## _041612b

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### Financial deepening and regulatory framework
- Regulation and supervision, including market conduct and consumer protection regulation, must accompany financial deepening since, in expanding the number, range and coverage of players, the latter can increase market inefficiencies.
- Need for a widening of the regulatory perimeter to include nonbank financial service providers for sustainable financial inclusion.
- Both micro- and macroprudential regulation proved necessary as systems deepened, and in response to challenges created by developments in established markets.
- Adequate cross-border arrangements are essential to support sustainable financial liberalization.

### I. FINANCIAL INNOVATION IN KENYA: THE M-PESA EXPERIENCE — Overview
- M-Pesa introduced in 2007 enabled customers to transfer money quickly and at a low cost via mobile phones, without the need to hold a bank account.
- Widespread use helped reduce transaction costs, facilitated personal transactions, and contributed to increased use of services of financial intermediaries as demand for banking services by the low-income segment expanded.

Key statistics (as at March/April 2011)
- M-Pesa transferred Ksh 86.84 billion equivalent to US$ 1.03 billion with 32.04 million transactions.
- Per day transactions: Ksh 2.8 billion or US$ 33 million.
- Average value per transaction: Ksh 2,711 equivalent to US$ 32 per transaction.
- Transaction cost: Ksh 30-35 or US$ 0.38-0.44 per transaction.
- M-Pesa users in April 2011 reached 14 million (40 percent of Kenya’s population).
- Mobile phone-based transfers were equivalent to 11 percent of GDP (The Economist, June 2010).

Features, drivers and market structure
- Service mechanics: account balances recorded on cell phones; transfers via SMS; network of agents for upload/withdrawal; creation of e-float.
- Origins: DFID-funded pilot; developed by Vodaphone and launched commercially by Safaricom in March 2007.
- Market shares: Safaricom holds 80 percent of the market (followed by Zain and Orange).
- Agent network: average of 500 users per agent; April 2011 about 28 thousand M-Pesa outlets.
- Pricing: Registration free; customers pay a flat fee of around US$.40 cents for transfers (US$.33 cents for withdrawals).

Users, usage patterns and recent developments
- Household survey findings (Jack and Suri, 2009):
  - 2008: annual expenditures of M-Pesa users were 67 percent higher than non-users; asset holdings were 113 percent higher.
  - Around 72 percent of households have at least one bank account among users, compared with 36 percent for non-users.
  - The percent of the banked population using M-Pesa increased significantly as banks allowed linking M-Pesa and bank accounts in 2009.
- 2010: introduction of M-Kesho (Safaricom–Equity Bank):
  - So far 700,000 accounts opened, with around US$8 million in total deposits.
- Competition: banks introduced mobile products; other mobile operators launched mobile money products (e.g., Zap, Yu Cash).

Government policies and supervisory measures
- CBK allows Safaricom to operate M-Pesa as a parallel payments system; customers’ funds deposited in a regulated financial institution and Safaricom deposits/earned interest are placed in a not–for–profit trust account.
- CBK introduced limits on transaction sizes to comply with AML criteria.
- 2010: CBK approved a new scheme enabling third parties or “agents” to conduct banking activities; currently, 8,800 agents operate, of which 6,740 are related to mobile-banking operations (67 percent in rural areas).
- 2009: introduction of three currency centers serving 172 commercial banks’ branches and accounting for over 12 percent of currency transfers in the country.

Lessons, risks, and recommendations
- Lessons:
  - Leveraging mobile phone technology is a promising vehicle for extending financial services to a large proportion of the population.
  - Potential to use mobile connectivity for savings, transfers, payments, pension and social welfare payments, loan disbursements and repayments once customers are connected.
- Risks and recommended actions:
  - Formalize M-Pesa operations in the National Payments Systems Bill; money stored in M-Pesa accounts is uninsured unless linked to a deposit account.
  - Continuously update operational risk regulations as technology and new operators evolve.
  - Incorporate credit, liquidity and operational risks associated with M-Pesa transfers into microfinance regulation and include consumer protection provisions.
  - Cross-border payments expansion requires strong coordination among country regulators.
- Transplantability: replication requires adaptation to local conditions (population density, banking infrastructure, national ID systems, competitive environment).

### Access to finance in the Philippines via mobile payments
Background and drivers
- Formal banking access limited: 6,867 ATMs at end-2006 versus approximately 7,100 islands.
- Bank penetration: 17 million bank depositors out of a total population of 88.7 million (as of end 2006).
- OFW remittances: approximately US$18 billion in 2008 (approximately 11 percent of GDP).
- Mobile market: 75 percent of the population are mobile phone subscribers; Filipinos send a billion text messages a day.

Mobile payment models and features
- Leading operators: Smart Communication and Globe Telecom.
- Common features: mobile account (not a bank account); cash deposits, withdrawals, purchases; P2P transfers; international transactions.
- Smart Money (launched 2000): reloadable payment card; works with 21 banks.
- GCash (launched 2004): operates without a bank partner; value pooled by a Globe subsidiary and matched 1:1 with deposits.

Regulation, supervision and institutional capacity
- BSP required mobile operators to register as remittance companies and comply with AML/CFT:
  - Officers/personnel in cash operations must undergo AMLC training.
  - Know-your-client requirements for each remittance; maintain records of all transactions for five years; report suspicious transactions.
  - BSP allowed certified mobile operators to conduct their own AML training to reduce compliance costs.
- E-money regulatory timeline:
  - 2000: Electronic Commerce Act.
  - 2009: BSP issued an e-money circular harmonizing rules for banks and nonbanks:
    - Limits on aggregate monthly load for e–money: PHP 100,000 or US$866.
    - Prohibition on charging interest on e–money.
    - Customer funds protection: non-prudentially regulated e–money issuers must keep sufficient liquid assets equal to outstanding e–money; liquid assets include bank deposits, government securities and other BSP-allowed assets.
    - Licensed nonbank e-money issuers required minimum capital of US$2 million.
- BSP institutional development: Core Information Technology Supervisory Group (CITSG); Inclusive Finance Advocacy Staff; Payment Systems Unit for RTGS oversight.

Risks and supervisory priorities
- Key risk categories:
  - Credit risk, operational risk, legal risk, liquidity risk, reputational risk, consumer protection, AML/CFT risk.
- Supervisory challenge: balance consumer protection/safety and support for innovation; unclear resolution processes if a mobile operator fails.

Impact and outcomes
- Over eight million users of e-money (Smart Money and GCash).
- Number of banks offering mobile payments rose to 47 rural banks in 2010 (from zero prior to 2005).
- Some banks lowered micro-finance loan rates by 50 basis-points on monthly rates for clients using ‘text-a-payment’.
- Cost comparisons:
  - Average inbound remittance: US$300; typical cost US$7–US$33 (between 2.5 percent and 10 percent of the value).
  - If routed via GCash or Smart Money, cost is less than one percent of the value.
  - Bank branch transaction cost: US$2.50; mobile phone transaction cost: US$0.50.
- Cash-in/cash-out points (nonbank agents) number approximately 15,000, in addition to most of the country’s 7,500 ATMs.

Key lessons and policy implications
- BSP allowed market-led innovation first and then developed prudential and e–money regulations (including the 2009 e–money circular).
- Combination of market initiative and enabling regulatory framework increased financial inclusion and reduced transaction costs.
- Ongoing priorities: mitigate residual system risks, clarify resolution mechanisms for failed mobile operators, streamline agent registration and training, and update legislation with evolving technologies.

### Uganda: financial system characteristics, microfinance, and mobile payments
System structure and access
- Commercial banks accounted for 83 percent of system assets; other credit institutions 4 percent; microfinance institutions (including credit cooperatives) 1 percent.
- 2001 banking-depth indicators (selected):
  - Uganda: Credit/GDP 5.8; Bank Deposits/GDP 19.3; Liquid Liabilities/GDP 14.9; Private Credit/GDP 38.9; Loan-Deposit Ratio 7.9; Overhead Costs 12.7.
  - SSA (avg.): Credit/GDP 19.1; Bank Deposits/GDP 31.3; Liquid Liabilities/GDP 23.6; Private Credit/GDP 74.2; Loan-Deposit Ratio 6.1; Overhead Costs 7.9.
- 2007 FinScope survey:
  - 62 percent of the population (about 18 million people) had no access to financial services of any form.
  - 65 percent of those without access were in rural areas.
  - For the 38 percent with access, non-regulated institutions were the predominant source (20 percent).

Microfinance, SACCOs, and outreach
- By end–July 2011: about 180 NGOs, several microfinance companies, and around 2,800 SACCOs.
- Total savings and share capital of all SACCOs about two percent of banking system savings.
- 1.5 million paid-up members.
- Largest institutions had around 800,000 loan accounts and 2.5 million sanctioned deposit accounts.
- 2009 FinScope: proportion accessing financial services (formal + informal) rose from 57 percent in 2006 to 72 percent in 2009.

Government policies and technology
- Passage of the MDI Act and amendments to the Financial Institutions Act to enhance Bank of Uganda (BOU) supervisory capacity.
- Rural Financial Services Strategy (RFSS) rolled out in 2008 to support SACCOs; policy allowed MDIs to transition into BOU-regulated institutions.
- Mobile payments adoption:
  - Average monthly growth in new mobile payments customers about five percent.
  - Light-touch regulatory stance by BOU encouraged product innovation and integration with formal payments infrastructure.
- Branch expansion: numbers of bank, credit institution and MDI branches have expanded more than two-fold since 2007.

Constraints, risks and lessons
- Legal and supervisory gaps: lack of comprehensive legal/regulatory framework for MFIs and SACCOs; UCSCU nominated as apex umbrella but lacks institutional capacity.
- Collateral and credit information issues: poor land titling, paucity of collateral, multiple borrowing (FinScope 2007: at least 22 percent of borrowers from formal institutions borrowed from more than one institution).
- Risk of proliferation of small SACCOs and political interference; subsidization and directed lending can create moral hazard and undermine market-led channels.
- Key lessons: enabling policy stance, work with formal and informal channels, and adopt adaptive regulation to support outreach while managing prudential risks.

### Nepal: developing interbank markets, central bank operations, and public debt management
Objectives and challenges
- Objectives: Improve effectiveness of monetary and FX operations, improve debt management, and improve conduct and transmission of monetary policy via functioning interbank money and FX markets.
- Challenges: structurally weak financial system; limited NRB independence; state-owned banks with negative net worth and high NPLs; large number of institutions stretching regulatory capacity.

Domestic market operations and instruments
- NRB instruments: outright purchase and sales auctions; repo and reverse repo auctions.
- Operational changes:
  - Maximum maturity for repo and reverse repo auctions increased to 45 days from 28 days.
  - Existing stock of non-interest-bearing securities converted to 91- and 364-day t-bills.
  - Standing repo facility provides temporary liquidity support up to seven days; interest rate is 50 basis points higher than the 91-day t-bill weighted auction rate.
  - General refinance facility priced at the Bank Rate; lender of last resort facility available for maximum six months with widened acceptable collateral.
  - Most interest rate controls removed though limits on banks’ interest rate margins remain; real interest rates have tended to be negative.

Public debt management
- Government instruments:
  - t-bills of maturities 28, 91, 182 days and 364 days.
  - Development bonds (NRB on behalf of government) with maturities up to five years; National Savings Certificates (NSC) with maturity of five years.
- Steps taken:
  - Separation of government debt management objectives from monetary policy objectives; NRB Open Market Operations Committee prepares an annual debt management plan.
  - Limit on net financing of the government by the NRB imposed.
  - Conversion of nonmarketable to marketable instruments to support market development.
- Remaining challenges:
  - Multiplicity of securities with different terms and non-uniform tax treatment.
  - Need for longer term securities with maturities of two to three years to extend the yield curve.

Foreign exchange market and frictions
- FX market fairly liberal but fixed exchange rate regime and NRB operational arrangements complicate interbank FX market development.
- As of December 31, 2010, about 3,660 institutions were licensed to deal in FX with the public.
- No active interbank FX market; turnover dwarfed by NRB daily standing window; FEDAN channeling can take up to five days and is a bottleneck.
- Development complicated by the exchange rate peg, frequent NRB interventions, one-way nature of foreign currency flows, and limited trader training.

Conclusions and lessons
- Reforms resulted in a standard set of tools to manage liquidity and initial debt market development.
- Active interbank markets require sustained reform, appropriate infrastructures, and incentives.
- Access to NRB facilities should be at penalty rates; NRB interventions reflecting fixed exchange rate policy complicate interbank FX market development.

### Deepening domestic debt markets: cross-country case studies and policy implications
Mexico: deepening of the local debt market (highlights)
- 2011 outstanding federal government securities amounted to 25 percent of GDP, composed of:
  - more than half in development bonds (discontinued in 2010),
  - 18 percent in Udibonos,
  - 4.5 percent in CETES.
- August 2011: federal government issued a US$1 billion bond with maturity of 100 years.
- 2010: Mexico included in Citigroup’s World Government Bond Index.
- Reforms included macroeconomic discipline, inflation control, floating exchange rate, repo markets, market makers, secured lending framework, insolvency law, payment system law, and expansion of investor base (pension funds).
- Foreign holdings of government securities: 1.3 percent in 2000, rising to 25 percent by November 2011, and 29 percent in February 2012.
- Key policy implications:
  - Well-functioning money market and yield curve across wide maturities are necessary.
  - Combine macro discipline with structural, regulatory, and infrastructure reforms.
  - Strengthen transparency, market discipline, and regulatory/supervisory capacity to broaden the investor base.

Turkey: post-crisis debt market development
- Post-2001 reforms led to:
  - gross government debt decline from 53 percent in 2000 to 41 percent in 2010.
  - introduction of medium- and long-term lira bonds (2-year in 2002; 5-year in 2005; first 10-year in 2010).
  - primary dealer market introduced in late 2002 with twelve banks as PDs.
  - de-dollarization from 60 percent in 2001 to around 30 percent in 2010.
- Policy lessons:
  - Credible control of inflation and macro stability are foundations for bond market development.
  - Money market development, issuance of a spectrum of government securities, tax incentives, and capital market oversight are required.
- Risks:
  - Banks’ dominance in government debt markets (around 35 percent of banks’ assets in government securities) exposes the sector to sovereign risk and could crowd out private lending.

Regional markets and initiatives
- East Asia:
  - Asia Bond Market Initiative (ABMI), Asian Bond Funds 1 and 2 (ABF1, ABF2).
  - CGIF established November 2010 as a trust of US$700 million to provide guarantees for local currency corporate bonds.
- WAEMU:
  - Operational since 1999; regional market dominated by treasuries issuing mostly t-bills (about 96 percent of securities traded in 2009).
  - Market represented only 1.7 percent of region’s GDP over 1999–2010.
  - Key constraints: lack of regional savings pools/institutional investors; high transaction costs; short-term investor preference; net bank holdings of government debt ~10 percent of total banking system assets over 2000–10.
  - Policies: CREPMF, BRVM, DC/BR, and BCEAO auctions; initiatives to improve ratings and harmonize taxation.

### Insurance sector reforms and market conduct (selected country examples)
India
- Liberalization opened the market to private firms with foreign participation; bancassurance important distribution channel.
- Rapid expansion of unit-linked insurance plans (ULIPs) between 2004/05 and 2009/10.
- October 2010 consumer protection rules for linked products:
  - locked-in period extended from three to five years;
  - front-end charges spread over locked-in period;
  - limits on expense allowances; introduction of a consumer affairs department.
- Expense ratios (expense as percentage of premiums, IRDA Annual Reports) — selected values:
  - All life insurers: 2001-02 0.19; 2002-03 0.37; 2003-04 0.31; 2004-05 0.20; 2005-06 0.18; 2006-07 0.17; 2007-08 0.18; 2008-09 0.19; 2009-10 0.17.
  - LIC: 2001-02 0.18; 2002-03 0.34; 2003-04 0.29; 2004-05 0.29; 2005-06 0.15; 2006-07 0.13; 2007-08 0.12; 2008-09 0.13; 2009-10 0.13.
  - Private non-life: 2001-02 0.33; 2002-03 2.03; 2003-04 2.62; 2004-05 2.88; 2005-06 2.92; 2006-07 2.86; 2007-08 2.63; 2008-09 2.69; 2009-10 2.88.
- Conclusion: consumer protection rules reduced uninformed sales and shifted customers toward more traditional products.

Barbados
- Pre-2009: insurance sector concentrated; life and non-life market shares concentrated in few firms.
- 2009 CLICO collapse exposed excessive related-party transactions and high-risk, illiquid investments.
- Regulatory response: creation of a nonbank supervisor, the Financial Services Commission in 2011; forensic audits and restructuring actions.

South Africa and Botswana
- HIV/AIDS shaped product innovation: actuarial modeling, periodic testing requirements, funeral insurance, universal life policy flexibility.
- Credit life insurance in Botswana became popular but expensive and generated moral hazard; insurers eventually exited the market.
- Innovations included affordable insurance to HIV-positive individuals conditional on monitoring and treatment; stronger consumer protection emphasis by the Financial Services Board.

### Uruguay: pre-crisis vulnerabilities, 2001–02 crisis, and reforms
Pre-crisis indicators (around 2000–2001)
- Credit-to-GDP ratio: 51 percent.
- As of December 2001, total deposits = US$15.4 billion (83 percent of GDP), of which 90 percent were foreign currency deposits, with 47 percent of these deposits being held by non-residents.
- Public bank NPLs and profitability (as of December 2001):
  - Non-performing loans to total loans: public banks 39.1 percent versus private banks 5.6 percent.
  - After tax return on equity: public banks minus 4.5 percent versus private banks minus 0.9 percent.

Crisis dynamics (2001–02)
- December 2001: Argentine capital controls triggered withdrawals from Uruguayan banks.
- By March 2002, 12 percent of total bank deposits—mostly from non-residents—had left the country.
- By end-July 2002, cumulative 38 percent of total deposits had been withdrawn from the system; 51 percent of deposits held by non-residents left the country.
- The peso depreciated by 57 percent over the same period.
- Credit to the non-financial sector shrank by 37 percent during 2002.
- GDP contraction for 2002 reached 107 percent (as stated in the source text).

Post-crisis policy response and regulatory reforms
- Reserve requirements differentiated by residence of depositors; reserve requirements on non-resident deposits were raised.
- Loan classification and provisioning:
  - Introduced seven-tier loan classification system.
  - New provisioning required assessment of repayment capacity with sensitivity analyses/stress tests; dynamic provisioning linked to credit growth (Uruguay among the first to introduce dynamic provisioning in 2001).
- Stronger liquidity requirements based on bands of deposit maturities.
- Limits on exposure to a single borrower, single sector, and single country.
- Cross-border regulation: subsidiaries, branches, and offshore offices of foreign banks subject to same prudential, inspection and reporting as domestic banks; MOUs signed with Spain, Argentina and other countries.
- Market development: establishment of a comprehensive credit bureau enabling monthly evaluation of consumer and mortgage loan quality.
- De-dollarization measures:
  - Deposit dollarization decreased by 15 percentage point (December 2002—October 2010).
  - Credit dollarization decreased by 24 percentage point.
  - Share of domestic currency denominated debt rose about 30 percentage points between end-2002 and end-June 2010.
  - Measures included higher reserve requirements on FX deposits, issuance of more index-linked local currency debt, capital requirements for FX open positions, and higher risk weight for loans in foreign currency to un-hedged borrowers.

Outcomes and assessment
- Banking soundness by late-2000s:
  - Banks rely on deposit funding, maintain substantial liquidity cushions, and carry little leverage.
  - Capital adequacy ratios exceed the regulatory minimum (eight percent) by a wide margin.
  - Overall loan-loss provisions stand at about six times the historically low level of nonperforming loans, partly reflecting dynamic provisioning.
- De-dollarization strengthened monetary transmission: exchange rate channel decreased in importance and interest rate channel improved (evidence from Santiago and Coble, 2011).
- Key lessons:
  - Financial deepening should be accompanied with appropriate prudential regulation and supervision.
  - Proactive monitoring, oversight and enabling policies lowered dollarization, reduced cross-border exposures, and strengthened financial soundness.

### Cross-cutting conclusions, policy implications and risks
- Macroeconomic stability (fiscal discipline, inflation control) is a pre-condition for financial deepening and bond market development.
- Well-functioning money markets and yield curves across a wide range of maturities enable effective monetary policy implementation.
- Institutional and infrastructure reforms (market makers, repo markets, secured lending, insolvency frameworks, payment system oversight, credit information systems) are key to market development.
- Regulation must balance innovation and inclusion with consumer protection and prudential safety; sequencing (market-led innovation followed by regulation) proved effective in several cases.
- Risks to monitor:
  - FX and maturity mismatches from foreign currency funding and FX-denominated lending.
  - Concentration and bank dominance in government debt holdings exposing banks to sovereign risk.
  - Proliferation of small, weakly supervised institutions (SACCOs, MFIs) and subsidized directed lending creating moral hazard.
  - Insufficient cross-border supervisory arrangements and gaps between payments and telecom regulators in mobile-led payments.
  - Need to widen investor base (pension funds, institutional investors, foreign investors) to improve market depth and maturity structure.

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES (IMF), content unit _041612b.*

### introduction of auction markets and efforts to improve debt issuance in Nepal and primary dealers

### introduction of auction markets and efforts to improve debt issuance in Nepal and primary dealers

### Financial deepening and regulatory framework
- Regulation and supervision, including market conduct and consumer protection regulation, must accompany financial deepening since, in expanding the number, range and coverage of players, the latter can increase market inefficiencies.
- Need for a widening of the regulatory perimeter to include nonbank financial service providers for sustainable financial inclusion.
- Both micro- and macroprudential regulation proved necessary as systems deepened, and in response to challenges created by developments in established markets.
- Adequate cross-border arrangements are essential to support sustainable financial liberalization.

### I. FINANCIAL INNOVATION IN KENYA: THE M-PESA EXPERIENCE — Overview
- M-Pesa introduced in 2007 enabled customers to transfer money quickly and at a low cost via mobile phones, without the need to hold a bank account.
- Widespread use helped reduce transaction costs, facilitated personal transactions, and contributed to increased use of services of financial intermediaries as demand for banking services by the low-income segment expanded.

### A. Background and key statistics
- Despite 46 percent of the population living in absolute poverty or on less than US$1.25 a day, and 32.7 percent still unbanked, Kenya shows the lowest percentage of the population excluded from financial services in a sample of comparable SSA countries.
- As at March 2011:
  - M-Pesa transferred Ksh 86.84 billion equivalent to US$ 1.03 billion with 32.04 million transactions.
  - Per day transactions: Ksh 2.8 billion or US$ 33 million.
  - Average value per transaction: Ksh 2,711 equivalent to US$ 32 per transaction.
  - Transaction cost: Ksh 30-35 or US$ 0.38-0.44 per transaction.
- M-Pesa users in April 2011 reached 14 million (40 percent of Kenya’s population).
- Mobile phone-based transfers were equivalent to 11 percent of GDP (The Economist, June 2010).

### B. Main features of mobile-based transfers in Kenya
- Service mechanics:
  - Users deposit money into an account recorded in their cell phones and transfer it using SMS technology to other users, including businesses, creating outstanding balances (e-float).
  - Money can be uploaded and withdrawn from a network of agents for airtime purchases, transfers, and bill payments.
- Origins and market structure:
  - M-Pesa started as a DFID-funded pilot project; developed by Vodaphone and launched commercially by Safaricom in March 2007.
  - Safaricom holds 80 percent of the market (followed by Zain and Orange).
- Agent network and scale:
  - M-Pesa deploys an agent-based system with an average of 500 users per agent.
  - In April 2011, about 28 thousand M-Pesa outlets offering financial services in Kenya.
  - Registration is free; customers pay a flat fee of around US$.40 cents for transfers (US$.33 cents for withdrawals).

### C. Users and usage patterns
- Household survey findings (Jack and Suri, 2009):
  - Within the low-income segment, M-Pesa users are wealthier than non-users, but the difference is declining over time.
  - In 2008, annual expenditures of M-Pesa users were 67 percent higher than non-users; asset holdings were 113 percent higher.
  - A 2009 survey update shows average income of M-Pesa users has declined over time as new segments joined.
  - Around 72 percent of households have at least one bank account among users, compared with 36 percent for non-users.
  - The percent of the banked population using M-Pesa has increased significantly as new users opened bank accounts and banks allowed linking M-Pesa and bank accounts in 2009.

### Recent developments and market evolution
- 2010: introduction of M-Kesho (mobile phone-based deposit account) in partnership between Safaricom and Equity Bank.
  - So far 700,000 accounts opened, with around US$8 million in total deposits.
- Increased competition and integration:
  - Banks introduced mobile products (KCB Connect, Pesa-Connect, Family Bank’s Pesa Pap).
  - Other mobile operators launched mobile money products (Zap by Zain, Yu Cash by Essar).

### D. What explains M-Pesa’s success?
- Key factors:
  - Dramatic expansion in mobile phone use — mobile phones increased from virtually zero in 1999 to nearly 21 million in 2010.
  - Inexpensive and flexible technology deployment and Safaricom’s strong market presence and brand recognition.
  - Favorable macro conditions incentivizing banks to penetrate new markets (post-2007 political riots, excess reserves, low interest rates).
  - Proactive bank initiatives — Equity Bank had 5.4 million customers in Kenya in 2010 (57 percent of the banked population) and led in lowering fees, eliminating minimums, and expanding branches.
- Demographic and economic demand drivers:
  - 17 percent of households depend on remittances as their primary income source.
  - Urbanization ratio of 22 percent, supporting strong rural-urban transfer demand.

### E. Government policies and supervisory measures
- Central Bank of Kenya (CBK) involvement:
  - CBK allows Safaricom to operate M-Pesa as a parallel payments system, requiring that customers’ funds be deposited in a regulated financial institution.
  - Safaricom deposits and earned interest are placed in a not–for–profit trust account.
  - CBK introduced limits on transaction sizes to comply with anti-money laundering (AML) criteria.
- Legal and institutional arrangements:
  - A trust company was created to run M-Pesa services in Kenya, operated locally by Safaricom but owned, hosted and developed by Vodaphone.
  - Incorporation of M-Pesa settlements into the payment system framework awaits approval of the new National Payments Bill.
- Further CBK policies to deepen intermediation:
  - 2010: approval of a new scheme enabling third parties or “agents” to conduct banking activities on behalf of financial institutions.
    - Currently, 8,800 agents operate, of which 6,740 are related to mobile-banking operations (67 percent in rural areas).
  - 2009: introduction of three currency centers serving 172 commercial banks’ branches and accounting for over 12 percent of currency transfers in the country.

### F. Lessons, risks, and policy recommendations
- Lessons:
  - Leveraging mobile phone technology is a promising vehicle for extending financial services to a large proportion of the population.
  - The potential to use mobile connectivity for savings, transfers, payments, pension and social welfare payments, loan disbursements and repayments is significant once customers are connected.
- Risks and recommended actions:
  - Formalize M-Pesa operations in the National Payments Systems Bill to provide sounder legal basis and ensure customer protection; currently, money stored in M-Pesa accounts is uninsured unless linked to a deposit account.
  - Operational risks need continuous updating of regulations addressing technological capabilities and control processes as new operators enter and technology evolves.
  - Regulation and supervision for microfinance should explicitly incorporate credit, liquidity and operational risks associated with M-Pesa transfers, and consumer protection provisions.
  - Cross-border payments expansion will require strong coordination among country regulators to manage new risks.
- Transplantability:
  - Replicating Kenya’s success requires adaptation to local conditions; factors such as population density, banking infrastructure, presence of national ID systems, and competitive environment affect outcomes.

### G. Conclusion
- Key lessons: Mobile phone technology can significantly expand financial access; additional financial services potential is large once customers are connected to mobile networks.
- Key policies: Flexible policies enabling rapid introduction of mobile transfers combined with regulations and control processes to maintain security have helped keep risks largely contained.
- Key risks: Need to enhance legal framework by incorporating M-Pesa into the National Payments Systems; operational risk remains a continuous challenge and supervisory authorities must update security systems as technology evolves.

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES, INTERNATIONAL MONETARY FUND*

### 21.      Access to finance in the Philippines via the formal banking sector is limited. A

### Access to finance in the Philippines via the formal banking sector is limited

### Background and context
- Formal banking access is limited: there were 6,867 ATMs in the country at the end of 2006 versus approximately 7,100 islands.
- Bank penetration: 17 million bank depositors out of a total population of 88.7 million (as of end 2006).
- Physical access constraint: banking or bill payment trips can take up to two days and may require a boat; informal “collectors” serve as alternatives.

### Emergence of mobile payments and motivating factors
- Mobile payments expanded as an alternative platform, driven by needs of overseas Filipino workers (OFWs).
- OFW remittances: approximately US$18 billion in 2008 (approximately 11 percent of GDP).
- Mobile market context:
  - 75 percent of the population are mobile phone subscribers.
  - Filipinos send a billion text messages a day.
- Mobile payments offered prospects to reach rural areas without heavy infrastructure investment and to reduce payments costs.

### Mobile payment models and product features
- Two largest telecommunication companies led services: Smart Communication and Globe Telecom.
- Common features of Smart Money and GCash:
  - Any mobile customer can sign-up and get a “mobile account” which is not a bank account.
  - Users can make cash deposits, withdrawals, and purchases.
  - Person-to-person (P2P) credit transfers as well as international transactions can be made.
- Smart Money (launched 2000):
  - Reloadable payment card accessible via Smart mobile phone or MasterCard "power card".
  - Smart’s bank partners hold Smart Money accounts and secure BSP approval/reporting.
  - Functions: prepaid reloading, bill payment, funds transfer, checkbook request, balance inquiry, ATM use at partner banks, MasterCard POS acceptance.
  - Smart works with 21 banks; all utilize Smart’s mobile banking platform and three utilize Smart Money’s e-money platform and issue smart money.
- GCash (launched 2004 by Globe):
  - Operates without a bank partner; clients load cash into electronic “wallets” and transact via SMS.
  - Value and transaction information held by a wholly-owned Globe subsidiary registered with BSP as a remittance agent.
  - Subsidiary pools customer funds and deposits them in commercial bank accounts in the subsidiary’s name; internal policy matches GCash outstanding value 1:1 with funds deposited.

### Regulatory development and supervision
- BSP role:
  - Supported development of network operator-led mobile payments while implementing regulations to protect consumers and the banking system.
  - Required mobile operators to register as remittance companies to conduct mobile payment activities.
- Registration and compliance requirements for mobile operators and agents:
  - Apply to BSP for registration (submit legal documents and pay a fee).
  - Officers/personnel directly involved in cash operations must undergo training by the Anti-Money-Laundering Council (AMLC).
  - For each remittance, complete know-your-client (Customer Due Diligence) on the sender (application form + government-issued ID).
  - Maintain records of all transactions for five years.
  - Report specified and suspicious transactions.
  - BSP allowed mobile operators to conduct their own AML training if it followed the AML Act and was certified by AMLC to reduce compliance costs.
- E-commerce / e-money regulatory timeline:
  - 2000: Electronic Commerce Act recognized validity of electronic transactions and signatures; initial regulation of mobile banking was ad-hoc.
  - 2004–2009: Mobile banking operated under BSP supervision while e-money specific rules were pending.
  - 2009: BSP issued an e-money circular that harmonized rules for banks and nonbanks issuing e-money:
    - Definition of e–money; prohibition on charging interest on e–money.
    - Limits on aggregate monthly load for e–money: PHP 100,000 or US$866.
    - Required complete and accurate records of e–money transactions.
    - E–money issuers could only engage in e–money and related businesses; otherwise must issue e–money through a separate dedicated entity.
    - Customer funds protection: non-prudentially regulated e–money issuers must keep sufficient liquid assets equal to outstanding e–money; liquid assets include bank deposits, government securities and other BSP-allowed assets.
    - Licensed nonbank e-money issuers required minimum capital of US$2 million.
- BSP institutional capacity building:
  - Created Core Information Technology Supervisory Group (CITSG) to address electronic banking and supervise providers.
  - Established Inclusive Finance Advocacy Staff as an “innovation unit.”
  - Created a Payment Systems Unit to oversee RTGS implementation.

### Risks identified and supervisory priorities
- Key risk categories (Box II.2):
  - Credit risk: settlements not immediate and interposed parties increase credit exposures.
  - Operational risk: losses from inadequate/failed internal processes, people, systems, or external events; fraud by customers/agents; electronic communications reliance.
  - Legal risk: uncertainty from evolving laws/regulations and enforcement.
  - Liquidity risk: retail agents may lack cash to meet withdrawals and may have weak liquidity management.
  - Reputational risk: agent underperformance, data loss, or liquidity shortfalls affecting banks’ public image.
  - Consumer protection: customers may face losses or lack clarity on rights when services are outsourced to agents.
  - AML/CFT risk: outsourcing account opening and transaction processing complicates customer due diligence and suspicious transaction reporting; banks bear risk of improper identification or laundering via agents.
- Supervisory challenge: strike balance between consumer protection/safety and support for innovation; unclear resolution processes if a mobile operator fails.

### Impact and outcomes
- Usage and reach:
  - Over eight million users of e-money (Smart Money and GCash).
  - Number of banks offering mobile payments increased from zero prior to 2005 to 47 rural banks in 2010.
  - Some banks lowered interest rates on micro-finance loans for clients that use ‘text-a-payment’ platform by 50 basis-points on monthly rates.
- Cost reduction:
  - Average inbound remittance: US$300; typical cost US$7–US$33 (between 2.5 percent and 10 percent of the value).
  - If routed via GCash or Smart Money, cost is less than one percent of the value.
  - Bank branch transaction cost: US$2.50; mobile phone transaction cost: US$0.50.
- Usage patterns:
  - Mobile payments primarily used by low-income Filipinos for domestic remittances.
  - One third of users use mobile payments to make purchases remotely.
- Physical access points:
  - Cash-in/cash-out points (nonbank agents) number approximately 15,000, in addition to most of the country’s 7,500 ATMs.
  - An untapped avenue: two million total airtime sellers.
  - Constraints: cumbersome registration for cash-in/cash-out points, difficulties in group registrations for merchant networks, delays in AML/CDD training outside Manila.

### Key lessons and policy implications
- Institutional and regulatory sequencing:
  - BSP allowed market-led innovation first and then developed prudential and e–money regulations (notably the 2009 e–money circular).
- Effectiveness:
  - Combination of market initiative by mobile network operators and an enabling regulatory framework increased financial inclusion and reduced transaction costs.
- Ongoing priorities:
  - Further work needed to mitigate residual system risks, clarify resolution mechanisms for failed mobile operators, streamline agent registration and training, and keep legislation up to date with rapidly evolving technologies.

*Source: _041612b - 21.      Access to finance in the Philippines via the formal banking sector is limited.*

### 38.      The predominant characteristics of the pre-2004 Ugandan financial system was small

### The predominant characteristics of the pre-2004 Ugandan financial system was small

### System characteristics and depth
- Commercial banks (predominantly subsidiaries of foreign banks) accounted for 83 percent of the system assets, other credit institutions 4 percent, and microfinance institutions (including credit cooperatives) 1 percent.
- Banking-depth indicators in 2001 (Table III.1):
  - Uganda: Credit/GDP 5.8; Bank Deposits/GDP 19.3; Liquid Liabilities/GDP 14.9; Private Credit/GDP 38.9; Loan-Deposit Ratio 7.9; Overhead Costs 12.7.
  - Kenya: Credit/GDP 22.6; Bank Deposits/GDP 42.9; Liquid Liabilities/GDP 34.9; Private Credit/GDP 60.1; Loan-Deposit Ratio 6.1; Overhead Costs 9.2.
  - Tanzania: Credit/GDP 6.8; Bank Deposits/GDP 22.2; Liquid Liabilities/GDP 16.7; Private Credit/GDP 40.9; Loan-Deposit Ratio 7.0; Overhead Costs 7.5.
  - SSA (avg.): Credit/GDP 19.1; Bank Deposits/GDP 31.3; Liquid Liabilities/GDP 23.6; Private Credit/GDP 74.2; Loan-Deposit Ratio 6.1; Overhead Costs 7.9.
- Share of total commercial bank loans and advances to agriculture declined from over 20 percent at end of the 1980s to less than five percent in 2004.

### Financial access and outreach
- By 2004, tier 1 to 3 financial institutions were in 51 of the 55 districts, serving about 87 thousand people per bank branch.
- Banking sector growth 2006–2010: assets nearly doubled to 28 percent of GDP.
- Despite growth, efficiency and rural/unbanked outreach did not improve commensurately; small system size limited economies of scale.

### Microfinance, SACCOs, and semi-/informal providers
- Semi-formal and informal providers (microfinance institutions, NGO-led entities, other informal operators) emerged as primary vehicles for rural financial outreach.
- MFI loan and deposit size (relative to GDP per capita):
  - Average loan balances: tier 4 institutions 54 percent of GDP per capita; tier 1 institutions 146 percent of GDP per capita.
  - Average deposits: tier 4 institutions about 10 percent of GDP per capita.
- 2007 FinScope survey:
  - 62 percent of Uganda’s population (about 18 million people) had no access to financial services of any form.
  - 65 percent of those without access were in rural areas.
  - For the 38 percent with access, non-regulated institutions were the predominant source (20 percent).
  - 58 percent of the urban and 65 percent of the rural population were outside reach of financial services.
- MFI activity and SACCOs (as of end–2003 and later developments):
  - By end–July 2011: about 180 NGOs, several microfinance companies, and around 2,800 SACCOs.
  - Total savings and share capital of all SACCOs was about two percent of banking system savings.
  - 1.5 million paid-up members.
  - The largest of these institutions had around 800,000 loan accounts and 2.5 million sanctioned deposit accounts.
- 2009 FinScope: proportion accessing financial services (formal + informal) rose from 57 percent in 2006 to 72 percent in 2009; informal providers accounted for a significant share of the increase.

### Government policies and regulatory changes
- Government supportive measures:
  - Passage of the MDI Act and amendments to the Financial Institutions Act to enhance Bank of Uganda (BOU) supervisory capacity.
  - Allowed larger MFIs to transition into BOU-regulated institutions (MDIs operating as “microfinance banks”), eased branch requirements, and permitted agency banking.
  - Rural Financial Services Strategy (RFSS) rolled out in 2008 to support SACCOs: creation of new SACCOs in every sub–county; encouragement of rural savings and credit use; subsidized credit to SACCOs to on-lend at government-determined interest rates.
- Outcomes:
  - Conversion to regulated status allowed MDIs to raise resources more cost-effectively and expand products.
  - Number of registered SACCOs doubled in less than two years following policy measures.

### Technology and mobile payments
- Mobile payments adoption:
  - Mobile payments enabled storing and transferring monetary value; average monthly growth in new customers was about five percent.
  - Light-touch regulatory stance by BOU encouraged product innovation and integration with formal payments infrastructure, including developments akin to a payment switch and growing formal integration.
- Expansion since 2007:
  - Numbers of bank, credit institution and MDI branches have expanded more than two-fold since 2007.
  - Spread of mobile payments service providers complements financial deepening.

### Institutional constraints and risks
- Legal and supervisory gaps:
  - Lack of a comprehensive legal and regulatory framework for MFIs and SACCOs; failures of some MFIs left customers without recourse.
  - Government nominated the Uganda Cooperative Savings and Credit Union (UCSCU) as the apex umbrella for SACCOs; UCSCU lacks institutional capacity for effective self-regulation and supervision.
- Collateral, credit information and borrower identification issues:
  - Paucity of collateral and poor land titling/registration hinder use of land as collateral and rural lending.
  - Absence of a sound credit culture, prevalence of multiple borrowing (FinScope 2007: at least 22 percent of borrowers from formal institutions borrowed from more than one institution), and loan defaults affect SACCO performance.
  - Credit reference bureau (CRB) launched in 2008 helps evaluate existing customers but does not resolve information gaps for new customers; some MFIs (including SACCOs) lack access to CRB.
- Risks from network effects and concentration:
  - New technologies may create network externalities resembling natural monopoly characteristics, raising legal, regulatory and oversight challenges potentially beyond central bank capacity.

### Impact assessment and lessons
- Access and sector evolution:
  - MFI sector grew from insignificant in the 1990s to a notable subsector over about 20 years.
  - Between 2005 and 2009, traditional bank-based access indicators improved and compare favorably to neighbors.
  - Licensing/transformation of MDIs into the formal sector increased competition, business orientation and innovation; Friends Consult Ltd. (2008) noted increased access to formal services two years after the first MDI licensing.
- Limitations to reducing un-banked population:
  - Despite growth in MFIs, the un-banked proportion did not decline dramatically; many rural communities may remain unattractive to MFIs due to low population density, poor roads, limited electricity and cellular networks, and low income levels.
  - Low financial literacy and insufficient skills, plus legal/regulatory frameworks not fully supportive of affordable rural-tailored products, restrict further gains.

### Guiding principles and global lessons (selected)
- From CGAP Guiding Principles on Regulation and Supervision of Microfinance (2003):
  - Prudential regulation and supervision are necessary for microfinance to reach full potential.
  - Supervisory capability, costs, and consequences should be examined early.
  - Minimum capital should be set high enough so supervisors are not overwhelmed by too many new institutions.
  - Micro-lending institutions should demonstrate profitable lending before being licensed to take deposits.
- From CGAP lessons on apex institutions (2002):
  - Apexes expand wholesale resources short-term but do not substitute for strong retail MFIs.
  - Apexes can weaken incentives for MFIs to seek commercial funds; political interference and overambitious disbursement targets are common problems.
  - Apexes are most useful when a critical mass of competent retail MFIs exists; initial funding should be modest and scaled to demonstrated capacity.

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICs – CASE STUDIES (excerpts).*

### 58.      Considering their combined size and the structure of the existing linkages of these

### 58.      Considering their combined size and the structure of the existing linkages of these entities with the formal financial sector, the underlying risks do not appear systemic in nature. However, other risks remain.

### Risks related to SACCOs, microfinance, and subsidization
- The creation of new SACCOs may risk fostering a potentially detrimental proliferation of small entities, challenging prudential capacity. Even where a SACCO may be warranted, the potential for politicization may cloud perspectives.
- The past failure of some SACCOs left their membership with no mechanism to recover their deposits. More failures could create a crisis of confidence.
- The subsidization of SACCOs and other savings and credit institutions erodes incentives for mobilizing savings, and may weaken lending standards.
- Efforts to enhance financial access through subsidization could have disadvantaged the “non-SACCOs” and could replace market-led channels with directed lending.
- Directed lending by the Government introduces distortions and, in the long run, could undermine the viability of MFIs and SACCOs.

### Risks related to mobile payments and payments infrastructure
- Where a national payments system law encompassing more recent technology developments is absent, the central bank’s regulatory and oversight actions could be challenged resulting in payments and reputational risk.
- The overtly cautious regulatory and oversight actions by the central banks could create regulatory gaps that allow monopoly product and pricing strategies and elements of retail payments infrastructure to develop without adequate and appropriate standards.
- In the event of operational failures, financial transactions completed without a legal basis for electronic signatures can pose particular risk not only for the development of mobile payments, but, where mobile-led payments environment integrate with the formal and regulated retail payments infrastructure.
- The lack of collaboration between the BOU and the Uganda Communications Commission (the telecom regulatory authority) allows the mobile operators and their products to grow without an assessment of the adequacy and appropriateness of the technology.

### E. Conclusion (paragraphs 59–61)
- Key lessons:
  - The Ugandan experience demonstrates that the government should adopt an enabling policy stance to enhance access, and that it is important to work with both formal and informal channels to achieve the broader financial inclusion objective.
- Key policies and impact:
  - The authorities adopted a policy of active encouragement of microfinance and SACCOs, supported with adaptive regulation.
  - The policy was successful in generating an expansion of these institutions and extension of services, while unregulated institutions continued to be an important source of savings and credit services.
  - The private development of mobile payment facilities, assisted by initial light regulation, has helped outreach and its adoption by banks is extending the formal system.
- Key risks:
  - i) a proliferation of small SACCOs have challenged regulatory and supervisory capacity, resulting in failures;
  - ii) government subsidization and directed credit can create moral hazard, reducing the incentive for appropriate credit risk assessment, possibly discouraging market-led services.
  - Mobile systems require regulation both from the payments and telecommunications perspectives, and while an initial light approach may be appropriate, national payment laws and oversight as well collaboration with telecommunications regulatory authority are necessary to avoid payments risks.
  - The proliferation of microfinance institutions, all focused on the least sophisticated rural population may result in unsustainable levels of rural indebtedness—what is now commonly referred to as the “Andhra Pradesh” phenomenon.

### IV. Formal banking intermediation in transition economies — selected findings (paragraphs 62–74)
- Initial conditions and macroeconomic collapse:
  - Modern banking institutions were virtually non-existent in the planned economies of central Europe and the former Soviet Union; the “mono-bank” system substituted for prudential regulations and supervision.
  - Inflation in CEE countries and the Baltic States averaged 200 percent in 1992, and, in some countries, inflation rates were well above 1,000 percent (Macedonia and Lithuania).
  - On average, inflation was substantially higher among the CIS countries, where average inflation reached 1,400 percent in 1992, and, in some countries, exceeded over 2,000 percent (Kazakhstan, Moldova, Russia, and Ukraine).
- Transformation phases for commercial banks (Cottarelli et al., 2003):
  - (i) the writing-off of a large share of the loans extended by public banks, mostly to state enterprises,
  - (ii) the sale of banks, primarily to foreign investors; and
  - (iii) the beginning of more standard banking operations, including increased lending to private enterprises.
- Drivers of banking sector deepening:
  - Macroeconomic stability, institution-building and banking sector reforms, and overall institutional quality and structural reforms were key factors.
  - EU membership provided strong impetus; prospect of EU membership made under-serviced markets attractive to European banks once macro stability and proper regulations were in place.
- Disinflation and credit dynamics:
  - Among CEE and Baltic countries, inflation declined relatively rapidly, averaging single digits by the late 1990s.
  - In CIS countries, inflation was more entrenched; the ratio of bank deposits to GDP picked up significantly after 2000 as macro stability improved.
  - Real interest rates fell sharply in line with disinflation, particularly after 2000; the decline was most pronounced in the Baltic countries.
- Institution-building and banking reform outcomes:
  - The liberalization process produced many new, often undercapitalized banks, placing burdens on underdeveloped regulatory structures and leading to banking failures and systemic crises in the early to mid-1990s.
  - Rapid privatization and consolidation occurred in the late 1990s and early 2000s, usually with participation of foreign banks; by mid-2000s, privatization was mostly complete in the CEE and Baltic countries.
  - Movement from mono-bank to two-tier banking systems occurred, though speed and comprehensiveness of reforms varied across countries.
- Remaining institutional gaps:
  - Crucial elements such as a functioning credit information system, credit registry, ratings agencies, and a reliably functioning court system took more time to develop.

*Source: Excerpt from the IMF chapter “ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICs – CASE STUDIES” (selected paragraphs 58–74).*

### 75.      Here again, EU accession considerations played a crucial role in spurring reforms in the

### _041612b - 75.      Here again, EU accession considerations played a crucial role in spurring reforms in the

### EU accession and banking-sector reforms
- EU accession considerations spurred reforms in the Baltic and many of the CEE countries.
- By the mid 2000s, CEE countries were more advanced in banking sector and financial market reforms than the CIS countries (Figure IV.2).
- The EU accession states were first to:
  - establish effective banking supervision and competitive banking systems,
  - make significant inroads in providing longer-term lending to the private sector.
- In the 2000s, CIS states strengthened frameworks for banking supervision and regulation, which helped increase private banking presence and contributed to the expansion of private sector credit since mid-2000s.
- Legal underpinnings improved, but laws addressing bank solvency and the rights of creditors often remain weak and incomplete.

### Banking developments in the run up to the crisis
- Rapid credit growth was a feature of several transition economies since the 2000s, driven by:
  - easing credit conditions (easier availability of credit and lower financing charges),
  - rising incomes and confidence,
  - optimistic expectations in the CEE and Baltic countries (Enoch and Ötker-Robe, 2007).
- Contributing factors to expanded banking activity:
  - crowding-in (reduced public sector borrowing),
  - progress in structural reforms (e.g., legal protection of creditor rights),
  - increased private participation in the banking sector (e.g., foreign bank entry),
  - competition, particularly in retail deposit taking.
- Banks with lower market share and with foreign participation expanded customer lending more rapidly than other banks (IMF, 2011).

### Distribution of bank lending and maturities
- Households were the main beneficiaries of bank lending.
- The 2006 EBRD Transition Report notes that in 2000-05 domestic credit to household was much higher in the CEE and the Baltic states than in the CIS region, although it remained below advanced country standards.
- Mortgage financing, as a share of total bank lending to the private sector, remained small, particularly among CIS countries, reflecting:
  - rapid growth of consumer lending,
  - weak property rights and unclear title deeds affecting the feasibility of mortgages.
- Loan maturities:
  - In the CEE and Baltic states, loan maturities lengthened, suggesting greater confidence in the financial system.
  - In the CIS countries, loan maturities remained short.
- Enterprises had more limited access to bank credits, particularly in the CIS countries, with internal funds remaining an important source of financing (around 60-70 percent) for working capital and investment.

### Risks from rapid credit expansion
- A substantial share of bank loans was denominated in foreign currencies as banks substituted foreign financing (wholesale funding) for a limited domestic deposit base, increasing exposure to foreign exchange (FX) risk.
- FX-denominated lending was prominent in the Baltic countries and several CEE countries (particularly countries in Southern and Eastern Europe that experienced hyperinflation in the 1990s).
- In some countries (e.g., Croatia), mortgages were denominated in euros (Bonin, 2008).
- Even when deposit bases were also in euros, FX risk was not eliminated because domestic slowdowns or exchange rate shocks could affect borrowers’ ability to repay in euros.
- Close parent-subsidiary relationships and high foreign concentration in local banking sectors left some transition countries vulnerable to economic shocks in parent countries (IMF, 2011).

### Conclusions: Key lessons, policies, and risks
- Key Lessons:
  - Macroeconomic stability is a pre-condition for financial intermediation to take-off.
  - Macroeconomic stability, regulatory and institutional reforms were critical for financial deepening.
  - Participation of foreign banks and access to cross-border financing was an important catalyst in financial deepening.
- Key policies and impact:
  - Countries with earlier macroeconomic stability and more advanced financial reforms experienced faster financial deepening.
  - Deepening was associated with strong regulatory and supervisory regimes and strengthened contractual and informational frameworks.
- Key risks:
  - Cross-border flows and foreign presence in banking created vulnerabilities, including:
    - sudden capital flow reversals,
    - household sector inability to service debt obligations, including those denominated in foreign currency,
    - greater exposure to transmission of macro-financial risks.

### Nepal: developing interbank markets and central bank operations — overview
- Objectives: Improve effectiveness of monetary and FX operations, improve debt management, and improve conduct and transmission of monetary policy via functioning interbank money and FX markets.
- Challenges:
  - Financial system structurally weak and rapid expansion since 2007 strained the NRB’s capacity.
  - Limited independence of the NRB adversely affects enforcement of regulations and monetary policy.
  - State-owned banks have negative net worth and high levels of non-performing loans.
  - Large number of institutions stretches regulatory capacity and contributes to excessive risk taking.
  - These conditions complicate development of vibrant interbank markets and transmission channels.

### Enhancing domestic market operations (Nepal)
- NRB instruments to manage domestic liquidity include:
  - outright purchase and sales auctions,
  - repo and reverse repo auctions.
- Operational changes and specifics:
  - Maximum maturity for repo and reverse repo auctions for open market operations increased to 45 days from 28 days to better manage rollover risks and adverse effects on liquidity conditions.
  - Existing stock of non-interest-bearing securities held by the NRB was converted to 91- and 364-day t-bills to provide greater flexibility.
  - A standing repo facility provides temporary liquidity support to banks for up to seven days.
  - The interest rate on the standing repo facility is 50 basis points higher than the 91-day t-bill weighted auction rate.
  - NRB has a general refinance facility priced at the Bank Rate and other refinance facilities, including export credits in foreign currency, and loans to industries and rural development banks.
  - In 2010, NRB introduced a refinancing facility to address liquidity pressures; this complemented a lender of last resort facility available for a maximum period of six months with acceptable collateral widened to include other than government securities.
  - Most interest rate controls and administrative allocations of credits removed, though limits are imposed on banks’ interest rate margins.
  - Real interest rates have tended to be negative.

### Public debt management (Nepal)
- Government issues:
  - t-bills of maturities 28, 91, 182 days and 364 days.
  - development bonds issued by the NRB on behalf of the government with maturities up to five years and carry a coupon rate paid semi-annually, issued at par on a subscription basis to financial institutions only.
  - National Savings Certificates (NSC) issued only to individuals, carry coupon interest and a maturity of five years.
- Steps taken:
  - Separation of government debt management objectives from monetary policy objectives; projections of government cash requirements are being made to strengthen liquidity management.
  - NRB Open Market Operations Committee prepares an annual plan for managing the debt based on the global ceiling on domestic financing determined as part of the budget approval.
  - Authorities impose a limit on net financing of the government by the NRB to help liquidity management.
  - Substituting marketable instruments for nonmarketable instruments contributed to market development.
- Remaining challenges:
  - Multiplicity of securities with different terms and non uniform tax treatment.
  - Need for longer term securities with maturities of two to three years to extend the yield curve and facilitate market development.

### Foreign exchange market (Nepal)
- FX market features:
  - Fairly liberal; banks allowed to engage in various FX transactions.
  - Fixed exchange rate regime and NRB operational arrangements complicate development of interbank FX market.
  - Banks free to fix exchange rates for prescribed convertible foreign currencies except Indian rupees.
  - As of December 31, 2010, about 3,660 institutions were licensed to deal in FX with the public.
  - Large banks allowed to engage in FX transactions with NRB to maintain foreign currency positions.
  - No limits on bid-ask spreads or commissions.
  - NRB does not participate in the forward FX market; banks may provide forward exchange cover for current account transactions under mutually agreed terms.
  - Banks and some financial institutions may enter into derivatives (forward operations, swaps, options, futures) and may invest convertible FX in various instruments with any maturity.
- Market structure and frictions:
  - No active interbank FX market; banks conduct occasional trades among themselves to meet positions.
  - No market makers and no commitment by commercial banks to quote two-way prices.
  - Turnover dwarfed by NRB, which provides a daily standing window with a buy and sell rate around the parity rate, not fostering interbank activity.
  - Channeling of commercial banks’ requests to transact with NRB through the Foreign Exchange Dealers Association of Nepal (FEDAN) can take up to five days and is viewed as a bottleneck.
  - Development of active interbank FX market is complicated by the exchange rate peg, frequent NRB interventions, one-way nature of foreign currency flows, and limited trader training and experience.

### Nepal conclusions and lessons
- Key reforms and impact:
  - Reforms resulted in a standard set of tools to manage liquidity: reserve requirements, standing facilities, and open market operations.
  - Debt markets have started to develop and a liberal exchange control system allows foreign currency trading.
  - Liquidity management has often led to swings in liquidity conditions, with an overall bias toward excess liquidity.
- Key lessons:
  - Development of active interbank markets requires sustained reform efforts, appropriate infrastructures, and incentives to encourage dealings.
  - Access to NRB facilities should be at penalty rates; the NRB should only deal with market participants in the interbank market and at market rates.
  - NRB interventions reflecting its fixed exchange rate policy complicate development of the interbank FX market.

*Source: _041612b - 75.      Here again, EU accession considerations played a crucial role in spurring reforms in the (IMF PDF content unit).*

### 102.      In Korea, in the late 1980s, the central bank promoted the establishment of brokers and

### In Korea, in the late 1980s, the central bank promoted the establishment of brokers and dealers for call transactions

### Korea: interbank market reform (late 1980s)
- Policy action: central bank promoted the establishment of brokers and dealers for call transactions to
  - enhance the adjustment function of the interbank market, and
  - break the segmentation of the existing call market between bank and nonbank financial institutions (NBFIs).

### Georgia: money market and central bank balance sheet (2007)
- Key lesson: development of a well-functioning money market and a yield curve across a wide range of maturities is necessary for effective monetary policy implementation.
- Institutional implication: a central bank should be equipped with a balance sheet that enables implementation of monetary policy both in terms of instruments and income to cover the cost of monetary policy.

### Mexico: deepening of the local debt market (case study highlights)
- Historical evolution and outcomes
  - First sovereign peso-denominated fixed rate Treasury securities (CETES) issued in January 1978; secondary market became operational in 1982.
  - By 2003, Mexico ranked as one of the most advanced government bond markets among emerging market countries.
  - 2011 outstanding federal government securities amounted to 25 percent of GDP, composed of:
    - more than half in development bonds (discontinued in 2010),
    - 18 percent in Udibonos (inflation-indexed development bonds),
    - 4.5 percent in CETES (t-bills, amounting to around 3 of GDP).
  - August 2011: federal government issued a US$1 billion bond, the “Bonos Global,” with maturity of 100 years.
  - 2010: Mexico included in Citigroup’s World Government Bond Index.
  - Mexico obtained an investment grade rating in March 2000.
  - By the eve of the global financial crisis:
    - lengthening of the average maturities to above 6 years contributed to resilience,
    - public, private, and financial balance sheets were sound,
    - lower debt levels, limited exposure to exchange and roll-over risks.

- Crisis drivers and initial constraints
  - 1976–1982: private and sovereign debt levels more than tripled; concentration of USD-denominated borrowing created currency mismatches preceding the 1982 crisis.
  - 1982: peso devalued; temporary moratorium on debt payments; authorities nationalized all domestic commercial banks; an IMF program followed.
  - Late 1980s: deficits financed with short- (mostly CETES) and medium-term domestic debt issuances; restructuring in 1989 and the Brady Plan in February 1990 renewed access to international capital markets.
  - 1994–95 Tequila Crisis roots: liberalization in absence of appropriate oversight; rapid credit expansion; asset-liability mismatches; concentration of market risks; Tesobonos exposed the country to significant FX risks; pegged exchange regime and depleted international reserves forced move to a floating exchange regime at the onset of the crisis in 1994.

- Reforms that deepened debt markets (post-1994–95; 2000–08)
  - Macroeconomic reforms:
    - adoption of fiscal discipline (fiscal responsibility law),
    - inflation control and adoption of inflation targeting,
    - floating exchange rate regime.
  - Market and instrument reforms:
    - issuance of higher volumes of one-day repo transactions, many collateralized with government securities; authorization of market makers to deepen liquidity in primary and secondary markets;
    - expansion of the yield curve with issuance of 3- and 5–year fixed coupon bonds in 2000;
    - shift away from foreign-currency denominated instruments;
    - diversification of funding resources and a pre-announced calendar of government security auctions.
  - Institutional and infrastructure reforms:
    - creation in 1995 of the National Banking and Securities Commission (CNBV);
    - May 2000 secured lending framework reform and Commercial Insolvency Law; adoption of a debt information registry;
    - 2001: Securities Market Law, CNBV Law, and Mutual Funds Law approved;
    - 2002: Payment System Law enacted; central bank became supervisory and regulatory authority of systemically important payment systems (SIPS);
    - 2005–2006: OTC and exchange-traded derivatives markets became fully integrated with the global derivatives market; first public mortgage-backed securitization in 2003.
  - Regulatory and transparency reforms:
    - June 2001 legal reforms to strengthen market discipline (e.g., reform of Mexican secrecy rules; changes in corporate governance);
    - Securities Market Law (LMV) passed in 2005 (fully operational since June 2006) strengthened CNBV’s authority and corporate governance of publicly listed companies;
    - Law of Management and Transparency of Financial Services approved in June 2007 to improve public availability of information.
  - Investor base expansion:
    - private pension fund system created in 1996 became a key institutional investor;
    - 2005: pension funds accounted for about 35 percent of all domestic fixed income securities placed by private issuers;
    - foreign holdings of government securities: 1.3 percent in 2000, rising to 25 percent by November 2011, and 29 percent in February 2012.

- Impact and lessons
  - The deepening of domestic debt markets contributed to reduced macro-financial vulnerabilities and increased resilience to shocks.
  - Key lessons:
    - Macroeconomic imbalances, government control of financial market operations, and reliance on foreign borrowing can constrain domestic debt market development.
    - Inadequate infrastructure, absence of supporting markets and investor base, and lack of appropriate oversight limit market development.
    - Deepening debt markets is not a substitute for fiscal responsibility and sound macroeconomic policies; domestic markets can magnify effects of poor policies and imbalances.

### Key policy implications (cross-cutting)
- Develop a well-functioning money market and a yield curve across a wide range of maturities to enable effective monetary policy implementation.
- Ensure central bank balance sheet capacity to implement monetary policy instruments and cover policy costs.
- Combine macroeconomic discipline (fiscal responsibility, inflation control, appropriate exchange rate regime) with structural, regulatory, and infrastructure reforms (market makers, repo markets, secured lending, insolvency framework, payment system oversight) to deepen domestic debt markets.
- Strengthen transparency, market discipline, and regulatory/supervisory capacity to foster investor confidence and broaden the investor base (including pension funds and foreign investors).

*Prepared by Maria Oliva (MCM); content drawn from the IMF case studies included in the supplied chapter excerpt.*

### 123.      During the second half of the twentieth century, the Turkish economy experienced

### _041612b - 123.      During the second half of the twentieth century, the Turkish economy experienced

### A. Historical context and macroeconomic instability
- Significant economic volatility and repeated crises characterized Turkey during the second half of the twentieth century.
- Hyperinflation and balance of payment crises were common features in every decade.
- Financial system features prior to 1980s: interest rate controls (in place since the 1940s), directed credit, and entry barriers.
- Because of rising inflation and low real interest rates, financial intermediation declined.
- In 1980, following another severe balance of payment crisis, Turkey adopted a stabilization and liberalization program to improve the balance of payments, reduce inflation, fiscal deficits and government dominance of the economy.
- The Turkish lira was devalued to increase competitiveness.
- Persistent fiscal deficits hindered the government’s ability to deal with macroeconomic imbalances and rising inflation:
  - inflation averaged around 50 and 80 percent in 1980s and 1990s, respectively, until the early 2000s.

### B. Financial liberalization, dollarization, and vulnerabilities
- Liberalization timeline:
  - Interest rate liberalization began in 1980, taking eight years to complete.
  - Turkish residents allowed to hold foreign currency deposits in 1984.
  - Capital account fully liberalized by 1990.
- In the absence of fiscal discipline, capital account opening attracted capital inflows in response to a large risk premium on government securities.
- Both residents (including financial institutions) and non-residents borrowed abroad and lent to the Treasury, exploiting interest rate differentials.
- The Central Bank of Turkey (CBRT) provided banks with liquidity to finance growing government debt, which reached 77 percent of GDP by end-2000.
- Prudential limits on FX exposures were not enforced and the economy became highly dollarized (over 60 percent in 2000–01).

### C. Early capital market evolution and crises
- Underdeveloped local capital markets remained largely unsupervised until 2000s.
- Interest rate liberalization in the 1980s led banks to issue certificates of deposit to brokers; unlicensed brokers issued promissory notes and traded corporate bonds and loans, evolving into a Ponzi scheme and leading to the collapse of five banks and financial crisis in 1982.
- Government responses included establishing the Capital Market Board and opening the Istanbul Stock Exchange in 1986.
- Commercial paper was introduced in 1987 and mutual funds entered markets; government securities’ real returns and tax treatment remained highly competitive relative to corporate bonds.
- Weak banking system and over-reliance on foreign inflows left the system vulnerable:
  - In 2000, portfolio losses and liquidity problems in a few banks led to a generalized loss of confidence and massive capital outflows.
  - Speculative attack on the lira in February 2001 forced the government to float the currency, resulting in sharp depreciation, high inflation, surge in interest rates, jump in government debt, and sharp contraction in economic activity.

### D. Post-crisis policy responses to develop domestic debt markets
- Policy objectives included reducing reliance on external financing and central bank financing of government.
- Fiscal reforms and improved economic performance led gross government debt to decline from 53 percent in 2000 to 41 percent in 2010.
- Treasury reduced the share of FX-denominated debt in total gross public debt by nearly 30 percentage points in the decade ending in 2010.
- 2001: CBRT granted greater autonomy and price stability made the sole primary objective.
- Early 2006: CBRT formally adopted an inflation targeting framework; central bank direct financing of the government was prohibited.
- 2005: CBRT heavily sterilized capital inflows to maintain price stability and enhance money market efficiency.
- Treasury–CBRT coordination and market transparency:
  - Instituted monthly meetings between Treasury and CBRT staff.
  - 2006: Treasury began publishing an issuance calendar with monthly borrowing plans and a 12-month debt profile report.
  - 2005: Government approved an Action Plan to harmonize regulations and Capital Market Board began modernizing the Capital Market Law.
- Primary dealer market:
  - Introduced in late 2002 to develop and enhance liquidity.
  - Twelve banks were appointed to act as primary dealers (PDs).
  - CBRT provided overnight and weekly repo facilities at pre-announced interest rates to support PDs.

### E. Instruments, market infrastructure, and de-dollarization
- New instruments and maturity extension:
  - Treasury introduced a 2-year fixed coupon lira-bond in 2002 and a 5-year fixed coupon bond in 2005.
  - In 2010, the Treasury introduced its first 10-year bonds—in fixed rate and CPI-indexed.
  - Strategic 2006-08 debt portfolio benchmarks included mainly lira instruments, fixed rates, discontinuing issuance of FX-indexed bonds and roll-over of no more than 80 percent of FX-indexed debt, and increasing average maturity of domestic borrowing.
- Derivatives and rating agencies:
  - Turkey Derivative Exchange (TurkDEX) officially became operational in 2005; offers two interest rate futures contracts and trading volume rose 2.5-fold between 2005 and 2010.
  - Nine credit rating agencies licensed and overseen by the Capital Market Board (CMB) disseminate credit information.
- De-dollarization trajectory:
  - Dollarization reduced from 60 percent in 2001 to around 30 percent in 2010.
  - Factors: economic stability, lower inflation, access to domestic currency financial assets, and prudential measures.

### F. Market structure and quantitative outcomes
- Foreign and international markets:
  - Turkey’s foreign debt (about 80 percent sovereign) market is liquid and among top emerging market bond markets.
  - Accounted for around 10 percent of the J.P. Morgan Emerging Market Bond Indices (EMBI) market capitalization in 2010.
  - Outstanding international debt securities accounted for eight percent of GDP in 2010.
- Domestic debt market development:
  - Share of domestic borrowing in government financing grew from about 55 percent in 2000 to over 75 percent in 2010.
  - Outstanding domestic government securities accounted for 99 percent of market capitalization.
- Corporate bond market:
  - Remains nascent; in 2011 outstanding corporate bonds represented merely six percent of the capital market, with average maturity shorter than government bonds.
  - Policy changes in early 2011: eliminated withholding tax on income from bonds with maturities over five years; withholding tax reduced from 10 percent to seven percent and three percent for 1–3 year and 3–5 year bonds, respectively.
  - First corporate lira-denominated bond issued in August 2006; October 2010 BRSA permitted banks to issue lira-denominated bonds.
- Role of banks and institutional investors:
  - Banks dominate the financial system with around 65 percent of total financial assets.
  - In 2010, 32 percent of banks’ assets were held in government securities.
  - Elsewhere the report notes banks have substantial holdings of government securities (around 35 percent of their total assets).
  - Mutual funds mainly invested in government securities: over 80 percent of portfolio vs. four percent in equities at end-2010.
  - Private pension saving funds introduced in 2003 provided long-term resources.
  - Institutional investors’ assets represented only 6.6 percent of GDP in 2009 (compared to 80 percent in Brazil and 40 percent in South Korea).

### G. Assessment of impacts
- Domestic debt market growth was a policy choice to reduce reliance on external financing, enabled by stabilization of inflation since 2003, improved regulation, and EU accession prospects.
- Macroeconomic stability and growth supported capital market growth:
  - Per capita GDP increased from USD4,200 in 2000 to over USD10,000 at end-2010.
  - Turkey’s saving rate was 15 percent compared to an average of 30 percent in other EMs at end-2010.
- Investor preferences:
  - Despite credibility gains, investors—especially banks—continued to prefer short-term instruments with floating rates, reflecting past economic volatility and hyperinflation.

### H. Policy lessons and risks
- Constraints and past drivers:
  - Macroeconomic instability fueled by fiscal indiscipline, financial sector and capital account liberalization encouraged foreign-funded financing of the deficit and risky behavior.
  - Premium on government debt relative to foreign interest rates incentivized banks to source funding abroad.
- Key policy actions that facilitated debt market development:
  - Macro front: fiscal control and credible anti-inflation policy.
  - Micro front: money market development, issuance of a spectrum of government securities, tax incentives, and establishment of risk-mitigating arrangements (derivatives markets, rating agencies).
- Key lessons:
  - Credible control of inflation and macroeconomic stability are foundations for bond market development.
  - Organizational measures (treasury–central bank coordination, market makers), money market and supporting arrangements, and effective capital market oversight are required to stimulate bond market development.
  - Paucity of institutional investors can constrain bond market growth.
- Risks:
  - Banks’ dominance in the government debt market exposes the sector to sovereign risks; banks’ substantial holdings of government securities (around 35 percent of their total assets) could expose balance sheets to sovereign risk in case of a sudden rise in interest rates.
  - Fiscal dominance in the banking sector crowds out lending to the private sector and could hinder economic development and growth.
- Recommendation:
  - Widen the investor base beyond banks to obtain diverse time horizons, risk preferences, and trading motives to support economic development and reduce volatility from foreign portfolio investment.

### I. Regional markets (introductory observations)
- Building regional markets can address small-market-size challenges by expanding investor base, reducing unit costs of financial infrastructure, transferring technology, and achieving scale efficiencies.
- Potential benefits of regional markets:
  - Adopting common transaction technologies to realize economies of scale in clearing, settlement, and trading systems and to reduce barriers to investors/intermediaries.
  - Expanding the investor base to mobilize local and international capital for public and private investment.
  - Pooling resources across a region to mitigate external vulnerabilities and reduce capital flight risk via “home-region investment bias.”
  - Enhancing cross-border trading to enable pan-regional portfolios without excessive transaction costs.
- Examples cited:
  - Asian Bond Market Initiative and WAEMU efforts to coordinate purchases of government and quasi-government securities, establish targeted funds, and create guarantee facilities for corporate bonds.

*Prepared by Abdullah Al-Hassan (MCM).*

### 147.      The main initial motivator for developing a local currency bond market in East Asia

### 147.      The main initial motivator for developing a local currency bond market in East Asia

### Motivations for developing local currency bond markets in East Asia
- The main initial motivator was the financial crisis in the late 1990s.
- Dependence on bank financing with insufficient oversight led to:
  - short-term investment and foreign currency funding of long-term investment;
  - maturity and currency mismatches that contributed to banking stress and the 1997 Asian financial crisis.
- A broad policy consensus emerged that well-functioning bond markets:
  - help diversify sources of funding and complement bank financing;
  - are comparatively better suited to servicing larger and more established companies, while banks are more adept at lending to smaller firms.
- Asian governments actively undertook initiatives to promote domestic local currency bond finance.
- Another regional motivation: enhance liquidity of domestic debt markets to overcome high fixed costs of operation and inability to achieve secondary market liquidity in some economies.
- East Asian economies coordinated policies at the regional level to promote a regional bond market.

### Reform initiatives in East Asia (2002 onward)
- Initiatives since 2002 included:
  - The initial Asia Bond Market Initiative (ABMI).
  - Asian Bond Funds 1 and 2 (ABF1 and ABF2), launched in 2003 and 2005, respectively, by the regional association of central bankers—for Australia; China, P.R.; Hong Kong, SAR; Japan; Korea; Malaysia; New Zealand; the Philippines; Singapore; and Thailand.
- Objectives of the bond funds:
  - Strengthen macro stability.
  - Provide investors with a transparent and cost-effective way to access local bond markets.
- ABF1 specifics:
  - Invests in a basket of US dollar-denominated bonds issued by sovereign and quasi-sovereign issuers in eight EMEAP markets—China P.R., Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand.
  - Allocates a portion of the regional central banks’ reserves to purchase government and quasi-government securities.
  - Eleven economies cooperated to set up a bond fund to promote regional and domestic bond markets.
- ABF2 extends the concept to bonds denominated in Asian currencies.
- Credit Guarantee and Investment Facility (CGIF):
  - Established in November 2010.
  - The CGIF is a trust of US$700 million.
  - Primary function: provide guarantees for local currency-denominated corporate bonds issued by firms in the region.

### Key policies and impact (East Asia)
- Progress drivers over the past decade:
  - Strong political commitment.
  - Attention to infrastructure and the design of bond funds.
  - Prudent macro policies in East Asia and investor confidence.
  - Initial commitment of central bank funds.
  - Market infrastructure design and arrangements to provide investors with a transparent and cost-effective means to access local bond markets.
  - Explicit attention to issuance for particular market segments, varied issuers and bond products.
- Outcome: The Asian bond market has contributed to improving liquidity in bond markets in the region.

### Key challenges (East Asia)
- Main challenges going forward include:
  - (i) further efforts at strengthening regional economic and financial integration;
  - (ii) efforts at eliminating the legal and regulatory barriers to market integration;
  - (iii) harmonization of market infrastructure/institutions such as clearing and settlement, credit rating, trading and risk mitigation arrangements.

### B. The WAEMU Regional Securities Market — Initial conditions and structure
- Operational since 1999 following the WAEMU Council of Ministers’ decision to establish a regional financial market to respond in a more transparent, efficient, and harmonized manner to financing needs.
- Facilitators of integration over the last decade:
  - the region’s monetary and economic integration;
  - relatively high macroeconomic and political stability—notwithstanding the crisis in Cote d’Ivoire;
  - the peg of the CFA franc to the euro.
- The WAEMU securities market includes both a local currency debt securities market and a stock market.
- The market has been mainly useful in sustaining treasuries’ cash flow needs amid uncertain and volatile aid flows and scarcity of regional bank financing.
- With the BCEAO’s decision to phase out statutory advances in 1998, issuance of government securities accelerated; issues by private corporations and regional institutions remained marginal.
- Regional institutions structuring the market:
  - Regional Council for Public Savings and Financial Markets (CREPMF) — surveillance body managing initial public offerings and regulating market participants.
  - Regional Stock Exchange Market (BRVM) — insures quotation and negotiation of transferable securities and supplies information to market participants.
  - Central Deposit and Settlement Organization (DC/BR) — fiduciary for securities holders and clearing house.
  - Active commercial operators: asset managers, asset custodians, business developers.
  - BCEAO auctions government securities.

### Issuers and market composition in WAEMU
- Four types of institutions allowed to issue in the regional debt market:
  - (i) member countries’ treasuries (t-bills and t-bonds);
  - (ii) private enterprises issuing corporate bonds;
  - (iii) regional institutions listing on the “regional segment” of the BRVM;
  - (iv) issuers residing outside WAEMU listing on the Kola bonds market segment.
- Principal issuers:
  - West African Development Bank (BOAD) is the main issuer of regional bonds.
  - International Finance Corporation (IFC) was the first international agency to issue Kola bonds at end-2006.
- Market composition indicators:
  - In 2009, Treasuries issued about 96 percent of the securities traded in the market, most being t-bills with less than 6-month maturities.
  - Bond issues by private corporations represented only 12 percent of total bills and bonds issued during the period 1999–2010.
  - BOAD issued about 20 percent of the total long-term securities in the period 1999–2010.
  - Total bills and bonds issued in the market represented only 1.7 percent of the region’s GDP over the period 1999–2010.
  - Secondary market activity remained marginal.

### Initiatives and reforms in WAEMU
- Governments sought credit rating services to attract greater and more diverse capital flows.
  - As of December 2010, only Benin, Burkina Faso, and Senegal had their local currency t-bills rated by internationally recognized agencies; only Senegal had obtained a rating for its local currency bond.
  - T-bills issued by Benin, Burkina, and Senegal are rated ‘B’ from Standard and Poors; Senegal bond is rated B+.
- ECOWAS launched a process in 2010 to harmonize the taxation of securities listed on the regional financial market.
- Government securities are tax-exempt.
- Several member states started using national cash flow plans to improve treasuries’ liquidity management and increasingly coordinated bill and bond offerings.

### Key challenges (WAEMU)
- Broader investor base needed:
  - Lack of regional savings pools and/or institutional investors (pension and social security funds) limits demand for long-term financial assets.
  - Foreign investors are largely absent owing to exchange regulations and yield spreads that may be too narrow relative to those in Europe.
  - Transaction costs in WAEMU seem high.
- Financing costs and maturity structure:
  - Financing costs on the regional market are relatively high given investor preference for short-term paper.
  - Governments may have difficulty implementing optimal debt management strategies given lack of interest in long-term securities and high rollover rate of short-term government debt.
  - Less than optimal financing conditions could yield higher returns for investors (mostly commercial banks) at the expense of governments.
- Systemic banking risk:
  - Development of the regional bond market has heightened banks’ cross-border regional exposures and potential systemic risk.
  - Net bank holdings of government debt amounted to about 10 percent of total banking system assets over the 2000–10 period, an amount roughly equivalent to the ratio of regulatory capital to risk weighted assets.
  - During the 2010 political standoff in Cote d’Ivoire, interruption of issues and bond repayments caused bond values to plummet, posing a temporary solvency threat to some banks; BCEAO offered to rollover maturing securities to prevent systemic banking failures.
- Additional constraints inhibiting long-term financing:
  - Uncoordinated bill and bond issuance schedules: governments are required to provide issuance schedules to the BCEAO at the beginning of each year, but these are neither binding nor coordinated among members.
  - Prudential regulation classifies t-bills as liquid and risk free investments that qualify as ‘bank capital’ for capital adequacy purposes, encouraging banks to hold t-bills rather than longer-term securities.
  - Excess liquidity in the financial system, lack of alternative investment instruments, and narrow spectrum of maturities encourage a “buy and hold” strategy, limiting secondary market development.
  - Limited availability of regional savings pools and high financing costs borne by borrowers hinder market development.
  - Few foreign investors, evidenced by low foreign portfolio inflows: an average of only US$40 million (0.1 percent of the region’s 2011 GDP) of net portfolio flows entered the WAEMU region (on an annual basis) between 1998 and 2010 (BCEAO data and IMF staff estimates).

### WAEMU conclusion: policies, impact, and risks
- Key policies and impact:
  - The WAEMU regional bond market has been successful in improving government financing.
  - Regional institutions for surveillance, trade and settlement were established.
  - Additional initiatives underway aim to improve international marketability of government securities and equalize tax treatment.
- Key risks:
  - While the t-bill market is operating well, several constraints inhibit the market’s ability to provide long-term financing (see challenges above).

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES (excerpt).*

### 168.      The reforms stimulated rapid growth in the insurance sector with improved products

### _041612b - 168.      The reforms stimulated rapid growth in the insurance sector with improved products

### India: Liberalization, market growth, product innovation, and consumer protection
- Reforms opened the market to private firms, "almost invariably with foreign participation," drawing on India’s large population and growing economy.
- Bancassurance became an important life insurance distribution channel.
- Policies sold in rural areas represented 13 percent of all private company policies in 2003 (see Sinha, 2007).
- Rapid expansion of life business, notably unit-linked insurance plans (ULIPs), grew very rapidly between 2004/05 and 2009/10 with the booming stock market and aggressive marketing.
- Regulatory investment constraints: 2008 life insurance regulations required that the solvency margin component of shareholders’ funds be invested in not less than 25 percent in government securities and 50 percent in government securities plus other approved securities (where other approved securities include state government bonds, guaranteed loans and guaranteed equity). These high regulatory ratios tended to inhibit investment in corporate securities.

Findings and problems
- Poorly informed agents were paid high commissions and sold unsuitable policies to uninformed consumers; policies often were not renewed and incurred high cancellation fees.
- Private life insurers had very high expenses, which were covered at the expense of customers.
- When the stock market run-up stopped, the ULIP market lost buoyancy; some private life insurers withdrew from the ULIP business.

Regulatory response and effects
- October 2010 consumer protection rules on linked products:
  - extension of the locked-in period from three to five years;
  - forced spreading of front-end charges over the locked-in period;
  - limits on expense allowances;
  - introduction of a consumer affairs department.
- Additional regulatory requirement: insurers were required to guarantee a return on pension products (which would reduce investment in equities and could discourage pension products).
- These rules helped reduce uninformed sales, encouraged policy renewal, and shifted new customers toward more traditional products.

Key statistics (expense ratios — expense as percentage of premiums, source: IRDA Annual Reports)
- All life insurers: 2001-02 0.19; 2002-03 0.37; 2003-04 0.31; 2004-05 0.20; 2005-06 0.18; 2006-07 0.17; 2007-08 0.18; 2008-09 0.19; 2009-10 0.17.
- LIC: 2001-02 0.18; 2002-03 0.34; 2003-04 0.29; 2004-05 0.29; 2005-06 0.15; 2006-07 0.13; 2007-08 0.12; 2008-09 0.13; 2009-10 0.13.
- Private non-life: 2001-02 0.33; 2002-03 2.03; 2003-04 2.62; 2004-05 2.88; 2005-06 2.92; 2006-07 2.86; 2007-08 2.63; 2008-09 2.69; 2009-10 2.88.
- State-owned non-life: 2001-02 0.28; 2002-03 0.34; 2003-04 0.40; 2004-05 0.39; 2005-06 0.42; 2006-07 0.36; 2007-08 0.35; 2008-09 0.38; 2009-10 0.39.

Conclusion (India)
- Key issue: Reforms aimed to develop an insurance sector capable of mobilizing funds for long-term development and extending efficient insurance services to disadvantaged groups.
- Key policies and impact: Private entry and foreign partnerships; regulations mandating minimum investments in government securities and sales to target social groups; rapid sector growth followed.
- Key concerns: A poorly informed competitive market led to consumer abuses that were subsequently addressed by consumer protection rules.

### Barbados: sector structure, mortgage exposure, and supervisory reform after CLICO
Initial conditions and market structure
- In 2005 there were 20 companies writing non-life insurance, with 60 percent of non-life premiums concentrated in three companies.
- Of the 11 life insurance companies, one had a market share of 50 percent.
- Non-life products dominated by motor insurance and accident and sickness; exposures to hurricanes, high property values, and compulsory motor third party liability influenced the sector.
- No restrictions on reinsurance cessions; companies free to make their own arrangements overseas.

Asset composition and mortgage role
- The insurance industry acted as a major supplier of mortgage finance in the 1980s and 1990s:
  - Share of residential mortgages averaged 29 percent throughout the 80s and early 90s before dropping to 25 percent in 1995 and 16 percent in 2000.
  - Mortgages were 23 percent of life insurance assets in 2006.
- Tables (Central Bank of Barbados, Annual Statistical Digest, 2007) show evolving distributions of residential mortgages and all insurance company assets (percent shares across lenders and asset classes).

Systemic failure and reform catalyst
- 2009 collapse of CL Financial Ltd (CLICO and BAICO among affiliates) exposed excessive related-party transactions, aggressive high-risk and illiquid investments, and high leveraging of group assets.
- CLICO-related market shares in 2005: CLICO International Life Ltd (CIL) 37 percent; BAICO 6 percent; CLICO International General Insurance 7 percent (premiums share).
- Central Bank of Barbados actions in 2009:
  - February 2009: provided liquidity support to CLICO subsidiaries in Barbados.
  - April 2009: agreed to contribute to a liquidity support fund for CLICO subsidiaries in smaller Caribbean countries.
  - June 2009: sale of CLICO subsidiaries placed in hands of a Government-controlled committee.
- Forensic audit ordered; legal action against CIL directors considered after their failure to observe a 2009 supervisory order to cease issuing new policies.

Regulatory response and impact
- In 2011 Barbados created a nonbank supervisor, the Financial Services Commission.
- Impact of reforms: supervisory framework substantially strengthened, though full effects on policyholders, fiscal and economic performance were unclear by late 2011; policyholders were advised that CLICO coverage remained effective while restructuring plans were presented in court.

Conclusions (Barbados)
- Key issue: inadequate supervision undermined sustainable development; initial sector expansion depended on firm-level management.
- Key policy and impact: industry assumed mortgage finance roles in absence of market alternatives until banking markets expanded.
- Key risk: lack of supervision enabled systemic cross-border risks through foreign-headquartered companies inadequately regulated at home and locally.

### South Africa and Botswana: HIV/AIDS-driven innovation and market responses
Initial conditions
- South Africa: market dominated by retirement funds; no public retirement provision; employers provide retirement benefits through funds held by long-term (life) insurance companies; legislation, regulation and supervision generally kept up to date (Long-term Insurance Act, 1998; Short-term Insurance Act, 1998; Financial Services Board enabling legislation amended in late 1990s).
- Botswana: insurance sector heavily influenced by South African parents; very high incidence of HIV/AIDS; until 2008 supervised by Registrar of Insurance in Ministry of Finance.

Market innovations addressing HIV/AIDS
- Industry actuarial modeling: Actuarial Society of South Africa’s AIDS Committee developed an AIDS and demographic model in 1989 with subsequent revisions.
- Measures employed:
  - Requirement of periodic HIV testing with high rates for those who did not take the test or tested positive.
  - Funeral insurance with higher than normal rates but low benefits or minimum waiting periods.
  - Universal life policies with increased flexibility tailored to individual circumstances.
- Credit life insurance in Botswana:
  - Became popular and was often required by banks, term lenders and retail creditors for loans.
  - Covered death from HIV-related causes and permitted loan extension despite high uncertainty.
  - Was very expensive and generated moral hazard and adverse selection; lenders had no incentive to control the risk, and insurers eventually pulled out of this market.

Impact and improved practices
- With some 40 percent of the adult population HIV-positive in Botswana, credit insurance likely permitted continued operation of the credit market.
- Insurers improved practices by requiring an HIV test; if negative on inception, the policy would continue to be honored if the insured later became infected.
- In 2005 a South African insurer began offering more affordable insurance to HIV-positive individuals conditional on steady monitoring and treatment; coverage conditions required regular testing and antiretroviral medication use as needed.
- The Financial Services Board (FSB) increased emphasis on consumer protection; IAIS principles stress market conduct supervision.

Conclusions (South Africa/Botswana)
- Key issue: HIV/AIDS caused severe morbidity and mortality effects leading to credit and insurance market failures.
- Key challenge: Credit life insurance was expensive and created perverse incentives; South Africa adopted consumer credit regulation and Botswana established a nonbank financial regulator in 2008 to strengthen supervision.

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES (excerpt).*

### 193.      In 2000, Uruguay’s banking system ranked among the deepest in the region. The credit-

### In 2000, Uruguay’s banking system ranked among the deepest in the region. The credit-

### Pre-crisis structure and vulnerabilities
- Credit-to-GDP ratio: 51 percent (ranked only below Brazil and Chile in the region).
- Uruguay was one of the most financially integrated emerging markets (measured by the sum of external assets and liabilities over GDP).
- Banking system characteristics:
  - Highly liberalized capital account; often attracted capital flows in times of turbulence in neighboring countries.
  - Substantial dollarization: as of December 2001, total deposits = US$15.4 billion (83 percent of GDP), of which 90 percent were foreign currency deposits, with 47 percent of these deposits being held by non-residents.
  - Around 45 percent of dollar deposits in the banking system were held by non-residents abroad as of end-2001; nearly 80 percent of these were in branches or subsidiaries of foreign banks.
  - Over 70 percent of foreign currency loans had been extended to residents, with the vast majority un-hedged and not earning foreign currency revenues.
- System structure and weaknesses:
  - Highly segmented: two large public banks (BROU and BHU) together accounting for 40 percent of system assets; approximately 30 private (mostly foreign) banks.
  - No specific prudential regulations regarding foreign currency-denominated deposits held by non-residents; no specific liquidity requirements or limitations on such deposits.
  - Supervision of state-owned banks described as generally weak and untimely.
  - Public banks exhibited weak lending practices and corporate governance; as of December 2001:
    - Non-performing loans to total loans: public banks 39.1 percent versus private banks 5.6 percent.
    - After tax return on equity: public banks minus 4.5 percent versus private banks minus 0.9 percent.

### The 2001–02 crisis: triggers, dynamics, and impact
- Trigger and contagion:
  - Crisis erupted in December 2001 when the Argentine government imposed capital controls and deposit freezes on its nationals; Argentine depositors withdrew funds from Uruguayan banks.
  - By March 2002, 12 percent of total bank deposits in Uruguay—mostly from non-residents—had left the country.
  - A second wave in April 2002 followed Uruguay’s downgrade from investment-grade status; domestic depositors feared a freeze.
- Deposit outflows and currency depreciation:
  - By end-July 2002, cumulative 38 percent of total deposits had been withdrawn from the system; 51 percent of deposits held by non-residents left the country.
  - The peso depreciated by 57 percent over the same period.
- Banking sector and real economy effects:
  - A majority of banks had become technically insolvent by mid-2002.
  - Credit to the non-financial sector shrank by 37 percent during 2002.
  - GDP contraction for 2002 reached 107 percent (text states "a GDP contraction of 107 percent for that same year").

### Underlying causes of vulnerability
- Cross-border exposure and weak oversight:
  - Significant cross-border banking exposure concentrated with Argentina.
  - Absence of consolidated supervision and formal information sharing between Uruguayan and Argentine supervisors led to underestimation of vulnerabilities.
- Balance-sheet mismatches:
  - High domestic liability dollarization combined with substantial foreign-currency lending to un-hedged residents created currency mismatches (including indirect mismatches to un-hedged borrowers).
- Systemic features amplifying risk:
  - Dollarization increased financial intermediation and foreign deposits but exacerbated vulnerability to sudden stops.
  - Weak internal controls, inadequate oversight, and poor risk management in state financial institutions.

### Policy response and regulatory reforms (post-2002)
- Immediate interventions:
  - First wave: targeted interventions to stem bank runs by providing liquidity and restructuring/liquidating troubled institutions.
  - Second wave: after stabilization, a series of regulatory and supervisory reforms were implemented.
- Key regulatory and supervisory reforms:
  - Reserve requirements differentiated by residence of depositors; reserve requirements on non-resident deposits were raised.
  - Loan classification and provisioning:
    - Introduced a seven-tier loan classification system.
    - New provisioning required assessment of repayment capacity with sensitivity analyses/stress tests for downturns, interest rate and exchange rate mismatches; penalizing categorization for debtors failing the test.
    - Introduced dynamic provisioning by linking provisioning to credit growth; Uruguay was among the first countries (the first in the region) to introduce dynamic provisioning in 2001.
  - Stronger liquidity requirements with a specific liquidity regime based on different bands of deposit maturities.
  - Limits on exposure to a single borrower, single sector, and single country to mitigate concentration and country risks.
  - Cross-border regulation: subsidiaries, branches, and offshore offices of foreign banks made subject to the same prudential, inspection, and regulatory reporting as domestic banks; BCU given authority to require closing of a foreign bank entity if host-country supervision inadequate; MOUs signed with several regulatory authorities.
  - Supervisory measures: requirement for integrated risk management systems, disclosure requirements on banks’ internal risk management practices, and periodic stress testing of corporate debtors.
  - Market development: establishment of a comprehensive credit bureau enabling monthly evaluation of consumer and mortgage loan quality and consolidated loan amounts.
  - De-dollarization measures:
    - Increased liquidity requirements on non-resident deposits.
    - Issuance of more index-linked local currency debt to promote de-dollarization.
    - Prudential regulations to encourage de-dollarization (e.g., higher reserve requirements on foreign currency deposits; larger capital requirements for foreign currency loans; limits on banks’ foreign currency exposures; tighter loan provisions for foreign currency lending to consumers and large corporations).
    - Since March 2009, BCU supporting development of exchange rate hedges to foster de-dollarization.
- Boxed summary of measures taken to address risks (selected items):
  - Liquidity risk from dollarization: higher reserve requirements on FX deposits.
  - Liquidity risk from cross-border exposure: increased liquidity requirement on nonresident deposits.
  - Credit risk from dollarization: higher capital requirements for foreign currency credit; increased risk weight of FX loans; amended loan classification and provisioning rules; strict criteria for classification of foreign currency consumption and housing loans.
  - Credit risks from cross-border exposures: set limits on country exposures.
  - FX risks and currency mismatches: capital requirements for FX open positions and higher risk weight for loans in foreign currency to un-hedged borrowers.
  - Cross-border risks from financial conglomerates: MOUs signed with Spain, Argentina, and other countries.

### Outcomes and assessment
- De-dollarization trends (December 2002—October 2010):
  - Deposit dollarization decreased by 15 percentage point.
  - Credit dollarization decreased by 24 percentage point.
  - Share of domestic currency denominated debt rose about 30 percentage points between end-2002 and end-June 2010.
- Policy effectiveness:
  - De-dollarization strengthened monetary transmission; evidence (Santiago and Coble, 2011) indicates that as de-dollarization progressed, the exchange rate channel decreased in importance and the interest rate channel improved.
- Financial soundness as of the late-2000s:
  - Banks rely on deposit funding, maintain substantial liquidity cushions, and carry little leverage.
  - Capital adequacy ratios exceed the regulatory minimum (eight percent) by a wide margin; compliance holds under BCU stress tests.
  - Overall loan-loss provisions stand at about six times the historically low level of nonperforming loans, partly reflecting dynamic provisioning.
  - Funding pressures at foreign parent banks did not spill over significantly to Uruguay, helped by limits on subsidiaries’ exposure to parents and regulatory changes.
  - Macro-prudential framework likely helped contain credit risk during 2006–08 via stringent loan classification and forward-looking provisioning, explicit limits on individual and sectoral exposures, and a strong liquidity system.

*Source: Excerpt from IMF chapter "ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES" (Uruguay case), pages provided in the source content.*

### introduction of an inflation targeting framework in 2008).

### _041612b - introduction of an inflation targeting framework in 2008)

### Banking system indicators and financial dollarization
- The banking system is described as "highly liquid and well capitalized, NPLs are low as are the share of nonresident deposits."
- Financial dollarization and related indicators were tracked across time (figures show Deposit Dollarization, Credit Dollarization, Financial Dollarization, Liquid Assets, Non-Performing Loans, Implicit Exchange Rate Risk Index, Non-resident Deposits, Bank Credit to the Private Sector) covering sample dates such as Jan-00, Nov-00, Sep-01, Jul-02, May-03, Mar-04, Jan-05, Nov-05, Sep-06, Jul-07, May-08, Mar-09, Jan-10, Nov-10, Sep-11, and specific comparative dates Dec-01 and Oct-10.
- Note on definition in figures: "1/ Foreign currency credit to the non-tradable sector as a percentage of total credit."

### Key Risks (paragraph 205)
- Despite significant financial deepening, Uruguay was "exceedingly vulnerable to the fallout from the Argentine crisis."
- High level of dollarization made the economy highly exposed to exchange rate shocks.
- Cross-border banking rendered the banking system susceptible to contagion from its partners.
- The domestic banking system was susceptible to external shocks given "the substantial currency and maturity mismatches in its balance sheets."

### Key Policies and Impact (paragraph 206)
- In the wake of the 2002 crisis, Uruguay overhauled its prudential framework to reduce the future risks of a crisis.
- Regulation and supervision of the financial system, in particular of the banking sector, "have improved significantly."
- Various measures were undertaken to internalize risks from dollarization and cross-border activities, increasing the capacity of the financial system to withstand shocks.
- Effectiveness of macro-economic policy improved as the de-dollarization process strengthened monetary transmission through the interest rate channel.

### Key Lessons (paragraph 207)
- Financial deepening should be accompanied with appropriate prudential regulation and supervision to reduce risks.
- Proactive monitoring and oversight and enabling policies played a key role in:
  - lowering dollarization in the banking system,
  - reducing cross-border exposures,
  - strengthening financial soundness.

*Source: ENHANCING FINANCIAL SECTOR SURVEILLANCE IN LICS – CASE STUDIES (International Monetary Fund), excerpts including paragraphs 205–207 and accompanying banking system figures.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2012/_041612b.pdf_