.
    - Liquidity pressures if depositors feel threatened by cyber-attacks.

*Sources: Central Bank of Armenia; Haver Analytics; and World Economic Outlook database.*

### Appendix I. Implementation of 2012 FSAP Recommendations

### Appendix I. Implementation of 2012 FSAP Recommendations

### Overview of implementation status (selected recommendations)
- Introduce liquidity coverage ratio for foreign currency  
  - Partial implementation: In 2013, the CBA introduced prudential FX liquidity ratios based on liquidity assets as a percentage of both total assets and demand liabilities.  
  - Basel III LCR ratio introduced only for monitoring purposes pending resolution of the shortage of HQLA in foreign currency.

- Government representative confidentiality and legal protection for staff  
  - Implemented: Government representative subject to Central Bank confidentiality; signs obligation not to disclose information received during Board meetings.  
  - Implemented: Amendment in Article 24 of LCB; Parliament passed the law on 13/12/2017. Amendment stipulates that the CBA, its governing bodies, employees or any other person who represents the CBA or is authorized to act on its behalf, cannot be held accountable (including for the compensation of losses) for a decision, action or inaction regarding the supervision of financial organizations if they act in accordance with the laws (bona fide).

- Exchange of information without an MOU  
  - Implemented: Amendment in Article 8 of LCB; Parliament passed the law on 13/12/2017. Amendment empowers the CBA to cooperate and share information (including confidential) with relevant foreign supervisors without requiring an international agreement and subject to appropriate confidentiality safeguards.

- Align minimum capital requirements across banks  
  - Implemented: Minimum capital requirements aligned for all banks by CBA Board Resolution No. 257-N of 24/11/2017.

- Acquisition requirement in Law on Banks  
  - Implemented: Amendment in Regulation 1, point 232.

- Avoid prudential regulation for development objectives  
  - Implemented: Minimum capital requirements aligned for all banks by CBA Board Resolution No. 257-N of 24/11/2017.

### Supervisory framework, Pillar 2, and risk management
- Structured dialogue and supervisory manuals  
  - Implemented: Provision included in the RBS manual (Approved by CBA Chairman Resolution No. 1/1001L of 19.12.2017) to set up more frequent (i.e. annual) structured dialogue with banks' Board or Senior Management on capital adequacy assessments.

- Pillar 2 guidance and risk coverage  
  - In progress: Regulation 4 provides guidance for banks to deal with risks not covered in Pillar 1; risk-based supervision manual provides guidance for supervisors to apply Pillar 2.  
  - Require banks to do self-assessments based on risk management principles issued by BCBS; further guidelines may be issued after evaluating self-assessments.  
  - Regulation 4 requires banks to have a risk management function that should take into consideration credit concentration risk, interest rate risk in the banking book, indirect foreign exchange risk, reputational and strategic risk.  
  - From 01.01.2017 the minimum capital requirement for banks was increased and can be used as a buffer to mitigate those risks.

- Supervisory methodology for capital add-ons and Pillar 2 integration  
  - Implemented: Provision included in the RBS manual (Approved by CBA Chairman Resolution No. 1/1001L of 19.12.2017). From 01/01/2017 the minimum capital requirement for banks was increased.

- Risk management focus and provisions distribution  
  - Implemented: Regulation 4 developed to focus on risk management rather than control and to reassess distribution of provisions between mandatory regulations and “comply or explain” guidance.

- Internal model validation and independent risk management  
  - Implemented: Amendments to Regulation 4 require banks to conduct an independent validation of internal risk models before their approval.  
  - Implemented: LBB and Regulation 4 define requirement to have a separate independent Risk management function for all banks.

### Market, FX, large exposures, and reporting
- Indirect FX risk and risk-management practices  
  - Implemented: Amendments to Regulation 4 define indirect FX risk and require banks to identify and monitor it; CBA supervisors assess bank evaluations.

- Align large exposures calculation with Basel methodology  
  - Partially implemented: LBB amended in 2017 providing legal base for alignment; CBA in process of internal discussions to address deviations.

- Offsite reporting on country and transfer risk  
  - Implemented: CBA developed a reporting system enabling monthly information on all types of exposures to non-resident counterparties, with detailed descriptions including country of counterparty residence.

- Market data valuation and independent testing  
  - Implemented: Banks do not heavily rely on internal models for market risk; responsibility shared between risk management and internal audit. Point 58 of Regulation 4 requires periodic revision of risk management processes including validity and completeness of input data and testing of assumptions.

- Frequency of revaluation and data verification  
  - Implemented: Banks prepare and publish financial statements in accordance with IFRS; banks undergo external auditing; banks report to the Central Bank per supervisory reporting rules.

### Operational risk, compliance, AML/CFT, and governance
- Operational risk reporting requirements  
  - Implemented: Regulation 3 (form 28) requires submission of reports on fraud and attempts of fraud; form 35 requires banks to inform CBA if they have incurred or expect to incur material losses due to operational risk and other risks, with specified content for submissions.

- Compliance and internal audit separation  
  - Implemented: LBB and Regulation 4 clearly separate compliance and internal audit functions; each bank must have an independent compliance function with independence and full access to the Board per Regulation 4.

- AML/CFT legislative reform and evaluation  
  - Implemented: Legislative package enacted on October 28, 2014 (passed June 21, 2014) introduced changes to 15 laws drafted by the FMC and other AML/CFT competent authorities, including: AML/CFT Law; Criminal Code; Criminal Procedure Code; Administrative Code; Law on Advertisement; Law on Advocacy; Law on Auditing; Law on Bank Secrecy; Law on Games of Chance; Law on Inspections; Law on Insurance; Law on Licensing; Law on Lotteries; Law on Notaries.  
  - Outcome: In December 2015, the 49th plenary session of the MONEYVAL Committee adopted the Fifth Round Mutual Evaluation Report on the Armenian AML/CTF system. The report concludes that, in terms of technical compliance, Armenia is fully or largely compliant with 35 out of 40 FATF Recommendations and, in terms of effectiveness, Armenia demonstrates a substantial level of effectiveness for 6, a moderate level of effectiveness for 3 and a low level of effectiveness for 2 Immediate Outcomes.

### Crisis management, resolution, and deposit insurance
- Legislation to report material operational changes to CBA  
  - Implemented: Regulation 3, as amended in 2012, requires banks to submit a quarterly report including information on material losses born or likely to be born by the bank from credit, market, operational, liquidity, reputation or other risks.

- Formalized contact with banks  
  - Implemented: Provision included in the RBS manual (Approved by CBA Chairman Resolution No. 1/1001L of 19.12.2017) to hold formal meetings (e.g., annually) with senior management of banks.

- Consolidated supervision legislation  
  - Implemented: LCB amended in 2015; Regulations covering identification procedure, prudential, reporting and disclosure requirements of financial groups issued in 2016. Design of consolidated supervisory framework included in third and fourth DPOs; legal acts developed with World Bank technical assistance.

- Hedging ability of borrowers information program  
  - Partially implemented: Consistent definition of unhedged FX credit risk established in June 2018; banks required to identify and monitor such risk. Information collections conducted ad hoc in 2014, 2015 and 2017.

- Use of Pillar 2 supervisory techniques  
  - Partially implemented: Certain Pillar 2 techniques introduced through the risk-based supervision program.

- Resolution triggers and regime  
  - Partially implemented: Triggers clarified. However, no special resolution regime; license revocation requires application to the court, which can refuse and reverse CBA’s resolution action(s).

- Deposit Guarantee Fund (DGF) reform and pay-out period  
  - Partially implemented: Amendments to RA Law on "Guarantee of remuneration of bank deposits of physical persons" passed by Parliament on 21/12/2015. DGF funds cannot yet be used for resolution; the remuneration procedure of guaranteed deposits improved. Time schedule in Law: since 2023 remuneration of guaranteed deposits shall be carried out by the Deposit guarantee fund after 7 days of bank insolvency, within 3 days upon receipt of the depositor's claim.

- DGF governance and participation of active bankers  
  - Partially implemented: An MOU between MOF, DGF and CBA addressed this issue but it has not been included in law; recommended to amend the DGF Law to cure the issue.

### Pension funds, secured transactions, and other reforms
- Pension funds investment policy and asset manager regulation  
  - Implemented in 2014: Investment policy is sound and there are well performing asset managers operating in the country.

- Pension regulation capacity at CBA  
  - Implemented in 2015: CBA developed in-house capacity to adequately regulate the sector.

- Assess reform transition cost of pension reform  
  - Implemented in 2015: Transition went smoothly and the system operates well.

- Civil Code and collateral registration/execution  
  - Largely implemented in 2015: New secured transaction regime implemented and performing well with further modifications underway.

*Source: Appendix I. Implementation of 2012 FSAP Recommendations (excerpt).*

### Appendix II. Banking Sector Stress Testing Matrix (STeM) — Bank Solvency Stress Test (top-down by FSAP team)

### Scope and coverage
- Institutions included: All 17 individual banks  
- Market share: 100 percent of all banks’ assets

### Methodology and risk factors modeled
- Credit risk: Statistical models relate loan losses to the macroeconomic scenarios. Risk-weighted assets are recalculated under the adverse scenario.  
- Market risk: Unexpected movements in interest rates revalue securities on the balance sheet classified to be reported at fair value.  
- Net interest income: Extrapolated from recent effective interest rates earned on interest-bearing assets and paid on interest-bearing liabilities.  
- Profits: Projected based on net interest income, loan losses, valuation changes and recent experience of net non-interest income.  
- Risk Horizon: 5 years.  
- Last historical information: December 2017

### Behavioral assumptions
- Dynamic balance sheets generated using an iterated static balance sheet approach with assets growing in line with nominal GDP.  
- No rebalancing of portfolio is allowed.  
- Credit supply effects are disallowed.  
- Maturing assets are replaced by exposures of the same type and risk.  
- Banks do not pay dividends.  
- The effective tax rate does not change.  
- Losses are recognized in the same year that loans are impaired.  
- If banks’ capital ratio falls below regulatory minimum during the stress test horizon, no corrective action is assumed.

### Adverse scenario and shocks
- Single adverse scenario combining two large shocks plausibly motivated by a fall in Russian GDP:  
  - Decline in demand for Armenian exports (copper) leading to fall in prices and quantity exported.  
  - Fall in Armenian remittance inflows reducing disposable income of Armenian households.  
  - These effects depress domestic aggregate demand; domestic currency depreciates in real and nominal terms.  
  - Local currency monetary policy tightened to fight currency substitution and inflationary pass-through in a dollarized economy, limiting some nominal depreciation.

### Sensitivity analysis
- Impacts of individual risks delineated.  
- Additional losses from potential low credit quality of restructured loans assessed by ad hoc magnification of projected loan losses.

### Adjustments
- None.

### Calibration of risk parameters and regulatory standards
- Default rates (PDs) and LGDs modelled statistically: PDs modelled according to historical relationship with past macroeconomic variables; LGDs modelled according to historical relationship with PDs.  
- Funding costs modelled statistically according to historical relationship with past macroeconomic variables and bank-specific solvency and asset quality.  
- Eligible capital and the Capital Adequacy Ratio (CAR) defined according to the CBA rulebook.  
- Hurdle rate for failures and recapitalization needs: regulatory minimum CAR of 12 percent of risk-weighted assets.

### Reporting format and outputs
- Evolution of CAR for the aggregate banking system.  
- Contribution of key drivers to aggregate net profits and aggregate CAR.  
- Capital shortfall, if any, in terms of nominal GDP.  
- Key vulnerabilities that are responsible for outcome.

*Source: Appendix II. Banking Sector Stress Testing Matrix (STeM) — Bank Solvency Stress Test (excerpt).*

### 1. Institutional

### 1. Institutional

### Institutional perimeter — Institutions included and market share
- Institutions included: 17 banking institutions.
- Market share: Captures entire domestic banking sector in Armenia.
- Data:
  - Latest data as of March 2018.
  - Data has been collected from supervisory reporting and bank internal assumptions mapped into a cash-flow template provided by the IMF.
  - Data based on contractual cash-flows over 10 maturity buckets (Day 1, Day 30, Day 60, Day 120, Day 180, Year 1, year 3, year 3+) in different currency breakdowns (DRAM, USD, EUR, other).
  - Bank internal assumptions regarding expected deposit outflows, loan generation and drawdown on contingent liabilities under business as usual assumption.

### Channels of risk propagation — Methodology
- Set of cash-flow based scenarios using stressed roll-over rates, inflow rates and haircut assumptions for the counterbalancing capacity in different maturity buckets.
- Impact of solvency on liquidity via three channels:
  - NPL impact on cash inflows,
  - capital ratios on cash outflows,
  - asset quality on counterbalancing capacity.

### Tail shocks — Size of the shock
- Bank run and dry up of wholesale funding markets over a set of scenarios in increasing severity.
- Stress scenarios are grouped into: mild market stress, medium market stress, severe market stress and a combined scenario (including market and idiosyncratic shocks).

### Risk and buffers
- Risks:
  - Funding liquidity shock.
  - Market liquidity shock.
- Buffers:
  - Counterbalancing capacity after considering haircuts to liquid assets.

### Regulatory and market-based standards and parameters
- Regulatory standards — Local regulatory prudential requirements:
  - minimum ratio of liquid assets to total assets on overall currency basis (15%) and in FX (4%);
  - minimum ratio of liquid assets to current liabilities on overall currency basis (60%) and in FX (10%).

### Reporting format of the results — Output presentation
- Hurdle metrics: remaining counterbalancing capacity at the end of the respective scenario horizon.
- Impact of scenarios measured in absolute terms and normalized to total assets, liquidity gaps by individual currency and survival periods expressed in days.

---

### Domestic and International Contagion Stress Test Analysis

### Institutional perimeter
- Domestic interbank contagion analysis:
  - Institutions included: All 17 individual banks, at the level of individual banks.
  - Market share: 100 percent of all banks’ assets.
- International inter-banking system contagion:
  - Institutions included: The banking systems of 31 countries, at the level of individual banking systems.
  - Market share: Unknown.

### Channels of risk propagation — Methodology and behavioral assumptions
- Methodology follows Espinosa-Vega and Sole (2010); this is a static balance sheet test with iterative computation that does not simulate time evolution.
- Channels of propagation include:
  - credit losses from counterparty default on claims receivable;
  - losses due to immediate need to repay an amount previously borrowed;
  - losses due to the forced sale of assets;
  - cascading distress due to insolvency.
- Behavioral assumptions:
  - Contagion happens instantaneously, so there is no time for the constituent banks to respond to the propagation of contagion.
  - Banks are assumed to be able to recover all collateralized obligations like repurchase agreements and swaps.
  - Contagion between banking systems also assumed instantaneous with no time to respond.

### Tail shocks — Scenario analysis and sensitivity
- Domestic scenarios:
  - For each bank, 16 scenarios corresponding to the insolvency of one counterparty bank.
  - For each bank, 240 scenarios corresponding to the joint insolvency of every pair of counterparty banks.
- International scenarios:
  - 30 scenarios corresponding to the insolvency of one (non-Armenian) counterparty banking system.
- Sensitivity analysis:
  - For each scenario initialization, a range of parametrizations are considered.
  - Cross-border claims between banking systems are measured in four different ways to check for robustness (international analysis).

### Adjustments
- None for both domestic and international contagion analyses.

### Regulatory and market-based standards and parameters — Calibration
- Baseline parameters match those used in Espinosa-Vega and Sole (2010), but a range of plausible parametrizations are considered.
- Regulatory standards:
  - Eligible capital and the Capital Adequacy Ratio (CAR) are defined according to the CBA rulebook.
  - Insolvency in these tests corresponds to eligible regulatory capital falling below zero.
  - Capital is defined as total eligible regulatory capital on a consolidated basis.

### Reporting format of the results — Output presentation
- Maximum single-counterparty loss to all individual banks.
- Maximum two-counterparty loss to all individual banks.
- Maximum single-counterparty loss to the Armenian banking system, by cross-border claim calibration system and by parametrization.

---

### Annex I — Report on the Observance of Standards and Codes — Basel Core Principles for Effective Banking Supervision

### Introduction and methodology
- Assessment completed as part of the FSAP jointly undertaken by the IMF and the World Bank in 2018; reflects regulatory and supervisory framework in place as of the completion of the assessment.
- Assessment conducted against the Basel Committee on Banking Supervision (BCBS) 2012 standard (revised Core Principles).
- Armenian authorities opted to be assessed against both essential criteria (EC) and additional criteria (AC) but graded on the basis of EC only.
- Grading is qualitative; emphasis placed on commentary accompanying each CP’s grading.
- The assessors held extensive meetings with CBA staff, commercial banks and other counterparts; CBA provided a self-assessment and preparatory questionnaires.

### Preconditions for effective bank supervision
- Preconditions include:
  - (i) sound and sustainable macroeconomic policies;
  - (ii) a framework for financial stability including policy formulation, mechanisms for inter-agency coordination, resolution and safety-nets;
  - (iii) a well-developed public infrastructure including a system of business laws, the accounting, auditing and legal professions, judiciary and clearing, payment and settlement systems;
  - (iv) transparency and market discipline.

### Main findings — Summary by topic
- Responsibilities, Powers, Independence, Resources, Accountability and Cooperation (Principles 1–3):
  - CBA’s supervisory responsibilities and powers are well established.
  - Accountability could be improved through public reporting of performance of the supervision function relative to its specific objectives.
  - MOUs with foreign supervisors should be revisited to address resolution strategies for large banks.
- Ownership, Licensing, and Structure (CPs 4–7):
  - Generally high level of compliance; appropriate legal requirements and review processes.
  - Approach to assessing fitness and propriety of major shareholders and senior management is appropriate.
  - Chief Risk Officers and Heads of compliance not yet included in licensing interviews; CBA prepared a draft amendment to address this.
- Ongoing Supervision (CPs 8–10):
  - CBA adopted Risk-Based Supervision (RBS) formally in 2017 to provide more forward-looking assessment of risks and their impact on capital and liquidity.
  - RBS aims to focus supervisory planning on emerging risks and firms with systemic impact, integrate macroeconomic perspective, and strengthen understanding of risk management.
  - Institution of risk teams and thematic inspections aids systemic view and risk-based resource allocation.
  - Program in first full cycle; initial results promising; supervisory activities planned for 2018 appear more balanced between off-site and on-site.
  - Supervisory reporting is strong; CBA has access to transactional information via credit registry and database of bank internal policies.
  - Areas for further development: non-discretionary framework for dealing with weak banks (PCA) and assessing resolvability in larger firms.
- Corrective and Sanctioning Powers (Principle 11):
  - CBA has a wide range of corrective and sanctioning powers; observed weaknesses in enforcement action for a pattern of large exposure breaches.
  - Inconsistencies in application of sanctions for large exposure breaches; CBA should review enforcement practices to ensure consistent application.
  - CBA should consider designing and implementing a Prompt Corrective Action regime.
  - CBA has yet to require larger banks to have recovery plans or to initiate resolution planning aligned with Financial Stability Board Key Attributes.
- Consolidated and Cross-Border Supervision (Principles 12, 13):
  - Laws and regulations identify affiliated entities as “financial groups” and subject them to consolidated supervision.
  - Regulations give CBA discretion to distinguish supervisory approaches among complex/not low-risk groups and low-risk groups.
  - All groups required to file consolidated returns and reports on inter-group transactions; not low-risk groups subject to prudential standards on consolidated basis.
  - No Armenian banks currently have foreign operations; subsidiaries of four foreign banks operate locally.
  - Supervisors attend supervisory colleges for two of these foreign banks.
  - For foreign owned large banks, CBA should contact home supervisors to understand recovery/resolution frameworks; MOUs should be updated to accommodate sharing of resolution-related information.
- Corporate Governance, Prudential Requirements, Accounting and Disclosure (Principles 14–29):
  - Corporate Governance regulations generally adequate; supervisory work conducted on bank strategic planning and risk management roles.
  - Need for supervisors to better understand and validate governance practices across firms.
  - Prudential standards and supervisory review of specific risks generally sound:
    - Capital adequacy based on Basel II definitions and risk-weightings; quality requirements for regulatory capital consistent with Basel III.
    - Laws and regulations provide flexibility for CBA to require good risk management systems; regulations require essential elements including stress testing capabilities and ICAAP processes.
    - Credit risk monitored closely via on-site reviews and off-site access to credit registry; unhedged FX borrowers represent significant risk and enhancements (e.g., more stringent and targeted DTIs and LTVs) are suggested.
    - Steps taken to provide a common supervisory definition of risk from unhedged FX borrowers for monitoring.
    - Problem assets monitored via monthly classification reports and credit registry activity; CBA historically maintained conservative provisioning and charge-offs.
    - Definitions of NPLs and restructured loans are not aligned with BCBS guidance from 2017; recommendation to adopt new definitions.
    - CBA began LCR and NSFR monitoring in 2015 and intends to adopt these measures pending resolution of a policy matter regarding FX reserve requirements that resulted in a misbalance between AMD and FX HQLA; CBA reviewing options to address issue and intends to adopt Basel III standards once obstacle addressed.
    - Regulations require only audit firms with broad based experience to audit banks; IFRS is the accounting standard; disclosure practices considered adequate based on IFRS and CBA requirements.
    - Measures to detect laundering of proceeds of corruption should be strengthened; law should explicitly require implementation of AML/CFT requirements for domestic politically-exposed persons.

### Annex Table 1 — Selected Compliance comments (Core Principles 1–5 excerpt)
- Core Principle 1 (Responsibilities, objectives and powers): Supervisory responsibilities and objectives of the CBA clearly enshrined in legislation; clarity regarding roles of deputy chairmen can be improved.
- Core Principle 2 (Independence, accountability, resourcing and legal protection for supervisors): Recommended that CBA enhance disclosure of specific supervisory objectives and outcomes; consider hiring individuals with prior experience/training in risk analytics, stress testing, and risk management.
- Core Principle 3 (Cooperation and collaboration): Authorities should consider publishing MOU with MOF and DGF to ensure information sharing and promote accountability and transparency; MOUs with foreign supervisors should be revisited to refer to handling problem financial institutions and resolution of failing banks.
- Core Principle 4 (Permissible activities): Only banks can accept deposits and provide banking activities defined as accepting deposit and extending credit; non-banking financial institutions are not allowed to take deposits.
- Core Principle 5 (Licensing criteria): Current laws and regulations cover key elements of an effective licensing framework; Chief Risk Officer and Head of compliance functions not yet included in interviews but draft amendment prepared.

*Source: cr18361 - 1. Institutional*

### 6. Transfer of

### 6. Transfer of significant ownership

### Transfer of significant ownership and major acquisitions
- The CBA has the appropriate powers to approve and reject applications by prospective owners to become substantial shareholders of a bank on both a consolidated and solo bank basis.
- The CBA has the legal powers to approve or reject acquisitions or investments by a bank.
- As part of the consolidation of the Armenian banking system, the CBA reviewed and approved four requests for acquisitions linked to mergers of banks since the last assessment.

### Supervisory approach
- The CBA formally adopted a risk-based supervision program (RBS) in December 2017 after a three-year pilot.
- The RBS requires an annual comprehensive risk assessment of each bank that includes:
  - identification of material operations;
  - evaluation of inherent risks and mitigating management controls;
  - assessment of “net risk” against the adequacy of capital and liquidity.
- Supervisory activities are planned annually based on needs for validating risks and controls.
- Program strengths:
  - comprehensive design;
  - forward looking assessments;
  - proportionate allocation of resources;
  - assessments of risks for both individual firms and across the system;
  - incorporation of macroeconomic factors.
- Current status and shortcomings:
  - Program is in its first cycle; gaps in supervisory information were identified and plans are directed towards addressing those areas.
  - Shortcomings in the Enforcement and Corrective (EC) framework included no assessments of resolvability and lack of a specific framework for weak banks (PCA).

### Supervisory techniques and tools
- Onsite validation inspections vs off-site analysis activities need a better balance.
- Prudential inspections have been limited the past two years due in part to training and process development for RBS.
- The 2018 plan appears to have better balance and should reduce information gaps evident in existing risk assessments.
- Risk teams are increasing activities to improve structural (system-wide) assessments and provide additional guidance to general examiners.

### Supervisory reporting
- Reporting is extensive and based on IFRS, although the CBA imposes a separate supervisory regime for asset classifications that determine provisioning, reserves and write-offs.
- Reports enable monitoring of prudential standards for capital, liquidity, asset quality, large exposures and FX positions.
- The CBA has access to a credit registry which enables near real-time monitoring of loan portfolios, including individual borrowers.
- Monthly, banks are required to submit classifications of loans based on the supervisors five grade scale.

### Corrective actions and sanctioning powers of supervisors
- Laws and regulations provide the CBA with sufficient tools to address unsafe and unsound practices within a bank or banking group in a timely fashion.
- Recommendation: CBA should develop a Prompt Corrective Action framework and disclose it to all stakeholders.
  - A Prompt Corrective Action requirement should prescribe mandatory and discretionary supervisory actions when an institution breaches specified capital thresholds and triggers.
- The current resolution framework should be revisited to allow the CBA to develop a regime specifically dedicated to banks in line with the Key attributes of the FSB.

### Consolidated supervision
- Laws and regulations classify affiliated entities as “financial groups”.
- Regulations give CBA discretion to distinguish supervisory approaches among complex/not low-risk groups and low-risk groups.
- All banking groups, irrespective of risk classification, are required to submit:
  - consolidated financial statements;
  - consolidated comprehensive income statements;
  - report on foreign exchange positions;
  - report on intra-group transactions.
- If classified not low risky, groups also submit reports on prudential standards.
- Low-risk groups are supervised on a solo basis, although all groups must report inter-group transactions.
- Currently there are no complex/not low-risk groups.

### Home–host relationships
- No Armenian banks currently have foreign operations.
- Subsidiaries of four foreign banks operate locally.
- Supervisors attend supervisory colleges when invited.
- Recommendation: for foreign owned large banks the CBA should reach out to home supervisors to gain understanding of their recovery/resolution frameworks; MOUs should be updated as necessary to accommodate sharing of resolution related information.

### Corporate governance
- Regulations and guidelines generally provide an adequate framework.
- Need to build out more structured (system-wide) understanding of practices across firms.

### Risk management process
- Significant changes in laws and regulation provide flexibility for the CBA to conduct and enforce the RBS.
- Regulations require banks to have essential elements for identifying and managing risk, including stress testing capabilities and ICAAP processes.
- CBA is reviewing regulations with industry input to align them with better practices.
- Supervisory field work to validate risk management systems and fill information gaps is ongoing; more needs to be done to assess the supervisor’s knowledge as fully sufficient.
- Recommendation: written guidance should be articulated for reviewing stress testing methodologies and results.

### Capital adequacy
- Current capital adequacy requirement applied to all banks in Armenia is mostly based on components of the standardized approach of Basel II (while the quality requirements for elements included in regulatory capital are consistent with the Basel III requirements).
- The CBA is implementing a Basel III plan, which should lead to Basel III full compliance in the next 5 years.
- As a practical matter, almost all capital of Armenian banks is CET1 as there is only a small market for subordinated or hybrid instruments.
- Armenian banks are already required to maintain a total capital of 12 percent and in most cases report significantly higher capital.
- CBA has adopted and is in the process of adopting other elements of Basel III (capital buffers and potentially a leverage ratio).
- Capital is calculated on a consolidated and solo basis for all banks and CBA has authority to impose additional capital requirements on individual banks, but it has not yet set minimum capital ratios for banks based on their risk profile.
- CBA has not introduced a leverage ratio; previous simulation showed a sector level of 13 percent in 2011, and 12.4 in 2017 (calculated based on Basel methodology). The lowest level of the leverage ratio in the banking system (5.3 percent) is above the Basel minimum level (3 percent).
- No draft regulation on leverage ratio has been prepared yet.
- Banks are required to use their own ICAAP results to detect whether existing capital is enough to withstand bank’s risks, but CBA does not receive nor challenge the outcome of these exercises.
- Recommendations:
  - CBA should complete adoption of Basel III capital buffers.
  - CBA should enhance its review of bank ICAAP processes and more comprehensively implement its Pillar 2 approach.

### Credit risk
- Credit risk is monitored through on-site inspection and off-site via reports and access to credit registry data.
- Supervisors sample credit files during inspections and have been known to challenge classifications and adequacy of reserves.
- Practices and procedures for assessing credit risk are generally adequate.
- Unhedged FX loans represent substantial risk to the banking system.
- Recommendation: CBA should closely monitor implementation of its new regulation requiring banks to identify and track unhedged borrowers based on a common supervisory definition and consider developing more formal reports from banks.

### Problem assets, provisions, and reserves
- CBA requires classifications of credits within a five-grade system based on delinquency with a qualitative adjustment for borrowers experiencing financial distress.
- Provisions and reserves are largely formulaic from those classifications, with qualitative adjustments also made.
- With adoption of IFRS 9 by all banks this year, CBA should evaluate opportunities to leverage IFRS reporting systems for assessing loan quality and reserves.
- Supervisors should assess IFRS 9 methodologies for managing credit risk.
- CBA uses a non-standard (more conservative) definition for NPLs (1-day delinquent) and renegotiated loans.
- BCBS guidance released April 2017 provides standardized regulatory definitions that should be adopted.
- CBA should collect information on restructured loans as part of regular reporting.
- Recommendations:
  - Address use of non-standard definitions for NPL and restructured loans based on 2017 Basel guidance.
  - Institute formal reporting on restructured loans.
  - Evaluate convergence between IFRS and supervisory reporting; focus supervisors on evaluating IFRS 9 credit risk management systems.

### Concentration risk and large exposure limits
- A number of banks have been identified as breaching large exposure limits.
- Sanctions/fines have been levied in some cases but have not been sufficient to prevent further violations.
- Inconsistency in application of sanctions for all breaches is problematic.
- Recommendation: CBA should review enforcement practices to consistently apply sanctions and have banks operate within prescribed limits.

### Transactions with related parties
- Very few full scope on-site examinations have been performed in the last 5 years.
- Recommendation: undertake further review of related party lending reporting to ensure banks capture all connected loans under current legislation.
- Additional recommendation: avoid warning bank owners with several days (5 days under Article 27.2 and 3 days under Article 29.1) of pending liquidation, a period when insiders could have opportunities for asset-stripping if supervisors are not on-site monitoring and authorized to block transactions.

### Country and transfer risks
- Based on monitoring, CBA considers country risk relatively low for the Armenian banking system; not a high priority.
- CBA has introduced general requirements to risk management for types of risk not included in Pillar 1, including country risk.
- Recommendation: assess implementation by banks of new requirements and, absent specific regulatory requirement, adequacy of banks’ policy in managing and setting limits for country risks.

### Market risk and interest rate risk in the banking book (IRRBB)
- Supervisors have inspection activities planned to establish a system-wide assessment of bank compliance with BCBS recommended practices.
- Compliance with recently introduced regulations regarding internal models needs evaluation.
- CBA should evaluate January 2016 BCBS Standards, “Minimum Capital Requirements for Market Risk” and the June 2017 consultative document “Simplified alternative to the standardized approach to market risk capital requirements.”
- CBA is considered in compliance with 2006 Basel II standardized approaches, but there is concern those may not be sufficiently dynamic to address growth in interest-rate risk.
- Recommendation: better integrate IRR stress testing into Pillar 2 capital requirements and evaluate the need to incorporate the 2016 Basel Standards for IRRBB, which would introduce:
  - more extensive guidance on expectations for a bank's IRRBB management process (interest rate shock scenarios, behavioral and modelling assumptions);
  - disclosure requirements for consistency, transparency and comparability;
  - an updated standardized framework; and
  - a stricter threshold for identifying outlier banks.

### Liquidity risk
- CBA’s approach to supervising liquidity risk is rated compliant with Core Principles.
- Recommendation: CBA should adopt the LCR and NSFR ratios.

### Operational risk
- Reinforced recently with creation of a Risk team dedicated to Operational risk.
- FSD activities indicate extensive focus on operational risk and risk management in the last two years (survey of top 10 risks in the banks in 2017, thematic examination on databases, on-site examination in 9 banks in 2018).
- Greater prudential focus compared to prior procedures allows examiners to dedicate resources to risks more likely to threaten bank soundness.
- FSD has a clear view of operational risks in the system and in each bank, though this must be confirmed through upcoming on-site focused examinations scheduled under RBS.
- CBA has yet to formally issue its draft regulation on outsourcing activities.

### Internal control, audit, financial reporting, disclosure, and AML/CFT
- Policies and procedures for evaluating internal control, compliance and internal audit functions appear adequate.
- Banks are required to be audited annually by a firm applying international auditing standards; in practice, only internationally recognized big firms (EY, PWC, KPMG, Deloitte, Grant Thornton Armenia) are permitted to audit banks.
- All public reporting is under IFRS and banks make required disclosures.
- A robust legal and regulatory AML/CFT framework is in place following several legal/regulatory changes.
- Armenia has introduced a risk-based approach to AML/CFT supervision in the banking sector and implementation is in progress.
- The FMC is considered to have skilled human resources and technical tools and procedures.
- Gap: there continues to be no legal requirements to implement enhanced due diligence measures on domestic politically-exposed persons (PEPs).

*Source: Republic of Armenia — International Monetary Fund (Annex Tables 1–2, cr18361).*

### 22. Market risk

### 22. Market risk

### Market risk — supervisory recommendations
- CBA should evaluate the January 2016 BCBS Standards, “Minimum Capital Requirements for Market Risk” and the June 2017 consultative document “Simplified alternative to the standardized approach to market risk capital requirements” for application locally.
- CBA should consider better integrating IRR stress testing into Pillar 2 capital requirements.
- Continued emphasis should be placed on development of supervisory guidance and building out system-wide understanding of practices across all banks.
- On-site validation work should assess compliance with new requirements for use of internal models (Regulation 4).

### 23. IRRBB
- Evaluate the need to incorporate, as appropriate to their jurisdiction, the recommendations in the 2016 Basel Standards for IRRBB that expands on risk management, stress scenarios, identification of outliers and disclosures.

### 25. Operational risk
- Issue the draft regulation on outsourcing activities.

### 29. Abuse of financial services — AML/CFT recommendations
- There continues to be no legal requirement to implement enhanced due diligence measures on domestic politically-exposed persons (PEPs).
- Amendments to the AML/CFT law should be made to introduce the definition of domestic PEPs and explicitly require their identification and the implementation of that enhanced due diligence measures in case of high-risk business relationships.
- The FMC should develop a specific AML/CFT risk-based supervision manual.
- The frequency of on-site examinations should also be increased compared to the current situation (only one targeted examination during the 2018 first semester in one of the banks where inherent risk is high).

*Source: cr18361 - 22. Market risk.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18361.pdf_