## _cr0564

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---

### Key systemic concerns and macro vulnerabilities
- Governance and ownership:
  - Growing role of the government in the banking and insurance system creates governance problems.
  - Opaque ownership of financial institutions and corporations; near-absence of fit-and-proper strategic investors.
  - Cross-ownership: some owners or banks also hold major shares in several insurance companies.
  - Supervisors (NBM) hampered by extraneous, oftentimes political constraints and difficulty obtaining useful information about some ultimate beneficial owners of banks.
  - Shareholders control nearly 40 percent of the banking system assets, including the assets of one systemic bank, and may be beyond the reach of the regulator.
- Macroeconomic and external exposures:
  - Direct financing of the state budget by the central bank against a weak fiscal and external situation endangers NBM independence.
  - Workers’ remittances officially estimated at almost 24 percent of GDP in 2003; remittances financed consumption-driven GDP expansion, rapid import growth, and widening trade deficit.
  - Dollarization combined with significant exchange rate volatility: foreign currency deposits to total deposits = 45 percent; foreign exchange lending ≈ 42 percent of total loans.
  - Exchange rate appreciation pressure from remittances: 2003 leu appreciation 4.5 percent vis-à-vis the dollar; 2004 staff estimate of almost 13 percent appreciation vis-à-vis the dollar and appreciation against a trade weighted currency basket.
- Monetary and fiscal policy interactions:
  - In May 2004 authorities required direct financing from the NBM totalling MDL 600 million to finance sovereign external debt payments.
  - Recommendation to tighten conditions for NBM lending to government, if not to prohibit; fiscal consolidation and appropriate debt management are prerequisites for effective monetary policy.

### Banking sector structure, capitalization, and market features
- Structure and ownership:
  - Sixteen Moldovan banks, all joint-stock companies.
  - One bank (the second largest) is state-owned with a 56 percent share.
  - Five banks are majority domestic-owned.
  - Three banks are 100 percent foreign owned.
  - Remaining banks are majority offshore owned or have controlling minority offshore owners; no offshore shareholder exceeds the 10 percent threshold that requires NBM approval.
- Capitalization and consolidation policy:
  - NBM progressively increasing minimum capital levels to MDL 150 million (about US$12 million) from MDL 96 million to stimulate mergers.
- Insurance sector:
  - Number of insurance companies = 50.
  - Gross premium income in 2003 = MDL 290 million; more than 98 percent was nonlife business.
- SMEs, leasing, microfinance:
  - Virtually all loans with maturities > one year are financed by international donors.
  - Leasing industry underdeveloped.
  - SCAs: network of 530 Savings and Credit Associations; SCAs’ aggregate loan portfolio grew by 62 percent and savings by 181 percent in 2003.
  - SCAs supervised by the State Supervision Board (SSB) in the Ministry of Finance; SSB needs considerable strengthening.

### Performance indicators, liquidity, and dollarization
- Asset, deposit, and loan growth:
  - Total deposits rose from MDL 1 billion to MDL 6.9 billion from 1999 through 2003.
  - Growth of loans during 1999–2003: about 250 percent.
  - Total loans increased from MDL 1.6 billion to MDL 6.1 billion since 1999.
  - Loans at the state-owned bank grew by 932 percent over this period.
- Liquidity and holdings:
  - Banks hold 75 percent of all government securities (about 6.5 percent of their total assets).
  - Banks’ liquidity has remained well above prudential requirements for the past five years; excess reserves on accounts at NBM are substantial and unremunerated.
- Nonperforming loans and provisioning:
  - Reported NPLs in categories C, D and E = 6.2 percent of total loans at year-end 2003.
  - Smaller banks’ NPL rate = 12.7 percent.
  - NBM loan classification Category B requires only a 5 percent provision; such classified loans represent 35.3 percent of total loans.
  - Year-end 2003 loan loss provisions cover 89 percent of nonperforming loans (C, D and E categories).
- Dollarization:
  - Dollarization remained just under half of total assets and deposits over the past five years.
- Selected financial soundness indicators (selected values):
  - Regulatory capital as percent of risk-weighted assets: 2003 = 31.8
  - Capital (net worth) as percent of assets: 2003 = 21.1
  - NPLs as percent of gross loans: 2003 = 6.2
  - Gross profits as percent of assets (ROA): 2003 = 4.5
  - Gross profits as percent of equity capital (ROE): 2003 = 20.3

### Stress testing, scenario results, and identified vulnerabilities
- Baseline and scenario CARs (as of December 31, 2003):
  - Baseline CAR (Total) = 31.8
  - Overall credit risk: CAR = 23.2; Number of banks below 12% CAR = 2
  - Shock to fuel and gas prices: CAR = 26.0; Number of banks below 12% CAR = 2
  - Indirect effect of deterioration of credit quality (exchange rate risk): CAR = 22.2; Number of banks below 12% CAR = 2
  - Direct effect of 10 percentage point rise in interest rate on CAR: CAR = 32.1; Number of banks below 12% CAR = 0
  - Combined effects of exchange rate depreciation and interest rate increases: CAR = 20.9; Number of banks below 12% CAR = 2
  - Additional effect of illiquidity of government securities (realization value of 50 percent of government securities): CAR = 15.5; Number of banks below 12% CAR = 6
- Key stress-test findings:
  - Credit risk is the major source of vulnerability; two banks (one holding 14 percent of total assets) can fall below the 12 percent CAR under severe generic credit-risk migration.
  - Sector most vulnerable to large exchange rate shocks (e.g., 40 percent nominal appreciation/depreciation scenarios), especially via indirect credit-quality deterioration due to foreign-currency lending.
  - Combined crisis scenario (depreciations of 40 percent USD and euro; 20 percent Russian ruble; NPLs rise to 39 percent): CAR would decline by 11 percentage points and two banks would fall below 12 percent CAR.
  - Adding illiquidity of government securities with 50 percent realization value reduces CAR further (additional 5.4 percentage points), pushing six banks below 12 percent CAR and CAR of group 1 to 9.2 percent.

### Ownership, governance, and supervisory shortcomings
- Ownership disclosure and insider risks:
  - Of fifteen privately held banks, five have majority shareholders owning 9.9 percent or smaller stakes; at least two other banks have more than 30 percent of capital in separate shareholdings < 9.9 percent each.
  - Seven banks with dispersed ownership are more susceptible to insider abuses and potentially money laundering; these smaller banks show sharply lower ROAs and ROEs, higher NPL levels, and heavy loan concentrations.
  - As of end-2003 three of the five smallest banks exceeded prudential limits for large borrowers, prompting NBM remedial requirements.
- State-owned bank concerns:
  - Ten-fold increase of its loan book over five years.
  - Concentration of state-owned enterprise borrowers and placement of substantial public deposits at below market rates.
  - Recent majority stake acquisition of an insurer; governance weaknesses (abrupt changes in board membership and oversight ministry).
  - Government decision to require joint-stock companies to pay a 30 percent dividend will reduce capitalization levels at all banks.
  - Recommended: time-bound corrective action plan, full evaluation of risk management and business plan, and government-developed privatization strategy.
- Bank-owned insurers and information gaps:
  - NBM lacks regular access to data on insurers’ financial condition, reserves, and risks covered.
  - Recommended safeguards: banks set aside reserves at least equal to their investment in insurer subsidiaries until transparent reporting is available; MOF to agree comprehensive information-sharing with NBM.
- Supervisory authority and legal gaps:
  - Supervisor approval limited to shareholdings of 10 percent or higher; recommendation to decrease limit to 5 percent.
  - NBM has adequate powers to deal with banks in distress but lacks legal protection/indemnification for supervisory staff.
  - No capital charge for market risk in current framework; recommendation to implement capital charge for market risk and country risk.
  - Limited authority for international consolidated supervision; laws and regulations do not properly address consolidated supervision.

### Recommendations and regulatory actions (selected)
- Banking system and ownership:
  - Develop a privatization strategy and a time-bound corrective action plan for the state-owned bank.
  - Require that banks owning stakes in insurance companies set aside special reserves.
  - Decrease the significant ownership threshold requiring NBM approval from 10 percent to 5 percent.
  - Strengthen fit-and-proper provisions and examine feasibility of restricting bank ownership to fit-and-proper strategic financial investors.
  - Issue instructions addressing accounting consolidation of affiliates and subsidiaries and require consolidated financial reports where required.
  - Issue regulations to require deduction of lending to connected or related parties from capital and to address market and country risks.
  - Require banks’ analysis of their clients’ currency positions.
- Monetary policy and liquidity:
  - Tighten criteria and limitations on direct financing of the government by the NBM.
  - Adjust reserve requirements: from July 2004 NBM introduced foreign currency reserve requirements for foreign currency deposits, decreasing the rate from 12 percent to 10 percent; switch reserve currencies gradually by shifting one percentage point every month to complete in 10 months.
  - Improve liquidity forecasting, expand instruments, and strengthen interest rate transmission.
- Payment, settlement, and crisis preparedness:
  - Implement RTGS and DNS for large-value and retail payments; update securities settlement system with collateralized intraday credit.
  - Draft rules/regulations, perform legal assessments, conduct comprehensive risk analysis, update and test contingency plans, and establish crisis management arrangements.
- Insurance, capital markets, and microfinance:
  - Enact modern insurance legislation to establish an independent regulator, increase capital requirements, harmonize prudential rules, and promote an actuarial profession and claims database.
  - Broaden investor base and reconfigure the stock market into a cost-effective "light stock market".
  - Rationalize SCA/SCC legal framework; adopt prudential norms by 2005; strengthen SSB supervisory capacity; align VAT status of lessors with banks to facilitate leasing.
- Anti-Money Laundering:
  - Clearly define AML law to include combating financing of terrorism; amend AML law to ensure full conformity with international standards; improve customer due diligence, suspicious reporting, coordination, enforcement, and the Service for the Prevention of Money Laundering’s analytical capacity.

### Legal, institutional, and transparency improvements for supervision and monetary policy
- Legal and operational improvements:
  - Restrict attendance of Ministers of Economy and Finance at NBM Council meetings on supervisory matters.
  - Separate the budget of banking supervision from the overall NBM budget.
  - Provide legal protection/indemnification for supervisory staff for actions taken in good faith.
  - Implement a defined process of cooperation and information sharing among domestic financial supervisors and with foreign supervisors; amend LFI to enable on-site examinations at overseas entities where needed.
  - Issue regulations to address accounting consolidation, require consolidated financial reports, and clarify rules on country risk and market risk reporting/charges.
- Transparency of monetary policy:
  - Specify what is meant by "stability of the national currency" and more criteria/limitations on financing the state.
  - Provide deeper explanations of policy instruments and consider publication of Council minutes and more frequent summary balance sheets.
  - Consider general rule on publication of aggregated information on emergency liquidity support and disclose internal governance procedures.

*Source: _cr0564 - Executive Summary and selected excerpts*

### Executive Summary ......................................................................................................

### _cr0564 - Executive Summary

### Key systemic concerns (from Executive Summary)
- Governance problems stemming from the growing role of the government in the banking and insurance system.
- Opaque ownership of financial institutions and corporations; near-absence of fit-and-proper strategic investors.
- Potential adverse impact of exchange rate appreciation (stemming from large foreign exchange inflows) on banks’ balance sheets through their clients.
- Effects of the recent credit boom: loans that may ultimately prove to be below par but do not yet appear in the classified categories.
- Supervisors (NBM) are hampered by extraneous, oftentimes political constraints and have difficulty obtaining useful information about some ultimate beneficial owners of banks.
- Banks may have only anecdotal evidence about shareholders that control many of their borrowers.
- Inability of the bank supervisor to ensure prudential limits for connected lending and large exposures are observed or to hold controlling shareholders fully accountable.
- Cross-ownership: some owners or banks also hold major shares in several insurance companies, exacerbating risks.
- Macroeconomic vulnerabilities that increase financial-system risk:
  - Direct financing of the state budget by the central bank against a weak fiscal and external situation.
  - Dependency on remittances.
  - Dollarization combined with significant exchange rate volatility.
- Prudential rules for handling exchange rate volatility and country risk are inadequate; rules on open foreign exchange positions need alignment with best international practices.
- Implementation gaps: written rules are largely consistent with international standards, but implementation is sometimes weaker.

### Banking sector structure and capitalization
- Number and ownership:
  - Sixteen Moldovan banks, all joint-stock companies.
  - One bank (the second largest) is state-owned with a 56 percent share.
  - Five banks are majority domestic-owned.
  - Three banks are 100 percent foreign owned (no first-tier foreign banks present as owners).
  - Remaining banks are majority offshore owned or have controlling minority offshore owners; no offshore shareholder exceeds the 10 percent threshold that requires NBM approval.
- Capitalization and consolidation policy:
  - NBM progressively increasing minimum capital levels to MDL 150 million (about US$12 million) from MDL 96 million to stimulate mergers.
- Insurance sector:
  - Number of insurance companies: 50.
  - Gross premium income in 2003: MDL 290 million; more than 98 percent was nonlife business.
  - Life insurance importance negligible; industry not a major source of long-term capital.
- SMEs, leasing, microfinance:
  - SMEs benefited little from recent growth in bank lending; lack of long-term resources.
  - Virtually all loans with maturities > one year are financed by international donors.
  - Leasing industry underdeveloped, partly due to tax disadvantages of lessors.
  - Microfinance growth: network of 530 Savings and Credit Associations (SCAs); SCAs’ aggregate loan portfolio grew by 62 percent and savings by 181 percent in 2003.
  - SCAs are deposit-taking institutions supervised by the State Supervision Board (SSB) in the Ministry of Finance; SSB needs considerable strengthening.
  - RFC (Rural Finance Corporation) channels donor funds to SCAs.

### Performance indicators and liquidity
- Key indicators and trends:
  - Reported nonperforming loans (NPLs) in categories C, D and E: 6.2 percent of total loans at year-end 2003.
  - Smaller banks’ NPL rate: 12.7 percent.
  - NBM loan classification Category B (“loans under supervision”) requires only a 5 percent provision; such classified loans represent 35.3 percent of total loans.
  - Year-end 2003 loan loss provisions cover 89 percent of nonperforming loans (C, D and E categories).
  - Banks hold 75 percent of all government securities (about 6.5 percent of their total assets).
  - Banks’ liquidity has remained well above prudential requirements for the past five years.
  - Excess reserves on accounts at NBM are substantial and unremunerated.
- Deposit and lending growth:
  - Total deposits rose from MDL 1 billion to MDL 6.9 billion from 1999 through 2003 (nearly 600 percent over five years).
  - Growth of loans during 1999–2003: about 250 percent.
- Dollarization:
  - Dollarization remained just under half of total assets and deposits over the past five years.
  - Foreign currency deposits to total deposits: 45 percent.
  - Foreign exchange lending: about 42 percent of total loans.

### Macroeconomic vulnerabilities (Systemic vulnerabilities — Macroeconomic Risks)
- Fiscal and external risks:
  - Moldova does not service part of its external debt, reducing short-term fiscal pressure but resulting in low credit ratings and reduced commercial banks’ access to external financing and confirmation of letters of credit.
  - Increased spending, particularly on wages, has a direct inflationary effect.
- Central bank direct financing:
  - In May 2004, authorities required direct financing from the NBM totalling MDL 600 million to finance sovereign external debt payments.
  - Prior NBM loans to the government had been successively renewed at maturity without reduction of principal under annual budget laws.
  - NBM’s direct lending to government—permitted by the Law—endangers its independence despite legal operational independence; recommendation to tighten conditions for NBM lending to government, if not to prohibit.
  - Fiscal consolidation and appropriate debt management are prerequisites for effective monetary policy.
- Remittances and external balance:
  - Workers’ remittances officially estimated at almost 24 percent of GDP in 2003.
  - Remittances financed consumption-driven GDP expansion, rapid import growth, and widening trade deficit.
  - Nonmarket-oriented policies and slow structural reforms have left an unfavorable business environment, threatening sustainability of GDP growth and preventing channeling remittances into productive uses.

### Supervisory, regulatory and market shortcomings
- Supervisory constraints:
  - Supervisors hampered by political constraints and limited information on beneficial owners.
  - NBM unable to ensure compliance with prudential limits for connected lending and large exposures.
- Regulatory gaps and required actions (excerpted from Box 1 — Summary of Key Recommendations)
  - Banking system:
    - Develop a privatization strategy and a time-bound corrective action plan for the state-owned bank.
    - Require that banks owning stakes in insurance companies set aside special reserves.
  - Bank regulation and supervision:
    - Decrease from 10 percent to 5 percent the limit of a significant ownership or controlling interest in a bank requiring prior NBM approval.
    - Strengthen the fit-and-proper provisions.
    - Examine feasibility of issuing regulations restricting bank ownership to fit-and-proper strategic (i.e., financial sector) investors.
    - Issue instructions addressing accounting consolidation of affiliates and subsidiaries and require consolidated financial reports where required.
    - Issue regulations to require deduction of lending to connected or related parties from capital and to address market and country risks.
    - Issue regulations or recommendations requiring banks to establish systems that accurately measure and monitor market risks.
    - Require banks’ analysis of their clients’ currency positions.
  - Monetary policy:
    - Tighten criteria and limitations on direct financing of the government by the NBM.
  - Payment and settlement systems:
    - Update rules and regulations for the new system and develop contingency plans.
  - Insurance sector:
    - Enact new insurance legislation to upgrade institutional structure, implementation and enforcement capacity of insurance supervision, and improve corporate governance.
    - Promote the actuarial profession and establish a reliable claims base.
  - Capital markets:
    - Develop action plans to broaden the investor base, strengthen confidence, consolidate instruments, and develop the secondary market.
    - Rationalize off-market exchanges and restructure the investment fund industry.
  - Microfinance and leasing:
    - Rationalize the legislative base.
    - Strengthen supervision of the sector.
    - Eliminate the tax disadvantage of lessors.
  - Anti-Money Laundering:
    - Clearly define the key concept of the AML law to include combating the financing of terrorism.
    - Amend the AML law to ensure full conformity with relevant international standards.
- Implementation vs. written framework:
  - Written prudential rules, accounting and auditing, and much of the legal infrastructure are to a large extent consistent with international standards; implementation, however, can be weak.
  - Prudential rules for exchange rate volatility, country risk, and open FX positions need strengthening and alignment with best international practices.

*Source: _cr0564 - Executive Summary*

### 15.      While the large inflows of workers’ remittances are unlikely to dry up suddenly,

### _cr0564 - 15.      While the large inflows of workers’ remittances are unlikely to dry up suddenly,

### Remittances: benefits and risks
- Large inflows of workers’ remittances are unlikely to dry up suddenly but pose several risks:
  - Exchange rate sensitivity: variations in remittance flows have significant effects on the exchange rate (as seen in early 2004).
  - External exposure: most Moldovan citizens abroad are working in Russia and the European Union; the Moldovan economy could be affected if those economies weaken; if their labor laws are changed; and/or if the enforcement of those laws is intensified.
  - Taxation and channeling risk: any attempt by the government to tax workers’ remittances may cause remitters to use channels outside the banking system and discourage individuals from using banks for their foreign exchange savings.

### Exchange rate, inflation, and competitiveness
- Remittances have increasingly put the Moldovan leu under appreciation pressure, threatening competitiveness and causing risks for banks’ balance sheets.
- Key observed currency movements:
  - 2003: the leu appreciated by 4.5 percent vis-à-vis the dollar in nominal terms.
  - 2004: the leu has appreciated both against the dollar (according to staff estimates by almost 13 percent) and a trade weighted currency basket, while inflation remained relatively high.
- Policy challenge for the NBM: reduce inflation while preventing further appreciation of the leu to support short-term competitiveness.
- Contributing uncertainty: the government’s external arrears contribute to uncertainty surrounding the exchange rate.

### Dollarization and foreign currency exposure
- High degree of dollarization is a source of financial vulnerability, particularly because the exchange rate has been quite volatile in the past.
- Lending restrictions and risks:
  - Banks may currently extend foreign currency loans to resident individuals or enterprises only for settlement of payment obligations to nonresidents.
  - Borrowers might not have foreign exchange revenues; banks are not permitted to extend such credits to exporters (except for official credit lines).
  - Risk of loss of confidence in the domestic currency could lead to a drawdown of domestic currency deposits, as occurred during the Russian crisis when the leu depreciated sharply vis-à-vis the dollar.

### Rapid credit growth and cyclical risks
- Rapid credit growth is the third substantial risk to financial stability.
- Risks identified:
  - Credit approval may become routine and less rigorous during growth phases.
  - Share of nonperforming loans likely to go down temporarily, masking underlying risks.
  - Lending cycle may be self-reinforcing; reversal if the economy weakens could place the banking sector under considerable pressure.

### Financial soundness, stress testing, and bank vulnerabilities
- Stress tests and analyses:
  - Various analytical and stress tests do not identify systemic vulnerabilities within the banking sector, though a few banks are consistently more vulnerable.
  - One large bank and a number of smaller banks with dispersed ownership are particularly vulnerable.
- Stress test findings:
  - The capital of a few banks is consistently vulnerable to credit risk, exchange rate risk, and a possible liquidity crisis.
  - Separate sensitivity and scenario analyses evaluated effects on banks’ CAR from sharp changes to credit risk, exchange rate fluctuations, interest rate changes, and effects of an illiquid government securities market.
  - The same banks were found susceptible in each test, sharply reducing their capital under strong shocks or simultaneous need to sell government securities to meet withdrawals.
  - For some banks, stress test results could be overly positive because insurance subsidiaries are not consolidated.

### Ownership, governance, and state involvement risks
- Cross-cutting vulnerabilities that could undermine financial sector resilience:
  - (i) the government’s growing role in the banking system;
  - (ii) the opaque ownership structure of a relatively large number of banks; and
  - (iii) the absence of fit-and-proper strategic investors.
- Potential consequences:
  - Distortionary market practices regarding pricing of loan risks, attracting deposits, or placement of inter-bank credits.
  - Neither the state-owned bank nor offshore-controlled banks have reliable means to raise new capital if called upon.
  - The NBM lacks means to fully hold controlling shareholders accountable or to apply full “fit and proper” standards to significant controlling shareholders.
  - Shareholders controlling nearly 40 percent of the banking system assets—including the assets of one systemic bank—may be beyond the reach of the regulator.
- State-owned bank specific concerns:
  - Exceptional—ten-fold—increase of its loan book over five years.
  - Concentration of state-owned enterprise borrowers.
  - Placement of substantial public deposits (including the Social Fund) at below market rates.
  - Recent majority stake acquisition of an insurer.
  - Weaknesses in governance reflected in abrupt changes of board membership and the ministry responsible for the bank’s oversight.
  - Government decision to require joint-stock companies to pay a 30 percent dividend will serve, among others, to reduce capitalization levels at all banks.
  - Vulnerability if a large state-owned enterprise borrower were to default, given reluctance to take legal action against state-owned enterprise borrowers.
- Recommended actions for the state-owned bank:
  - New board urged to develop a time-bound corrective action plan to address findings of the end-2003 external audit report and NBM on-site examination.
  - Evaluate fully the bank’s existing risk management practices and its business plan.
  - Government urged to develop a privatization strategy for the bank.

### Bank-owned insurance subsidiaries and supervisory gaps
- Regulation of banks’ insurance subsidiaries is neither coordinated nor robust, creating potential systemic risk if a bank-owned insurer cannot honor commitments.
- Specific concerns:
  - State-owned bank holds majority stake in a full-service insurer covering life, auto, commercial, etc.
  - NBM has no regular access to data on insurance companies’ financial condition, reserves, and types of risks covered.
  - If an insurer experiences a large/unexpected loss without adequate reserves or reinsurance, the shareholder bank’s capital could be at risk to the extent of its investment.
  - Banks carry no reserves for such activities and NBM has no established means to exchange information with insurance supervision to evaluate bank-owned insurers’ risks.
- Recommended safeguards:
  - Banks’ boards should scrutinize financial condition and risks assumed by their insurance subsidiaries.
  - Banks should be required to set aside reserves at least of their investment as a minimum until regular and transparent reporting of subsidiaries’ finances is available.
  - MOF urged to draw up a comprehensive agreement with the NBM on sharing information regarding activities of all banks’ insurance subsidiaries.

### Ownership disclosure, insider lending, and small banks’ risks
- Ownership disclosure deficiencies:
  - Of fifteen privately held banks, five have the majority of shareholders owning 9.9 percent or smaller stakes, most domiciled off-shore.
  - At least two other banks have more than 30 percent of their capital in the form of separate share holdings of less than 9.9 percent each.
  - None of these controlling shareholders is obliged to fulfill existing NBM fit and proper regulations for shareholdings of 10 percent or larger.
- Consequences and observed metrics:
  - Seven banks with dispersed ownership are more susceptible to insider abuses and potentially money laundering, with fewer resources for internal controls and IT systems.
  - These smaller banks exhibit sharply lower ROAs and ROEs, higher NPL levels, and heavy loan concentrations.
  - As of end-2003 three of the five smallest banks exceeded prudential limits for large borrowers, prompting NBM remedial requirements.
  - Despite high capitalization levels, persistence of low earnings calls into question business model and long-term viability.
- Regulatory recommendation:
  - NBM urged to continue regular scrutiny of risk management processes, financial condition, and practices of these banks.

### Investment climate and strategic investors
- Moldova has been unable to attract reputable strategic investors into the banking sector, owing in part to ownership issues and perceptions of macroeconomic environment.
- Reputable foreign banks’ reluctance exacerbated by the country’s external arrears.
- Seven of fifteen private banks controlled by mostly opaque off-shore entities holding less than 10 percent stakes further harms investor perceptions.
- Result: limited knowledge transfer from multinational banks.

### Supervision, regulation, and legal gaps
- Supervisory framework:
  - Framework is reasonably comprehensive and, with some exceptions, adheres to the Basel Committee’s Core Principles as summarized in the Report of the Observance of Standards and Codes.
  - Supervisory independence exists formally but could be constrained in practice by participation of the Ministers of Economy and Finance at NBM Council of Administration meetings.
  - Legal protection for supervisors is not addressed in framework laws or supporting regulations.
  - Limited cooperation and information sharing among domestic agencies responsible for financial system soundness.
- Shareholder identification and large exposures:
  - Deficiencies exist in identifying bank shareholders below the significant interest threshold.
  - Under the Law on Financial Institutions (LFI) and specific regulations, NBM can grant authorization for acquisitions of holdings of 10 percent or higher in an existing bank.
  - Lack of information about identity of some individual shareholders casts doubt on whether total loans of groups of closely related borrowers can be accurately measured.
  - Absence of guidelines/limits and reporting requirements covering country risk.
  - Law and regulation do not include a capital charge for market risk except for foreign exchange risk.
- Consolidated supervision:
  - NBM has only limited legal authority to supervise banks on an international consolidated basis.
  - NBM has initiated formal relationships with foreign supervisors enabling consolidated supervision over foreign owned banking entities, including on-site inspections and information sharing, but laws and regulations do not properly address the issue.

### Medium-term challenges — Banking sector and credit growth
- Rapid loan growth since 1999 raises concerns about credit evaluation and monitoring capacity:
  - Total loans increased from MDL 1.6 billion to MDL 6.1 billion (more than three fold since 1999).
  - Loans at the state-owned bank grew by 932 percent over this period.
  - Much of credit growth reflects inflow of foreign exchange that increased banking system liquidity.
- NBM mitigation and further needs:
  - NBM requires banks to have separate risk management units to identify and reduce specific risk exposures.
  - Further improvement needed especially among smaller banks to assess broad sectoral risks from exchange rate and interest rate movements, not solely individual borrower cash flows.
  - Recommendation to collect and track sectoral leverage indicators (e.g., debt-to-equity ratios of the corporate sector and sub sectors, household debt-to-GDP) as early warning signs.
  - Banks should factor borrowers’ open foreign exchange positions in credit risk analysis, even when distinguishing importers and exporters is difficult.

### Deposit insurance
- A deposit insurance scheme covers individual depositors up to MDL 4,500 (around US$380) per depositor per bank, financed from contributions by banks.
- Recommended enhancements:
  - Supplement Deposit Insurance Law with regulations that define precisely the events that trigger payments by the Deposit Insurance Fund (DIF) (e.g., court determination of insolvency, NBM declaration that a bank is unable to meet obligations).
  - NBM should determine whether illiquidity justifies triggering DIF payments (which would precede liquidation).
  - DIF would step into shoes of small depositors by subrogation in liquidation; amendment to Insolvency Law passed in June 2004 gives DIF claims priority over unsecured creditors.

### Systemic liquidity management and monetary policy
- NBM’s mandate and operational challenges:
  - Law on the NBM stipulates main objective is stability of the national currency, but NBM grapples with multiple, occasionally contradictory objectives: curtailing inflation, preserving foreign exchange stability, and lowering interest rates.
- Liquidity management problems:
  - Market competition distorted by cheap liquidity provided from Social Fund money deposited with the state-owned bank.
  - Massive remittances supply liquidity regardless of central bank policy.
  - Interest rate transmission mechanism is weak due to liquidity management problems, lack of instruments, and underdevelopment of markets.
  - NBM aims to influence market interest rates via a “corridor” of policy rates, but monetary policy largely operates through quantitative measures (reserve requirement).
  - Liquidity forecasting is difficult and complicated by uncertainty over whether/when the government will meet external obligations.
- Reserve requirements adjustments:
  - From July 2004, NBM introduced foreign currency reserve requirements for foreign currency deposits, decreasing the rate from 12 percent to 10 percent.
  - Process of switching reserve currencies will take place gradually, by shifting one percentage point every month and completing in 10 months, so as not to release additional leu liquidity at once.

### Access to credit, microfinance, and SCAs/SCCs
- Savings and Credit Associations (SCAs) regulatory needs:
  - Regulatory framework under which SCAs were created and function needs improvement to ensure sector sustainability.
  - New prudential norms (capital, liquidity, reserves, delinquency) to cover all potential risks are being developed and should be adopted by 2005.
  - New draft Law on Savings and Credit Cooperatives (SCCs) under discussion envisages participation of legal persons and potential broadening of scope, which could put into question treatment of SCCs as NBFIs.
  - Existing and proposed laws need careful examination for mutual consistency with the Law on Financial Institutions.
- Strengthening the SCA system:
  - Improve governance and management/accounting capability.
  - Strengthen supervisory authority and capacity of the SSB to complete liquidation of insolvent SCAs.
  - Enhance sanctions to facilitate enforcement of regulations.
  - Align regulatory framework with good practice.
  - Adjust VAT status of lessors to be the same as for banks to facilitate leasing development.

*Source: _cr0564 - 15.      While the large inflows of workers’ remittances are unlikely to dry up suddenly,*

### 37.      The legal framework governing the regulation and supervision of Moldova’s

### _cr0564 - 37.      The legal framework governing the regulation and supervision of Moldova’s

### Legal framework and banking supervision
- The NBM Law and the LFI are described as "well-drafted, sound, and in most respects in harmony with modern central banking law practices."
- The laws establish operational independence of the NBM, and banking supervision and internal governance rules are "mostly appropriate."
- The NBM is granted "adequate powers to deal with banks in distress."
- A noted shortcoming: lack of immunity broadly applied. While the Governor has explicit immunity from suit, best practice is to extend such immunity from civil proceedings to other officials, including the bank supervisory staff.

### Implementation and enforcement issues
- Implementation and enforcement of applicable laws in Moldova are "uneven."
- Causes identified:
  - Limited and inadequate resources
  - Excessive bureaucracy
  - State intervention
  - Relatively low level of respect for the rule of law (as evidenced by surveys and rankings from EBRD and World Bank)
- Business environment indicators:
  - "Risks and costs of doing business are high"
  - "Administrative burdens of all kinds are excessive"
  - "Regulatory compliance costs are among the highest in the region"
  - "The licensing regime remains one of the most restrictive among transition economies"
- Frequency of inspections is characterized as a symptom of excessive bureaucracy rather than effective enforcement.
- Although the duration and cost of inspections have decreased, they "still remain greater than in most neighboring countries."

### Payment and settlement systems (Section F)
- Existing systemically important payment system is run by the NBM and consists of a designated gross settlement system for both large-value payments and retail payments.
- NBM's reform plan includes:
  - Setting up an RTGS-system for large-value payments
  - A designated net settlement system (DNS) for retail payments
  - An updated securities settlement system for government securities with a facility for collateralized intraday credit
- Key implementation tasks and recommendations:
  - Find the right balance between payments settled in the RTGS and in the DNS to ensure cost-effectiveness of each component.
  - Draft rules and regulations for the new systems in a timely manner.
  - Produce a brochure on the functioning of the systems and risk management.
  - Conduct an assessment to verify whether the present legal basis supports the new infrastructure and complies with international payment principles and recommendations for securities settlement.
  - Adapt organizational arrangements to the continuous-running requirements of an RTGS system.
  - Undertake a comprehensive and systematic risk analysis of the planned system to identify and address shortcomings.
  - Update and test contingency plans, including planning for a backup site situated at a longer distance from the production site.
  - Establish crisis management and incident organization arrangements and prepare them to be ready for action.

### Insurance sector (Section G)
- The insurance sector "exhibits a multitude of problems" that must be resolved before healthy growth can occur.
- Specific recommendations and findings:
  - Withdraw preferences from the recently established state-owned insurance company, which is reportedly used by state-owned enterprises and government departments to channel insurance business.
  - Develop the institutional structure, implementation, and enforcement capacity of insurance supervision currently within the MOF.
  - Transfer the right to license new insurance companies from the Licensing Chamber to the supervisor.
  - Promote establishment of a reliable claims database to help insurers and supervisors price products appropriately.
  - Undertake an education campaign to explain to the public the potential advantages and uses of insurance products.
  - Complete work on new, modern insurance legislation envisaging:
    - Establishment of an independent insurance regulator and supervisor
    - Increase in capital requirements
    - Harmonization of prudential requirements with applicable best practice standards
  - Based on best practices, separate life and nonlife activities so that one activity cannot be required to support the other; before separation, develop a suitable regulatory framework for life insurance.
  - Strengthen coordination between the insurance sector and its regulatory body.

### Capital markets (Section H)
- Capital markets are "underdeveloped and shallow."
- Observations:
  - Primary market for government securities is well-organized but dominated by commercial banks.
  - Secondary market is "almost nonexistent."
  - Market liquidity is constrained by absence of nonresidents, who "have sold their holdings in the wake of the Russian crisis and have not returned since then."
  - Equity market investor scarcity is exacerbated by market fragmentation.
- Recommendations:
  - Broaden the investor base.
  - Strengthen the supervisor (National Securities Commission of Moldova) "without increasing the number of staff."
  - Draw up a strategic plan for sector development.
  - Reconfigure the stock market into a cost-effective and operationally-efficient "light stock market" to revive activity.

### Anti-Money Laundering and Combating the Financing of Terrorism (Section I)
- Moldova is described as vulnerable to illicit activities due to poverty, an open economy in a sensitive region, and the unresolved issue of Transnistria.
- Progress has been made in AML/CFT, but "considerable work remains to be done" to achieve an overall effective regime, including:
  - (i) Legislative changes to the AML Law and the Criminal Code penalizing the financing of terrorism
  - (ii) Legislative and implementation measures related to customer due diligence and the reporting of suspicious transactions
  - (iii) Mechanisms for coordination of national AML/CFT initiatives and measures related to international cooperation
  - (iv) Enhancements in enforcement
  - (v) Improvements in the operation of the Service for the Prevention of Money Laundering, which "does not yet appear to be in a position to add significant value through its analysis of the information it collects"
- Note: The full assessment of AML/CFT is scheduled to be conducted in early 2005 by MONEYVAL, the FATF-type regional body for Europe.

### Selected quantitative indicators and financial-sector diagnostics (excerpts from Tables)
- Real sector, 2000–2003 (selected):
  - Real growth rate: 2000 = 2.1; 2001 = 6.1; 2002 = 7.8; 2003 = 6.3
  - Nominal GDP (MDL million): 2000 = 16,020; 2001 = 19,052; 2002 = 22,556; 2003 = 27,297
  - Nominal GDP ($ million): 2000 = 1,289; 2001 = 1,480; 2002 = 1,662; 2003 = 1,957
  - CPI Inflation (average): 2000 = 31.3; 2001 = 9.8; 2002 = 5.3; 2003 = 11.7
  - Average monthly wage (Moldovan lei): 2000 = 408; 2001 = 519; 2002 = 704; 2003 = 912
  - Average monthly wage (U.S. dollars): 2000 = 33; 2001 = 40; 2002 = 52; 2003 = 65
  - Foreign savings (percent of GDP): 2000 = 8.2; 2001 = 2.5; 2002 = 4.4; 2003 = 6.8
  - Gross investment (percent of GDP): 2000 = 15.4; 2001 = 16.7; 2002 = 16.3; 2003 = 17.1
- External sector (selected):
  - Current account balance (millions of U.S. dollars): 2000 = -105.7; 2001 = -37.4; 2002 = -73.9; 2003 = -132.4
  - Current account balance (percent of GDP): 2000 = -8.2; 2001 = -2.5; 2002 = -4.4; 2003 = -6.8
  - Gross official reserves (millions of U.S. dollars): 2000 = 226.0; 2001 = 228.5; 2002 = 268.8; 2003 = 302.3
  - Gross official reserves (months of imports): 2000 = 2.5; 2001 = 2.1; 2002 = 1.9; 2003 = 1.7
  - External debt/GDP (percent) (public and publicly guaranteed debt, including IMF): 2000 = 124.2; 2001 = 107.7; 2002 = 105.5; 2003 = 96.2
- Structure of the financial system (selected, 1999–2003):
  - Number of deposit-taking institutions: 1999 = 20; 2000 = 20; 2001 = 19; 2002 = 16; 2003 = 16
  - Total assets of deposit-taking institutions (in millions of lei): 1999 = 3,201.3; 2000 = 4,667.7; 2001 = 5,976.5; 2002 = 7,920.1; 2003 = 10,289.9
  - Total assets of deposit-taking institutions (percent of GDP): 1999 = 26.0; 2000 = 29.1; 2001 = 31.4; 2002 = 35.1; 2003 = 37.7
  - Number of insurance companies: 1999 = 44; 2000 = 45; 2001 = 44; 2002 = 49; 2003 = 50
- Financial soundness indicators of the banking sector (selected):
  - Regulatory capital as percent of risk-weighted assets: 1999 = 46.0; 2000 = 48.6; 2001 = 43.1; 2002 = 36.4; 2003 = 31.8
  - Capital (net worth) as percent of assets: 1999 = 28.9; 2000 = 30.6; 2001 = 27.5; 2002 = 23.0; 2003 = 21.1
  - NPLs as percent of gross loans (NPLs are loans in categories C, D, and E): 1999 = 29.3; 2000 = 20.6; 2001 = 10.4; 2002 = 7.7; 2003 = 6.2
  - Gross profits as percent of assets (ROA): 1999 = 4.2; 2000 = 7.4; 2001 = 4.3; 2002 = 4.3; 2003 = 4.5
  - Gross profits as percent of equity capital (ROE): 1999 = 18.0; 2000 = 25.0; 2001 = 14.3; 2002 = 16.7; 2003 = 20.3

### Stress testing and scenario analysis (excerpt from Table 4; as of December 31, 2003)
- Baseline CAR: Regulatory capital as a percent of risk-weighted assets = 31.8 (Total)
- Selected scenario impacts on CAR and number of banks below 12% CAR:
  - Overall credit risk: CAR = 23.2 (Total); Number of banks below 12% CAR = 2 (Total)
  - Shock to fuel and gas prices: CAR = 26.0 (Total); Number of banks below 12% CAR = 2 (Total)
  - Indirect effect of deterioration of credit quality (exchange rate risk): CAR = 22.2 (Total); Number of banks below 12% CAR = 2 (Total)
  - Direct effect of 10 percentage point rise in interest rate on CAR: CAR = 32.1 (Total); Number of banks below 12% CAR = 0 (Total)
  - Combined effects of exchange rate depreciation and interest rate increases: CAR = 20.9 (Total); Number of banks below 12% CAR = 2 (Total)
  - Additional effect of illiquidity of government securities (realization value of 50 percent of government securities): CAR = 15.5 (Total); Number of banks below 12% CAR = 6 (Total)
- Footnote highlights (summarized exactly as presented):
  - 1/ NPLs as percent of gross loans equal 31 percent, the average during the 1998–1999 currency crisis. To achieve this, migration of loans from categories A and B by 24 percent and 30 percent respectively with increases of 300 percent in C, 650 percent in D, and 1,050 percent in E to hold total loans constant.
  - 2/ NPLs rise to 13 percent, achieved by a decrease in agricultural sector loans in A and B by 24 and 30 percent respectively, and an increase in C, D, and E to keep total agricultural loans in each bank constant.
  - 3/ Loans to energy sector migrated from A and B by 39 percent and 50 percent, respectively, in the first round, and then loans to the corporate sector migrated from A and B by 24 percent and 30 percent, respectively, resulting in an NPL of 22 percent in the overall banking sector.
  - 4/ Effect on CAR through changes in open foreign currency positions of a nominal appreciation of MDL/USD and MDL/euro exchange rates by 40 percent, and of MDL/Russian ruble exchange rate by 20 percent.
  - 5/ Net effect of an additional indirect effect of a rise in NPLs to 31 percent achieved by a loan migration similar to footnote 1, above.
  - 6/ Direct effect of 10 percentage point rise in interest rate on CAR through changes in net interest income within a 1-month horizon.
  - 7/ Net effect of an additional indirect effect of a rise in NPLs to 14.4 percent achieved by a loan migration of 8 percent and 10 percent from A and B, respectively.
  - 8/ Indirect effect assuming a deterioration of NPLs to 31 percent achieved by a loan migration similar to footnote 1, above.
  - 9/ Combination of footnote 4 (with depreciations), footnote 6, and increase in NPL to 39 percent (maximum NPL experienced during the 1998–99 crisis).
  - 10/ Combination of and realization value of 50 percent of government securities.

*Italic: IMF staff report excerpts as provided in the source content.*

### 44.      This detailed assessment of Observance with the Basel Core Principles for Effective

### This detailed assessment of Observance with the Basel Core Principles for Effective Banking Supervision

### Institutional setting
- Assessment conducted by Walter Zunic, World Bank, and Stefan Spamer, Deutsche Bundesbank, in May 2004.
- The Law on the National Bank of Moldova (NBM) specifies that the NBM, through its Department of Banking Regulation and Supervision, is responsible for banking supervision in Moldova.
- The NBM is the sole authority for carrying out banking supervision for banking institutions licensed under this law.
- NBM objective: maintain the financial stability of the banking system with a view to protecting the interests of depositors.

### General preconditions for effective banking supervision
- Banking sector characteristics:
  - Concentrated, underdeveloped, and less than efficient.
  - Five large banks account for 71 percent of total banking sector assets and 75 percent of total banking sector deposits.
  - Lack of product diversification, poor banking skills, and inadequate lending and crediting policies limit development of new banking services.
  - Resulting high interest margins and transaction costs transferred to private sector.
- Access to finance constraints:
  - Median debt to asset ratio of a large sample of enterprises is a mere 9 percent, lower than in any other country in Europe, with little change since 1998.
  - Main factors restricting access to finance:
    - (i) lack of long-term bank financing;
    - (ii) legal and regulatory restrictions on transactions and lending denominated in foreign currencies;
    - (iii) lack of basic banking skills and a developed product base; and
    - (iv) underdevelopment or lack of alternative forms of financing.
  - Nonbank, capital market, and insurance sectors are embryonic.

### Main findings — Basel Core Principles (by CP groups)
- CP 1 (Objectives, autonomy, powers, and resources):
  - No visible evidence of government or industry interference, but ministers responsible for economic and financial matters may attend NBM Council meetings without restriction; interference cannot be ruled out.
  - NBM has, in general, adequate independence to deploy banking supervision resources.
  - Legal protection for supervisors is not addressed; no formal NBM indemnification policy for employees defending actions while discharging duties.
  - Limited system of cooperation and information sharing among domestic agencies responsible for financial system soundness.
- CPs 2–5 (Licensing and Structure):
  - Under the LFI, NBM can grant authorization for acquisitions or increases of qualifying holdings in an existing bank; supervisor approval limited to shareholdings of 10 percent or higher.
  - Situation exists where individual shareholders of 9.9 percent own a majority of the capital of five banks; most such shareholders are corporations registered in off-shore centers.
  - LFI defines upper limit for investments in other companies that are not credit institutions at 15 percent of regulatory capital and total investments not exceeding 50 percent of banks regulatory capital without written supervisory approval.
  - NBM requires banks to report all ownership in subsidiaries and affiliated companies.
- CPs 6–15 (Prudential regulation and requirements):
  - Capital adequacy rules generally conform to the Basel Capital Accord 1988, but do not include a capital charge for market risk.
  - NBM maintains adequate systems for monitoring/evaluating large exposures and connected lending, but insufficient information about financial interests of a large percentage of shareholders complicates assessment of regulatory compliance.
  - Large exposure limit is 25 percent of bank or banking group capital; consistent with international standards but possibly relatively high given small size of system and economy.
  - Supervisor should consider limit on banks’ deposit exposures to other banks where placement is over 15 days in maturity.
  - No controls or limits on banks’ cross-border exposures.
  - Banks are not required to have systems that accurately measure and monitor market risk.
  - Moldova has relatively comprehensive laws for dealing with money laundering and other financial crimes; AML/CFT compliance to be assessed fully in 2005.
- CPs 16–20 (Methods of ongoing supervision):
  - NBM conducts full scope, comprehensive on-site examinations of banks on an annual basis.
  - Comprehensive off-site monitoring exists, with analysis of a wide range of information provided monthly and quarterly.
  - No specific instructions addressing accounting consolidation of subsidiaries; no evidence of group-wide approach to supervision.
  - Supervision on a consolidated basis is not carried out in Moldova.
- CP 22 (Formal powers of supervisors):
  - Law on Financial Institutions empowers NBM to issue decisions to restore rightful conditions and remove abuses, develop corrective action and early intervention; range of remedial actions includes withdrawal of bank's license.
  - Adequate enforcement powers available and close to Basel recommendations.
  - No mechanism for automatic imposition of administrative or penal sanctions.
  - Supervisor lacks authority to publish details of enforcement actions it imposes.
- CPs 23–25 (Cross-border banking):
  - Framework lacks specific provisions for global consolidated supervision.
  - NBM responsible for granting permission for Moldovan banks to operate branches or establish subsidiaries abroad, but has only limited authority to supervise overseas branches of locally incorporated banks.
  - No legal provisions for establishing contact and sharing information on a reciprocity basis with other supervisors; confidentiality is protected.
  - Foreign banking institutions in Moldova subject to similar regulatory requirements as other banks.
  - NBM has powers to share information needed by home country supervisors for consolidated supervision, but no formalized legal procedure for host-to-home information sharing.

### Main recommendations — Recommended Actions to Improve Compliance with the Basel Core Principles
- CP 1 Objectives, Powers, and Resources:
  - Restrict the attendance of ministers responsible for economic and financial matters in meetings of the Council of Administration of the NBM to matters not related to supervisory issues.
  - Separate the budget of banking supervision from the overall budget of the NBM.
  - Change the law to include legal protection for supervisors.
  - Implement a defined process of cooperation between domestic financial supervisors and regulators.
  - Clarify legal possibilities for exchange of confidential information and implement provisions to restrict usage of this information.
- CP 3 Licensing Criteria:
  - Require a description of the corporate ownership structure to determine suitability of major shareholders, transparency of structure, and source of initial capital.
- CP 4 Ownership:
  - Decrease the limit of a significant ownership or controlling interest from 10 percent to 5 percent.
- CP 5 Investment Criteria:
  - Develop procedures for banks to notify investments in nonbank entities that do not meet thresholds defined by regulation.
- CP 6 Capital Adequacy:
  - Implement a capital charge for market risk and country risk.
- CP 8 Loan Evaluation and Loan-Loss Provisioning:
  - Adopt a robust definition of problem loan restructuring.
  - Issue instructions for loan loss provisioning of some off balance sheet accounts.
  - Require written bank policies to grade and estimate loan loss probability.
- CP 9 Large Exposure Limits:
  - Encourage banks to fully ascertain nature of connections between borrowers and stockholders.
  - Establish a limit on banks’ deposit exposures to other banks.
- CP 10 Connected Lending:
  - Require deduction of lending to connected or related parties from capital or the collateralization of such loans.
- CP 11 Country Risk:
  - Issue a regulation or recommendation to specifically address country risk and design a reporting system for country/transfer risk.
- CP 12 Market Risks:
  - Issue regulations or recommendations requiring banks to establish systems that accurately measure and monitor market risk.
  - Provide additional training to analysts and inspectors.
- CP 13 Other Risks:
  - Provide guidance to banks for identifying, measuring, monitoring, and controlling reputation risk and risks associated with acquisition of business entities.
- CP 15 Money Laundering:
  - Appoint bank supervisors to become specialists in AML procedures and liaise with the Center for fighting Economic Crime and Corruption.
- CP 20 Consolidated Supervision:
  - Address in instructions accounting consolidation of affiliates and subsidiaries, and instruct banks to prepare, where required, consolidated financial reports.
- CP 22 Remedial Measures:
  - Indicate in regulation the specific measures used to address particular problems.
- CP 23 Globally Consolidated Supervision:
  - Amend the Law on Financial Institutions to acquire power to carry out necessary on site examinations at overseas entities of Moldovan banks.
- CP 24 Host Country Supervision:
  - Clarify NBM’s authority to prohibit banks from operating in countries where secrecy or other laws prohibit free flow of information.
  - Amend laws to ensure reciprocal information sharing with foreign supervisors.
- CP 25 Supervision Over Foreign Banks’ Establishments:
  - Refer to CP 24.

### Authorities’ response to the assessment (banking supervision)
- Authorities broadly agree with the BCP assessment and are determined to improve the legal framework and supervisory methods.
- Budgetary comment: budget requirements for bank supervision are fully met from the operating budget of the NBM; authorities find it inconvenient to determine a separate budget for supervisors outside the aggregate.
- Legal protection comment: although no clear protection to individual staff exists, the NBM is the legal person responsible for any possible legal actions.
- Authorities requested additional technical assistance for handling some risks; assistance was provided in December 2004.

### Transparency of monetary policy — legal and institutional framework overview
- Law on the National Bank of Moldova adopted in 1995 with IMF technical assistance, with some subsequent revisions.
- Law defines primary objective of NBM as maintenance of stability of its national currency.
- Law stipulates: “the NBM in cooperation with the government shall formulate and implement monetary and foreign exchange policy ... taking into account the prevailing economic and financial conditions of the Republic.”
- Law guarantees operational independence of NBM with respect to government and administrative bodies; Finance Minister and Minister of Economy allowed to attend central bank meetings but do not have voting power.
- NBM responsibilities include design and conduct of monetary policy; issuance of licenses and supervision of financial institutions; management of foreign exchange reserves and conduct of foreign exchange policy; conduct of payment operations; issuance of banknotes and coins.
- NBM monetary policy instruments include open market operations, overnight credits and deposits, deposit auctions, the Lombard facility, and reserve requirements; NBM relies mostly on reserve requirements.

### Main findings — monetary policy transparency
- Institutional relationship:
  - Institutional relationship between monetary and fiscal operations defined in Law on the NBM.
  - Direct purchasing of government securities in the primary market is prohibited; lending to the government is permitted by law.
  - NBM assumes agency roles for government: foreign exchange reserves management, representation in international financial institutions, international payment operations, and certain banking operations on account of the government.
- Governance:
  - NBM governed by Council of Administration of five members: Governor (chairman) and four Vice-Governors.
  - Members appointed by Parliament, upon proposal of NBM; terms of appointment are seven years, with possibility of renewal.
  - Dismissal: Governor can be dismissed by two third of total number of deputies for specific acts of criminal behavior, bankruptcy, and incapacity due to personal misconduct; other members dismissed by simple majority of total number of deputies for same causes.
- Disclosure practices:
  - Monetary policy decisions announced on same day through press releases and on the NBM’s website.
  - NBM publishes Annual Reports, Quarterly Bulletins, Monthly Monetary syntheses, and various announcements on the website.
  - Disclosures include framework, instruments, and targets of monetary policy; monetary policy decisions; data reporting requirements for financial institutions; and rules and regulations governing operations with financial and nonfinancial public.
  - Financial accounts of the central bank audited annually by an independent auditor; findings disclosed in the Annual Report.

### Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code — Monetary Policy (summary)
- I. Clarity of Roles, Responsibilities and Objectives:
  - Specify what is meant by the stability of the national currency.
  - Specify more criteria and limitation on financing the state.
- II. Open Process for Formulating and Reporting Monetary Policy Decisions:
  - Provide deeper explanation of policy instruments and operations, with clearer descriptions of relations between instruments.
  - Consider disclosure of minutes of the Council meetings.
- III. Public Availability of Information on Monetary Policy:
  - Consider publishing the summary balance sheet on a frequent (e.g., quarterly) and pre-announced schedule.
  - Consider a general rule on publication of aggregated information on emergency liquidity support.
- IV. Accountability and Assurances of Integrity:
  - Disclose specific regulations related to the internal control system of the NBM to the public.
  - Enact a law to provide legal protection to the supervisory agency and its staff for actions taken while discharging their duties in good faith.

### Authorities’ response — monetary policy transparency
- NBM generally agrees with most assessments and recommendations; provided clarifying information taken into account.
- Specific comments:
  - (i) Ultimate objective of monetary policy cannot be specified given Moldovan macroeconomic environment, but concrete policy objectives for each year are clearly explained in annually published statement on review and assessment of monetary policy and foreign exchange policy, even though it is not a legal document.
  - (ii) Conditions for lending to the government are set forth in the Law on the NBM and are considered sufficient.
  - (iii) No practice to regularly disclose minutes of Council meetings, but public has access when Council decides to do so.
  - (iv) Internal auditing process is not usually disclosed in many other countries.
  - (v) Although no clear protection to individual staff, the NBM is the legal person responsible for any possible legal actions.

### Transparency of banking supervision — institutional and market structure overview
- NBM is responsible for regulation and supervision of the banking sector as codified in the Law on the National Bank of Moldova.
- Institutional framework set out in the Law on the National Bank of Moldova, the Law on Financial Institutions, and relevant Regulations.
- Financial system largely dominated by the banking sector.
- Few banks with foreign participation; none with majority strategic foreign ownership typical of more advanced transition economies; most foreign participants from neighboring countries.
- International financial institutions present in the capital of five banks operating in the country.

*Italic: Source — This detailed assessment of Observance with the Basel Core Principles for Effective Banking Supervision (IMF/World Bank FSAP assessment, May 2004).*

### 65.      The responsibility of the NBM for bank supervision is clearly stated in the relevant

### _cr0564 - 65.      The responsibility of the NBM for bank supervision is clearly stated in the relevant

### Governance and transparency of NBM supervision
- The responsibility of the NBM for bank supervision is clearly stated in the relevant laws.
- The NBM engages in an ongoing consultation process involving nongovernmental bodies in the development of financial policies, e.g., consulting the bankers’ association or specific banks in issuing rules and regulation.
- There are currently no formal procedures for the sharing of information and consultation between local financial agencies.
- The Republic of Moldova concluded arrangements on the cooperation in the area of the supervision of financial institutions with foreign supervisory entities; however, there is insufficient public disclosure of the existence of procedures of such arrangements.
- The NBM routinely publishes reports in the middle of each month, though there is no pre-announced publication date.
- When emergency liquidity support was made available to banks in the past, information about such assistance was not published.
- Internal governance procedures (including the tasks of internal audit) are in place, but are not published.
- No law provides for legal protection to the supervisory agency and its staff for actions taken while discharging their duties in good faith.
- There is no formal NBM indemnification policy protecting employees against the costs of defending their actions while discharging their duties.

### Recommended Action Plan to Improve Observance of IMF’s MFP Transparency Code Practices — Banking Supervision
- V. Clarity of Roles, Responsibilities, and Objectives of Financial Agencies Responsible for Financial Policies
  - The relationship between financial agencies should be publicly disclosed.
- VI. Open Process for Formulating and Reporting of Financial Policies
  - Additional information should be made available on the bilateral arrangements between domestic and international financial agencies (including central banks).
- VII. Public Availability of Information on Financial Policies
  - The NBM should consider a general rule on publication of aggregated information on emergency liquidity support.
- VIII. Accountability and Assurance of Integrity by Financial Agencies
  - A law should be enacted to provide for legal protection to the supervisory agency and its staff for actions taken while discharging their duties in good faith.
  - Internal governance procedures should be publicly disclosed.

### Authorities’ response
- The NBM was in general agreement with most of the assessments and provided additional clarifying information taken into account in this document.
- The NBM objected to the findings about the legal protection for supervisors, insisting that such provisions are not necessary, as according to Article 38 (7) banks may only complain against the National Bank of Moldova.

### Stress tests on the Moldova banking system — overview
- Sensitivity analyses revealed credit risk to be the major source of vulnerability.
- Stress tests included:
  - (i) a deterioration in credit quality due to shocks to external demand for agricultural products;
  - (ii) an increase in oil and gas prices that has a direct effect on credit portfolios of banks exposed to this sector, and an indirect ripple effect on banks’ exposure to the corporate sector;
  - (iii) an appreciation of nominal exchange rates (as the inflow of foreign workers’ remittances has a strong effect on exchange rates) with additional credit quality implications;
  - (iv) direct and indirect (credit quality) effects of an increase in domestic lending rates;
  - (v) a scenario with a combination of interest rate and exchange rate risks;
  - (vi) the risk of illiquidity of government securities in anticipation of liquidity risks.
- Among market risks, the banking system seems more vulnerable to high (yet plausible) rates of exchange rate changes, rather than to interest rate movements through deterioration in credit quality.
- Balance sheet data on all 16 banks for end-December 2003 were used.

### Credit-risk stress-test design and assumptions
- Tests assume loan migration from higher to lower credit-classification categories in response to a shock; the corresponding increase in loan-loss provisions is subtracted from both regulatory capital and risk-weighted assets to yield the new (adjusted) CAR.
- Given the high baseline CAR, a significant effect is perceivable only with migration from category A (‘standard’) and substantial migration from category B (‘under-supervision’) to categories C, D, and E.
- Generic credit-risk (second-round) test:
  - Resulting NPL assumed to match average NPL during the 1998–1999 currency crisis—31 percent of gross loans (average between September 1998 and December 1999).
  - To achieve 31 percent NPL: decline in loans from category A by 24 percent, and from B by 30 percent (with corresponding increases in C, D, and E to hold total loans constant).
  - Outcome: two banks (one holding 14 percent of total assets) move below the minimum CAR of 12 percent.
  - CAR of the overall banking system decreases by 8.6 percentage points.
  - Banks in group 3 (except for one) are unaffected owing to very small credit portfolios.

### Sectoral credit-risk tests — results
- Agriculture shock:
  - Migration of agricultural loans from categories A and B by 24 percent and 30 percent respectively.
  - Result: NPL of the banking system rises to 13 percent of gross loans.
  - Conclusion: banking system resilient to moderate agricultural shocks.
- Fuel price shock:
  - Primary round: migration of energy-sector loans from categories A and B by 39 and 50 percent respectively, redistributed to C, D, and E.
  - Secondary round: overall corporate loans migrate by 24 and 30 percent from A and B respectively (using generic credit risk assumptions).
  - Result: NPL of 22 percent for the overall banking system.
  - Outcome: banking system vulnerable to fuel price shocks; asymmetric migration pushes two banks (one systemically important) below the 12 percent minimum CAR.

### Exchange rate, interest rate, and combined-shock findings
- Exchange rate risk:
  - Direct balance-sheet effects limited by modest open foreign exchange positions within regulatory limits.
  - Indirect exposure: large share of credit extended in foreign currency exposes sector to credit-quality deterioration from sudden large exchange rate shocks.
  - Assumption: banks equally exposed to exporters and importers; effect on credit quality symmetric for appreciations and depreciations.
  - Vulnerability manifest for large (for example, 40 percent) exchange rate appreciations and depreciations when accompanied by higher credit risks.
  - Asymmetric migration of loans pushes two banks below the minimum CAR, reducing banking system CAR by almost 10 percentage points.
- Interest rate risk:
  - Changes in interest rates affect net interest income (NII), profits, and retained earnings (capital).
  - Interest rate changes have a stronger effect on NPLs than exchange rate changes historically.
  - Banking system has positive repricing gaps for most horizons—an interest rate increase would tend to raise CAR for the overall banking sector due to higher NII.
  - Negative repricing gaps faced by a few banks are small and do not result in significant capital losses in case of interest rate increases.
  - System not very vulnerable to interest rate shocks unless accompanied by very large credit-quality effects; in that case overall CAR reduces by 8.5 percentage points with two banks falling below the minimum CAR.

### Crisis-combination scenario and illiquidity of government securities
- Crisis scenario:
  - Sudden depreciation of 40 percent of the USD and euro exchange rates, and 20 percent of that of the Russian ruble prompted by a presumed sudden decline in foreign workers’ remittances, accompanied by an increase in borrowing rates.
  - Assuming NPLs rise to the maximum level experienced during the 1998–99 crisis—39 percent NPL achieved by 32 and 40 percent migration of loans from A and B respectively into C, D, and E:
    - CAR of the banking system would decline by 11 percentage points.
    - Two banks would fall below the 12 percent minimum CAR.
- Adding illiquidity of government securities:
  - Given thin market and large holdings by banks, the price of such securities would decline, eroding realization value of such assets.
  - Assuming banks recover only 50 percent of the value of such securities:
    - Banking system would lose an additional 5.4 percentage point of CAR.
    - CAR of group 1 would decline to 9.2 percent.
    - Six banks (4 in group 1, and 1 each from groups 2 and 3) would be pushed below the 12 percent minimum CAR.

*Source: _cr0564 - 65.      The responsibility of the NBM for bank supervision is clearly stated in the relevant*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0564.pdf_