## Banking Reform in the Lower Mekong Countries

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---

### Introduction
- Scope: review of recent banking reform efforts in the lower Mekong countries (LMCs) — Cambodia, the Lao People’s Democratic Republic (Lao P.D.R.), and Vietnam — with cross-country comparisons and options for further reform.
- Context:
  - Dual challenge: sustainable development from a low-income base and transition from centrally planned to market-based economies.
  - Two-tier banking systems introduced in the late 1980s; state-owned banks continue to dominate in Vietnam and Lao P.D.R.
  - Cambodia’s primary challenge: reconstruct a banking system after decades of civil strife.
- Key systemic features and vulnerabilities:
  - SOCBs account for more than 70 percent of all bank deposits in Vietnam and Lao P.D.R.
  - Cambodia: Foreign Trade Bank (FTB) remained key; lax licensing led to proliferation of weak joint-venture banks that hindered confidence.
  - Legacy of directed lending and weak prudential practices produced high exposure to SOEs and large NPLs in Vietnam and Lao P.D.R.

### Approaches to Banking Reform
- Common objectives across LMCs:
  - Restructure dominant SOCBs and put banks on a commercial footing.
  - Strengthen regulatory, supervisory, and institutional frameworks.
  - Improve accounting and disclosure standards.
- Vietnam — strategy and components:
  - Authorities retained full ownership and control of SOCBs and did not rely on strategic foreign investors.
  - Reform pillars:
    - Phased and conditional recapitalization with public funds, conditional on bank-specific operational and financial reform targets, especially NPL resolution and credit risk management.
    - Phaseout of policy lending.
    - Improved accounting and disclosure through International Accounting Standards (IAS) audits and loan classification aligned with international standards.
    - Phasing-in of prudential standards (e.g., capital adequacy ratios).
  - Note: An 8 percent capital adequacy requirement was adopted in 1999 but not enforced.
- Lao P.D.R. — model, measures, and use of advisors:
  - Modeled on Vietnam’s approach but with less emphasis on internal capacity for change.
  - Immediate measures: credit ceilings, prohibition of lending to defaulting borrowers, commitment to avoid new noncommercial lending.
  - International resident advisors placed in banks to certify that new loans (above certain thresholds) are approved on commercial criteria; advisors cannot prevent noncompliant loans.
  - Advisors assist with transparent loan classification and provisioning; international supervision expert advising the central bank; on-site supervision strengthening part of IMF conditionality.
  - Medium-term measures: phased recapitalization conditional on NPL resolution, potential upgrade of resident advisors to co-managers, consolidation of smaller SOCBs, lifting restrictions on foreign bank competition, opening one SOCB to strategic foreign equity partnership.
- Cambodia — rebuilding a banking system:
  - Reform pillars:
    - Re-license only viable commercial banks under a new banking law, with liquidation of nonviable banks or those failing corrective measures (including higher minimum capital).
    - Strengthen banking supervision via new regulations on capital adequacy and loan classification/provisioning and strengthen National Bank of Cambodia (NBC) supervision capacity, including a resident advisor.
    - Restructure the only SOCB (FTB) by introducing commercial business criteria, appointing an outside director with international banking experience, recapitalizing, and preparing for privatization through invitation to a strategic foreign investor.

### Progress in Banking Reform
- Overall assessment:
  - Cambodia: considerable progress in rebuilding and supervision; banking system health visibly improved though still early stage.
  - Vietnam and Lao P.D.R.: restructuring at an earlier stage; particular difficulty where SOCB-SOE relationships are concerned.
  - Resident advisors in Lao P.D.R. appear relatively effective given smaller problem banks.
- Cleaning up balance sheets and recapitalization:
  - Vietnam:
    - NPLs to SOEs accumulated to D 23 trillion, representing about twice their capital, 5 percent of GDP, and 15 percent of all outstanding credit to the economy by end-2000.
    - About two-thirds of the NPLs were to SOEs.
    - Resolution of collateralized NPLs was sped up and helped meet the first quarterly NPL resolution target in March 2002.
    - SOCBs missed subsequent targets by a wide margin due to failure to resolve uncollateralized NPLs to SOEs.
    - All SOCBs became eligible for state-funded recapitalization; two phases of recapitalization completed by June 2003 provided banks with nonnegotiable recapitalization bonds of D 5.3 trillion (nearly 1 percent of GDP).
    - Cumulative NPL resolution targets cited: March 2002 target: 10% of NPLs; Sept. 2002 target: 25% of NPLs.
  - Lao P.D.R.:
    - NPL ratios ranged from more than 20 percent to about 70 percent across SOCBs; about 70 percent of all NPLs considered state related.
    - Resolution of NPLs is a criterion for phased recapitalization, with criteria pending an assessment of NPL stock.
    - Process to resolve “triangular debt” started in 2003 through debt clearance bonds issued by Ministry of Finance at below-market interest rates.
  - Cambodia:
    - Re-licensing program led to closure of 15 banks; only viable banks re-licensed and higher minimum capital required.
    - The only state bank was recapitalized to meet new capital requirements.
    - Banking system appears well capitalized with an average capital asset ratio (CAR) of over 50 percent in September 2002.
    - Asset quality concerns persist: NPLs still about 12 percent of total loans at end-2002 (based on partial data).
- Putting banks on a commercial footing:
  - Vietnam:
    - SOCBs continue to prioritize asset growth over profitability and capital adequacy.
    - SOCBs allowed interest rate margins to erode by largely refraining from raising lending rates while offering higher deposit rates to finance rapid credit growth.
    - Capital-asset ratios (measured using domestic accounting standards) have declined further (capital measured before injection of recapitalization bonds in 2002 Q3).
    - Some new lending to SOEs shifted to specialized policy-lending institutions (e.g., Development Assistance Fund, DAF), but SOCBs remain the largest SOE credit providers.
  - Lao P.D.R.:
    - Credit growth dropped markedly after stricter lending measures and placement of resident advisors.
    - Resident advisors certify commercial appraisal of new loans above thresholds and assist in credit risk management capacity building.
    - Indications that sharp restraint on credit may be adversely affecting economic activity, although non-SOCB credit continued to grow.
    - Credit policy since March 2002 would limit new lending (except undisbursed loans) if flow NPLs (new NPLs since 2000) exceed 15 percent.
  - Cambodia:
    - FTB separation from NBC (August 2000), Board establishment, and appointment of outside director (June 2001).
    - FTB announced partial privatization plans (January 2003) and seek strategic international investor.
    - System-wide lending limited: loans account for about one-third of banks’ total assets; structural constraints persist (weak corporate sector, absence of reliable borrower information, weak contract enforcement).

### Strengthening accounting standards and audits
- 2001 and 2002 audits at both international and domestic accounting standards were completed by international auditing firms at end-2003, providing an independent assessment of the financial situation of SOCBs and their progress toward reforms.
- Vietnam: improved loan classification standards need to be fully enforced; IAS audits would provide an independent assessment of banks’ performance.
- Lao P.D.R.: recently completed external audits will help improve transparency and resident advisors are expected to help implement the improved accounting standards.
- Measured NPLs to GDP still appears relatively low compared with other transition economies, but paucity of comparable data on NPLs, loan loss provisioning, and capital hampers cost assessment.
- Specific measures:
  - Vietnam: Decision 1627 (December 2001) requires banks to classify the entire loan balance as overdue if any interest and/or principal payment is overdue.
  - Four large SOCBs in Vietnam undergoing IAS audits beginning with year 2000 accounts and instructed to implement initial plans for phasing in loan loss provisions; implementation remains nontransparent.

### Banking supervision and enforcement
- Status and challenges:
  - Vietnam: allocation of supervisory responsibilities among SBV departments is complex and may need simplification; enforcement mechanisms where banks violate prudential and other regulations need to be tightened; SBV’s co-ownership function at the SOCBs may undermine credibility of enforcement.
  - Lao P.D.R.: strengthening on- and off-site inspections to monitor bank developments in a timely manner is part of the overall reform strategy but pending specific measures of implementation and enforcement.
  - Cambodia: comprehensive legal changes (new central bank and financial institutions law), detailed prudential regulations (capital adequacy, liquidity, exposure limits, loan classification and provisioning), regulations on prompt corrective action, and standardized manuals for off-site and on-site inspections have been implemented; re-licensing completed; technical assistance and increased staff resources have supported gradual enhancement of supervisory activities.

### International comparison with transition economies and China
- Intermediation and structure:
  - Macroeconomic stability and rapid monetization have led to bank intermediation in Vietnam that is well above the two other LMCs and many transition economies.
  - Controlling for stage of development, Vietnam’s intermediation levels are comparable with China.
  - Intermediation levels in Lao P.D.R. and Cambodia have remained relatively low, reflecting limited access to banking services in rural areas and limited confidence; high levels of dollarization remain.
- Similarities and differences with China:
  - Gradual reforms, strong growth, relative macroeconomic stability → high bank intermediation in China and Vietnam.
  - Significant NPLs in state enterprise sector in China and Vietnam.
  - China adopted in 2002 a five-tier loan classification system and phased-in provisioning and transferred a significant portion of NPLs to a centralized Asset Management Company (AMC); Vietnam and Lao P.D.R. leave NPL resolution largely the responsibility of individual banks.
  - Experience suggests AMC success in reducing reform cost is mixed.
- Cost of banking reform:
  - Appears relatively modest for the lower Mekong countries but could rise significantly with delays in reforms.
  - Ultimate cost depends on credibility and timeliness of hard budget constraints on banks and the corporate sector, reforms in bank management, profit orientation, enhanced credit risk management, governance, and regulatory framework.
  - Delays in addressing structural weaknesses, especially at the interface to the corporate sector, likely increase the ultimate cost of reform.

### Challenges — Maintaining reform momentum and policy recommendations
- Core reforms required:
  - Strengthen incentives for managers and staff to ensure commercially based decision making:
    - Governments should set explicit performance benchmarks and compensate management and staff accordingly.
    - Performance should be based in particular on profits after adequate provisioning for risks and nonperforming loans.
    - Vietnam’s current compensation scheme rewards balance-sheet growth while not penalizing risky businesses; SOCB managers’ salary tied to enterprise size and some profit-related portion unadjusted for risks.
    - Curtail political influence on banks, including by party committees and agencies at the local level.
  - Build capabilities for sound commercial decision making, especially improved credit risk management:
    - Twinning arrangements with internationally reputable partners could transfer management know-how.
    - Strengthen training of thousands of credit officers and managers, including through increased technical assistance.
    - Resident advisors in Lao P.D.R. are already in place to certify loans are extended on commercial criteria.
  - Strengthen creditor rights and provide banks with more effective means to resolve NPLs, especially loss-making SOEs:
    - Progress in reforming the banking system depends on progress in reforming the state enterprise sector and enforcement of hard budget constraints, particularly in Vietnam.
- Measures to create a more conducive environment:
  - Create a level competitive playing field:
    - Current framework in Vietnam and Lao P.D.R. restricts the type of deposits foreign bank branches can offer, the branch network, and the acquisition of domestic banks.
    - Vietnamese commitments under the USBTA would phase out competitive restrictions on U.S. banks; these should apply to all foreign banks to promote a more competitive domestic banking environment.
    - Most important concessions under the USBTA include: (1) phase-in of national treatment in the dong deposit market; (2) national treatment in equity participation in privatized SOCBs; and (3) majority foreign ownership of banking institution after three years of the agreement.
  - Strengthen bank supervision: Without improved supervision, progress in bank restructuring cannot be independently assessed, undermining reform incentives.
  - Strengthen accounting standards: Banks’ recapitalization needs should be based on the IAS accounts to transparently reflect the past and future cost of their operations to taxpayers and increase accountability.
- Cambodia-specific recommendations to promote financial intermediation:
  - Develop a system of reliable borrower information, requiring firms to use a common set of accounting standards and produce financial statements.
  - Strengthen contract enforcement.
  - Improve availability of financial services in rural areas.
  - Upgrade the FTB’s management, including eventual privatization.
  - These challenges are recognized in the NBC’s Financial Sector Blueprint for 2001–10.

### Concluding remarks
- In Lao P.D.R. and Vietnam, SOCBs remain wholly state owned and transition to commercially oriented banks relies essentially on internal resources and credibility of government-set incentives.
- Reinforcing efforts already emerges in Vietnam in three critical areas:
  - (1) Strengthening incentives for reform of banks and their management, including through performance contracts and strict recapitalization conditions;
  - (2) Improving credit risk management in line with international practice, supported by substantial technical assistance (including through twinning arrangements);
  - (3) Providing banks with more effective mechanisms to resolve NPLs.
- Without these changes, Vietnam’s banking sector problems are likely to grow further (China’s example).
- Lao P.D.R. progress is facilitated by relatively limited role of SOEs and smaller bank size, allowing resident advisors to put SOCBs on a commercial footing and strengthen accounting frameworks.
- Moving beyond current approaches in Vietnam and Lao P.D.R. would likely entail privatization of a large SOCB by seeking a strategic foreign equity partner, an approach under consideration in China.
- Cambodia’s challenge is to continue developing a commercial banking system that promotes efficient investment and growth.

### Key statistics (selected figures quoted in text and tables)
- The Lower Mekong Countries and China—Selected Banking Indicators in 2003:
  - Total credit to GDP: China 165.55; Vietnam 51.8; Lao P.D.R. 11.1; Cambodia 8.0
  - NPLs to GDP: China 20.6; Vietnam 7.8; Lao P.D.R. 3.0; Cambodia 1.1
- From Table 1 (As of end-2003; or latest date available):
  - Breakup of monobank system: Vietnam 1989; Cambodia 1989; Lao P.D.R. 1989; China 1984
  - Number of state-owned commercial banks (SOCBs): Vietnam 6; Cambodia 1; Lao P.D.R. 2; China 4
  - Number of joint-stock banks: Vietnam 35; Cambodia 3; Lao P.D.R. 3; China 11
  - Number of foreign banks 2/: Vietnam 29; Cambodia 9; Lao P.D.R. 8; China 13
  - Market share of SOCBs in percent of credit to the economy: Vietnam 72.6; Cambodia 9.5; Lao P.D.R. 53.5; China 55.8
  - Market share of SOCBs in percent of credit to state-owned enterprises (SOE): Vietnam 91.1; Cambodia 0; Lao P.D.R. 74.1; China 0
  - Market share of SOCBs in percent of total deposits: Vietnam 74.0; Cambodia 19.3; Lao P.D.R. 73.6; China 58.6
  - Total deposits (in percent of GDP): Vietnam 56.0; Cambodia 14.4; Lao P.D.R. 17.2; China 182.8
  - Credit to the economy 3/ (in percent of GDP): Vietnam 51.8; Cambodia 8.0; Lao P.D.R. 11.1; China 165.5
  - Credit to SOEs (in percent of GDP): Vietnam 17.1; Cambodia 0; Lao P.D.R. 0; China 4.4
  - Credit to the private sector (in percent of GDP): Vietnam 34.7; Cambodia 8.0; Lao P.D.R. 6.7; China 0
  - Nonperforming loans (NPLs) 4/ (in percent of GDP): Vietnam 7.8; Cambodia 1.1; Lao P.D.R. 3.0; China 20.6
  - Average annual credit growth 5/: Vietnam 25.9; Cambodia 15.6; Lao P.D.R. 30.0; China 18.4
  - Government revenues (memorandum item): Vietnam 22.9; Cambodia 10.4; Lao P.D.R. 10.9; China 18.6
- From Table 2 (selected qualitative assessment for Vietnam):
  - SOCBs dominate system (more than 70 percent of credit); more than 20 foreign banks and more than 30 semi-private joint-stock banks compete in niche markets.
  - NPLs at 4 dominant SOCBs representing about 15 percent of loans in 2000, or about 5 percent of GDP.
  - Tentative recapitalization estimates range between 4 percent and 7 percent of GDP.
  - SOCBs subject to IAS audits; loan classification enhanced and adequate provisioning to be phased in.
  - Capital adequacy: 8 percent; adopted in 1999 but not enforced for SOCBs; supervisors unable to make risk-weighted assessment.

### Country snapshots and selected indicators
- Cambodia:
  - 1999: 2 SOCBs, 7 foreign banks, 22 private banks.
  - Following restructuring: 1 SOCB, 3 foreign banks, 9 private banks, and 4 specialized institutions.
  - Estimated cost of bank restructuring (November 2003): about 0.46 percent of the average nominal GDP in 2002–03 (US$3,851 million).
  - One remaining SOCB (Foreign Trade Bank) fully recapitalized to meet minimum capital requirement (US$13 million).
  - Average CAR for restructured banks about 54 percent in 2002; loans account for about one-third of banks’ total assets.
  - NPLs about 12 percent of total loans at end-2002 (based on partial data).
- Lao P.D.R.:
  - Two SOCBs dominate the banking system, representing about three quarters of total bank deposits and nearly 60 percent of total bank credit.
  - First recapitalization in mid-1990s not linked to operational restructuring, resulting in increasing NPLs, about 70 percent state-related.
  - Phased and conditional recapitalization through 2002–05, with the threat being replacement of management and enhanced role for international advisors.
  - International advisors ensure implementation of loan classification in line with international standards. SOCBs are subject to IAS audits.
  - Capital adequacy target: 8 percent; prudential regulations and standards to be raised/phased in gradually.
- China (for comparison):
  - At end-2001 NPLs of state-owned banks averaged more than 30 percent of total loans (excluding 14 percent of loans transferred to AMCs in 1999–2000).
  - 1999–2000 transfer of 14 percent of total (about 17 percent of GDP) loans to an AMC.
  - Adoption in 2002 of new loan classification and phased-in provisioning approaching international standards.
  - Capital adequacy adopted as targets (8 percent) with the Commercial Bank Law in 1995; risk weights generally consistent with the Basle Capital Accord except for treatment of large SOEs.

*Source: IMF Policy Discussion Paper PDP/04/5, “Banking Reform in the Lower Mekong Countries,” Prepared by Olaf Unteroberdoerster, September 2004.*

### Section 1

### Banking Reform in the Lower Mekong Countries

### Introduction
- Scope: review of recent banking reform efforts in the lower Mekong countries (LMCs) — Cambodia, the Lao People’s Democratic Republic (Lao P.D.R.), and Vietnam — with cross-country comparisons and options for further reform.
- Context:
  - Dual challenge: sustainable development from a low-income base and transition from centrally planned to market-based economies.
  - Two-tier banking systems introduced in the late 1980s; state-owned banks continue to dominate in Vietnam and Lao P.D.R.
  - Cambodia’s primary challenge: reconstruct a banking system after decades of civil strife.
- Key systemic features and vulnerabilities:
  - SOCBs (state-owned commercial banks) account for more than 70 percent of all bank deposits in Vietnam and Lao P.D.R.
  - Cambodia: Foreign Trade Bank (FTB) remained key; lax licensing led to proliferation of weak joint-venture banks that hindered confidence.
  - Legacy of directed lending and weak prudential practices produced high exposure to SOEs and large NPLs in Vietnam and Lao P.D.R.

### Approaches to Banking Reform
- Common objectives across LMCs:
  - Restructure dominant SOCBs and put banks on a commercial footing.
  - Strengthen regulatory, supervisory, and institutional frameworks.
  - Improve accounting and disclosure standards.
- Vietnam: strategy and components
  - Authorities decided to retain full ownership and control of SOCBs and not rely on strategic foreign investors.
  - Reform pillars:
    - Phased and conditional recapitalization with public funds, conditional on bank-specific operational and financial reform targets, especially NPL resolution and credit risk management.
    - Phaseout of policy lending.
    - Improved accounting and disclosure through International Accounting Standards (IAS) audits and loan classification aligned with international standards.
    - Phasing-in of prudential standards (e.g., capital adequacy ratios).
  - Note: An 8 percent capital adequacy requirement was adopted in 1999 but not enforced.
- Lao P.D.R.: model, measures, and use of advisors
  - Modeled on Vietnam’s approach but with less emphasis on internal capacity for change.
  - Immediate measures: credit ceilings, prohibition of lending to defaulting borrowers, commitment to avoid new noncommercial lending.
  - International resident advisors placed in banks to certify that new loans (above certain thresholds) are approved on commercial criteria; advisors cannot prevent noncompliant loans.
  - Advisors also assist with transparent loan classification and provisioning; international supervision expert advising the central bank; on-site supervision strengthening part of IMF conditionality.
  - Medium-term measures: phased recapitalization conditional on NPL resolution, potential upgrade of resident advisors to co-managers, consolidation of smaller SOCBs, lifting restrictions on foreign bank competition, opening one SOCB to strategic foreign equity partnership.
- Cambodia: rebuilding a banking system
  - Reform pillars:
    - Re-license only viable commercial banks under a new banking law, with liquidation of nonviable banks or those failing corrective measures (including higher minimum capital).
    - Strengthen banking supervision via new regulations on capital adequacy and loan classification/provisioning and strengthen National Bank of Cambodia (NBC) supervision capacity, including a resident advisor.
    - Restructure the only SOCB (FTB) by introducing commercial business criteria, appointing an outside director with international banking experience, recapitalizing, and preparing for privatization through invitation to a strategic foreign investor.

### Progress in Banking Reform
- Overall assessment:
  - Cambodia: considerable progress in rebuilding and supervision; banking system health visibly improved though still early stage.
  - Vietnam and Lao P.D.R.: restructuring at an earlier stage; particular difficulty where SOCB-SOE relationships are concerned.
  - Resident advisors in Lao P.D.R. appear relatively effective given smaller problem banks.
- Cleaning up balance sheets and recapitalization
  - Vietnam:
    - NPLs to SOEs accumulated to D 23 trillion, representing about twice their capital, 5 percent of GDP, and 15 percent of all outstanding credit to the economy by end-2000.
    - About two-thirds of the NPLs were to SOEs.
    - Resolution of collateralized NPLs was sped up (e.g., permitting banks to bypass state auction center) and helped meet the first quarterly NPL resolution target in March 2002.
    - SOCBs missed subsequent targets by a wide margin due to failure to resolve uncollateralized NPLs to SOEs.
    - All SOCBs became eligible for state-funded recapitalization; incentives for reform diluted by continued government ownership.
    - Two phases of recapitalization completed by June 2003 provided banks with nonnegotiable recapitalization bonds of D 5.3 trillion (nearly 1 percent of GDP).
    - Vietnam: cumulative NPL resolution targets cited: March 2002 target: 10% of NPLs; Sept. 2002 target: 25% of NPLs.
  - Lao P.D.R.:
    - NPL ratios ranged from more than 20 percent to about 70 percent across SOCBs; about 70 percent of all NPLs considered state related (lent to SOEs or for policy purposes).
    - Resolution of NPLs is a criterion for phased recapitalization, but setting criteria pending an assessment of NPL stock.
    - Process to resolve “triangular debt” (government arrears to banks’ SOE borrowers) started in 2003 through debt clearance bonds issued by Ministry of Finance at below-market interest rates.
  - Cambodia:
    - Re-licensing program led to closure of 15 banks; only viable banks re-licensed and higher minimum capital required.
    - The only state bank was recapitalized to meet new capital requirements.
    - Banking system appears well capitalized with an average capital asset ratio (CAR) of over 50 percent in September 2002.
    - Asset quality concerns persist: NPLs still about 12 percent of total loans at end-2002 (based on partial data).
- Putting banks on a commercial footing
  - Vietnam:
    - SOCBs continue to prioritize asset growth over profitability and capital adequacy.
    - SOCBs allowed interest rate margins to erode by largely refraining from raising lending rates while offering higher deposit rates to finance rapid credit growth.
    - Capital-asset ratios (measured using domestic accounting standards) have declined further (capital measured before injection of recapitalization bonds in 2002 Q3).
    - Some new lending to SOEs shifted to specialized policy-lending institutions (e.g., Development Assistance Fund, DAF), but SOCBs remain the largest SOE credit providers.
  - Lao P.D.R.:
    - Credit growth dropped markedly after stricter lending measures and placement of resident advisors.
    - Resident advisors certify commercial appraisal of new loans above thresholds and assist in credit risk management capacity building.
    - Indications that sharp restraint on credit may be adversely affecting economic activity, although non-SOCB credit continued to grow.
    - Credit policy since March 2002 would limit new lending (except undisbursed loans) if flow NPLs (new NPLs since 2000) exceed 15 percent.
  - Cambodia:
    - FTB separation from NBC (August 2000), Board establishment, and appointment of outside director (June 2001).
    - FTB announced partial privatization plans (January 2003) and seek strategic international investor.
    - System-wide lending limited: loans account for about one-third of banks’ total assets; structural constraints persist (weak corporate sector, absence of reliable borrower information, weak contract enforcement).
- Improving regulatory framework, accounting standards, and banking supervision
  - Loan classification and IAS audits:
    - Vietnam: Decision 1627 (December 2001) requires banks to classify the entire loan balance as overdue if any interest and/or principal payment is overdue.
    - The four large SOCBs have been undergoing IAS audits beginning with year 2000 accounts and were instructed to implement initial plans for phasing in loan loss provisions.
    - Implementation remains nontransparent and plans to address key IAS audit qualifications have not yet been carried out.
  - Lao P.D.R.:
    - Adequate loan classification standards already in place; resident advisors instrumental in aligning banks’ accounting practices with these standards.
  - Cambodia:
    - New regulations on capital adequacy and loan classification/provisioning; strengthened NBC supervision capacity with resident advisor.

*Source: IMF Policy Discussion Paper PDP/04/5, “Banking Reform in the Lower Mekong Countries,” Prepared by Olaf Unteroberdoerster, September 2004.*

### Section 2

### _pdp05 - Section 2

### Strengthening accounting standards and audits
- 2001 and 2002 audits at both international and domestic accounting standards were completed by international auditing firms at end-2003, providing an independent assessment of the financial situation of SOCBs and their progress toward reforms.
- In Vietnam, improved loan classification standards need to be fully enforced; IAS audits would provide an independent assessment of banks’ performance.
- In Lao P.D.R., recently completed external audits will help improve transparency and resident advisors are expected to help implement the improved accounting standards.
- Measured NPLs to GDP still appears relatively low compared with other transition economies, but paucity of comparable data on NPLs, loan loss provisioning, and capital hampers cost assessment.

### Banking supervision and enforcement
- Efforts to strengthen banking supervision are still at an early stage:
  - In Vietnam, allocation of supervisory responsibilities among SBV departments is complex and may need simplification.
  - Enforcement mechanisms where banks violate prudential and other regulations need to be tightened.
  - SBV’s co-ownership function at the SOCBs may undermine credibility of enforcement.
  - In Lao P.D.R., strengthening on- and off-site inspections to monitor bank developments in a timely manner is part of the overall reform strategy but pending specific measures of implementation and enforcement.
- Cambodia: comprehensive legal changes (new central bank and financial institutions law), detailed prudential regulations (capital adequacy, liquidity, exposure limits, loan classification and provisioning), regulations on prompt corrective action, and standardized manuals for off-site and on-site inspections have been implemented; re-licensing completed, substantial technical assistance and increased staff resources have supported gradual enhancement of supervisory activities.

### International comparison with transition economies and China
- Macroeconomic stability and rapid monetization have led to bank intermediation in Vietnam that is well above the two other LMCs and many transition economies.
- Controlling for stage of development, Vietnam’s intermediation levels are comparable with China, which have consistently exceeded by far those of other transition economies.
- Intermediation levels in Lao P.D.R. and Cambodia have remained relatively low, reflecting limited access to banking services in rural areas and limited confidence in the banking system; high levels of dollarization remain.
- State-owned banks with weak lending practices and limited accounting and supervisory standards are common in Vietnam, Lao P.D.R., and many CIS countries; Cambodia resembles more the successful reformers of Central and Eastern Europe due to vigorous implementation of regulatory and supervisory frameworks and opening the banking sector to foreign private investors.
- China similarity:
  - Gradual reforms, strong growth, relative macroeconomic stability → high bank intermediation.
  - Significant NPLs in state enterprise sector in China and Vietnam.
  - China adopted in 2002 a five-tier loan classification system and phased-in provisioning.
  - China transferred a significant portion of NPLs to a centralized Asset Management Company (AMC); Vietnam and Lao P.D.R. have NPL resolution remaining the responsibility of individual banks.
  - Experience suggests AMC success in reducing reform cost is mixed.
- Cost of banking reform:
  - Appears relatively modest for the lower Mekong countries but could rise significantly with delays in reforms.
  - Ultimate cost depends on credibility and timeliness of hard budget constraints on banks and the corporate sector, reforms in bank management, profit orientation, enhanced credit risk management, governance, and regulatory framework.
  - Delays in addressing structural weaknesses, especially at the interface to the corporate sector, likely increase the ultimate cost of reform.

### Challenges — Maintaining reform momentum and policy recommendations
- Core reforms required (emphasized for Vietnam, to a lesser extent Lao P.D.R.):
  - Strengthen incentives for managers and staff to ensure commercially based decision making:
    - Governments should set explicit performance benchmarks and compensate management and staff accordingly.
    - Performance should be based in particular on profits after adequate provisioning for risks and nonperforming loans.
    - Vietnam’s current compensation scheme rewards balance-sheet growth while not penalizing risky businesses; SOCB managers’ salary tied to enterprise size and some profit-related portion unadjusted for risks.
    - Curtail political influence on banks, including by party committees and agencies at the local level.
  - Build capabilities for sound commercial decision making, especially improved credit risk management:
    - Twinning arrangements with internationally reputable partners could transfer management know-how.
    - Strengthen training of thousands of credit officers and managers, including through increased technical assistance.
    - Resident advisors in Lao P.D.R. are already in place to certify loans are extended on commercial criteria.
  - Strengthen creditor rights and provide banks with more effective means to resolve NPLs, especially loss-making SOEs:
    - Efforts to reform the banking system depend on progress in reforming the state enterprise sector and enforcement of hard budget constraints, particularly in Vietnam.
- Measures to create a more conducive environment:
  - Create a level competitive playing field:
    - Current framework in Vietnam and Lao P.D.R. restricts the type of deposits foreign bank branches can offer, the branch network, and the acquisition of domestic banks.
    - Vietnamese commitments under the USBTA would phase out competitive restrictions on U.S. banks; these should apply to all foreign banks to promote a more competitive domestic banking environment.
    - Most important concessions under the USBTA include: (1) phase-in of national treatment in the dong deposit market; (2) national treatment in equity participation in privatized SOCBs; and (3) majority foreign ownership of banking institution after three years of the agreement.
  - Strengthen bank supervision:
    - Without improved supervision, progress in bank restructuring cannot be independently assessed, undermining reform incentives.
  - Strengthen accounting standards:
    - As long as banks can hide problems, incentives for reform will remain ineffective.
    - Banks’ recapitalization needs should be based on the IAS accounts to transparently reflect the past and future cost of their operations to taxpayers and increase accountability.

- Cambodia-specific recommendations to promote financial intermediation:
  - Develop a system of reliable borrower information, requiring firms to use a common set of accounting standards and produce financial statements.
  - Strengthen contract enforcement.
  - Improve availability of financial services in rural areas.
  - Upgrade the FTB’s management, including eventual privatization.
  - These challenges are recognized in the NBC’s Financial Sector Blueprint for 2001–10.

### Concluding remarks
- In Lao P.D.R. and Vietnam, SOCBs remain wholly state owned and transition to commercially oriented banks relies essentially on internal resources and credibility of government-set incentives.
- Reinforcing efforts already emerges in Vietnam in three critical areas:
  - (1) Strengthening incentives for reform of banks and their management, including through performance contracts and strict recapitalization conditions;
  - (2) Improving credit risk management in line with international practice, supported by substantial technical assistance (including through twinning arrangements);
  - (3) Providing banks with more effective mechanisms to resolve NPLs.
- Without these changes, Vietnam’s banking sector problems are likely to grow further (China’s example).
- Lao P.D.R. progress is facilitated by relatively limited role of SOEs and smaller bank size, allowing resident advisors to put SOCBs on a commercial footing and strengthen accounting frameworks.
- Moving beyond current approaches in Vietnam and Lao P.D.R. would likely entail privatization of a large SOCB by seeking a strategic foreign equity partner, an approach under consideration in China.
- Cambodia’s challenge is to continue developing a commercial banking system that promotes efficient investment and growth.

### Key statistics (selected figures quoted in text and tables)
- The Lower Mekong Countries and China—Selected Banking Indicators in 2003:
  - Total credit to GDP: China 165.55; Vietnam 51.8; Lao P.D.R. 11.1; Cambodia 8.0
  - NPLs to GDP: China 20.6; Vietnam 7.8; Lao P.D.R. 3.0; Cambodia 1.1
- From Table 1 (As of end-2003; or latest date available):
  - Breakup of monobank system: Vietnam 1989; Cambodia 1989; Lao P.D.R. 1989; China 1984
  - Number of state-owned commercial banks (SOCBs): Vietnam 6; Cambodia 1; Lao P.D.R. 2; China 4
  - Number of joint-stock banks: Vietnam 35; Cambodia 3; Lao P.D.R. 3; China 11
  - Number of foreign banks 2/: Vietnam 29; Cambodia 9; Lao P.D.R. 8; China 13
  - Market share of SOCBs in percent of credit to the economy: Vietnam 72.6; Cambodia 9.5; Lao P.D.R. 53.5; China 55.8
  - Market share of SOCBs in percent of credit to state-owned enterprises (SOE): Vietnam 91.1; Cambodia 0; Lao P.D.R. 74.1; China 0
  - Market share of SOCBs in percent of total deposits: Vietnam 74.0; Cambodia 19.3; Lao P.D.R. 73.6; China 58.6
  - Total deposits (in percent of GDP): Vietnam 56.0; Cambodia 14.4; Lao P.D.R. 17.2; China 182.8
  - Credit to the economy 3/ (in percent of GDP): Vietnam 51.8; Cambodia 8.0; Lao P.D.R. 11.1; China 165.5
  - Credit to SOEs (in percent of GDP): Vietnam 17.1; Cambodia 0; Lao P.D.R. 0; China 4.4
  - Credit to the private sector (in percent of GDP): Vietnam 34.7; Cambodia 8.0; Lao P.D.R. 6.7; China 0
  - Nonperforming loans (NPLs) 4/ (in percent of GDP): Vietnam 7.8; Cambodia 1.1; Lao P.D.R. 3.0; China 20.6
  - Average annual credit growth 5/: Vietnam 25.9; Cambodia 15.6; Lao P.D.R. 30.0; China 18.4
  - Government revenues (memorandum item): Vietnam 22.9; Cambodia 10.4; Lao P.D.R. 10.9; China 18.6
- From Table 2 (selected qualitative assessment for Vietnam):
  - SOCBs dominate system (more than 70 percent of credit); more than 20 foreign banks and more than 30 semi-private joint-stock banks compete in niche markets.
  - NPLs at 4 dominant SOCBs representing about 15 percent of loans in 2000, or about 5 percent of GDP.
  - Tentative recapitalization estimates range between 4 percent and 7 percent of GDP.
  - SOCBs subject to IAS audits; loan classification enhanced and adequate provisioning to be phased in.
  - Capital adequacy: 8 percent; adopted in 1999 but not enforced for SOCBs; supervisors unable to make risk-weighted assessment.

*Source: _pdp05 - Section 2 (IMF PDF chapter).*

### Section 3

### _pdp05 - Section 3

### Cambodia — Incidence and State of Transition
- In 1999, there were 2 SOCBs, 7 foreign banks, and 22 private banks.
- Following restructuring, there are 1 SOCB, 3 foreign banks, 9 private banks, and 4 specialized institutions.
- Rapid increase in number of weak banks due to lax licensing requirements combined with macro-instability resulted in loss of confidence and marginal levels of bank intermediation.
- In November 2003, the estimated cost of bank restructuring was about 0.46 percent of the average nominal GDP in 2002–03 (US$3,851 million).
- One remaining SOCB (Foreing Trade Bank) fully recapitalized to meet minimum capital requirement (US$13 million).
- One remaining SOCB (Foreign Trade Bank) was legally separated from NBC in December 2000, and an outside director appointed to the Board in 2001. The process to seek foreign strategic equity partner started in January 2003.
- One remaining SOCB (Foreign Trade Bank) subject to a program external audits with a view to remove qualifications.
- 20 percent; due to stricter prudential regulation, in particular increase in capital requirements, average CAR for restructured banks about 54 percent in 2002.
- Nearly completed.

### Cambodia — Market Structure and Outcomes
- Market structure: one remaining SOCB, multiple foreign and private banks, and specialized institutions as above.
- Outcome: stronger prudential regulation and much higher reported capital adequacy for restructured banks (about 54 percent in 2002).

### Lao P.D.R. — Incidence and State of Transition
- Two SOCBs dominate the banking system, representing about three quarters of total bank deposits and nearly 60 percent of total bank credit.
- First recapitalization in mid-1990s not linked to operational restructuring, resulting in increasing NPLs, about 70 percent state-related.
- Not available. (Cost of bank restructuring not available in source.)
- Phased and conditional through 2002–05, with the threat being replacement of management and enhanced role for international advisors.
- Two smaller SOCBs were consolidated with a view to seek strategic equity partner for one of the two remaining nationwide SOCBs over the medium term.
- International advisors ensure implementation of loan classification in line with international standards. SOCBs are subject to IAS audits.
- 8 percent. Overall, prudential regulations and standards to be raised/phased in gradually.
- State banks continue to dominate banking system, but their share has been declining.

### China — Incidence and State of Transition
- At end-2001 NPLs of state-owned banks (two-thirds of the financial system) averaged more than 30 percent of total loans (excluding 14 percent of loans transferred to AMCs in 1999–2000).
- Not available. (Cost of bank restructuring not available in source.)
- In 1999–2000 transfer of 14 percent of total (about 17 percent of GDP) loans to an AMC. Other capital injections not strictly linked to improved efficiency.
- Not applicable. (State of transition entry labeled not applicable in source.)
- Adoption in 2002 of new loan classification and phased-in provisioning approaching international standards.
- Adoption as targets (8 percent) with the Commercial Bank Law in 1995; riks weights generally consistent with the Basle Capital Accord except for treatment of large SOEs.
- State banks continue to dominate banking sector with gradual improvements in NPL resolution and operational efficiency, while interest rates remain partly administered.

### Cross-Country Indicators (as presented in figures)
- Figures presented: Banking System Performance in Selected Transition Economies, Total Deposits (In percent of GDP), Lending to Private Sector (In percent of GDP), Interest Rate Spread (lending rate minus deposit rate in local currency).
- Notes from figures: data series reference years 1996–2001; some latest available data pertain to 1999; certain definitional notes (e.g., defined as lending to non-SOEs; credit of state-banks to non-SOEs in 1996 and 2000).

*Source: _pdp05 - Section 3 (extracted content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2004/_pdp05.pdf_